The Latest Paradigm Shift in the Accounting World - Essay Example

Cost Management An overview of the latest paradigm shift in accounting world Table of Contents Introduction 2 Nature of Accounting 3 Financial Accounting and Management Accounting – compared and contrasted 4 Management Accounting and Cost Accounting – compared and contrasted 5 Changing organisation structure and individual responsibilities of Management Accountants 8 Interaction between management accounting and cost management 11 Tools of Cost Management 15 Zero Based Budgeting 15 Value Analysis 16 Business Process Reengineering 17 Target Costing 19 References 21 Introduction The world economy is going through an especially difficult stage with an unprecedented downturn enveloping almost all economies of the world that has created total chaos in the business sector upsetting profit forecasts and budgets and spreading panic in corporate corridors. The overwhelming refrain is one of tightening of belt through reduction of expenditure in a desperate and, often self defeating, attempt to stay afloat. It is an accounting truism that profit is nothing but the difference between revenue and cost and when dull market conditions prevent even the best marketing brains from boosting sales, the only option available to even the most adventurous management is to reduce costs to maintain the existing profit level. At a cursory glance it seems to be the only and might be the most prudent approach that any management might conceive. But ill conceived cost reduction triggered as a panic reaction to the gloomy market scenario might cause more harm to the company than any good as expenditures that are absolutely imperative for the company’s health might be sacrificed in this new avalanche of trimming down of expenses. The role of the management accountant as a custodian of entire database of the company has thus assumed a critical importance as the management accountant occupies a vantage position from where a critical and dispassionate evaluation of exiting cost structure and a prudent management of costs, as contrasted to cost reduction, can be implemented. There has thus been a phenomenal, and largely unnoticed, shift in the role of management accountant in managing a business. But this change can be properly appreciated only if one examines the basic nature of accounting and the inherent differences that exist between financial, management and cost accounting. This knowledge will equip an avid observer the wherewithal to adequately appreciate the subtle difference between cost and management accounting and cost management. Nature of Accounting The basic objective of accounting is interpretation of financial data to provide a sound basis for action by management, investors and other stockholders in the entire commercial venture. (Paton 1949) Thus, from a means-end perspective the end is an expected cache of sound and economically relevant information and the means adopted can best be referred to as descriptions. From a more practical aspect it can therefore be said that accounting provides information for two distinct but inextricably interlinked purposes; the first one quite obviously consists of reporting to managers within the organization and the second not so obvious but equally important purpose being reporting to persons outside the organization who have a legitimate interest in its affairs. (American Accounting Association 1966) While the first purpose is more akin to what we refer to as Management Accounting the second purpose, which is furnishing details to outside agencies, is basically the domain of financial accounting. This brings us to the important issue of identifying the core features that differentiate financial accounting from its counterpart management accounting. Financial Accounting and Management Accounting – compared and contrasted As already hinted above, financial accounting deals with reporting information that pertains to the financial position, performance, and conduct of a firm for a given period to a set of users and the market in general. In contrast, management accounting is more tilted towards providing relevant and timely information to internal managers as a tool for internal decision making. There is of course no confusion that both are production processes of different accounting data for different problem-solving situations. The basic difference between the two schools of accounting is that while financial accounting is the result of applying generally accepted accounting principles (GAAP) to the recording of transactions between different entities thus conforming to a set of rules established over time by the accounting profession, management accounting derives its techniques from different disciplines, including accounting, for internal problem solving. Therefore, management accounting techniques may differ from GAAP techniques and from one firm to another. They do not conform to any set of prescribed rules, and much may be left to the decision maker’s philosophies. (Boyd and Taylor 1961) The other pertinent feature that differentiates financial accounting from management accounting is that while in the former instance the accountant plays the role of manufacturer of the available data, in the latter instance, the accountant dons the garb of user of the available financial data and associate and amalgamate those with his or her entire knowledge of the business world to arrive at prudent business decisions. Thus, conventional accounting limits itself to accounting techniques, principles, and practices, and rarely deals with decisions other than those required in the preparation of financial statements. But management accounting attempts to evaluate and factor in external and internal business environment to make a decision related to a business problem. To this list of differences, it may be also added that financial accounting data are required to be objective and verifiable, while management accounting emphasizes relevance and flexibility. (Bassett 1962) Management Accounting and Cost Accounting – compared and contrasted The lines of distinction between management and cost accounting very often get blurred and the main tenet for distinction lies mainly in the point of emphasis. Cost accounting