Decision Making with Managerial Accounting - Example

Decision Making with Managerial Accounting Task Table of Contents Table of Contents 2 Introduction 3 Part Managerial Accounting 3 The role of the management accountant and management accounting 4 Ethical concerns 5 Managerial accounting techniques 6 Part 2 6 Costing methods 6 The absorption costing method 7 The ABC system 8 Budgeting 9 Capital investment decision techniques 10 Conclusion 12 References 13 Introduction This paper presents some of the managerial accounting techniques used to enhance the decision-making process in organizations. Management accounting is the sole responsibilities of the management accountants of the enterprise. The management accountants are required to rely on the various management accounting techniques to aid the analysis of the organization’s internal affairs and enhance the decision-making process. On that note, the paper will be presented in two parts. The first part covers the following: the role of managerial accounting and the management accountants in an organization; the ethical concerns for the management accounting; a brief description of three managerial accounting techniques. The second part presents discussions of the costing methods, budgeting, and capital investment decision skills. Part 1: Managerial Accounting Management accounting is concerned with the delivery and clarification of the information needed by management at all levels for the following purposes: first, to enhance the formulation of the organization’s policies. Second, to facilitate planning of the organization’s activities in the long-term, medium-term and short-term. Third, to ensure that the organization’s activities are under control. Fourth, to enhance the decision-making process. Last, to improve performance evaluation. On the other hand, financial accounting ensures the provision of information to parties outside the organization. It involves measuring, classifying, summarizing and reporting financial information, which is used in making economic-related decisions. The financial information is contained in the financial statements of businesses (Davis & Davis, 2012). The role of the management accountant and management accounting Management accounting involves the following procedure: information identification, measuring, data analyzation, data analyzation, and communication. The transmission of the information is necessary to enhance informed decision-making to facilitate the achievement of the organization’s objectives (Davis & Davis, 2012). It is the obligation of the management accountant to ensure the implementation of the process mentioned above. The role of the management accounting and the management accountant are to plan, organize, control, direct, communicate and motivate. First, Planning is the primary function of the management by means of which the managers decide the goals to be accomplished and the course of actions to be followed to deliver the goals (Davis & Davis, 2012). Planning gives the managers warning of possible future risk and, therefore, motivates them to make an informed decision consistently. The management accountant helps to formulate plans for providing information used in deciding the product, the target market, and the appropriate prices. In addition, the management accountant analyzes the capital budgeting proposals (Davis & Davis, 2012). The second role is the control. It is the process that involves the comparison of the actual performance and the planned to identify any possible deviation from the budget. The corrective active is implemented in the event a deviation is identified. Controlling can be defined as the process of compelling the actual events to conform to the planned events (Davis & Davis, 2012). The management accounting enhances the process by providing performance evaluation reports that compare the actual performance with the expected result for each responsibility center. A responsibility center is a division of an enterprise under the authority and accountability of the management accountant. The management accounting is also expected to draw the manager’s attention to those specific activities whose performance deviate from the plan (Davis & Davis, 2012). The third role is organizing. It involves the establishment of the structure within which the required activities are to be performed and the assignment of responsibilities to the respective parties. Organizing involves the creation of decision units such as department, sections, and branches. In this case, the management accounting is expected to provide information on the performance of each of these departments. The fourth role is motivation. It involves the process of influencing human behavior so that the employees identify with the objectives of the corporation and make decisions that enhance the achievement of goals. It has been determined that the employees can be motivated by budgets and performance reports produced by management accountants. However, the objectives can only be a source of motivation when they are challenging but feasible in reality (Davis & Davis, 2012). The fifth role is communication. The process of communication ensures that information is passed from one individual to another or from one department to another. The management accountant enhances the communication process by maintaining an efficient system of communication. The management accounting information system is an example of an efficient information system (Davis & Davis, 2012). Ethical concerns The increasing importance of the accounting information has put pressure on relevant authorities to implement a code of conduct for the management accountants while in practice. As has been mentioned above, the