CHAPTER ONE

INTRODUCTION TO MANAGEMENT ACCOUNTING

Chapter Objectives
Upon completing study of this chapter, you will be able to:
 Describe the purpose of accounting system.
 Identify the role accountant
 Explain the four fundamental management processes that help organizations to attain their
goals.
 Explain the major differences between cost, management and financial accounting.
 Briefly describe some of the major principles of cost accounting system.
 Identify ethical consideration of cost accounting.

1.1 Introduction
Your study of accounting so far has probably focused on financial accounting, which is
concerned with the preparation of information about an organization’s past operations.
This information is reported to individuals and groups external to the organization, such as
creditors and stockholders, in the form of financial statements (balance sheet, income
statement, and statement of cash flows). These external groups and individuals use the
financial statements to assist with making such decisions as generating a loan or investing in
the stock of a company.

In this course, you will study management accounting, which is also concerned with
providing information to assist with decision-making. Unlike financial accounting,
management accounting provides information for internal decision makers; that is, the
managers of an organization. Managers use this information to make decisions, such as:
 how many units to produce,
 what price to charge for the product, and
 whether to purchase a new piece of equipment.
Since the decisions managers make are different from those made by creditors and stockholders,
managers often need different information than do creditors and stockholders. In addition,
the information that managers’ need differs with the type of decision they are making.

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 1.2 Accounting Systems and Their Purposes
All accounting information is accumulated to help someone (may be a company president, a
production manager, a sales manager, a shareholder, a small business owner, a politician
and others) to make economic decisions.

In general, users of accounting information fall into three categories:

i) Internal managers who use the information for short-term planning and controlling
routine operations.
ii) Internal managers who use the information for making non-routine decisions and
formulating overall policies and long-range plans. Examples of these non-routine
decisions include:
 Investment in equipment.
 Pricing products and services.
 Choosing which products to emphasize or de-emphasize.
iii) External parties, such as investors, creditors and government authorities, who use the
information for making decisions about the company.
Each of the above purpose of an accounting system may require different ways of aggregating or
reporting data. Despite these differences, most organizations prefer a general-purpose
accounting system that can supply appropriate information for all three types of users.

An accounting system is a formal mechanism for gathering, organizing, and communicating

information about an organization’s activities. A good accounting system helps an
organization to achieve its goals and objectives by helping to answer the following three
types of questions:
I. Scorecard questions. Am I doing well or poorly?
II. Attention-directing questions. Which problems should I look into?
III. Problem solving questions. Of the several ways of doing the job, which is the best?
To answer each of the above questions, one can classify accounting data as: scorekeeping
data, attention-directing data and problem solving data, respectively. Furthermore,
depending upon the classification of accounting information, the accountant’s task of
supplying information can be identified as scorekeeping task, attention-directing task and
problem solving task.

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a) Scorekeeping task: This is an accumulation and classification of data. This aspect of
accounting enables both internal and external parties to evaluate organizational
performance. The collection, classification and reporting of scorekeeping information is
the task that dominates day-to-day accounting. Examples of scorekeeping (scorecard)
task include:
 Posting daily cash collections to customers’ accounts.
 Preparing journal entries for depreciation of equipment.
 Processing monthly payroll.

b) Attention-directing task: It is the task of reporting and interpreting information that

helps managers to focus on operating problems, imperfections, inefficiencies, and
opportunities. This aspect of accounting helps managers to concentrate on important areas
of operations promptly enough for effective action.

Attention directing is commonly associated with current planning and control, and with
the analysis and investigation of recurring routine internal accounting reports. The
following activities fall under attention directing based on the function that the accountant is
performing.
 Interpreting why a branch did not meet its sales quota.
 Interpreting variances on a post office supervisor’s performance report.
 Analyzing for the president the impact of net income of a contemplated new product.

c) Problem solving task: This task of the accountant involves quantification of the likely
results of possible courses of actions and often recommends the best course to follow.
Problem solving is commonly associated with nonrecurring decisions, situations that
require special accounting analyses or reports.
Examples of activities performed by an accountant that could be classified as problem-solving
task include:
 Preparing, for production manager, a cost comparison for two computerized
manufacturing control systems.
 Analyzing the cost of several different ways to blend raw materials in the
foundry.

