CHAPTER 4

Management Decision Making

About This Chapter

In the previous chapter, we concentrated on financial accounting, which is concerned with the performance and position of the entire organization. Business success, however, depends on the detailed information that is available to managers so that they can make decisions, investigate problems, set performance targets, and carry out their responsibilities of managing an organization or a part of it.

It is the responsibility of managers to plan and control activities whether this is for a division, branch, or a specific activity. To do this successfully, a manager requires detailed information in a timely manner to make appropriate decisions. Managers need data that is relevant to their responsibilities and that is received in time for them to take action. They also need to understand the definitions used in relation to the costs of various activities and feel confident in analyzing that cost information.

Managers are interested in issues such as the costs of operating a particular activity, making a specific article, operating different types of machinery, and selecting different methods of working. Understanding the components of cost and being able to use them assists managers in controlling the operations and activities on a daily basis, to plan for the future, and to decide on alternative courses of action. In this chapter, we concentrate on the different costing methods and techniques that are available and are used in various industries and circumstances.

Cost or Management Accounting

From the days that businesses started operating, the owners and managers would keep some basic accounting records. As the years passed, a body of techniques and methods were established that went under the general heading of cost accounting. In the United States, in 1919, a meeting of accountants was held and the National Association of Cost Accountants (NACA) was formed. This was later to become the Institute of Management Accountants with a membership of 125,000 (Parks 2019).

The term “cost” accounting refers to the actual methods and techniques for identifying the total costs of each part of productive activity. These results are usually compared to the past or planned results. Management accounting is reporting the results to internal managers. This may be on a monthly, weekly, or in some instances, on a daily basis. The terms are sometimes used interchangeably but both manufacturing and service organizations use cost/management accounting.

It is important to emphasize that, unlike financial accounting, there are no regulations requiring organizations to use cost/management accounting and organizations do so because of the very useful information it generates for managers. The dominant characteristics of cost/ management accounting are:

If you are examining a company’s management accounting records, you will find that it is focused on the costs incurred by the organization when conducting its activities. This is because until you know the cost of a product or service, you cannot set the selling price and earn a profit. The term “cost” can be used in many different situations and the definition of cost can depend on the nature of activities. The best place to start is by identifying what we mean when we ask what “it” costs whether it is a product or service. The accounting term used to identify the “it” is “cost object.”

The Cost Object

A cost object is anything for which cost data is required. This may be the sales manager wanting to know the costs of running the sales department. The production manager may be interested in the total cost in one unit of production. The transport manager wants to know the costs of delivering goods to specific locations.

All these managers have different information needs that the costing system in an organization attempts to satisfy. However, this requires collecting and analyzing the information that is available and, in some cases, collecting additional information. This can be an expensive process so decisions need to be made on the importance of the information to management.

Having identified the cost object, you need to identify the different types of costs that are involved with that particular object. The main classifications are direct material costs, direct labor costs, and indirect costs also referred to as overheads.

In a manufacturing industry, the direct costs of materials and labor are usually easy to identify. Records will be available to show the cost of materials used and the cost of wages for those working on production. Usually, the direct costs vary in line with production activity. Records will be kept of labor hours and material usage. In a service industry, it can be more difficult in identifying the direct costs incurred.

Total direct costs vary with activity levels. There may be an occasional increase in the costs of materials or a wage rise. These are one-off increases and we will have to take them into our calculations. However, the main reason for direct costs fluctuating is activity levels. The more you make, the more the total cost.

Indirect costs (overheads) include the costs of running the organization and tend to be fixed and do not change by activity levels although there may be other reasons, for example, the provider of the services such as insurance and government charges are usually increased by the supplier without reference to the user. The critical issue in all types of industry is the method to be applied to share the total overhead costs for the organization over the various activities and the cost objects generated within one financial period.

Direct Costs

These types of costs can be identified with a specific cost object, which may be a particular product, service, department, or other cost object. Examples are raw materials used in production and labor costs where they can be traced to that particular activity.

