The nature and purposes of management accounting


The essay will provide information related to management accounting, its nature and purposes. Information related to various cost accumulation and measurement techniques will also be provided. Further, planning and decision making issues and pricing decisions techniques in the context of management accounting will also be included. Lastly, information related to the performance evaluations and feedback techniques will also be provided.

Management Accounting:

Different managers take different kinds of business decisions within an organisation. Basic information should be presented to the managers so that reasonable decisions can be taken. There are accounting systems in place for the managers so as to provide them information contents. As noted by Drury (2008), managers need information that will assist them in their decision making and control activities. Management accounting systems provide information specifically for the use of the managers within an organisation. Information within an organisation is basically for two main groups of people. There are financial accounts which are prepared for external stakeholders of the organisation, i.e. shareholders, suppliers, employees, tax authorities, etc. and there are management accounts which are prepared for internal managers of the company.

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'Management accounting is a specialist branch of accounting which has developed to serve the particular needs of the management (Weetman, 2006). Management accounts are basically used to aid management to record, plan and control the organisation's activities and to help the decision making process. There is a legal requirement for the company to prepare to financial accounts for its external stakeholders but in the case of management accounts there is no legal requirement to prepare the accounts. Management accounts are only prepared internally as when it is required by the managers within an organisation. Since management accounts are for internal purposes only, the format of management accounts is entirely at management discretion. There are no strict rules to govern the way management accounts are prepared or presented. Each organisation can devise its own management accounting system and format of the reports. Management accounts focus on specific areas of an organisation's activities. Information produced through management accounts are used to aid a decision rather than to be an end product of a decision. Sometimes management need to know non monetary information as well for example, distance traveled by sales force of the organisation, units production in a year, labor hours and machine hours etc. Management accounts incorporate non monetary measures as well so as to help management to take decisions by taking into account many factors. Accounts prepared through management accounting systems are both an historical record and a future planning tool for the management.

Cost Accumulation and Measurement Techniques:

Cost accounting is part of management accounting system. Cost accounting basically provides a bank of data for the management accountant to use. Cost accounting is concerned with three main things which are as follows: Preparation of statements for example budgets, etc., collection of cost data and applying costs to inventory, product and services. The aim of cost accounts is to compute the costs of goods produced or services provided, the costs of departments or other work sections, revenues and profitability of products or services, department or an organisation as a whole. Basically there are two main costs of a product produced or services provided. There is direct cost and indirect cost. There are various techniques to measure the cost of a product produced.

Absorption Costing:

The objective of absorption costing is to include in the total cost of a product an appropriate share of the organisation's total overhead or indirect costs. An appropriate share basically means that an amount which reflects the amount of time and effort that has gone into producing one unit of the product. Absorption costing is a method for sharing overheads between different products on a fair basis. In absorption costing all production overheads are incurred in the production of the organisation's output and so each unit of the output receives some benefit from theses costs. Each unit of the output is therefore charged with some of the overhead costs. This can be explained by an example (1.1).

Suppose that a company makes and sells 100 units of a product. The prime cost per unit is 6 and unit selling price is 10. Production overheads costs is 200 and admin, selling and distribution costs are 150, the profit can be calculated as follows:

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Sales (100 units * 10) = 1000

Prime Costs (100 * 6) = (600)

Production overheads = (200)

Admin, Sell, Dist = (150)


Profit 50

In absorption costing, overheads costs will be added to each unit of product.

Prime cost per unit 6

Production overheads (200 for 100 units) 2


Full Factory Costs 8

The profit would be calculated as follows:

Sales 1000

Factory Cost of sales(100*8) (800)

Gross Profit 200

Admin, Sell, Dist (150)


Net Profit 50

Absorption costing is used for inventory valuations, pricing decisions and for establishing the profitability of different products. There are basically three stages of absorption costing which are Allocation, Apportionment and Absorption. Overhead allocation is the process by which whole cost items are charged directly to a cost unit or cost center. Apportionment is a procedure whereby indirect costs are spread fairly between cost centers. Costs of service cost centers are apportioned to production cost centers. Absorption is the process whereby overhead costs allocated and apportioned to production cost centers are added to unit, job or batch costs.

Marginal Costing:

Alternative to absorption costing method is marginal costing method. In marginal costing method only variable costs are charged and computed as cost of sales of the products produced. A contribution calculation is also done. Contribution is calculated as sales revenues minus variable costs. In marginal costing system work in progress and finished goods are calculated at marginal or variable production costs. Fixed costs in marginal costing system is treated as a period cost and charged in full to the profit and loss statement directly.

