Management Accounting - Case Study Example

Management Accounting Executive Summary The use of standard costing and variance analysis has gained popularity and acceptance in the global business arena. In our business organisation, the use of traditional variance analysis has been instrumental in the management accounting department’s decision making. However, the widespread use of standard costing and their perceived importance have declined over the years as new production processes replaced the traditional assembly line and mass production. The traditional variances are then replaced by operational and planning variance which is better suited to the current business needs. This report concludes that the use of traditional variance will generate more benefits for the company than the planning and operational variance. It asserts that the utilization of the traditional variance analysis will enable the company to make use of its familiarity of variance analysis. Furthermore, this type of analysis will serve as a viable control for the Management Accounting department. I. Introduction Most of you are probably aware of my recent hiring in the management accounting department of your esteemed organization. The company is performing well by the grace of God and continues to grow with every passing year. All of us have witnessed how the company prospered amidst pressures and challenges from the business environment. My role in the organization is primarily to assist the management accounting department in coming at par with modern management accounting trends. I hope that in this position, I will be able to impart my knowledge and skill to help our company in coming up with profitable business decisions. Management accounting is “the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control the activities of an organisation” (Financial Management & Control 2005). As this definition suggests our management accounting department has a wide scope of responsibilities that involves presentation of information to all levels of management within our company. This information is further used by management to assist in planning and decision making activities. Our Management Accounting department is also heavily involved in budgeting process along with establishing procedures and culminating subsidiary budgets into an overall master budget. This report aims to acquaint you with how the Management Accounting department uses variance analysis within the management processes of the company. As variance analysis have become an integral tool in decision making within the organisation, it is important that all everyone grasps this important concept. In relation to this, this report will compare traditional variance analysis and operational and planning variance. A good starting point will be the discussion of standard costing. Afterwards, the use of variance analysis (traditional and operational and planning) will be discussed. This report will wrap up with its recommendations. II. Standard Costing A major source of data for our department is the costing records and accounts. Cost accounting is a very essential aspect of every business organization. In the simplest sense, cost accounting can be defined as “process of tracking, recording and analyzing costs associated with the activity of an organization, where cost is defined as 'required time or resources' (Cost Accounting 2006).” In essence, cost accounting is a field in management accounting which is tasked to give numerical values or figures to each activity in a company's supply chain. The method which is used by a firm has a huge impact in the operation of a business organization as the costing system serves as the basis for major organizational decisions. Cost accounting is an integral part of management accounting and involves budgets, standard costs and actual costs of various activities along with the analysis of variances, profitability and other social usage of funds. The facts discussed above give rise to the importance of employing an accounting method which takes into account the full costs of operation. Consequently, full cost accounting allows managers to give an appropriate cost to the company's products and services to include a fair share of overheads to each unit produced. Standard costing is an integral part of cost accounting. Variance analysis is based on this standard costing system. This system is in use in our company and helps plan and budget business activities, provide a basis for performance measurement; and motivate management to work towards achieving company objectives. The standard costing system entails preparation of standard costs, comparison of standard with actual costs, and regular review of preset standards. Standard costs themselves consist of two estimates which include a physical measure of the resources required for each unit of output followed by the expected price for each unit of the respective resource. Primarily we need to identify the resources required for each output unit which includes types of raw material or components, labour skill set and type of machinery. Standards within a standard costing system may be affected by a whole range of issues. The four types of standards are basic standard, ideal standard, attainable standard, and current standard. As pointed out earlier standard costing is part of the cost control system and incorporates standard costs and variances into ledger accounts. It should be noted that standard costing is a cost accounting technique that incorporates standard costs and variances into ledger accounts. Standard costing carries out variance analysis using the normal, double entry ledger accounts. Control is achieved by comparing actual performance with the preset standard and assessing the cause for the difference. It is these differences that are called variances. Breaking up of amounts and figures has to take place (Albery 1953). III. Variance Analysis Variance analysis an important tool for business organizations which aid them in decision making. As stated by Herbert (1998), “Variance analysis provides a framework for business managers to breakdown the overall performance of an organisation, so that each individual element of the business can be isolated and analysed in turn.” We need to be clear about the fact that variance analysis is the analysis of performance by means of variances where variances are the difference between the actual and the standard costs. The main reason for calculating variances is to show the effect of the variance on the actual profit compared to the budget. The resulting affect is known as the profit variance. Variances which cause the actual profit to be greater then expected are known as favourable variances and those causing