In a manufacturing organization, materials that can be identified directly with the product are likely to be significant. The increasing use of mechanization and robotics has, in some industries, reduced the amount of direct labor required. But be cautious: in some industries, where skilled labor is an essential part of the manufacturing process, the cost can be high. There is also the possibility that where machinery is introduced to replace labor, there the depreciation cost on the machinery will be a fixed cost.

Generally, in service industries, direct labor will be high and material costs low or even insignificant. An accounting firm doing a major audit will have high direct labor costs incurred by the people doing the audit but practically zero direct material costs.

Calculating the cost of direct materials to specific cost objects can cause difficulties. These fall under two headings: the practical and the price. On a practical basis, good records and work procedures are essential to ensure that wastage of materials does not occur, as any wastage represents a cost that should be avoided. An organization should ensure that materials ordered are correctly received from the suppliers, stored in safe and secure conditions, and only issued when required by production. This usually safeguards the processing of the correct quantity of materials.

The delivery of materials may take place over a period of time, and this does not necessarily synchronize with the quantities being issued to production. Prices will therefore vary over that period of time due to factors such as:

Different methods can be used for determining the price of the materials issued to production. Of course, the method chosen for issues to production also affects the value of the closing inventory. This amount will be shown on the financial statements, and financial accounting standards determine which methods are acceptable, as explained in Chapter 2. Most companies will select a method that meets the requirements of the financial accounting standard and also establishes a cost that is useful for management. Whatever method is used, the overriding requirement for financial accounting is that inventory should be valued at the lower of its cost and the net realizable value (i.e., the amount it could be sold for less the costs of selling).

The cost of direct labor is usually based on the remuneration system used in the company. It is essential that a sound record system is in place to charge the correct cost of labor to the appropriate activity. For example, in a manufacturing organization, piecework tickets or swipe cards may be used to record the times of different types of labor at various stages of the production process. Time sheets are widely used in the manufacturing and service industries. For example, employees in accounting or law firms will record their billable hours for each client’s job.

Indirect Costs

In addition to those direct costs that can be identified with the production or service activity, there are also indirect costs. These cannot be identified with an individual cost object as they may be organizational or departmental wide. For example, supervisor salaries, heating in the buildings, and telephone costs, which in many organizations can be higher than the direct costs. Frequently, these indirect costs or overheads can be grouped under the following headings:

Depending on the nature of the organization’s activities, there may also be distribution overheads and research and development overheads. In some organizations, the distribution cost of a particular product can be significant and identified directly with the job. Research costs are usually regarded as overheads but for a large project, these may be considered direct.

In a service organization, the overheads can be substantial. If you stay in a hotel, the costs of cleaning your room and the complimentary breakfast are insignificant. It is the property tax for the hotel site, the depreciation charge on fixtures, furniture and equipment, lighting and heating, and the hotel staff you see, such as the employees at the front desk. These are the indirect costs of running the hotel. These indirect costs will tend to remain the same irrespective of changes in the level of activity.

Fixed and Variable Costs

Fixed costs refer to those costs that stay the same in total regardless of changes in levels of activity but can change either upwards or downwards for other reasons. For example, the local government may raise the tax it charges on properties. This is nothing to do with activity levels and the nature of the cost is still regarded as fixed.

Although the fixed cost in total remains the same for the financial period, the fixed cost per unit can change as activity levels change, as the following example shows.

Example of changes in fixed costs

Endow manufactures and installs children’s slides. The Factory Manager cannot understand why the total cost of manufacturing a slide changes throughout the year. The Accountant explains that the fixed cost is $18,000 in total for the financial year. This must be paid regardless of changes in activity.

The information is given to the manager on a monthly basis. As the fixed costs do not fluctuate depending on the activity levels, the fixed cost per month is calculated as $18,000/12 = $1,500 per month. However, production levels fluctuate throughout the year. This means that the fixed cost per unit can change each month. She demonstrates this with the following Table 4.1.

Table 4.1 Fixed cost behavior with fluctuating activity levels

	January	February	March
Fixed cost	$1,500	$1,500	$1,500
Number of slides	10	30	50
Fixed cost per slide	$150	$50	$30

The Marketing Manager says that this seems unfair but the Accountant responds that the Factory Manager is responsible for ensuring efficient output and not for the total fixed cost. Although the fixed cost in total remains the same for the financial period, the variable costs are the costs that change in total as activity changes. In their organization, the variable costs were essentially labor and materials. These were budgeted at $100 slide. Using the above example of activity levels, the variable costs are shown in the following Table 4.2.

