Costing and Budgeting in Management Accounting - Assignment Example

Unit 9: Management Accounting: Costing and Budgeting 9 1. ify different types of cost. It is important for managers of a company to periodically read and scrutinize management accounting as it helps them to take major decisions regarding functioning of the company. They can garner both financial and non financial information from management accounting. According to CIMA (Chartered Institute of Management Accountants), management accounting has been defined as “the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of information that is used by management to plan, evaluate, and control within an entity and to assure appropriate use of an accountability for its resources” (Belkaoui, 2002, p.2). There is a basic difference between management accounting and financial accounting. While the former provides necessary information to the management so that they can make right decisions for the company, the latter provides financial data to the shareholders, creditors and other stakeholders so that they can get information about past and present conditions of the company. Management accounting provides information about future trend of the company as managers need this information to make long term decisions while financial accounting provides factual data to shareholders and creditors so that they assess the performance of the company as their funds are in stake. One major purpose of management accounting is to provide cost information about products and services. Costs are classified into five broad groups – behavior, traceability, controllability, relevance, and function. Behavior costs can be fixed, variable or mixed. Fixed costs do not change with increase in the volume of production like rent, variable costs can increase with increase in the volume of production like wages and cost of raw materials, and mixed costs are combination of both fixed and variable costs. Traceability costs can be direct costs that are incurred specifically for production like wages of factory workers, and indirect costs that cannot be specified as specific cost of production like salaries of office employees. Controllability costs can be controllable like wages of workers since number of labors can be reduced with proper management, and uncontrollable costs like house rent has to be paid irrespective of the volume of production. Costs of relevance can be sunk, out-of-pocket, and opportunity costs. Sunk costs are those expenses that have been made and cannot be recovered like costs incurred in installing a machinery which turns out to be unproductive. Opportunity costs are not actual expenses but loss of making increased revenue by choosing to do one activity over another. For instance, a company may buy a land to add to its fixed assets and then does not have sufficient funds to buy machinery at a discount. This means the company will lose the opportunity to increase production. In this case, the company will have to buy the machinery later when there will be no discounts, and that will be out-of-pocket expenses. Finally, function costs can be product costs that are incurred for the period of production or period costs which are incurred during a fiscal year. World Travel Ltd. is considering opening two new offices in Birmingham and Glasgow. For this purpose the company needs to estimate future increased sales, to avoid incurring expenses more than the projected revenues from increased sales. 9.1.2. Use different costing methods. There are various methods of costing that different companies use to ascertain their cost of products. The method which is used by any company depends upon the type of product it manufactures and the production system it applies. With the help of manufacturing costing methods, it is possible to know the value of inputs and outputs of production process. The information that is ascertained with the help of a rigid accounting system, the cost per unit of production can be ascertained. Based on this information, management can made decisions regarding future investments, increasing production level, etc. The different methods of costing will be discussed in this section. One method of costing is job costing which is concerned with estimating the cost of each job or work order. This method is applied by those companies that execute work according to order from customers like printing shops where customers place orders for printing documents. In such a case, a job cost sheet is needed to be created to know the profit or loss from each job. Then there is contract costing which a company uses in case of contract jobs by construction of a bridge. In this case, each contract job is granted as a distinct cost unit to make decisions regarding cost management. The third method of costing is batch costing and is implemented in those companies that treat each batch of production as a distinct cost unit. Here, batch of production means similar kinds of products like in a toy factory there can be separate production units each for dolls, balls and toy cars. In this case, the total cost of a production batch is divided by the number of units produced to ascertain the cost per unit of each type of product. Then there is process costing in those companies where there are different production processes to arrive at the final product. Here, each process of production is considered as a separate cost unit. In these companies, the output of one production process becomes the raw material for the next production process like in textile or chemical industries. The fifth method of costing is service costing which is applied in companies that provide certain services to customers like a water supply company or an electricity company. The final method of costing is operating costing where the production is a single continuous process like mines or drilling. In this case, the total cost of production is ascertained to find out cost per unit to determine the profit or loss. There is also multiple costing which is a combination of one or more of the above mentioned methods of costing depending upon the production process and type of product or service. 