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AF006 BD5 D 01
AF006 BD5 D 01
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Board of Directors
President
Vice-President Marketing
Vice-President Production
Vice-President Finance
Accounting Department
Management Accounting
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the major assumptions will be detailed below. Five categories of assumptions will be presented: 1. Basic goals 2. Role of management 3. Nature of Decisionmaking 4. Role of the accounting department 5. Nature of accounting information Basic Goal Assumptions - The basic goals or objectives the business enterprise may be multiple. For example, the goal may be to maximize net income. Other goals could be to maximize sales, ROI, or earnings per share. Management accounting does not require a specific of type of goal. However, whatever form the goal takes, management will at all times try to achieve a satisfactory level of profit. A less than satisfactory level of profit may portend a change in management. Role of Management Assumptions - The success of the business depends primarily upon the skill and abilities of managementwhich skills can vary widely among different managers. The business is not completely at the mercy of market forces. Management can through its actions (decisions) influence and control events within limits. In order to achieve desired results, management makes use of specific planning and control concepts and techniques. Planning and control techniques which management may use include business budgeting, costvolumeprofit analysis, incremental analysis, flexible budgeting, segmental contribution reporting, inventory models, and capital budgeting models. Management, in order to improve decisionmaking and operating results, will evaluate performance through the use of flexible budgets and variance analysis. Decision-making Assumptions - A critical managerial function is decision making. Decisions which management must make may be classified as marketing, production, and financial. Decisions may also be classified as strategic and tactical and longrun and shortrun. A primary objective of decisionmaking is to achieve optimum utilization of the businesss capital or resources. Effective decisionmaking requires relevant information and special analysis of data. Accounting Department Assumptions - The accounting department is a primary source of information necessary in makingdecisions. The accounting department is expected to provide information to all levels of management. Management will consider the accounting department capable of providing data useful in making marketing, production, and financial decisions. Nature of Accounting Information - In order for the accounting department to make meaningful analysis of data, it is necessary to distinguish between fixed and variable costs and other types of costs that are not important in the recording of business transactions. Some but not all of the information needed by management can be provided from financial statements and historical accounting records. In addition to historical data, management will expect the management accountant to provide other types of data, such as estimates, forecasts, future data, and standards. Each specific
Production
Units of equipment Factory workers wages Overtime, second shift Replacement of equipment Inventory levels Order size Suppliers
Financial
Issue of bonds Issue of stock Bank loan Retirement of bonds Dividends Investment in securities
An understanding of financial statements is critical to the ability of management to make good decisions. Financial statements, although prepared by accountants, are actually created by management through the implementation of decisions. The historical data from which accountants prepare financial statements result from actual management decisions. The reader and user of financial statements is not primarily the accountant but management. From a management accounting point of view, it is management rather than accountants that needs to have the greater understanding of financial statements. The income statement and the balance sheet can be viewed as a descriptive model for decisionmaking. Financial statements reflect success or lack of success in making decisions. Management can be deemed successful when the desired income has been attained and financial position is considered sound. To achieve managerial success management must manage successfully the assets, liabilities, capital, revenue and expenses. Financial statements, then, serve as a ready and convenient check list of decisionmaking areas. The basic balance sheet equation, of course, is A = L + C. A management accounting interpretation is that the assets or resources come from the creditors (liabilities) and the owners (capital). It is management responsibilities to manage both sides of the equation. That is, management must make decisions about both the resources (assets) and the sources of the assets (liabilities and capital). Each item on the balance sheet is an area of management. Stated differently each item on financial statements represents a critical area sensitive to mismanagement.
Management Accounting
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Cash, accounts receivable, inventory, fixed assets, accounts payable, etc. can be too large or too small. Given this fact, then, for each item there must be the right amount or optimum. It is managements responsibility to make the best decision possible regarding each item on the financial statements. Gross mismanagement of any single item could either result in the failure of the business or the downfall of management. Following are some examples of decisions associated with specific financial statement items: Balance Sheet Items Cash Accounts receivable Inventory Fixed asset Bonds payable Income Statement Items Sales Salesmen compensation Advertising Decision Minimum level Credit terms Order size Capacity size Amount and interest rate Price, number of products, number of sales people Salaries and commission rate Media, advertising budget
The statement that the management accountant will be required to furnish information not of a historical nature means that the accountant will have to deal with planned and estimated or future data. Furthermore, much of this data will be not be found in the historical data bank from which the accountant prepares financial statements. The management accountant may be required to do analysis requiring data of an economic nature. For example, analysis of pricing may require data about the companys demand curve. Labor cost analysis may require estimating the productivity of labor relative to various wage rates. Decision-making in Management Accounting In management accounting, decisionmaking may be simply defined as choosing a course of action from among alternatives. If there are no alternatives, then no decision is required. A basis assumption is that the best decision is the one that involves the most revenue or the least amount of cost. The task of management with the help of the management accountant is to find the best alternative. The process of making decisions is generally considered to involve the following steps: 1 Identify the various alternatives for a given type of decision. 2. Obtain the necessary data necessary to evaluate the various alternatives. 3. Analyze and determine the consequences of each alternative. 4. Select the alternative that appears to best achieve the desired goals or objectives. 5. Implement the chosen alternative. 6. At an appropriate time, evaluate the results of the decisions against standards or other desired results.
