Cost Accounting Techniques and Tools

Cost accounting is important subject when it comes to planning and control and pricing diecisons. Effective cost accounting controls exists today that can help us to remove unwanted costs at the planning stage, or even during the progress of the operations.

COST ACCOUNTING: CONCEPTS AND TECHNIQUES

PART 1: INTRODUCTION

We all face the fundamental economic problem of how to allocate scarce resources. This is a problem that confronts every company, every government, and us as a society. It is a problem that we each face in our families and as individuals.

In the United States and throughout most of the world, there are institutions that facilitate this allocation of scarce resources. The New York Stock Exchange is one such institution, as is the London Stock Exchange, the Chicago Board of Trade, and all other stock, bond and commodity markets. These financial markets are sophisticated and apparently efficient mechanisms for channeling resources from investors to those companies that investors believe will use those resources most profitably.

Banks and other lending institutions also allocate scarce resources across companies, through their credit and lending decisions. Governments allocate scarce resources across segments of society. They collect taxes from companies and individuals, and allocate resources to achieve social and economic goals.

All of these institutions use financial accounting as a primary source of information for these allocation decisions. Investors and stock analysts review corporate financial statements prepared in accordance with Generally Accepted Accounting Principles. Banks review financial statements as well as projections of cash flows and financial performance. The Internal Revenue Service taxes income that is calculated only slightly differently from income for financial reporting purposes. In effect, the same set of financial accounting rules is used by these different users, with only minor modifications.

However, this is only part of the story, because when I buy stock in Microsoft, whether my investment turns out to be profitable depends largely on the operational, marketing and strategic decisions that Microsoft’s managers make during the time that I hold my investment. And when Microsoft’s management team sits down to decide what products to develop, which markets to enter, and how to source production, they are not, almost certainly, looking at the company’s most recent annual report or any other financial accounting report. By the time the annual report is available, the information is too old, and in any case, it is too highly summarized; there is not enough detail and not enough forward-looking data. Rather, when Microsoft’s management team makes decisions, it bases these decisions on management accounting information. This is definitional. By definition, management accounting is the information that managers use for decision-making. By definition, financial accounting is information provided to external users.   

Hence, both financial accounting and management accounting are all about allocating scarce resources. Financial accounting is the principle source of information for decisions of how to allocate resources among companies, and management accounting is the principle source of information for decisions of how to allocate resources within a company. Management accounting provides information that helps managers control activities within the firm, and to decide what products to sell, where to sell them, how to source those products, and which managers to entrust with the company’s resources.

In other news, General Motors’ common stock rose $1.10 today following the announcement that the company has successfully installed an improved management accounting system.

           

If management accounting so important, why are we not likely to see a headline like the fictional announcement shown above? There are two reasons. First, management accounting information is proprietary; public companies are generally not required to disclose management accounting data nor much detail about the systems that generate this information. Typically, companies disclose very little management accounting information to investors and analysts beyond what is imbedded in financial reporting requirements. Even very basic information, such as unit sales by major product category, or product costs by product type, is seldom reported, and when it is reported one can be sure that management believes voluntary disclosure of this information will be viewed as “good news” by the marketplace.    

The second reason we are not likely to see a headline like the one above is that most management accounting systems seem to work reasonably well most of the time. Hence, it is difficult for a company to gain a competitive advantage by installing a better management accounting system than its competitors. However, this observation does not imply that management accounting systems are not important. On the contrary, as the following news story indicates, poor management accounting systems can significantly affect the investment community’s perception of a company’s prospects.

NEW YORK TIMES OCTOBER 28, 1997 Oxford Health Plans said yesterday that it had been losing money because it fell behind in sending bills to customers and underestimated how much it owed doctors and hospitals. Shares fell 62%. Stephen Wiggins, chairman of Oxford, said the company had belatedly discovered that many customers were not paying premiums, often because the company was late in sending bills.   Oxford acknowledged that it had fallen behind in payments to hospitals and doctors as it struggled with a new computer system.With incomplete information in its computers, it had to advance money to doctors and hospitals without verifying that they were obeying Oxford's rules. Mr. Wiggins said Oxford would add about 0.5% to spending on administration next year in an effort to insure there are no similar problems. “The important thing," he added, "iswe're the same company we were on Friday, except our market value has dropped by half.”

Health insurance is a relatively stable industry. 1997 was the middle of a strong bull market. What was the problem with Oxford such that in this environment it should lose half its stock value almost overnight? The answer is that its management accounting system was broken, big time. Management accounting is something like indoor plumbing. When it functions properly, we tend to take it for granted, but when it breaks down, we quickly develop a greater appreciation for it.