9.1.3. Calculate costs using appropriate techniques. The different costing methods can be calculated with appropriate techniques. Various costing problems that occur in practical situations can be solved by using different kinds of techniques. Direct costs include wages and salaries of workers, and this does not only include the monetary payment every month but also other benefits given to them the employees like health insurance, house rent allowance, paid leaves, maternity leaves, etc. The regular technique is to add the total wages and salaries, and dividing the total amount with the total number of employees to find out the average amount. However, in every company not all employees receive same amount of salary or same kinds of benefits like older employees will have different insurance premiums than the younger group. Although a rough estimation can be made by averaging the salaries of all employees, given the fact that some employees receive greater benefits than others, it is prudent to separate calculation for each group of employees based on the benefits they receive. Net present value (NPV) is defined as the difference between the net current cash inflows and the net current cash outflows over a period of time. For example, in case of making any investment decisions, first it is required to calculate the net cash revenue that can be earned for the entire period of the investment. Then, the second step is to discount the interest rate that will be equivalent to the risks associated with the investment. The resultant value will be the investment’s net present value. The investment will be profitable if this value is greater than zero. In short, NPV is the amount derived by deducting initial costs of a project from future cash inflows. Therefore, World Travel Ltd. needs to consider NPV to estimate the cash revenues that can be earned from opening new offices. Benefit cost analysis (BCA) is the process by which business decisions are made. It is the calculation of expected gains from a new business venture by subtracting the costs that will be incurred to set up the business. For example, if a foreign owned company decides to set up a factory in a developing country, then it will have to consider the BCA by comparing the benefits and costs at market price. If the benefits exceed, then the investment on the factory will be profitable for the owner of the company. Similarly, World Travel Ltd. will have to use BCA to assess the profitability of opening the two new offices. 9.1.4. Analyse cost data using appropriate techniques. There are three types of cost analysis techniques – cost allocation, cost effectiveness analysis, and benefit cost analysis. Cost allocation is comparative a simpler techniques. It is an accounting tool that allows management to assess the cost of production per unit or cost incurred per service. The other two types of cost analysis techniques involve looking at the long term investments, and therefore can be considered by World Travel Ltd. as it will be making long term investments on new offices. From analysis of cost data, many information can be derived. First, it can tell the benefits of any future investments and this will help management to make expansion decisions. Second, cost data can tell the benefits of the current production process or service, and what kind of interventions can prove to be cost effective. Third, analysis of cost data can also reveal the ways to reduce extra costs. Since cost analysis techniques include a systematic collection of necessary data, therefore the information can be accurate. With the help of the information received from cost data analysis, management can make decisions regarding allocation of resources and funds. However, there are certain complications attached to cost analysis techniques like they need great deal of technical knowledge and skill. There are several steps that can be taken to assist proper cost analysis techniques. First thing is to understand the definite structure of the company and its annual goals and objectives. Second thing is to identify all the direct costs of production, and accordingly assign them to the particular project. For instance, if an employees is devoting half his time to one project and another half of his time to another project, then half of his salary should be assigned to each project. Similarly, indirect costs also need to allocated to different programs. Based on this, each project’s total cost can be calculated as the sum of its direct costs and allocated indirect costs. 9.2.1. Prepare and analyse routine cost reports. Cost reports provide information about expenses incurred over a specific period of time. Cost reports can be divided into two categories – routine reports and special reports. Routine report is the most common form of cost reports that is maintained by every organization. It is prepared based on a pre-determined period of time like cost reports are made for every week or every month. There is need to be given a specific time for the person responsible to prepare cost reports. This specific time is dependent on the various elements like extent and details of each report, the authority who will be responsible for studying the weekly or monthly reports, required data to derive information for the report and the date within which the data will be available to the person who will be preparing the cost reports. Special reports are needs during special period when special events take place. In the case of World Travel Ltd., since it is considering expansion of business activities, special reports need to be prepared to keep track of the expenses incurred on expansion activities. Special reports are not prepared for a specific period and so they are not limited by any time frame. For the preparation of special reports, it is important that there is coordination between different departments and functions. Other than business expansion, special reports are prepared when there is sudden fall of sales level, new products are about to be launched in the market, new technology will be implemented in the production process, introducing new training programs for employees, and also special reports are made when there is sudden malfunctioning of plants and machinery. Moreover, the manner in which cost reports will be prepared also depends upon who will be studying the reports. For instance, reports can be prepared for top level management and executives, or heads of various departments, or for lower level personnel like factory supervisors or section officers (Mittal, 2006, p.834). 