deals mainly with cost accumulation, inventory valuation, and product costing. It emphasizes the cost side. The objective function is implicitly perceived to be cost minimization. Similarly, management accounting deals with the efficient allocation of resources. The objective function may be perceived to be profit maximization. It is also believed that the cost accountant and the management accountant are performing different activities; cost control is in the domain of the cost accountant, while cost reduction is in the domain of the management accountant. (Horngren and Foster 1991) A cursory examination of accounting textbooks shows that, in general, those labelled “cost accounting” emphasize cost control while those labelled “management accounting” or “managerial accounting” emphasize planning, which may have reinforced the belief in a difference between both areas. (Earley 1955) It would be prudent, however, if one does not indulge in much hair splitting and instead consider management accounting as an attempt to bring techniques from other disciplines into the area of cost accounting. In fact, in recent years, the scope of cost accounting has been enlarged in various ways in the sense that it develops normative models to be applied in the accounting context with an emphasis on mathematical, statistical, and operations research techniques thereby emphasizing not only the explanatory but also the predictive ability of accounting data. Cost accounting stresses the behavioural impact of accounting information on the users and uses non-accounting information – economic, environmental, and qualitative – to improve the relevance of management accounting data. Cost accounting also merges economic and social goals and consequently draws the accountant into program budgets and "performance" auditing in not-for-profit organizations. It relies on more frequent and heavier use of computers, leading to a centralization of information and the expected candidature of the management accountant for the job of the "information manager" having overall responsibility of this resource. This enlargement of the scope of cost accounting into management accounting made the distinction between a cost accountant and a management accountant all the more difficult so much so that AAA Committee on Courses in Managerial Accounting had to make the following appropriate assumptions that spelt out in no uncertain terms that managerial accounting encompasses the entire formalized information function of an organization with the accountant being the best candidate for a manager of this information system. Managerial accounting being essentially a cross disciplinary managerial activity should integrate material from the computer, the quantitative, and the behavioral sciences areas while continuing with the traditional emphasis on internal problem solving through the use of more sophisticated approaches to issues at hand. (AAA Committee on Courses in Managerial Accounting 1972) In brief, management accounting should go beyond cost accounting and integrate various relevant issues from organization theory, behavioural sciences, information theory, and so on, in a multidisciplinary approach aimed at facilitating the production of information for internal decision making. More and more people – inside the business world and out – realize the significant changes which have been taking place for years in accounting and the role of the accountant in business. No longer is he/she simply a recorder of business history. He/she now plays a dynamic role in making business decisions, in future planning and in almost every aspect of business operations. This new accountant is called a Management Accountant and he sits with top management because his responsibility is developing, producing and analyzing information to help management make sound decisions. Management accounting is generally considered as a discipline that applies “appropriate techniques and concepts in processing the historical and projected economic data of an entity to assist management in establishing a plan for reasonable economic objectives, and in the making of rational decisions with a view towards achieving these objectives." (AAA Committee on Management Accounting 1958) Similarly the emergent conceptual framework of management accounting started by the National Association of Accountants defines it as the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of financial information used by management to plan, evaluate, and control within an organization and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatory agencies, and tax authorities. (National Association of Accountants 1981) Changing organisation structure and individual responsibilities of Management Accountants Many accounting researchers have long been predicting an impending change in environment and role for management accountants resulting from competition, regulation, and manufacturing and information technology. (Baker 1992) Disagreement exists regarding the nature of changes and whether any change is actually taking place. A few accounting researchers are of the opinion that there would be an increased need for management accounting but a decreased need for management accountants as accounting function will be decentralized to those on the shop floor. After new management accounting systems are in place, much of the day-to-day management accounting can be transferred to the workforce. (Cooper 1996) Another stalwart in accounting research predicts an increased reliance on blue-collar workers as they become knowledge-workers, and a part of the aggregate brainpower of the organization; they are supposed to help figure out how to improve quality, speed production, and contribute to customer satisfaction. (Elliot 1992) The management accounting department may adopt a supportive and monitoring role rather than a more proactive decision-making role. (Kaplan 1995) Such a sea change in responsibilities has actually been made possible by awesome innovations and inventions that have overwhelmed the information technology sector. Companies have long used computerized accounting systems, including in-house creations and purchased systems, but a limiting factor was their inability to interface with