Objectives of Managerial Accounting

A basic objective of managerial accounting is to improve the effectiveness of both the management planning and control functions. Plans should be developed on the same information base as the mechanisms of control. Planning depends on the same reporting and control mechanisms that make central oversight possible and decentralized management feasible. [3] Building the mechanism of control on one data base (financial accounting) and the planning process on another (program analysis) places too great a burden on the management system as the intermediary. Managerial accounting involves in the formulation of financial estimates of future performance (the planning and budgeting processes) and, subsequently, the analysis of actual performance in relation to those estimates (program evaluation and control).

Functions of Managerial Accounting

Managerial accounting is concerned primarily with four basic functions: management planning, cost determination, cost control, and performance evaluation. Significant features of managerial accounting are summarized in Exhibit 4. Component costs must be determined before decisions can be made regarding the commitment of resources in support of particular programs or objectives. Costs must be evaluated, both in the immediate future and in the long run, and must be weighed against anticipated benefits. Once commitments have been made, costs must be monitored and controlled to ensure that they are appropriate and reasonable for the activities performed. And the overall performance of a program, activity, or subunit must be evaluated to improve future decisions regarding resource allocation.

Exhibit 4. Components of Managerial Accounting

o Experimentation and innovation are encouraged in the types of management information provided.

o Information generated for planning and programming purposes to establish a better balance with the control function of accounting.

o Cost consciousness is increased among operating units through the identification of cost and responsibility centers and the use of performance standards.

o Cost analyses facilitate the linkages among management control, program budgeting, and performance auditing.

o Emphasis on cost estimation for planning or control purposes, rather than on financial reporting.

o Costs are monitored to determine if they are reasonable for the activities performed.

o Performance standards (workload and unit cost data) added to traditional accounting control mechanisms by which legal compliance and fiscal accountability are evaluated.

o Crosswalks of financial data are accommodate various external and internal reporting needs.

The informational boundaries of managerial accounting are not rigid or predetermined by standards of "general practice." There is little point in collecting data, however, unless their value to management exceeds the cost of data collection. [4] Managerial accounting provides financial interpretations that can assist in the formulation of policies and decisions and in the planning and control of current and future operations. Such internal reporting to management often requires the collection and presentation of financial information in formats that are completely different from those followed for external reporting purposes. [5]

Managers often need information on a real-time basis--that is, as problems occur and opportunities arise. They may be willing to sacrifice some precision to gain currency of data. Therefore, in managerial accounting, approximations often are as useful as--or even more useful than--numbers calculated to the last penny. In spite of the mystique that often surrounds its data, financial accounting cannot be absolutely precise. Thus, the difference is actually one of degree.

The success of a decentralized management system depends on an understanding at the department level of the rules of the game, as well as the incentives and expectations that govern the planning and budgeting functions. An important task of managerial accounting is to enlarge the circle of those familiar with the processes of planning, budgeting, and control through the communication of pertinent management information as well as financial data.

The cost categories frequently encountered in managerial accounting are listed and defined in Exhibit 5. Many of these cost categories operate in opposing pairs; for example, product and period costs, investment and recurring costs, out-of-pocket and sunk costs.

Exhibit 5. Cost Categories Used in Managerial Accounting

o Engineered costs are any costs that have an explicit, specified physical relationship with a selected measure of activity. Most variable costs fit this classification. Direct labor and direct material costs are prime examples.

o Discretionary costs are fixed costs decided upon by management at the beginning of a budget period as to the maximum amounts to be incurred. Examples include research and development, advertising, employee-training programs, and day-care services for employees' children.

o Committed costs consist of those fixed costs associated with the physical plant and equipment of the organization. Examples include depreciation, rent, property taxes, and insurance. Salaries of key personnel may also be considered committed costs. Such costs often cannot be reduced without adversely affecting the ability to meet long-range goals.

o Product costs are initially identified as part of the inventory on hand. They become expenses only when the inventory is sold.

o Period costs are deducted as expenses during a given fiscal period without having been previously classified as product costs (for example, general administrative expenses).

o Out-of-pocket costs involve current or upcoming outlays of funds as a result of some decision

o Sunk costs have already been incurred and, therefore, are irrelevant to the current decision-making process. Allocation of costs based on depreciation and amortization schedules are examples of sunk costs.