9.2.2. Use performance indicators to identify potential improvements. Performance indicators are the tools with which the performance of an organization is assessed and monitored at regular intervals. For some organizations, successful performance indicates smooth running of the organization with daily functions operating without any difficulties. For these organizations success means full customer satisfaction, zero defects, etc. For other organizations, success means faster achievement of goals than the previous year. For World Travel Ltd., success indicates expected revenues from the new offices that will be opened in Birmingham and Glasgow. Therefore, after considering the purpose of the organization, it is important to implement appropriate performance indicator tools. There are various categories of key performance indicators like quantitative indicators, practical indicators, directional indicators, actionable indicators, and financial indicators. Quantitative indicators are numerical data that describe the company’s performance. Practical indicators assess various functions of the company. Directional indicators provide data that inform where the company is making progress or not. Actionable indicators provide information that tells whether the activities of the company are well in control so that expansion activities can be started. Financial indicators provide the current financial picture of the company. For World Travel Ltd., appropriate performance indicators will tell whether the company is ready for expansion, and whether it has sufficient resources to open new offices in new regions. Performance indicator tools should be easy to implement and should be easy to understand. Before implementing key performance indicator tools, it is necessary to have information about the structure of the company, and the requirements of the performance indicator tools. Performance indicator tools can follow the SMART criteria. This means the tools must be implemented for a specific purpose like World Travel Ltd. needs to know the financial position of the company so that management can make proper decisions regarding its expansion. Performance indicator tools need to assess the company’s performance in measurable terms so that its growth can be understood. Moreover, the process of implementing performance indicator tools need to be achievable, and the improvement of the tools need to be relevant to the performance of the company. 9.2.3. Suggest improvements to reduce costs, enhance value and quality. The purpose of garnering information is that management needs to be updated about proceedings of the company so that it can make right decisions to convert all its resources into profitable ventures. Enhancing quality of production is one major way of reducing costs. Poor quality can lead to increased cost as it cause wastage of raw materials. Value analysis is another essential element of a company as it is a “functionally oriented scientific method to improve the product value from the customer’s point of view with reference to the elements of the product cost in order to accomplish the desired functions at the least cost of the resources deployed to produce the product” (Mukherjee, 2006, p.97). While value analysis is concerned with existing products and services, value engineering is concerned with designing of new products. The principle goal of value analysis is to scrutinize those aspects of production which are proving to be too much cost oriented, and to find ways to reduce or eliminate those aspects of production or modifying the aspects to make them more cost effective. Value can be of two types – use value which is the practice condition of the product, and esteem value which is enhanced value of the product created by marketers. Enhanced value is created by smart strategies of promotions so that consumers will start believing the product has more value than other similar products in the market. For value analysis, several steps can be taken. First, there should be information about the product’s future potentials as well as market demand of the product. Second, alternate designs can be created which should fulfil the needs of the market, and it is important to assess the value of the alternate designs. As for value engineering, there are several factors like a product can be redesigned to fulfil the latent desires of consumers. It is important to implement technologies for increasing both the quality and quantity of production of goods and services with minimum labour and reduced costs. Every business is part of a competitive market. Improvement of quality can ensure reduced wastes and increased consumer demand. In many cases managers view quality as burden on costs and so gives it less importance than cost and delivery. This is because they believe that quality can be enhanced only through expensive technological processes and slow inspection methods. Business enterprises that believe in supplying high quality goods to consumers know that by increasing satisfaction level of consumers it is possible to create more demand which will increase sale volumes which in turn will offset any extra costs associated with quality production. Moreover, these enterprises are also aware that in the long run cost of quality production will decline because of technological improvement and efficient processes will occur due to quality improvement effort. 9.3.1. Explain the purpose and nature of the budgeting process. Budget is the financial planning made by an organization in the context of future income and expenditure. Any company is engaged in financial relationship with suppliers, banks, debtors, creditors, government agencies, and so on. By analyzing the financial transactions with each party, it is possible to know the current positing of the company. There are three main purposes of budgeting. First, the future income and expenditure can be estimated which means probable profits can be found out. The second purpose is to provide the management a financial framework based on which major decisions can be taken. Moreover, budgeting helps to compare the estimated profits and the actual profits of a company. With the help of budgeting management will become cognizant about maximum profits that can be made with proper utilization of resources. If actual performance of the company is below this estimation then management can focus on motivating the employees to enhance their performance. Moreover, current expenditure can be controlled to increase revenues. The performance of the company can be monitored with a proper budgeting process. Budgeting needs to be performed keeping in view the goals and objectives of a company. Budgets are way of planning the activities of an organization so as to successfully achieve its goals. On the other hand, if there is lack of concrete goals and objectives in an organization then budgeting sets the process so that the organization can find its objectives from the set actions. Thus, budgeting process “is an unfolding of the firm and its goals and a creation of part of the environment to which the corporation then adjusts” (Sabre & Ketz, 2014, p.60). 