Accounting for Management
1 Introduction
The purpose of management accounting is to assist management in running the business in ways that will improve the performance of the business.
CIMA defines management accounting as “the application of the principles of accounting and financial management to create, protect, preserve and increase value for the stakeholders of for-profit and not-for-profit enterprises in the public and private sectors”.
Two things follow from that definition and they shape the whole of P1. Management accounting is for management — an internal audience with a decision to take — and it exists to change what the organisation does, not merely to record what it has done. Everything in this paper is a technique for producing a number that someone is going to act on.
The recording for this chapter walks the material in the same order as the sections below, and it is worth an hour of anyone's time. Three points before you play it.
Prior papers: the recording refers to “paper F3” and “paper F2”. Those are ACCA paper codes — this lecture is a re-cut of an older ACCA recording. The CIMA equivalents are BA3 Fundamentals of Financial Accounting and BA2 Fundamentals of Management Accounting.
The second A of ACCURATE: the recording reads it as Accessible and this chapter, like most CIMA material, reads it as Authoritative. Both are genuine qualities of good information and section 4 now lists both, so neither reading loses you a mark.
Coverage: the recording predates sections 2 and 8. It says nothing about the four rationales for costing or about the management accountant's ethical duties, and both are examinable. Read those two sections; do not expect to hear them.
2 Costing, and the reasons it is done
2.1 What costing is
Costing
Costing is the process of determining the cost of a cost object — a product, a service, an activity, a project, a customer, a department, or anything else whose cost management wants to know.
A cost object is simply the thing being costed. The rest of section A of the syllabus is about how it is done; this section is about why it is done.
Costing is not the same as management accounting, and it is not an end in itself. Nobody wants a cost for its own sake. A cost is calculated because a particular question has to be answered, and the question determines what a useful answer looks like.
2.2 The four rationales for costing
There are four reasons an organisation calculates costs. They are not alternatives — most organisations have all four running at once — but they pull in different directions, and a cost that serves one of them well may be useless for another.
Rationale | The question it answers | The kind of cost it needs | Where P1 works it |
Inventory valuation | What are the units we have made but not yet sold worth? | A full production cost per unit — direct costs plus a share of production overhead | Chapter 3 (absorption costing); chapter 6 (joint products) |
Profit reporting | What profit did we make this period, and where did it come from? | A cost of sales, measured consistently period to period | Chapter 3 (marginal and absorption profit); chapter 9 (operating statements) |
Cost management and transformation | What is causing us to spend this money, and can we spend less of it? | Cost analysed by activity and by cause, not by product alone | Chapter 4 (ABC); chapter 5 (throughput); chapter 7 (modern costing) |
Decision-making | Which of these courses of action should we take? | Only the future cash flows that change because of the decision | Chapter 14 (relevant costing); chapter 15 (CVP); chapters 5 and 8 (scarce resources) |
Inventory valuation is the oldest of the four and the only one with an external rule attached. Unsold production is an asset, and it has to be measured. That measurement has to include a share of the cost of running the factory, which is why the absorption of overheads in chapter 3 matters far beyond the arithmetic.
Profit reporting follows immediately from it: whatever is not carried forward in inventory is charged against this period's revenue. Because the two are the same arithmetic seen from opposite ends, the choice of costing method changes the reported profit whenever the level of inventory moves — the point chapter 3 proves.
Cost management and transformation asks a different question altogether. It is not interested in what a unit costs so much as in why it costs that, because a cost whose cause is understood is a cost that can be attacked. This is the rationale behind activity based costing, behind the cost of quality framework and behind environmental costing, and it is the one the syllabus's own introduction has in mind when it says a candidate should be able to “develop their own ways of calculating costs when existing methods are no longer appropriate”.
Decision-making is the most demanding, because it throws away most of the cost information the other three rationales produce. A decision is affected only by cash flows that are still in the future and that change as a result of the decision. Costs already incurred, and overhead the organisation will pay whatever it decides, are irrelevant to it — even though both are essential to inventory valuation and profit reporting.
2.3 Different costs for different purposes
The consequence is the single most important idea in this chapter: one cost object has more than one cost, and none of them is the “real” one. Which cost is right depends entirely on the rationale.
Take a product that uses $12 of materials and labour and is made in a factory whose fixed overheads work out at $8 a unit at the budgeted level of output.
