97 management accounting complete

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Management accountingT. Ahrens

2790097

2005

Undergraduate study inEconomics, Management,Finance and the Social Sciences


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Contents

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Contents

Introduction 1

Aims 1

Learning outcomes 1Why study management accounting? 1

Organising your studies 2

Essential reading 4

Further reading 4

Examination advice 5

Abbreviations 6

Chapter 1: Modern management accounting 7

Essential reading 7

Further reading 7

Aims 7

Learning outcomes 7Introduction 7

Management accounting, cost accounting and financial accounting routineand non-routine information provision 8

From record keeping to problem solving? The strategic turn in management accounting 9

Price leadership and differentiation 10

Calculating success 10

Strategic management accounting 11

Information technology 11

Enterprise Resource Planning Systems (ERP) 12

Planning, controlling and experience 13

The budgeting process and beyond budgeting 14Decision-making and organisational goals 15

Stakeholders 15

Sample examination question 16

Suggestions for answering the sample examination question 16

Chapter 2: Decision-making 17

Essential reading 17

Further reading 17

Aims 17

Learning outcomes 17

Levels of decision-making 17

The importance of cash flows 18Opportunity costs 19

The concept of relevant costs and revenues 20

Identifying relevant costs and revenues 21

Purchased resources 21

Resources already under the organisations control 22

Decision-making and current replacement cost 22

Comparing cash flows in the long run 23

Discounting 24

The net present value decision rule 24

Making estimates for project appraisals 25

Problems with the opportunity cost concept 27Uncertainty and relevant information 28

Characteristics of useful information 28


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Objective and subjective probabilities 29

Expected value 30

The value of information 30



Chapter 3: Cost behaviour 33

Essential reading 33Aims 33


Introduction 33

The elements of total costs and their behaviour 33

Direct and indirect costs 34

Fixed and variable costs 34

Costs in-between 35

The identification of cost drivers 36

Allocation 37

Cost estimation 37

Linear regression 39Error terms and outliers 39

Cost-volume-profit and break-even analysis 40



Chapter 4: Costing and pricing 43


Aims 43


Costs and pricing 43

Contribution margin pricing 44

Short-term decisions with one scarce resource 45Contribution per bottleneck resource 46

More than one scarce resource: linear programming (LP) 46

Dual prices (shadow prices) and opportunity costs 48

Dual (shadow) prices 49

Opportunity costs 49



Chapter 5: Budgeting and control 51


Further reading 51

Aims 51Learning outcomes 51

The purposes of budgets 52

Budget organisation 53

Budget frequency 53

Types of budgets 54

Budgeting and control 55

Variance analysis 57

The interpretation of variances 59



Chapter 6: Traditional cost systems 61Essential reading 61

Aims 61

Management accounting

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Chapter 9: Performance measurement systems 89


Further reading 89

Aims 89


Introduction 89

Main components of performance measurement systems 90

Financial records 90

Responsibility structures 90

The three most common responsibility centres: cost centres, profit centresand investment centres 91

Transfer prices 91

Transfer-pricing methods 91

Gasoil & Co. 92

Divisional and corporate profit calculations 93

How a transfer price may lead to sub-optimal decisions 94

Financial measures 95

Divisional performance 97



Chapter 10: Strategic management accounting 99


Further reading 99

Aims 99


Target costing 100

Life cycle costing 101

Quality costs and the theory of constraints (TOC) 101

Costs of quality 102

Techniques used to identify quality problems 103

Theory of constraints (TOC) 104

Bottlenecks 104

The balanced scorecard 104

Lead and lag indicators 105

Evidence 106

Outlook 106

Enabling management control systems 107



Appendix: Sample examination paper 109


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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 Elements of accounting and finance (or 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 online through the University of London online library (see below

Reading). 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 objectives

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.

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


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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 essentialreading 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 objectives 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 maintext. As you read, try to relate the text to the learning objectives 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 theindividual 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.

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 isappropriate 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

Introduction

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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

Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting: a

managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition(international) [ISBN 0-13-099619-X].

