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Management Accounting For Decision Making Notes

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MODULE 1: MANAGEMENT ACCOUNTING FOR DECISION MAKING Lecture 1 - Accounting and Decision Relevance READING 1: The Information Executives Really Need - Drucker (1995)

* Overrated and underrated the importance of information in the organisation
- Overrated possibilities of computer-generated 'business models' that could make decisions/run businesses
- Underrated new tools

* Greatest contribution of data processing capacity has been to operations

* Failed to realise how new tools would change tasks to be tackled - concepts (business) and tools (information) are mutually interdependent and interactive - new information forces us to see business differently From Cost Accounting to Yield Control

* Biggest redesign from traditional costing to ABC
- Traditional costing: Total manufacturing costs = Sum of individual operations; costs to do a task
- ABC: Manufacturing is integrated process starts when supplies, materials and parts arrive, continues even after finished product reaches end user; costs to not do a task - better cost & result control

* Strong implications for services
- Traditional cost accounting makes wrong assumptions (starts with cost of individual operations whereas services must assume one cost; cannot split between fixed and variable; cannot substitute capital for labour)
- E.g. banks - started to centre costs around customers (fixed cost per customer -
yield per customer determines cost & profitability)
- Some areas (e.g. research labs) productivity impossible to measure - will always rely on judgement > measurements but for knowledge-based/service work tools developed to measure costs and link to results
- E.g. car manufacturers did not realise negative impact of rebates/discounts etc. as only focused on manufacturing process - lesser impact if they had used ABC ABC shows impact of changes in costs & yields of each activity on the results of the whole From Legal Fiction to Economic Reality

* To succeed in competitive environment, company must know costs of entire economic chain and work with other members of chain to manage costs and maximise yield -
change from costing only internal operations to costing entire economic process

* Concept of 'company' is economically fiction; (e.g. Coca Cola used to be a franchisor, now company owns most of its bottling operations however customers do not care)

* Many cases of newcomers taking over established leaders - always because new company knows and manages costs of entire economic chain rather than own costs

* E.g. Toyota manages costs of suppliers & distributors ('members of keiretsu'); initially demonstrated by Durant for General Motors; copied by Sears, M&S, Wal-Mart

* Driving force of change to economic-chain costing is switch from cost-led costing (i.e. add premium to costs) to price-led costing (i.e. what customer is willing to pay)

* Can be a difficult to change - requires (1) uniform accounting systems at companies along entire change (2) information sharing along supply chain Information for Wealth Creation

* Enterprises run to create wealth not control costs - not reflect in traditional costing; executives require 4 sets of diagnostic tools to make informed judgements:

(1) Foundation Information: Cash flow, liquidity projections, common ratios (interest coverage, asset turnover, quick ratio etc.) (2) Productivity Information: Total Factor Productivity - EVA - measures value added over all costs (including cost of capital) thus measures productivity of all factors of production; Benchmarking - comparing one's performance with best performance in industry/anywhere in business (3) Competence Information: Being able to do something others cannot do at all or find difficult to do even poorly; Must keep careful track of competitors' performances (look for unexpected success/failures) - allows early recognition of opportunities; all organisation need to records/appraise innovative performance (4) Resource-Allocation Information: Allocation of capital and performing people convert into action action whatever information management has about its business; measures by ROI/Payback Period/CF/Discounted PV however should use all 4 (must try to answer what will happen if proposed investment fails? if investment successful what will it commit us to?) Where the Results Are

* 4 kinds of information tell us account current business - inform tactics

* For strategy, need organisation information about the environment (outside the company i.e. consider non-customers as well as customers; outside the industry)

* Must use available information - common assumption that conditions must be what we think they are/what we think they should be

* Few multinationals (e.g. Coca-Cola, Nestle, Unilever) building systems to gather/
organise outside information but ignored by majority

* Will require external sources - majority of information is outside the company; need outside help to questions and challenge company's strategy (e.g. using new kinds of software informational tailored to specific groups)

* Conceptually many new measurements have been discussed for many years, but new technical data processing ability to allow it to be done quickly/cheaply

* New tools not important but the concepts underlying them

* No longer focused on buying low/sell high; instead defines business as organisation that adds value and creates wealth

READING 2: When and Why to Measure Costs Less Accurately to Improve Decision Making - Merchant & Shields (1993)

* Recent emergence of a new consulting industry who assist clients with design and implementation of ABC

* Produce accurate cost data because based on better models of resource consumption.

* Better and improved cost accounting systems often valuable, but reporting and use of more accurate cost measurements is not always in organisations best interest

* Accuracy includes two measurement characteristics: precision and freedom from bias; precise measure has no randomness and an unbiased measure is skewed. Some companies add systematic biases and imprecision to cost systems: 1) Those with costs biased upwards 2) Costs biased downwards 3) Costs defined less precisely
- Legal biases and imprecisions that improve decision-making. Upwardly Biased Costs
- Allows for positive effects on pricing decisions in firms that face competitive pricing situations
- Overstated costs protect firms from shaving margins excessively to secure business
- Example 1: An apparel company used upwardly cost bias data for years - cost 'pads' (the overestimate), only known to senior staff are embedded in the standard cost of labour, fabric, freight. Prices set by adding 45% to standard cost. The sales people are allowed to give discounts, the cost pads prevent the sales people from giving discounts that reduces prices down to the true cost
- Example 2: Managers of the NuTone Housing Group used similar type of bias cost system. Biases added by setting lenient labour time standards. Labour and overhead costs overstated. The NuTone system however was different from the apparel company, the top-level managers were aware of the biases in the costs. However managers unconsciously used data and acted as if were accurate.
- Example 3: Nearly 25% of the people in executive classes use this kind of information to meet their time obligations. They set their watches ahead a few minutes to help overcome being late even though they know their watch is biased. Downwardly Biased Costs
- Two potential rationales: (1) Motivational rationale of 'target costing' (sets standards of cost based on estimates of what an item should cost in order to compete effectively) - targets below attainable standards leading to innovation (2) Desire to stimulate consumption of services (e.g. underestimating costs of computer, library, and audit to stimulate demand) Lower Precision
- Data less precise - understates some product/service costs and overstates others
- Better at inducing specific positive behaviour systems than more accurate systems
- Use of small number of cost pools and cost drivers to produce complex products -
focus employee attention on performance areas management decide are critical
- Example 1: In mid-1980s managers at Tektronix Portable Instruments Division were implementing a JIT/TQC manufacturing strategy. They chose to implement a cost system assigning the broad range of material support expenses with a single cost driver to encourage design engineers to reduce the parts, vendors, etc. Relatively