other systems within the organization. A recent development in information technology is the wholly integrated management information system. These systems encompass almost every aspect of the information system of a company, including accounting, manufacturing, and marketing. Software changes in this case involved switching to SAP (Systems, Applications and Products in Data Processing), a developer of integrated business application software. An advantage of SAP software lies in real-time integration, linking a companys business processes and applications while supporting immediate responses to change throughout the organization on a departmental, divisional or global scale. Another major advantage of integrated software systems is the compatibility among software programs representing different functions of an organization. Software packages representing accounting, manufacturing, inventory, and sales have existed for many years. In many cases, prior to the use of integrated software, effective interface among these systems was lacking. Often, monitoring and facilitating interfaces were a standard part of a cost accountants duties during the closing process. With the introduction of the new software much of the time-consuming reconciliation activities associated with periodic closings have become things of past. Only one set of balances exists; transactions are recorded automatically when plant personnel close production orders, ship inventory, or receive materials. Instead of reconciling balances during closing and making correcting entries, accountants monitor the plants progress toward entering all production orders and shipments of inventory. If the accountant detects a mistake, plant personnel must make correcting entries because of authorization limits placed on job functions. The new system places a greater emphasis on maintaining a good working relationship with plant personnel and a greater responsibility on plant personnel for maintaining the accuracy of cost information. Though accountants were relived to a huge extent from the burdensome and extremely tedious workload, the major concern expressed by them was the feeling of a loss of control over the accounting process. Most of the responsibility for initiating and recording accounting entries had been shifted to non-accounting plant personnel. As a result, accountants felt less involved in the accounting process and more involved in coaching, monitoring, and support activities. The basic responsibility of cost accountants is to ensure the integrity of reported financial numbers associated with inventories and expenses. The manner in which these responsibilities are performed has changed dramatically and the cost accountant’s role has expanded to include support or coaching plant personnel as they perform activities that create accounting entries. (Boer 1995) Interaction between management accounting and cost management The management and cost accounting professions are going through a major sea change as two opposing forces come into play. The first is the downsizing through reengineering of the finance – and hence management accounting function; the second is the growing importance of cost management. As downsizing continues, many of the traditional accounting responsibilities have become automated and the number of accountants required in the centralized finance department has been dramatically reduced. Only those accountants willing and able to adapt to this new environment will have a chance to survive. (Pierce 2003) The growing importance of cost management is a result of increased competition. As competition increases and profit margins fall, effective cost management becomes ever more important to the success of the company. The management accountant, as the companys measurement specialist, can play an essential role in the development and implementation of a broad array of cost management programs. Unfortunately, at the heart of this vision is a critical misconception – that cost management is a subset of management accounting. Indeed, the two are closely related, but they are independent fields of knowledge. To justify this statement, it is necessary to illustrate how the two fields differ. First, there are cost management techniques that do not rely on accounting to any extent, such as just-in-time production and micro-profit centres. Second, there is no need for cost management systems and financial reporting systems to be able to reconcile in detail. Third, cost management data should be collected by the user, not the accountant. Finally, many management accounting techniques do not involve cost management. That cost management techniques require no accounting is captured in a statement by Kuniyasu Sakai, the founder of the Taiyo Group, a highly successful Japanese conglomerate: "It is the size of a company that matters. When a company gets too large, it cannot respond in time. You need small flexible companies to survive. Breaking of large companies into smaller independent units is a powerful form of cost management." (Hannon 2001) When companies in the Taiyo Group split into smaller entities, no input from management accountants is involved in the splitting. The "child" starts as a division and is slowly weaned from its parent. It is the ability of the child to stand on its own, not some accounting analysis, that drives the process. It is easy to muddle management accounting and cost management. Activity-based costing (ABC), the process of determining the accurate cost of products, looks like a management accounting technique, but it is not; it is a cost management technique. ABC systems do not need to reconcile at the product level with a companys financial reporting systems. They should be stand-alone systems that are not subject to accounting rules. This lesson was learned by Hewlett-Packard, which originally had tied its cost driver accounting (CDA) systems (its version of ABC) to its financial reporting system. Only later did the company realize that problems, such as having to increase driver rates to avoid reporting large costs of underused capacity, were connected to this decision. The main problem was that the CDA system was designed to assist product engineers in designing new low-cost