Cost Management Accounting - Literature review Example

Cost Management Accounting Name Institution Date Topic 1: Ethics and Budgeting Periasamy (2010) quotes the chartered institute of management accountants’ definition of budgeting as a financial statement that is prepared and approved before a given time period, that describes the policies that will be pursued during this period so as to achieve a specific goal. According to the author, budgeting has become a critical application of management accounting, which has been accepted as a significant tool for short-term planning and control. Camillus (1986) notes that planning and control are processes that have been considered fundamental to the management practice. Early researchers considered planning and control as the start and end of the management process. Persistent developments in planning and control practices saw the emergence of budgeting systems as the answer to planning and control for management (Camillus, 1986). As part of the planning and control process, budgeting has been used to set objectives, evaluate, allocate resources, and reward performance (Amey, 1979) as well as shaping decision making and directing executive manager’s towards realisation of the general objectives of organizations (Covaleski et al, 2003). As Greenwood (2002) explains, capital budgeting is seen as the specified plan of action that is used for allocation of organization resources for long-term planning. After the completion of planning exercises by the senior management, the agreed long term strategy must be interpreted into an action plan that will actually allocate resources. This plan of action could be called the capital budget and the process referred to as capital budgeting (Greenwood, 2002). Periasamy (2010) defines budgetary control as the establishment of budgets that relate to several activities and then making comparisons between the budgeted figures and the real performance in order to discover any deviations. While this is considered a good process for the performance of organizations, other researchers have found counterproductive effects that have been associated with the budgeting process (Jensen, 2003). Jensen (2003) further says that when people are paid depending on how they perform in relation to a budget or target, they tend to begin to game the system. When they do this, they cause more harm than good in two major ways. The concerned individuals, including the supervisors and subordinates, will be tempted to lie in the information needed for the coordination of activities in critical parts of the organization. Secondly, they may game the realization of the targets and budgets and end up destroying value for the organization. Budget systems are usually based on the principle that managers and top employees get rewards if they achieve their targets during the period (Locke, 2001). When they fail to impress with their performances, these managers may face punishment. Most managers understand the impact of these systems on incentives, but they rarely pay attention this fact. Once these managers know that they will get bonuses when targets are realised, they are likely to get tempted to set targets that can easily be reached. Once the targets are set within limits that are easily attainable, the managers will ensure that these targets are realised no matter how. Their approach may be so vigorous and unrealistic and they may engage in processes that will damage the company (Jensen, 2003). Example 1: An example would be a case where managers from a heavy manufacturing company who were focused on achieving their budget targets and getting their bonuses, decided to transport their incomplete products from the company warehouse in England to the Netherlands. This decision was arrived at since the managers wanted to ensure that they realised the sales revenue earlier. The unfinished products were assembled in a warehouse much closer to the customers, but at great inconvenience and higher costs for the company. By completing assembly close to the customers, the managers managed to book the sale in the necessary quarter. They therefore won their bonuses, but greatly lowered the company’s overall net income. Since they had met their budget, they were assured of the bonuses, but the company was obviously in a state worse off than before the effort. Example 2: The case for Informix, a company dealing with Internet software, and its auditor is a revelation of how far managers and employees can go to realised the budget targets. In this case, $142 million was paid for settlement of lawsuits filed by SEC for illegal increases in earnings by $295 million during the period 1994-1997. The managers and other personnel were charged for moving revenues to the previous quarter by changing dates and other sales agreement evidences. The charged persons were also accused of engaging in side agreements allowing payments and other refunds like paying fictitious consulting fees and other fees in order to refund customers software licence fees. Other charges included recognition of amounts meant for software maintenance as those for software licensing and recognition of amounts on disputed claims. As Carreras, Mujtaba & Cavico (2011) posit, even though the accuracy of forecasts by analysts is suspect, managers will always experience the pressures to meet these targets or even exceed expectations. These pressures will usually lead executives to arrive at decisions that are designed to satisfy expectations, and in other instances, to influence accounting practices to achieve these targets. Although “earnings management” concept is known