Management accounting

T. Ahrens
AC3097, 2790097

2011

Undergraduate study in Economics, Management, Finance and the Social Sciences

This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. Materials for these programmes are developed by academics at the London School of Economics and Political Science (LSE). For more information, see: www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by: T. Ahrens, BA, MSc, PhD, Professor of Accounting, Warwick Business School, University of Warwick. This is one of a series of subject guides published by the University. We regret that due to pressure of work the author is unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

The University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom Website: www.londoninternational.ac.uk

Published by: University of London University of London 2005 Reprinted with minor revisions 2011 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to contact copyright holders. If you think we have inadvertently used your copyright material, please let us know.

Contents

Contents

Introduction ............................................................................................................ 1 Aims ............................................................................................................................. 1 Learning outcomes ........................................................................................................ 1 Why study management accounting? ............................................................................. 1 Organising your studies ................................................................................................. 2 Essential reading ........................................................................................................... 4 Further reading.............................................................................................................. 4 Online study resources ................................................................................................... 6 Examination advice........................................................................................................ 7 Frequently asked questions about 97 Management accounting....................................... 8 Abbreviations ................................................................................................................ 9 Chapter 1: Modern management accounting ....................................................... 11 Essential reading ......................................................................................................... 11 Further reading............................................................................................................ 11 Aims ........................................................................................................................... 11 Learning outcomes ..................................................................................................... 11 Introduction ................................................................................................................ 12 Management accounting, cost accounting and financial accounting routine and non-routine information provision ................................................................................ 12 From record keeping to problem solving? The strategic turn in management accounting 14 Price leadership and differentiation .......................................................................... 14 Calculating success...................................................................................................... 15 Strategic management accounting .............................................................................. 15 Information technology................................................................................................ 16 Enterprise Resource Planning Systems (ERP) ................................................................. 16 Planning, controlling and experience .......................................................................... 18 The budgeting process and beyond budgeting ............................................................ 18 Decision-making and organisational goals ................................................................... 19 Stakeholders................................................................................................................ 19 A reminder of your learning outcomes.......................................................................... 20 Sample examination question ...................................................................................... 20 Suggestions for answering the sample examination question ........................................ 21 Chapter 2: Decision-making ................................................................................. 23 Essential reading ......................................................................................................... 23 Further reading............................................................................................................ 23 Aims ........................................................................................................................... 23 Learning outcomes ...................................................................................................... 23 Levels of decision-making ............................................................................................ 23 The importance of cash flows....................................................................................... 25 Opportunity costs ........................................................................................................ 25 The concept of relevant costs and revenues .................................................................. 26 Identifying relevant costs and revenues ........................................................................ 27 Purchased resources ................................................................................................... 27 Resources already under the organisations control....................................................... 28 Decision-making and current replacement cost............................................................. 28 Comparing cash flows in the long run .......................................................................... 29 Discounting ................................................................................................................. 30 The net present value decision rule ............................................................................. 30
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Making estimates for project appraisals ...................................................................... 31 Problems with the opportunity cost concept ................................................................. 33 Uncertainty and relevant information ........................................................................... 34 Characteristics of useful information ............................................................................ 34 Objective and subjective probabilities........................................................................... 35 Expected value ............................................................................................................ 36 The value of information .............................................................................................. 36 A reminder of your learning outcomes.......................................................................... 37 Sample examination question ...................................................................................... 37 Suggestions for answering the sample examination question ........................................ 37 Chapter 3: Cost behaviour .................................................................................... 39 Essential reading ......................................................................................................... 39 Aims ........................................................................................................................... 39 Learning outcomes ...................................................................................................... 39 Introduction ................................................................................................................ 39 The elements of total costs and their behaviour ........................................................... 39 Direct and indirect costs............................................................................................... 40 Fixed and variable costs ............................................................................................... 40 Costs in-between ........................................................................................................ 41 The identification of cost drivers ................................................................................... 42 Allocation.................................................................................................................... 43 Cost estimation ........................................................................................................... 43 Linear regression ......................................................................................................... 45 Error terms and outliers ............................................................................................... 45 Cost-volume-profit and break-even analysis ................................................................. 46 A reminder of your learning outcomes.......................................................................... 47 Sample examination question ...................................................................................... 47 Suggestions for answering the sample examination question ........................................ 48 Chapter 4: Costing and pricing ............................................................................. 49 Essential reading ......................................................................................................... 49 Aims ........................................................................................................................... 49 Learning outcomes ...................................................................................................... 49 Costs and pricing......................................................................................................... 49 Contribution margin pricing ......................................................................................... 50 Short-term decisions with one scarce resource.............................................................. 51 Contribution per bottleneck resource ........................................................................... 52 More than one scarce resource: linear programming (LP) .............................................. 52 Dual prices (shadow prices) and opportunity costs........................................................ 54 Dual (shadow) prices ................................................................................................... 55 Opportunity costs ........................................................................................................ 55 A reminder of your learning outcomes.......................................................................... 56 Sample examination question ...................................................................................... 56 Suggestions for answering the sample examination question ........................................ 57 Chapter 5: Budgeting and control ........................................................................ 59 Essential reading ......................................................................................................... 59 Further reading............................................................................................................ 59 Aims ........................................................................................................................... 59 Learning outcomes ...................................................................................................... 59 The purposes of budgets .............................................................................................. 60 Budget organisation .................................................................................................... 61 Budget frequency ........................................................................................................ 61 Types of budgets ......................................................................................................... 62 Budgeting and control ................................................................................................. 63 Variance analysis ......................................................................................................... 65
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The interpretation of variances ..................................................................................... 67 A reminder of your learning outcomes.......................................................................... 68 Sample examination question ...................................................................................... 69 Suggestions for answering the sample examination question ........................................ 69 Chapter 6: Traditional cost systems...................................................................... 71 Essential reading ......................................................................................................... 71 Aims ........................................................................................................................... 71 Learning outcomes ...................................................................................................... 71 The nature of costing systems and their integration into financial accounting systems .. 71 Cost centres and control .............................................................................................. 72 Process costing ............................................................................................................ 73 Example of process costing .......................................................................................... 73 Job costing .................................................................................................................. 75 Batch and contract costing .......................................................................................... 76 Allocation of fixed overheads ....................................................................................... 76 Example of an absorption costing system ..................................................................... 77 Variable costing ........................................................................................................... 79 A reminder of your learning outcomes.......................................................................... 79 Sample examination question ...................................................................................... 80 Suggestions for answering the sample examination question ........................................ 80 Chapter 7: Activity-based costing (ABC) .............................................................. 81 Essential reading ......................................................................................................... 81 Further reading............................................................................................................ 81 Aims ........................................................................................................................... 81 Learning outcomes ...................................................................................................... 81 Overhead creep in multi-product firms ....................................................................... 81 Instruments Inc............................................................................................................ 82 Over- and undercosting ............................................................................................... 82 Cost drivers ................................................................................................................. 83 Cost pools ................................................................................................................... 83 Cross-subsidisation ...................................................................................................... 84 Towards activity-based management ........................................................................... 84 Products and processes................................................................................................ 85 Customer focus ........................................................................................................... 85 Service industries ......................................................................................................... 85 ABC adoption.............................................................................................................. 85 The costs of ABC ......................................................................................................... 86 Some problems with ABC ............................................................................................ 86 Homogeneity of cost pools........................................................................................... 86 Homogeneity of cost drivers ......................................................................................... 87 Outlook ....................................................................................................................... 87 A reminder of your learning outcomes.......................................................................... 88 Sample examination question ...................................................................................... 88 Suggestions for answering the sample examination question ........................................ 88 Chapter 8: Inventory costing ................................................................................ 89 Essential reading ......................................................................................................... 89 Further reading............................................................................................................ 89 Aims ........................................................................................................................... 89 Learning outcomes ...................................................................................................... 89 Introduction ................................................................................................................ 89 The purposes of standard costing ................................................................................. 90 How to develop standards ........................................................................................... 90 When is standard costing recommended? .................................................................... 91 Actual costing ............................................................................................................. 91
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Inventory accounting and income measurement ........................................................... 92 Marginal (or direct or variable) costing ......................................................................... 93 Absorption (or full) costing .......................................................................................... 93 Production volume variance ......................................................................................... 94 Profit impact of different methods ................................................................................ 95 The key lies in the inventory ......................................................................................... 97 How to cheat with inventory accounting ...................................................................... 98 A reminder of your learning outcomes.......................................................................... 98 Sample examination question ...................................................................................... 98 Suggestions for answering the sample examination question ........................................ 99 Chapter 9: Performance measurement systems ................................................. 101 Essential reading ....................................................................................................... 101 Further reading.......................................................................................................... 101 Aims ......................................................................................................................... 101 Learning outcomes .................................................................................................... 101 Introduction .............................................................................................................. 101 Main components of performance measurement systems ........................................... 102 Financial records ....................................................................................................... 102 Responsibility structures ............................................................................................ 102 The three most common responsibility centres: cost centres, profit centres and investment centres .................................................................................................... 103 Transfer prices ........................................................................................................... 103 Transfer-pricing methods ............................................................................................ 104 Gasoil & Co. .............................................................................................................. 104 Divisional and corporate profit calculations ................................................................ 105 How a transfer price may lead to sub-optimal decisions .............................................. 106 Financial measures .................................................................................................... 107 Divisional performance .............................................................................................. 109 A reminder of your learning outcomes........................................................................ 111 Sample examination question .................................................................................... 111 Suggestions for answering the sample examination question ...................................... 111 Chapter 10: Strategic management accounting ................................................. 113 Essential reading ....................................................................................................... 113 Further reading.......................................................................................................... 113 Aims ......................................................................................................................... 113 Learning outcomes .................................................................................................... 113 Target costing............................................................................................................ 114 Life cycle costing ....................................................................................................... 115 Quality costs and the theory of constraints (TOC)........................................................ 115 Costs of quality ......................................................................................................... 116 Techniques used to identify quality problems .............................................................. 116 Theory of constraints (TOC) ........................................................................................ 117 Bottlenecks ............................................................................................................... 118 The balanced scorecard ............................................................................................. 118 Lead and lag indicators .......................................................................................... 119 Evidence.................................................................................................................... 119 Outlook ..................................................................................................................... 120 Enabling management control systems ...................................................................... 121 A reminder of your learning outcomes........................................................................ 121 Sample examination question .................................................................................... 122 Suggestions for answering the sample examination question ...................................... 122 Appendix: Sample examination paper ............................................................... 123

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Introduction

Introduction
Aims
This course is designed to give students a grounding in the key concepts and techniques of management accounting, and to prepare them for the use of recent innovations in the management accounting function. Traditionally concerned with the recording and measurement of costs, management accountants have increasingly become concerned with supporting the management of organisational strategy. This has entailed the inclusion of non-financial information in management accounting reports that are becoming increasingly tailored to organisational circumstances. Underlying this work of providing information is a core of economic principles, to which I will make reference throughout this subject guide. Your subject guide is arranged in three main sections. The first section introduces traditional and contemporary functions of management accounting and some of the key economic concepts underlying management accounting. The second section covers costing principles and costing systems, with some recent managerial applications, such as activity-based management. The third section puts costing principles and systems into context by explaining what roles they would play as part of an organisations performance measurement and strategic management accounting systems. Prerequisite If taken as part of a BSc degree, 25 Principles of accounting must be passed before this course may be attempted.

Learning outcomes
At the end of this course, and having completed the Essential readings and activities, you should be able to: assess the possible uses of information for different types of decision making calculate and distinguish between different types of costs and explain the role of costs for pricing and other business decisions prepare budgets and explain the significance of budgets for planning and control explain the functioning of costing systems and analyse, calculate and interpret variances discuss the problems of performance measurement and control in divisionalised organisations and calculate simple measures of performance explain the changing role of management accounting.

Why study management accounting?

After completing your degree you may want to work in government, for a firm, or for a non-profit-making organisation. Whatever you do, you will meet people who are concerned with the resources which you consume to do your work, and who will ask what the benefits of your activities
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97 Management accounting

are. They will very often want to measure your departments inputs and outputs in money. Theirs is the language of cost, revenue and return on investment. They rely on some form of accounting to evaluate the internal functioning of your organisation. This is what is called management accounting or managerial accounting. Whether or not you want to be a specialist in this field, you will become involved in discussions of the uses of resources. This subject is intended to help you understand the thinking behind management accounting calculations, devise alternative ways of accounting for organisational activities and put accounting into perspective relative to other ways of describing the organisation. Think back to 25 Principles of accounting. How would you describe the nature of the accounting knowledge with which you are now acquainted? Is it a science? Is it an art? Is it a more or less coherent set of rules for practice? There seem to be elements of all of those three labels in accounting. You can find theory, for instance, on the notions of wealth, income and profit. To calculate the profit of an accounting period you need to rely on experience to carefully balance somewhat contradictory principles, such as the matching and the prudence principle. Finally, accounting also contains certain rules, relating, for example, to depreciation or to the arrangement of financial statements. Often, those rules are laid down in accounting standards, the law, government regulation, audit practice statements, etc. You can see that accountants need to draw on theory and their experience to arrive at judgements that can be justified within the existing rules of practice.

