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COST AND MANAGEMENT ACCOUNTING

In cost accounting, primary emphasis is on cost and it deals with collection,
analysis, relevance, interpretation and presentation for various problems of
management. Management accounting utilizes the principles and practices of
financial accounting and cost accounting in addition to other management
techniques for efficient operation of a company. Both have the same objectives of
assisting management in it’s functions of planning, decision making, controlling
and techniques like budgetary control, standard costing, marginal costing.

RESPONSIBILITY ACCOUNTING
collection, summarization, and reporting of financial information about various
decision centers (responsibility centers) throughout an organization; also called
activity accounting or profitability accounting. It traces costs, revenues, or profits
to the individual managers who are primarily responsible for making decisions
about the costs, revenues, or profits in question and taking action about them.
Responsibility accounting is appropriate where top management has delegated
authority to make decisions. The idea behind responsibility accounting is that each
manager's performance should be judged by how well he or she manages those
items under his or her control.

Responsibility accounting is an underlying concept of accounting performance

measurement systems. The basic idea is that large diversified organizations are
difficult, if not impossible to manage as a single segment, thus they must be
decentralized or separated into manageable parts. These parts, or segments are
referred to as responsibility centers that include:
1) revenue centers, 2) cost centers, 3) profit centers and 4) investment centers.

This approach allows responsibility to be assigned to the segment managers that

have the greatest amount of influence over the key elements to be managed. These
elements include revenue for a revenue center (a segment that mainly generates
revenue with relatively little costs), costs for a cost center (a segment that
generates costs, but no revenue), a measure of profitability for a profit center (a
segment that generates both revenue and costs) and return on investment (ROI) for
an investment center (a segment such as a division of a company where the
manager controls the acquisition and utilization of assets, as well as revenue and
costs).
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Advantages and Disadvantages

Responsibility accounting has been an accepted part of traditional accounting

control systems for many years because it provides an organization with a number
of advantages. Perhaps the most compelling argument for the responsibility
accounting approach is that it provides a way to manage an organization that would
otherwise be unmanageable. In addition, assigning responsibility to lower level
managers allows higher level managers to pursue other activities such as long term
planning and policy making. It also provides a way to motivate lower level
managers and workers. Managers and workers in an individualistic system tend to
be motivated by measurements that emphasize their individual performances.
However, this emphasis on the performance of individuals and individual segments
creates what some critics refer to as the "stovepipe organization." Others have used
the term "functional silos" to describe the same idea. Consider 9-6 Exhibit below 1.
Information flows vertically, rather than horizontally. Individuals in the various
segments and functional areas are separated and tend to ignore the
interdependencies within the organization. Segment managers and individual
workers within segments tend to compete to optimize their own performance
measurements rather than working together to optimize the performance of the
system.
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ADVANTAGES DISADVANTAGES

1. Provides a way to manage a large diversified The point at left has some credibility at the division
organization. Better decisions can be made at the level, but the system must be managed as a system not
local level. a group of subsystems. A RA stovepipe organization
creates conflicts between segments, e.g., transfer
pricing problems, purchasing department buying on the
basis of price, production departments pushing
defective products downstream to maximize labor
efficiency and production volume measurements.

2. Provides incentives to department managers This causes competition between segments and
and individuals to optimize their individual individuals rather than cooperation and teamwork.
performances. Prevents goal congruence. Creates slack and excess,
e.g., inventory buffers, excess capacity, people, and
vendors. Promotes ranking people which ignores
statistical variation. According to Deming, this
destroys moral, intrinsic motivation and teamwork.

3. Provides managers with the freedom to make Tends to ignore many, if not most interdependencies
local decisions. within the system. Decisions are based on self interest
rather than the best interest of the system.

4. Provides top management with more time to According to Deming, a system cannot manage itself.
make policy decisions and engage in strategic
planning.

5. Allows management to avoid understanding This is how management accounting lost relevance
the system by using top down remote control according to Johnson and Kaplan.
based on accounting measurements. Supports
point 4. The top down approach also ignores the concept of
continuous improvement and Deming’s concept of
leadership, i.e., managers need to understand the
system so that they can help facilitate improvement,
not judge and blame people for variations in financial
accounting results.

6. Supports management and individual Specialist can not understand the system and the
specialization based on comparative advantage. system cannot manage itself.
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Objectives of Responsibility Accounting

Responsibility accounting is a method of dividing the organizational structure into
various responsibility centers to measure their performance. In other words
responsibility accounting is a device to measure divisional performance
measurement may be stated as under:
1. To determine the contribution that a division as a sub-unit makes to the total
organization.
2. To provide a basis for evaluating the quality of the divisional managers
performance. Responsibility accounting is used to measure the performance of
managers and it therefore, influence the way the managers behave.
3. To motivate the divisional manager to operate his division in a manner
consistent with the basic goals of the organization as a whole.

Problems in Responsibility Accounting

While implementing the system of responsibility accounting, the following
difficulties are likely to be faced by the management:
1. Classification of costs: For responsibilityaccounting system to be affective a
proper classification between controllable and noncontrollable costs is a prime
requisite. But practical difficulties arise while doing so on account of the complex
nature and variety of costs.
2. Inter-departmental Conflicts: Separate departmental persuits may lead to
inter-departmental rivalry and it may be prejudicial to the interest of the enterprise
as a whole. Managers may act in the best interests of their own, but not in the best
interests of the enterprise.
3. Delay in Reporting: Responsibility reports may be delayed. Each responsibility
centre can take its own time in preparing reports.
4. Overloading of Information: Responsibility accounting reports may be
overloading with all available information. This danger is inherent in the system
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but with clear instructions by managementas to the functioning of the system and
preparation of reports,etc., only relevant information flow in.

5. Complete Reliance will be deceptive: Responsibility accounting can’t be relied

upon completely as a tool of management control. It is a system just to direct the
attention of management to those areas of performance which required further
investigation.

An example to explain Responsibility Accounting

CONSOLIDATED P&L Account

(Source: Wikipedia.org)

An integrated textile unit showed a net profit after tax of Rs.272 million. Its
ROI (Return on Investment), was 17.5% which is much above the supposed cost of
capital of 12.5%.

The company was operating three divisions: (i) Spinning Unit, (ii) Weaving Unit
and (iii) a Finishing Unit. As of now, it is not apparent who earned what. So
managers of the three departments would be asking for bonuses or rewards.

Now suppose, the company asks its accountants to prepare Division-wise P&L
account and present the same to the management for performance appraisal of the
three managers.
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DIVISION WISE ACCOUNTS

(Source: Wikipedia.org)

After considering division-wise performance, who do you think deserve the bonus?

Only the manager, Spinning Division, deserves the bonus. Manager Weaving has
just broken even by earning profit equal to cost of capital. Manager Finishing was
really a drag on the company’s resources and its losses were only hidden in
consolidated statements because of substantial contribution made by Spinning
Unit.

However, this is over-simplified example but it brings  glaring facts to the notice of
the management and other users of the accounts.
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RESPONSIBILITY CENTER
A responsibility center is an organization unit that is headed by a manager who is
responsible for its activities. In a sense, a company is a collection of responsibility
centers, each of which is represented by a box on the organization chart. This
responsibility centers form a hierarchy. At the lowest level are the centers for
sections, wok shifts, & other small organization units. Departments or business
units comprising several of these smaller units are higher in the hierarchy. From
the stand point of senior management & the board of directors, the entire company
is a responsibility center, though the term is usually used to refer to units within the
company.t
Nature of responsibility center :
A responsibility center exists to accomplish one or more purposes, termed its
objectives. The company as a whole has a goals, & senior management decides on
a set of strategies to accomplish these goals. The objective of the company’s
various responsibility centers are to help these strategies. Because every
organization is the sum of its responsibility centers, if each responsibility center
meets its objectives, the goals of the organization will have been achieved.
Above diagram illustrates that core operation of every responsibility center.
Responsibility centers received inputs, in the form of materials, labor, & services.
Using working capital (e.g. inventory, receivables), equipment, and other assets,
the responsibility center perform its particular function, with the ultimate objective
of transforming its inputs into outputs, either tangible (i.e., goods) or intangible
(i.e. Services). In a production plant, the outputs are goods. In a staff units, such as
human resources, transportation, Engineering, accounting , and administration, the
output are services.
The products (i.e. goods and services) produced by a responsibility center may be
furnished either to another responsibility center, where they are inputs, or to the
outside market place, where they are outputs of the organization as a whole.
Revenues are the amounts earned from providing this outputs.

Relation between Inputs and Outputs :

Management is responsible for ensuring the optimum relationship between inputs
and outputs. In some centers, the relationship is casual and direct, as in a
production department, for example, where the inputs of raw material become a
physical part of the finished goods. Here, control focuses on using the minimum
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input necessary to produce the required output according to the correct

specifications and quality standards, at the time requested, and in the quantities
desired.
In many situations, however, inputs are not directly related to outputs. Advertising
expenses is an input i.e. intended to increases sales revenue, but since revenue is
affected by many factors other than advertising, the relationship between increased
advertising and any subsequent increased in revenue is rarely demonstrable, and
the management’s decision to increase advertising expenditures is typically based
on judgment rather than data. In research and development, the relationship
between inputs and outputs is even more ambiguous, the value of today’s R & D
effort may not be known for several years, and the optimum amount that a given
company should spend for R & D is indeterminable.

Types of Responsibility centers :

There are four types of responsibility centers, classified according to the nature of
the monetary inputs and /or outputs that are measured for control purposes:
Revenue Centers, Expense Centers, Profit Centers and Investment Centers.
1. Revenue Centers : In a revenue center, output (i.e. revenue) is measured in
monetary terms, but no formal attempt is made to relate input (i.e. Expense
or cost) to output. (If expense was matched with revenue, the unit would be
a profit center). Typically revenue centers are marketing/sales units that do
not have authority to set selling prices and are not charged for the cost of
goods they market.
2. Expenses Centers : Expense centers are responsibility centers whose inputs
are measured in monetary terms, but whose outputs are not.
3. Profit centers : When a responsibility center’s financial performance is
measured in terms of profit, the center is called a profit center. Managers of
profit center should also be responsible for revenues as well as costs, which
implies that there should be sufficient decentralization of authority within
the company to permit profit center, managers to make decisions about
selling prices and output levels at those prices.

4. Investment centers : It is a classification used for business units within an

enterprise. The essential element of an investment center is that it is treated
as a unit which is measured against its use of capital, as opposed to a cost or
profit center, which are measured against raw costs or profits.
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COST CENTER
Cost Centers are held responsible for the costs incurred but not for generating
revenue i.e. ., either the costs or the level of outputs can be independently
controlled but not both. It operates in 2 ways.
A cost center is part of an organization that does not produce direct profit and adds
to the cost of running a company. Examples of cost centers include research and
development departments, marketing departments, help desks and customer
service/contact centers.
Although not always demonstrably profitable, a cost center typically adds to
revenue indirectly or fulfills some other corporate mandate. Money spent on
research and development, for example, may yield innovations that will be
profitable in the future. Investments in public relations and customer service may
result in more customers and increased customer loyalty.
Because the cost center has a negative impact on profit (at least on the surface) it is
a likely target for rollbacks and layoffs when budgets are cut. Operational
decisions in a contact center, for example, are typically driven by cost
considerations. Financial investments in new equipment, technology and staff are
often difficult to justify to management because indirect profitability is hard to
translate to bottom-line figures.
Business metrics are sometimes employed to quantify the benefits of a cost center
and relate costs and benefits to those of the organization as a whole. In a contact
center, for example, metrics such as average handle time, service level and cost per
call are used in conjunction with other calculations to justify current or improved
funding. A cost center is one which is responsible only for the control of costs it
does not concern itself with pricing of products or even investing the surplus in a
fruitful manner, its only concern is with respect to managing the Costs it
encounters. Cost centers are the various departments to which various Kinds of
costs are allocated. In layman terms-If the executive of Administrative department
drinks the coffee than the cost cannot be charged to manufacturing department but
to administrative department. Technical terms packaging cost is allocated to sales
and distribution department. Cost of raw material to manufacturing dept and so on.
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COST
In performing managerial functions of planning and control, the manager should
know costs of each alternative. Costs data are also needed to make decisions such
as pricing, volume, make or buy, replacements, asset acquisition, product mix etc.
Further the performance of executives and their sub ordinates can be evaluated and
controlled only when a comparison of actual cost incurred and the costs that should
have been incurred is made. COST AND COST CURVES
MANUFACTURING COSTS
Manufacturing is a process of converting raw materials into finished goods through
the use of labor service and other facilities in factories 1. DIRECT MATERIAL
COST 2. DIRECT LABOR COST 3. FACTORY OVERHEAD COST
In a manufacturing company, manufacturing costs will include material, labor and
factory overheads, while nonmanufacturing costs will include distribution and
administration expenses.
DIRECT MATERIALS COST.
Materials are physical commodities that enter into the making of a product. These
are stores or raw materials. Direct materials are those which can be directly and
conveniently identified with the physical units of finished product. These materials
really enter into, and become part of a finished product. For eg, leather used to
manufacture shoes or wood used to make chair or steel to make steel almirah are
direct materials since they can be directly traced to finished products. Indirect
materials are used to in the manufacturing operations, but do not become part of
the finished products and cannot be identified separately .eg are cotton waste,
lubricants, grease. Oil etc.
DIRECT LABOR COST
Like materials, labor is also classified as direct and indirect. Direct labor is one
which is directly involved in converting raw materials into finished goods. These
labor costs vary very closely with units of finished goods. The wages paid to
workers who operate the machine is an example for Direct labor. Indirect labor is
required to perform manufacturing activities generally, but is not directly involved
in the conversion of raw materials into finished goods. Eg, wages paid to Foreman,
clerks, time keepers, purchase and store items, maintenance employees. Indirect
labor is included in factory overhead
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FACTORY OVERHEADS
It comprises of all indirect manufacturing costs which cannot be identified with
specific units of finished products. All manufacturing costs except direct materials
except direct materials and direct labor are included in factory overheads. Two
important elements of factory overhead are indirect materials cost and indirect
labor costs. Other indirect costs included in the factory overheads are factory rent,
depreciation, repairs, maintenance, power, light, taxes etc.
Again divided into Variable factory overhead & Fixed factory overhead .Variable
factory overheads is one which varies in direct proportion to units of output –
example is supplies. fixed factory overhead is non variable with production
depreciation, insurance, rent, supervisor’s salary
Combining Elements of Manufacturing cost
Direct mat cost + Direct Labor cost = Prime cost
Prime cost + Factory Over Head = Factory cost
Factory Cost + Sales Over Head = Total Cost

COST OF PRODUCTION
Supply of a commodity by the cost of its production. In order to produce a
commodity, the producer must have the factors of production. He should pay
wages to the laborers, interest to capital, rent on land, payment for raw materials,
transportation cost etc.

CONCEPT OF COST OF PRODUCTION

COSTS ARE SOMETIMES CLASSIFIED AS NOMINAL OR MONEY COST
and REAL COST.
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NOMINAL/MONEY COST AND REAL COST

Nominal cost is the money cost of production. It is also called the expenses of
production- payment to factors of production, raw materials etc. Make sure that the
price he gets for the product covers, in the long run, nominal profit also.
Real cost: - Alfred Marshall regarded pain and sacrifices of labor as real cost of
production. It is the actual expenses incurred for organizing a product or services.
These are costs generally recorded in the accounts i.e. wages paid, interest paid,
cost of materials purchased etc

EXPLICIT COSTS AND IMPLICIT COSTS.

Cost of production can be classified as EXPLICIT COSTS and IMPLICIT COSTS.
EXPLICIT COSTS are also called paid- out costs to those from whom he has
obtained factors of production or services. For instance, he has to pay wages to the
labors employed, interest on capital, rent for land and building. These are
EXPLICIT COSTS. • IMPLICIT COSTS are costs which have not paid out to
others but the costs which the entrepreneur pays to himself. Perhaps he himself is
the owner of the business, invested his own capital or borrowed capital, may be the
Managing Director for which he may not draw salary. If he had lent out these
factors to outside, he would have received remuneration from them. • Hence, they
must be taken into account while calculating profit. But since they are not actually
paid out to anybody, they are called IMPLICIT COSTS
• OPPORTUNITY COST is the cost expressed in terms of opportunity sacrificed.
It is the income from the next best alternative sacrificed. • Resources are scarce and
they have alternate uses. When a resource is put to one use, its alternate uses are
sacrificed. The cost of alternative sacrificed is called opportunity cost. • For
example, • A person invests Rs 1 lakh in business and earn 12% ret urn in
investment. Suppose the next best alternative is to deposit the amount in a bank for
10% interest. • If the money is t o be invested in business, t he interest income has
to be sacrificed. • Thus we can say t hat that the opportunity cost of investment of
Rs I lakh in business is t he interest income from bank deposit i.e. 10%
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SELLING COSTS
Selling costs are the costs of marketing, advertisement and salesmanship. Essential
in the competitive economy. These costs are incurred to attract customers. Selling
costs are a peculiarity of an imperfect market and have no place in a fully
competitive market where dealers are supposed to be fully aware of the quality of
the goods and the conditions of the market.

FIXED AND VARIABLE COSTS.

PRIME OR VARIABLE COST:- They include the money cost of raw material
used in making the commodity, the wages of the labor and wear and tear of the
machine etc. for e.g., if you ask a carpenter what he would charge for the chair, he
would first think of the wood and cane that he used and the number of days worked
to make it. This is prime/variable cost. Prime cost varies with quantity produced. If
more chairs are made, more money will be spent. If production is stopped, the
prime costs disappear. Prime costs, therefore, are also called the Variable costs
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MANAGING COST CENTER (CASE STUDY)

As 2006 started off, the financial picture of NationLink Wireless was looking up.
Thanks to a strong market in managing corporate wireless accounts, NationLink
had generated $1.5 million in revenue the previous year. This was a major
improvement, given that its owner, Andy Bailey, had sold the company years
before — only to buy it back in 2002 when it was in dire financial straits.

"When we took the company back, it was way upside down," Bailey said. “We cut
costs like you wouldn’t believe for two years. We were able to pay off a huge
amount of debt for our small company and brought ourselves to the point where we
could start growing again."
Bailey wanted to expand NationLink's staff of 12 employees (down from a onetime
high of 35) and to grow revenue to $2.5 million within 15 months — and double it
again in a year.
The challenge Bailey confronted was to resume spending for growth without losing
the cost-control discipline developed over the last three years. "We’ve built a
culture of cost containment and frugality, and we could lose that as more money
falls to the bottom line and people are doing well," Bailey said. “It doesn’t matter
how much money you make; you always spend it all. We can't let ourselves get
back into that trap."
In March Bailey and his company became part of AllBusiness.com's special 6 for
'06 project and were paired with cost-center expert Denise O’Berry. "Andy had a
good handle on what he needed to do; he just needed someone to help focus his
efforts," O’Berry said. "Andy’s biggest obstacle is he often seizes on the idea of
the moment and doesn’t stay on track with what he’s doing."

The Power of Teamwork

Under O'Berry's guidance, Bailey began managing his business with a clearer eye
on cash flow rather than just receivables. “As a sales-driven company, we tend to
rely on more and more sales to drive the business," he wrote in his 6 for '06 blog
early on in the project. "We are learning that with every new sale there are
additional support and service costs ... it’s a hard lesson but we are learning it."
As part of that lesson, Bailey assigned each employee specific "expense lines" to
monitor. In short order, the staff began cutting costs. "This creates teamwork like
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you have never seen, and everyone is aware of the expenses their group incurs,”
Bailey wrote in May. They started reusing copier paper and turning off the lights.
"It's not the $2.40 cents worth of paper they saved that thrills me. It's the idea of
everyone thinking in those terms."
One of Baily’s initial concern was how to attract top-rate employees with highly
competitive pay packages, while also keeping salary and benefit costs in check. To
that end, he decided to create a new compensation plan that used profit — not
revenue — as a key measure of success. He also included all his staff, not just his
salesforce, in the new plan, which quickly received rave reviews from his
employees.
At the same time, he began to share important financial details with them, such as
the costs involved in hiring a new employee. "My team didn't realize how much it
actually cost to have someone work with us," he said at the time. As they grew to
understand the financial picture better, NationLink's employees began to be more
cost conscious.
"A lot of owners hesitate to share numbers with their employees, [even] when
they're the ones who can come up with ideas to make things better and make things
happen," said O'Berry.
Bailey's newfound openness was put to the test when two administrative staff
members asked to turn a part-time hourly person into a full-time employee. Bailey
discussed the cost of adding new employees and explained that NationLink could
not hire anyone unless it could match the cost with additional revenue. He asked
the staff members to analyze two options: improving efficiency while keeping the
employee part-time or increasing revenue and hiring the worker full-time.
Tracking Progress
Before the 6 for '06 project, Bailey had always managed his business on a profit-
and-loss basis. Typically, he determined how many lines of service or new
activations the company needed to do in a given 30-day period to break even, and
simply aimed to top those figures as much as possible.
"At the end of the month, we looked at the results and moved on without ever
thinking how to get cash in quicker or have more on hand," Bailey said. "We knew
what we had to do to cover our expenses because we'd been doing it that way for
13 years."
In that respect, O'Berry said, Bailey was like most small business owners. "He
knew how much he had to do each month to meet cash-flow requirements. But
those details end up cluttering an owner's mind. If you want to really manage your
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cash flow, you have to look at the big picture, not on a daily or monthly basis, but
six months or a year down the road."
With O'Berry's help, Bailey and his wife began working on a cash-flow budget. To
O'Berry, a cash-flow budget — a projection of the cash a company will receive and
spend in a given month — is invaluable for providing "a consistent picture of your
cash flow and what you'll have in the bank at any given time." It is also a great way
of analyzing your company's costs and seeing where cuts can be made.
The value of the cash-flow budget, Bailey now recognizes, is that it gives
management and the board of directors a sense of where the company is
financially. "If we put money into Web site development, we can track what it
produces over time," Bailey says. "And in retrospect, if you see something doesn't
work, you can ask why and make adjustments so maybe it does.
"If you're a small business that doesn't have a cash-flow budget, sit down and make
yourself one," Bailey says. "You'll be able to see your history, where you are today
and in the future. You can quickly make adjustments to improve your chances of
accomplishing what you want."
LESSONS LEARNED

 Pay employees based on each business unit’s profit rather than sales.
 Assign “expense lines” for individual employees to monitor.
 Develop a cash-flow budget.
 Use your cash-flow budget to gauge what new initiatives are working
and which ones aren’t.
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Conclusion

Responsibility accounting is a management control system for measurement of

division performance of an organization. Responsibility accounting focuses on
responsibility centers such as cost centre, profit centre and investment centre. For
effective implementation of responsible accounting certain principles must be
followed. Responsibility accounting helps not only in control but in planning and
decision making too.
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BIBLIOGRAPHY

1. M. Fremgen : Accounting for Managerial Analysis (Richard Irwin, Homewood,

Ilinos, 1976)
2. R. N. Anthony and G. A. Welsch: Management Accounting (Richard D. Irwin
Homewood Illinois 1977)
3. D. T. Decoster and E. L. Schafer: Management Accounting (John Willey &
sons)
4. M. Y. Khan & P. K. Jain: Management Accounting, Tata Mc. Graw Hills
Publishing Co., Ltd., 1997.