o Marginal costs represent the cost of providing one additional unit of service (or product) over some previous level of activity. An example would be the cost of keeping the library open an extra hour each evening.

o Differential costs (or incremental costs) represent the difference in total costs between alternative approaches to providing some product or service.

o Opportunity costs involve the maximum return that might have been realized if resources had been committed to an alternative investment; that is, the impact of having to give up one opportunity to select another.

o Associated costs are incurred by beneficiaries in using programs or services. An example is the cost incurred by individuals in traveling to a public recreational facility.

o Investment costs vary primarily with the size of a particular program or project but not with its duration.

o Recurring costs are operating, maintenance, and repair costs that vary with both the size and the duration of a program. Recurring costs may include salaries and wages, equipment maintenance and repair, and materials and supplies.

o Life-cycle costs are incurred over the useful life of a facility or duration of a program, including investment costs, research and development costs, operating costs, and maintenance and repair costs.

Managerial accounting provides information to internal users in making decisions about the development of resources and the exploitation of program opportunities. Although managerial accounting reports contain financial data, much of the information in these reports is non-monetary --for example, number of employees, number of hours worked, quantities of materials used, purpose of travel, and so forth. As discussed later in this chapter, managerial accounting includes estimates and plans for the future of cost centers and responsibility centers, as well as information about the past.

Public organizations often must operate under an accounting system developed to satisfy externally imposed legal requirements, rather than to meet their own management needs. A state university, for example, may have to operate under an accounting system that meets the financial reporting requirements of the state. Such an accounting system may trackrevenue and expenditures on a cash basis and require account close-outs at the end of the fiscal year. Externally funded, sponsored research projects within the university, however, do not operate on a cash basis and do not conveniently match the fiscal year cycle anticipated by the state accounting system. These sponsored programs may produce as much as one-third of the total financial resources of the university and may have a multiplicity of reporting requirements not easily served by the state accounting system. Managerial accounting techniques make it possible to "crosswalk" data from the accounting system mandated by the state to formats more applicable to sponsor requirements.

Cost Approximation Methods

Cost approximation, or cost estimation, involves efforts to find predictable relationships between a dependent variable (cost) and an independent variable (some relevant activity), so that costs can be estimated over time based on the behavior of the independent variable. This cost function is often represented by the basic formula:

y = a + bx,

where y is the dependent variable (cost), x is the independent variable, and a and b are approximations of true (but unknown) parameters. For example, if the cost of inoculating 20 children is $50, and the cost of inoculating 50 children is $80, then the fixed costs (a) are $30 and the variable costs (b) can be calculated as $1 per child.

In practice, cost approximations typically are based on three major assumptions: (1) linear cost functions can be used to approximate non-linear situations; (2) all costs can be categorized as either fixed or variable within a relevant range; and (3) the true cost behavior can be sufficiently explained by one independent variable instead of more than one variable. Problems of changing price levels, productivity, and technological changes also are assumed away under this approach. The analytical task is to approximate an appropriate slope coefficient (b)--defined as the amount of increase in y for each unit increase in x--and a constant or intercept (a)--defined as the value of y when x is 0. The analyst may use goodness-of-fit tests, ranging from simple scatter diagrams to full-fledged regression analysis, to ensure that the cost function is plausible and that the relation-ship is credible.

Four major types of cost functions are suggested by the previous discussion of fixed and variable costs (see Exhibit 2):

(1) Total fixed cost does not fluctuate as x changes: y = a, because b = 0.

(2) A proportionately variable cost fluctuates in direct proportion to changes in x: y = bx, because a = 0.

(3) A step-function (or semi-fixed) cost is nonlinear because of breaks in its behavior pattern: y' = a', y'' = a'', y''' = a''', and so forth.

(4) A mixed or semi-variable cost is a combination of fixed and variable elements; that is, total cost fluctuates as x changes within the relevant range, but not in direct proportion: y = a + bx.

The first three of these cost functions are relatively straightforward and simple to resolve. The mixed-cost situation is the most common, however, and the most problematic. The fixed portion of a mixed cost typically is the result of providing some initial capacity. The variable portion is the result of using the capacity, given its availability. A photocopying machine, for example, often has a fixed monthly rental cost plus a variable cost based on the number of copies produced.