Purpose | Cost used | Why |
Valuing closing inventory | $20 | A full production cost is required; the overhead has to be carried in the asset |
Deciding whether to accept a one-off order that uses spare capacity | $12 | The fixed overhead is unaffected by the decision, so it is not a cost of taking the order |
Setting a long-run list price | $20 plus a margin | Over the long run every cost, including the fixed overhead, has to be recovered |
Deciding whether to close the product line | $12 plus any fixed cost that would be saved | Only the overhead that actually disappears is relevant |
A student who learns one cost per unit and applies it everywhere will get roughly half of P1 wrong. A student who asks “what is this number for?” before calculating it will not.
Matching the rationale to the question
For each of the following, state which of the four rationales for costing is being served.
The financial controller needs a value for the 4,000 finished units in the warehouse at the year end.
A production manager wants to know why the set-up costs of the assembly line rose 30% last year while output was flat.
The sales director asks whether a customer's offer of $14 a unit for 2,000 units is worth accepting, given that the factory is working below capacity.
The board is reviewing a monthly statement showing gross profit by product group.
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3 Data and information
One way of assisting management is to provide them with good information to help them with their decisions.
The information can be provided in different ways, but is usually in the form of reports. For example, a report analysing the costs of producing each of several products may assist management in deciding which products to produce.
It is the management accountant who will be expected to provide the information, and in order to do so he or she needs to collect data.
Data and information
Data consists of the facts that are gathered and stored. Data has no clear meaning until it is processed — analysed and sorted — into information.
An organisation selling in several countries records every individual sale. That record is data: management cannot use a list of 10,000 transactions. Sorting those sales by country and presenting the result as a percentage of the total is information, because it is now capable of being acted on. Turning the first into the second is the management accountant's job.
4 What makes good information?
Good quality information should be ACCURATE:
Quality | What it means | |
A | Accurate | Correct, and to an appropriate degree of precision |
C | Complete | Nothing material left out — but not padded with what is not needed |
C | Cost effective | The cost of producing it is less than the benefit of having it |
U | Understandable | Expressed so that its user, who is not an accountant, can use it |
R | Relevant | To the decision actually being taken |
A | Authoritative | From a source the user can trust — and accessible to the user who needs it, in the form they need it |
T | Timely | Available before the decision has to be taken, and up to date |
E | Easy to use | Presented so that it can be read and acted on quickly |
Cost effectiveness is the one candidates forget. Preparing a report costs money — systems time, and the management accountant's own time — and there is a point beyond which more accuracy, more detail or more frequency costs more than the better decisions it produces are worth. This is the same idea that reappears in chapter 4 as the practical objection to activity based costing, and in chapter 7 as the cost of quality.
5 The main managerial processes
The main areas of management accounting, and therefore the shape of the rest of this paper, are:
Costing — identifying the cost of producing an item or providing a service, in order, for example, to assist in setting a selling price (chapters 2 to 8).
Planning — for example, planning how many staff will be required in the factory next year. Formal planning is budgeting (chapters 11 and 12).
Decision making — for example, deciding what selling price to charge for a new product, or which products to make when a resource is scarce (chapters 5, 8, 14 and 15).
Control — for example, checking month by month whether the organisation is over or under spending on wages, and investigating why. Formally this is variance analysis (chapters 9 and 10).
Performance evaluation — comparing the performance of managers or departments against budgets or targets (chapters 9 and 11).
Two of these are worth separating carefully, because candidates conflate them. Planning sets what should happen; control compares what did happen with the plan and does something about the difference. A budget without a comparison afterwards is not control, and a variance nobody investigates is not control either.
6 The different levels of planning
Level | Horizon | Typical decision | Information it mainly needs |
Strategic planning | Long term, e.g. 5 to 10 years | What new markets to enter? What new products to launch? Where to build? | Largely external — competitors, markets, technology, regulation — and summarised |
Tactical planning | Medium term, usually the next year, and more detailed | How many staff to employ next year? What to budget for materials? | A mixture of internal and external; this is where the budget sits |
Operational planning | Short term — this week, tomorrow | Which supplier to use for next week's purchase? How many hours to roster? | Almost entirely internal, and detailed |
The levels are sequential. A strategic decision to launch a product is what makes next year's tactical budget for that product possible, and the budget is what makes this week's operational decisions possible. The information needed changes as you go down: strategic planning needs a broad, largely external, largely non-financial picture; operational planning needs precise internal detail, quickly.
7 Management accounting compared with financial accounting
The two are separate jobs, even where the same person does both.
