Part One Introduction to Management Accounting 1. 1 Introduction to management accounting 3. 2 An introduction to cost terms and concepts 21

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1 Contents Preface xxi Part One Introduction to Management Accounting 1 and Cost 1 Introduction to management accounting 3 The users of accounting inforrnation 4 Differences between management accounting and financial accounting 5 The decision-making process 5 Changing competitive environment 10 Changing product life cycles 11 Focus on customer satisfaction and new management approaches 11 The impact of the changing environrnent of management accounting systems 14 Functions of management accounting 15 Behavioural, organizational and social aspects of management accounting 17 Summary of the contents of this book 17 Guidelines for using this book 18 Summary 19 Key terrns and concepts 19 Key examination points 20 2 An introduction to cost terms and concepts 21 Cost objects 21 Direct and indirect costs 22 Period and product costs 24 Cost behaviour 24 Relevant and irrelevant cost and revenues 29 Avoidable and unavoidable costs 30 Sunk costs 30 Opportunity costs 31 vii

2 viii CONTENTS lncremental and marginal costs 31 Job costing and process costing systems 32 Maintaining a cost database 32 Self-assessment questions 35 Summary 35 Key terms and concepts 36 Recommended reading 36 Key examination points 36 Questions 36 Part Two Cost Accumulation for Inventory Valuation and Profit Measurement 43 3 Cost assignment 45 Assignment of direct and indirect costs 46 Different costs for different purposes 47 Cost-benefit issues and cost systems design 48 Assigning direct costs to cost objects 49 Blanket overhead rates 50 Cost centre overhead rates 51 The two-stage allocation process 52 An illustration of the two-stage process for a traditional costing 55 An illustration of the two-stage process for an ABC system 60 Extracting relevant costs for decision-making 63 Budgeted overhead rates 64 Under- and over-recovery of overheads 65 Maintaining the database at standard costs 66 Non-manufacturing overheads 66 Self-assessment questions 69 Summary 71 Key terms and concepts 72 Recommended reading 72 Appendix 3.1: lnter-service department reallocations 72 Appendix 3.2: Other allocation bases used by traditional systems 77 Key examination points 79 Questions 80 4 Accounting entries for a job costing system 97 Materiais recording procedure 98 Pricing the issues of materiais 98 Control accounts 100 Recording the purchase of raw materiais 101 Recording the issue of materiais 103 Accounting procedure for labour costs 104 Accounting procedure for manufacturing overheads 106 Non-manufacturing overheads 107

3 CONTEN1S ix Accounting procedures for jobs completed and products sold 108 Costing profit and loss account 108 Interlocking accounting 109 Accounting entries for a JIT manufacturing sytem 110 Contract costing 112 Work in progress valuation and amounts recoverable on contracts 117 Self-assessment question 119 Summary 120 Key terms and concepts 120 Recommended reading 121 Key examination points 121 Questions Process costing 133 Flow of production and costs in a process costing system 134 Process costing when ali output is fully complete 135 Process costing with ending work in progress partially complete 141 Beginning and ending work in progress of uncompleted units 144 Partially completed output and losses in process 149 Process costing for decision-making and control 149 Batchj operating costing 150 Surveys of practice 151 Self-assessment questions 153 Summary 154 Key terms and concepts 155 Appendix 5.1: Losses in process and partially completed units 155 Key examination points 160 Questions Joint and by-product costing 173 Distinguishing between joint products and by-products Methods of allocating joint costs 175 lrrelevance of joint cost allocations for decision-making Accounting for by-products 184 By-products, scrap and waste 185 Self-assessment question 187 Summary 188 Key terms and concepts 188 Recommended reading 188 Key examination points 189 Questions Income effects of alternative cost accumulation systems 201 Problem of terminology 202 External and internal reporting 202 Variable costing 204 Absorption costing 205 Variable costing and absorption costing: a comparison of their impact on profit 206