Organising your studies

If you are following regular instructions at a teaching institution you ought to read through each chapter of the subject guide once before you attend any relevant teaching sessions to get the flavour of the topic. Take it as an opportunity to learn to read faster. Read the introduction of each chapter completely, then read only the first and the last sentence of each paragraph. Scan the lines in between. If you do not get a sense of the argument, read paragraphs completely. This should not take you longer than 10 or 15 minutes per chapter. After attending the lecture, you should then read the chapter more slowly. With your newly-gained overview of the topic, you can probably do that in 3040 minutes. It is important to take your time to think about the activities in the chapter. Often things seem clear to you so long as you just follow my writing. When you are asked to do the activities you have a chance to express things in your own words and explain things to yourself. Teaching is the best way of learning! How should you use the textbook? The reading relevant to each chapter is listed at the beginning of each chapter. The Essential reading consists of one or more textbook chapters and specified journal articles that are mostly available through the University of London Online Library (see below). In working with the textbook it is important to remember that the subject guide is not meant to replace the textbook. The subject guide provides a framework for your study, contains aims and learning outcomes for each topic, and references to the Essential and Further reading, acts as a pointer to the most important issues in each topic, provides additional explanations where appropriate, and contains additional worked examples, activities to involve you in the topic and clarify its relevance, and sample exam questions. Your use of the textbook depends very much on whether you receive instruction from a teaching institution or whether you study by yourself.
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Introduction

If you receive instruction, the main role of the textbook is to support what you have learned at your teaching institution. It can confirm what you have learned already and present topics in a slightly different light. As you read the textbook, ask yourself, how do the chapters relate to the subject guide? Which are useful examples, where does the textbook chapter elaborate a concept in more depth, and where does it simplify the argument made in the subject guide. The many examples in the textbook allow you to become more secure in your understanding of specific techniques. Depending on how familiar you are with the topic when you start reading the assigned material, it might take you between 45 and 90 minutes. I would recommend that you read the textbook after your instruction most students prefer this and find it saves them time. However, some students find that they are not able to follow the instruction as well as they would like to if they leave the Essential reading until after the instruction. In this case you should read the relevant sections in the textbook beforehand. But be sure to return to the Essential reading after the relevant teaching session because the instruction often highlights important aspects of a topic that you did not notice upon first reading. If you study by yourself, the textbook and the other readings are your main source of knowledge. This means you will need more time on each topic, typically between one and a half and two hours. Start always with the textbook before moving on to journal articles. Make sure you understand the logic of the learning outcomes at the beginning of each chapter. Read carefully through the assigned material, making sure you understand how the various exhibits and the summaries in the margins relate to the main text. As you read, try to relate the text to the learning outcomes for this chapter. After completing a chapter, go over the summaries in the margins again and make sure they still make sense! In my experience, for checking that you really understand a chapter, it is useful to wait for a day or two before attempting the problem for self-study at the end of each chapter. They have detailed solutions for your guidance. After completing the work for each topic you should have a sense of how the material integrates with the previous topics. This subject guide is written in order to support you in this. Especially if you study by yourself you should benefit from the fact that the textbook takes a holistic approach to the subject of management accounting. It does not make artificial distinctions between the main topics of the individual chapters, but makes reference to relevant issues at different point in the book. For example, activity-based costing (ABC) has its own chapter (Chapter 5) but reference to ABC is also made on page 337 because ABC is relevant to the question of cost behaviour. The advantage of this holistic approach is that it explains the relevance of certain techniques in relation to different ideas within management accounting. Therefore, if you seek to find out more about a particular topic or technique, consult firstly the glossary and then the index. Follow up the references from the index to find out about the different ideas in relation to which a topic or technique is explained. Management accounting is a practice that has developed over a long time and in response to different demands. As a consequence, it does not always appear logical at first! When you have finished your textbook reading, and made such notes as you consider useful, you should test your understanding of the topics covered by attempting the sample questions that appear at the end the relevant chapter of this subject guide or the exercises that appear at the end the relevant chapter of the textbook.
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It is helpful to look back regularly to the earlier chapters of the subject guide, in order to refresh and reinforce your understanding of the earlier topics. Also, it is a good idea to follow up some of the references provided in the textbook together with the suggestions for Further reading which I give you in the subject guide. Even though I have indicated how much time I think is appropriate for working through the guide and the readings, it is difficult to predict how much time different students need to spend on this topic. Overall, you will probably need to devote between three and four and a half hours per week in addition to any time you may have spent in lectures. That should cover lecture preparation, organisation of lecture notes after the lecture, reading in the guide, Essential reading, Further reading and exercises.

Essential reading
The essential textbook for this course is:
Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting: a managerial emphasis. (Upper Saddle River, NJ: Prentice Hall Publishing, 2009) thirteenth edition (international) [ISBN 9780135046340 or 9780131355583].

This subject guide is largely a commentary on that book and I recommend that you purchase it. If you find an earlier edition second hand (at a good price!) it would be equally suitable. Detailed reading references in this subject guide refer to the editions of the set textbooks listed above. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check the virtual learning environment (VLE) regularly for updated guidance on readings.

Further reading
Please note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the VLE and University of London Online Library (see below). Other useful texts for this course include:
Ahrens, T. and C.S. Chapman Accounting for flexibility and efficiency: A field study of management control systems in a restaurant chain, Contemporary Accounting Research 21(2) 2004, pp.271301. Ahrens, T. and C.S. Chapman Occupational identity of management accountants in Britain and Germany. European Accounting Review 9(4) 2000, pp.47798. Balakrishnan, R. and G.B. Sprinkle Integrating Profit Variance Analysis and Capacity Costing to Provide Better Managerial Information, Issues in Accounting Education (May 2002) Vol. 17 Issue 2: pp.149162 [concentrate on the case study in this paper]. Chapman, C.S. and W.F. Chua Technology-driven integration, automation and standardisation of business processes: implications for accounting. In A. Bhimani (ed.) Management Accounting in the Digital Economy. (Oxford: Oxford University Press, 2003) pp.7494.

Introduction Cooper, R. and R.S. Kaplan Measure Costs Right: Make the Right Decisions, Harvard Business Review (SeptemberOctober 1988): pp.96103. Cooper, R. and W.B. Chew Control Tomorrows Cost Through Todays Design, Harvard Business Review (JanuaryFebruary 1996): pp.8097. Covaleski, M.A., J.H. Evans III, J.L. Luft and M.D. Shields Budgeting Research: Three Theoretical Perspectives and Criteria for Selective Integration, Journal of Management Accounting Research (2003) Vol. 15: pp.351. Friedman, A.L. and S.R. Lyne Activity-based techniques and the death of the beancounter, European Accounting Review 6(1) 1997, pp.1944. Goldratt, E. and J. Cox The Goal. (North River Press, 1992) second edition. Hayes, R.H. and W.J. Abernathy Managing our way to economic decline, Harvard Business Review 58(4) 1980, pp.6777. Hopper, T., T. Koga and J. Goto Cost accounting in small and medium sized Japanese companies: an exploratory study, Accounting & Business Research, (Winter 1999) Vol. 30 Issue 1: pp.7387. Ittner, C. and D. Larcker Moving From Strategic Measurement to Strategic Data Analysis, C.S. Chapman (ed.) Controlling Strategy: Management, Accounting and Performance Measurement. (Oxford: Oxford University Press, 2005). Ittner, C. and D. Larcker (2003) Coming up Short on Nonfinancial Performance Measurement, Harvard Business School Press, 81/11: pp.8895. Johnson, H. and R. Kaplan Relevance lost: The rise and fall of management accounting. (Boston: Harvard Business School Press, 1987) [ISBN 0875841384]. Kaplan, R.S. and S.R. Anderson Time-Driven Activity-Based Costing, Harvard Business Review (November 2004) Vol. 82 (Issue 11): pp.13140. Kaplan, R.S. and D.P . Norton Transforming the Balanced Scorecard from Performance Measurement to Strategic Management: Part I, Accounting Horizons 15(1) 2001a, pp.87105. Kaplan, R.S. and D.P . Norton Transforming the Balanced Scorecard from Performance Measurement to Strategic Management: Part II, Accounting Horizons 15(2) 2001b, pp.14761. Mouritsen, J. Five aspects of accounting departments work, Management Accounting Research 7(3) 1996, pp.283303. Narayanan, V .G. and R.G. Sarkar The Impact of Activity-Based Costing on Managerial Decisions at Insteel Industries A Field Study, Journal of Economics & Management Strategy (Summer 2002) Vol. 11, number 2: pp.25788. Roslender, R. and S.J. Hart In search of strategic management accounting: theoretical and field study perspectives, Management Accounting Research 14(3) 2003, pp.25579. Sahay, S.A. Transfer Pricing Based on Actual Cost, Journal of Management Accounting Research Vol. 15 2003, pp.17793. Simmonds, K. Strategic Management Accounting, Management Accounting 59(4) 1981, pp.2629. Simon, H.A. Centralisation Vs Decentralisation in Organizing the Controllers Department. (Houston: Scholars Books Co., 1954) third edition. Spiller Jr., E.A. Return on Investment: A Need for Special Purpose Information, Accounting Horizons (June 1988) Vol. 2, Issue 2: pp.110. Verdaasdonk, P . and M. Wouters A generic accounting model to support operations management decisions, Production Planning & Control, (September 2001) Vol. 12 Issue 6: pp.60521.

Unless otherwise stated, all websites in this subject guide were accessed in April 2011. We cannot guarantee, however, that they will stay current and you may need to perform an internet search to find the relevant pages.

97 Management accounting

Online study resources

In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library. You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register! As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account. If you forget your login details at any point, please email uolia.support@ london.ac.uk quoting your student number.

The VLE
The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly. The VLE provides a range of resources for EMFSS courses: Self-testing activities: Doing these allows you to test your own understanding of subject material. Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references. Past examination papers and Examiners commentaries: These provide advice on how each examination question might best be answered. A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material. Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions. Recorded lectures: For some courses, where appropriate, the sessions from previous years Study Weekends have been recorded and made available. Study skills: Expert advice on preparing for examinations and developing your digital literacy skills. Feedback forms. Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates.

Making use of the Online Library

The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you
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Introduction

will be required to register and use an Athens login: http://tinyurl.com/ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons. For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php

Examination advice
Important: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. The subject is examined in a written unseen examination which lasts for three hours. There are two sections. Section A contains four questions which require the use of calculations to answer the question. Section B has essay questions. There are four questions in each section. You must answer four questions in total; two from section A, one from section B, and one further question. All questions carry equal marks, 25 in total. Where the questions require you to answer different parts, the relative weighting of marks is given. Typically, those questions which ask you to perform calculations also ask you to interpret your results in a later part. Some of the essay questions may give you a further choice of two questions. At the end of each chapter in the subject guide I will be showing you one or two sample questions. Note that the questions cannot usually be answered with reference to only one chapter in the subject guide, but require you to integrate the material with other chapters, textbook and journal article reading, and also with other subjects, such as 25 Principles of accounting. Before you are examined, you will be sent past examination papers and associated Examiners commentaries for this course. The Examiners commentaries contain valuable information about how to approach the examination and so you are strongly advised to read them carefully. Past examination papers and the associated commentaries are valuable resources when preparing for the examination. Students may bring into the examination hall their own hand-held electronic calculator. If calculators are used they must satisfy the requirements listed in the Regulations. Remember, it is important to check the VLE for: up-to-date information on examination and assessment arrangements for this course where available, past examination papers and Examiners commentaries for the course which give advice on how each question might best be answered.

