1. Discuss the need for investing in the latest software of management accounting as well as financial accounting in your selected organization, highlighting differences between management accounting and financial accounting.
2. Evaluate the importance of classifying costs on the basis of types, behavior, function and relevance in business decision making, with suitable examples.
3. Discuss the objectives of preparing budgets and provide examples for operational budgets.
4. Explain how standard costs are used for variance analysis and discuss the terms favorable and adverse variances with suitable examples.
1. Need for investment in latest software
Information is the life blood of organisational decision making. Management accounting tends to provide information which is used by internal stakeholders for decision making. On the other hand financial accounting tends to cater to information needs of the external stakeholders. With regards to internal stakeholders, it is imperative that the information provided must be accurate or else the organisational decisions with regards to production, pricing and marketing may be incorrect which could be fatal in the hyper competitive business markets prevailing today (Drury, 2008). Investing in the latest software can offer various advantages to financial accountants and management accountants.
Financial accounting and software
Financial accounting primary caters to the information needs of the external stakeholders primarily the shareholders. The accounting software ensures that the accuracy of the information is enhanced. Additionally, it assists in the auditing of the financial information which is presented to the external stakeholders in a timely manner. Besides, through the usage of latest software, detailed information could be provided about the performance of each product and also each of the geography which may not be possible without the usage of technology. This enables the stakeholders to take prudent decisions with regards to dealings with the company based on detailed accurate information (Brigham & Ehrhardt, 2013).
Management accounting and software
The management requires constant information so as to take decisions with regards to organisational operational strategy. The use of latest software would aid to a large extent in ensuring that such information is easily available in the manner required by the management. Also, the information standards would be enhanced with detailed analysis available which would improve the overall quality of decision making. Additionally, with the reduction of manual entries, the overall information quality would tremendously improve. Further, the access of information would also tremendously improve along with lowering the overall turnaround time which is pivotal in modern organisations where timely decisions need to be taken (Seal, Garrison and Noreen, 2012).
2. Importance of cost classification
The need for cost classification into various subtypes is explained below.
- Classification on type
In case of manufacturing operations, the costs incurred are of various types namely for raw material, labour and other manufacturing overheads. It is imperative to distinguish amongst these costs so as to take prudent business decisions. For instance, with regards to manufacturing overhead allocation, techniques such as ABC may be involved and hence it is imperative to distinguish this cost from the other costs. Further, it is also imperative for the company to measure these costs separately so that the savings if any in these aspects can be measured separately. For instance, the impact of purchasing policy and inventory management would be evident in the raw material cost and hence this needs to be measured separately. Additionally, the extent of labour efficiency or any incentives provided to them can be measured through labour cost measurement which is possible only if the cost are segregated in accordance with type (Bhimani et. al., 2008).
- Classification on behaviour
In case of manufacturing operations, the various costs tend to behave differently with regards to volume and thus can be termed into three categories namely fixed costs, variable costs and semi-variable costs. While fixed costs are insensitive to changes in volume, the variable costs are the most sensitive to volume change. It is very imperative to distinguish the costs on type of behaviour (Brealey, Myers & Allen, 2008). For instance, assume that only 80% of the total manufacturing capacity is being utilised for the plant. The company receives an offer to provide a quantity equivalent to 10% of the capacity at a particular cost. In order to evaluate such a proposal, it is imperative to consider only the variable component of the costs as the incremental fixed costs for the proposal would be zero. Further, for pricing decisions and breakeven analysis, it is essential that the cost on the basis of behaviour should be segregated (Drury, 2008).
- Classification on function
For an organisation, there are various departments which essentially perform different functions in the value chain and the associated costs need to be distinguished. For instance, costs may be segregated on the basis of production, sales, distribution, finance, quality check and R & D. It is imperative to segregate these costs so that the management could take measures to optimise the costs incurred. Further, the core aspect is also decided in this manner (Parrino & Kidwell, 2011). For instance, if production is typically the most cost consuming, then the focus would be rationalisation of production processes so as to enhance efficiency and thereby save money. Besides, there are certain costs that may be directly attributed to a particular product but there are certain indirect costs such as administration, finance, customer support which need to be allocated to various product lines based on usage (Seal, Garrison and Noreen, 2012).
- Classification on relevance
For decision making by the management, only selected costs are considered pivotal and relevant. This concept is particularly relevant in case of capital budgeting where often there are past costs or sunk costs that are irrelevant to decision making an hence need to be ignored. Further, with regards to taking an incremental order in case of idle capacity, the fixed costs are irrelevant costs while the variable costs are relevant costs (Petty et. al., 2008).
3. Operational Budgets – Objectives and Examples
Budgets are omnipresent in various organisations as a periodic exercise which raises question with regards to the underlying utility of this cost consuming exercise. The objectives of preparing budgets are highlighted below (Drury, 2008).
- It acts as a guidance and control tool which outlines the priorities of the business. For instance, if the R&D budget of a firm enhances, it signals to the internal stakeholders that company is focused towards R & D. On the other hand, a decrease in budgetary allocation to a particular function, project or department usually is associated with decreasing priority.
- It is a useful tool to predict the cash flow at different times and hence decide on whether the company would experience a cash surplus or deficit. Based on these projections, the company can make suitable arrangement especially for those months when it is likely that a cash crunch would be observed.