This subject guide is largely a commentary on that book and I recommend

that you purchase it. If you find a tenth edition second hand (at a good

price!) it would be equally suitable.

Further reading

It is essential that you support your learning by reading as widely as possible

and by thinking about how those principles apply in the real worlds. To help

you read extensively, all external students have free access to the University

of London online library where you will find either the full text of or an

abstract of many of the journal articles listed in this subject guide. You will

need to have a username and password to access this resource. Details can be

found in your handbook or online at:

www.external.ull.ac.uk/index.asp?id=lse

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(2004) 21(2): 271301.

Ahrens, T. and C.S. Chapman Occupational identity of management

accountants in Britain and Germany.European Accounting Review (2000)

9(4): 477498.

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: 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.

Cooper, R. and R.S. Kaplan Measure Costs Right: Make the Right Decisions,

Harvard Business Review (SeptemberOctober 1988): 96103.

Cooper, R. and W.B. Chew Control Tomorrows Cost Through Todays Design,

Harvard Business Review (JanuaryFebruary 1996): 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: 351.

Friedman, A.L. and S.R. Lyne Activity-based techniques and the death of the

beancounter,European Accounting Review (1997) 6(1): 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 (1980) 58(4): 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: 7387.

Ittner, C. and D. Larcker Moving From Strategic Measurement to Strategic Data

Analysis, C.S. Chapman (ed.) Controlling Strategy: Management, Accountingand 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: 8895.


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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): 131140.

Kaplan, R.S. and D.P. Norton Transforming the Balanced Scorecard from

Performance Measurement to Strategic Management: Part I,Accounting

Horizons (2001a) 15(1): 87105.Kaplan, R.S. and D.P. Norton Transforming the Balanced Scorecard from

Performance Measurement to Strategic Management: Part II,Accounting

Horizons (2001b) 15(2): 147161.

Mouritsen, J. Five aspects of accounting departments work,Management


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:

257288.

Roslender, R. and S.J. Hart In search of strategic management accounting:

theoretical and field study perspectives,Management Accounting Research

(2003) 14(3): 255279.Sahay, S.A. Transfer Pricing Based on Actual Cost ,Journal of Management

Accounting Research(2003) Vol. 15: 177193.

Simmonds, K. Strategic Management Accounting,Management Accounting

(1981) 59(4): 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: 110.

Verdaasdonk, P. and M. Wouters A generic accounting model to support

operations management decisions,Production Planning & Control,

(September 2001) Vol. 12 Issue 6: 60521.

Examination advice

Important: the information and advice given in the following section 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 currentRegulations for

relevant information about the examination, and the current Examiners

reports 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 forthree 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 and at least one from each section. 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 journalarticle reading, and also with other subjects, such as Elements of

accounting and finance (or Principles of accounting).

Introduction

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Before you are examined, you will be sent past examination papers and

associated Examiners reports for this unit. The Examiners reports 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 reports are valuable resources when preparing for the examination.

Both question papers and reports for the last three years are available online

but you should be aware that the syllabus and subject guide were revised for

2005 and bear this in mind as you look at past examination papers. You

should also consult the Examination section of your Student Handbook.

Abbreviations

Following is a list of abbreviations used in this subject guide.

ABC activity-based costing

ABM activity-based management

CVP cost-volume-profit analysis

ERP enterprise resource planning system

JIT just-in-time inventory system

LP linear programming

NPV net present value

OWM owners wealth maximisation

R&D research and development

RI residual income

RoI return on investment

SMA strategic management accounting

TOC theory of constraintsWACC weighted average cost of capital


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Chapter 1: Modern management accounting

Essential reading

Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting: amanagerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition

(international) [ISBN 013099619X] Chapter 1.

Mouritsen, J. Five aspects of accounting departments work,Management


Further reading

Ahrens, T. and C.S. Chapman Occupational identity of management

accountants in Britain and Germany,European Accounting Review (2000)

9(4): 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 (1997) 6(1): 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,

(2003) 14(3): 255279.

Simmonds, K. Strategic Management Accounting,Management Accounting

(1981) 59(4): 2629.