Table 4.2 Variable cost behavior with fluctuating activity levels

	January	February	March
Variable cost per slide	$100	$100	$100
Number of slides	10	30	50
Total variable cost	$1000	$3000	$5000

The different behaviors of fixed and variable costs need to be borne in mind when you are attempting to analyze financial information. A manager can only lower the fixed cost per unit by achieving maximum activity levels. The variable cost per unit is dependent on the controls that are placed on costs that vary with levels of activity. Materials consumed in production being the prime example.

The problem of fixed costs is where there is a significant downturn in business. A company can observe its activity levels decreasing and also the direct costs, but the fixed costs are likely to remain the same. Unless a solution can be found, this leads to bankruptcy of the company.

The Industry Perspective

There is no legislation for companies to do management accounting. Companies can therefore choose which method of costing to adopt or decide to not have a management accounting system, but this would be unusual. Not only does an organization choose the method of costing it will use but also how frequently the system will generate information for the managers. Usually, it will be no more than monthly that the management information is available, although some companies have weekly reporting. On key activities, there may even be daily reporting of the main figures.

Different types of industries will select the costing method that provides the financial information to help them manage. The main distinction is between service companies and manufacturing companies. From your own experience, you will appreciate that these are very different industries with different functions and outputs. In this section, we consider the distinctive features, as far as costing is concerned for each industry.

The Service Sector

A simple definition of the service sector is difficult as it covers such a range of activities from hairdressers, concert halls, auto repair shops, and banks. There is no specific method of costing designed exclusively for organizations in the service sector. This is not to argue that the costing methods used in the service and manufacturing sectors are exactly the same. However, the two industries are very different and the service industry has specific issues to resolve if it is attempting to introduce a costing system.

Service organizations usually have little inventory and the distinction between costs related to the product and costs related to a financial period may not be relevant. It is difficult to separate service organizations’ costs into their fixed and variable elements. Specific costs are not easily traceable to certain revenue or output items. Finally, a substantial share of the costs are overhead costs, which are usually more difficult to categorize than direct costs.

In service organizations where an easily identifiable cost object can be devised or where there are identifiable jobs, the procedures we have explained in this chapter can be applied for the allocation of overheads and the calculation of an allocation rate. Remember that a cost object may not be a physical item such as a tire for a car. It may be that a cost object has to be generated, which is hypothetical and not physical. For example, a hotel may decide on an occupied bed night as a cost object. Their need is to know how much it costs to let a room for one night. A transport company may develop a hybrid measure combining weight and distance kilometers. The company will know how much it costs to transport a certain weight of material for one kilometer.

Although costing in the service sector can cause problems, most companies will have some form of budgetary control system. This may be a basic system but provides management with targets they should meet and how successful they were in meeting these targets. We explain budgetary control later in this chapter.

The Manufacturing Sector

In the manufacturing sector, there is normally an identifiable product or products. The company may make only one product or several products. It may be that the product has to go through various stages of manufacture. The product is partially made in one process, then moves on to the next process for more work to be carried out. The finished output at one stage of production becomes the input for the next stage. Each stage or process can usually be clearly identified and is often contained in a separate department.

Where the product has to move through various processes, management usually wants to know the costs that are involved at each stage. It is this detailed knowledge that helps managers to make decisions and identify issues arising from a particular stage of production. If management is keeping a close watch on the costs at each stage of production, it may concentrate only on direct costs as indirect costs remain the same irrespective of the level of activity.

It is usually possible to identify the direct costs. There will be material costs, which can be very expensive in some companies, and labor costs although these have become less important in some sectors of industry as mechanization has become more advanced. There is a problem that occurs at the end of each financial period. We know the number of units completed during the financial period but a number of cost objects are not completed and will progress to the next period. For financial accounting, we need to know the cost of these incomplete units but these are usually not so important for management accounting information. What may be important is how many incomplete units there are and the reason for this.