to follow accounting standards and regulations, the tactic is regarded as deceitful since it is intended to mislead stakeholders. Example 3: An example of the effect of analyst forecast on budgeting process would be the case for a big telecommunications company back in the 1990s. The managers of the company decided to consider the company as one of those in the “tech sector”. They referred to Wall Street when they had to set financial goals for the company. During this time, Wall Street was forecasting double digit growth within the tech sector in net incomes so the managers agreed on a 12% growth every year. They also assumed that expenses would not rise during this period. To make these a reality, the managers had to take certain liberties. When a question was raised about what would make the mid-year revenues to rise, it was explained that the extra revenue was expected from new products. When this was investigated further, it was found that the products had not been developed yet, but the targets had to remain unchanged. Due to this approach to the budget, sales targets had to be set very high. By mid-year, more than 60% of the sales force received negative performance reviews for failing to meet the targets set for sales. Minimizing the Risk Budgets and budgeting systems are known to influence the proportion of resources of organizations that are allocated to managers and the performance objectives upon which they will be evaluated and therefore rewarded. As a result, according to the Kren, (1992), budgeting systems greatly influence the attitudes, performance and behaviours of the managers. Two major behaviours that result have been found to be the creation of budgetary slack and data manipulation (Young, 1985; Merchant, 1990). Organizations must therefore seek to address these issues in order to improve the ethical performances of the budgeting systems. Budgeting slack represents the difference between targets that have been put into the plan and the actual capabilities of the organizations. Budgeting systems enable managers to understate revenues and, in other cases, overstate costs. Data manipulation, on the other hand, involves the managers’ efforts to look good by changing indicators that are used for their performance evaluation. Researchers have found that budget systems that put great emphasis on achievement of targets encourage these unethical behaviours (Onsi, 1973; Merchant, 1990). Organizations, therefore, have the chance of carefully designing budgeting systems in a manner that will minimize these trends. Other researchers also believe that perceived fairness of these systems has great potential to minimize unethical behaviours. Different types of perceived fairness can be achieved (e.g. interactional or distributive) through various process depending on the theories pursued (e.g. Uncertainty Management Theory). Jensen (2003) believes that most participants in the budgeting system do not consciously believe that they are lying or acting without integrity. In fact, in several organization cultures, much of such behaviours are expected of any responsible manager. To stop the unethical behaviours and gaming of budgets, it is critical that organizations begin by doing away with the use of budgets and targets in their compensation, reward and promotion systems. Jensen (2003) further explains that removing targets and budgets from the compensation formula solves the problem since if bonus or promotion is a result of what has been accomplished, and not whether or not budgets or targets have been achieved, then individuals will not have any financial motivation to lie or hide information in the budgeting process. In this way, budgets could be successfully used for planning and control as was intended and a significant cause of damage to the organization’s integrity eliminated. Topic 2: Accounting for Overheads Cooper and Kaplan (1988) argued that managers in manufacturing companies make critical decisions about pricing, process technology and product mix, basing their assessments on inaccurate cost information. Worse still, there is no alternative information that could alert the managers that these costs have been badly flawed. In most companies, these problems will only be detected after the companies have experienced deteriorated competitiveness and profitability. Inaccurate cost information experienced now is a consequence of sensible choices that were made several years ago, when manufacturing companies focused on a narrow range of products. During that time, the costs related to direct labour and materials, which were the most important factors for production, were easily traceable to specific products. Consequentially, problems associated with allocation of corporate and factory overhead by burden rates were not significant. Again, the expenses of collection and processing of information meant that it was not easy to justify more effective allocations of such costs and other indirect costs. In recent times, there have been witnessed proliferations of marketing channels and product lines. Direct labour does not represent a significant proportion of corporate costs anymore. Other expenses related to factory support operations, distribution channels, marketing and several other overhead functions have greatly increased. Most companies, however, still carry out cost allocation of these increasing overhead and support costs using their shrinking direct labour base. These simplistic approaches are not justifiable, particularly because of the falling costs of information technology (Cooper & Kaplan, 1988). Manufacturing overheads are influenced by