Financial accounting | Management accounting | |
Purpose | To report the results and position of the entity to those outside it | To help management run the entity and improve its performance |
Required by law? | Yes — entities must keep records and produce financial statements | No. It is produced because it is useful, not because it is compulsory |
Audience | External: shareholders, lenders, tax authorities, the public | Internal: management only |
Frequency | At least annually | Whenever it is useful — commonly monthly |
Time focus | Historical: what has already happened | Mostly forward-looking: budgets, forecasts, and decisions not yet taken |
Format and rules | Prescribed — law and accounting standards | Whatever format is most useful. There are no external rules |
Coverage | The entity as a whole | Any part of it: a product, a department, a customer, a process |
Precision | Must be accurate and auditable | An approximation available in time beats an exact figure that arrives too late |
The two can also value the same thing differently and legitimately so. Inventory in the financial statements has to be measured at full production cost; the same inventory in a management report may be measured at variable cost, because that is more useful for the decision in hand. Chapter 3 shows what that difference does to reported profit.
8 The ethical duties of the management accountant
Management accounting has no external rulebook and no audit. Its numbers are produced internally, are seen only by management, and are frequently the basis on which the same management is judged and paid. That combination is exactly why professional ethics matters more here than in financial reporting, not less.
8.1 The five fundamental principles
CIMA's Code of Ethics, which follows the international code for professional accountants, sets out five fundamental principles. They apply to every number in this paper.
Principle | What it requires | How it is breached in P1's own material |
Integrity | To be straightforward and honest in all professional and business relationships | Reporting a cost or a variance you know to be misleading, or staying silent when a report you produced is being used to mislead |
Objectivity | Not to allow bias, conflict of interest or undue influence to override professional judgement | Choosing an absorption basis, a cost driver or a budget assumption because of the answer it produces rather than because it reflects cause and effect |
Professional competence and due care | To maintain the knowledge and skill required, and to act diligently | Applying a costing method to a situation it does not fit, or reporting a figure without checking the data behind it |
Confidentiality | Not to disclose information acquired at work, and not to use it for personal advantage | Passing costings, margins or a tender price to a competitor, a supplier or a friend |
Professional behaviour | To comply with relevant laws and regulations and to avoid conduct that discredits the profession | Concealing a breach; retaliating against someone who raises one |
8.2 Where the pressure actually comes from
The threats a management accountant meets are rarely dramatic. They are ordinary requests made by people with authority, and they cluster in a few places, every one of which is a chapter of this paper:
Reporting: pressure to change a variance explanation, to reclassify a cost so that it falls in another manager's report, or to hold an adverse figure back until next month (chapters 9 and 10).
Inventory and profit: pressure to keep producing so that fixed overhead is absorbed into inventory rather than charged against this period's profit. The output is not needed; the reported profit rises anyway. This is the mechanism chapter 3 explains, used improperly.
Budgeting: building slack into a budget so that the target is easy to beat, or accepting a target known to be unachievable rather than argue with the person setting it. The syllabus examines ethical considerations in budgeting, and chapter 11 works them.
Short-term decisions: presenting a make-or-buy, shutdown or pricing analysis with the costs selected to support a conclusion already reached, or leaving out a consequence that is real but inconvenient. The syllabus examines ethical considerations in short-term decision-making, and chapter 14 works them.
Presenting a number that is technically defensible but that you know will be misread is not a neutral act.
A management accountant who absorbs overhead onto a product on a basis that is arguable, knowing the report will be used to close a line that is in fact profitable, has not breached a rule of arithmetic. Integrity and objectivity are not rules of arithmetic. The test is whether the presentation, taken as a whole, will lead a reasonable user to the right conclusion.
8.3 What to do about it
The professional response follows the same sequence whatever the pressure is:
Establish the facts, and be sure the issue is real and correctly understood.
Raise it with the person concerned, and then, if that fails, with the next level of management, keeping a record of what was said and when.
Use whatever internal escalation route exists — an audit committee, a whistleblowing line, a non-executive director.
Take confidential advice from the professional body.
If the matter cannot be resolved and the organisation persists, consider whether continued association is possible — resignation is the last step, not the first.
Absorbing overhead into inventory
You are the management accountant of a manufacturing division. Budgeted fixed production overhead is $600,000 a year, absorbed at $6 per unit on budgeted output of 100,000 units. Demand this year will be about 80,000 units.
With two weeks of the year left, the divisional manager — whose bonus depends on the division's reported profit — instructs the factory to run at full capacity to the year end and produce 20,000 units for which there are no orders. He asks you to prepare the year-end management accounts on the usual absorption basis.
Required:
Explain how the instruction affects the division's reported profit.
Identify the fundamental principles that are threatened.
State what you should do.
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Ethics is examined in P1 in two named places — ethical considerations in budgeting and ethical considerations in short-term decision-making. Chapters 11 and 14 work those in their own context. What this section gives you is the framework both of them rest on.
9 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Accounting for Management
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