Types of Costing

Manufacturing and service industries are very different and the types of costing they use mirrors these differences. However, one of the most frequent questions used when making any decisions in either industry is “What did it cost?” The answer will depend on the industry you are in, the size of the organization, and the purpose for wanting this information. Not surprisingly, several costing methods have evolved and in this section we consider these.

There are no regulations controlling the nature of the accounting information that is used specifically by managers to manage an organization. However, it is essential that the system of cost accounting generates data that is useful and at the end of a financial period and does not give figures that are significantly at variance with the legally required financial accounts.

In this section, we are providing a general view of the different types of costing methods. Organizations will modify, adapt, and change the method to suit their own particular needs. What they will find is that all the methods are “costly” to operate but without the information a well-designed system provides, you cannot plan, measure, and benefit from your work.

Process Costing

Process costing method is normally used where the manufacturing is conducted in a series of separate stages until there is the final product that can be sold. In some organizations, there may be more than one final product. For example, a company may make a standard model and add something to it so that it also has a “superior model” for sale at a higher price.

Where there is only one final product, the costs of each of the separate processes are identified for a specific period and divided by the output to give an average cost per unit. Direct costs for a process can be identified from the accounting records and overheads will be allocated to the separate processes. A company may collect only the information on direct costs as the indirect costs will remain the same. The average cost of each cost unit can be calculated at each stage by simply dividing the total cost of that process for a period of time by the number of cost units produced in that period. The costs for the cost units are aggregated to give the final total cost for all of the processes that production goes through.

Often there is not one single product. There will be a main product, joint products, and by-products. It is further complicated by calculating the value of work in progress at the end of the financial period and accounting for normal and abnormal losses that have occurred during the production process.

The work in progress at the end of the first stage of production means those units are still incomplete and have to be finished before they can be transferred to stage 2. These are incomplete units but we need to put a value on them. These units will also incur additional costs in the next financial period so that the units are complete.

Process Costing Example

To demonstrate the application of process costing, we will assume that we are concerned with stage 1, which is January. There are several pieces of information we require at the end of January. We want to know the cost of the completed units, the costs of any normal or abnormal losses and, most importantly, how much it has cost us in January in Process 1 to produce incomplete units, which are referred to as work in process (WIP). If, at the end of January, there were 10,000 units that had been only

50 percent completed, we would say that these were the equivalent of 5,000 completed units. If the cost of a completed unit is $0.50, so the cost of our 10,000 incomplete units is 10,000 × $.50 = $5,000.

This may seem a somewhat inexact way of calculating the costs of incomplete units but we have what is known as “The cost of costing.” Generating financial information is expensive and management must decide how much information they require to make decisions. Assuming that the production process is well managed, the method of costing for processes is fairly straightforward and giving time and attention to the costs of incomplete units on a monthly basis may not be of use to everyday management. It is important for financial accounting where it is essential to identify the full cost of the products and the value of the closing inventory.

Job Costing

Manufacturing and service organizations carrying out work that has been specifically requested need to know the cost of each individual job, as this will be related to the selling price. Job costing, also known as specific order costing, is the accounting method used by such organizations. Whether a quote has to be provided for painting the outside of a domestic residence or for building a bridge across a river, control of costs is essential. The purpose of the method is to “quote” the cost of a job, whether it involves a tangible product or a particular service for a client. The quote is based not only on all the costs for doing the job but also a measure of profit. This is not usually disclosed to the customer.

Jobs are usually identified as a piece of work, carried out to a customer’s specific requirements. A company taking on a job can record the direct costs, such as materials and labor but there are also the overhead costs such as administration, advertising, and depreciation on equipment.

Jobs can be very small and of short duration such as having the local garage servicing your car or a company decorating your house. The garage and the decorators will want to keep control of their costs so that they make a profit. The garage will have its fixed costs, as explained above, but there will be the variable costs of the mechanic’s time and the materials that are used.

Some jobs can be very big and take months to complete. Jobs such as building a new factory or building a bridge over a river will require material and labor but also heavy machinery that will be used on several different jobs. On these long-term jobs, it is essential that the accountant and the manager in charge of the job communicate, as work is processed.