products. Unfortunately, the adjusted driver rates were inappropriate for this task. To avoid distorting the design process, Hewlett-Packard subsequently decoupled the two systems and now its CDA systems are independent of its financial reporting systems. For inventory valuation (which is where product costing and financial reporting interface), Hewlett-Packard uses a simple material dollar allocation scheme. This system is not capable of reporting accurate product costs, but it is capable of reporting accurate inventory valuations. In fact, it cannot report the cost of individual products, only the value of inventory and cost of goods sold. For product costing, Hewlett-Packard uses CDA. This approach confirms that an ABC system should be separate from the financial reporting system. As long as the value of inventory reported by the ABC system (by summing up the reported costs) is in the vicinity of that reported by the inventory valuation system, all is well. (R. Cooper 1997) Once the ABC system is decoupled from financial accounting, it can become a tool of pure cost management and be used to help the company increase profitability. For management accountants, this decoupling reduces the importance of their role in developing and implementing ABC and other cost management systems. But one should not overlook the cardinal principle that users should have the dominant role in developing cost management systems because they are the individuals who use the data. One of the important criticisms of accounting information is that it is too aggregate and too late. This criticism arises when individuals try to use accounting reports in ways for which they were not designed; for example, for real-time feedback. Many firms have learned that for cost management purposes it is better to have the user collect the data, transform it and send it to the accounting department than it is to have accounting collect it. This shift reflects the proactive nature of cost management. In contrast, management accounting information typically has a monthly or longer period perspective and is used reactively to evaluate performance. (Homes 2001) Effective cost management requires in-depth knowledge of a companys strategy and production or service delivery systems. This knowledge is necessary if a cost management program is to add value as costs are reduced. . Since it is easier to teach cost management to the functional specialist than it is to teach the job to the management accountant, the bulk of the growth in jobs created by the adoption of cost management will be among the functions, not the finance department. In other words, downsizing will result in fewer management accountants. However, management accountants can and should substantially contribute towards development of cost management programs if they have expertise in systems design and change management. These management accountants should also have the acumen to relate strategy to cost management together with the mindset to help functions specialists take advantage of the information that is provided by the new cost management systems. (Dempsey and Vance 2006) Tools of Cost Management Cost management has its focus firmly fixed on cost reduction in such a manner where per unit cost of production is reduced without impairing the quality or usability of the output. There are two approaches to cost management – reactive and proactive. Reactive, as the name suggests is more in the form of a knee-jerk reaction by the management where there is percentage reduction of cost across the board in all departments and functions without delving in detail about the pernicious impact of such a blanket cost curtailment. Proactive cost management; on the other hand, attempt to continuously reduce costs through tools such as Zero Base Budgeting, Value Analysis, Business Process Reengineering and Target Costing. Zero Based Budgeting In direct contrast to incremental budgeting where previous period’s actual data is either increased or decreased by some percentage across the board without any reference to the actual working conditions at the shop floor, supply status in input market or the degree of competition in the product market; zero based budgeting starts from scratch (that justifies its name of Zero Based) where each expenditure needs to be justified before it is approved. Previous period’s actual expenditure has got no relevance in determining current period’s approved expenditure. A budgeting method that is so thorough quite obviously discourages carrying forward of previous period’s inefficiencies but one must also appreciate the fact that there will be substantial volume of paperwork involved as each manager has to justify every single rupee they spend. Such a rigorous approach to expenditure automatically ensures all wasteful or avoidable expenditures are ruthlessly pruned and all inflated forecasts are brought back to proper size. Zero based budgeting forces managers to search for the most cost efficient method of completing a particular job and allocates resources in the best possible manner as every manager critically evaluates the cost of every unit of resource and the benefit expected from it before channelizing it for a particular use. As a manager has to justify each and every expense, items like research and development that not only has a considerable gestation period but also is highly uncertain as regards the probable returns, tend to get ignored while production enjoys the maximum focus. Repairs and especially preventive maintenance also tend to get overlooked in such form of cost management and might result in serious production breakdown at some point in future. Value Analysis Value is defined as a ratio of function to cost. Thus, value can be increased either by increasing functionality or by reducing cost. One of the basic touchstones of value analysis and value engineering is that cost should never be reduced to such an extent that it affects functionality in an adverse manner. Value engineering is an analytical, step-wise, organized and creative team approach designed to examine all the facets of cost and functions of a product or equipment or system to identify and eliminate unnecessary costs that are incurred in non-essential use or quality or