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Sometimes this classification of accounting information may overlap. A single data may
serve to answer one or more of the questions to be dealt with a good accounting system. For
example, the scorecard and attention-directing data are closely related. The same
information may serve as a scorecard function for a manager and an attention-directing
function for the manager’s superior. Consider a performance reports in which actual results of
decisions and activities are compared with previously determined plans. By pinpointing where
actual results differ from plans, such performance reports can show managers how they are doing
and show the managers’ superiors where to take action. In addition the actual results help
answer scorecard questions of financial accounting, which is concerned with reporting the results
of the organization’s activities to external parties.

In contrast, problem-solving information may be used in long-range planning and in making

special, nonrecurring decisions, such as whether to make or buy parts, replace equipment,
or add or drop a product. These decisions often require expert advice from specialists such
as industrial engineers, budgetary accountants, and statisticians.

1.3 Management Process and Accounting

Many different kinds of organization affect our daily lives. Manufacturers, retailers, service
industry firms, agribusiness companies, nonprofit organizations, and government agencies,
provide us with a vast array of goods and services. All of these organizations have a set of goals
or objectives. An airline’s goals might be profitability and customer service. A city police
department’s goals would include public safety and security coupled with cost minimization.
Whatever the goals of an organization are, the task of management is to see that how much their
goals are achieved. In pursuing an organization’s goals, managers carry out four basic activities:
decision making, planning, directing and motivating and controlling. Management accounting
information plays a vital in these basic management activities.

Decision Making: In decision-making, managers choose among a variety of alternatives that

affect a particular course of action. Decisions should be based on information. Management
accountant should be flexible in providing whatever quantitative and non-quantitative
information is needed to reduce management’s uncertainty.

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In decision-making, accountants and managers have different roles. Managers usually identify
decisions to be made. Likewise, they usually are better able to identify alternatives to be
considered in a decision. For example, a purchasing manager can usually identify possible
sources for material to be used in a manufacturer’s product. The accountant is often the major
source of information that managers use to help them decide which alternative to choose. For
each alternative the manager wishes to consider, the accountant attempts to identify events that
are likely to significantly affect the outcome. For each combination of event and alternative, the
accountant provides forecasts or estimates of the likely outcome. The accountant, for example,
will forecast the cost of acquiring different amounts of material from different suppliers for the
decision considered by the purchasing manager here above. The manager then must select the
alternative to be taken. The alternative chosen depends on the manager’s beliefs about the future
events, the accountant’s forecasts or estimates, and the various outcomes.

Steps in Decision-Making Process

1. Identify the problem and uncertainties
2. Obtain information: Gathering information before making a decision helps managers gain
a better understanding of the uncertainties.
3. Make predictions about the future: On the basis of this information, makes predictions
about the future.
4. Make decisions by choosing among alternatives: When making decisions, strategy is a
vital guidepost; many individuals in different parts of the organization at different times
make decisions. Consistency with strategy binds individuals and time lines together and
provides a common purpose for disparate decisions. Aligning decisions with strategy
enables an organization to implement its strategy and achieve its goals. Without this
alignment, decisions will be uncoordinated, pull the organization in different directions,
and produce inconsistent results.
5. Implement the decision, evaluate performance, and learn: Management accountants
collect information to follow through on how actual performance compares to planned or
budgeted performance (also referred to as scorekeeping). The comparison of actual
performance to budgeted performance is the control or post-decision role of information.
Control comprises taking actions that implement the planning decisions, deciding how to
evaluate performance, and providing feedback and learning to help future decision making.
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Learning is examining past performance (the control function) and systematically exploring
alternative ways to make better-informed decisions and plans in the future. Learning can lead to
changes in goals, changes in strategies, changes in the ways decision alternatives are identified,
changes in the range of information collected when making predictions, and sometimes changes
in managers.

Planning: Planning refers to developing a detail financial and operational description of

anticipated operations. In planning, managers must decide what actions they intend to take
during the next operating period or periods and what targets they intend to achieve. To assist the
manager in the planning phase, the management accountant accumulates an information base for
forecasting future potential outcomes that may arise if an action is taken. For example,
production managers decide how many units they intend to produce. When they make this
decision, the production managers usually do not know exactly how many units will be required
to satisfy customer demands. To assist the production managers, accountants forecast the costs
of producing and storing different quantities of units. Using this information, the managers can
consider the possible consequences of producing more units than are sold.