Once a strategic decision has been made, then a specific management tool can be used to aid in making the tactical decision. For example, if the strategic decision has been made to avoid stock outs, then a safety stock model may be used to determine the desired level of inventory.
Management Accounting
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The classification of decisions as strategic and tactical logically results in thinking about decisions as qualitative and quantitative. In management accounting, the approach to decisionmaking is basically quantitative. Management accounting deals with those decisions that require quantitative data. In a technical sense, management accounting consists of mathematical techniques or decision models that assist management in making quantitative type decisions. Examples of quantitative decisions include: Decision Price Inventory order size Purchase of new equipment Credit terms Sales people compensation Shortrun Versus Long-run Decision-making The decisionmaking process is complicated somewhat by the fact that the horizon for making decisions may be for the shortrun or longrun. The choice between the shortrun or the longrun is particularly critical concerning the setting of profitability objectives. A fact of the real business world is that not all companies pursue the same measures of success. Profitability objectives which management might choose to maximize include: 1. Net income 2. Sales 3. Return on total assets 4. Return on total equity 5. Earnings per share The decisionmaking process is, consequently, affected by the profitability objective and the choice of the longrun versus the shortrun. If the objective is to maximize sales, then the method of financing a new plant is not immediately important. However, if the objective is to maximize shortrun net income, then management might decide to issue stock rather than bonds to avoid interest expense. In the shortrun, profits might suffer from expenditures for preventive maintenance or research and development. In the long run, the companys profit might be greater because of preventive maintenance or research and development. Although the interests of management and the organization may be presumed to coincide, the possibility of making decisions for the shortrun may cause a conflict in interests. An individual manager planning to make a career or job change might have a tendency to make decisions that maximize profitability in the shortrun. The motivation for pursuing shortrun profits may be to create a favorable resume. The tools in management accounting such as CVP analysis, variance analysis, budgeting, and incremental analysis are not designed to deal with long range objectives and decision. The only tools that looks forward to more than one year Quantitative Criterion Maximum income Minimum total inventory cost Lowest operating costs Maximum net income/sales Minimum total compensation
Financial Statement Items Balance Sheet: Cash Accounts receivable Inventory Fixed assets Income Statement: Sales Expenses Net income
Management Accounting Tools Cash budget Capital budgeting models Incremental analysis EOQ models, Safety stock model Incremental Analysis, Capital budgeting CVP analysis, Segmental reporting Incremental analysis CVP analysis, Incremental analysis Direct costing
Management Accounting
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Figure 2.2 Management Accounting Tools 1. 2. 3. 4. 5. Comprehensive business budgeting Flexible budgeting and variance analysis Variance analysis Capital budgeting Incremental analysis Keep or replace Additional volume of business Credit analysis Demand analysis Sales people compensation analysis Capacity analysis Costvolumeprofit analysis Cost behavior analysis Return on investment analysis Economic order quantity analysis Safety stock/lead time analysis Segmental reporting analysis
6. 7. 8. 9. 10. 11.
Decision-making and Required Information The assumption that management will use management accounting tools in making decisions places a burden on the management accountant. Each tool requires special information. The management accountant will be asked to provide the specialized information needed. Management accounting texts have traditionally emphasized the mechanics of techniques with little emphasis on how to obtain the necessary data. In many cases, the inability to obtain the required information has rendered a particular technique useless. The following illustrates the kind of information required for certain selected tools: Tools Flexible budget Variance analysis EOQ models Incremental analysis Capital budgeting models Costvolumeprofit analysis Required Information Variable cost rates Standard costs Purchasing cost, carrying cost Opportunity cost, escapable costs Future cash inflows, future cash outflows Variable cost percentage, fixed cost, desired income
These relationship as discussed may be used to develop a comprehensive management accounting decision model for a manufacturing business. The complete version of this model as it applies to a manufacturing firm from a management accounting viewpoint is illustrated in the appendix to this chapter as Exhibits I, II, and III. Summary From a management accounting point of view the primary purpose of management is to make decisions that may be classified as marketing, production, and financial. The tactical decisions which must be preceded by strategic decisions provide the historical data from which the accountant prepares financial statements. In addition to being statements summarizing historical transactions, financial statements may be regarded as a descriptive model for decisionmaking. Every item or element on the financial statements is the result of a decision or decisions. For each decision, there exists a management accounting tool that may be used to make a good decision. However, the management accounting tools can be used only if the management accountant is successful in providing the information demanded by the particular tool.
