The Essay On The Importance Of Management Accounting Discusses Types Of Costs, Advantages Of Budgeting, And Variance Analysis.

Management Accounting

1. Discuss the importance of management accounting for your selected organisation and differentiate between management accounting and financial accounting.

2. Evaluate different classifications of costs (types, behaviour, function and relevance) with examples.

3. Explain the meaning of variance analysis and discuss the most commonly derived variances, outlining the problems and limitations.

4. Identify different operational budgets and explain the advantages of preparing.

Management Accounting is a system of partnering in management decision making. The main priority is to give the right information to the right person at the right time.The management accounting reports help the decision makers in their day to day management and control of their functions.This report attempts to describe how Management Accounting can help M/s Silicon Inc., operating in the Automobile components manufacturing industry, to improve its operating efficiency by controlling costs and improving profitability. Section I discusses the concept of Management Accounting, its importance and also distinguishes it with Financial Accounting. Section II evaluates the various types of costs, their behaviour, functions & relevance. Section III explains the meaning of variance analysis, its relevance & limitations. Section IV identifies different operational budgets and the advantages of preparing them.

Importance & Relevance

Management accounting basically relies on the financial accounting data and presents it in a manner and format relevant to the requirement of the decision makers. These reports are prepared and shared on periodic basis like weekly/ fortnightly/ monthly etc.

For eg. a weekly scrap generation report can help the production manager to analyse the in-process losses and decide on machine calibration/preventive maintenance in a timely manner. A monthly labour efficient variance report can help the Human Resources manager to analyse the labour efficiency issue and address them in a timely manner

The benefits of Management Accounting are given below:

Proper presentation financial data

Managers are able to timely decisions

Better equips managers for decision makers

There will be better acceptability for every decision taken

The entire organisation will speak the same language

Difference between both the methods is illustrated in a tabular form below

Sl. No.	Particulars	Management Accounting	Financial Accounting
1.	Used by	People inside the organization	People outside the organization such as shareholders, Government etc.
2.	Relevance	Supports decision making	Reports the end result of the business
3.	Mandatory?	No	Yes
4.	Flexibility	Reporting is flexible according to need	Reporting requirement is rigid
5.	Data coverage	Current issues and future forecast	Past data upto the reporting date
	Periodicity	As per requirement	End of every accounting period
6.
7.	Reports	Prepared in customised formats	As prescribed by standards such as GAAP or IFRS
8.	End user focus	Focuses on each department or individual	Pertains to the entire organization
9.	Rules	No legal requirement or rule	As prescribed by standards such as GAAP or IFRS
10.	Format	No prescribed format	There are specific formats for presenting data

Types of costs

All costs can be categorised based on the following

Relevance

Behaviour

Function

Each of these are explained below

Sunk Cost

Sunk cost is also called as historic cost. This cost is not considered relevant for decision making as it has already been incurred and cannot be recovered. Example Fixed assets purchased.

Opportunity Cost

It is a cost that arises due to non-selection of second best alternative .There is cost directly incurred in this case. It is the value of the foregone alternative which is considered relevant for decicsion making. This helps in evaluating the various investment. Example, a company has certain spare machine in the factory where it can either put to use and generate certain output or it can sell it out. If it decides to sell it, then it has to forgo the option of generating the output and the net income which the product would have earned. The foregone income is the opportunity cost

Differential Cost

Differential cost refers to the difference between the two available alternatives courses of action. If the organisation chooses one alternative against another, then if would have to incur certain incremental costs. Differential cost helps in choosing the better alternative over the others. In the above example, the normal costs of maintaining the machine would not be required to be incurred after sale. The savings in maintenance cost will become the differential cost.

Fixed Cost- Fixed cost do not vary with level of production output. This is independent of any business activity or volume of production. Example, Administration Staff salary, Rent

Variable Cost – The variable cost changes according to the change in level of activity , the higher activity tends to higher variable cost and vise. Material cost , labor cost are the example of variable cost

Mixed Cost- Costs which have both fixed and variable components. For example Store & Consumable are consumed in machines according to design and any consumption beyond a certain limit will increase with an increase in the level of output.

All the three above costs can be graphically represented as follows

Product cost

Product Costs are all those costs incurred towards manufacturing a particular product. Product cost is further classified into the following:

Direct Materials – All the costs incurred to purchase the raw materials

Direct Labour – The cost of labour time spent in manufacturing

Manufacturing Overheads – All the indirect costs incurred in production excluding the direct material & labour.

Period Cost

Period cost are all the costs other that the Product cost. Example marketing costs, administrative costs etc. It is the cost of running the business. These costs cannot be assigned to the products. Most of the time, these costs are not manufacturing costs.