- It is used to model the various scenarios and impact of these scenarios on the financial performance of the business. Based on these scenarios, the company can take reasonable assumptions so as to realistically predict the future performance. Additionally, the company can chalk out the strategy for unfavourable circumstances by understanding the likely impact on the financial performance.
- It is also used as a mechanism to allocate resources to the various department based on which they could plan their activities and achieve the objectives expected from these. It is imperative that the budgetary allocation should be proportionate to the responsibilities allocated and activity level expected.
- Budgets are an effective mechanism of measuring performance since the budget serves as a benchmark for the organisational performance. The actual performance of the business is compared with the benchmark performance and the deviation in the performance can be analysed along with the contributory reasons. This is a critical function and in turn also determines the incentives of various employees.
Depending upon the exact focus area of a particular operational budget, there are various forms which have been briefly highlighted below (Parrino & Kidwell. 2011).
- Master budget – It is a detailed projection of operational performance of business in a particular time period. It comprises three main financial statements namely cash flow statement, income statement and balance sheet.
- Cash Flow budget – This presents the prediction for the expected cash inflow and outflow and thus enables the firm to decide on whether any financing shortfall would arise and make timely arrangements to address the same. This is particularly useful for seasonal businesses or businesses with irregular sales pattern.
- Financial Budget – This indicates the amount of revenue and also the cost incurred for deriving the same. The usage of this type of budget is common for mergers and acquisition proposal evaluation.
- Static Budget – This is a budget in which there is no change in the items with alteration in the sales level and hence this has only limited usage. This is deployed only in sectors and markets where there is less variation in volume sales and can be predicted with high accuracy.
- Flexible Budget – This is defined as the budget where the constituent items vary with the volume of the sales. This is significant in businesses where the sales volume tends to show high variation. Because of the inherent flexibility that this budget offers with regards to static budgets, this leads to more effective controlling and operational planning.
4. Variance Analysis – Use of standard costs and Unfavourable /Favourable variances
Variance analysis is the quantitative analysis which computes the deviation of the actual figures with the budgeted numbers. In computation of variance analysis, a key enabling role is played by the standard costs. Standard costs may be referred to as those costs which are used by the organisation for deriving the budget (Drury, 2008). For instance, during the estimation of budget, the management may expect the cost of labour be $ 2 per unit which becomes the standard cost with regards to labour cost. However, the actual labour cost per unit may be greater or smaller which essentially leads to deviation known as variance analysis. Hence, this standard costs serves as a significant benchmark and therefore it is imperative that this cost must be realistic and achievable so as to minimise the variance caused. An unrealistically low standard cost may lead to high unfavourable variances which would defeat the underlying purpose of conducting variance analysis (Brealey, Myers & Allen, 2008).
Variance analysis enables the management to compute deviations and thus explore the underlying cause so as to take corrective measures. The same is particularly required in case of unfavourable variance. Additionally, the variances may also be analysed using a trend line so as to identify any main anomalies that require further introspection (Petty et. al., 2015). The examples of various favourable and unfavourable analyses are shown below (Seal, Garrison and Noreen, 2012).
- Purchase Price Variance
It compares the standard purchase price with the actual price. Favourable variance would arise when the actual price would be lower than the standard purchase price while unfavourable variance would be when actual price is higher. It is in the organisational interest that the purchase price of material should be lower and hence lower cost than expected is favourable since it would increase the profits,
- Labour Rate Variance
It compares the standard labour rate with the actual rate. Favourable variance would arise when the actual rate would be lower than the standard labour rate while unfavourable variance would be when actual rate is higher. It is in the organisational interest that the labour rate should be lower and hence lower cost than expected is favourable since it would increase the profits
- Labour Variance Efficiency
It compares the actual labour usage efficiency with the standard assumed at the time of budget formulation. If the labour took more time per unit, then this variance would be unfavourable as it would lead to higher costs than anticipated and thereby reduce the overall profit.
- Variable Overhead Spending Variance
It compares the actual overheads (variable) with standard overheads cost of variable nature. Higher cost than budgeted or standard would be reflective of unfavourable variance as it would lower the profit of the operations while lower cost than expected would be favourable.
It can be inferred from the above that any variation of cost and price from the budgeted values that leads to decrease in overall profits is unfavourable while any deviation that leads to increase in profits is favourable as explained above. Also, the variances can be determined by comparison of the actual cost with the standard cost assumed at the time of budgeting formulation (Bhimani et. al., 2008).
Bhimani, A, Horngren, CT, Datar, SM & Foster, G 2008, Management and Cost Accounting 4th eds., Prentice Hall/Financial Times, Harlow
Drury, C 2008, Management and Cost Accounting, 7th eds., Thomson Learning, London
Parrino, R & Kidwell, D 2011, Fundamentals of Corporate Finance, 3rd eds., Wiley Publications, London
Petty, JW, Titman, S, Keown, AJ, Martin, P, Martin JD & Burrow, M 2015, Financial Management: Principles and Applications, 6th eds., Pearson Australia, Sydney
Seal, WB, Garrison, RH and Noreen, EW 2012, Management Accounting, 4th eds., McGraw -Hill Higher Education, Maidenhead