information provided by the management accountant is for the internal use. Due to the dynamism of the competitive environment, management accountants are required to maintain a high level of competence in their work to ensure continuity in the provision of critical information (Davis & Davis, 2012). Second, since the management accounting information is for internal use, it should be out of reach for the external parties. Therefore, the management accountant should uphold a high level of confidentiality. Third, the management accountants should be incorruptible. They must, at all times, align their interest with the objectives of the company to avoid negative influence from the material and financial benefits. Last, the management accountants are expected to be objective. They must provide the actual information without any slight change. That applies to both favorable and unfavorable information from the users’ perspective (Davis & Davis, 2012). Managerial accounting techniques There are several managerial accounting techniques. However, only three are covered in the paper. They are the breakeven analysis, the expense budget, and the inventory management. First, the breakeven analysis determines the sales levels that the company must achieve to recover the total cost of operation (Davis & Davis, 2012). It is also used to determine the level of sales required to achieve a targeted level of profit. Second, the expense budget, just like any other budget, controls the expenditure standards of the company. It minimizes the wastage of funds thus reduces costs. Last, the inventory management technique ensures that the firm maintains the appropriate level of stock. The method reduces cases of inventory shortage of surplus thus, minimizes the opportunity cost, inventory damage, and storage costs (Davis & Davis, 2012). Part 2 Costing methods There are numerous costing methods used in the companies. However, for the purpose of this presentation, the focus will be on only two of the methods. That is, the conventional absorption costing and the activity based costing system (ABC system). Activity based costing is a concept that refers to the ascertainment of various activities involved in the manufacture of goods and services. After that, the overhead costs are allocated to each activity and then assigned to the products and services. The costing system has been widely adopted to enhance cost management methods (Goektuerk, 2007). The ABC systems, primarily, facilitate the process of providing the necessary accounting information to various users. Companies use the costing system in determining the accurate cost related to the production process. The information is critical in decision-making concerning the pricing strategies, determination of production costs, etc. On the other hand, the absorption costing method is an approach that assumes that all the costs incurred during the manufacture of goods and services relate to the respective products and services (Goektuerk, 2007). In other words, the conventional absorption costing system does not provide additional information to the management. Below is an instance of the difference between the two costing methods derived from company X (the name is withheld to ensure confidentiality). Company X produces products XYI, YZT, and ABW. The production cost per unit of the products are determined using the two costing methods (Goektuerk, 2007). The absorption costing method Absorption rate for machine department Machine overhead/ product (1.2 *hours) Overheads Costs £ 504,000 Product XYI YZT ABW Machine hours 420,000 Hours 2 5 4 Absorption rate (504,000/420,000) = 1.2/hr Cost 2.4 6 4.8 Absorption rate for Assembly Department Assembly overhead/product (0.825*hours) Overheads Costs £ 437,000 Product XYI YZT ABW Machine hours 530,000 Hours 7 3 2 Absorption rate (437,000/530,000) = 0.825/hr Cost 5.775 2.475 1.65 Total cost per unit per product = (overhead costs + variable costs) Product XYI YZT ABW Variable cost 32 84 65 Machine costs 2.4 6 4.8 Assembly costs 5.775 2.475 1.65 Total costs 40.175 92.475 71.45 The ABC system XYI YZT ABW Machining services = 0.85 0.85 100,000 = 85,000 0.85 200,000= 170,000 0.85 120,000 = 102,000 Assembly services = 0.6 0,6 350.000 = 210.000 0,6 120.000 = 72.000 0,6 60.000 = 36.000 Set-up costs = 50 50 120 = 6.000 50 200 = 10.000 50 200 = 10.000 Order processing = 4,875 4,875 8.000 = 39.000 4,875 8.000 = 39.000 4,875 16.000 = 78.000 Purchasing = 7,5 7,5 3.000 = 22.500 7,5 4.000 = 30.000 7,5 4.200 = 31.500 Total 362.500 321.000 257.500 Units 50.000 40.000 30.000 Overhead per unit = 7.25 8.025 8.583 Total cost= Variable cost +Overheads Product XYI YZT ABW Variable cost 32 84 65 Overheads 7.25 8.025 8.583 Total cost 39.25 92.025 73.583 Based on the determined total cost of manufacturing the three products it is clear that the costs are different due to the methods used. Like mentioned above, the difference in the cost of the products is due to the different assumptions of the methods. Nevertheless, it has been proven that the ABC system is more appropriate than the conventional method because it provides additional information useful in the decision-making process. Therefore, management accountants are advised to implement the ABC system (Drury, 2007). Budgeting Budgeting is a concept that refers to the procedure of monetizing an individual or organizational plan to facilitate the achievement of objectives within a defined period. Budgetary planning can be considered as a short-lived measurement and monitoring of long-lived strategic plans of an entity. Strategic planning involves the formulation of strategic plans that state and describe the goals to be pursued and achieved with respect to the corporate policy