9.3.2. Select appropriate budgeting methods for the organisation and its needs. For every organization, budgeting needs to be an active process and should have significant impact on the financial outcome. One important thing is that the methods that are implemented remain aligned with the technical competence of the budgeting department so that the entire process runs smoothly. Success of a budgeting method is dependent on the efforts by the members of the organization to comply with the budget to derive optimum economic results. The budgeting method should be such that budgets can be prepared before time, i.e. before the start of a new financial year so that in the year ahead the budget can be implemented. Moreover, if during the year there is need of revisions in the budget then care should be taken that such revisions do not hamper the smooth execution of business activities. Budgeting is needed since it allows management to make prudent financial decisions so that expansion plans can be executed smoothly. For expansion, budgeting should allow increased cash inflows as there will be need of extra cash for any unforeseen issues. 9.3.3. Prepare budgets according to the chosen budgeting method. A company needs to strive to remain in competition within the framework of several internal and external factors like political, economical and social structures. The owners delegate most of their responsibilities to the senior management thus elevating the power of the management to decide a company’s objectives and to design policies for the purpose of realisation of those objectives. It is only with the guidance obtained by budgeting process, the management can make operational and strategic reconfigurations of resources for the purpose of consolidating the position of the company in the competitive market. The independent controlling power of the management separate from the owner ensures that the sole objective of profit optimization cannot be realised since the company’s policies and behaviors are also controlled by various other factors. Technically, profit can be maximized if the organization can detect “marginal cost, marginal revenues and production output up to a point where marginal cost of the last unit produced just equates to the marginal revenue received from its sale.” (Haslam et al, 2000, p.4) In fact, a set of rules and regulations of accounting helps the management to identify the production cost and sale price of each unit to determine the company’s performance in the fields of production and sales. The annual reports reflect the performance patterns of a company from one period to the other. Based on these annual reports appropriate budgeting process needs to be selected. 9.3.4. Prepare a cash budget. Cash budget portrays the actual financial condition of a company, since it plans the future activities. The first thing that needs to be done is to estimate the cash inflows of future specific period, and based on the available cash plans can be made regarding expenses. Effective cash budgets helps to control expenses so that there is always available cash for repayment of short term and long term loans. The first step is to make a sales budget. With this, the production department will prepare a budget of how many units need to be manufactured to reach the estimated sales volume. Based on this, other managers can prepare budgets purchase of raw materials, administration costs, direct and indirect costs, etc. Final estimated cash balance is the difference between estimated cash revenues and estimated cahs expenses. 9.4.1. Calculate variances, identify possible causes and recommend corrective action. Budgets are prepared based on past records of financial transactions, and accordingly future revenues and expenses can be estimated. However, variances occur when the real cash transactions differ from the estimates ones. Variances can be favourable is sales volume is excess of estimated volume or production cost is lower than the estimated cost, and vice versa. Variance occur for several reasons like breakdown of machinery, increase of salaries, increase of cost of raw materials, changes in the market demand, etc. Based on the reasons, corrective actions can be taken. If sales become lower, then production quality can be enhanced or promotions can be boosted. 9.4.2. Prepare an operating statement reconciling budgeted and actual results. Budget statement should be prepared based on the same accounting principles that are used for preparing actual financial statement. Only then both statements can be reconciled. World Travel Ltd. needs to prepare a budget statement by estimating expenses for opening new offices. The actual statement will reflect the cash transactions for purchasing furniture and fittings for the new offices, loans for external sources, etc. Expansion can be successful if the actual cash balance remains below the estimated cash balance. 9.4.3. Report findings to management in accordance with identified responsibility centres. In most companies, there are responsibility centres to whom individual manager remain accountable. These centres designate duties and responsibilities to each manager. Managers need to prepare reports to assess the performance of each responsibility centre to compare estimated or budgeted performance of the centre and the actual performance of the centre. It is prudent to prepare a flexible budget since managers should not be held responsible for uncontrollable costs. References Belkaoui, A. (2002) Behavioral Management Accounting, Greenwood Publishing Group Mittal, D.K. (2006) Cost Accounting, Galgotia Publications Mukherjee, P.N. (2006) Total Quality Management, PHI Learning Pvt. Ltd. Sabre, R.M. & Katz, J.E. (2014) Corporate Planning and LAN: Information Systems as Forums, Academic Press Read More