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The key issue in this context is how a strategic management accountant will add value to Jessup Ltd. The company is successful but it is felt that there should be a better management of the accounting function. This report analyzes some of the key roles played by strategic management accountants and how they will benefit a service organization. It also outlines the meaning of relevant and irrelevant costs and revenue and how they influence decision making. Finally, the benefits and problems of activity based costing are discussed.
KEY ROLES PLAYED BY A STRATEGIC MANAGEMENT ACCOUNTANT
According to CIMA (2000), strategic management accounting is defined as a form of management accounting in which emphasis is placed on information which relates to factors external to the firm as well as non-financial information and internal generated information.
Strategic management accounting differs from traditional management accounting in three important respects. One, the former is an extension of traditional management accounting's internal focus to include external information about competitors. Two, it identifies the relationship between strategic position chosen by the firm and the expected emphasis on management accounting. Finally, strategic management accounting helps the firm gain competitive advantage by analyzing how to decrease costs or enhance the differentiation of a firm's products through exploiting linkages in the value chain and optimizing cost drivers.
While Jessup is a very successful company, clearly it is outdated when it comes to the latest cutting edge accounting practices. Traditional management accounting has ceased to become relevant in the modern competitive workplace and is being superseded by strategic management accounting. There are a plethora of strategic management accounting practices that could be successfully implemented at Jessup including strategic pricing and costing, value chain costing and life cycle costing. All these are highly useful to an organization but they require the knowledge and expertise of a strategic management accountant.
A strategic management accountant has the potential to transform an organization. He or she can help formulate the competitive strategy to achieve competitive advantage. According to Porter (1990), competitive advantage can be achieved either through cost leadership or differentiation. A strategic management accountant can assist in achieving the first function by instituting greater cost reduction and savings. Otherwise, the strategic management accountant can assist in the second function by exploiting linkages in the value chain and optimizing cost drivers (Langfield-Smith, 2008). Other strategic tools like quality costing can help increase customer satisfaction and all this contribute to achieving competitive advantage.
In traditional management accounting, only financial measures are considered. Though important, they distort the actual position of the company as success is a combination of financial and non-financial factors. Strategic management accounting encompasses non-financial measures and incorporates them into meaningful action. Hence, in strategic management accounting, all strategies come from the company's vision and mission and trickle down to all aspects of operations. A corporate strategy describes how a company will gain competitive advantage by being different or better than its competitors. Examples of strategies include low cost, complete customer solutions and product leadership.
One of the best strategic management accounting tools that is used to enhance competitive advantage is the balance scorecard. This is a system that translates an organization's strategy into clear objectives, measures, targets and initiatives organized by four perspectives. They are the financial, customer, process and learning and growth perspectives. In addition to maintaining past performance financial measures, the balanced scorecard incorporates the drivers of financial performance of the future. These drivers are found in the customer, process and learning and growth perspectives, are selected from an explicit and rigorous translation of the organization's strategy into tangible objectives and measures.
The benefits from the scorecard are realized as the organization integrates its new measurement system into management processes that communicate the strategy to employees, align employees' individual objectives and incentives to successful strategy implementation and integrate the strategy with ongoing management process: planning, budgeting, reporting and management meetings.
RELEVANT AND IRRELEVANT COSTS AND REVENUES IN STRATEGIC MANAGEMENT ACCOUNTING DECISION MAKING
Managers must evaluate the financial implications of decisions that require trade-offs between the costs and the benefits of different alternatives. Financial implications are important when considering decisions in the service industry such as whether to purchase services such as consultants or to simply hire in-house consultants. Financial information about the different types of costs forms the basis of decisions about the organization's activities and processes.
Whether particular costs and revenues are relevant for decision making depends on the decision context and the alternatives available. When choosing among different alternatives, managers should concentrate only on the costs and revenues that differ across the decision alternatives. These are the relevant costs or revenues.