framework. Therefore, through budgeting, a long-term corporate plan can be turned into action (Touche, Opkin, & Halpin, 2013). The results of a budgeting process are used for performance evaluation, coordination, communication, motivation, clarification of responsibility and authority, planning, cost control and decision-making. There are different types of budgets depending on the organization’s needs. They are purchasing budget, sales budget, the cash budget, material usage budget, capital expenditure budget, etc. (Albrecht, 2007). Below is a monthly sales budget of company T. The company produces two products (NIKS and ARGS). Sales Budget Qty (units) Revenue (SHS) NIKS 4,500 144,000*1 ARGS 4,000 176,000*2 TOTALS 320,000 The above budget is used to achieve the purposes of budgeting mentioned above. More importantly, budgeting is used to detect variances and implement the appropriate corrective measure. For instance, company T planned to achieve the sales level of $ 320,000 per month. If the actual sales level falls short of the plan, the company will be required to correct the shortfall by implementing an appropriate strategy (Albrecht, 2007). Capital investment decision techniques Investment appraisal techniques are used to assess the viability of projects and investments. Investors and company managers use the evaluation techniques to determine the rate of return on investments and the ability of the projects to create value for enterprises. The internal rate of return (IRR), the net present value (NPV), and the payback period (PbP) are the appraisal techniques covered. The difference between the evaluation techniques will be driven home using the following example (Götze, Northcott, & Schuster, 2008). A company is considering undertaking a project A that requires an initial cash outlay of Sh 10,000 and with a useful life of 5 years. The company required rate of return is 10% and the appropriate corporate tax rate is 50%. The project will be depreciated on a straight line basis. The cash flows expected to be generated by the projects are as follows. The project’s depreciation cost = (10,000 – 0) /5,000 = $ 2,000. Project A Annual Cashflow Cashflows before depreciation 4,000 Less Depreciation 2,000 Profits before taxes 2,000 Less taxes (50%) 1,000 Profits after tax 1,000 Add back depreciation 2,000 Cashflows after taxes 3,000 First, the payback period is the time it takes to get back the amount initially invested in a project. Every investor has an acceptable payback period. However, the project with a shorter payback period is preferred to that with a longer payback period. On that note, the payback period for project A = (initial investment/cash flow after tax) = (10,000/3) = 3.333 years or 3years and 4 months. Based on the analysis, the payback period of project A is short (Götze, Northcott, & Schuster, 2008). Second, the net present value (NPV) is a method that determines the difference between the sum of discounted cash flow and the initial cost of the project. The rule of thumb when using this appraisal tool is to consider projects whose NPV is either equal to or is above zero. The NPV of project A = (annual cash flow after tax * PVIFA 10%, 5 years) – Initial investment. = (3,000 * 3.791) – 10,000 = $ 1,373. Based on the analysis, the decision is that the project should be considered since it has a positive NPV (Götze, Northcott, & Schuster, 2008). Third, the internal rate of return is the cost of capital at which the net present value of an investment is equal to zero. The rule of thumb for this technique is to accept projects whose IRR are above the cost of capital (Pogue, 2010). The IRR of project A is as below. NPV = 3,000 X PVIFA r%, 5years - 10,000 = 0 PVIFA r%, 5years = 10,000 = 3.333 3,000 From the table, r lies between 15% and 16%. We use linear interpolation to compute the exact rate. PVIFA 15% = 3.352 PVIFA 15% = 3.352 PVIFA required = 3.333 PVIFA 16% = 3.274 Difference 0.019 Difference 0.078 IRR = 15% + (16 - 15) (0.019) = 15.24% 0.078 Based on the IRR (15.24%), Project A should be pursued since the IRR is greater than the cost of capital (Pogue, 2010). Conclusion The paper has presented the difference between the ABC system and the absorption costing method from where it is stated that the ABC system is better for decision making than the absorption. The role of management accountants is included as well as well as the ethical code of conduct expected of them while in practice. The paper has covered three investment appraisal techniques (the NPV, IRR, and PbP). These tools are necessary in decision-making. The completion is increasing growing and so is the significance of the management accounting information. On that note, the management accountants are required to rely on the various management accounting techniques to aid the analysis of the organization’s internal affairs and enhance the decision-making process. References Albrecht, W. S. (2007). Accounting, concepts & applications. Mason, Ohio: Thomson/South-Western. Davis, C. E., & Davis, E. (2012). Managerial accounting. Hoboken, N.J: John Wiley & Sons. Drury, C. (2007). Management and cost accounting. London: Thomson Learning. Goektuerk, H. (2007). Activity-Based Costing (ABC) - advantages and disadvantages: How ABC can be applied to institutions of higher education. München: GRIN Verlag GmbH. Götze, U., Northcott, D., & Schuster, P. (2008). Investment appraisal: Methods and models. Berlin: Springer. Pogue, M. (2010). Corporate investment decisions: Principles and practice. New York, N.Y: Business Expert Press. Touche, B. L., Opkin, M., & Halpin, J. (2013). The budget-building book for nonprofits: A step-by-step guide for managers and boards. San Francisco, Calif: Jossey-Bass. Read More