4 x CONTENTS A mathematical model of the profit functions 208 Some arguments in support of variable costing 209 Some arguments in support of absorption costing 211 The variable costing versus absorption costing debate 212 Relevant costing 213 Altemative denominator levei measures 214 Self-assessment question 219 Surnrnary 220 Key terms and concepts 221 Appendix 7.1: Derivation of the profit function for an absorption costing system 221 Key examination points 221 Questions 222 Part Three Information for Decision-making Cost-volume-profit analysis 235 The economist's model 236 The accountant's cost-volurne-profit model 239 Application to longer-term time horizons 241 A mathematical approach to cost-volurne-profit analysis 242 Margin of safety 246 Constructing the break-even chart 246 Altemative presentation of cost-volurne-profit analysis 246 Cost-volurne-profit analysis assurnptions 248 Cost-volurne-profit analysis and computer applications 253 Self-assessment questions 255 Surnrnary 255 Key terms and concepts 257 Appendix 8.1: CVP analysis applied absorption costing 257 Key examination points 260 Questions Measuring relevant costs and revenues for decisionmaking 279 The meaning of relevance 280 Importance of qualitative factors 280 Special pricing decisions 281 Product-mix decisions when capacity constraints exist 286 Replacement of equipment - the irrelevance of past costs 288 Outsourcing and make or buy decisions 290 Discontinuation decisions 295 Determining the relevant costs of direct materiais 297 Determining the relevant costs of direct labour 297 Misconceptions about relevant costs 299 A comprehensive example 300 Self-assessment questions 305

5 CONTENTS xi Summary 307 Key terms and concepts 307 Recommended reading 307 Appendix 9.1: The theory of constraints and throughput accounting 308 Key examination points 311 Questions Activity-based costing 335 The role of a cost accumulation system in generating relevant cost information for decision-making 336 Types of cost systems 337 A comparison of traditional and ABC systems 338 The emergence of ABC systems 338 Errors arising from relying on misleading product costs 340 Designing ABC systems 342 Activity hierarchies 345 Activity-based costing profitability analysis 346 Resource consumption models 349 Selecting the cost driver denominator levei 351 Cost versus benefits considerations 353 Periodic review of an ABC database 353 ABC in service organizations 354 ABC cost management applications 354 Pitfalls in using ABC information 355 Self-assessment question 359 Summary 360 Key terms and concepts 360 Recommended reading 361 Key examination points 361 Questions Pricing decisions and profitability analysis 371 Economic theory 372 Calculating optimum selling prices using differential calculus 376 Difficulties with applying economic theory 377 The role of cost information in pricing decisions 378 A price setting firm facing short-run pricing decision 378 A price setting firm facing long-run pricing decision 379 A price taker firm facing short-run product-mix decision 385 A price taker firm facing long-run product-mix decision 385 Cost-plus pricing 387 Pricing policies 390 Customer profitability analysis 391 Self-assessment question 395 Summary 396 Key terms and concepts 396 Recommended reading 397 Key examination points 397 Questions 397

6 xii CONTENTS 12 Decision-making under conditions of risk and uncertainty 411 A decision-making model 412 Risk and uncertainty 412 Probabilities 414 Probability distributions and expected value 415 Measuring the amount of uncertainty 416 Attitudes to risk by individuais 419 Decision-tree analysis 420 Cost-volume-profit analysis under conditions of uncertainty 422 Buying perfect and imperfect inforrnation 423 Maximin, maximax and regret criteria 424 Portfolio analysis 425 A more complex illustration 426 Self-assessment question 431 Summary 432 Key terrns and concepts 433 Recommended reading 433 Appendix 12.1: Cost-volume-profit analysis under conditions of uncertainty 433 Key examination points 437 Questions Capital investment decisions: Objectives of capital budgeting 454 A decision-making model for capital investrnent decisions 454 The theory of capital budgeting 456 The opportunity cost of an investment 457 Compounding and discounting 458 The concept of net present value 460 Calculating net present values 461 The internal rate of return 462 Relevant cash flows 465 Timing of cash flows 466 Comparison of net present value and internal rate of return 466 Profitability index 470 Techniques that ignore the time value of money 471 Payback method 471 Accounting rate of return 474 The effect of perforrnance measurement on capital investrnent decision 475 Qualitative factors 476 Self-assessment question 479 Summary 480 Key terrns and concepts 480 Recommended reading 480 Key examination points 481 Questions 481