97 Management accounting

Frequently asked questions about 97 Management accounting

We hope that the following information helps to clarify some potential areas of concern regarding this course. Q: Why does course 25 overlap in content, in some parts, with course 97? A: Although there may appear to be overlap between 25 Principles of accounting and course 97, the management accounting section of course 25 is at a basic level, thus ensuring that students who are not taking course 97 nevertheless have an adequate grounding in management accounting. Course 97 gives students an opportunity to focus in-depth on management accounting. The work done in course 25 can be regarded as a good basic grounding, but the examination paper for course 97 will test in more depth and will require greater knowledge of the way in which management accounting information is used and fits within modern business. Q: Are the practice questions in Horngren the right standard for the examination? What will the Examiners expect? A: The Examiners presume that students have completed and understood all of the Essential reading for the course, and for those aiming for the highest marks, some of the Further readings for the course. This includes practising using numerical questions from the textbook. The only topic which does not seem to have appropriate practice questions in the textbook is linear programming; however you are directed to work through the example; which is Exhibit 11-14 in Horngren and referred to in the subject guide on pages 5253. Much of the basic calculation work has been done in preparation for other courses including 25 Principles of accounting (which is a prerequisite for this course) and 04A Statistics 1 which many of you will also be studying. Q: Where do I get the answers for the examples in the textbook? Horngren has a student solution manual available, but be sure to check that you are purchasing the correct edition of the manual as the book is regularly updated. An example of this is ISBN 9780136001478. You might also be interested to look at http://wps.prenhall.com/bp_horngren_ cost_13 which you dont need a password to access. It has multiplechoice questions, exercises, activities, examples and short videos which accompany the book.

Introduction

Abbreviations
ABC ABM CVP ERP JIT LP NPV OWM R&D RI RoI SMA TOC WACC activity-based costing activity-based management cost-volume-profit analysis enterprise resource planning system just-in-time inventory system linear programming net present value owners wealth maximisation research and development residual income return on investment strategic management accounting theory of constraints weighted average cost of capital

97 Management accounting

Notes

10

Chapter 1: Modern management accounting

Chapter 1: Modern management accounting

Essential reading
Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting: a managerial emphasis. (Upper Saddle River, NJ: Prentice Hall Publishing, 2009) thirteenth edition (international) [ISBN 9780135046340 or 9780131355583] Chapter 1. Mouritsen, J. Five aspects of accounting departments work, Management Accounting Research (1996) 7(3) pp.283303.

Further reading
Ahrens, T. and C.S. Chapman Occupational identity of management accountants in Britain and Germany, European Accounting Review 9(4) 2000, pp.477498. Chapman, C.S. and W.F. Chua Technology-driven integration, automation and standardisation of business processes: implications for accounting, A. Bhimani (ed.) Management Accounting in the Digital Economy. (Oxford: Oxford University Press, 2003) pp.7494. Friedman, A.L. and S.R. Lyne Activity-based techniques and the death of the beancounter, European Accounting Review 6(1) 1997, pp.1944. Johnson, H. and R. Kaplan Relevance lost: The rise and fall of management accounting. (Boston: Harvard Business School Press, 1987). Roslender, R. and S.J. Hart In search of strategic management accounting: theoretical and field study perspectives. Management Accounting Research, 14(3) 2003, pp.255279. Simmonds, K. Strategic Management Accounting, Management Accounting 59(4) 1981, pp.2629. Simon, H.A. Centralisation Vs Decentralisation in Organizing the Controllers Department. (Houston: Scholars Books Co., 1954) third edition.

Aims
The aim of this chapter is to clarify what the term modern management accounting means and why it has gained currency. It also outlines how recent changes in the management accounting function have affected the role of the management accountant in organisational practice.

Learning outcomes
After completing this chapter and the Essential reading and activities, you should be able to: define the terms modern management accounting and strategic management accounting explain why organisations have become concerned with modern management accounting evaluate the extent to which modern management accounting has changed the role of the management accountant.

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Introduction
Modern management accounting is a term that has become more popular over the last decade or so. It implies a changing set of preoccupations among management accountants. In the past the vast majority of management accountants have been regarded as technical specialists whose expertise lay in the operation of accounting and other information systems. This included the preparation of reports to support management decision-making. Recently, more emphasis has been put on giving commercial advice to management.

Management accounting, cost accounting and financial accounting routine and non-routine information provision
In contrast with financial accounting, which is concerned with accounting reports for the external constituents of an organisation, such as banks, investors, trade unions, suppliers, customers and the government, management accounting produces the reporting for a key internal constituent, namely management. The idea is to produce and communicate information that is relevant to managerial decision-making. Management accounting is therefore much more detailed and potentially much more varied than financial accounting because it ought to respond to specific information requests rather than follow general reporting standards that are valid for very different types of organisations. This is not to say that all management accounting reporting is ad hoc. An important distinction with respect to management accounting work is that between routine and non-routine reporting. Routine reports regularly cover defined aspects of organisations, such as efficiency variances of certain input factors, which allow the charting of trends over time and structured comparisons between different entities within the organisation. They can be prepared according to widely-used principles of calculation or be tailor made for the organisation. Nonroutine reports analyse one-off events or decisions that can benefit from in-depth studies of their different aspects. It is often said that routine reports concern ongoing operations and non-routine reports tend to be concerned with investment decisions. Often this is the case but it is also possible that non-routine reports are prepared to address specific aspects of operations, such as the further analysis of unusual production variances. Likewise, certain kinds of investment decisions may, especially in large organisations with great investment volumes, be highly routinised. A typical textbook definition of management accounting is that it measures and reports financial and non-financial information that helps managers make decisions to fulfil the goals of an organization (Horngren et al., 2009), which covers routine and non-routine decisions. Management accounting builds on financial accounting information because it requires measurements and records of business transactions from diverse systems such as creditors and debtors records, the payroll, the fixed asset inventory, etc. It also builds on cost accounting, defined as the provision and communication of cost information. In addition, management accountants can create additional fictitious or notional accounting information, for example, by charging opportunity costs for uses of capital. Imagine, for example, two manufacturing divisions engaged in similar activities and producing similar output levels.
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Imagine further that one division uses twice as much working capital (debtors, inventory, cash) as the other. In terms of reported profit, based on financial accounting records, those two divisions are very similar. But the division that produces its results with less working capital achieves a preferable result because it leaves a lot of working capital unused. Thereby, it allows the organisation to expand activities with the unused working capital, thus potentially enhancing profitability. Management accountants may therefore decide to include a notional interest charge on working capital when calculating the financial contribution of the divisions. This incentivises divisional managers to be economic with working capital by, for example, seeking to minimise inventory or asking debtors to pay earlier. The overall financing costs of the organisation would be lower as there would be lower interest payments on bank overdrafts, loans, bonds, etc. Cost accounting is more technically oriented than management accounting. It measures and reports financial and non-financial information relating to the cost of acquiring or consuming resources in an organisation (Horngren et al., 2009). Cost management, by contrast, is defined by Horngren et al. (2009) as the approaches and activities of managers in short-run and long-run planning and control of decisions that increase value for customers and lower costs of products and services. This makes cost management a key part of the organisations general management strategies and their implementation. How important is cost reduction for organisations? Is it a relevant strategy for all organisations? This is probably not the case. Some organisations focus their management attention on, say, market differentiation strategies, thereby avoiding price competition. They may not possess the management capacity to also pursue an elaborate cost reduction strategy (although in principle price competition and market differentiation strategies do not preclude each other). Activity Fill in the following table based on your understanding of the previous section. Reread the section if necessary. Characteristics of financial accounting Users of information Extent of formal regulation Degree of uniformity across different organisations Degree of detail Likelihood of including non-financial information Relevance for managerial decision-making
Table 1.1: A comparison of financial accounting and management accounting

Characteristics of management accounting

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From record keeping to problem solving? The strategic turn in management accounting
The relationship between management accounting and strategic management has over the last decade or so been undergoing some changes. By strategic management, I mean those aspects of management that are concerned with the core competencies of the organisation. Typically, those core competencies are defined with respect to an organisations relationships with customers, suppliers, competitors, and the markets for labour and capital. The core competencies describe what the organisation can (uniquely) offer its customers in ways that are superior to the competition, using its own process capabilities as well as its relationships to suppliers and its own specific access to labour and capital markets.

Price leadership and differentiation

Two generic strategies that are frequently distinguished are price leadership and differentiation. Price leadership implies low prices combined with a standardised offering. The strategic effort goes into developing a customer proposition that appeals to large numbers of customers and can be provided at low cost. Product variation or even tailoring products to individual customers wishes is then not usually part of the product offering. Budget airlines are a recent and fairly extreme example of this strategy. By contrast, differentiation emphasises the satisfaction of individual customers wishes as closely as possible, be it with respect to quality of manufacture, ease of use, flexibility of application or delivery, product variety, reliability or any combination of these. An example would be luxury motor vehicle manufacturers. Product cost is also a concern for organisations that pursue this strategy but not to the same extent as for those that pursue price leadership. Even though the strategy literature often portrays price leadership and differentiation as strategic opposites, in practice one usually finds combinations of the two, for example, in the various markets for electronic consumer goods. There are different reasons for this. In large organisations some divisions may tend towards one strategy and some towards the other. During their life cycle, certain products may start out as differentiated products that are tailored towards the high price segment (perhaps because they are innovative), and later they may be marketed to compete mainly on price (perhaps because many competitors have entered this market, production volumes have increased and high quality is no longer a differentiating factor). The strategic relevance of management accounting would depend on the extent to which it supports management in finding out which strategy is most promising for an organisation. Here one would expect management accountants to prepare alternative scenarios together with marketing, product, and production managers who assess the long-term profitability of operating in different markets, offering different pricevalue combinations to different customer segments. In target costing, value engineering and life cycle costing, for example, which are explained in later chapters, and which you should look up in your textbooks glossary, the experience has been that such efforts are best placed in the development and design stages of a new product because here a large percentage of a products cost is built into its design. The role of management accountants can be
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to advise on the cost implications of certain design choices and calculate the added revenue that can be expected from additional product attributes (e.g. reliability, functionality, appearance, etc).

Calculating success
Strategic management is, however, also concerned with finding out if certain strategies have been pursued successfully. Here management accountants can prepare cost and revenue information by product, product group and market segment, calculating variances in sales volumes, sales mix and market shares, and their implications for profitability. Ideally one would want to calculate the profit impact of pursuing certain strategies. A common problem in this respect is the isolation of causal factors because the environments of organisations tend to change in many respects at the same time from one reporting period to the next. At a more elementary level, strategic cost accounting might calculate the costs of providing certain product attributes that are important for an organisations strategy. For example, a fast food chain might want to calculate the cost of providing high levels of cleanliness through its estate, or a vehicle manufacturer the cost of being able to offer engines with lower emissions than the competition.

Strategic management accounting

In the 1980s management accounting and accountants were criticised for their failure to recognise organisations new strategic priorities (Johnson and Kaplan, 1987), and from this decade stem many of the initiatives to make management accounting more strategically relevant. The reproach was that management accounting was in fact dominated by financial reporting requirements and took no account of what decision-makers wanted to know. For example, standard costing systems allocated overhead costs to products that were not causing them, and standard costs were updated so infrequently that changes in the design and manufacture of products quickly made them obsolete. One of the attempts to correct the shortcomings of traditional standard costing systems was Activity-based costing (ABC), which sought to allocate manufacturing overheads depending on the manufacturing activities that were caused by a product, and which is the subject of Chapter 7. A more general suggestion to enhance the managerial relevance of management accounting was Simmonds (1981) concept of Strategic Management Accounting. It focused on the incorporation of marketing knowledge into management accountants roles. A recent study by Roslender and Hart (2003) suggested that even though the term strategic management accounting itself was not common in practice, on the whole, the management accountants whom they studied could be said to possess more strategic roles now than they had in the past. Studies of the role of the management accountant in organisational management in different countries have found that commercially aware and active management accountants distinguish commercial involvement from the bean counter mentality of old (e.g. Friedman and Lyne, 1997). By bean counting they meant an overriding concern with administration, record keeping, and elementary financial reporting work. In terms of Simons (1954) old distinction between the roles of the management accountant namely, record keeping, attention directing and problem solving this implies a shift in emphasis from the first to the last two.
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Information technology
If the calls for greater strategic relevance have been an important criticism that led to conceptual changes within management accounting, an important enabler of those changes has been the technical advances in information technology. Contemporary accounting and information systems are significantly more powerful and easier to operate than they were only a few years ago. Generally speaking, it is now easier to extract information from the systems that are used in organisations. Management accountants can offer information that is better tailored to answer the questions of managers. In some cases, managers can now directly access information. As a consequence, less effort is needed on the part of management accountants to administer information systems and serve simply as mediators between an organisations management and its information systems. There is now the potential for management accountants to become much more actively involved in management decision-making. That said, a questionnaire survey by Mouritsen (1996) about the accounting function in the 800 largest Danish firms suggested that reports of the disappearance of the bean counters are premature. This was one of the largest surveys of accountants in industry with a response rate of almost 50 per cent, yielding 370 usable responses. While it is true that many traditional record keeping and administrative tasks can now be automated and consume less working time of the management accountants, 50 per cent of respondents ranked general ledger work and internal controls as important or very important aspects of accounting departments work. 56 per cent said the same for record keeping, 63 per cent for work on financial accounts, and 54 per cent for the layout of reports. Thus it would seem that the tasks of information systems design, the structuring of data capture, watching over data integrity, etc. are still regarded as central to the tasks of accounting departments. However, commercial awareness and involvement were also rated highly. 46 per cent said that internal consulting was an important task, and about 75 per cent of respondents mentioned the importance of budgeting and variance analysis. In practice it would appear that good commercial advice depends on reliably and sensibly structured data. Both data and advice need to be regarded as priorities. Activity Read Mouritsens (1996) paper and list the five aspects of the work of the accounting department that he found in his study. Then write one paragraph explaining if and how Simons three roles can be mapped on Mouritsens five aspects.