With all the jobs, the provider of the service or product need to maintain control of the costs incurred in doing the job to ensure that there is a profit to be gained. Usually, each job is specific to the client. The time it takes to do the job is critical and is recognized as the cost object. To ensure a project is profitable, the provider will need to control its direct costs such as labor and materials. However, it will also need to have a method for charging overheads to the job.

In some industries, it is sometimes possible to negotiate the price of a job on a cost-plus policy. The final selling price is calculated by adding an agreed fixed-profit margin to the cost of the job. This approach has a number of weaknesses, as there is no incentive to control the cost of the job. It ignores market conditions, and the total costs are dependent on the method of overhead recovery. If a client does enter into such a contract, it is essential that the job specification is agreed in minute detail.

Job Costing Example

Home Protect is a small enterprise and designs and installs security systems for domestic and commercial buildings. It manufactures the security system itself to meet the requirements of the purchaser. It pays its direct labor $10 per hour and there is the cost of the materials. It adds 15 percent to the production cost of the job to cover the administration and selling costs (the overheads). It also adds 20 percent to the installation costs for overheads. It has been requested to submit a quote for a security system for a private dwelling. It calculates its costs as follows.

	$
Costs for manufacturing system
Material	1,250
Labor (30 hours @ $10 per hour)	300
	1,550
Manufacturing overheads ($1,550 × 15%)	235
	1,785
Costs for installation
Labor (12 hours @ $10 per hour)	120
Installation overheads ($120 × 20%)	25
	1,930

Home Protection gives a quote of $2,500

Your first reaction on seeing this quote (which will not be shown to the potential customer) is that there are errors in the additions. Remember that this is a quote and Home Protection are not certain that the customer will accept it. The calculations are generally close and the quote given allows Home Protection some bargaining leeway if it wants the job. Remember. Home Protection still has to meet the costs of its own premises, advertising, and salaries of staff, in other words, the overheads.

Good accounting can be extremely helpful. To achieve absolute precision can be expensive and we sometimes have to judge if precise management accounting data is worth the cost in generating it. Even with financial accounting, we do not expect companies to report to the nearest dollar. Refer back to Chapter 3 and you will see that financial accounts, which are legally required, may be drawn up to the nearest one million dollars.

Where the final selling price is calculated by adding an agreed fixedprofit margin to the cost of the job, there are a number of weaknesses, as there is no incentive to control the cost of the job. It ignores market conditions, and the total costs are dependent on the method of overhead recovery. If a client does enter into such a contract, it is essential that the job specification is agreed in minute detail.

Where the jobs are specifically designed for one customer, job costing can provide managerial advantages. It provides controls on the operations. In the case of Home Protection, the hours the job is expected to take. It is a basis for improving quotations in the future. Finally, in some industries, certain jobs are so repetitive and financially minor that the company does not need to cost each job. Everyday examples are oil changes for your car and visits to the hair dresser. Although there is a customer (yourself) and the job is specifically for you, the service provider usually has a standard price based on previous experience. This “average” cost is deemed sufficiently precise in management accounting terms.

Full Costing or Absorption Costing

In recent years, there have been suggestions to calculate the full costs of an organization’s activities. The full cost would include social, environmental, and economic costs. The traditional accounting approach is therefore expanded to include costs that make up what is referred to as the triple bottom line, a term introduced by John Elkington (1997). We will examine these developments in Chapter 6 but in this chapter, we explain “full costing,” without including these other costs, although we do not deny their importance.

Full costing, also known as absorption costing or traditional costing, is usually linked to the manufacturing sector of industry. The purpose of this method is to identify and to value the material, labor, and overhead costs incurred to provide a product or service. The method was developed in the manufacturing sector and reflects the priorities of production facilities.