7 CONTENTS xiii 14 Capital investment decisions: The evaluation of mutually exc1usive investments with unequal lives 494 Capital rationing 496 Taxation and investment decisions 498 The effect of inflation on capital investment appraisal 501 Ca1culating risk-adjusted discount rates 504 Ca1culating the required rates of returns on a firm's securities 508 Weighted average cost of capital 508 Traditional methods of measuring risk 509 A summary of risk measurement techniques 514 Authorization of capital investment proposals 517 Review of capital investment decisions 518 Self-assessment question 523 Summary 525 Key terms and concepts 525 Recommended reading 525 Key examination points 526 Questions 526 Part Four Information for Planning, Control and Performance Measurement The budgeting process 545 Stages in the planning process 546 The multiple functions of budgets 549 Conflicting roles of budgets 551 The budget period 551 Administration of the budgeting process 552 Stages in the budgeting process 553 A detailed illustration 557 Sales budget 557 Production budget and budgeted stock levels 560 Direct materiais usage budget 561 Direct materiais purchase budget 561 Direct labour budget 562 Factory overhead budget 562 Selling and administration budget 563 Departmental budgets 564 Master budget 564 Cash budgets 566 Final review 566 Computerized budgeting 567 Activity-based budgeting 567 The budgeting process in non-profit-making organizations 571 Zero-based budgeting 574 Self-assessment question 577

8 xiv CONTENTS Summary 578 Key terms and concepts 578 Recommended reading 579 Key examination points 579 Questions Management control systems 593 Contrai at different organizational levels 594 Different types of controls 594 Results or output controls 597 Cybemetic contrai systems 598 Feedback and feed-forward contrais 599 Harmful side-effects of contrais 599 Advantages and disadvantages of different types of contrais 60 I Management accounting control systems 602 Responsibility centres 603 The nature of management accounting control systems 605 The contrallability principie 607 Setting financial perforrnance targets 612 Participation in the budgeting and target setting pracess 617 Side-effects arising from using accounting information for performance evaluation 620 Se1f-assessment questions 623 Summary 625 Key terms and concepts 626 Recommended reading 626 Key examination points 626 Questions Contingency theory and organizational and social aspects of management accounting 647 Contingent factors 648 Types of contrais in relation to the transforrnation pracess and output measurement 654 Scorekeeping and uncertainty 656 Pragrammed and non-programmed decisions 658 Accounting information, decision-making and uncertainty 658 Purposes of management accounting 661 Summary 667 Key terms and concepts 668 Recommended reading 669 Key examination points 669 Questions Standard costing and variance analysis Operation of a standard costing system 672 Establishing cost standards 675 Types of cost standards 678

9 CONTENTS xv Variance analysis 680 Material variances 682 Material price variances 682 Material usage variance 684 Joint price usage variance 685 Total material variance 686 Labour variances 687 Wage rate variance 687 Labour efficiency variance 688 Total labour variance 688 Variable overhead variances 689 Variable overhead expenditure variance 689 Variable overhead efficiency variance 690 Similarities between materials, labour and overhead variances 690 Fixed overhead expenditure or spending variance 691 Sales variances 691 Total sales margin variances 692 Sales margin price variance 693 Sales margin volume variance 693 Difficulties in interpreting sales margin variances 693 Reconciling budgeted profit and actual profit 694 Standard absorption costing 694 Volume variance 696 Volume efficiency variance 697 Volume capacity variance 698 Summary of fixed overhead variances 698 Reconciliation of budgeted and actual profit for a standard absorption costing system 700 Performance reports 700 Self-assessment questions 705 Summary 706 Key terms and concepts 707 Key examination points 708 Questions Standard costing and variance analysis 2: further aspects 729 Direct matrials mix and yield variances 729 Sales mix and sales quantity variances 734 Recording standard costs in the accounts 738 Accounting disposition of variances 745 Ex post variance analysis 747 Variance analysis and the opportunity cost of scarce resources 750 The investigation of variances 754 Types of variances 755 Simple rule of thumb cost investigation models 756 Statistical models not incorporating costs and benefits of investigation 757 Decision models with costs andd benefits of investigation 759 Quantity variances 761 Criticisms of standard costing 763