Enterprise Resource Planning Systems (ERP)

In the discussion on the changing roles of management accountants one needs to keep in mind that new technology does not automatically mean less administrative work for management accountants. An interesting case in point are the implications for record keeping of Enterprise Resource Planning Systems, also known as ERP . Your textbook discusses them on pages 6889. ERP has been a key technological innovation of the past decade and many large companies have spent very large sums on buying ERP systems from companies such as SAP , Oracle, PeopleSoft, and many others that are described on websites such as: http://www.olcsoft.com/top%20ERP% 20vendors.htm.
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The basic idea of ERP was to replace the multiple stand-alone information and accounting systems that had historically evolved in organisations with one all-encompassing information system that would minimise data duplication and avoid the need for comparisons of the data between systems. With ERP , all the reports which needed to draw on, for example, the number of units in inventory of a certain finished good, would find that information in just one file, such that the information would not be held in any other file. So, for example, the material requirement planning systems, the production planning systems, the sales forecast systems, the customer order and shipping systems, and the various accounting reports that would use this inventory number would all be fed the same number from the same file. This means there would be no need for updating other systems when this number changed and there could consequently be no confusion due to time lags between updates of different systems a common problem within traditional information technology environments. On the face of it ERP looked like a great example of how unrewarding manual record keeping and administrative work could be reduced, freeing up the time of management accountants to concentrate on giving commercial advice to managers sometimes referred to as adding value. While some of those expectations were met by ERP systems, they did, however, also generate novel requirements for record keeping and data integrity work. Because they sought to represent all organisational processes in one system in real time, ERP systems required many organisational members who used to provide information on paper or on subsidiary electronic systems to enter information straight into the ERP system. Often this happened through the automatic capture of their dayto-day work. However, that day-to-day work usually contains data errors, which can now enter the new ERP systems unchecked. So, for example, a mistakenly-entered invoice amount may be fed directly and immediately into budgets, material ordering systems, creditor management reports, etc. (Chapman and Chua, 2003). Data entry mistakes can have greater and more immediate impact in ERP systems. This has created new threats to organisational data integrity and new record keeping work for management accountants. Another important point to bear in mind in the discussion of the modernisation of management accounting is that traditional record keeping and modern business advice exist in parallel, and that there are potential advantages to this. A study by Ahrens and Chapman (2000) suggested that record keeping work served as an important entry level task for junior management accountants. Through such work they gained experience of specific organisational processes and the different ways in which they are related to accounting and organisational information systems more generally. Record keeping work can thus be useful experience on the basis of which management accountants can, later in their career, adopt a more advisory role that is of greater commercial and strategic relevance. Giving commercial and strategic advice sounds great as a task for junior management accountants but in reality it is something that newcomers need to grow into over time. Entry level work lays the foundation for a more important role later in the career.

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Planning, controlling and experience

The headings most commonly used to describe management accountants work are planning, control and performance evaluation. The more senior the management accountants who are involved in any of those three roles the more experience of the detailed workings of the organisation they need. This is because they are interacting with senior line managers who are responsible for large arrays of organisational activity and who tend to have themselves complex insights into the workings of the organisation that they built up over time. If, as a management accountant, you want to discuss commercial opportunities and strategic priorities with those managers, and be in a position to effectively contest their views of what is and is not realistically possible for the organisation to achieve, you cannot do without experience gained either in your organisation or with a competitor, or, sometimes, in a different industry with similar characteristics. Planning and control are sequential. Control (defined on page 836 of your textbook) only makes sense if actual results can be compared against a benchmark the plan. In some organisations it makes sense to develop the plan largely as a continuation of historical performance. Other organisations prefer to question their planning assumptions more rigorously every time they make a new plan, often because their operations and competitive environment are subject to greater change.

The budgeting process and beyond budgeting

Central to planning is the budgeting process, which is discussed in greater detail in Chapter 5. The budget is a financial plan of the organisational future. It typically comprises a budget profit and loss account, a budget balance sheet, and a budget cash flow statement for the organisation as a whole as well as for its key sub-units, be they divisions, research laboratories, factories, sales organisations, etc. Organisations determine on a need-to-know basis how far down in the organisational hierarchy they want to draw up complete budget profit and loss statements for organisational sub-units. Sometimes a factory only budgets costs (especially when it is not involved in the process of selling and has little influence over revenues), and a sales office only budgets revenues and the costs of running the office. It would often not budget the costs of goods sold for the products that it sells, because those would be controlled by the factories that supply its products. In this case it would make sense for a larger entity, for example, a division that controls both the sales office and the supplying factories, to budget profits because this division is responsible for revenues and costs (and, by implication, profit and loss). In the debate around strategic management accounting, budgeting has been criticised for being too administratively oriented, not producing enough commercially-relevant information, and being too time consuming. In practice, budgeting processes that take up nine months prior to the financial year for which they are meant are not unusual. Typically, it takes a long time to collect cost and revenue estimates from numerous budget holders, coordinate them, and, finally, communicate a coherent plan. Budgeting has also been criticised for inducing a culture of complacency with respect to performance targets. Managers whose departments perform well against budget may not be willing to push their subordinates to achieve better than budgeted results because, firstly, budgets tend to reward fulfilment of expectations, not overfulfilment, and, secondly, overfulfilment may lead to heightened expectations in subsequent

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budgeting rounds. Managers may thus be tempted to initially hide the effects of process improvements and other cost savings and only use them to improve the financial results of their units gradually as and when future budgets demand such improvements. At the heart of the detection of organisational slack and similar problems lie the ways in which budgets are used and the kinds of expectations organisational members have of them. A diverse group of organisations that have since 1972 come together in the Consortium for Advanced Manufacturing International (CAM-I, see website www.cam-i.org/) has formed a sub-committee, known as the Beyond Budgeting Round Table (www.bbrt.org/), which is specifically concerned with improving the budgeting process. The Round Table is exploring ways of using budgets more flexibly in ways that alleviate budgets performance reducing effects, for example, by introducing stretch targets, and finding ways of overcoming the gaming and creation of slack that often occurs in the process of agreeing performance targets. A commentary in the British newspaper The Observer provides an easily-understandable overview over some other key problems with budgets and makes reference to the Beyond Budgeting Round Table. (http://observer.guardian.co.uk/business/ story/0,6903,1174315,00.html). Activity Visit www.bbrt.org and have a good look around the website, then rank what you regard as the 10 most important criticisms of traditional budgeting practice. Which criticisms would you regard as unimportant?

Decision-making and organisational goals

Underlying the difficulties of detecting organisational slack, or even deciding what counts as organisational slack, is the definition of organisational goals. Especially when you deal with matters of organisational strategy, one managers slack can be another managers strategic resource. How much money should be budgeted for activities of strategic relevance, such as research and development (R&D), advertising, sales promotion, process improvement, the speed of logistics, etc.? The key task in management accounting is to relate budgets to organisational tasks in ways that enhance the likelihood that the organisation meets its strategic objectives. From an economics point of view, those objectives are easily defined. The organisation should maximise its cash flows over its lifetime. Discounting those cash flows to the present gives the economic value of the organisation, or the price that the organisations owners can demand when they sell it. From an economic point of view, therefore, management accounting is concerned with owners wealth maximisation or OWM, which we will discuss in more detail in the next chapter.

Stakeholders
However, owners are not the only organisational stakeholders. The social environment of an organisation typically includes employees, customers, neighbours, and suppliers, to name but a few. Not-for-profit organisations may, moreover, need to consider much wider concerns. For example, universities can be held accountable by students, parents and the wider scientific community. Hospitals are subject to the concerns of patients, their relatives, the professional associations of doctors, the governments drug regulators, etc.
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Even when the number of stakeholders is small and there is agreement that financial success is an important criterion for organisational performance, there may exist significant differences of opinion as to what concrete actions to take to achieve financial success. Production engineers tend to have different solutions to organisational problems from marketing managers. Both groups have incentives to depict particular organisational problems in ways that suggest a solution that is designed and implemented by them, thus increasing their own influence in the organisation. A behavioural perspective on the organisational uses of management accounting would take such possibilities into account. An important point from a behavioural standpoint is that, strictly speaking, organisations have no goals at all only individuals have. The expression organisational goal could then be taken as a shorthand for some sort of aggregate of the goals of individual organisational members. Economists would regard OWM as the measure of aggregate organisational goals. Behaviourists, by contrast, allow conflicting goals within the organisation. What gets talked about or written down as the goals of the organisation or the organisational mission statement would then appear as a temporary settlement of ongoing dispute that depends on the shifting powers of organisational subgroups with conflicting (and presumably changing) interests. The implications for the role of management accounting in decisionmaking are profound. There would be no a priori normatively correct answer because different coalitions within the organisation would prefer different types of outcomes that cannot be clearly ranked on a scale of payoffs. The resolution of potential conflict becomes a key task of management. Management accounting often carries great weight in the formulation of organisational objectives and the weighing of alternative courses of action. One can therefore expect senior management as well as the different organisational coalitions to attempt to use information selectively to present the management accounting information most suitable for their causes.

A reminder of your learning outcomes

By the end of this chapter and having completed the Essential reading and activities, you should be able to: define the terms modern management accounting and strategic management accounting explain why organisations have become concerned with modern management accounting evaluate the extent to which modern management accounting has changed the role of the management accountant.

Sample examination question

To what extent do you regard the current concerns with the strategic relevance of management accounting as technologically driven?

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Suggestions for answering the sample examination question

This question can be answered in many different ways. One possibility is to start by making a list of technological reasons for the emergence of strategic management accounting. Looking at those reasons more closely, are you sure that all of them are purely technological? Why were the technologies introduced? Now you could move on to explaining what other influences contributed to the emergence of, and demand for, strategic management accounting. A different way of answering the question would be to distinguish between enablers of strategic management accounting and demand factors. Some of the enablers could be broadly labelled as technological, but were there perhaps other enablers, too? And was the demand for strategic management accounting purely driven by considerations of strategy making?

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Notes

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Chapter 2: Decision-making

Chapter 2: Decision-making
Essential reading
Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting: a managerial emphasis. (Upper Saddle River, NJ: Prentice Hall Publishing, 2009) thirteenth edition (international) [ISBN 9780135046340 or 9780131355583] Chapter 11 (without appendix on linear programming) and Chapter 21.

Further reading
Hopper, T., T. Koga and J. Goto Cost accounting in small and medium sized Japanese companies: an exploratory study, Accounting & Business Research (Winter 1999) Vol. 30, Issue 1 pp.7387. Verdaasdonk, P . and M. Wouters A generic accounting model to support operations management decisions, Production Planning & Control (September 2001) Vol. 12 Issue 6 pp.60521.

Aims
This chapter covers the economic foundations of management accounting theory and practice. Specifically, it suggests that management accounting ought to help in decision-making; indeed, that the support of decisionmaking processes is its main purpose. To highlight some of the most important aspects of decision-making, this chapter introduces you to different levels and stages of decision-making. The chapter also explains the uses of the concept of uncertainty and derives from this the concept of the value of information and how it can be calculated. Throughout, the chapter emphasises the centrality of the concepts of relevant information and relevant costs for the course as a whole and for the examination.

Learning outcomes
After completing this chapter and the Essential reading and activities, you should be able to: distinguish different types of decision-making define the terms opportunity cost and relevant information conduct long-term project appraisals using relevant information calculate the value of information under uncertainty.

Levels of decision-making
The American Accounting Association defined accounting as:
[...] the process of identifying, measuring, and communicating economic information to permit informed judgements and decision by users of information.

This means that accounting plays a role at several levels and in several stages of organisational processes: 1. Setting the objectives of the organisation. 2. Determining the strategy for achieving the organisations objectives, given the resources available to the organisation, and the environment in which it operates.
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3. Determining plans, both long-range and short-range (such as the annual budget), aimed at achieving the organisations strategic goals. 4. Controlling the organisation by comparing actual performance against that planned, and by reviewing and modifying the organisations plans in the light of experience. 5. Communicating the organisations plans and their outcome. Communication is maybe the most important process in which management accounting is involved because it is not only related to spreading the objectives of new plans; more significantly, the language which is used to deal with processes can have wide-ranging effects on their outcomes. For example, if you set objectives and strategies with financial performance measures in mind, you signal different priorities from someone who plans with reference to, say, new technologies and market share. Management accountings main role in these processes is the provision of information to assist in decision-making. Decisions arise at three levels: strategic planning, management control and operational control. The level of strategic planning has perhaps the greatest long-term significance for the organisation, and decisions at this level are likely to be crucial for the organisations survival and growth. Such decisions will relate to the organisations overall goals and the long-term strategy for achieving these goals. Strategic decisions will be made relatively rarely and after extensive consideration. Management control is a more frequent and regular process, and may well follow a weekly, monthly, quarterly or, at most, annual cycle. It is concerned with the implementation of the organisations strategic plan, by ensuring that the necessary resources have been obtained and are being used efficiently and effectively. Operational control focuses on specific tasks as they are carried out, trying to ensure that this happens efficiently and effectively. As an example of the different levels, consider an organisations manufacturing operations. At the strategic level, the organisation will determine matters such as: a. whether to adopt a high technology or a low technology production method b. whether to manufacture large volumes of a small range of products or smaller volumes of a larger product range c. whether to concentrate production geographically or to disperse it. The decisions taken at the strategic level will imply certain detailed plans for the organisations manufacturing. Therefore, at the management control level, decisions will need to be made as to the resources required to put the strategic manufacturing plan into operation, for example, how much of which materials to use, and the usage of such materials will need to be monitored and controlled periodically to ensure that they are being used efficiently. This might involve the setting of quality criteria for deciding whether products have been satisfactorily manufactured. At the level of operational control, decisions will be made about particular batches of goods produced, for example, whether they meet the criteria of quality set at the management control level.

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The importance of cash flows

In decision-making we distinguish typically between the short and the long term. In short-term decision-making, we can usually ignore the time value of money, and therefore avoid the need to discount cash flows. Nonetheless, in making short-term decisions, we still need to focus on the cash flows involved in our decisions, and we use the goal of owners wealth maximisation to argue that we should assess alternative actions in terms of the amount by which they are expected to change the future net cash flows of the organisation. When we consider any action, we should therefore attempt to identify how, and by how much, the organisations cash balances will change as a result of taking the action. Cash inflows will arise from revenues generated by selling goods and providing services, from interest and dividends received, from tax refunds and subsidies, and from the sale of assets. Cash outflows will arise from purchasing the resources (goods and services, people and machines) needed to undertake the course of action. For short-term decision-making, we need some baseline against which we can identify the cash flows that change as the result of taking a particular course of action. The baseline can be defined as the consequence of taking an alternative decision. Given the baseline, we may then attempt to estimate the changes in cash flow (the incremental cash flows) that arise from the course of action being considered. The baseline we normally assume is the total net cash flows associated with the best available alternative to the action under consideration. This baseline is chosen because we assume that the actions of the organisation are determined rationally, and this implies that the organisation will always select the best available alternative if the particular action under consideration is unavailable. Activity Read pages 422425 and the concepts in action box on page 424 of your textbook, and write a definition of the term opportunity cost in one sentence.

Opportunity costs
Within this framework, we may define cost as any decrease in wealth (measured in cash terms) brought about by a decision to use a particular resource or set of resources. By measuring the decrease in wealth by reference to the next best alternative, we are effectively using the economic concept of opportunity cost. Economists define opportunity cost as the benefits foregone by not adopting the next best alternative, where benefits can relate to any economic benefit, not only cash. Examples of opportunity cost are more easily presented as situations of choice under resource constraint. Suppose you have an amount of money free to spend at the end of the month. You have been looking forward to a holiday trip for a long time, but now realise that your house needs some repair work fairly urgently. The opportunity cost of going on holiday would be to delay the house repair with all the problems to which this course of action may give rise. The opportunity cost of having the repairs carried out would be to forego the enjoyment of the holiday. The example shows that your personal opportunity costs can be very subjective, depending on the utility of the benefits which you forego. However, for short-term decisionmaking purposes, the most relevant economic benefits are likely to be expressible in terms of cash.

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Activity What opportunity costs did you incur by enrolling on the University of London International Programmes?

The concept of relevant costs and revenues

Decision-relevant costs (and benefits) have three essential characteristics. Although what follows concentrates on costs, analogous arguments apply for revenues. 1. Only cash costs are relevant. From an economic point of view, anything that does not bring about a cash change to the organisation (immediate or future) is irrelevant to the decision. It is important to emphasise the cash basis for decision-making, as several items are treated as costs for financial accounting purposes (and, indeed, in certain aspects of management accounting) that are not directly associated with present or future cash changes. The classic example is depreciation. This is an allocation of the cost of a fixed asset (such as a machine) over the periods during which the asset is used or on some other basis associated with the usage of the asset. Depreciation is not itself a cash outflow (the cash outflow was the original cost of the asset) and hence is ignored in cash-based decision-making. Note that, while only cash costs are relevant, we must take into account all cash costs, both direct and indirect. It is sometimes difficult to identify and quantify all the indirect cash costs. For example, if the organisation chooses a particular action, perhaps to sell a certain type of product, this might make customers more likely to do business with the organisation in the future; but how is the cash impact of this to be estimated? Nonetheless, all cash impacts should be included where possible in the decision-making process. 2. Only differential cash costs are relevant. This flows from our baseline of the next best alternative: any cash costs that would be incurred whether or not the course of action is taken should be ignored, as they would be incurred under the next best alternative and are thus already reflected in the baseline. Some care is needed in identifying the costs that are genuinely differential in the context of a particular decision, especially where following a particular course of action would use resources that would otherwise be allocated to the next best alternative. Where the action under consideration and the next best alternative are mutually exclusive, and resources already contracted for would be used either for the action under consideration or for the next best alternative action, then the cost of those resources cannot be regarded as differential and should be ignored. An example of this would be an airlines decision to provide passenger services from Hong Kong to one of two possible new locations where ground staff handling additional check-ins and baggage have already been contracted. 3. Only future cash costs are relevant. The decision can only change future cash flows, it cannot act retrospectively to change cash flows already incurred. This could either have been the actual spending of cash (past costs) or the incurring of an obligation to spend cash that cannot be avoided (committed costs). The rule is therefore: for making decisions, only differential future cash flows should be considered. This principle implies that the costs taken into consideration for decision-making purposes, and the
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amounts at which those costs are measured, will often be quite different from the costs and amounts used in financial accounting statements. By including only differential costs, we ignore those costs not changed by the decision. The costs actually affected by the decision will very much depend on the scope of the decision itself. For very short-term decisions, most resources to be used will already be contracted for, so that the costs that will change as a result of the decision will relate to relatively few items. For example, it may be impossible in the very short term for a business to increase (or decrease) its workforce and its equipment. If the cost of labour and machinery is effectively fixed, so that the only cost that could change is that relating to materials, it may well be rational to accept a contract to manufacture and sell goods whose selling price exceeds the cost of materials alone. This may be advantageous even though the selling price is significantly less than the accounting cost including wages and depreciation of equipment, if the next best alternative leaves the resources idle that would otherwise be used to fulfil this contract. As the decision horizon lengthens, fewer costs become unavoidable, and more become relevant. At the extreme, all future costs become relevant, but past costs will always remain irrelevant. Activity A customer offers to buy from your company 100 electrical engines of a standard design but with a slight modification to its electricity intake. Both the workers and the supervisors of your factory are paid fixed monthly salaries. You expect to have some spare production capacity over the coming weeks. The material cost of one engine is estimated to be $500. To manufacture the altered design specified in the order, you would have to modify some of your production machinery. An engineer would have to work on it for eight hours and use materials worth $3,000. The customer offers to pay $650 per engine. Your companys list price for the standard design is $880. What further information do you require to decide whether you should accept the offer?

Identifying relevant costs and revenues

What general factors are involved in applying the opportunity cost concept to a concrete decision? The first stage is to identify the resources required for the action under consideration and incorporate them in alternative budgets. The resources will typically include materials, labour, machines and other services. We shall see in Chapter 4 that these are the basic elements of overall cost. Having identified the resources required, it is then necessary to find out whether or not the organisation already has each resource in its control. For example, materials to be used might already form part of the organisations inventory, labour needed to carry out the action under consideration might already be employed, and so on.

Purchased resources
If the resource is not already controlled by the organisation, then it must be purchased, and the measure of the cost to the organisation is the current purchase price of the resource. For many resources, this current price provides a suitable measure with no need to make adjustments. Problems arise, however, when it is considered appropriate to acquire some resource to undertake a particular action, and the resource in question will provide services over and above those needed for the action under consideration. For example, in order to accept a contract to manufacture a particular product, it might be necessary to acquire the services of a special machine. The organisation might simply hire the
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machine for the contract, in which case the cost of the machine is the hire charge. But what if it is decided that the machine should be bought outright, and the organisation intends to use the machine on other contracts, as well as the one under consideration? In these circumstances, to assign the whole cost of the machine to the particular contract currently under consideration would be misleading, as we would effectively be overcharging this contract for the machine and undercharging other contracts. It is necessary in such circumstances to somehow allocate the cost of the machine to the contracts that will benefit from its use. Various techniques for performing such an allocation have developed, but the methods that are considered to come closest to a rational economic allocation of cost are too advanced to address in this subject guide. It is important to realise that the problem exists, and that the current replacement price for a resource that must be acquired for an action is not always the straightforward measure of opportunity cost.

Resources already under the organisations control

What if the organisation already controls the resource? In this case, we must consider how the resource would be used if the organisation were to reject the action under consideration and were to adopt the next best use for the resource. By undertaking the action, the next best use cannot be undertaken with that particular resource. If there is in fact no next best use for the resource, then the organisation bears no economic cost in using the resource for the action under consideration. This might be the case where the action under consideration makes use of the labour services of employees who would otherwise be paid for doing nothing. However, for most resources, there will be an alternative use. Bear in mind that the next best use for the resource could be to sell it immediately. If the resource is used for the action under consideration, the sales revenue that would otherwise be received will have to be sacrificed. In these circumstances, the opportunity cost of the resource is the net realisable value foregone of the resource. If there is an alternative use for the resource, then it will be necessary, if the resource is assigned to the action under consideration, to replace the resource to enable the next best alternative to be carried out. Materials that would otherwise be used elsewhere will have to be replaced, and the opportunity cost is therefore the replacement cost of the materials. If labour is transferred from other jobs, it will be necessary to employ replacement labour, so the opportunity cost is the pay due to the replacement workers. So for resources that would have to be replaced, the measure of opportunity cost is current replacement cost. Activity Read the section Insourcing-versus-outsourcing and make-versus-buy decisions in your textbook (pages 41921) and work through example 2.

Decision-making and current replacement cost

You should note carefully that, for decision-making purposes, the original historical cost of the resources is not relevant, only current replacement cost and net realisable value. This reflects the forward-looking nature of decision- making. What has already happened is no longer relevant for decisions. For financial accounting purposes, however, historical costs are still important in practice, because most financial statements are drawn up using the Historical Cost Convention (i.e. using the actual costs
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at the time they were incurred). A common criticism of this accounting convention is that the costs it reports are not relevant for decisionmaking. You should also note that costs allocated to a particular resource or overall opportunity because of a financial accounting convention or a management decision are normally irrelevant within the context of opportunity costs. Thus depreciation (as a financial accounting allocation) and apportioned general overheads (as a management accounting allocation see Chapter 4 of this subject guide) are not relevant. However, specific changes in cash flows, such as an incremental expenditure on overhead services, are relevant. Activity A department store considers closing one of its branches. Which of the following list is relevant information? Information on
Hourly wages for sales assistants Rent of property Premium for fire insurance (one policy for the whole company) Local authority taxes Sales revenue Bulk buy discount which the company negotiates with suppliers Renovations of premises which were carried out last year Head office overheads which are allocated to branches based on sales revenue Salary of branch manager Trade union relationships

Yes

No

Comparing cash flows in the long run

Future differential cash flows are relevant in the short and the long run. In the long run you need, however, to be aware of what is known as the time value of money. The time value of money is the result of the existence of investment, lending and borrowing opportunities and of peoples preference for immediate rather than future uses of money. The time value of money concept recognises that holding on to money, rather than using it now presents an opportunity cost in itself. By holding on to money you forego profitable investment opportunities. At a minimum, you could, for example, deposit money in a savings account and receive interest (or, if receiving interest is forbidden, lend the money for a fee or for a profit share). The interest rate on the capital markets therefore determines the opportunity cost, also known as the cost of capital. Management accounting uses the cost of capital (or i for rate of interest) to express future cash receipts and payments in terms of their present value. This is necessary because the receipt of $100 in a years time is worth less to you than the receipt of 100 now. Activity Before showing you the relevant equations, see if you can understand the principle of comparing cash flows at different points in time intuitively, through an example. Suppose
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you are selling a piece of land today. The selling price is $1,000. As you sign the contract, the buyer offers you to pay you $1,100 in a years time instead of $1,000 now. Assume that i, the cost of lending and borrowing (you can also think about it as the cost of capital) is 9 per cent per year (also often expressed as p.a. = per annum). Would you rather be paid now or in one year? Hint: compare the difference between the cash flow now and in one year with the opportunity cost of delaying payment (i.e. how much do you lose by accepting payment in one years time?) An individual will be indifferent between receiving an amount of capital C now and C(1+i)n in n years time because he or she could lend C (the $1,000 for which the land is sold) at the market rate of interest i (which would be $1,000 9 per cent for the year). For this to hold, we need to assume perfect capital markets with identical lending and borrowing rates, no transaction costs and no single individual able to affect the equilibrium interest rate by the amounts he or she chooses to lend or borrow. Note that the reason why an individual is indifferent to an amount paid now and a greater amount paid in the future is not the inflation rate. The examples that we use in this subject guide ignore inflation. The reason is that an amount paid now contains opportunities for investment. That makes it more valuable than the same amount paid in the future. The difference, C i, is the opportunity cost of deferring receipt of C by one year.

Discounting
Calculating the present value of a future cash flow is usually called discounting. The present value approach allows us to reduce all the various cash flows associated with a project to one figure, the net present value (NPV). We calculate the discounted present values of the various cash flows associated with the project, and add them up (remembering that cash inflows are usually taken to be positive and cash outflows negative). The total we arrive at is the NPV of the project. For example, assume a project that involves an outflow of 5,000 immediately, and that will produce inflows of 1,000 at the end of the first year, 2,000 at the end of the second year and 4,000 at the end of the third year. The NPV of the project, assuming an interest rate of 10 per cent (i=0.1) is: Cash outflow + [cash inflow year 1/(1+i)1] + [CF year 2/(1+i)2] + [CF year 3/(1+i)3] = 5000 + 1000/1.1 + 2000/1.21 + 4000/1.33 = 5000 + 909 + 1653 + 3005 = 567. The actual calculation of NPVs is often made more straightforward by the use of discounting tables, which is explained in your textbook.

The net present value decision rule

The NPV rule simply states that a business should accept any project that yields an NPV that is positive, as acceptance of such projects will increase (or, in the case of a zero NPV project, not decrease) the value of the business. The NPV of a project is effectively its value in cash terms at the time of decision, that is, the NPV is the amount of cash that the business would be indifferent between accepting immediately and undertaking the project, with its associated cash flows. The business could in principle borrow not only the cash needed to invest in the project but also the NPV
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of the project; it could then pay the NPV to the owners of the business, and be able (just!) to repay its loan and the related interest out of the cash inflows from the project, so long as the interest rate of the loan is equal to the rate of discount used to determine the NPV . In practice, there are three stages in a project appraisal: 1. estimate the date and amount of the relevant cash inflows and outflows associated with the project 2. discount the cash flows at an appropriate discount rate 3. assess the project using the NPV rule. The relevant cash flows are those that would change as a result of accepting the project. Some care is needed here, as it is necessary to include not only the initial cost of the project and any ultimate realisable value but also any relevant operating cash receipts and payments and any indirect benefits and costs such as capital investment grants, tax allowances and tax payments on operating profits that would arise from accepting the project. If the acceptance of the project would involve the commitment of working capital, which will require cash to fund it, then this should also be taken into account in the appraisal. Conversely, it is important not to confuse the appraisal of the investment decision by including cash flows relating to the way in which the project is to be financed (such as interest charges). One important point to note is that, because we are interested in cash flows, accounting allocations such as depreciation, which do not represent cash flows, should not be taken into account in calculating NPV . Thus the NPV should reflect the net cash flow from year to year associated with the project and not the accounting profit. Activity Now read the section Discounted cash flow (pp.76163) in your textbook, paying particular attention to exhibit 21-2.

Making estimates for project appraisals

If we are appraising a project whose associated cash flows are known and certain, the calculation of NPV is a fairly mechanical exercise in identifying the dates and amounts of the various relevant cash flows and performing the appropriate discounting exercise. However, where the cash flows are uncertain, they must be estimated, and this is reflected in appraisals in practice either by calculating a range of NPVs, usually for the worst likely cash flows, the best likely cash flows, and some average value of cash flows, or by calculating expected cash flows using probability estimates (sometimes called certainty equivalents) and discounting these. There are problems with the latter approach, as it is strictly only valid where the cash flows forecast in any one year are independent of those forecast in any other year. For many projects, however, there is likely to be a strong association between the levels of cash flow achieved from one year to another. Calculation of a range of NPVs (and perhaps using these together with overall probability estimates to calculate an expected NPV for the project) overcomes this problem. The second stage of the appraisal involves the choice of an appropriate discount rate. In a certain world, given perfect capital markets, this will simply be the equilibrium market rate of interest. In an uncertain world, however, matters are more complicated, and it is usual for a business to use its cost of capital the rate of interest it has to pay for its long-term
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finance for discounting purposes. Calculating the cost of capital is a difficult procedure in practice. First of all, it is necessary to determine what should be included as capital. This is usually taken as the longterm finance of the business, and is classified into debt capital (long-term loans) and equity capital (shares or other ownership interests). It is then necessary to identify the cost (usually measured as the rate of return) of the various components of capital. Here it is important to note that the true rate of return must be used, not the nominal rate of return offered by a component of capital. For example, the dividend paid on an equity share might be expressed as 10 per cent of the nominal value of the share, but the true return is given by expressing the monetary amount of the dividend as a percentage of the current market value of the share. Appreciations in share price are another source of returns to the shareholder, but they are more difficult to incorporate in the cost of capital. They are not paid in cash by the company, but they can be seen as an opportunity cost. If the company had not already issued a share in the past, it could issue it now (after its share price went up) and obtain more money from the buyer of the newly-issued share. Share price appreciations for all shares should be expressed as a percentage of the market value of the company because they constitute an opportunity cost of having used shares to finance the company in the past and not, say, bonds. Another problem in estimating the cost of a component of capital is deciding whether to use a pre-tax or post-tax rate of return. Certain types of capital are often taxed differently from other types, and the tax treatment depends on the tax laws of the country in which the business operates. Usually, however, interest on debt capital is deductible from the profits of the business before they are assessed to whatever tax is levied on profits, while dividends and other payments to owners are not deductible. If after-tax rates of return are used in calculating the NPV of a project, the after-tax cash flows should be discounted. The final problem comes in combining the rates of return for the various components of capital into one overall cost of capital (the weighted average cost of capital WACC). The rates of return for the various components should be weighted by the market values of the components (not their book values), in the same way that the rates of return are themselves based on market values. One important point to note is that care must be taken in appraising projects which it is intended will be financed out of a new issue of a particular type of capital. It is sometimes suggested that, in these circumstances, the appropriate cost of capital to use is the cost of the new specific finance, the marginal cost of capital. This would indeed be correct if the new issue of capital had no impact on the overall capital structure of the business, but this is seldom the case. For example, if the business were to choose to finance the project by debt capital (the cost of which is usually less than WACC), this would increase the gearing (i.e. the relative importance of loans in the overall capital structure; this is sometimes called the leverage) of the business as a whole. The greater the gearing of a company, the more risky becomes its equity capital, and holders of equity capital would require a greater return than before to compensate them for the additional risk that they are forced to bear. The true marginal cost of capital should incorporate not only the direct cost of the incremental capital issued to finance the new project but also any indirect costs arising in respect of other components of capital. I include the ideas mentioned in this paragraph because you will find them useful for making connections for your study of finance. They are not examined as part of Management accounting.
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Activity You receive a proposal to invest in energy-saving light bulbs in your factory. How do you determine the relevant costs? Outline the decision-making process.

Problems with the opportunity cost concept

Central to the decision-making concept is the notion of opportunity costs. You should understand several problems of the opportunity cost approach. 1. The approach assumes that decision-makers are able to identify the next best action in any given circumstances. But this might imply an evaluation and ranking of all conceivable alternatives. In practice, the examination of alternative actions is likely to be limited to those immediately obvious to the decision-maker. For example, it might be assumed by the decision- maker that materials already in inventory will be replaced, even though the actual next best use of the materials is left unspecified. 2. The determination of opportunity cost in a complex organisation becomes complicated, as it is not always obvious at which level the cash changes caused by the decision should be analysed. For example, the decision might be analysed at the level of an operating division of the organisation, so that only those cash changes that may be observed at divisional level are identified. The problem with this from the perspective of the organisation as a whole is that, first, indirect cash changes elsewhere in the organisation might be omitted and, secondly, many of the cash changes identified at divisional level will reflect cash transfers with other divisions of the organisation, so that the net cash flow for the organisation as a whole is zero. This might lead to the taking of decisions that are optimal for the division in isolation but suboptimal for the organisation as a whole. (We return to this problem in Chapter 9.) 3. Opportunity costs are forward looking, but in practice they are often estimated on the basis of past experience of costs and revenues associated with similar actions; however, it is not always straightforward to estimate future cash flows from past data. 4. Traditional accountants often have difficulty in understanding and accepting the basis of opportunity costs, particularly the treatment of past costs. To the traditional accountant, past costs are actual costs that have been incurred, so how can they be irrelevant? Moreover, much traditional management accounting has emphasised the need to recover costs that have been incurred, through the earning of sales revenues. These attitudes have some validity, in that the costs that have already been incurred are likely to determine the range of possible future actions for the organisation, allowing some options and ruling out others. Also, for the organisation to survive in the long run, it is necessary for revenues to cover costs. In the short term, however, the relevant costs to be covered by revenues are not those that the traditional management accountant calculates but rather the opportunity costs. 5. The opportunity cost concept implies a model of rational decisionmaking, yet it is not obvious that this model is an appropriate description of reality within organisations. People working in organisations have many other concerns besides rational decisionmaking.
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Activity What might those other concerns be?

Uncertainty and relevant information

Those other concerns notwithstanding, the assumption of rational decision-making enables us to calculate the value of information under uncertainty. Take Yassin, for example, who sells cheap umbrellas outside an underground train station on Singapores Orchard Road. On rainy days, he sells many umbrellas to people who have forgotten theirs and do not want to get wet. On sunny days, no one buys umbrellas, and Yassin would prefer to stay at home and work in his garden. Every day, Yassin must decide whether to go to work or stay at home. If he stays at home and the day is rainy, Yassin loses a days sales, but if the day is fine, he can enjoy his garden. If he goes to work and the day is rainy, Yassin can sell his umbrellas, but if the day is fine, he makes no sales, has to pay his fares to central Singapore, and wastes the day. Activity What is Yassins opportunity cost of travelling from his house in the suburbs to the centre of Singapore to sell umbrellas? We may express the possibilities for Yassin in terms of the satisfaction that he gains from the various outcomes. (These satisfaction values are arbitrary, for the purposes of illustration, and the units are unspecified.) Have a look at the following table. State of weather Fine Yassins action Stay at home Go to work +10 10 Rainy 0 +30

Table 2.1: Example of outcomes from decision under uncertainty

From the table, you can see that, if it is going to rain, Yassin would prefer to go to work. If it is going to be fine, Yassin would prefer to stay at home. Information about the likely state of the weather would help Yassin in deciding what action he should take at the start of the day. Can you imagine how valuable that information would be for Yassin? What is at stake? What does he stand to gain or lose from not knowing whether it will rain or not?

