The accounting system as a whole is valuable to management not because it answers questions, but because it raises them. An effective use of management accounting is more concerned with why things are as they are, rather than with whatthey are – which is the province of general accounting.
Raising questions about what might not go right is so important because the more dynamic is the market, the less sure management is that answers it has adopted in the form of plans for operations are those that they should be. The after-effects of business decisions are always finely balanced as:
● Market conditions change
● Competition increases, and
● New products take the market away from the old.
In a way, senior executives are in the position of scientific experimenters.
Certain things about the company’s operations are fairly well understood, and on the basis of that understanding hypotheses are developed in the form of strategic or tactical moves. But other things are uncertain, and hypotheses about them may not be well documented.
● Whether or not the hypotheses being made are sound can be determined by observing the results that follow their application.
● This is, however, a course full of risks. Like the scientific experiment that fails, an unsuccessful plan is merely a challenge to the invention of better hypotheses for future experimentation.
But can the company afford to follow an after the facts approach? Ifnot, thenthe better solution is proactive experimentation, with a most careful evaluation of cause and effect. Cost structures offer themselves to such an approach (more on this later). Chapter 7 focused on the need for cost control. The theme in this sec- tion is cost-finding.
Management accounting contains stuff which, when properly exploited, helps in deriving business intelligence. This leads to finding means of improving corporate governance. It may also allow events to be uncovered that should not have hap- pened in the first place. For instance, violations of company rules that should be sanctioned internally, rather than waiting for regulatory action and associated penalties.
Mid-March 2005 the Securities and Exchange Commission filed a civil lawsuit against the former CEO of Qwest, Joseph Nacchio, and six other former execu- tives of the firm. They have been accused, among other things, of fraudulently reporting $3 billion in revenue to seal a merger with another telecom company in 2000. The SEC wants the executives to repay bonuses and options accrued during the period. Qwest would have been much better off if:
● Its internal control system had reported such misbehaviour to the board, and
● The board had taken immediate disciplinary action, rather than waiting for the regulator to intervene and penalize the firm.
Such a proactive stance would have been in accordance with the principle that management’s rationale is that of planning, directing, and exercising control. In this connection, management accounting is important inasmuch as it is facilitat- ing control action. Cost control provides an example.
The problem of cost-finding is one of the great puzzles in practically every enter- prise. Cost standards, and data concerning costs, are obviously a large part of management accounting, and they also constitute a considerable part of the domain of economic analysis. Moreover, cost data has a significant impact on company governance.
For starters, the form in which cost data is most frequently encountered is as units cost, not as abstract and general interpretations of outlay, or resource allo- cation. A unit cost is cost of ‘something’ that has to be compared to a standard in
order for management to decide if it is high, low, or just right. This short para- graph tells us that a cost control system rests on two pillars:
● Established standard unit costs, and
● Timely reporting of actual unit costs.
The latter are provided through management accounting, fulfilling the require- ment that cost planning and cost control presuppose the existence of a reporting mechanism, bringing forward values that permit comparison of current measure- ments against standards and get immediate results. Comparing an actual cost to a standard provides ratios that can be readily understood by anyone concerned.5 The unit cost may correspond to a component of a product or service. It may tar- get production chores, an administrative duty, the cost of a function, a process, an activity, a method of doing something. The fact that there can be many dif- ferent kinds of cost units increases the flexibility to costing operations.
● Costs are related to efficiency, production processes, price policy, financial activities, and any other issue whose cost matters.
● The fact that costs nearly always have to be thought of as ‘costs of some- thing’ makes it necessary to specify the item with which cost is associated, if the cost figure is to mean much.
The problem of establishing standard costs and selecting cost units for system- atic treatment in an accounting system, is that stereotypes of rules and proce- dures will not do. There is need for a great deal of adaptation – all the way to using cost information with respect to the various purposes to be served.
● Some costs are fixed over relevant ranges of activity
● Others vary in pattern with respect to output, scope of operations, quality level, and other independent variables.
Costs may be controllable or noncontrollable, avoidable or unavoidable, linear or nonlinear in their statistical behaviour, efficient or wasteful. There are many ways of classifying costs, and by consequence cost data, just like there are many questions that can be raised about them. From the managerial viewpoint, there is also an emphasis upon the behaviour of costs, particularly those:
● Running out of control, or
● Putting the firm in an unfavourable position versus competition.
Therefore, it is to be expected that management accounting makes full use of replacement costs, efficiency ratings, and competitive data in preparation of
meaningful and useful reports for corrective action. Moreover, the concept of unit cost has to be further elaborated so that it involves not only the notion of a unit with which the cost is associated but is also a connection, a causal rela- tionship between:
● Cost figure, and
● Cost unit.
Such association of money with units of production, distribution, service, or any other activity tends to express the idea that there is a kind of cause-and-effect relationship between cost measurement and the object to which this cost is cou- pled. Beyond this the cost of a given unit is part of the continuum, or larger aggregate to which that unit belongs. For instance, the process of production is an assimilation of various kinds of economic services. A similar statement is valid about sales, trading, and other jobs.
Cost accounting, which is an integral and important part of management account- ing, is made more complex by the fact that costs are often incurred jointly, in the sense that the absence or alteration of one or more of them may make the aggre- gate cost difficult to analyse. Some costs are incurred simply because:
● Other costs have been incurred, or
● An entire range of factors must be provided to obtain desired results.