Ideally, mixed costs should be subdivided into two accounts--one for the variable portion and the other for the fixed portion. In practice, how-ever, such distinctions are seldom made because of the difficulty of assigning day-to-day cost data to variable and fixed categories. Even if such distinctions were possible, the advantages might not be worth the additional effort and costs.

Several basic methods are available for approximating cost functions --the five most commonly applied are listed in Exhibit 6. These methods are not mutually exclusive and frequently are used in tandem to provide cross-checks on assumptions.

Exhibit 6. Methods for Approximating Cost Functions

o Analytic or industrial engineering methods entail a systematic examination of labor, materials, supplies, support services, and facilities--sometimes using time-and- motion studies--to determine physically observable input-output relationships.

o Account analysis involves a classification of all relevant accounts into variable or fixed cost categories by observing how total costs behave over several fiscal periods.

o High-low methods call for estimations of total costs at two different activity levels, usually at a low point and a high point within the relevant range. The difference in the dependent variable is divided by the difference in the independent variable to estimate the slope of the line represented by b.

o Visual-fit method is applied by drawing a straight line through the cost points on a scatter diagram, which consists of a plot of various costs experienced at various levels of activity.

o Regression methods refer to the measurement of the average amount of change in one variable that is associated with unit increases in the amounts of one or more other variables.

Whatever method is used to formulate cost approximations, it is important in managerial accounting to have reasonably accurate and reliable cost predictions. Such cost estimates usually have an important bearing on a number of operational decisions and can be used for planning, budgeting, and control purposes. The division of costs into fixed and variable components (and into engineered, discretionary, and committed categories) highlights major factors that influence costs. Although cost functions usually represent simplifications of underlying true relationships, the use of these methods depends on how sensitive the decisions of the manager are to the errors that may be introduced by these simplifications. In some situations, additional accuracy may make little difference in the decision; in others, it may be very significant. Selection of a cost function is often a trade-off between the cost and value of information. [6]

Responsibility and Cost Centers

The concept of responsibility accounting has emerged to accommodate the need for management information at a more specific level of detail than can be provided by financial accounting procedures. Responsibility accounting attempts to report results (actual performance) in such a way that: (1) significant variances from planned performance can be identified, (2) reasons for variances can be determined, (3) responsibility can be fixed, and (4) timely action can be taken to correct problems.

Under this approach, pertinent costs and revenues are assigned to various organizational units--departments, bureaus, and programs--designated as responsibility centers. In the private sector, responsibility centers may take several forms:

(1) A cost center is the smallest segment of activity or area of responsibility for which costs are accumulated.

(2) A profit center is a segment of a business, often called a division, that is responsible for both revenue and expenses.

(3) An investment center, like a profit center, is responsible for both revenue and expenses, but also for related investments of capital.

Outside of relatively large corporations, the cost center is the most common building block for responsibility accounting. In fact, the terms cost center and responsibility center are often used interchangeably.

Responsibility accounting placing emphasis on specific costs in relation to well-defined areas of responsibility. Managers often inherit the effects of their predecessors' decisions. Long-term effects of such costs as depreciation, long-term lease arrangements, and the like, seldom qualify as controllable costs on the performance report of a specific manager.

Most models that measure performance in the private sector are tied to profits--for example, profit percentage (profit divided by sales), return on investment (profit divided by initial investment), or residual income (profit minus a deduction for capital costs). Profits are seldom a viable measure at the cost center level, however. Rather, performance is most often measured by comparing actual costs against a budget. A variance is defined as the difference between the amount budgeted for a particular activity and the actual cost of carrying out that activity during a given period. Variances may be positive (under budget) or negative (over budget).

Performance data can be developed for management purposes independent of the budget and control accounts. This kind of performance reporting has been used in the justification of resource requests and in the assessment of cost and work progress where activities are fairly routine and repetitive. Under this approach, units of work are identified, and changes in quantity (and, on occasion, quality) of such units are measured as a basis for analyzing financial requirements. The impact of various levels of service can be tested, and an assessment can be made of changes in the size of the client groups to be served. This approach is built on the assumption that certain fixed costs remain fairly constant regardless of the level of service provided and that certain variable costs change with the level of service or the size of the clientele group served. Marginal costs for each additional increment of service provided can be determined through such an approach. With the application of appropriate budgetary guide-lines, these costs can then be converted into total cost estimates.