Job Costing:

Sometimes production work is undertaken by an organisation according to the specifications of its customers. In job costing a job is a cost unit which mainly consists of a single order or a contract. According Drury (2008), job costing relates to a costing system where each job is unique in itself. The customer basically approaches the organisation and indicates the requirements for the job. The management then agrees with the requirement and then prepare a cost estimates for the job. Material, labor and overheads are computed and a profit margin is calculated. If the estimate is accepted then the job is scheduled for completion. An example is shown in Appendix 2, p 8).

Activity-Based Costing:

Activity-Based Costing (ABC) is also an alternative costing technique to absorption costing methods. ABC basically involves the identification of the factors or the cost drivers which cause the costs of an organisation's major production activities. Overheads are traced to products using transaction-based cost drivers for example no. of production runs, no. of orders received etc. Cost drivers for short-term costs are volume related. The procedure involve in ABC are as follows: Identification of organisation's major activities, Identification of the factors which determine the size of the costs of an activity, Collection of the costs associated with each cost drivers into cost pools. Charge costs to products on the basis of their usage of the activity. The relationship between absorption costing and ABC is illustrated in (Appendix 5, p 10).

Planning and Decision-Making:

Drury (2008) said that relevant costs and revenues are those future costs and revenues that will be changed by a decision. When taking short term decisions management has to take into account the relevant costs associated with the decisions. Relevant cost is an important concept and it helps the manager to only focus on those factors which affect the short-term horizon of the decision. Basically relevant costs are future cash flows arising as a direct consequence of a decision. Relevant costs are of three types: They are future costs, they are in cash, and they are incremental costs. Management takes many short-term decisions, these include make or buy decisions, further processing decisions, and outsourcing and shut down decisions (Appendix 3, p 8).

CVP Analysis:

Cost-Volume-Profit analysis is the study of the interrelationships between costs, volume and profit at various levels of activity. It is important for the management of an organisation to know the profit level and margin which can achieved if the certain production level is undertaken. CVP analysis also provide information related to the breakeven point which is the activity level where there is neither profit not loss for the organisation. Moreover CVP analysis can provide information related to the amount by which actual sales can fall below anticipated sales without incurring loss. Other information related to CVP analysis is included in (Appendix 4, p 9).

Budgeting Process:

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'Planning is a very general term which covers the longer term strategic planning and shorter term operational planning.' (Weetman, 2006). Budgeting process provide an efficient system through which managers can effectively plan and control various production activities within an organisation. A budget is basically a quantified plan of action for a forthcoming accounting period. A budget is a plan prepared by the management of an organisation of what the management is aiming to achieve and what are the targets it has set for itself for a particular accounting period. Budgeting process involve the identification of the principal budget factor which is factor which limits the overall production of the company. Sales budget is then prepared, production and non-production overheads budget is then prepared. Fixed budget is the budget which remains unchanged regardless of the production activity within an organisation. Flexible budget is a budget which is designed to change as volume of activity changes. Flexible budget are prepared for controlling purposes.

Decision-Making under Risk and Uncertainty:

Techniques which reduce the uncertainty are as follows: Market researching, Conservative approach, worst/most likely/best outcomes estimates and pay-off tables. Pay-off tables identify and record all possible outcomes in a given situation. In order to reduce risk probabilities and expected values are calculated. Expected values indicate what an outcome is likely to be in the long term with repetition. There are also certain rules for making decisions under risk and uncertainty. These are Maximin, Maximax, and Minimax regret. Sensitivity analysis can also be undertaken.

Pricing Decisions:

Other than costs there are also other things which have influences on the price of the products an organisation produced. Pricing decisions is one of the most important decisions a manager takes into account. There are various strategies through which a manager can take decisions regarding the price of the product to be charged to the consumers. There is cost-plus pricing, marginal cost-plus pricing, market skimming pricing, market penetration, complementary product pricing, product-line pricing, volume discounting, price discrimination, relevant cost pricing and minimum pricing. Details related to pricing strategies are in (Appendix 6, p11).

Performance Evaluations and Feedback:

Performance evaluations or performance measurement aims to establish how well something or somebody is doing in relation to a plan. There are financial performance indicators i.e. profit, sales, costs, cash flows etc. and non-financial performance indicators. Basically, performance evaluations provide information related to the direction of the managers. There are short-term and long-term directions. Performance measures are devised by the management to reward behavior and direction of the managers that maximises the corporate good.