simple design is important at Tektronix as their life cycle is short so competitive advantage is gained by introducing products sooner. This relatively simple cost system motivated the engineers to design simpler products requiring lower development time.
- Example 2: Mangers at Zytec simplified cost system over time to focus employees attention on what managers believed were most important cost reduction factors eventual only included single cost driver (cycle time)
- Example 3: Managers at HP modified their cost system seven times between 1985-1988 to help their design engineers learn more about the economics of manufacturing. It started with one cost driver and increased to nine; cost system was still simpler. Main point is that cost systems did not precisely capture the complexity of the production process.
- Example 4: Practice of using a single allocation base (direct labour) in many Japanese firms - greater use of technology improves long term competitiveness hence Japanese managers allocate costs using labour cost base to focus design engineers attention on identifying opportunities to reduce products labour content. Who should not use less accurate cost systems?
- Not suitable if firm is selling a commodity product
- In the above examples, managers had a clear strategy and used their cost systems to implement strategies and not develop them
- When making make/buy decisions it is important to have accurate cost systems. General Motors generated a cost system with 5000 activity cost pools and 100 cost drivers for a single plant. Inaccurate cost systems can identify priorities for competitive success by focusing on those activities and resources with cost reduction potential Example: Schrader Bellows an accurate cost system was developed to help with the marketing and pricing decisions/strategies. Schrader Bellows personnel developed a cost system with 28 activity cost pools and 16 different second stage cost drivers. Previous cost system had one cost pool and used labour as second stage allocation. Product costs under the new system were a lot different and in line with the market prices. Therefore, both accurate and inaccurate cost systems can be desirable depending on firms priorities

Lecture 2 - Costing and Pricing in the Short-Term READING 1: Management & Cost Accounting Chapter 10 (Bhimani et al, 2012) Information and the Decision Process Decision Model: Formal method for making a choice, frequently involving quantitative and qualitative analyses - accountants supply data (input to decision making)
- 5 Step Process: (1) Gathering information e.g. historical costs (2) Making predictions e.g. predict future costs (3) Choosing an alternative i.e. using (1) and (2) to choose between 2 possible routes (4) Implementing the decision (5) Evaluating the performance The Concept of Relevance Relevant costs: Expected future costs that differ among alternative courses of action Relevant revenues: Expected future revenues that differ among alternative actions Differential cost: The difference in total cost between two alternatives - difference between total costs and relevant costs should be equal as irrelevant costs will not affect differential cost Quantitative factors: Outcomes that are measured in numerical terms; can be financial (costs of direct materials, direct manufacturing labour, marketing) or non-financial (reduction in page download time for Internet company, on-time flight arrivals for airline) Qualitative factors: Outcomes that cannot be measured in numerical terms (e.g. employee morale) - can also be relevant!!
One-Off Special Orders
- Decision of accepting or rejecting one-off special orders when there is idle production capacity and where the order has no long-run implications
- Assume all costs can be classified as variable (per specific driver) or fixed
- Can be analysed in absorption-costing format (fixed manufacturing costs are included as product costs) or in a contribution income statement (only considering relevant costs)
- Absorption-costing can be misleading!! - comparisons should be based on relevant (or total) costs
- Incremental Costs - additional costs to obtain additional quantity, over & above existing or planned quantities of a cost object (usually no incremental FC for special order)
- Important to not assume that all variable costs are relevant and all fixed costs are irrelevant; to avoid error require each item to both (1) Be an expected future revenue or cost (2) Differ among the alternatives
- Generally use total cost rather than unit costs in relevant-cost analysis Outsourcing and Make-Or-Buy Decisions
- Outsourcing - Process of purchasing goods and services from outside vendors rather than producing the same goods or providing the same services within the organisation
- Make-or-buy decisions often dictated by qualitative factors (do not have knowledge to product, want to keep processes private, quality, dependability etc.) or cost
- Often choice is not fundamentally whether to make or buy, it is how best to use available facilities
- Opportunity Cost - the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use - seldom incorporated into formal financial accounting reports because costs do not entail cash receipts/disbursements (also can be illustrated through carrying costs)

Product-Mix Decisions Under Capacity Constraints
- Firms must decide which products to make and in what quantities
- Aim for the highest contribution margin per unit of the constraining factor - that is, the scarce, limiting or critical factor (e.g. machine hours)
- Use optimisation techniques (e.g. LP - refer to MG211 notes) to make decisions Customer Profitability & Relevant Costs
- Companies must often decide whether they should add some customers and drop others
- Use relevant-cost/relevant-revenue analysis to make decisions (e.g. relevant-cost analysis of dropping/adding a customer) Irrelevance of Past Costs and Equipment Replacement Decisions
- Book value costs of equipment irrelevant in equipment replacement decisions, instrad should consider current disposal price of old machine and cost of new machine
- Sunk Cost - past costs that are unavoidable because they cannot be changed, no matter what action is taken

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