Variances, budgeted results, and other techniques of responsibility accounting are relatively neutral devices. When viewed positively, they can provide managers with significant means of improving future decisions. They can also assist in the delegation of decision responsibility to lower levels within an organization. These techniques, however, are frequently misused as negative management tools--as means of finding fault or placing blame. This negative use stems, in large part, from a misunderstanding of the rationale of responsibility accounting.

Passing the buck is an all-too-pervasive tendency in many large organizations. This tendency is supposedly minimized, however, when responsibility is firmly fixed. Nevertheless, a delicate balance must be maintained between the careful delineation of responsibility, on the one hand, and an overly rigid separation of responsibility, on the other. Many activities may fall between the cracks when responsibility is too strictly prescribed. This problem is particularly evident when two or more activities are interdependent. Under such circumstances, responsibility cannot be delegated too far down in the organization, but must be maintained at a level that will ensure cooperation among the units that must interact if the activities are to be carried out successfully

Responsibility Center Management

Principles and techniques of responsibility accounting and activity-based cost management have been borrowed and combined in what has come to be known as Responsibility Center Management (RCM). Under the traditional approach to fund accounting, operating units are only responsible for the management of their direct costs. Direct costs can be narrowly or broadly defined; the more narrow the definition, the larger the aggregate amount of indirect costs. Under RCM, a series of centers have primary responsibility for the management of resources and costs (as well as the broader mission for which these resources and costs are allocated). These centers, for the most part, are equivalent to existing organizational units.

Under Responsibility Center Management, all of the sources of financial support (revenue or income) are attributed to the responsibility centers on some consistent basis. All costs--direct and indirect--also are allocated to each responsibility center. Not all units receive revenue or income from external sources, however. Costs associated with internal service units are either charged to the responsibility centers on a "fee for service" basis or are recovered from the responsibility centers through some form of assessment.

Traditional cost accounting models use direct cost factors (e.g., labor hours, machine hours, material dollars) as surrogates to allocate the cost of service units as overhead. These allocation factors tend to vary proportionately with the volume of goods produced or services provided. Cooper and Kaplan have argued that this approach is flawed because certain cost behavior is a function of the activities carried on in support departments and should not be driven by volume-related allocation factors. [7]

The Activity-Based Costing (ABC) model, which Cooper and Kaplan developed, assigns costs to activities--the processes or procedures that cause work to be performed in an organization. Cost management and cost control can then focus on the sources of cost rather than on where the costs are incurred or reported. By focusing on the root cause of a cost rather than addressing symptoms, managers can learn how to identify and eliminate waste.

Costs must be traced from the traditional cost accounting structure (which identifies what resources are being used) to the activities (which relates why the resource is being consumed--for what purpose). Tracing costs can involve actual (historical) costs or budgeted costs. Some costs can be directly associated with an activity (most labor costs, for example), whereas other costs have to be allocated (such as utilities or rent). Costs of supporting departments are initially accumulated in overhead cost pools and are then allocated to appropriate activities.

The volume of each activity's output must be quantified, either as an actual (historical) volume or as a projected volume (define an output measure). The total cost of each activity is then divided by its total volume to determine the average cost per unit of output. The total costs of individual activities then are allocated to responsibility centers or activity centers (i.e., groups of having a common objective). Finally, performance measures are identified to determine the results achieved by an activity or activity center (e.g., average cost per patient treated for a particular ailment).

The ABC method for allocating costs is more complex and requires additional time and effort to determine the attribution of indirect costs. In many situations, it is uncertain whether marked difference results are obtained by using the ABC method instead of more traditional approaches. If the costing system is used to determine fees or prices or to measure performance of selected activity centers or indirect cost pools, then the more complex ABC methodology may be appropriate.