the actual profit to be less then expected are known as adverse variances. The reconciliation between actual and budgeted profits using variances is presented as an operating statement. The operating statement is based on an absorption or marginal costing basis. III. A. Traditional Variances Traditional variance analysis gives us six types of variance: 1. Direct material total cost variance which is the difference between the actual cost of actual number of units produced and its budgeted cost in terms of material; 2. Direct material price variance which is the difference between the standard cost and the actual cost for the actual quantity of materials used or purchased; 3. Direct material usage variance or direct labour total cost variance which is difference between the standard quantity of materials that should have been used for the number of units actually produced, and the actual quantity of materials used, valued at the standard cost per unit of material; 4. Direct labour rate variance or direct labour efficiency variance or variable production overhead total cost variance; 5. Variable production overhead expenditure (or rate) variance or variable production overhead efficiency variance or fixed production overhead total cost variance; and 6. Fixed Production overhead expenditure variance or Fixed production overhead volume variance. Traditional variance analysis assumes that the number of labour hours paid equals the number of hours used in production. This may not always be the case. Even direct labour is often paid for non-productive hours, such as when waiting for machine repairs, this is known as idle time. It has been suggested at many instances that bad budgeting results in variance analysis. Useful information can be obtained from variances if the original standards are examined at the end of the accounting period to determine if they are realistic or not. If standards are unrealistic they can be revised, with hindsight and performance compared with the revised standards. Operational variances are those that are found by comparing actual performance with revised standards. III. B. Planning and Operational Variance Planning and operational variances are a diversion from the traditional variance analysis process. The operational variance can be further split into price and usage variances. These variances are used to estimate the differences in the company’s budget brought about by revisions in standard quantity and standard price. Planning and operational variance are often used when companies decide to find the impact of change in supplier and new equipment in the cost and efficiency of cost components. The following formulas are used in calculating these variances: Planning variance (Usage) = (original standard quantity - revised standard quantity) x revised standard price Operational variance (Usage) = (revised standard quantity- actual quantity) x revised standard price Planning variance (Price) = Original standard input x (original standard price - revised standard price) Furthermore, planning and operational variance calculations are renamed when the calculation is carried out for sales volume variance. In this case the new names given to planning and operational variances are: Planning: Market volume variance Operational: Market share variance 5.0. Comparison Some authors such as Ruhl have criticized traditional variance analysis as well. While acceptable for external financial reporting, product costing and variance analysis are two separate functions of a cost system. Therefore, the assumptions used for product costing can be inappropriate for variance analysis purposes. When production volume is not the correct cost driver, the cost system does not reflect the true economics of production. Managers may be led to the wrong conclusions although most managers will intuitively know when this happens. Unlike Traditional variance analysis the use of planning and operational variances is not common which in itself gives an idea of the relative drawbacks that must be associated with its use. Primarily the establishment of ex post-budgets is extremely difficult. Managers whose performance is reported as poor using such a budget will be unlikely to accept them as performance measures because of the subjectivity in setting such budgets. There is a reasonable amount of administrative work involved. Analysing the traditional variances consumes enough time but that followed by an analysis on identifying which variances are controllable and which ones are not is an even lengthier process. This will end up wasting our valuable resources which could be put to much better use elsewhere. The analysis tends to overstate the interrelationship of variances, providing managers with an ever ready list of excuses for their below par performance. Eventually poor performance will be blamed as the cause of a badly set budget. George Brown also states several reasons why planning and operational variance may be dysfunctional like lack of loyalty to existing suppliers; cost which may occur due to inability of the new supplier to deliver the component as required to meet production/sales schedules; and costs which may occur due to problems with the quality of the new component. IV. Recommendation and Conclusion Now that we have an idea about traditional variance analysis along with planning and operational variance analysis we will be able to clearly see why the traditional approach is better for our company. At present our company uses variance analysis as one of its main forms of management control but I’m sure many of you were vague about our management control operations. I hope I have cleared a lot of misconceptions and helped you all see variance in a new light. I would request you all to make a decision about how we decide to use variances in the future. I fully support traditional variance analysis as opposed to operational and planning variance analysis. We will save time and money by using traditional variance analysis and as a result we can eventually utilize those savings to fine tune our performance even further. References Albery, M, 1953, Analysis versus Interpretation of Cost, Accounting Review, Vol. 28, No. 3 (Jul., 1953), pp. 425-430 Brown, G. M, n.d., Management Accounting UK (June): pg 48-50. 1987 Cost Accounting. 2006. Retrieved 04 April 2006, from http://en.wikipedia.org/wiki/Cost_accounting Drury , C, 1992, Standard Costing, Academic Press Herbert, I, 1998, Understanding Variance Analysis, Retrieved 31 August 2006, from http://www.accaglobal.com/publications/studentaccountant/13858 Lynch, F, May 2005, Financial Management & Control, FTC Foulks Ruhl, J. M., 1995, Activity-based variance analysis. Journal of Cost Management (Winter): 38- 47. Read More