In calculating the cost of an object, the material and labor costs present no major problems. There will be a system in place to record the costs incurred on a regular basis. We have the problem of factory overheads. These cannot be directly identified with a single product but relate to the entire output. As we explained earlier in this chapter, although the output may fluctuate, the fixed costs in total remain the same. Examples of such costs are:

These indirect costs must be added to the direct or prime costs to ascertain the total production cost, also known as factory cost or total factory cost of finished goods. If these total costs are deducted from the sales figure, we will know the manufacturing profit, or loss if that is the case. We emphasize that we are only calculating the profit for the manufacturing process. There will be other costs at the company level.

A manufacturing account will be similar to the following outline:

Manufacturing Account for the Period Ended ……
Direct materials (Opening stock + purchases – closing stock)	X
Direct wages	X
Direct expenses	X
Factory overheads	X
Factory (prime) cost	X

Although the above statement requires substantial data collection and analysis, it does not analyze all the costs incurred. We have to make adjustments for any work in progress at the start of the period and any work in progress at the end of the period. There may also be some difficulties in deciding which costs are “factory” costs and which are company costs. However, this information can be expensive to collect and is required only if it helps managers to make decisions.

In our example, we have used only one production center. There could be more than one such center in the same building or factory. A company may have two or more factories with the main management being in a completely separate building. If this is the case, we have to share the total overheads of the organization over the various production cost centers. For example, the costs of cleaning, lighting, heating, and insurance need to be charged in some way to each production department. The procedure usually followed is to charge those overheads to the department that causes them. If there is more than one production center, the remaining overheads are shared over all the centers.

Our example above gives the cost of manufacturing for a period of time. What we need to know is the total manufacturing cost of one item we are manufacturing. Although we have shared the overheads for the entire factory, we need to charge an appropriate amount to the cost object, that is, the articles we are making. There are several ways of doing this. Three methods that are used frequently are:

The Cost Object

Assuming that we are making only one type of product, we can divide the department overheads by the number of units going through that department. This gives an average overhead cost per unit.

Labor Hour Rate

It may be that there are two or more different types of objects manufactured. The overhead costs can be divided by the total hours of manufacturing to give an hourly rate for manufacturing. Note that this is not the direct labor cost but the share of overheads cost and is added to the direct costs to give the total production cost.

Machine Hour Rate

The production process may be highly mechanized. In this scenario, you would charge the overheads to the cost object on the basis of the machine hours incurred.

Activity-Based Costing (ABC)

Full costing, although it provides a substantial amount of information to assist decision making, involves considerable arbitrary decisions on cost allocation. It may be that the amount of work required and the nature of the organization’s activities make full costing difficult to apply. An alternative method is available known as Activity Based Costing.

Kaplan and Bruns (1987) posited the first treatise of activity-based costing as an alternative to full costing. Their suggestions explained the value of this alternative accounting method in the manufacturing sector. This was particularly helpful as there were indications that, in some areas of manufacturing, the proportion of the direct costs was falling and the indirect costs were increasing.

It is difficult to determine the benefits of ABC rather than Full Costing. Many claims have been made on its application in industry and various studies have been conducted to assess its usage. The results suggest that the claims made on using this method are higher than the actual rate of adoption. White, Anistal, and Anistal (2015) referred to the ABC Paradox as the actual adoption of the system did not match the somewhat extravagant claims made for its usefulness. Our opinion is that companies devise, structure, and implement any method of data collection and analysis to meet their own current information needs. In doing this, they carefully analyze the costs of operating the method.

You may encounter different methods of Full Costing and Activity Based Costing than the “book methods” we describe. Usually, the methods we have described and variations on them are there to meet the information needs of the managers. Most methods will treat direct costs as we have described above. It is in deciding how to account for overheads where there are differences.

With both the main methods and their variations, companies tend to use predetermined overheads. These will be the budgeted total costs for rent, insurance, electricity, power, and other indirect costs because the company cannot wait for the actual amounts, some of which may not be known until the end of the financial year.

The purpose of ABC, as with full costing, is to determine the total cost of a product, service, or activity. ABC differs from Full Costing as it uses the concept of “cost pools.” Instead of allocation rates to charge overheads to the products, what is known as “cost drivers” are identified.

The main activities in the organization are classified as cost pools. These could be the existing functional departments or areas where there is considerable activity and cost expenditure. ABC has been criticized and Kaplan, Anderson, and Stevens (2004) proposed a simplified ABC. Undoubtedly, companies if they are considering adopting ABC, are going to design a system that provides the information they need at a cost they are willing to bear.