Once income/revenue and costs have been fully allocated to the responsibility centers, in all likelihood, there will be some "surpluses" and some "deficits." Some responsibility centers will be assigned costrs that exceed their assigned income/revenue. The deficits or shortfalls between total costs and revenues/income must be covered through some form of subvention--that is, a central allocation to ensure the continued operation of programs existing at the time the new allocation model is implemented. On the other hand, units should be permitted to retain all or a major portion of their "surpluses."

Multipurpose Accounting System

As discussed previously, the object-of-expenditure budget and accounting classification--with its detailed enumeration of object and subobject codes --offers two distinct advantages over other account classification systems: (1) accountability--a pattern of accounts is established that can be controlled and audited; and (2) personnel management information--the control of personnel requirements can be used to control the entire budget. These two characteristics have sustained the object-of-expenditure format for more than seventy-five years. More recent efforts to develop financial information that is more responsible to the needs of management have found these features somewhat intransigent to other objectives, however.

Data Crosswalks

The budget allocation for the Financial Management Department of the City of Rurbana can serve to illustrate a multipurpose accounting system that builds on the two basic characteristics of an object of expenditure classifi-cation. The Financial Management Department consists of five agencies: the City Treasurer's Office, the Accounting Division, the Budget Division, the Data Processing Section, and the Purchasing Office. A program budget has been adopted on an experimental basis as part of the Rurbana's efforts to develop improved financial management and accounting procedures. Four major programs have been identified for the Financial Management Department: Cash and Debt Management, Program Budgeting, Financial and Managerial Accounting, and Procurement and Inventory Maintenance. Since these programs cut across the organization-al lines of the five agencies, expenditure data must be "crosswalked" to provide an accounting summary on a program basis. A crosswalk refers to any data conversion which involves a change in classification systems (for example, from objects of expenditures to programs, or vice versa).

The objective is to record expenditures by agency and by program. An initial distribution was accomplished in the budget-building phase and is reflected in the administration of the budget in terms of allocations and allotments. Line-item budget allocations to the five agencies of the Financial Management Department are summarized in Exhibit 7. These budget allocations, in turn, have been "crosswalked" to the four programs which have been identified for the department's operates during the current fiscal year, as shown in Exhibit 8.

Exhibit 7. Budget Allocations by Agencies

Exhibit 8. Budget Allocations by Programs

Program expenditures at the end of nine months of the current fiscal year are summarized in Exhibits 9 and 10 by the four programs and the five agencies of the Financial Management Department. Multi-digit account codes facilitate the assignment of expenditures in such a crosswalk of accounting data from programs to agencies. As expenditures are recorded to the program accounts, a parallel record is easily maintained at the agency level.

From the data in Exhibits 9 and 10, it may be noted that, at the three-quarter point in the fiscal year, the rate of expenditures for each of the programs exceed the 80 percent level. Overall departmental spendingat the end of nine months is at the 80.2 percent level. By examining the expenditure data by agency, it may be seen that commitments under the Data Processing Section are a major contributor to the fact that the rate of expenditures is running ahead of expectations. Salaries and related personnel costs in this unit are 81 percent expended, while the budget allocation for contractual services is 89 percent expended. At the program level, these expenditures are spread across all four programs because of the range of data processing requirements. Thus, it is important for program managers to have timely data on expenditures both by programs and by the agencies authorized to make such commitments.

Exhibit 9. Expenditures by Programs at the end of 9 Months

Exhibit 10. Expenditures by Agencies at the end of 9 Months

Expenditures Versus Costs

In order to determine where the costs come from, it is necessary to know the amount of costs from each department or agency that goes into each program. These cost allocations are illustrated in Exhibit 11. In this context, program entities represent cost centers or responsibility centers.

It is important to note that total costs exceed recorded expenditures by $100,000. From the discussion of the basis of accounting, it may be recalled that expenditures are measured by the amount of actual cash paid out during a given fiscal period. On an accrued cost basis, however, adjustments must be made for inventories, depreciation of fixed assets, and other accounts. Such adjustments are critical in answering the basic question: How much does a program actually cost?