Characteristics of useful information

Let us now examine the characteristics of the information that Yassin needs. 1. Relevance. The crucial factor for Yassins decision is the state of the weather, so only information about the weather will be relevant. Facts such as yesterdays football scores will be irrelevant, and would not constitute relevant information for Yassins decision. 2. Significance. Yassin wants information about todays weather in Singapore. Information about todays weather in New York or yesterdays weather in Singapore are unlikely to be significant. (They might be significant if they are related in some way to todays weather, so in certain circumstances information about yesterdays weather will be significant if it is a good predictor of todays weather.)
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3. Reliability. Yassin will place greater value on weather forecasts that give good predictions than on those that do not. A weather forecaster who is biased in some way (perhaps he or she is an optimist, and tends to predict better weather on average than actually occurs) will be less reliable than one who is free from bias. Weather forecasts based on forecasting procedures that can be verified are likely to be more reliable than those based on unverifiable procedures. 4. Understandability. Yassin simply wants a forecast of whether the day will be rainy or fine. A complicated forecast, complete with obscure charts and diagrams, might not be of much use to Yassin, particularly if he needs to spend a lot of time trying to understand what the complicated forecast is saying. 5. Sufficiency. Yassin wants a forecast covering all the day, so a forecast relating only to the morning would be insufficient. Similarly, Yassin wants a clear-cut forecast implying either that it will be rainy or that it will be fine: sometimes weather forecasters try to cover both alternatives in a vague statement, but this would not tell Yassin anything. 6. Practicality. Yassin wants the forecast at the time he has to make the decision, so a forecast available to Yassin only at the end of the day would be too late. It would have no value for Yassin. In Singapore, weather forecasts are usually free: they are obtained from radio, television or newspapers and not paid for separately. If Yassin was prepared to pay for a weather forecast, how much do you think he would be prepared to pay for it? In general terms, it would have to be no more than the value which the information has for him. From this example, we can see that not every fact represents information for a particular decision. Facts or data are usually regarded as information only if they are likely to change the expectations of the person receiving them. Moreover, information will be significant only if it is likely to change the outcome of the decision under consideration. In some circumstances, the outcome of a particular choice of action might be such as to dominate all other alternative choices, whatever might be the true data about unknown matters. (For example, if Yassin were able to sell his umbrellas regardless of the weather, he would decide to go to work every day.) In such cases, data about the unknown matters will not change the dominant action implied by the decision. But where facts will make a difference to the action chosen, we will call those facts information, and the information has value. We can often quantify the value of information, as we do in the section below. Conversely, information will often have a cost, and it is not sensible to pay more for information than it is worth. Activity Read the Appendix to Chapter 3 Decision models and uncertainty on pages 10710 of your textbook and solve problem 3-40 on p.118.

Objective and subjective probabilities

On the assumption that the weather in the future will be similar to that in the past, historic frequencies of rain and sunshine may be used to estimate the probabilities of the weather in the future. Our records might show rain on six days out of every 10. We could use this frequency to estimate the probability of rain as 0.6 or 60 per cent or 3/5. Where probabilities are derived from frequencies, we often describe them as objective probabilities. While many management decisions arise in circumstances
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where the past is a good guide to the future, it is often necessary to take decisions where the future is uncertain but there is no past data on which to base estimates of future probabilities. In such cases, involving one off decisions, it is impossible to lay down rules for estimating future probabilities, and we often talk of the decision-maker using subjective probabilities in his or her decision-making process.

Expected value
The expected value of an outcome is found by adding together the value of each possible outcome multiplied by the probability that the outcome will occur. For example, suppose that we estimate that a project will earn a profit of 1,000 with probability 0.3, 2,000 with probability 0.5, and 3,000 with probability 0.2. Then the expected value of the profit is: (1,000 0.3) + (2,000 0.5) + (3,000 0.2) = 1,900. You should note that the expected value is not necessarily equal to one of the possible outcomes. It measures the average profit that would be expected if the project were to be repeated many times under the same conditions. Returning to the example of Yassin, there are two possible states of the world: fine and rainy. Suppose that our decision-maker, Yassin, believes that the probability that it will be fine is 0.4 and that it will be rainy is 0.6. (Note that these probabilities add up to 1.0, as it is certain that one of the two states will occur.) We can work out the expected value of each of Yassins possible actions in terms of units of satisfaction: stay at home go to work (+10 0.4) + (0 0.6) = 4 (10 0.4) + (+30 0.6) = 14.

Yassin maximises the expected value of his satisfaction by going to work every day.

The value of information

Given an uncertain world, the expected value rule enables us to choose between alternative actions, so long as we are able to assign probabilities to the various possible states of the world. Are there circumstances in which decision makers can improve the expected outcome? Can they refine the decision making process? If Yassin knew at the start of the day what the weather was going to be, he could choose to stay at home if it was going to be fine (achieving 10 units of satisfaction) or go to work if it was going to rain (achieving 30 units). What, however, is his best choice without this information? At present, given the uncertainty about the weather, his best choice is to go to work every day. How would certain information about the weather change his choices? Assume that the probability of a fine day is still 0.4 and of a rainy day 0.6. If Yassin has perfect knowledge of the weather, he will stay at home on average four days out of 10 and go to work on average six days out of 10. The expected value of his satisfaction will therefore be: (10 0.4) + (30 0.6) = 22 This is greater than Yassins expected satisfaction if he always goes to work, regardless of the weather. That means that perfect knowledge of the weather improves Yassins decision making by 22 14 = 8. If Yassin were able to acquire a weather forecast that was correct every time he could pay up to eight units for the forecast and still be no worse off than if he did not use the forecast at all.
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A reminder of your learning outcomes

By the end of this chapter and having completed the Essential reading and activities, you should be able to: distinguish different types of decision-making define the terms opportunity cost and relevant information conduct long-term project appraisals using relevant information calculate the value of information under uncertainty.

Sample examination question

The notion of relevant costs is impractical for management practice because it ignores past cash flows. Critically discuss this statement.

Suggestions for answering the sample examination question

It might be worth pointing out that the relevant cost definition seeks to establish a theoretical yardstick for identifying how organisations can identify the most profitable courses of action. Insofar as this theoretical yardstick presents problems in practice it is useful to explain in what ways practice differs from the assumptions on which theoretical concepts are founded. In practice accountants may be uncomfortable with the idea that past cash flows are irrelevant. They often suggest that investments made in the past should be utilised. For theoretical economists, by contrast, bygones are bygone. Just because money was spent on a certain project does not mean for them that more money should be spent on it, for example, to complete it. One of the reasons why they think like this is that they assume perfect capital markets. If another, more promising project can be identified, they assume that capital can be raised for it. In reality, organisations face credit limits and may not possess the option of raising large amounts of fresh capital. Accountants realise that past cash flows produce dependencies as well as expectations that often make it attractive to stay with an ongoing project, even if new opportunities open up.

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Notes

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Chapter 3: Cost behaviour

Chapter 3: Cost behaviour

Essential reading
Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting: a managerial emphasis. (Upper Saddle River, NJ: Prentice Hall Publishing, 2009) thirteenth edition (international) [ISBN 9780135046340 or 9780131355583] Chapters 2, 10 and 3.

Aims
This chapter introduces the cost terminology used in this guide. It explains cost behaviour as fundamental to costing systems and shows how to chart fixed and variable costs. Cost-volume-profit analysis (CVP) is introduced as a key management accounting technique for diverse decision-making situations. Cost estimation is mentioned as an important topic for management accounting practice even though it is of minor theoretical relevance for the course.

Learning outcomes
After completing this chapter and the Essential reading and activities, you should be able to: distinguish different types of costs structure problems in ways that lend themselves to the application of CVP explain the differences between cost estimation techniques.

Introduction
The basic framework of the decision-making approach to management accounting may still seem somewhat abstract, but you will find that it is an important basis for approaching the remainder of this subject. It will also help you structure your thinking when you come into contact with management accounting in your future career. You have by now spent some time thinking about how to approach what if questions; what will be the effect on resources if we do X? This chapter stays with the what if question but focuses in more detail on the daily work of management accountants. It looks at costs, specifically, at what happens to costs if organisational activity varies. This is called cost behaviour. Cost behaviour depends on activities which cause costs to occur. Those activities are called cost drivers. The chapter also considers how costs can be estimated. Also, you will learn about cost-volume-profit (CVP) analysis which is a technique linking organisational activity to cost and profit that allows us to determine the minimum level of activity for profitability: the so-called break-even point.

The elements of total costs and their behaviour

Probably the biggest part of management accounting in practice is cost accounting. It measures and reports financial and non-financial information that helps managers make decisions to fulfil the goals of an organisation. The component elements of total cost may be presented as follows (sums in bold):
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Direct material cost Direct labour cost Direct expenses Prime cost Production (or factory) overhead Production (or factory) cost Administrative overhead Selling and distribution overhead Total cost

X X X X X X X X X

It should be noted that this analysis of total cost is similar to the overall analysis that might appear in a profit and loss account: the difference is that the profit and loss account reflects all the costs attributable to a particular period while the cost statement above relates to a particular product or service. Also management accounts tend not to include the detailed expenses for financing and taxation.

Direct and indirect costs

Costs are traditionally classified in a number of different ways. The first important distinction is that between direct and indirect costs. Direct costs are those that can be directly related to a cost object. A cost object can be any product or service. Direct costs include, for example, the cost of materials specifically used in manufacturing a product or providing a service, specific labour costs that can be identified with the work involved in manufacturing a product or providing a service and other expenses that can be specifically identified with a product or service. Indirect costs are those costs that cannot be specifically attributed to a good or service. Indirect costs are also known as overheads. They are often classified into: 1. production overhead: all indirect material cost, indirect labour and indirect expenses incurred in the factory from receipt of an order for goods to be produced until completion of production 2. administration overhead: all indirect material, labour and expense costs incurred in the direction, control and administration of the organisation 3. selling overhead: all indirect materials, labour and expenses involved in promoting sales 4. distribution overhead: all indirect materials, labour and expenses incurred in preparing the finished product for despatch and in distributing the product to its destination.

Fixed and variable costs

The second important way of classifying costs is as fixed or variable costs. Fixed costs are those that arise in relation to the passage of time and which, within certain output and turnover limits, tend to be unaffected by fluctuations in the level of output or turnover. Fixed costs tend to be overheads such as rent, insurance and the cost of managerial staff. It is important to remember that costs are, strictly speaking, only fixed in relation to a particular time horizon: in the very long run, no costs are truly fixed, in the sense that they cannot be altered. They will vary with large variations in production output, for example, when a second factory
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is built next to the original one. It is also important to note that costs may be fixed over a particular range of output levels but start to vary outside that range. The converse of a fixed cost is a variable cost, which is a cost that tends to follow (in the short term) the level of activity of the organisation. Traditionally, examples of variable costs have been taken as materials used, labour directly employed on production, and selected overheads such as power used to drive machines. However, with the exception of materials used, many costs are in practice (at least in the short term) effectively fixed: for example, if production workers are paid wages independent of the volume of production, and it is difficult to increase or decrease the size of the workforce, labour costs behave as if they are fixed in the short term. Variable costs are usually taken as varying linearly with the level of activity (that is, a graph of cost against activity level is an upward-sloping straight line, like exhibit 23 in your textbook), and this implies that the variable cost per unit of output is constant at all levels of output. However, in practice variable costs might not be linearly related: for example, unit variable costs might gradually decrease relative to the level of output (as would be the case where there are economies of scale available from production), gradually increase (if there are diseconomies of scale) or exhibit a more complex relationship. However, it may be possible to regard variable costs as approximately linear over a relevant range of output.

Costs in-between
Some costs do not fit neatly into either the fixed or variable categories. One important type of cost is the step fixed cost. This is a cost that is fixed over relatively short activity ranges, but which increases dramatically as the level of activity moves from one range to another. For example, for a particular range of outputs, a business may need to employ only one production supervisor on a fixed salary. However, to increase production beyond this range will require the employment of a second supervisor. The fixed cost of supervisory salaries increases suddenly and then continues at the new level until output is such that a third supervisor needs to be employed. This is graphically illustrated in exhibit 2-4 of your textbook. Another important cost category is that of semi-variable costs. These are costs that reflect both a fixed and a variable component. An example of a semi-variable cost would be a charge for electricity based on a fixed monthly charge (paid whatever quantity of electricity is consumed) and a charge per unit of electricity actually consumed (which will therefore vary with the level of activity). There are other, more complicated, relationships that might exist between activity levels and costs, but for many purposes we can assume that (at least over the range of output that interests us) total cost may be divided into a fixed element, which does not vary over the range of output, and a variable element, related linearly to output. Expressed algebraically, we can define total cost using the following equation: y = a + bx where y = total cost, a = fixed cost b = unit variable cost, x = units of output. An example of a total cost curve is represented by line AB in exhibit 3-2 of your textbook.

