Chapter One: Introduction to Management Accounting

1.1 MANAGEMENT ACCOUNTING: AN OVERVIEW

Your study of accounting so far has probably focused on financial accounting, which is
concerned with the preparation of information about an organization’s past operations. This
information is reported to individuals and groups external to the organization, such as creditors
and stockholders, in the form of financial statements (balance sheet, income statement, and
statement of cash flows). These external groups and individuals use the financial statements to
assist with making such decisions as generating a loan or investing in the stock of a company.

In this course, you will study management accounting, which is also concerned with providing
information to assist with decision-making. Unlike financial accounting, however, management
accounting provides information for internal decision makers; that is, the managers of an
organization. Managers use this information to make decisions, such as how many units to
produce, what price to charge for the product, and whether to purchase a new piece of
equipment. Since the decisions managers make are different from those made by creditors and
stockholders, managers often need different information than do creditors and stockholders. In
addition, the information that managers’ need differs with the type of decision they are making.

1.2 ACCOUNTING SYSTEMS AND THEIR PURPOSES

All accounting information is accumulated to help someone (may be a company president, a

production manager, a sales manager, a shareholder, a small business owner, a politician and
others) to make economic decisions. In general, users of accounting information fall into two
categories:
Internal managers: who use the information for short-term planning and controlling routine
operations.
External parties: such as investors, creditors and government authorities, who use the
information for making decisions about the company.

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Each of the above purpose of an accounting system may require different ways of aggregating or
reporting data. Despite these differences, most organizations prefer a general-purpose
accounting system that can supply appropriate information for all two types of users.

An accounting system is a formal mechanism for gathering, organizing, and communicating

information about an organization’s activities. A good accounting system helps an organization
achieve its goals and objectives by helping to answer the following three types of questions:
a. Scorecard questions. Am I doing well or poorly?
b. Attention-directing questions. Which problems should I look into?
c. Problem solving questions. Of the several ways of doing the job, which is the best?
To answer each of the above questions, one can classify accounting data as scorekeeping data,
attention-directing data and problem solving data, respectively. Furthermore, depending upon
the classification of accounting information, the accountant’s task of supplying information can
be identified as scorekeeping task, attention-directing task and problem solving task.
Scorekeeping task: This is an accumulation and classification of data. This aspect of accounting
enables both internal and external parties to evaluate organizational performance. The
collection, classification and reporting of scorekeeping information is the task that dominates
day-to-day accounting. Examples of scorekeeping (scorecard) task include:
o Posting daily cash collections to customers’ accounts.
o Preparing journal entries for depreciation of equipment.
o Processing monthly payroll.
Attention-directing task: It is the task of reporting and interpreting information that helps
managers to focus on operating problems, imperfections, inefficiencies, and opportunities. This
aspect of accounting helps managers to concentrate on important areas of operations promptly
enough for effective action. Attention directing is commonly associated with current planning
and control, and with the analysis and investigation of recurring routine internal accounting
reports. The following activities fall under attention directing based on the function that the
accountant is performing.
Interpreting why a branch did not meet its sales quota.
Interpreting variances on a post office supervisor’s performance report.
Analyzing for the president the impact of net income of a contemplated new product.
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Problem solving task: This task of the accountant involves quantification of the likely results of
possible courses of actions and often recommends the best course to follow. Problem solving is
commonly associated with nonrecurring decisions, situations that require special accounting
analyses or reports. Examples of activities performed by an accountant that could be classified
as problem-solving task include:
 Preparing, for production manager, a cost comparison for two computerized
manufacturing control systems.
 Analyzing the cost of several different ways to blend raw materials in the foundry.
Sometimes this classification of accounting information may overlap. A single data may serve to
answer one or more of the questions to be dealt with a good accounting system. For example, the
scorecard and attention-directing data are closely related. The same information may serve as a
scorecard function for a manager and an attention-directing function for the manager’s superior.
Consider a performance reports in which actual results of decisions and activities are compared
with previously determined plans. By pinpointing where actual results differ from plans, such
performance reports can show managers how they are doing and show the managers’ superiors
where to take action. In addition the actual results help answer scorecard questions of financial
accounting, which is concerned with reporting the results of the organization’s activities to
external parties.

In contrast, problem-solving information may be used in long-range planning and in making

special, nonrecurring decisions, such as whether to make or buy parts, replace equipment, or add
or drop a product. These decisions often require expert advice from specialists such as industrial
engineers, budgetary accountants, and statisticians.