The major adjustment occurs in capital outlay ($80,000), which is assigned to the Data Processing Section and distributed equally across all four programs. Other adjustments are evident in supplies ($5,000) under Purchasing; travel ($5,000) by the City Treasurer under Cash and Debt Management; and contractual services ($10,000) incurred by the Budget Division under the Program Budget From an accounting standpoint, the most valuable type of program crosswalk is one that brings together the types of costs by cost center or department for each program. Therefore, in order to compare program costs with the overall effectiveness of program activities, it is essential that a program budget be based on costs rather than expenditures.

Exhibit 11. Operating and Capital Costs by Programs at the end of 9 months

Summary: Future-Oriented Accounting Information

The primary concern of financial accounting is the accurate and objective recording of past events (financial transactions). The basic objective of cost and managerial accounting is the provision of information for improved financial management decisions.

This discussion has focused on the techniques of cost accounting, on the basic functions of managerial accounting--and especially cost determination and cost control--and on responsibility accounting that support these basic functions. Five basic cost components involved in any activity or program are: (1) labor (personnel), (2) contractual services, (3) materials and supplies, (4) equipment expenses, and (5) overhead or indirect costs. Various accounting mechanisms must be used to ensure the proper recording of costs These mechanisms, for the most part, are embodied in the procedures of cost accounting.

Whenever the full cost of a service or product must be determined, costs must be allocated according to their variable, fixed, direct, and indirect components. Fixed costs of any project remain constant as the volume of activity increases; on a per unit basis, these cost become progressively smaller. Variable costs are more or less uniform per unit, but the total of these costs increases as the volume of activity increases. A direct cost is incurred in support of a specific, identifiable purpose. An indirect cost is associated with more than one activity or program and cannot be traced directly to any individual activity.

An important step in controlling costs is to determine how they function under various conditions. This process, called cost approximation or cost estimation, involves efforts to find predictable relationships (cost functions) between a dependent variable (cost) and one or more independent variables (organizational activities). Several methods for approximating cost functions were discussed in this chapter, the most reliable being the regression method.

Responsibility accounting seeks to assign accountability to those sectors of an organization (cost centers and responsibility centers) in which day-to-day influence can be exercised over the costs in question. The concept of controllable costs--that is, any cost that can be influenced by a given cost center manager during a given period--is a key to respon-sibility accounting. The emphasis on controllable costs and budgeted results makes responsibility accounting a good supporting component of the financial management process.

Activity-Based Cost Management techniques are designed to provide more definitive bases by which to allocate costs--and in particular, overhead costs--to activities and clusters of activities through the identification of cost drivers. The ABC approach provides a more accurate representation of indirect cost attributions than can be obtained by using surrogate measures, such as direct labor hours or direct material costs.

Under Responsibility Center Management, primary responsibility for the management of all sources of external financial support and all costs --direct and indirect--associated with achieving the goals and objectives of an organization are assigned to various centers. Internal service units are supported either on a "fee for services" basis or through some form of assessment.

Finally, a multipurpose accounting system was presented to show how accounting data can be crosswalked between agencies and programs to provide important management information during the fiscal year one which to base cost allocation and cost control decisions. Such information is essential to an evaluation of the overall effectiveness of program activities.

Endnotes

[1] Leo Herbert, Larry N. Killough, and Alan Walter Steiss, Governmental Accounting and Control (Monterey, CA: Brooks/Cole Publishing, 1984), p. 212.

[2] For a fuller discussion of accrual accounting procedures, see Leo Herbert, Larry N. Killough, and Alan Walter Steiss, Accounting and Control for Governmental and Other Nonbusiness Organizations (New York: McGraw-Hill Book Company, 1987), chapter 1.

[3] Robert Zemsky, Randall Porter, and Laura P. Oedel, "Decentralized Planning: To Share Responsibility," Educational Record 59 (Summer 1978): 244.

[4] Robert N. Anthony and James S. Reese, Management Accounting: Text and Cases (Homewood, IL.: Richard D. Irwin, 1975), p. 422.

[5] James H. Rossell and William W. Frasure, Managerial Accounting (Columbus, OH: Charles E. Merrill, 1972), p. 4.

[6] Charles T. Horngren, Introduction to Management Accounting, (Englewood Cliffs, NJ: Prentice-Hall, 1978), p. 225.

[7] Robin Cooper and Robert Kaplan, "Activity-Based Costing," Journal of Cost Management (Summer 1988).

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