MANAGEMENT ACCOUNTING – COST CLASSIFICATION, VARIANCE ANALYSIS AND BUDGET PREPARATION
Executive Summary 4
1. Management Accounting, its Importance and Comparison to Financial Accounting 5
Management Accounting versus Financial Accounting 5
2. Different Classifications of Costs (Types, Behaviour, Function and Relevance) with Examples 6
a. Cost Classification by Behaviour 6
Semi-Variable Costs 7
Variable Costs 7
b. Cost Classification by Function 7
c. Cost Classification by Relevance 8
3. Variance Analysis Commonly Derived Variances, Problems and Limitations 9
a. Commonly Derived Variances 9
Material Cost Variance 10
Labour Cost Variance 10
Overhead Variance 10
Controllable Variance 10
b. Problems and Limitations of Variance Analysis 11
4. Different Operational Budgets and their Advantages 11
a. Master Budget 11
b. Operating Budget 12
c. Cash Flow Budget 12
d. Financial Budget 13
e. Static Budget 13
References 14
Executive Summary
This research is aimed at demonstrating that management accounting is important for internal management of an organisation. It is important to the business for carrying out different analyses for facilitating internal management to make confidential and timely business decisions. It is different from financial accounting that is carried for facilitating external parties or stakeholders. Every business has to incur costs to generate sales revenue and net income. These costs could be classified on the basis of behaviour, function and relevance to particular situations. This research also discusses variance analysis which is an important technique for comparing planned and actually realised financial performance concerning budgets. The last section of this report is aimed to determine different types of budgets which every business should prepare for keeping an effective control over its financial performance. The importance of every budget form is also presented in the same section.
Management Accounting – Cost Classification, Variance Analysis and Budget Preparation
Management Accounting, its Importance and Comparison to Financial Accounting
Accounting utilized by the internal management of an organization to prepare confidential reports and make decisions concerning daily business operations is referred to as management accounting . It facilitates managers of an organization to what the business should sell and how, by performing the relevant cost analysis. Using management accounting, managers could examine different cost structures among different alternatives and disregard common ones. Here, management accounting helps managers decide whether to discontinue operations or add more product lines.
This accounting is also important for managers of an organization to perform target market analysis to employ Activity Based Costing (ABC) technique on sales structure depending upon the profitability of a certain customer base. For manufacturing concerns, management accounting offers an added feature to perform make or buy analysis concerning production or purchase of raw materials. Management accounting is also important for an organization as it utilizes financial and non-financial data to make timely daily business decisions. This facilitates managers in continuous improvement endeavours if the data is used intelligently.
Management Accounting versus Financial Accounting
The accounting used by internal stakeholders (managers and employees) of an organization is known as management accounting whereas financial accounting is primarily used by external stakeholders (such as investors and tax authorities etc) . In former accounting, reports can be generated at any point of time (daily, weekly or monthly basis) whereas, in financial accounting, reports are generated for a specific time period like a financial year or period.
Management accounting primarily deals with confidential financial reports prepared exclusively for senior management of an organization . Comparatively, financial accounting involves preparation of those reports that could be generated by both the internal and external users/stakeholders. The accounting used by managers of an organization to make decisions about daily business operations on the basis of current and future trends is known as management (managerial) accounting. The accounting used to evaluate past performance of an organization to determine the existing financial health of the business is called financial accounting.
Different Classifications of Costs (Types, Behaviour, Function and Relevance) with Examples
Cost Classification by Behaviour
Here, the costs are classified by behaviour when manufacturing costs increase or decrease with a change in the level of production. The examples of costs by behaviour include fixed, semi-variable and variable costs of production.
Fixed costs
They remain unchanged regardless of the volume of units produced and are related to a specific time period such insurance expenses and factory rent etc. The cost per unit is inversely proportional to the volume produced .
Semi-Variable Costs
A specific portion of these costs remains variable and the balance remains fixed. The most prominent example is of electricity bill in case semi-variable costs. The electricity cost per unit “keeps changing” up to a certain level of an electricity bill/charges (let’s say up to $5,000) as per production volume. However, if an electricity bill is more than $5,000 then, the cost per unit remains “constant of fixed” .
These costs are also known as “mixed” ones. Another example of mixed costs is the telephone expense where the line rent and subscription charges remain fixed whereas per minute cost is a variable one. Delivery costs could also be considered mixed costs as they contain a fixed portion of depreciation expenses while their fuel expense is variable in nature.
Variable Costs
These costs are in direct proportion to the number of units produced. In other words, variable costs increase or decrease depending upon the volume or level of production. Examples include direct labour and direct material used in manufacturing activity.
Cost Classification by Function
Such costs are classified based on activity performed. It is sub-divided into different costs that include costs of production (manufacturing) and commercial activities. Manufacturing costs include direct labour, direct materials, and factory overhead costs. However, costs related to commercial activities are further categorised into marketing, distribution, administrative and financing costs.
Direct material payments are those raw material costs that are involved directly into the manufacturing of a product where prominent examples include wood used to make furniture, paper in books, leather used in shoe making and plastic material utilised for preparing water tank etc.
All those workers and employees who are directly involved in the production process, when paid wages by the management is termed as direct labour cost. However, wages paid apprenticeship on the production floor is not considered a labour cost due to no significant value to an organisation .
Indirect expenses concerning materials and labour are known as overhead costs of a factory or unit. Examples include research and development expenses.
