Running Head: Management 1

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1 Running Head: Management 1 Topic : Management Accounting Techniques Paper Type : Coursework Word Count : 3000 Words Pages : 12 pages Referencing Style : APA Referencing Education Level: Bachelors Management Accounting Techniques Student Name Student ID Number Course Code

2 Management 2 Management Accounting Techniques Introduction Management accounting refers to the process that measures and reports information regarding economic activity of an organisation. This information is to be used by managers to plan, evaluate performance, and manage operational controls. The management accounting system is typically merged into the financial accounting system. Particularly, the costing system of the products/services is the area of focus in determining the amount of inventory in balance sheet, and the amount of cost of goods sold in the income statement. The information in management accounting is typically financial in nature as well as dollar-denominated, but recent trends have shown that management accountants have increasingly shown interest in collecting and reporting nonfinancial information also (Drury, 2008). Master Ltd is a supplier of car accessories and aftermarket parts. They have their own manufacturing facilities for some parts, such as exhaust systems and brake pads, and also distribute items from other suppliers. Their customer s range from small single shop specialist retailers to the large multiple retail chains. Given their rapid growth in sales in recent years the management have recently reviewed a number of practices which are causing concern given their falling profitability and increasing level of customer complaints. This paper aims to critically evaluate various practices in Master Ltd with respect to pricing strategy, control policies and budgeting methods to identify a number of difficulties that they are facing due to these practices. Once problems are identified, this paper aims to recommend alternative practices with respect to each problem.

3 Management 3 Existing Problems Mater Ltd is using cost plus pricing method. Master Ltd determines the cost on the basis of traditional machine based absorption costing approach. The managers of Master Ltd have raised their concerns about the prices of the products being determined by cost plus pricing strategy because the market is highly competitive. A highly competitive market requires low prices to ensure sustainability and growth of sales. Thus the underlying reason of the concerns of the managers must be high prices. Since this method is producing high prices therefore they are facing difficulty in the market. To analyse this concern one must analyse the effects of pricing strategy as well as costing approach of the company. If pricing is suitable then there must be some changes made to costing approach and vice versa. The analysis may also indicate that both pricing strategy and costing approach should be changed to increase profitability and reduce customer complaints. Pricing Strategy of Master Ltd Manufacturers usually set prices by using Cost-plus pricing method. By using this this strategy, manufacturers determine prices by adding all costs both direct and indirect costs that accumulated into the product and then they add a certain percentage of mark-up to determine the price. Thus an optimal gross profit per sale is obtained by this approach. However, this strategy lacks marketing-oriented considerations. Following are some common problems that a company is likely to face by following this cost plus pricing policy in a competitive market (Guerreiro, Cornachione Jr, and Kassai, 2012). Limits Differentiation: A cost-plus pricing strategy fails to address innovation put into design or acquisition of goods

4 Management 4 Lacks Market Orientation: this pricing strategy ignores marketability concerns No Competitive Consideration: it an internal process entirely. It ignores competitor brands and prices Production Inconsistency: since production costs are rarely static therefore it becomes a functional problem in this strategy In terms of profitability the cost plus pricing policy has following drawbacks (Bellamy and Benson, 2012). It is very inefficient because the prices of products are inflexible therefore increasing profitability by differentiating prices in the market is limited Profit losing isolationism prevails by following this strategy. It discourages market research and thus prices and costs of competing products are ignored which decrease profitability of the company This strategy completely ignores affordability of the customers. Ignoring customers and their willingness to pay for the product; a company is likely to lose its market share Since Master ltd is pursuing cost plus pricing methodology therefore it is essential to learn how costing system can affect the profitability of the company. Master Ltd is using absorption costing method. Following is a discussion that illustrates absorption costing and emphasises its effects on the profitability of Master Ltd. Absorption Costing Method A manufacturing company has options to use absorption costing or any other method for costing of product. It is essential to learn implications of each option. Using Absorption costing a company applies part of fixed overhead costs to the unit cost of product. A company simply divides fixed costs by the number of units manufactured during the period. In other words