One category of costs that often causes confusion for decision makers consists of those incurred in the past, or sunk costs. Sunk costs are the costs of resources that already have been committed and cannot be influenced by any current action of decision. In other words, sunk costs are necessary for an activity and cannot be recovered or reversed if that activity ceases. Since sunk costs cannot be influenced by whatever alternative the manager chooses, they are not relevant to the evaluation of alternatives. It should be remembered that not all sunk costs are fixed costs.
In some cases, a fixed cost may be recoverable after the activity has ceased. For example, a Broadway troupe is putting on a play and has signed a lease on a theater for 6 months. If the play is a flop and closes within a week, the fixed cost of the lease may not be sunk if the troupe can sublet the theater and recover its money. Uncertainty is an important qualitative factor that must be considered in decision making.
Relevant costing is especially significant in some situations. They include decisions on whether to make or buy a product, to further process a product in the case of joint costing, closing down a department or subsidiary and in limiting factors. Let us now consider a few examples in detail.
It is impossible for businesses to produce and sell as much as they want. Limitations on production may be due to shortage of resources such as direct material, labour, machine time and capacity. Factors of production that are scarce are known as limiting factors/ key factors of production. Therefore, a business must prioritize production.
ABC Limited manufactures three products X, Y and Z.
The limiting factor is labour hours. The total labour time available is 3, 000 hours.
Which product is the most profitable?
Which product should be given priority for the time available?
Total time to manufacture X = 2 x 1, 500 = 3, 000 hours is not enough to manufacture the rest so we will manufacture X only to maximize profits.
Make or Buy
Businesses very often have to decide whether to buy a component from outside or to make it internally. Sometimes, outside suppliers can offer the company a product or component at a price below the business' own total costs. Companies use outside suppliers because of urgent orders from customers, production bottlenecks such as machine breakdowns and limiting factors of production. On the other hand, companies may not want to buy from outside suppliers for reasons such as fear that the supplier may not meet delivery times or supply good quality times or to maintain control over its operations.
Brown Manufacturing Ltd uses a component 'noir' in its products. To make the component internally would take five hours and would involve a marginal cost of RM15. To manufacture the component would involve work on a machine that is being used to make product 'blanche'. The product takes one hour to make and its marginal cost is RM5. The product's selling price is RM8. An outside supplier has offered to supply the component 'noir' at RM20 each. Should the company make or buy the component?
Therefore, it is better to buy the component.
Management is sometimes faced with the problem of replacing an old machine with a new one. Sometimes a decision to replace a machine which has not completed its useful life with a better machine which reduces operating cost has to be made. In such decisions, only the expected future costs should be considered. The book value of the old machine and profit or loss on disposal is irrelevant.
Cecilia Ltd operates a machine costing RM30, 000. The current book value of the asset is RM10, 000. The remaining productive life of the machine is 4 years. The machine is depreciated on a straight line basis. Its present disposal value is RM1, 000 and in 4 years, it will have no disposal value. At a trade exhibition, the production manager saw a machine to which he was particularly attracted. The new machine cost RM15, 000. It has a productive life of 4 years and has no disposal value at the end of its life. What appears most attractive is that the variable production cost will be drastically reduced by the new machine from the current RM20, 000 to RM14, 000 per annum. The manager has informed the board of the new machine and has suggested that the old machine be replaced immediately. Should the board accept the new machine?
Therefore, the company should replace the old machine.
These are a few examples of how relevant and irrelevant costs and revenue play a role in decision making in strategic management accounting. Managers must be able to identify the costs and revenues relevant for the evaluation of alternatives. Equally important, they must recognize that some costs and revenues are not relevant in such evaluations.
BENEFITS AND PROBLES OF INTRODUCING ACTIVITY BASED COSTING INTO A SERVICE ORGANIZATION
Activity based costing (ABC) systems typically use a simple two-stage approach similar to but more general than traditional cost systems. Traditional cost systems use actual departments or cost centres for defining cost pools to accumulate and redistribute costs. ABC systems instead, use activities for accumulating costs. The design of an ABC system starts by asking what activities are being performed by a department's resource. ABC then assigns the resource expenses to activities on the basis of how much of the resources each activity uses.