1.3 MANAGEMENT PROCESS AND ACCOUNTING

Many different kinds of organization affect our daily lives. Manufacturers, retailers, service
industry firms, agribusiness companies, nonprofit organizations, and government agencies,
provide us with a vast array of goods and services. All of these organizations have a set of goals
or objectives. An airline’s goals might be profitability and customer service. A city police
department’s goals would include public safety and security coupled with cost minimization.
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Whatever the goals of an organization are, the task of management is to see that they are
achieved. In pursuing an organization’s goals, managers carry out four basic activities: decision
making, planning, directing and motivating and controlling. Management accounting information
plays a vital in these basic management activities.

Decision Making: In decision-making, managers choose among a variety of alternatives that

affect a particular course of action. Decisions should be based on information. Management
accountant should be flexible in providing whatever quantitative and non-quantitative
information is needed to reduce management’s uncertainty.

In decision-making, accountants and managers have different roles. Managers usually identify
decisions to be made. Likewise, they usually are better able to identify alternatives to be
considered in a decision. For example, a purchasing manager can usually identify possible
sources for material to be used in a manufacturer’s product. The accountant is often the major
source of information that managers use to help them decide which alternative to choose. For
each alternative the manager wishes to consider, the accountant attempts to identify events that
are likely to significantly affect the outcome. For each combination of event and alternative, the
accountant provides forecasts or estimates of the likely outcome. The accountant, for example,
will forecast the cost of acquiring different amounts of material from different suppliers for the
decision considered by the purchasing manager here above. The manager then must select the
alternative to be taken. The alternative chosen depends on the manager’s beliefs about the future
events, the accountant’s forecasts or estimates, and the various outcomes.
In any decision-making process, qualitative and quantitative information is vital. In business
firms financial information is the backbone among others. This information is provided by
accounting system. Decision-making process involves basically the following activities:
 Define the problem: this is the most important phase of a decision-making process
because all other activities in the process depend on this phase. If one does not have a
clear understanding of the specific problem he/she may spend valuable time and energy
in identifying alternatives and gathering probably irrelevant data. Moreover, incorrectly
defined problems waste time and resources. That is why it is usually said that defining
problem is solving 50% of the problem.
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  Gathering relevant information: decision makers may desire different types of
information to assist them in making decisions. Some of this information could be
subjective or objective. Whatever the nature of the nature of the information is, it must be
relevant to the decision at hand. Therefore, in this phase of decision-making process, it is
very important to select those data, which affect the decision to be made.
 Make the decision: in some situations, once the problem is defined, alternatives are
identified, and relevant data are gathered, then it may be simple to make a decision.
However, problems may not be in black and white. Usually no single variable dominates
in making the decision.
The use of accounting in a decision- making process plays a significant role in gathering relevant
information for the decision maker.

Planning:- planning refers to developing a detailed financial and operational description of

anticipated operations. In planning, managers must decide what actions they intend to take
during the next operating period or periods and what targets they intend to achieve.
To assist the manager in the planning phase, the management accountant accumulates an
information base for forecasting future potential outcomes that may arise if an action is taken.
For example, production managers decide how many units they intend to produce. When they
make this decision, the production managers usually do not know exactly how many units will be
required to satisfy customer demands. To assist the production managers, accountants forecast
the costs of producing and storing different quantities of units. Using this information, the
managers can consider the possible consequences of producing more units than are sold.

Directing and Motivating: Directing and motivating involves mobilizing human resources to
carry out plans and run routine operations. In addition to planning for the future, managers must
oversee day-to-day activities and keep the organization functioning smoothly. This requires the
ability to motivate and effectively direct people. Managers assign task to employees, arbitrate
disputes, answer questions, solve on-the-spot problems, and make many small decisions that
affect customers and employees. In effect, directing is that part of the managers’ work that deals
with the routine and the here and now. Management accounting data, such as daily sales reports,
are often used in this type of day-to-day decision-making.
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Controlling: Controlling means insuring that the plan is actually carried out and is appropriately
modified as circumstances change. In controlling, managers measure actual results against
norms to determine if operations are proceeding as planned. Management accounting generates
actual costs, compares them to planned costs, and reports major differences to management so
that management can exert influence for the purpose of bringing actual results in line with
planned results.

