1.0 Introduction
Strategic Management Accounting is concerned with providing information that will support the strategic plans and decisions made within a business. It is a development in the accounting literature that acts as a framework for the various strategic elements in the discipline of management. The objective of Strategic Management Accounting (SMA) is to provide information to managers that will help them to run business in a way towards achievement of strategic management of businesses' strategic objectives.
1.1 Cost Centres
According to (Chartered Institute of Management Accountants) CIMA Official Terminology, a cost centre is a production or service location, function, activity or item of equipment for which costs are accumulated. It can be divisions, departments, outlets, or even individual products within an organisation.
Typical examples of Cost Centres are many branches of Building Societies and Banks. In these cases all costs are allocated to a branch. So for example, the branch will be charged for the brochures it uses, its wage bill, its telephone costs, and will be apportioned part of head office costs. The overhead costs allocated can often be linked to the income earned by each branch, and therefore profitability of each branch can be judged. There are two types of Cost Centres; the production cost centres that are directly involved with the production process for example, the cutting and finishing department. The other one is the service cost centres, which provide support services for the production cost centres. Examples include the maintenance department and the stores.
1.1.1 Advantages and Disadvantages of Cost Centre Managers
A Cost Centre Manager's job is to produce the demanded quantity and mix of widgets in an efficient manner.
Advantages of Cost Centre Managers are as follows:
Motivate staff, who feel committed to the cost centre
Improve monitoring of costs and expenditure
Improve management information on profit-ability
Improve monitoring of investment returns
Determine the outputs that will be produces as well as the expected inputs required to produce each unit of output
Allow the business to identify which areas are most profitable
Help with the organisation of departments and resources
Control over costs
Disadvantages of Cost Centre Managers are as follows:
Incorrect allocation of overheads can lead to under or overestimated of profitability
Increases administration and paperwork
The performance is evaluated by a complex system of cost variances that compare actual to budgeted cost performance
No control over revenue or capital
1.2 Profit Centre
Profit Centres take the basic idea of cost centres somewhat further. They are run as a separate business within a business. They will buy services from other divisions and profit centres within the parent organisation, and then selling their output on to the final customer or to another part of the parent organisation. However, they will have an own profit and loss account and bid for investment capital from the parent company. An example of an organisation operating profit centres is Corus (formerly British Steel). Within Corus the Tin Plate division operates as a profit centre. Corus Tin Plate buys services and goods from within the organisation, and sells output to other divisions and to external customers.
1.2.1 Advantages and Disadvantages of Profit Centre Managers
Advantages of Profit Centre Managers are as follows:
Allows decision-making and power to be delegated effectively
Improves speed and efficiency of decision making
Increased motivation
Responsible for both costs and revenues in their divisions
Responsible for production and sales performance and decide on matters such as pricing, marketing, volume of output, sources of supply and sales mix
Allows more effective use of bonuses and other forms of financial motivation, all linked to profitability of profit centre
Assigned non-current assets and working capital by top management
Generate profits from the effective use of assets
Create value from the resources the company has put at their disposal
Free to follow own judgement except within explicit constraints
Hold a combination of all kinds of goals simultaneously
Disadvantages of Profit Centre Managers are as follows:
Profit Centre Managers are frequently caught in a cruel dilemma. They are often asked to carry out policies that they strongly feel to be unwise. Yet, they know that they will be held responsible for failure, whatever the cause
Loss of overall control of the company
Working towards different or non-company agendas
Increased opportunity for empire building by management
Do not have the authority to determine the level of capital investment in their facilities
The executive stress is difficult to overstate when there is conflict between policy restrictions, near term performance, the long term good of the company and personal survival
Situation becomes more difficult when corporate staff becomes deeply involved of how the business should be run. Hence, the most important decisions a manager makes tend to depress short term reported performance in order to significantly improve long term results
Corporate Management has a different concept of the requirements for future success from the concepts of the Profit Centre Management
1.3 Investment Centre
An Investment Centre is a profit centre with added authority to make investment decisions. It is, in many respects, a business within a business. In its strongest form of costs, revenues, the acquisition and disposal of the assets it supports the division's activities. In fact, it is an area of responsibility.
(Du Pont) was the first major company in the United States to recognize that the performance of an investment centre must consider the level of investment along with the income generated from the investment. Return on Investment (ROI) measures the rate of return generated by an investment centre's assets.
Investment Centre Managers are evaluated with metrics as (ROI) and economic value-added.
ROI evaluates an investment's potential by comparing the magnitude and timing of expected gains to the investment costs. For example, a new initiative costs $500,000 and will deliver an additional $700,000 in increased profits. Simple ROI = gains - investment costs ÷ investment costs. ($700,000 - $500,000 = $200,000. $200,000 ÷ $500,000 = 40%) This calculation works well in situations where benefits and costs are easily known, and is usually expressed as an annual percentage return.
Therefore performance appraisal within investment centres is, based upon two element, profit and investment.