We have described the two methods used but it is important to remember that companies use costing techniques to meet their own information needs. This collection and analysis of data can be very expensive. There is no legislation that forces an organization to use management accounting.

These discussions on the use or non-use of ABC and its application in companies support the statement we made in Chapter 1. Financial accounting is strongly regulated and companies follow these regulations. Management accounting is not regulated and it is companies’ decisions that shape the system they use.

Budgetary Control

There are very few organizations that would not be using some form of budgetary control, no matter how basic it is. A budget is a quantitative or a financial statement prepared before the start of a trading or financial period. This could be a month or a year. The budgets are for a specific time period and set out the business goals to be met during that period. The budget may be for the entire organization but it is normal to also set budgets for different departments or activities.

Even a small organization may construct a simple budget for a year. With larger companies, it is usually divided into smaller periods of a month. Budgets, at least at the top level, are usually in financial terms but non-monetary measures may also be used for separate departments. This could be the sales quotas to be achieved or the number of products to be manufactured in the period. A sales budget would usually have an analysis of the total sales revenue projections. The analysis may be by product, market, advertising and promotion costs, and individuals’ sales targets.

It is essential that the budgets for individual sections of the organization are coordinated. It is useless to produce a sophisticated sales budget showing the trend of sales through the period without keying in to other budgets. The manufacturing section will need to know the requirements and the transport section. It will also entail the purchasing department to ensure that the materials are available at the appropriate time and price.

At the end of a budget period, whether this be a month or a week, the actual achievements are measured and compared with the budget. Differences, known as variances, between the budget and actual performance should be investigated.

If you are investigating the performance of an organization or examining the management of a specific function, it is essential that you review any budget that has been prepared and the actual results achieved. Too often, budgets take an optimistic view and the test of its worth is the actual results that are achieved and, where appropriate, the reasons they vary from the budget.

Standard Costing

Standard costing establishes the costs to be incurred. It is used to provide managers with a reporting method and to provide control over costs. The organization determines planned levels of expenditure and income and the actual costs are recorded. The difference between what has been planned and what was achieved is a variance that probably requires investigation to determine the reasons for the difference. Standard costing is usually used for individual products and processes and is frequently used in manufacturing.

The basic concept of the technique is that a cost has been predetermined and the actual cost is compared with it. The difference between the two amounts is known as a variance. If the actual cost is higher than the predetermined standard, the difference is known as an adverse variance. If the actual costs are lower, it is a favorable variance. We will demonstrate the application of standard costing for both direct materials and direct wages. The following diagram illustrates the connections.

Standard Costing – Direct Variables

The bottom line of the diagram is where the main interest lies. Essentially, it gives the answers to the four following questions.

You will find that most manufacturing organizations, whatever their size, will have some standard costing system. It may be scribbled in a notebook or be a computerized system. The purpose is the same—it provides managers with information so that they can manage more successfully.

Conclusions

In this chapter, we have explained the techniques and methods that can be used to help managers make their organization successful. Unlike financial accounting, there are no rules or regulations that lay down what companies must do. A management accounting system can be expensive to operate. Unless it provides useful financial information to managers, it is not worth undertaking. However, there are some business activities, unless they are very small, where only the material costs and direct labor are important. Overheads can be substantial and greatly increase the total costs of your products and services.

There are different approaches to calculate what a product or service costs. The first step is to determine the classification of the costs that are being incurred. We have considered the characteristics of direct costs and indirect costs. We have also explained the main costing methods used by organizations to ensure efficiency.

Having explained the techniques and methods available, in the next chapter, we explain how you can apply this knowledge.

Action Plan

We have given a broad view of the various methods and techniques used for management decision making. The processes we have explained can be applied, in many forms, to most organizations, even the smallest ones. A good example is a simple service such as hair dressing, car cleaning, and other activities carried out by one person with few materials used. The costs incurred in carrying out the activity will be essentially for labor and the overhead costs for operating the business. If you are examining a particular organization, the steps are: