Introduction to Management Accounting

Lesson 1

Introduction into Management

Accounting Decision Making

1
 Learning Objective

This chapter aims to test the students ability to :

Distinguish between management accounting

and financial accounting
Identify and describe the elements involved in the
decision making process
Apply and evaluate techniques used in the
management decision making

2
 Learning Outcomes

•At the end of this chapter , the students

should be able to:
Discuss the usefulness of dividing costs into
variable and fixed components in the context
of short-term decision making
Explain the possible conflicts between
financial and management accounting and
the convenient availability of information for
decision making
3
 Cost Analysis
When individuals & businesses recognise the need to
attach costs to activities and products

Examples:
Examples: Direct
Direct and
and indirect
indirect costs
costs to
to products
products and
and
services
services -- WHY????
WHY????

To enable the fixing of Costs should be known to

selling price as low as enable manager to be able
possible while still to pre-determine selling
covering costs price. The manager uses
standard costing approach
to apply costs to products
4
 Manufacturing Costs

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product

5
 Direct Materials
Those materials that become an integral part
of the product and that can be conveniently
traced directly to it.

Example:
Example: A
A radio
radio installed
installed in
in an
an automobile
automobile

6
 Direct Labor
Those labor costs that can be easily traced to
individual units of product.

Example:
Example: Wages
Wages paid
paid to
to automobile
automobile assembly
assembly workers
workers

7
 Manufacturing Overhead
Manufacturing costs that cannot be traced
directly to specific units produced.
Examples:
Examples: Indirect
Indirect labor
labor and
and indirect
indirect materials
materials

Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, janitors and automobile assembly plant.
security guards.
8
 Classifications of Costs
Manufacturing costs are often
classified as follows:

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Material
Material Labor
Labor Overhead
Overhead

Prime Conversion
Cost Cost

9
 Management Accounting
The presentation of accounting information in such a way
as to assist management in the creation of policy and
the day to day operations of the business

Management accounting focused on:

•Responsibility centres and accountability of managers to these centres
•Mathematical models for optimising product mix with limiting resources
or constraining factors
•Use of probability and decision theory for analysis of cost-volume-profit
decisions under uncertainty etc.

10
 Comparison between Management &
Financial Accounting
Management Accounting
• Focus – helps to record,
plan and control activities
and aids the decision
making process
• Users – by managers and
employees within an
organisation
• Emphasis – on both
monetary and non
monetary issues. It is a
future planning tool
Financial Accounting
 Focus – helps to record
the performance of the
organisation over a
defined period of time and
the state of affairs at the
end of that period
 Users – by external users
like shareholders, banks,
creditors.
 Emphasis – on monetary
issues. It is a historical
picture of past operations 11
The Decision Model

12
 The Decision Making Process
• Step 1 – Identify objectives. The
organisation’s goals and objective must be
defined to ensure managers are able to
assess which course of action available is
the most appropriate.

13
 The Decision Making Process
• Step 2 – Search for alternative courses of
action. All possible courses must be
identified to provide flexibility to the
decision maker. E.g. to increase market
share, a company can consider
developing new products to existing
customers, new products for new markets
or existing products to new markets.

14
 The Decision Making Process
• Step 3 – Collect data about the alternative
courses of action. The type of data that
needs collecting will depend on the type of
decision. If the decision is concerning the
long-term future, information required
would involve facts about the environment.

15
 The Decision Making Process
• Step 4 – Select appropriate course of
action that best satisfies the organisational
objectives.
• Step 5 – Implement decision
• Step 6 – Compare actual and planned
outcomes and take necessary corrective
action

16
The information for decision making
• Assessing what is involved. Once the
decision-maker’s intentions are clear, the
manager must think through exactly what
is involved in the implementation process.
Entails charting out the various stages of
the decision, step by step

17
The information for decision making
• Identifying the resources required. This is
the most important part of the decision
making process as it involves the
commitment of certain resources of the
organisation and the manager would have
to consider the opportunity costs involved

18
Relevant costs & Decision Making
• Relevant Costs
– Costs that are appropriate for decision making
– Represented by
• future costs, not what has already been incurred
as this decision cannot be altered
• Cash flows i.e. costs or charges that reflect
additional spending. Depreciation, fixed overhead
absorbed, etc must be ignored
• Incremental costs, i.e. the cost must arise as a
direct consequence of a decision
19
Relevant costs & Decision Making
• Avoidable Costs
– Specific costs of an activity which would be
avoided if the activity did not exist. Relevant
costs
• Opportunity Costs
– The value of the benefit sacrificed when one
course of action is chosen, in preference of
another. The opportunity cost is represented
by the forgone potential benefit which could
have been earned but given up
20
Relevant costs & Decision Making
• Non-relevant costs
– Irrelevant to decision making
– Sunk Costs
• Costs that have been incurred irreversibly or
committed prior to a decision point
– Committed costs
• Costs arising from prior decisions which cannot, in
the short term be changed. E.g. commitment to
purchase a fixed asset as part of the strategic
planning process. A contract has been entered
21
 Relevant costs & Decision Making
• Fixed & Variable costs
– Variable Costs
• Most likely to be considered relevant, unless in
some case it has already been incurred. E.g. if the
company has some units of stock which it has
already purchased but no longer used in a regular
basis and which does not have scrap value
• In such cases, relevant costs of material is not
relevant. If material has scrap value, then the
relevant cost would be the potential scrap value as
it is considered opportunity cost forgone
22
Relevant costs & Decision Making
• Fixed Costs
– Most likely considered irrelevant
– Unless the fixed cost is directly attributable to
a certain level of activity.
– Example
• Increase in fixed costs if certain extra activities are
undertaken
• Decrease / increase in fixed costs entirely if a
decision were undertaken to reduce or shut down
an acitivity
23
 Rules for Identifying Relevant
Costs
• Cost of material
• Current replacement costs, unless materials have
already been purchased but will not be replaced
• Higher of current resale value or the value they
would obtain if they would be put to an alternative
use
• If the materials have no resale value and no other
possible use, then the relevant cost of using them
i.e. the opportunity cost would be nil

24
 Quick Check 
Material
Material Units
Units Units
Units Book
Book R’sible
R’sible Replace
Replace
Req’d
Req’d in
in Stock
Stock Value
Value Value
Value Value
Value

A
A 1,000
1,000 00 00 00 6.00
6.00

B
B 1,000
1,000 600
600 2.00
2.00 2.50
2.50 5.00
5.00

C
C 1,000
1,000 700
700 3.00
3.00 2.50
2.50 4.00
4.00

DD 200
200 200
200 4.00
4.00 6.00
6.00 9.00
9.00
Material
Material B
B is
is used
used regularly
regularly and
and ifif units
units are
are required
required for
for this
this job,
job, they
they would
would
need
need to
to be
be replaced
replaced toto meet
meet other
other production
production demand.
demand. Material
Material C C& &DD are
are
in
in stock
stock as
as the
the result
result of
of previous
previous buying
buying andand they
they have
have aa restricted
restricted use.
use. No
No
other
other use
use could
could be
be found
found for
for material
material C C but
but the
the units
units of
of material
material D D could
could be
be
used
used in
in another
another job
job as
as substitute
substitute forfor 300
300 units
units of
of material
material E, E, which
which currently
currently
costs
costs $5.00
$5.00 per
per unit
unit (for
(for which
which there
there is
is no
no stock
stock currently)
currently)
25
 Quick Check 
Required:
Required:
Calculate
Calculate the
the relevant
relevant costs
costs of
of material
material for
for
deciding
deciding whether
whether or
or not
not to
to accept
accept the
the contract.
contract.

26
 Rules for Identifying Relevant
Costs
• Labour
• Often labour is paid irrespective of the decision
being made, therefore irrelevant.
• However, if paid in piecemeal, then relevant
• If the labour could be put to alternative use, then
labour becomes variable and is relevant

27
 Rules for Identifying Relevant
Costs
• Machines
• Using machines will involve some incremental
costs.
– Repair costs arising from use
– Hire charges
– Any fall in resale value of owned assets which results
from their use
• Depreciation is not a relevant cost

28
Controllability and Relevance

29
LO1: Understand how to identify the costs and benefits of decision options.
Problem
Controllability and relevance (LO1)
Sam Walters is leaving tomorrow for a three-day business trip and
is trying to decide the most economical way to get to and from the
airport and his home. Sam could either drive (using his own car)
or take the shuttle. If Sam drives, then he estimates that it will
cost $0.30 per mile driven in operating costs (e.g., for gas and oil)
and $7.50 per day for parking. The one-way cost of the shuttle is
$25. Sam’s home is exactly 30 miles from the airport.

Required:
a)What are the controllable costs for Sam’s decision?

b)What are the relevant costs and benefits for Sam’s decision?

c)Are the controllable costs the same as the relevant costs for Sam’s
decision? If so, why? Can controllability and relevance give the same costs
and benefits even when the status quo is not a feasible option?

30
Problem (Continued)
a)What are the controllable costs for Sam’s decision?
A cost is controllable if it changes relative to the
status quo. Relative to not taking the business trip
(the status quo where Sam does nothing), Sam
expects to incur the following costs under each
option:

31
Problem (Continued)
a)What are the controllable costs for Sam’s decision?
 Thus, we find that Sam prefers driving to taking the shuttle. Sam’s
preference for driving versus taking the shuttle changes as the
length of his trip changes (e.g., for a five-day trip, the shuttle is
cheaper as the cost of driving increases by $15 while the cost of
taking the shuttle stays the same).
 For short-duration trips, driving (and parking at the airport) is
cheaper than taking the shuttle.
 For trips that are longer in duration, taking the shuttle is
cheaper than driving.
 We can link this to students’ behavior – for winter break, it is likely
that students take the shuttle to the airport to avoid 2-3+ weeks of
parking costs. For shorter trips (e.g., Thanksgiving, long weekend at
home), it is likely that many students drive and use the airport
parking lot.
32
Problem (Continued)
b) What are the relevant costs and benefits for Sam’s
decision?
A cost is relevant if it differs across decision options. We
also know that relevant costs are a subset of controllable
costs. By examining the controllable costs in part [b], we
find that all of the controllable costs are relevant – i.e., the
options do not share any common costs.

Thus,
Thus, the
the relevant
relevant costs
costs of
of driving
driving =
= $40.50,
$40.50,

and
and the
the relevant
relevant costs
costs of
of taking
taking the
the shuttle
shuttle =
= $50.
$50.

33
Problem (Concluded)
c) Are the controllable costs the same as the relevant costs
for Sam’s decision? If so, why? Can controllability and
relevance give the same costs and benefits even when the
status quo is not a feasible option?
Yes, for Sam’s decision, the set of controllable costs is the
same as the set of relevant costs. Moreover, we find that
controllability and relevance give us the same amounts
even when the status quo is not part of the opportunity
set. How can this happen?

The
The answer
answer isis that
that controllability
controllability and
and
relevance
relevance will
will give
give us
us the
the same
same amounts
amounts when
when
decision
decision options
options do
do not
not share
share any
any common
common
costs
costs or
or benefits.
benefits. That
That is,
is, when
when each
each cost
cost or
or
benefit
benefit is
is unique
unique to
to aa specific
specific decision
decision option.
option.

34
Opportunity, Outlay, and Differential Costs
Differential
Differentialcost
costisisthe
thedifference
differencein
in
total
totalcost
costbetween
betweentwo twoalternatives.
alternatives.

Differential
Differentialrevenue
revenueisisthe
thedifference
differencein
in
total
totalrevenue
revenuebetween
betweentwotwoalternatives.
alternatives.

Incremental
Incrementalcost
costare
areadditional
additionalcosts
costsor
orreduced
reduced
benefits
benefitsgenerated
generatedby
bythe
theproposed
proposedalternative.
alternative.

Incremental
Incrementalbenefits
benefitsare
arethe
theadditional
additionalrevenues
revenuesororreduced
reduced
costs
costsgenerated
generatedbybythe
theproposed
proposedalternative.
alternative.

35
Opportunity, Outlay, and Differential Costs
An
An incremental
incremental analysis
analysis isis an
an analysis
analysis of
of the
the
additional
additional costs
costs and
and benefits
benefits of
of aa proposed
proposed alternative.
alternative.

An
An opportunity
opportunity cost
cost isis the
the maximum
maximumavailable
available
contribution
contribution to
to profit
profit forgone
forgone (or(or passed
passed up)
up) by
by
using
using limited
limited resources
resources for for aa particular
particular purpose.
purpose.

An
An outlay
outlay cost
cost requires
requires aa cash
cash disbursement.
disbursement.

36
Opportunity, Outlay, and Differential Costs
Nantucket
Nantucket Nectars
Nectars has
has aa machine
machine for for
which
which itit paid
paid $100,000
$100,000 and
and itit isis sitting
sitting idle.
idle.

Nantucket
Nantucket Nectars
Nectars has
has three
three alternatives:
alternatives:
1.
1. Increase
Increase production
production ofof Peach
Peach juice
juice
2.
2. Sell
Sell the
the machine
machine
3.
3. Produce
Produce aa new
new drink
drink Papaya
Papaya Mango
Mango

37
 Opportunity Cost
Peach Juice Contribution margin is $60,000.
Sell machine for $50,000.
Produce Papaya Mango juice with projected sales of $500,000.

Revenue
Revenue $500,000
$500,000
Costs:
Costs:
Outlay
OutlayCosts
Costs 400,000
400,000
Financial
Financialbenefit
benefitbefore
beforeopportunity
opportunitycosts
costs $100,000
$100,000
Opportunity
Opportunitycost
costof
ofmachine
machine 60,000
60,000
Net
Netfinancial
financialbenefit
benefit $$40,000
40,000

38
 Quick Checks Before we end
• Machines
• The contract requires 200 hours of labour at RM 5 per hour.
Employees possessing the necessary skills are currently
employed by the company but they are idle at present due to
the economic downturn.
• The contract will require the use of a storage unit for three
months. Co M is committed to rent the unit for one year at a
rental of RM50 per month. The unit is not in use at present.
The neighbouring business has recently approached Co M to
rent the unit from to them for RM70 per month.
• What are the relevant costs for both situation?

39
 Assumptions in Relevant
Costing
• Relevant costs are future costs and has to be
predicted. Therefore for relevant costing
approach to be effective several assumptions
will have to be made:
– Cost behaviour patterns must be known
– The amount of fixed costs, unit variable costs,
sales price and sales demand are known with
certainty
– Objective of decision making in the short-term is to
maximise profit
– Information available for the decision is complete
and reliable
40
Qualitative Factors in Decision
Making
• Qualitative factors are factors which might
influence the decision but which cannot be
quantified in terms of relevant costs or
benefits.
– The availability of cash
– Employees
– Customers
– Competitors
– Timing Factors
– Suppliers
– Flexibility of options 41
 The End

End of Lesson 1