1.3.1 Advantages and Disadvantages of Investment Centre Managers
Advantages of Investment Centre Managers are as follows:
Discretion over capital expenditure and working capital decisions as well as production and sales performance
Responsible for profits
Authority to plan, control and responsibility within divisionalised organizations
Responsible for selection and performance of particular investments
More powerful strategy management system built upon the framework of strategy maps and Balanced Scorecards to motivate, align and evaluate the performance
Decisions are often made in a more timely fashion
By pushing decision-making authority, managers most familiar with the a problem have the opportunity to solve it
The use of enterprise resource planning (ERP) systems to provide information to managers throughout an organization
Disadvantages of Investment Centre Managers are as follows:
Financial metrics are no longer sufficient for measuring the annual performance of the managers to create long-term value
Ethical impact of decisions-making
Changing market and economic conditions
Unexpected production problems
Fails to build lower-level employee that may cause conflict
Time-consuming and difficult to manage logistically
Managers become so concerned with own areas of responsibility that they lose sight of the big picture. Because of this lack of focus on the company as a whole, managers may tend to make decisions benefiting their own segments, which may not always be in the best interest of the company
Lack of coordination and communication between segments
Difficult to share unique and innovative ideas
May result in duplicative efforts and duplicative costs
Lack of well-developed and well-designed information systems
Economic factors influence such as: high inflation, strength of underlying capital markets and the strength of the local currency
Social, cultural, political and language barriers
PART B
A study by Horngren (1995) found that the focus of cost management should be on decisions and the various cost management techniques, systems and measurements that spur and help managers to make wiser economic decisions.
2.0 Marginal or variable costing
Marginal costing is also termed as variable costing, a technique of costing which includes only variable manufacturing costs , in the form of direct materials, direct labour, and variable manufacturing overheads while determining the cost per unit of a product. Marginal costing is an alternative method of costing to absorption costing. Closing stocks of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred.
The marginal cost of a product -"is its variable cost". This is normally taken to be; direct labour, direct material, direct expenses and the variable part of overheads.
The term 'contribution' mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus
MARGINAL COST = VARIABLE COST DIRECT LABOUR
+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
2.1 Advantages of Marginal Costing
Simple and easy method to use
The mark-up percentage can be varied. In practice, mark-up pricing is used in businesses where there is a readily identifiable basic variable cost
2.2 Disadvantages of Marginal Costing
It gives fixed overheads in pricing
3.0 Full or absorption costing
Absorption costing is a costing technique that includes all manufacturing costs, in the form of direct materials, direct labour, and both variable and fixed manufacturing overheads, while determining the cost per unit of a product. It is also referred to as the full- cost technique.
3.1 Advantages of full or absorption costing
A business might have an idea of the percentage profit margin it would like to earn and so might decide on an average profit mark-up as a general guideline for pricing decisions. This would be particularly useful for businesses that carry out a large amount of contract work or jobbing work, for which individual job or contract prices must be quoted regularly to prospective customers.
3.2 Disadvantages of full or absorption costing
Perhaps the most significant problem with full costing is that it fails to recognise that since demand may be determined by price; there will be a profit-maximising combination of price and demand. This approach to pricing will be most unlikely to arrive at the profit-maximising price.
Prices must be adjusted to market and demand conditions: the decision cannot simply be made on a cost basis only.
4.0 Activity Based Costing (ABC)
In 1988 (Cooper and Kaplan) developed a more refined approach for assigning overheads to products and computing product costs, the Activity Based Costing (ABC). ABC is a dynamic approach to determining costs by assigning them to the principal activities performed within an organization.
4.1 Advantages of ABC
Greater understanding of customer profitability
Identification of non value-adding activities; that is tasks which add no further value to the product or service, such as manual checking of customer orders and specifications
Identification and understanding of cost behaviour and thus the potential to improve cost estimation
Improves accuracy and utility value of management information, thus enabling managers to make better informed decisions a both tactical and strategic levels
Allows all managers to understand and control costs in their area
By involvement with ABC, accountants can now contribute to the organisation's future, rather than merely reporting on its past
4.1 Disadvantages of ABC
Identifying cost drivers is a problem. This would need to be explored with each department manager
Overheads, common to several cost-pools, may be required to be arbitrarily apportioned across all product lines or customers. Examples: rent; rates; insurance; depreciation; power; heat and light
Overall time and cost involved in implementation.
Departmental resistance to change, or to provide information
Reluctance to change traditional accounting methods
5.0 Example illustrating why Marginal costing is better than absorption costing and the reason for the choice
XYZ produces a product that sells for £60 per unit. Variable production costs are £35 per unit and the fixed production costs of £30,000 per period are absorbed on the basis of the normal capacity of 5,000 units per period. Fixed administration, selling and distribution overheads are £19,000 per period. There was no opening inventory for the latest period. We shall be calculating the profit reported for sales of 5,000 units last period for production volumes 5,000 units, 6,000 units and 7,000 units, using Absorption and Marginal costing.
Absorption costing
Fixed production cost per unit = £30,000/5,000 = £6 per unit
Full production cost per unit = £35 + £6 =£41 per unit
Marginal costing
This example above demonstrates an important point when considering the impact on profit reporting of marginal and absorption costing methods.
For a given level of sales, marginal costing will report the same level of profit whatever the level of production. In contrast, absorption costing will report higher levels of profit for the same level of sales, if production levels are higher.
Here, the criticism of the use of absorption costing for the internal reporting of profit is that, if a manager's reward is based on the profit for the period, the manager will be encouraged to increase production even if the resulting output cannot be sold.
5.1 Example illustrating why Marginal costing is better than ABC and the reason for the choice
Example if a firm needs to access the viability of two products; it needs to look at the cash flow of the two products/ services:
Product A:
Variable cost - $10,000
Sales : $50,000
Other marginal cosy of prod: $25,000
Contribution: $15,000
Product B:
Variable cost - $15,000
Sales: $65,000
Other marginal cosy of prod: $15,000
Contribution: $35,000
Therefore, product B is more profitable as the organisation is earning more in terms of contribution and is sufficient to cover other fixed cost.
Marginal costing helps management to decide on pricing policy:
The need to make a profit
Market demand
Requirement to increase marketing share for a product
Competition from other firms
Maximum utilisation of resources
Economic condition
Political factors
In the ABC approach the coating system produce different figures for net operating income and difference can be quite large though managers preferred this approach for internal decision making.
6.0 Example illustrating why Absorption costing is better than marginal costing and the reason for the choice
The normal level of activity for the current year is 60,000 units, and fixed costs are incurred evenly throughout the year.
There were no stocks of the product at the start of the quarter, in which 16,500 units were made and 13,500 units were sold. Actual fixed costs were the same as budgeted.
Then, various calculations regarding Absorption vs. Marginal costing can be worked out as under:-
The rate of absorption of fixed production overheads will therefore be:
Rs.1, 50, 000 ÷ 60,000 = Rs. 2.50 per unit.
(i) The fixed production overhead absorbed by the products would be 16,500 units produced Ã- Rs. 2.50 = Rs. 41,250
(ii) Budgeted annual fixed production overhead = Rs.1, 50, 000
Actual quarterly fixed production overhead = budgeted quarterly fixed
production overhead (1,50,000 ÷ 4)
Production overhead absorbed into production [see (i) above]
Over -absorption of fixed production overhead
(iii) (a) Profit statement for the quarter, using Absorption Costing
In the context of costing of a product/service, an absorption costing considers a share of all costs incurred by a business to each of its products/services. In absorption costing technique; costs are classified according to their functions. The gross profit is calculated after deducting production costs from sales and from gross profit, costs incurred in relation to other business functions are deducted to arrive at the net profit.
Absorption costing gives better information for pricing products as it includes both variable and fixed costs. Hence, Profits as shown by Marginal and Absorption Costing techniques are not the same
6.1 Example illustrating why Absorption costing is better than ABC and the reason for the choice
The traditional approach to fixed overhead absorption has the merit of being simple to calculate and apply. However, simplicity does not justify the production and use of information that might be wrong or misleading. ABC undoubtedly requires an organisation to spend time and effort investigating more fully what causes it to incur costs, and then to use that detailed information for costing purposes. But understanding the drivers of costs must be an essential part of good Performance Management.
7.0 Example illustrating why ABC is better than marginal costing and the reason for the choice
Marginal costs change in total in proportion to the level of activity. For example if a carmakers production increases by 5%, its tire costs will increase by about 5%.
The ABC method of estimating costs has many advantages over marginal costing methods. More costs can be accurately traced to the product under study, which results in the ability to achieve more relevant pricing. In addition, more accurate costs help in the decision-making process. Because ABC has built-in flexibility, study planners can experiment with various what-if scenarios before the project begins and even change the study design after the study is underway.
7.1 Example illustrating why ABC is better than absorption costing and the reason for the choice
An alternative method of absorbing overheads is to use activity-based costing, where costs are collected on the basis of the activities which consume resources and overheads are allocated to products on the basis of appropriate cost drivers.
Examples:
Stores costs (say £20,000) may be driven by the number of requisitions raised (say 50)
A cost per requisition can therefore be calculated (£20,000/50 = £400)
A particular product line will therefore absorb stores costs on the basis of the number
of requisitions raised in order to produce that line. So, if to produce all of Product X
required 6 requisitions, then Product X would absorb £400 x 6 = £2,400 of stores costs
If 12,000 units of Product X were made in total, the element of stores cost in the overall
unit cost of Product X would be £2,400/12,000 = £0.2
8.0 Appendices
APPENDIX A
An example of Overhead Allocation
Wages of the supervisor of department A £200
Wages of the supervisor of department B £150
Indirect materials consumed in department A £50
Rent of the premises shared by departments A and B £300
The cost accounting system might include three cost centres
Cost centre: 101 Department A
Department B
Rent
Overhead costs would be allocated directly to each cost centre, i.e. £200 + £50 to cost centre 101, £150 to cost centre 102 and £300 to cost centre 201. The rent of the factory will be subsequently shared between the two production departments, but for the purpose of day to day cost recording in this particular system, the rent will first of all be charged in full to a separate cost centre.