5 Management 5 Absorption costing or full costing includes fixed overhead costs allocates equal portion of the overheads to all finished units. Following are some adverse implications of this method on the company (Zimmerman and Yahya-Zadeh, 2012). Inadequate for Managerial Decision Making: since this method allocates overhead costs to each unit it seems that additional units would increase overall cost while in fact they are represent marginal revenues which in turn implies that profitability will increase with additional units (Needles and Crosson, 2013). Costs Hide in Inventory: Inventory is usually shown as an asset and allocating fixed cost to asset hides overall cost of the company as cost of goods sold unless those units are sold (Ibid). Unsuitable for Irregular Volume: Absorption costing is suitable for those companies which are have uniform sales using consecutive periods while Master Ltd is enjoying increase in sales. Thus currently it appears that fixed cost of Master Ltd is increasing which in fact it is not (Maher, Stickney, and Weil, 2011). The drawbacks of cost plus pricing policy show that it is not an effective policy for costing for a company which is operating in a competitive market. In competitive market price differentiation can play a competitive edge and ultimately increase the profitability but currently Master Ltd cannot do so. Therefore profitability of the company is decreasing. Regarding absorption costing the main drawback that it poses to Master Ltd is that it is not suitable for increasing trend in sales. Thus if master Ltd is forced to decrease prices due to increase in competition or a competitor reduces its prices then managerial decisions taken on the basis of absorption costing will be inefficient for the company. Performance measurement

6 Management 6 Performance Management (PM) addresses the issues related to planning, measuring, and evaluating the effectiveness of a company. The primary goal of PM is to integrate all financial and operational data to ensure high quality, greater reliability, and consistent availability. Controlling systems reflect new objectives and strategic directions in projects and products by presenting forecasts, budgets, and other management reports. The system must constant changes in the company and its operating environment. The basic purpose of controlling system is to make changes easier (Rummler and Brache, 2012). Currently Master Ltd is using standard costing and Return on Capital Employed (ROCE) for control purposes and to support responsibility accounting. ROCE measures the profitability of a company by showing net profit generated by each dollar of assets employed. Standards Costing alarms the management when an unfavourable variance in any cost centre appears. The management responds to the variance and introduce corrective measures. The responsibility accounting approach creates an environment where every manager is evaluated on controllable measures. A manager is held responsible to control a part or subunit of a business and performance of managers are evaluated on the effectiveness of the decisions that he/she makes without the interruption of higher management to run the unit smoothly and efficiently. Thus whenever a variance occurs in Master Ltd related manager is held responsible for it. This is not a suitable method for Master ltd because it does not reflect the efficiency of managers truly. For example if sales manager succeeds to increase sales but due to pricing policy and costing system the profitability is not improving then the performance of sales manager is not prominent. This is why a number of managers are showing concerns that there should be rather comprehensive set of performance indicators that reflect the true performance of management or the performance of a responsibility centre.

7 Management 7 Budgeting Process: Incremental Budgeting The budgeting process is a part of management control systems and assists in planning, coordinating, and controlling processes. Master Ltd is using Incremental budgeting method. Incremental budgeting is a traditional method budgets for new periods are obtained by current budget as a base and adding incremental amounts to it. The incremental amounts are determined by addressing various measures for example inflation, costs or pre-planned increment in sales. For Master Ltd, there are a number of disadvantages of this approach that are generating complaints from customers, concern of managers as well as declining trend in profitability (Hope and Fraser, 2013). Drawbacks of Incremental Budgeting for Master Ltd It includes all existing costs and activities while ignoring any changes. The managers do not care to reduce costs as their performance is being judged by incremental budgeting. A manager might end up spending money in the department even if it is not necessary in the hope to get more budget amount next year. They have no incentives to reduce costs. Since performance targets remain unchallenging as they majorly underpinned on past performance allowing some sort of a token increase. Thus, inefficiencies from existing period are transferred carried forward to new periods. For example cost managers may not want reduce costs just because they are not being evaluated so thus profitability of the company decreases each year because costs are increasing each period with increments added to them every period.

8 Management 8 Alternative Approaches for Master Ltd to eliminate Issues From the discussion above it is evident that Master Ltd has to make major changes in its operating strategies with respect to pricing, costing, and budgeting approaches. A suitable pricing strategy will enable the firm to determine a price that is based on costs as well as other factors that are being ignored by cost-plus pricing method. In addition absorption costing is not working efficiently for the company and the profitability is decreasing while incremental budgeting leaves no incentives for the managers to decrease costs which will allow marketers to pursue a dynamic pricing policy to maximise sales and ultimately profitability. Following are recommendations to each of those issues. Recommended pricing Policy: Break-even Pricing Since prices are vital to the profitability of the company and provided that Master Ltd is working in a competitive market where decreasing price may play a major role in increasing market share; it is important for the Master Ltd to identify a price where the company cannot afford a decrease. A break-even price is a price at which company neither makes profit nor make loss. This price will tell the management the limit to which they can decrease the prices of their products while maintaining profitability or in other words while operating at zero profitability (Cremer and Gahvari, 2013). A break-even price is basically obtained by calculating minimum number of units that must be sold without incurring a loss. The marketers can compare existing demand of products in the market and compare with break-even number of units to identify how much units are there in the demand that will yield them profit. Furthermore, the breakeven pricing emphasises the level of

9 Management 9 fixed costs and variable cost and allows the management to analyse their costs and identify opportunities for minimisation of costs. If fixed costs are higher than the variable costs then increase in sales would increase in the overall profitability. Thus the company should focus on decreasing the fixed overhead costs. While on the other hand if fixed costs are low and variable costs are higher than every increase in the production will increase the overall cost therefore the company should focus on decreasing variable costs (Schindler, 2011). Master Ltd should identify which part of their overall cost is higher as well as identify opportunities to minimise both fixed overhead and variable costs. This will create incentive for managers also to work efficiently and minimise waste to claim higher performance. Recommended Costing System: Activity Based Costing System Activity Based costing Activity Based Costing (ABC) refers to an accounting methodology that emphasises on activities instead of products. It increases the accuracy and efficiency of available resources by improving allocation efficiency. ABC assigns cost to activities depending upon the resources that they consume in producing the products. ABC then assigns cost to cost objects, for example customers or products, depending upon the use of activities. ABC enables the mangers to monitor the flow of activities in the production system by studying the links between the activities (i.e. resource consumption) and cost objects. There are four core categories of this flow: Cost drivers, Cost object, Activity cost drivers, and Resource cost drivers. All activities are categorised into four categories, which is called the manufacturing cost hierarchy (Kaplan, R., & Anderson, 2013). The categories of activities are:

10 Management Unit level activities: The costs of primary activities have strong correlations with the number of units produced. Variable costs increase with increase in production. 2. Batch level activities: The number of batches of units produced drives the cost of manufacturing support activities. For instance Machine reset costs i.e. where a machine has to be reset before next batch of production. Fixed costs are relevant here. 3. Product level activities: The costs of activities that occur once in the production life cycle for example designing costs, parts specifications costs and technical drawings costs. 4. Facility level activities: there are some costs which management is unable to relate with product line, however, the management relates them to maintenance of the building and premises. For examples cost of building maintenance, cost of plant security, cost of business rates, etc. Salaries are also included in this category It is important to note that the first category and the last category of ABC are the same compared to traditional absorption costing method thus if the company majorly depends upon these costs then ABC will not make significant improvement (Dale, Van Der Wiele, and Van Iwaarden, 2013). But considering the products of Master Ltd the costs fall majorly in the second and third categories and thus it is expected that ABC will significantly improve efficiency in Master Ltd. This is because changes in the design of Master Ltd product line such as break-pads occur frequently. Therefore the company has to make changes in the design frequently to remain up to date with the existing demand. Benefits to Master Ltd

11 Management It will encourage managers in Master Ltd to focus on activities instead of products as there are various activities that are similar in different departments for example handling of materials, quality control, repairs to machines, etc. 2. Managers will identify Costs with activities and then they will allocate costs to products or services depending upon suitable cost drivers. Thus accuracy of product costs is increased. Since significant portion of total costs comprises of overhead costs of the firm, Master Ltd will be able to increase the accuracy of allocation of overhead costs to products. 3. Managers will be managing activities instead of products. Any change in activity will lead to a change in cost. Thus, if the efficiency of activities management increases overall costs are expected to fall thereby allowing competitive pricing strategy. 4. It will encourage the managers to improve and make wiser economic decisions to improve them. Managers will tend to identify relationships between activities and costs in rather accurate manner. 5. ABC identifies problem areas such as high costs areas for the management to develop corrective measures Recommended Performance Measurement for Master Ltd It is recommended that Mater Ltd should measure performance on the basis of the specific objectives with respect to following perspectives: financial perspective, customer perspective, process perspective, and learning and development perspective. Each of them should be based on specific objectives and activities. ROCE should be used as financial performance measure because it reflects the interest of owners or shareholders. ROCE is the most significant objective

12 Management 12 of a manufacturing company. The customer perspective should show how customers see the company and what their expectations are to minimise customer complaints. The processes perspective should enable the management to identify areas of improvement and evaluate the managers on their ability to improve activities and reducing costs. The learning and development perspective must facilitate change and improvement in production and other functions in current and future periods. The management must understand the potential of intangible infrastructure, i.e. information systems organisation, employees, corporate culture, etc. Strategic goals regarding each perspective for Master Limited is given in the figure below (Tung, Baird, and Schoch, 2013)

13 Management 13 Recommendations for Budgeting: Activity Based Budgeting (ABB) Activity-based budgeting refers to the process of planning and controlling all expected activities within the organisation in order to make a cost-effective budget which makes accurate forecasts of workload under pre-determined strategic goals. ABB expresses the expected activities in quantitative terms which reflect forecast of the management regarding workload and requirements of both financial and non-financial strategic goals. It also facilitates planned

14 Management 14 changes in improving performance (Marginson, 2013). For Master Ltd the key elements of ABB are: expected activity/type of work to be performed quantity of activity / work to be performed cost of activity / work to be performed In essence ABB will enable the Master Ltd management to focus on the activities and business processes in the company. It will help to optimise allocation of resources to all expected activities as well as workload according to the pre-determined goals for example increase in profitability by reduction in costs and flexibility in prices (Shim, J, Siegel, and Shim, A. 2012). In this way Master Ltd can maximise the efficiency of the production.

15 Management 15 References Bellamy, J., & Benson, S. (2012). U.S. Patent No. 8,326,773. Washington, DC: U.S. Patent and Trademark Office. Cremer, H., & Gahvari, F. (2013). Atkinson-Stiglitz and Ramsey reconciled: Pareto efficient taxation and pricing under a break-even constraint. Dale, B. G., Van Der Wiele, T., & Van Iwaarden, J. (2013). Managing quality. John Wiley & Sons. Drury, C. (2008). Management and cost accounting. Guerreiro, R., Cornachione Jr, E., & Kassai, C. R. (2012). Determining the" plus" in cost-plus pricing: a time-based management approach. Journal of Applied Management Accounting Research (Jamar), 10(1), Hope, J., & Fraser, R. (2013). Beyond budgeting: how managers can break free from the annual performance trap. Harvard Business Press. Kaplan, R., & Anderson, S. R. (2013). Time-driven activity-based costing: a simpler and more powerful path to higher profits. Harvard business press. Maher, M., Stickney, C., & Weil, R. (2011). Managerial accounting: An introduction to concepts, methods and uses. Cengage Learning. Marginson, D. (2013). Budgetary control. The Routledge Companion to Cost Management, 9. Needles, B., & Crosson, S. (2013). Managerial accounting. Cengage Learning. Rummler, G. A., & Brache, A. P. (2012). Improving performance: How to manage the white space on the organization chart. John Wiley & Sons. Schindler, R. M. (2011). Pricing strategies: a marketing approach. Sage. Shim, J. K., Siegel, J. G., & Shim, A. I. (2012). Budgeting for Cost Management: Activity Based Budgeting and Life Cycle Budgeting. Budgeting Basics and Beyond, Fourth Edition, Tung, A., Baird, K., & Schoch, H. P. (2011). Factors influencing the effectiveness of performance measurement systems. International Journal of Operations & Production Management, 31(12), Zimmerman, J. L., & Yahya-Zadeh, M. (2011). Accounting for decision making and control. Issues in Accounting Education, 26(1),