10 xvi CONTENTS The future role of standard costing 765 Self-assessment question 771 Summary 771 Key terms and concepts 772 Recommended reading 772 Key examination points 772 Questions Oivisiona financia performance measures 791 Divisional financial performance measures 791 Functional and divisionalized organizational structures 792 Profit centres and investrnent centres 793 Advantage of divisionalization 794 Disadvantages of divisionalization 795 Pre-requisites for successful divisionalization 795 Distinguishing between the managerial and economic performance of the division 796 Alternative divisional measures 796 Return on investrnent 799 Residual income 800 Economic value added (EVA ) 801 Determining which assets should be included in the investrnent base 802 The impact of inflation 803 The impact of depreciation 803 The effects of performance measurement on capital investment decisions 804 Determining the divisional cost of capital charge 808 Addressing the dysfunctional consequences of short-term financial performance measures 808 Self-assessment question 813 Summary 814 Key terms and concepts 815 Recommended reading 815 Appendix 20.1: Reconciling short- and long-term residual income measures 815 Key examination points 820 Questions Transfer pricing in divisionalized companies 837 Process of transfer pricing 838 Alternative transfer pricing methods 839 Market-based transfer prices 841 Marginal cost tansfer prices 844 Full-cost transfer prices 846 Cost-plus a mark-up transfer prices 846 Negotiated transfer prices 847 An illustration of transfer pricing 848 Proposals for resolving transfer pricing conflicts 852 Domestic transfer pricing recommendations 855 International transfer pricing 856 Economic theory of transfer pricing 857

11 CONTENTS xvii Self-assessment question 865 Summary 866 Key terms and concepts 867 Recommended reading 867 Appendix 21.1: Economic analysis of transfer pricing 867 Key examination points 873 Questions 873 Part Five Cost Management Accounting Cost management 889 Life-cycIe costing 890 Target costing 891 Kaizen costing 896 Activity-based management 896 Business process re-engineering 900 Cost of quality 900 Cost management and the value chain 904 Benchmarking 906 Management audits 906 Just-in-time systems 907 Summary 913 Key terms and concepts 914 Recommended reading 915 Key examination points 915 Questions 915 and Strategic Management 23 Strategic management accounting 923 What is strategic management accounting? 923 The balanced scorecard 928 Establishing objectives and performance measures 931 The financial perspective 931 The customer perspective 932 The internal business perspective 934 The learning and growth perspective 938 Performance measurement in service organizations 939 Summary 943 Key terms and concepts 943 Recommended reading 944 Key examination points 944 Questions 944

12 xviii CONTENTS Part Six lhe Application of Quantitative Management Accounting Cost estimation and cost behaviour 953 Methods to General principies applying to estimating cost functions 954 Cost estimation methods 955 Multiple regression analysis 962 Factors to be considered when using past data to estimate cost functions 964 Relevant range and non-linear cost functions 966 A summary of the steps involved in estimating cost functions 966 Cost estimation when the leaming effect is present 968 Estimating incremented hours and incremental cost 971 Leaming curve applications 972 Cost estimation techniques used in practice 973 Self-assessment questions 975 Summary 976 Key terms and concepts 977 Recommended reading 977 Appendix 24.1 Tests of reliability 977 Key examination points 984 Questions Quantitative models for the planning and control of stocks 993 Why do firms hold stocks? 994 Relevant costs for quantitative models under conditions of certainty 994 Determining the economic order quantity 995 Assumptions of the EOQ formula 998 Application of the EOQ model in determining the length of a production run 999 Quantity discounts 1000 Determining when to place the order 1001 Uncertainty and safety stocks 1002 The use of probability theory for determining safety stocks 1004 Control of stocks through classification 1005 Other factors influencing the choice of order quantity 1007 MateriaIs requirements planning 1008 Just-in-time purchasing and manufacturing 1010 Self-assessment questions 1013 Summary 1013 Key terms and concepts 1014 Recommended reading 1014 Key examination points 1014 Questions 1015

13 CONTENTS xix 26 The application of linear programming to management accounting 1029 Single-resource constriants 1029 Two-resource constraints 1030 Linear programming 1031 Graphical method 1032 Simplex method 1038 Interpreting the final matrix 1042 Opportunity cost 1043 Substitution process when additional resources are obtained 1043 Uses of linear programming 1044 Self-assessment questions 1047 Summary 1049 Key terms and concepts 1049 Appendix 26.1 The application of linear programming to capital budgeting 1049 Key examination points 1052 Questions 1052 Notes 1067 Bibliography 1073 Appendices Appendix A 1080 Appendix B 1084 Appendix C 1088 Appendix D 1089 Appendix E 1090 Ansers to self-assessment questions 1093 Case study problems 1143 Index 1189