Cost Classification by Relevance
These kinds of costs are related to a specific outcome of any decision made by the management. This cost is completely dependent upon the pursuit of different production alternatives. This concept eliminates the need for unnecessary information that may complicate the decision-making process . Being decision specific, relevant costs may be applicable and relevant in one particular decision or alternative but may become irrelevant in another situation. The decision to keep or sell a business segment, produce or buy raw materials as well as acceptance of special order are some of the examples of costs classified by relevance. Sunk costs and opportunity costs are specific examples. In all, relevant costs differ among different alternatives to a certain production activity. When any manufacturing activity is changed, added or eliminated for continuous improvement, relevant costs applicable in one situation become irrelevant in another one .
Variance Analysis Commonly Derived Variances, Problems and Limitations
In the field of management accounting, the quantitative examination of differences between actual and budgeted/planned financial performance is known as Variance Analysis It is an analytical technique used by finance and accounting managers for comparing actually realized financial performance figures or outcomes with the budgeted estimates. In other words, after a financial accounting period ends, managers examine the actual sales and cost figures for comparing them to what was planned a year ago .
Because of the highly volatile business environment, an organization would be able to achieve only a few budgeted figures while witnessing a variance or deviation in most of the accounts of financial statements. In this regard, variance analysis facilitates managers to determine root causes of such a deviation in sales revenue actually generated and operating expenses paid over a certain accounting period from the budgeted figures. This requires managers to prepare “flexible budget” to make variance analysis more meaningful. This type of budget acts as a bridge between the originally planned budget which is fixed and the actually realized financial results.
Commonly Derived Variances
Typical variances derived for analysis include material variances, overhead variances, labour cost variances, and controllable variances. All of these are commonly derived ones as they tend to examine the difference and root causes for deviation from planned (budgeted or standard) expenses set at the beginning of the period and actually paid costs as well as business expenses for the period. Before measuring a variance or deviation for managerial analysis, it is imperative that the most commonly derived ones should be classified into distinct categories in the following manner:
Material Cost Variance
It determines the difference between actual material cost used as well as the actual standard cost for produced output.
Labour Cost Variance
This variance derives a difference between the direct wages actually paid to employed labour as well as the direct labour cost attributable to a certain output produced.
Overhead Variance
This variance highlights between the standard overhead cost allowed for actual production level (in terms of labour hours or production units) and the actual cost of overhead accounted (paid) for.
Controllable Variance
A variance is said to be controllable and sustainable or has reached an optimal level whenever department, an individual or any division/section could be held responsible for such a deviation.
Problems and Limitations of Variance Analysis
The very first problem and limitation of variance analysis is the time delay. Managers need ample time to gather information, update the budgeted figures and report to the concerned management. In the meantime, the highly volatile business environment changes instantly for which it is imperative to gather information and share feedback much faster. Variance analysis requires time to measure the deviation and determine the root causes of a certain deviation till which the whole situation changes. Managers feel pressurised to keep themselves highly updated about any change in the budgeted figures and report immediately.
Another problem and limitation of variance analysis is that it may not yield required useful information this is so because actual results need to be compared with standard or planned figures. These budgeted figures may have been derived from political understanding or bargaining among different managers. The third limitation of variance analysis is that though the deviation may be favourable or favourable, it fails to reflect actual performance and efficiency of concerned managers.
Different Operational Budgets and their Advantages
Every organization, regardless of its size and operations, prepare five forms of operational budgets that include master, operating, cash flow, financial and static one. Their advantages are elaborated as follows:
Master Budget
This budget projects/dictates the manner in which an organization will pursue its business aspects over the budgeted period. The major advantage of preparing the master budget is that it summarizes projected activities in the form of a cash budget as well as budgeted financial statements through inputs from various departments. Using department-specific master budgets, managers can plan and determine performance standards is another advantage offered by master budget.
Operating Budget
This budget offers a greater advantage to summarize sales revenue, costs of generating such sales revenue and all operating expenses surrounding basic operational activities of an organization on a daily basis. Revenue stream in operating budget offers information on the sale of products and services whereas costs and expenses portion highlight administrative as well as overhead costs directly attributable to manufacturing activities. The greater benefit of preparing an operating budget is that it could be broken down to report weekly, monthly, semi-annually, quarterly and early reports. Because of this added advantage, managers can compare on-going financial performance at regular intervals throughout the financial accounting year to plan and make adjustments to variances, if any.
Cash Flow Budget
This budget is important to be prepared as it highlights cash inflows and outflows on a daily basis. Another advantage of preparing cash budget is that it helps managers predict the cash conversion cycle to collect and generate cash while making cash based payments. By using a cash budget, managers are able to monitor cash flow stream and pinpoint any shortfall in sales revenue generating capacity as well as internal controls to keep costs and operating expenses under control. Other advantages of preparing a cash budget include the suggestion of inventory levels and production cycles to keep all necessary resources available for manufacturing activities .
Financial Budget
Financial budgets outline the manner in which a business expects to receive and spend financial resources, particularly, from core business operations and another income stream. It also highlights different ways in which the generated revenue is consumed by an organization’s capital expenditures . Executive managers prepare financial budgets for leveraging different sources of financing as well as determine the actual value of an organization for public offerings of stock and mergers. One of the major advantages offered by financial budgets is the examination of an organization’s financial health or performance through different business cycles (the peaks and troughs). This is so because asset management concerning investments, buildings, major equipment, property, and other fixed/non-fixed assets have a significant influence on the company’s financial health.
Static Budget
This budget is important as it highlights only those financial areas where variation in sales revenue is witnessed while expenditures remain the same. This primarily concerns fixed cost structure in every department. The static budget provides an advantage to managers to set aside a fixed amount of money to meet contingencies and departmental needs without exceeding the actually allocated budget.
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