The above costs can are explained in the below diagram

Meaning

Variance Analysis essentially compares the actual performance with respect to the planned performance. Such analysis can give businesses good insights into the causes of not achieving the planned profits. Identification of root cause helps in taking the proper corrective actions and prevent it from recurring. This is a very effective control mechanism.

The variances can be broadly classified as in the diagram below

These broad variances and the further subdivisions are explained below.

Sales Variance

Sales variance measures change in profit due to a variance in sales. The Sales Volume can be on account of Sales Volume variance & Sales Price variance.

Management accounting vs Financial Accounting

Sales Volume variance = (Actual Unit Soldx Standard Profit) – (Budgeted Units Sold x

Standard Profit)

Favourable Sales Volume indicates a higher actual profit than the budgeted profit due to more than expected sales achieved through better marketing for the product in the market

Sales Price variance = (Actual price x Actual Units sold)– (Standard price x

Actual Units sold)

A favourable Sales price variance indicates the product has been able to fetch a better price in the market through better negotiation and demand.

Material Variance

The above variance is derived by differentiating the actual material cost versus the standard material cost. This can be a result of a Material Price variance or a Material Usage variance.

Material Price Variance = (Actual Price x Actual Quantity)– (Standard Pricex

Actual Quantity)

A favourable material price variance indicates a probable slump in the market due to which raw material is available at a cheaper price. It may also indicate a good negotiation.

Material Usage Variance = (Actual quantityx Standard price) – (Standard Quantity x

Standard price)

This can be further divided into Material Mix variance & Material Yield variance. Material mix variance occurs when there a change in the product mix versus the standard mix. In such circumstances, if the cheaper material is used less in place of the costlier material due to a change in mix, then it can result in a adverse material mix variance. A lesser usage of material vis a vis the standard design can result in a favourable yield variance. This may be due to better shop floor control and regular maintenance of machines.

Labour Variance

This is the difference between the Actual Labour cost versus the Standard Labour cost. This can be a result of a Labour Rate variance or a Labour Efficiency variance.

Labour Rate Variance = (Actual Ratex Actual Hours) – (Standard Rate x

Actual Hours)

A favourable Labour rate variance indicates that labour is available at cheaper rates in the market

Labour Efficiency Variance = (Actual hours x Standard Rate)– (Standard hours x

Standard Rate)

A favourable labour efficiency variance indicates an overall improvement in efficiency of the labour employed. This may be due to better motivation and better working conditions in the factory.

Overhead variance

This is the measure of variance between the standard overhead expenses versus the actual overhead expense. This may be a result of operational efficiency and cost saving initiatives. It may also be a result of wrong estimation of standards.

Types of Cost

Problems & Limitations

Though variance analysis is a good tool to identify inefficiencies in the system, the method has certain inherent limitations which are as follows

This is not universally applicable and works mostly in manufacturing indutries

Not practical in non-standard production process/batches

An error in standard setting can give wrong results

This method requires regular monitoring and tracking failing which results cannot be achieved.

Managers would be tempted to build budget slack thereby making the process ineffective

Possibility of compromising on product quality for the sake of improving yield variance

Operational budget is projects the financial plan of a business for a defined period of time. Operational budget requires proper planning of all the phases of operations.

The most common types of operational budgets are explained below

1. Profit Budget

Here both the revenue & expense budgets are combined to arrive at gross and net profits. In this process the adequacy of revenue vis a vis the expense in evaluated. This helps in allocating managers with their share of organisations performance.

1. Revenue (Sales) Budget

Revenue budget is fixed after studying the market and scope for expansion of business. It projects the sales for the budget period and identifies the revenues generating areas.

1. Purchase Budget

Proper vendor selection, exploring market and availability of the raw material is the important parameter here. Timing and volume planning will ensure availability of stock adequate to cater to production budget.

1. Production Budget

A good production budget will be set in such a way that there is a proper balance between an overproduction and a stock out situation. Volume and timing of production is also set in this process for the budget period.

1. Direct Labour Budget

Proper manning and proper matching of the right job with the right skill set are important parameters to be considered here.

Importance of Operational Budget

• Regular tracking and monitoring helps in maintaining revenue and cost levels at optimum
• Helps in projecting future expenses with reasonable level of accuracy
• Helps in identifying potential setbacks and equips to recover from them
• Ensure accountability from the managers due to their ongoing involvement and regular monitoring

Section V: Recommendation& Conclusion

Management accounting, through its process of timely reporting, periodic variance analysis and budgeting perfectly complements the Employees and Managers in their day to day decision making process. The management accounting reports also have a high level of accuracy as most of the data is derived out of financial accounting data. A robust Management Accounting system which gives timely reports and timely and useful information helps all departments in achieving their results which collectively contributes towards operational efficiency, controlling costs and improving profitability. It is hence recommended that a robust Management Accounting system be implemented in SiliconInc.

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