Definition and Scope of Management Accounting:

Management accounting is the process of measuring and reporting information about economic activity within organizations, for use by managers in planning, performance evaluation, and operational control:

-         Planning: For example, deciding what products to make, and where and when to make them. Determining the materials, labor, and other resources that are needed to achieve desired output. In not-for-profit organizations, deciding which programs to fund.

-         Performance evaluation: Evaluating the profitability of individual products and product lines. Determining the relative contribution of different managers and different parts of the organization. In not-for-profit organizations, evaluating the effectiveness of managers, departments and programs.

-         Operational control: For example, knowing how much work-in-process is on the factory floor, and at what stages of completion, to assist the line manager in identifying bottlenecks and maintaining a smooth flow of production.

Also, the management accounting system usually feeds into the financial accounting system. In particular, the product costing system is usually used to help determine inventory balance sheet amounts, and the cost of sales for the income statement.

Management accounting information is usually financial in nature and dollar-denominated, although increasingly, management accounting systems collect and reportnonfinancial information as well.

The mechanical process of collecting and processing information poses substantial and interesting challenges to large organizations. Also, there are important conceptual issues about how to aggregate information in order to measure, report, and analyze costs. Issues of how to allocate costs across products, services, customers, subunits of the organization, and time periods, raise questions of substantial intellectual content, to which there are often no clear answers.  

Management accounting is used by businesses, not-for-profit organizations, government, and individuals:

-     Businesses can be categorized by the sector of the economy in which they operate. Manufacturing firms turn raw materials into finished goods, and we also include in this category agricultural and natural resource companies. Merchandising firms buy finished goods for resale. Service sector companies sell services such as legal advice, hairstyling and cable television, and carry little if any inventory. Businesses can also be categorized by their legal structure: corporation, partnership, proprietorship. Finally, businesses can be categorized by their size.

-     Not-for-profit organizations include charitable organizations, not-for-profit health care providers, credit unions, and most private institutions of higher education.

-     Government includes Federal, state and local governments, and governmental agencies such as the post office and N.A.S.A.

All of these organizations use management accounting extensively. Also, individuals use the economic concepts that form the foundation of management accounting in their personal lives, to assist in decisions large and small: home and automobile purchases, retirement planning, and splitting the cost of a vacation rental with friends.

Management Accounting and Financial Accounting Compared:

The field of accounting consists of three broad subfields: financial accounting, management accounting, and auditing. This classification is user-oriented. Financial accounting is concerned with communicating accounting information to external parties. Management accounting is concerned with generating accounting information for managers and other employees to assist them in performing their jobs. Auditing refers to examining the authenticity and usefulness of all types of accounting information. Other subfields of accounting include tax and accounting information systems.

Because many students taking management accounting have just completed a course in financial accounting, it is useful to examine the ways in which management accounting differs from financial accounting:

Financial Accounting	Management Accounting
Mandatory for most companies. Financial reporting is required byU.S. securities laws for public companies. Private companies with debt are often required by lenders to prepare audited financial statements in accordance with GAAP.	Mostly optional. However, it is inconceivable that a large company could operate without sophisticated management accounting systems. Also, legislation such as the Sarbanes-Oxley Act of 2002 sets minimum standards for public companies for their internal reporting systems.
Follows Generally Accepted Accounting Principles (GAAP) in theU.S., and other uniform standards in other countries.	No general principles. Companies often develop management accounting systems and measurement rules that are unique and company-specific.
Backward-looking: focuses mostly on reporting past performance.	Forward-looking: includes estimates and predictions of future events and transactions.
Emphasis on reliability of the information	Can include many subjective estimates.
Provides general purpose information. Investors, stock analysts, and regulators use the same information (one size fits all).	Provides many reports tailored to specific users.
Provides a high-level summary of the business	Can provide a great deal of detail.
Reports almost exclusively in dollar-denominated amounts. A recent exception is the increasing (but still infrequent) use of the Triple Bottom Line.	Communicates many nonfinancial measures of performance, particularly operational data such as units produced and sold by product type.

These differences are generalizations, and are not universally true. For example, GAAP allows some important choices, such as the FIFO or LIFO inventory flow assumption. Also, GAAP uses predictions of future events and transactions to value assets and liabilities under certain circumstances. Nevertheless, the differences between financial accounting and management accounting shown above reveal important attributes of financial accounting that are driven by the goal of providing reliable and understandable information to investors and regulators. These individuals are often far removed from the companies in which they are interested, so a regulatory and self-regulatory institutional structure exists to ensure the quality of the information provided to them.