The principal advantage of ABC is that it overcomes some of the limitations of traditional costing systems. Traditional systems often tend to rely on arbitrary allocations of indirect costs. In particular, they rely extensively on volume-based allocations. Many indirect costs are not volume-based, but if volume-based allocation bases are used, high-volume products are likely to be assigned with a greater proportion of indirect costs than they have consumed whereas low-volume products will be assigned a lower proportion. In these circumstances, traditional systems will over-cost high-volume products and under-cost low-volume products. In contrast, ABC systems recognize that many indirect costs vary in proportion to changes other than production volume. By identifying the cost drivers that cause the costs to change and assigning costs to costs objects on the basis of cost driver usage, costs can be more accurately traced. It is claimed that this cause-and-effect relationship provides a superior way of determining relevant costs.
Although ABC had its origins in manufacturing companies, today many service organizations are obtaining great benefits from this approach. Service companies in general are ideal candidates for ABC, even more than manufacturing companies. First, virtually all the costs for a service company are components of costs, such as direct materials to individual products. Service companies have few or no direct materials, and many of their personnel provide indirect support to products and customers. Consequently, service companies do not have direct, traceable costs to serve as convenient allocation bases.
The large component of apparently fixed costs in service companies arises because they have virtually no material costs. Service companies must supply virtually all their resources in advance to provide the capacity to perform work for customers during each period. Fluctuations during the period of demand by individual products and customers for the activities performed by these resources do not influence short term spending to supply the resources.
Therefore, the variable cost from an incremental transaction for many service industries is close to zero. For example, a transaction at a bank's ATM requires an additional consumption of a small piece of paper to print the receipt - but no additional outlay. Therefore, service companies making decisions about products and customers on the basis of short-term variable costs might provide a full range of all products and services to customers at prices that could range down to near zero.
In practice, many companies' ABC models are not quiet as simple to implement as examples in textbooks appear. Companies have experienced several problems when they attempt to apply ABC to their complex enterprises. First, the process to interview and survey employees to get their time allocations to multiple activities is time consuming and costly. And because of the high cost of continually updating the ABC model, many ABC systems are updated only infrequently, leading to out-of-date activity cost driver rates and inaccurate estimates of process, product and customer costs.
Managers also question the accuracy of the system since cost assignments are based on individuals' subjective estimates of how they spend their time. Apart from the measurement error introduced by employees' best attempts to recall their time allocations, the people supplying the data might bias or distort their response. As a result, managers often argue about the accuracy of the model's estimated costs and profitability rather than address how to improve the inefficient processes, unprofitable products and customers, and considerable excess capacity that the model has apparently revealed.
Another problem is that the traditional ABC models find it difficult to add new activities or add more detail to an existing activity. As the activity dictionary expands either to reflect more granularity and detail about activities performed or to expand the scope of the model to the entire enterprise, the demands on the computer model used to store and process the data escalate dramatically. Such expansion has caused many homegrown ABC systems to exceed the capacity of their generic spreadsheet tools. The systems often take days to process one month of data, assuming the solution converges at all.
These data collection, storage and processing problems have become obvious to many ABC implementers. But a subtle and more serious problem arises from the interview and survey process itself. When people estimate how much time they spend on a list of activities handed to them, invariably they report percentages that add up to 100%. Few individuals report that a significant percentage of their time is idle or unused. Therefore, cost driver rates are calculated assuming that resources are working at full capacity. However, this is more the exception than the norm. Beyond the distortion caused by assigning unused capacity costs to products, a second-order effect occurs when managers take activity based management (ABM) actions. They can decrease the production of unprofitable products, increase the production run sizes, change product mix and improve process efficiencies. In the short run, these actions increase unused capacity, but unless the cost of the unused capacity is excluded from future cost assignments to product and customers, the apparent gains from these apparently desirable ABM actions get reallocated back to the remaining products, raising their costs and lowering their reported profitability.
In conclusion, a strategic management accountant will be very beneficial to Jessup Ltd as we will have a better idea of how to better manage costs and revenues. The accountant will be of invaluable assistance when formulating the long term strategic plan of the company so that we can reach greater heights of success.