appearance or reliability or customer feature. Business organisations undertake value analysis programmes with the objective of eliminating unnecessary cost without sacrificing quality and to enhance cost effectiveness through timely implementation of economically advantageous change. One other equally important objective of such businesses is to provide value added product to the customer so that their goodwill not only remains intact but also starts soaring. Just as it happens in the case of any other form of management led group activity, the effectiveness of one’s effort in conducting a value study depends on the level of cooperation that is forthcoming from peers, co-workers, and other segments of the organisation. ‘People problems’ are the most difficult to solve so they should be sorted out before the project is embarked on. (Bhasin 2003) Business Process Reengineering Business process reengineering is one of the most favoured methods adopted by business entities to improve their efficiency and enjoy the benefits of consequent reduction in cost of running the business. Business process reengineering (BPR), if implemented properly, radically transforms an organisation to substantially improve its level of performance. BPR accepts that there are two cornerstones of any organisation – people and processes. Even if an organisation is endowed with a dedicated and highly motivated human resource, still cumbersome processes might rob the organisation of gaining the maximum advantage from this highly valued asset. Thus, BPR identifies bottlenecks in processes and weeds out non-essential processes and tries to transform how people work. Minor alterations that might not seem to be significant at first glance might often reap enormous benefits in the form of enhanced cash flow, vastly improved service delivery and consequent rise in levels of customer satisfaction. Even such an apparently inconsequential act of improving the level and quality of documentation can have as much as 10% positive impact on the efficiency of a business. The best way to successfully implement a BPR is to take a top down approach that would encompass the entire organisation instead of trying to improve the efficiency of isolated projects. The entire process should start with drafting a clear, concise and contemporary mission statement that would set in unambiguous terms where the organisation would like to see itself at some equally clearly defined point of time in future. The mission statement then should be given a more concrete shape by formulating a business strategy that flows from that statement. The next most obvious document that needs to be drafted and would have a direct impact on available human resources and prevailing processes in the organisation would be the guideline detailing expected response from the workforce that must be scrupulously adhered to and would be absolutely imperative to achieve the stated targets. Once the expected nature and intensity of response from labour force is documented, the next step would involve construction of key performance measures that would be used as benchmarks while tracking progress or otherwise of the organisation. Management should now engage in serious bouts of brainstorming to identify initiatives that should originate from the top and have a salutary impact on the levels of efficiency. Once these basics are put in proper place, BPR exercise can commence in right earnest. Such an exercise that permeates through the entire organisation would obviously generate mounds of data and the organisation must have in place proper software that would be able to efficiently handle such huge volumes of data and be extremely user friendly so much so that each member of the workforce feels comfortable in handling it. If the software is too complicated or cumbersome to work with, it would de-motivate all those who need to extract maximum benefit from the software to make the entire exercise a success. (Carter 2005) Target Costing It is a simple and no frills approach that generates a decidedly favourable impact on levels of efficiency and profitability of a business without the associated accessories of fancy software and often unintelligible technical jargons. Target costing is nothing but mostly logical, disciplined common sense that can be imbedded into a companys existing procedures and processes without much of a hassle. Target costing recognises that there are variables that are beyond the control of the company and considers those as parameters and tries to work its way around these uncontrollable issues. The price ruling at the marketplace is one such parameter and so is the desired level of profit. Profit is another such parameter as it is largely determined by the expectation of the stockholders and the financial markets.  And, the desired profit is further benchmarked against others in the same industry and against all businesses. Target costing tries to even out all these mutually conflicting variables and attempts to produce an output that is within the limitations imposed. This approach stands apart from the traditional cost-plus approach as such a mindset might end up with the business offering customers something they cannot or would not afford. The basic process of this method consists of four simple steps that are: Define the product – What sort of product do the customers want Set the target – What price would the consumers be willing to pay and what would be the cost of production Achieve the target – How the target can be reached Maintain competitive cost – How to stay ahead of competition Target costing first determines the price market would accept and then determines the desired level of profitability that would be just enough to keep the business interested in producing that particular product. The target cost can then be obtained by deducting desired profit per unit from the price that would be sustainable in the market. Though it sounds pretty elementary and absolutely obvious, there are numerous firms that still follow the traditional and extremely risky cost-plus method of pricing their outputs. (Bird, Albano and Townsend 2009) References AAA Committee on Courses in Managerial Accounting. 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