Directing and Motivating: Directing and motivating involves mobilizing human resources to
carry out plans and run routine operations. In addition to planning for the future, managers must
oversee day-to-day activities and keep the organization functioning smoothly. This requires the
ability to motivate and effectively direct people. Managers assign task to employees, arbitrate
disputes, answer questions, solve on-the-spot problems, and make many small decisions that
affect customers and employees. In effect, directing is that part of the managers’ work that deals
with the routine and the here and now. Management accounting data, such as daily sales reports,
are often used in this type of day-to-day decision-making.

Controlling: Controlling means insuring that the plan is actually carried out and is appropriately
modified as circumstances change. In controlling, managers measure actual results against
norms to determine if operations are proceeding as planned. Management accounting generates
actual costs, compares them to planned costs, and reports major differences to management so
that management can exert influence for the purpose of bringing actual results in line with
planned results.

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In the control phase, managers seek to identify segments of the business whose actual
performances differ from planned performances. Differences between actual and planned
performances can be analyzed as to effectiveness and efficiency. Effectiveness refers to the
degree to which a goal, objective, or target is met and efficiency deals with the success in using
least resources in relation to a given level of outputs.

1.4 Comparison between Financial, Cost and Management Accounting

1.4.1 Financial and Management Accounting

Financial accounting and management accounting have different goals. Financial accounting
focuses on reporting to external parties such as investors, government agencies, banks, and
suppliers. It measures and records business transactions and provides financial statements that
are based on generally accepted accounting principles (GAAP). The most important way that
financial accounting information affects managers’ decisions and actions is through
compensation, which is often, in part, based on numbers in financial statements.
Management accounting: measures, analyzes, and reports financial and nonfinancial
information that helps managers make decisions to fulfill the goals of an organization. Managers
use management accounting information to develop, communicate, and implement strategy.
They also use management accounting information to coordinate the value chain (sequence of
business functions) i.e. Research and development (R&D), Design of products and processes,
Distribution, Customer service, production, and marketing decisions and to evaluate
performance. Management accounting information and reports do not have to follow set
principles or rules. The key questions are always (1) how will this information help managers do
their jobs better, and (2) do the benefits of producing this information exceed the costs?

*The value chain is the sequence of business functions in which utility (usefulness) is added to
the products or services of an organization. These functions are as follows:
 Research and development (R&D) –the generation of, and experimentation with, ideas
related to new products, services or processes.
 Design of products, services or processes –the detailed planning and engineering of
products, services or processes.
 Production – the coordination and assembly of resources to produce a product or deliver a
service.

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  Marketing – the manner by which individuals or groups (a) learn about and value the
attributes of products or services, and (b) purchase those products or services.
 Distribution – the mechanism by which products or services are delivered to the customer.
 Customer service – the support activities provided to customers.

Major Philosophies of Management Accounting

Management accounting exists to help managers make better decisions. Changes in the way
managers operate require reevaluating the design and operation of the management accounting
systems themselves. Important management themes that are shaping management accounting
systems around the globe include the following:

1) The primacy of customer satisfaction

Customers are pivotal to the success of an organization. The number of organizations aiming to
the “customer-driven” is large and increasing.

2) Linking planning and control to key success factors

Customers are demanding ever-improving levels of performance regarding several/all of the
following factors;
 Cost. Organizations are under continuous pressure to reduce the cost of the products or
services they sell their customers.
 Quality. Customers are expecting highest levels of quality and are less tolerant of low
quality than in the past.
 Time. Time has many components, including the time taken to develop and bring new
products to the market, the speed at which an organization responds to customer
requests, and the reliability with which promised delivery dates are met.
 Innovation. There is heightened recognition that a continuing flow of innovative
products or services is a prerequisite for the ongoing success of most organizations.

Cost accounting provides information for management accounting and financial accounting.
Cost accounting measures, analyzes, and reports financial and nonfinancial information relating
to the costs of acquiring or using resources in an organization. For example, calculating the cost

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of a product is a cost accounting function that answers financial accounting’s inventory-valuation
needs and management accounting’s decision-making needs (such as deciding how to price
products and choosing which products to promote). Modern cost accounting takes the
perspective that collecting cost information is a function of the management decisions being
made.

Note: The major function of cost accounting is cost accumulation for inventory
valuation and income determination. Management accounting, however,
emphasizes the use of the cost data for planning, control, and decision-making
purposes.