many cost drivers, further complicating the allocation process. Ahn (1998) argues that as a result of the widespread automation in production lines, manufacturing overheads continue to increase as direct labour costs reduce. The change in cost structure has been cause of increasing concern for manufacturing overhead cost drivers. Various cost management techniques have been developed, including the Activity Based Costing (ABC). Some researchers advocating for ABC have asserted that manufacturing overhead cost drivers are complexity-related activities as opposed to volume-related efforts. Other researchers, on the other hand, claim that evidence does not sufficiently verify the claims made by those who support ABC (Ahn, 1998). Ahn (1998)’s findings revealed that complexity-related activities actually drives overhead costs. The findings also indicated that volume-related activity variables also contributed positively to the overheads. While these findings partly supported traditional cost allocation practices, additional findings revealed that structural complexity variables somewhat provided explanation about the deviation of supporting activity variables. The complexity of the modern production factory presents great challenges for allocation of these costs. These complexities have been brought about by a variety of technologies, complex production stages and flow patterns at the factory. As Riley (1987) further explained, the extent of vertical integration, uncertainty in demand and the production policies may increase the complexities of production. With these complexities, the cost structure has increased in hierarchy so that complexities of production plants directly result to activities that drive overheads. As Ittner and Macduffie (1995) point out, option and parts complexity within the manufacturing environment, both contribute adverse impacts on overhead, and reflect significant logistics, supervising and coordinating challenges that are associated with increased number of parts as well as sophisticated manufacturing activities. Example 4: The difficulties in allocation of overheads greatly increase when manufacturing companies produce and sell multiple products. An example would be a case where two plants produce a simple product, like ball point pens. The two plants are same in size, with equal capital investment. Each year, one plant produces a million blue pens. The second plant also makes blue pens, but not more that 100,000 every year. The second plant additionally produces 60,000 yellow pens, 15,000 green pens, 20,000 purple pens etc. On overall, the second plant produces about 1,000 different products, their volumes ranging between 400 and 100,000 units. The average yearly output is the same as that of the first plant, so that the two plants require equal standard direct labour hours, material and machine hours. With all these similarities, the second plant will have a bigger production support staff since more people will be needed to carry out machine scheduling and inspections, reception and inspection of materials, movement of inventory, assembling and shipping order, designing and implementation of engineering change orders and so on. The second plant would also run with significantly higher levels of idle time, scrap, inventory, overtime and rework. The second plant’s detailed plant support resources and the associated production inefficiencies will likely result to significant distortions in the cost-system, making it very challenging to accurately allocate overheads (Cooper & Kaplan, 1988). Strategies to Make Overhead Allocations Accurate and Reliable According to Cooper and Kaplan (1988), several companies still employ direct labour hours methods to allocate costs. Other companies have recognised the declining significance of the direct labour, and have used two other allocation bases. The materials-related expenses are directly allocated to items as a percentage mark up over the direct materials costs. In extensively automated processing environment, the allocation of production costs are accomplished using processing time, or machine hours. The authors believe that existing systems used for costing often understate profits on high-volume profits. These systems also commonly overstate profits on other products, like speciality items. Cooper & Kaplan (1988) propose that an activity based cost system would greatly help organizations achieve strategic signals that are not misguided and would help these organizations generate undistorted information. To achieve such an activity based system, organizations will have to first need to collect accurate information on material costs and direct labour and then examine the requirements of specific products as far as indirect resources are concerned. Organizations must ensure that they concentrate on costly resources, put emphasis on those resources that depict varying consumption rates depending on product and product type and identify resources with demands patterns that do not correlate with traditional allocation measures like materials, direct labour and processing time. A factory that manufactures products that have high ratios of factory costs to overall costs should focus on systems that will emphasize tracking of manufacturing overheads to products. Those that produce consumer goods should analyse the marketing, and distribution, and then serveice costs through product lines customers, regions and channels. Companies that have invested on modern technologies will need to examine the demands made on engineering, process development resources and product improvement by the various final products