Management Accounting
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Credit
Incremental analysis
Fixed Assets
Capital budgeting
Capital budgeting
Amount to pay/ not pay Amount borrow/ repay Interest rate/ lender Shares to issue Shares to retire
Bonds payable
Stockholders Equity Common stock Leverage / risk Shares to issue Amount needed ROI analysis Incremental analysis Cost of capital analysis Incremental analysis Cost of capital analysis Cost of capital Cost of issuing ROI data ROI data Cost of capital
Retained earnings
Sales
Cost of goods sold Beginning inventory Cost of goods mfd. Ending inventory Gross profit Expenses Selling Sales people salaries Commissions Sales people training Travel Advertising Packaging Bad debts Sales office rentals Office operating Home office
Salary Number of sales people Commission rate Number of new people Amount of advertising Bad debt estimate
Price of product Calls per month Fixed and vari able costs Sales forecast Market potential Bad debt prob ability
General and Admin. Executive salaries Secretaries Supplies Depreciation Travel Net income
Amounts of salaries
CVP analysis
Management Accounting
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Freight-in
Incremental analysis
Quantity discount schedule List prices Fixed and variable costs Relevant costs Wage rates Productivity rates Variable cost rates Cost factors Physical factors
Direct labor
Wage rate Number of workers Second shift/ overtime New equipment Keep or replace Wage rates
Incremental analysis
Fixed Manufacturing Overhead Fixed direct labor Utilities Production planning Purchasing & receiving Factory insurance Depreciation, equipment Deprecation, building Factory supplies Capacity Capacity Capacity Capacity Capacity Capacity Capacity Capacity Keep or replace Keep or replace Keep or replace Incremental analysis CVP analysis Incremental analysis Incremental analysis Incremental analysis Incremental analysis Incremental analysis Incremental analysis Incremental analysis Fixed and variable product cost Fixed and variable product cost Fixed and variable product cost Fixed and variable product cost Fixed and variable product cost Fixed and variable product cost Fixed and variable product cost Fixed and variable product cost
List four examples of strategic decisions. List six examples of tactical decisions. What type of financial goals may management set for the business? What is the primary role of management in a business from a management accounting point of view? In what different ways may decisions be classified? What kinds of information can the management accountant be expected to provide to management? Explain how financial statements can be used to identify the decisions that management is required to make. Management accounting consists of a set of tools. For each of the following tools list the basic information required. 1. 2. 3. 4. 5. 6. 7. Business Budgeting Costvolumeprofit analysis Flexible budgeting Return on investment analysis Segmental contribution income statements Economic order quantity model Incremental analysis
Management Accounting
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Exercise: 2.1 Strategic and Tactical Decisions For each item listed below, indicate (4) whether that decision is primarily strategic in nature or primarily tactical in nature. Classifying Management Decisions
Strategic Decision 1 2 Management has decided to sell on credit. Management has decided to keep the cash balance as low as possible. Management has set a minimum balance of $100,000 for the cash account. Management has decided to keep the turnover ratio of management as low as possible. Management has decided for this quarter that an inventory turnover ratio of 12 is desirable. Management has decided to determine the correct order size by use of an EOQ model. Management for the current quarter set the safety stock of raw materials at 1,000 units. Management has decided to use internal financing as a means of expending the business. Management has decided to issue $10,000,000 in 10 year bonds. Management has decided it wants to be a high volume seller by setting price to be the lowest in the industry. Management for the current quarter set price at $300. Management has decided to compensate sales people with an above industry average commission rate. Management for the current quarter set the sales people commission rate at 10%. Management has decided to motivate factory workers with a wage rate that is above the industry average. Management has decided that the current quarter wage rate should be $15 per hour. Tactical Decision
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11 12
13
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Helpful information
Types of Information
A. Fixed expenses B. Variable cost rates C. Demand curve D. Carrying cost of materials
E. Purchasing cost of materials F. Maximum capacity required G. Calls per monthsales people H. Escapable expenses I. Inescapable expenses
J. Cost of capital K. Direct costs L. Indirect costs M. Price of product N. Quantity discount schedule O. Cost of equipment different suppliers