Simon, H.A. Centralisation Vs Decentralisation in Organizing the ControllersDepartment. (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 reading this chapter and the essential reading, 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.

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


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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 financialaccounting 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 andnon-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. Non-routine

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., 2003),

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 communicationof 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. 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, thuspotentially enhancing profitability. Management accountants may therefore

decide to include a notional interest charge on working capital when


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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., 2003, p.836). Cost management, by contrast, is defined by Horngren et

al. (2003) 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. (p.837). 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.

Table 1.1: A comparison of financial accounting and management accounting

Characteristics of Characteristics offinancial accounting management accounting

Users of information

Extent of formal regulation

Degree of uniformity acrossdifferent organisations

Degree of detail

Likelihood of includingnon-financial information

Relevance for managerialdecision-making

From record keeping to problem solving? The strategic turnin 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 andits own specific access to labour and capital markets.


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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 ofcustomers 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 theextent 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 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 oforganisations tend to change in many respects at the same time from one

reporting period to the next.


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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.

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 administerinformation systems and serve simply as mediators between an


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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 ofbudgeting 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.

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 lagsbetween updates of different systems a common problem within traditional

information technology environments.


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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 usedto 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 day-to-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 themodernisation 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 juniormanagement 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.

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 havethemselves 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


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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 organisationalfuture. 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 thiscase 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, co-ordinate 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 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 problemslie 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 web site http://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).


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Activity

Visit www.bbrt.org and have a good look around the web site, 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 goalsUnderlying 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. Theorganisation 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 organisationsmay, 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.

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 inways 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 missionstatement would then appear as a temporary settlement of ongoing dispute

that depends on the shifting powers of organisational sub-groups with

conflicting (and presumably changing) interests.


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The implications for the role of management accounting in decision-making

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 differentorganisational coalitions to attempt to use information selectively to present

the management accounting information most suitable for their causes.

Sample examination question

To what extent do you regard the current concerns with the strategic

relevance of management accounting as technologically driven?

Suggestions for answering the sample examinationquestion

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 managementaccounting purely driven by considerations of strategy making?


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Chapter 2: Decision-making

17


Essential reading

Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting:a managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition

(international) [ISBN 013099619X] 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: 7387.

Verdaasdonk, P. and M. Wouters A generic accounting model to support

operations management decisions,Production Planning & Control

(September 2001) Vol. 12 Issue 6: 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 decision-making

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 andrelevant costs for the unit as a whole and for the examination.

Learning outcomes

After reading this chapter and the essential reading, 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 whichmanagement 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 theorganisation, 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 thestrategic 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.

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,


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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 underconsideration. 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 379 (bottom of page)380 and the concepts in action box on page 381 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 decision-

making purposes, the most relevant economic benefits are likely to be

expressible in terms of cash.

Activity

What opportunity costs did you incur by enrolling on the University of Londons External

Programme?


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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, anythingthat 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 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 affectedby 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


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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 wagesand 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 isestimated 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 currentpurchase 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 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


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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 whowould 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 375377) and work through example 2.

Decision-making and current replacement cost

You should note carefully that, for decision-making purposes, the originalhistorical 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 at the time they were incurred).

A common criticism of this accounting convention is that the costs it reports

are not relevant for decision-making. 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 accountingallocation) 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.


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Activity

A department store considers closing one of its branches. Which of the following list is

relevant information?

Information on Yes NoHourly 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

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 ofinvestment, 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 ofcomparing cash flows at different points in time intuitively, through an example. Supposeyou are selling a piece of land today. The selling price is $1,000.As you sign the contract, thebuyer offers you to pay you $1,100 in a years time instead of $1,000 now. Assume thati, the cost of lending and borrowing (you can also think about it as the cost of capital) is9 per cent per year (also often expressed as p.a. = per annum). Would you rather bepaid 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 loseby accepting payment in one years time?)


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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 x 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 x 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). Wecalculate 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 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 outflowsassociated with the project

2. discount the cash flows at an appropriate discount rate


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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.

ActivityNow read the section Discounted cash flow (pages 720722) 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 l

97 management accounting complete

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