and production lines. To effectively improve the performance of the costing systems, organizations must realise the need to identify those resources that have the most significant potential for contributing to distorted information under the traditional systems. These activities include those for which the normal surrogates like material quantities, or labour hours, do not adequately represent methods of source consumption. The critical factor to be kept in mind is that part of the company that seems to grow when the company increases its product line diversity, production technologies, consumer base, marketing channels, etc. Ahn (1998) stresses the importance of effective management of overhead costs, noting that analyses into cost structures have revealed that overhead percentage in manufacturing environment was twice as big as those related to direct labour costs. The author further mentions that volume and support activities positively influence overheads are must be considered during costing. The author therefore suggests that volume as well as complexity-related support activity drivers are critical during cost allocation and are useful components for cost management efforts. Organizations should focus on activities like process balancing, purchasing control activities as well as change activities. Ben-Arieh & Qian (2003) also support adoption of activity based costing methods, noting that these methods are more accurate for cost estimation and calculation. These authors state that ABC methods could be used to trace costs using activities that are performed on the cost objectives and help organizations achieve more accurate cost information that could traced. The method could help these companies classify activities as value-added and as non-value added and in this way, enable the elimination of those activities considered non-value added. Case study: The case for Ripken Products, a manufacturing company, reveals the benefits of the Activity Based Costing (ABC) method, and exposes the flaws of allocating overhead costs based on traditional absorption costing methods. This case also reveals why overhead cost assignment on traceable consumptions of resources is likely to lead to accurate product costing. The company produces four types of chemical eradicators, but in the recent meeting, the CEO had announced that one of the products was being eliminated from the company’s product line (Jones, 2014). Using the company’s traditional methods, the following was part of its manufacturing budget: Direct material costs of $900,000 Manufacturing overhead of $ 1,680,000 Direct labour costs of $840,000 Basing on its estimated 2013 costs for manufacturing, the company determined that its budget manufacturing overhead rate for that year was $2.00 of the manufacturing overhead for every $1.00 of the direct labour. The company’s 2013 budgeted manufacturing costs, by product and in total was as presented in Table 1 (see appendix). For the allocation of the total budget manufacturing overhead of $1,680,000 to each of the products, each product’s direct cost was multiplied by 2.00 (budget manufacturing overhead rate). Table 2 represented Ripken Products’ 2013 pro forma income statement. When the vice president Rick Dempsy decided to apply the new ABC method with the help of a student intern, they managed to come up with table 3 which identified the six manufacturing overhead groups as well as their costs. They then comprised the total budgeted manufacturing overhead costs for 2013 and organised the information into tables 4 and 5 which revealed the company’s transactions and cost drivers. On close scrutiny of the results, the vice president discovered that distortions were noticeable in the company’s unit production costs that had been previously reported as $1.00 for the products A, B, and C, with $3.00 for product D. To correct the errors, the overhead allocations in table 1 were erased since they never took into account the activities that contributed to the costs. The vice president and the student realised that there was need to redistribute the $1,680,000 to the four products. The result was table 6. The resulting this information, the resulting pro Forma revealed that product D was most profitable (table 7). The CEO was therefore misguided in his decision to eliminate this product. Products A and C were actually the less profitable (Jones, 2014). References Cooper R. & Kaplan R.S. (1988). Measure Costs Right: Make the Right Decisions. Harvard business review: 96-103. Onsi M. (1973). Factor Analysis of Behavioural Variables Affecting Budgetary Slack. The Accounting Review, Vol. 48, No. 3: 535. Ittner C.D. & Macduffie J.P. (1995). Explaining plant-level differences in manufacturing overhead: structural and executional cost drivers in the world auto industry Production and operations management, Vol. 4, No. 4: 312-334 Riley, D.W. (1987). Competitive Cost-Based Investment Strategies for Industrial Companies. Manufacturing Issues (Booz-Allen & Hamillton) Ahn T. (1998).Cost Drivers of Manufacturing Overhead: A Cross-sectional Analysis of Automobile Component Manufacturing Plants. 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Ripken Products: A Case For Learning Activity-Based Costing. Journal of Business Case Studies. Volume 10, Number 2, pp. 137- 146. Appendix: Table 1: Estimated Manufacturing costs using absorption costing Table 2: Pro Forma Income Statement Table 3: Estimated manufacturing Overhead (2013) Table 4: Transactions by Product (2013 Estimates) Table 5: manufacturing overhead cost for 2013 using ABC Table 6: Pro Forma income Statement using ABC Read More