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1.5. Distinction between Financial Accounting and Management Accounting

Similarities of Management and Financial Accounting

i. Both rely on the same accounting information system: It would be a waste of money to
have two different data collecting systems existing side by side. One part of the overall

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 accounting system is the cost accounting system, which accumulates cost data for use
in both management and financial accounting.
For example: production cost data typically are used in helping managers set prices,
which is a management accounting use. However, production cost data also are used
to value inventory on a manufacturer’s balance sheet, which is a financial
accounting use.
ii. Both rely heavily on the concept of responsibility, or stewardship:
 Financial accounting is concerned with stewardship over the company as a
whole;
 Management accounting is concerned with stewardship over its parts, and this
concern extends to the last person in an organization who has any
responsibility over cost.

1.4.2 Cost and Management Accounting

These two types of accounting do not have clear cut territorial boundaries. However,
distinction between the two may be made on the following points:
Basis Cost Accounting Management accounting
1. Scope is limited to providing cost information for  is broader than cost accounting,
managerial uses  it provides cost accounting as
well as financial accounting for
managerial uses.
2. Emphasis Mainly emphasis on cost ascertainment & Main emphasis on planning,
Control to ensure maximum profit. controlling and decision making to
max profit.
3. Evaluation Evaluation of cost accounting is mainly due Evaluation of management accounting
to the limitation of financial accounting. is due to the limitation of cost
accounting. In fact, management
accounting is an extention of the
managerial aspects of cost accounting.
4.Techniques Various techniques used by cost accounting Management accounting also uses all
employed include standard costing and variance these techniques used in cost accounting

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 analysis, marginal costing and cost- but in addition it also uses techniques
volume profit analysis, budgetary control, like ratio analysis, funds flow
uniform costing and inter-firm comparison, statement, operation research and
etc. certain techniques from various
branches of knowledge like
mathematics which so-ever can help
management in its tasks.

Fig.1.2 distinctions between Cost accounting & management accounting

1.6. Evolution and Development of Cost Accounting

Widespread growth of industrialization in the western world during the last half of the 19th
century gave rise to the development of cost accounting. With the advent of the factory system,
necessity for accurate cost information was felt to bring efficiency in production. In spite of that,
there was slow development of cost accounting during the 19th century. Until the last 20 years of
the 19th century there was much literature on the subject of cost accounting in England and even
then very little was to be found in the United States. Most of the literature until this time
emphasized the procedures for the calculation of prime costs only”.
Several reasons for the late development of cost accounting can be attributed as given below:
 Overheads (i.e. indirect costs) constituted a small part of total cost in the early period of
the factory system as costly machinery was uncommon during these days. Necessity of
cost accounting is felt more if overheads from a significant portion of total cost.
 A tendency among the cost accountants to keep their costing methods strictly secret was
also responsible for slow development of cost accounting.
 Until the late 19th and early 20th centuries, manufacturing processes were simple and
firms were producing a small variety of products. Because of these facts also,
development in cost accounting also slow.
The most rapid development in cost accounting took place after 1914 with the growth of heavy
industry and mass production methods when costs (i.e. overheads) other than materials and labor
constituted a significant portion of the total cost of production. The scientific management
movement led by Taylor gave impetus to the development of cost accounting because it

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contributed to the use of standard costs in planning manufacturing operations and in evaluating
performances.

1.7. The objectives and functions/role/ of Cost Accounting

Objectives of Cost Accounting
The main objectives of cost accounting are as follows:
1) Ascertainment of cost: This is the primary objective of cost accounting. For cost
ascertainment, different techniques and systems of costing are used under different
circumstances.
2) Control of cost: Cost control aim at improving efficiency by controlling and reducing
costs. This objective is becoming increasingly important because of growing
competition.
3) Determination of selling price: Cost accounting provides cost information on the basis of
which selling prices of products or services may be fixed. In periods of depression, cost
accounting guides in deciding the extent to which the selling prices may be reduced to
meet the situation.
4) Guide to business policy: Cost accounting aim at serving the needs of management in
conducting the business with utmost efficiency. Cost data provide guidelines for various
managerial decisions like make or buy, selling below cost, utilization of idle plant
capacity, introduction of a new product, etc.