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Activity From your own experience, think of three examples of each of the costs discussed above. Dont forget to specify with regard to which cost object you define direct and indirect costs. 1 Direct Indirect Fixed Variable Step-fixed Semi-variable Some students mistakenly equate variable costs with direct costs and fixed costs with indirect costs (overheads). Often variable costs are direct (e.g. direct material costs) and fixed costs are indirect (e.g. rent), but this is not always the case. Importantly, what is classified as direct and indirect depends on the cost object! Activity Carefully study exhibit 2-5 in your textbook and explain all four combinations given in the diagram. 2 3

The identification of cost drivers

Much of the work of the cost accountant is involved in dividing up overall costs for particular expense items and assigning these to particular products or services, so that the total cost of each product or service may be ascertained. Sometimes, it is possible to identify whole items of cost that are specifically attributable to a particular product, in which case we are said to allocate the cost to the product. In other cases, a cost may be incurred on behalf of two or more products, and we must therefore apportion the total cost to the relevant products. We often speak in more general terms of allocation or apportionment of costs to cost objects. Those cost objects are anything for which we wish to ascertain a cost. Typically, we are interested in knowing the costs of two types of cost objects: cost units and cost centres. What do we mean by these terms? A cost unit is an arbitrary unit of production, service or time in relation to which costs may be ascertained or expressed. The unit selected must be appropriate to the organisation, be it a business or a not-for-profitorganisation, and one with which expenditure may be readily associated. Typical cost units might be physical units of production, such as a can of baked beans or a motor car, or some unit of quantity or volume, such as a kilogram of sugar or a tonne of steel. In some cases, the cost unit might be a unit of time, for example, an hour of time charged to a client by a professional (so your lawyer knows how much to bill you), or a unit of service, for example, a share purchase made by a stockbroker. A cost centre is a location, person, or item of equipment (or group of these) for which costs may be ascertained. In a factory, cost centres might be departments such as stores, maintenance, personnel or design; operational cost centres such as the machines or operators performing a particular operation; particular salespeople, departmental supervisors or managers; or particular contracts or customers. Activity Think of five further examples of cost centres.
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Allocation
To calculate total costs for particular cost objects, it is necessary to allocate or apportion costs first to cost centres and cost units. The overall criterion used for this is cost causation. If you are to calculate the economic resource consumption of cost objects it is advisable to follow the lines of causality from the cost object to the consumed resource and then to ascertain its value. The link between the two is called cost driver. Cost drivers are variables the occurrence of which drives or causes costs. Activity Study exhibits 2-1 and 2-2 in your textbook and read pages 5354. In practice this is usually not as straightforward as it sounds, particularly in a large complex operation with hundreds and thousands of machines, people, and products. Often, management accountants therefore employ a two-stage process of allocating and apportioning costs to cost objects. Firstly, costs might be assigned to cost centres on a particular basis and, secondly, the cost per cost centre further assigned to individual cost units. Several different cost drivers (they are sometimes called bases of apportionment or allocation) are used in practice, and cost accountants often attempt to select a suitable driver in the light of the cost being apportioned. Some drivers, with examples of costs for which they could be used, are: 1. capital values for insurance and depreciation of plant and machinery 2. relative area of floor space for rent, cleaning expenses, light and heat, depreciation of buildings 3. number of employees for personnel office, canteen, safety and first aid 4. number of set-ups for machines or production lines for engineering overheads, production planning overheads 5. number of purchase orders for purchase department overheads 6. number of warehouse orders for overheads for the organisations internal logistics 7. number of orders to change product design for design engineering overheads. You can see that there are different drivers available for the same costs, and the cost accountant must, in the end, select an arbitrary basis of apportionment. Activity Consider an organisation which you know well. (Take the institution where you are studying if you have little work experience.) What are its most significant cost components? Labour? Materials? Process improvement? Different forms of administration? What causes those costs? What are their drivers? How could you allocate cost to those managers or administrators who should be held responsible for them?

Cost estimation
Complete allocation and apportionment of costs may be carried out only at the end of a period, when the total costs to be assigned have been determined. If the purpose of cost attribution is simply to achieve an ex post measure of the cost of the organisations products, for the purposes of control or otherwise, then this retrospective cost attribution will be acceptable. For many purposes, however, the end of the period is too
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late: estimates of cost will be needed for planning, pricing and control purposes at the time when goods are produced and services provided, and indeed before such a time. Different techniques exist for estimating costs, some of which rely on the classification of costs into fixed and variable categories to estimate a cost function of the form y = a + bx, as discussed in the previous section. In such a function, the independent variable x is sometimes units of output, but could be a measure of input such as machine hours or labour hours. Sometimes there might be circumstances in practice where total cost is better expressed as a function of two or more variables rather than one, but for expository purposes, textbooks usually assume that total cost is a linear function of a single variable, normally output. Cost estimation usually involves two aspects: estimation of the usage of factors of production such as materials, labour and overheads, and estimation of the cost of such factors. The first method of cost estimation is the engineering method, which gets its name from estimates determined by engineers of the materials, labour and overheads required to manufacture a product or provide a service. Materials needed will be estimated from the specification of the product, labour from time and motion studies and estimates of the operations needed to make the product, and overheads from estimates of capital equipment needed and other costs to be incurred. The engineering method is particularly relevant where there is little past information on which to base a cost function, but it is costly to operate, and not always easy to carry out. However, the use of the engineering method is often associated with a standard costing system (described in more detail in Chapter 8), which helps to integrate the cost estimates into the overall control system of the organisation. Where past data exist relating to the product in question, these may be used to estimate a cost function. Past data may be used to obtain directly a cost function expressed in monetary terms or indirectly to estimate how production inputs are related to production outputs. To estimate a cost function, it is necessary for us to be satisfied that the relationship between costs and output shown in the past will give us reliable information about the relationship at present and in the future. There are three important factors to take into account when using historical data. 1. Choice of independent variable: we usually select output level, although the total cost for an item may depend on many factors, such as level of output, total machine hours, total labour hours, volume and quality of materials and so on. While cost estimates might be more accurate if a multivariate cost function were used, it is likely that the various variables selected will themselves depend to a great extent on the level of output. If the independent variables are not truly independent, there is little extra benefit from a multivariate function in comparison with a univariate one, where the independent variable is level of output. 2. Selection of time period: the period covered by past data should be reasonably long, so as to allow for a large number of observations, but circumstances during the period should be comparable to the current and future environment, so that it is reasonable to use cost functions based on past data for future cost estimations. In this context the learning curve effect may assist in the estimation. This effect arises because organisations tend to become more efficient at the production of an item as time passes. Initially, the product is new, the workforce has to learn how to make it, the specification of the product may need to be modified in the light of manufacturing experience, and, overall,
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unit costs will be relatively high. As time passes, the organisation becomes more experienced and efficient at manufacturing the product, and unit costs fall. The graph of unit costs over time shows a curve which falls rapidly to begin with and then starts to level off. This is called the learning curve. In order to estimate future costs, it is necessary either to exclude or to adjust observations where the learning curve effect is likely to be significant. 3. Examination of accounting data: it is important to make sure that any biases, which might be induced in the data by the methods by which the data are compiled, are identified and adjusted for. Where data cover a long time period, allowance must be made for inflation so that the cost function reflects current prices. When the data have been collected and, where necessary, adjusted to reflect inflation and accounting biases, they may be used to estimate a cost function. This estimation may be carried out using approximate methods, such as basing the function on the highest and lowest values of total cost or plotting the observations on a graph of output against total cost and fitting a line to the observations visually.

Linear regression
A different approach uses the statistical technique of linear regression. This approach determines a line of best fit using the method of least squares. Your textbook describes the mechanics of calculating the least squares line of best fit (see exhibits 10-6 and 10-8), but it is worth pointing out that the actual calculations would usually be carried out in practice using appropriate computer programs. The linear regression approach has two important advantages over less sophisticated methods. First, we can estimate how good is our line of best fit, using the correlation coefficient. The closer r2 approaches 1, the closer our line of best fit explains the variation in total cost (or other dependent variable) in terms of output (or whatever other independent variable we use). Second, the linear regression method can be easily extended to cope with several independent variables, using multiple regression analysis (although this makes a computer almost essential). The computer programs used for multiple regression analysis are sophisticated, and are capable of identifying situations of multicollinearity, where the independent variables are in fact interdependent, so that a cost function based on the smallest number of significant variables may be derived. Although regression analysis is a valuable tool in cost estimation, it must be remembered that, as a statistical method, it makes various assumptions about the data that might not be true in practice. For example, it may classify data in one category despite underlying differences.

Error terms and outliers

Before discussing these, it is necessary to introduce the expression error term. The regression equation derived from the method of least squares allows us to calculate an estimated value of our dependent variable (such as total cost) for any value of the independent variable (such as total output). If we compare the estimated value with the observed value y for that level of activity x, the error term is simply the difference in y. Now, the method of least squares mathematically forces the mean of the error terms for all the observations to equal zero. This means that the regression equation derived is very sensitive to isolated observations lying far from the line of best fit, which are called outliers. If outliers were not included,
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the regression equation could be quite different (and the value of r2, measuring goodness of fit, would almost certainly be higher). It is often the case that there are special factors explaining the occurrence of specific outliers, which can be adjusted for, and it is useful to try to identify potential outliers visually before the regression calculations are performed. There are two further technical problems. 1. The method of least squares assumes that the error terms are independent of each other, but in some cases they are not: this is referred to as autocorrelation. An example arises where the observations are affected by seasonal factors, which should have been adjusted for before performing the regression. The seasonal factors will leave the observations subject to a particular underlying pattern in addition to any fundamental trend. 2. The method of least squares assumes that the likely size of the error terms is independent of the value of the independent variable: that is, the error term does not grow larger as the level of output increases. Where the size of the error term does increase (referred to as heteroscedasticity), the regression equation becomes less reliable. The existence of heteroscedasticity is often an indication that there is an underlying growth or inflation factor that has not properly been adjusted for. Standard statistical regression computer programs often determine whether autocorrelation and heteroscedasticity are significant problems. The use of regression analysis to estimate a cost function is a useful technique, but it is more of a blunt instrument than the engineering method, as it breaks total cost down only into fixed and variable elements. For many purposes, this is enough, but where detailed estimates of all the elements of total cost are needed, something like the engineering method must be used. As already mentioned, standard costing is likely to be based on engineering cost estimates, but any other detailed costing will also need such an approach. Activity Define the following: autocorrelation error term heteroscedasticity the learning curve effect linear regression multicollinearity outliers. Check that you know how to use these terms appropriately before continuing.

Cost-volume-profit and break-even analysis

The division of total costs into fixed and variable components lies at the heart of cost-volume-profit analysis (CVP), which focuses on four key business variables: costs, revenues, volume of output and profits. CVP looks at changes in total costs and in profits arising through changes in the volume of output, and may be used in decisions about pricing, the best balance (or mix) of sales from several products, and many other short-term decisions.
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An important concept in CVP analysis is that of the contribution margin (sometimes referred to simply as contribution). If we are able to divide total costs into a component which is fixed and independent of output over a particular range and a component which is variable and proportionate to output over that range, then the contribution margin is calculated by deducting variable costs from revenue. Over the output range, the contribution margin will itself be proportionate to the volume of output (assuming that the unit selling price of output is independent of volume). We may compare the contribution margin at a particular output level with the fixed costs to see whether a net profit or loss will be made at that level: where the contribution margin exceeds the fixed costs, a net profit arises, and vice versa. The point at which contribution margin is equal to fixed costs is called the break-even point at this level of output, the net profit is zero, and total costs equal total revenues. Calculating the break-even point indicates the minimum output level needed for sales of a product to be profitable. Remember that several assumptions underlie the determination of the break-even point: 1. fixed costs are constant 2. variable costs vary linearly with output 3. sales revenues per unit of output are constant 4. volume of output is the only factor affecting total cost. These assumptions are often unrealistic in practice, so break-even analysis must be regarded as a rough guide rather than a precise one. The breakeven chart is the most common way of presenting the relationship between total costs and total revenues at different output levels, and finding the break-even point. The break-even point occurs where the profit line (the line representing profit as a function of output) cuts the output axis: at this point, profit is zero. If you look closely at the break-even chart you notice that it fails to show net profit or loss clearly at different output levels. To remedy this, the profit volume chart has been developed. This is a graph of volume against profit (or loss) at each level of output. Profit volume charts and break-even charts may be used to illustrate what happens when changes occur in key variables, such as fixed costs, variable costs and selling price. Activity Compare the CVP chart in exhibit 3-2 with the profit-volume graph in exhibit 3-3 and explain how the latter is derived from the former.

A reminder of your learning outcomes

By the end of this chapter and having completed the Essential reading and activities, you should be able to: distinguish different types of costs structure problems in ways that lend themselves to the application of CVP explain the differences between cost estimation techniques.

Sample examination question

What are the principle ideas underlying cost-volume-profit analysis, what are possible applications, and what are its limitations?
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Suggestions for answering the sample examination question

This question can be answered by rereading this chapter and the textbook.

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