The combination of resources essential to the processes characterizing a com- pany entail that very often costs are joint and inseparable at the very point at which they are incurred. In many cases, failure to note the jointness of cost at point of incurrence produces cost figures that are difficult to interpret, or out- right irrelevant. Another challenge in costing is the assignment of costs to time periods. This, too, is largely a joint cost problem.
One way to allocate costs that cross products, processes, and time periods is by means of conventions characterizing costing. For instance, a basic convention of product cost-determination is the distinction between directand indirectcosts, the former identifying costs incurred at product units in terms of physical accompaniments.
For instance, in manufacturing the working rule is likely to be a requirement that a given cost must be physically identified with the operation or product unit, if it is to be considered a direct cost. If it cannot be so identified, it is an indirect cost.
Indirect costs bring up the issue of their assignment to units of product or serv- ice, usually based upon assumed relationships between cost incurred and the things that can be related to the product or service. This is essentially a subjec- tive measurement. There is no single best method of assigning indirect costs to productive units. Company rules usually prescribe how the allocation should be done. Once this is decided, it should be mapped into the management account- ing report.
Notes
1 D.N. Chorafas, Implementing and Auditing the Internal Control System, Macmillan, London, 2001.
2 D.N. Chorafas, The Real-time Enterprise, Auerbach, New York, 2005.
3 D.N. Chorafas, Corporate Accountability, with Case Studies in Finance, Macmillan/Palgrave, London, 2004.
4 D.N. Chorafas, The Management of Equity Investments, Butterworth-Heinemann, London, 2005.
5 D.N. Chorafas, Operational Risk Control with Basel II: Basic Principles and Capital Requirements, Butterworth-Heinemann, London and Boston, 2004.
9
Budgeting: A Case Study on Financial Planning
1. Introduction
The budgetis a financial plan. A formal written statement of management’s plans for the future, expressed in quantitative terms. The financial allocations the budget makes, as well as statistics derived from them, chart the course of future action.
For this reason, the budget should contain sound attainable objectives rather than approximations or mere wishful thinking. Beyond being a financial plan:
● The budget is a planning model and the means used for its development are planning instruments.
● As a formal form of planning, the budget works well when the company has the proper methodology, solid cost data and management resolve to keep within budgeted figures.
An alternative view of the budgetary process is that this year’s budget is just a downpayment for things to be done in the years to come. Each of those years will have its own budget. A company’s business is not a snapshot but a sustained effort over time.
Chapter 7 and Chapter 8 have explained the reason why a great deal of attention must be paid to costs. The whole process of financial planning is based on them.
Costing makes the budget an orderly presentation of projected activity for the next financial year, based on the amount of work to be done.
While budgeting is the process of planning, and provisioning financially, the overall activity of the enterprise for a specified period of time, usually a year, it is no carte blancheto spend money. The most important objective of this formal planning process is to:
● Fit together the separate financial plans made for various segments of the entity
● Assure that these plans harmonize with one another, and
● See to it that the aggregate effect of all of them on the whole firm is satis- factory.
The earliest financial plans were imposed budgets; they were edicts promulgated by management which, in effect, implied that the different departments and business units shall do ‘such’ and ‘such’. The results obtained from these imposed budgets were frequently unsatisfactory because different parts in the organization tended to:
● Resent them, and
● Disregard them.
The more modern trend in budgeting is in the direction of allowing the depart- ment head, or business unit chief – which means the people held responsible for performance – to have a considerable voice in the preparation of the budget. This makes the budget an interactive process between headquarters and organiza- tional units.
A general principle of financial planning to assure a budgetary agreement is to ask for the participation of the person whose performance is to be measured, in the process of setting the standard. Beyond this, practically every industrial sec- tor has its own particular features as far as budgets, and the budgetary process, are concerned. For instance, typically, a financial institution has two budgets:
● An interest budgetwhich covers the cost of money.
This includes interest paid to current account deposits (if any), savings, time deposits, debt instruments, different other IOUs and, of course, money bought from other banks and institutional investors or loaned by the central bank. No two credit institutions have the same profile of bought money and of deposits.
● A non-interest budget, which covers everything else – the so-called over- head.
This ‘everything else’ is a mixed bag. In it are included salaries and wages of managers, traders, loans officers, investment advisors, tellers, secretaries, and all other personnel. Also the cost of real estate, utilities, information technology (IT), telecommunications, and so on.
Once again, no two banks have the same ratio between interest budget and non- interest budget, as percentages of total budget. At UCLA, my professors taught their students the total budget divides as two-thirds for interest budget, one-third for non-interest budget. This is, however, an average figure.
Another criterion differentiating one bank from another is the overhead – which, in banking jargon, essentially means personnel costs. Well-managed banks do their utmost to keep this overhead below 50% of the non-interest budget. In poorly managed banks, the overhead reaches 75% or more – leaving peanuts for other important services like state of the art IT, networks, and first class branch offices which, in spite of the Internet, are the windows of the bank to its client population.
Manufacturing, too, has its own standards, with different main budgetary chapters than those prevailing in banking. These are divided into research and development,
capital investments, procurement, marketing, sales, after sales service, and admin- istrative activities (which are again called ‘overhead’, but the meaning is that of expenses other than direct labour and direct materials).
Whether we speak of banking or of manufacturing, the level of activity in each channel, and corresponding costs, conditions the budgetary allocation in direct and indirect expenses. The reader will recall that all costs matter, but indirect expenses are those where management should pay great attention, and keep them in control.