In the control phase, managers seek to identify segments of the business whose actual
performances differ from planned performances. Differences between actual and planned
performances can be analyzed as to effectiveness and efficiency. Effectiveness refers to the
degree to which a goal, objective, or target is met – and efficiency – deals with the success in
using least resources in relation to a given level of outputs.

1.4 COMPARISON BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING

Management accounting is entirely new area of accounting that has gained importance, for the
last 4 or 5 decades. The historical development of management accounting is a relatively recent
phenomenon, especially compared with financial accounting. Financial accounting is a very old
system of accounting that was developed to meet the requirements of business for recording,
classifying, and summarizing mercantile transactions. In contrast, management accounting was
relatively sophisticated and provided the essential information needed to manage the mass
production of textiles, steel, and other products. Management accounting has its roots in the
industrial revolution of the 19th century. During this period, there was little need for elaborate
financial accounting systems, since most firms were tightly controlled by a few owner-managers,
and corporate borrowing was based largely on personal relationships.

1.4.1 Limitations of Financial Accounting

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For quite a long period in the history of accounting, managers in the discharge of their
managerial functions used the financial accounting. And it was limited and inadequate in regard
to the information that it can supply to management. The following are some of the limitations of
financial accounting, among others:
It shows only overall performance: Financial accounting provides information about profit, loss,
cost etc. of the collective activities of the business as a whole. It does not give data regarding
departments, products, processes and sales territories, etc.
Historical in nature: Financial accounting is historical in nature, since the data are summarized
only at the end of the accounting period. There is no system of computing predetermined costs
for example.
No performance appraisa:. In financial accounting, there is no system of developing norms and
standards to appraise the efficiency the use of materials, labor and other costs by comparing the
actual performance with what should have accomplished during a given of time.
Not helpful in evaluating strategic decisions: The financial records are based on certain
conventions and concepts. Few of these are not relevant in decision- making by management of
any undertaking. For example, financial accounting is not helpful to evaluate decision listed here
below:
a. What should be the level of output for a desired profit under the given conditions of
production?
b. What is the impact of prices level changes on the economic position of the enterprise?
c. What should be the reasonable cost per unit of output?
d. Should we build a new plant or modernize the old one?
e. How far we can go in lowering prices to increase our sales volume?
f. Is our plant operating efficiently and economically?
g. Which of our costs are out of line, and how can they can be controlled?
h. Are our sales prices set realistically in relation to costs?
Owing to the limitations of financial accounting as an effective tool of management, we need
some system of accounting which may help the management in the successful discharge of its
important duties of planning, implementation of plans, controlling and evaluation of business
performance. As the name suggests, Management accounting is any form of accounting that is
useful to management in the discharge of its managerial functions for efficient utilization of
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business resources to achieve the fundamental objective of optimizing profit. Put differently,
management accounting can be defined as the process of identifying, measuring, accumulating,
analyzing, preparing, interpreting and communicating information that helps managers to fulfill
organizational objectives.
1.5 Distinction between Financial Accounting and Management Accounting
There are several major differences between financial accounting and management accounting.
They differ in primary users, in orientation of reports, in point of emphasis between the past and
the future, in the type of data provided to users, and in several ways. These differences are
described here below.
Primary Users: One important difference between management and financial accounting
information is the intended users. Financial accounting reports are prepared for the use of
external parties such as shareholders and creditors, whereas management accounting reports are
intended to be used by managers inside the organization. However, this does not mean that
financial accounting is not useful to management.
Emphasis on the Future/Time Orientation: Since planning is such an important part of the
manager’s job, management accounting has a strong future orientation. In contrast, financial
accounting primarily provides summaries of past financial transactions. The difficulty with
summaries of the past is that the future is not simply a reflection of what has happened in the
past. Changes are constantly taking place in economic conditions; customer needs and desires,
competitive conditions, and so on. All of these changes demand that manager’s planning be
based in large part on estimates of what will happen rather than on summaries of what has
already happened.
Emphasis on Precision: Management accounting information is usually less precise than
financial accounting information. The latter one reports on events that have already occurred and
are governed by structured reporting rules. Therefore, financial accounting is composed of
measurements that are often very precise. Management accounting information, which focuses
on future actions, is composed of estimates and forecasts. It is not possible for estimates and
forecasts to be as precise as measurements of past activities.
Reporting Flexibility /Freedom of Choice: Financial accounting statements prepared for
external users must be prepared in accordance with generally accepted accounting principles
(GAAP). External users must have some assurance that the reports have been prepared in
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accordance with some common set of ground rules. These common ground rules enhance
comparability and reduce fraud and misrepresentation, but they do not necessarily lead to the
type of reports that would be most useful in internal decision-making.
Management accounting is not bound by generally accepted accounting principles. Managers set
their own ground rules concerning the content and form of internal reports. The only constraint
is that the expected benefits from using the information should outweigh the costs of collecting,
analyzing, and summarizing the data.
Reporting Entity: Financial accounting information tends to report the activities of the
organization as a whole. This is because creditors and stockholders are usually concerned with
performance of the whole organization. If a bank loans money to a business, the loan is not to the
manager of a product line, but instead to the company as a whole. Likewise, a stockholder
purchases stock in the company as a whole, not in a specific product of the company.
Management accounting tends to focus on segments of the organization because most managers
are responsible for the operations of only a segment of the organization, not the whole
organization. Therefore, the managers are interested in operations of their specific segments.
These managers may wish to know about specific products, particular groups of customers, or
employees in a particular department of the organization. If the manager is making decisions
about products, the accountant will organize the data by product. If the decision compares
different sales territories, the data will be organized by sales territory.
Compulsion: Financial accounting is mandatory; that is, the preparation of financial accounting
reports and statements is must in certain undertakings (in case of a company form of
organization) where these are a necessity in others. Various outside parties such as regulatory
bodies and the tax authorities require periodic financial statements. Management accounting, on
the other hand, is not mandatory. A company is completely free to use or not to use management
accounting. There are no regulatory bodies or other outside agencies that specify what is to be
done, or, for that matter, whether anything is to be done at all. Since management accounting is
optional, the important question is always, “Is the information useful?” rather than,” Is the
information required?”
Description /Nature of Data Reported: Since many of the decisions that managers make require
non-financial information, management accounting information includes quantitative data that is
not financial. For example, accountants often report production quantities, capacity utilization
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estimates, material scrap rates, quality control measures, employee turnover statistics, and
market share estimates.
In addition to non-financial quantitative data, management accounting reports non-monetary
events, like technical changes, political changes, market competition and so on. However,
almost exclusively monetary transactions are recorded in financial accounting.
Publication: Management accounting statements are prepared for the benefit of management
only and these are not published. Furthermore, they are confidential. In contrast, financial
accounting statements like income statement, balance sheet and others are published for the
benefit of the public.
Source of Data: In financial accounting, the sources of information are journal and ledger
accounts that form the basis for drawing income statement and balance sheets. Thus, the source
of information is almost exclusively drawn from the organization’s basic accounting system,
which accumulates financial information. But management accounting draws information both
from internal as well as external sources. The external sources of information may be the
magazines, newspapers and other publications.
Delineation of Activities: Management accounting is less sharply defined. That is, there is
heavier use of related disciplines such as economics, statistics, decision science and behavioral
sciences. Financial accounting, however, is more sharply defined because there is lighter use of
related disciplines.
Time Span: Financial accounting presents 1 year or 1-quarter reports whereas management
accounting presents reports covering shorter or longer periods, varying from hourly to 10 to 15
years.
Summarizes the Differences Between Financial and Management Accounting Information
Items of Financial Accounting Management Accounting
Difference
Primary Users External decision makers, such Internal decision makers-managers at
as creditors, stockholders, tax various levels.
authorities and regulators
Time orientation Past Oriented Future oriented
Precision Precision of information is No emphasis is given to actual figures.
required Approximate figures are considered more
useful than exact figures.
Freedom of choice Must follow GAAP Need not follow GAAP
Reporting entity Organization as a whole. That Detailed segment reports about

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 is, only summarized data for the departments, divisions, products,
entire organization are customers and employees are prepared.
presented.
Compulsion Mandatory for external reports Not mandatory
Description Monetary Monetary and non-monetary
Publication Financial accounting statements Management accounting statements are
are published not published
Source of data Internal sources Both internal and external sources
Delineation of More sharply defined Less sharply defined
activities
Time span Less flexible, usually 1 year or Flexible, varying from hourly to 10 to 15
1 quarter years.

From the above table, the distinction between financial accounting and management accounting
becomes quite clear. Although many differences exist between them, they are similar in at least
two ways.
Both rely on the same accounting information system. It would be a waste of money to have
two different data collecting systems existing side by side. One part of the overall accounting
system is the cost accounting system, which accumulates cost data for use in both management
and financial accounting. For example, production cost data typically are used in helping
managers set prices, which is a management accounting use. However, production cost data also
are used to value inventory on a manufacturer’s balance sheet, which is a financial accounting
use.
Both rely heavily on the concept of responsibility, or stewardship. Financial accounting is
concerned with stewardship over the company as a whole; management accounting is concerned
with stewardship over its parts, and this concern extends to the last person in an organization
who has any responsibility over cost.
MAJOR THEMES IN MANAGEMENT ACCOUNTING
Several major themes influence all aspects of management accounting. Among others, the three
themes will be described briefly now. Because of their important, they will also be mentioned
often in succeeding units.
Information and Incentives: The need for information is the driving force behind management
accounting. Management accounting information is supplied to a decision maker to facilitate
and influence decision. Information usually is provided to a manager to assist her/him in
choosing among alternative. Often, that information is also intended to influence the manager’s

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decision. Information usually is provided to a manager to assist her/him in choosing among
alternative. Often, that information is also intended to influence the manager’s decision.
Behavioral Implications: The reactions of both individuals and groups to management
accounting information will significantly affect the course of events in an organization.

The better a management accountant’s understanding of human behavior is, more effective he or
she will be as a provider of information.
Cost – Benefit Balance: Information is a commodity. Like other goods, information can be
produced, purchased and consumed. As it is true of all goods and services, information entails
both costs and benefits. The cost of providing management accounting information to the
managers, for example, include the cost of compensation for the controller and Accounting
Department personnel, the cost of purchasing and operating computers, and the cost of the time
spent by the information users to read, understand, and utilize the information. The benefits
include improved decisions, more effective planning, and efficiency of operations at lower costs,
and better direction and control of operations.
Role of Management Accountancy
The role of management accounting and financial accounting is quite different from each other
as they have different goals altogether. Management accounting measures, analyzes, and reports
financial and non financial information that helps managers to take decisions to fulfill the goals
of an organization.
Managers use management accounting information to choose, communicate and implement
strategy. They also use management accounting information to coordinate product design,
production and marketing decisions.
Management accounting focuses on internal reporting. The following points highlight the role
played by Management Accounting in the business organization.

A. Implementing Strategy:
Managers implement strategies by translating them into actions. Creating value for customers is
an important part of planning and implementation of strategies. Strategic planning and
implementation will include decisions regarding the design of products, services or processes,
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research and development, production, marketing, distribution and customer services. Each of
this area is important for satisfying customers and keeping them satisfied. Management
accounting will help to track the costs of each of the activity mentioned above. The ultimate
target is to reduce costs in each category and to improve efficiency. Cost information also helps
managers make cost benefit analysis. For example, managers can find out that is it cheaper to
buy products from outside vendors or to do manufacturing in-house? Is it worthwhile to invest
more resources in design and manufacturing if it reduces costs in marketing and customer
service?
B. Supply Chain Analysis:
Companies can also implement strategy, cut costs and create value by enhancing their supply
chain. The term ‘Supply Chain’ describes the flow of goods, services and information from the
initial sources of materials and services to the delivery of products to customers regardless of
whether those activities occur in the same organization or in other organization. Customers
expect improved performance from companies through the supply chain. They expect that the
companies should perform all these activities in an efficient manner so as to reduce costs and
also maintain quality of the products and the products be available easily for them. This is no
doubt a daunting task and the management accounting plays a vital role in ensuring value for
money for the customers. Tools like standard costing and target costing can be used effectively
for cost control and cost reduction and thus ensure reasonable prices for customers. A system of
budgets and budgetary control will ensure continuous planning and monitoring various functions
and thus provide for introspection. Continuous improvement in these activities will help in
creating value for customers.
C. Decision Making:
One of the important functions of management is decision making. Management Accounting
helps in this crucial area by providing relevant information to the management. Techniques like
marginal costing helps to generate information, which will be useful for taking decisions.
Decisions include make or buy decisions, adding or dropping a product line, working of
additional shift, shut down or continue operations, capital expenditure decisions and so on.
Decisions based on information are expected to be more rational and objective rather than
subjective.
D. Performance Measurement:
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 Management accounting helps immensely for the measurement of performance of the
organization. The main aspect of performance measurement is comparison between the targets
and actual. There are several tools and techniques like budgets and budgetary control, standard
costing and marginal costing, which are used in measuring the actual performance against the
target performance. This will facilitate introspection and corrective action can be taken for
further improving the performance.

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