For example, financial accounting uses historical information, not because investors are interested in the past, but rather because it is easier for accountants and auditors to agree on what happened in the past than to agree on management’s predictions about the future. The past can be “audited.” Investors then use this information about the past to make their own predictions about the company’s future.

As another example, financial accounting follows a set of rules (GAAP in the U.S.) that investors can study. Once investors obtain an understanding of GAAP, the fact that all U.S. companies comply with the same rules greatly facilitates investors’ ability to follow multiple companies. Also, the fact that financial reporting is mandatory for all public companies ensures that the information will be available.

Management accounting, on the other hand, serves an entirely different audience, with different needs. Managers need detailed information about their part of the organization, so management accounting provides detailed information tailored for specific users. Also, managers must make decisions, sometimes on a daily basis, that affect the future of the business, and they need the best predictions of the future that are available as input in those decisions, no matter how subjective those estimates are.  

Management Accounting Institutions:

The most important professional association of management accountants in the U.S. is the Institute of Management Accountants (IMA). There are similar organizations in other countries. Formerly the National Association of Accountants, the IMA has about 100,000 members. Its headquarters are in Montvale, NJ, outside of New York City, and there are local chapters throughout the country.

The IMA sponsors the Certified Management Accountant’s certification program. Certification requires passing the CMA examination, and working for two years in a field related (at least loosely) to management accounting. The exam is similar to the CPA exam, although it is broader in scope and places less emphasis on financial reporting and auditing. Unlike the CPA certification, which is required by state laws of accountancy for practicing public accountants, the CMA certification is voluntary. Next to the CPA, the CMA and CIA (Certified Internal Auditor) are probably the most widely-recognized certifications of accountants in the U.S.

The IMA issues a Code of Professional Ethics for management accountants, which is mandatory for CMAs. The Code clearly indicates that management accountants have responsibilities to the public as well as to organizations for which they work. The Code provides explicit guidance on how management accountants should respond to questionable or clearly improper financial or regulatory reporting practices in their organizations, which is probably the most difficult ethical issue that every management accountant should be prepared to encounter. Anyone who becomes a management accountant (even if he or she does not become a CMA), and anyone who works with or supervises management accountants, should become familiar with the CMA’s ethical standards.

The IMA supports research on management accounting, sponsors continuing education seminars, publishes materials on management accounting topics (some of which are available at no charge from the IMA website), and publishes a monthly magazine called Strategic Finance (prior to March 1999, the magazine was calledManagement Accounting). Strategic Finance is probably the premier management accounting magazine for practitioners in the U.S.   

A Note on Terminology:

Because management accounting developed over many decades in a decentralized fashion, within leading companies of the day and without the direction of a regulatory or self-regulatory rule-making body, terminology has evolved that is sometimes redundant and sometimes inconsistent. A single concept can go by multiple names, and the same term can refer to multiple concepts.

For example, full costing has two meanings, one of which is synonymous with absorption costing. Variable costing is synonymous with direct costing, and overhead is synonymous with indirect costs. However, direct costs, direct costing, and the direct method of cost allocation all refer to different concepts and techniques. 

There is nothing “normal” about a normal costing system. A standard costing system is closely related to—but not quite synonymous with—the concept of a standard cost.

Management accounting and managerial accounting are synonymous. However, the relationship between these terms and cost accounting is ambiguous. Many accounting practitioners use these terms interchangeably. When cost accounting is distinguished from management accounting, cost accounting sometimes refers to accounting for inventory, and as such, the term applies primarily to manufacturing and merchandising firms. In this case, cost accounting would be a large subset of the management accounting system, because most but not quite all of the accounting activity inside manufacturing and merchandising companies relate to inventory. Alternatively, cost accounting is sometimes distinguished from management accounting in the following way: if the answer depends upon the accounting techniques employed, the question is a cost accounting question; if the answer is independent of the accounting techniques employed, the question is a management accounting question. For example, the valuation of ending inventory depends on whether the company uses the LIFO (last in, first out) or FIFO (first in, first out) inventory flow assumption. That is cost accounting. However, the determination of whether the company would be more profitable in the long-run by closing the factory and sourcing product from an independent supplier is independent of the inventory flow assumption or any other accounting choice. That is a management accounting problem.

Even recent advances in management accounting are sometimes associated with ambiguous or redundant terminology. For example, supervariable costing is synonymous with throughput costing.

Textbooks usually shelter students from this ambiguity in terminology, by defining terms carefully, avoiding redundancy, and maintaining consistency. However, the ambiguity exists out there in practice.