Functions/role/ of Cost Accounting

Cost accounting furnishes management with the necessary accounting tools for planning and
controlling activities. Specially, the collection, presentation and analysis of cost data should help
management by accomplish the following tasks:
i. Creating and executing plans and budgets for operating under expected competitive
and economic conditions
ii. Establishing costing method and procedures that permit control
iii. Determining company costs and profit for an annual accounting period
iv. Creating inventory values for costing and pricing purposes
v. Choosing from/ among two or more alternative which might increase revenues or
decrease costs.

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 1.8. Major Principles in Management Accounting
Several major themes influence all aspects of management accounting. Among others, the three
themes are:
Information and Incentives/Different costs for Different Purpose/: The need for information is
the driving force behind management accounting. Management accounting information is
supplied to a decision maker to facilitate and influence decision. Information usually is
provided to a manager to assist her/him in choosing among alternative. Often, that
information is also intended to influence the manager’s decision.

To illustrate, let us consider Fitun Regional Hospital’s annual budget. As part of the budget
approval process, the administrator and the trustee will make important decisions that determine
how the hospital’s resource will be allocated. Throughout the year, the decisions of management
will be facilitated by the information contained in the budget. Management decisions also will
be influenced by the budget, since at year-end actual expenditures will be compared with the
budgeted amounts. Expenditures will then be requested for any significant deviations.

Cost – Benefit Balance/Approach/: Information is a commodity. Like other goods,

information can be produced, purchased and consumed. As it is true of all goods and
services, information entails both costs and benefits.
 The Cost: of providing management accounting information to the managers, for
example, include the cost of compensation for the controller and Accounting
Department personnel, the cost of purchasing and operating computers, and the cost of
the time spent by the information users to read, understand, and utilize the
information.
 The Benefits: include improved decisions, more effective planning, and efficiency of
operations at lower costs, and better direction and control of operations.
Thus, there are both costs and benefits associated with management accounting information.
The desirability of any particular management accounting technique or information must be
determined in light of its costs and benefits.

Behavioral and Technical Considerations: The cost-benefit approach is the criterion that
assists managers in deciding whether, say, to install a proposed budgeting system instead of

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continuing to use an existing historical system. In making this decision senior managers consider
two simultaneous missions: one technical and other behavioral.
The technical considerations help managers make wise economic decisions by providing
them with the desired information (for example, costs in various value-chain categories) in an
appropriate format (such as actual results versus budgeted amounts) and at the preferred frequency.
Now consider the human (the behavioral) side of why budgeting is used. Budgets induce a different
set of decisions within an organization because of better collaboration, planning, and motivation. The
behavioral considerations encourage managers and other employees to strive for achieving the goals
of the organization.

Both managers and management accountants should always remember that management is not
confined exclusively to technical matters. Management is primarily a human activity that should
focus on how to help individuals do their jobs better for example, by helping them to understand
which of their activities adds value and which does not. Moreover, when workers underperform,
behavioral considerations suggest that management systems and processes should cause
managers to personally discuss with workers ways to improve performance rather than just
sending them a report high-lighting their underperformance.

1.9.Ethical considerations in Management Accounting

Professional accounting organizations, which represent management accountants in many

countries, promote high ethical standards. Each of these organizations provides certification
programs indicating that the holder has demonstrated the competency of technical knowledge
required by that organization in management accounting and financial management, respectively.
In the United States, the Institute of Management Accountants (IMA) has also issued ethical
guidelines. These are:
1. Confidentiality: Each practitioner has a responsibility to:
Keep information confidential except when disclosure is authorized or legally
required.
Inform all relevant parties regarding appropriate use of confidential
information. Monitor subordinates’ activities to ensure compliance.
Refrain from using confidential information for unethical or illegal advantage.

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2. Integrity: Each practitioner has a responsibility to:
Mitigate actual conflicts of interest. Regularly communicate with business
associates to avoid apparent conflicts of interest. Advise all parties of any
potential conflicts.
Refrain from engaging in any conduct that would prejudice carrying out
duties ethically.
Abstain from engaging in or supporting any activity that might discredit the
profession.
3. Credibility: Each practitioner has a responsibility to:
Communicate information fairly and objectively.
Disclose all relevant information that could reasonably be expected to
influence an intended user’s understanding of the reports, analyses, or
recommendations.
Disclose delays or deficiencies in information, timeliness, processing, or
internal controls in conformance with organization policy and/or applicable law.

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