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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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These principles are applied in the collection, recording and reporting of financial information. It therefore follows that information used by managers for decision-making is subject to the same principles, and therefore to the same limitations. One of the most important pieces of financial information for line


managers is cost, which forms the basis for most of the following chapters.

The calculation of cost is determined in large part by accounting principles and the requirements of financial reporting. The cost that is calculated under these assumptions may have limited decision usefulness.

Cost terms and concepts

Cost can be defined as ‘a resource sacrificed or foregone to achieve a specific objective’ (Horngren et al., 1999, p. 31).

Accountants define costs in monetary terms, and while we will focus on monetary costs, readers should recognize that there are not only non-financial measures of performance but also human, social and environmental costs. For example, making employees redundant causes family problems (a human cost) and transfers to society the obligation to pay social security benefits (a social cost). Pollution causes long-term environmental costs that are also transferred to society. These are as important as (and perhaps more important than) financial costs, but they are not recorded by accounting systems (see Chapter 7 for a further discussion). The exclusion of human, social and environmental costs is a significant limitation of accounting.

For planning, decision-making and control purposes, cost is typically defined in relation to a cost object, which is anything for which a measurement of costs is required. While the cost object is often an output – a product or service – it may also be a resource (an input to the production process), a process of converting resources into outputs or an area of responsibility (a department or cost centre) within the organization. Examples of inputs are materials, labour, rent, marketing expenses etc. Examples of processes are purchasing, customer order processing, order fulfilment, despatch etc.

Businesses typically report in relation to line items (the resource inputs) and responsibility centres (departments or cost centres). This means that decisions requiring cost information on business processes and product/service outputs are difficult, because most accounting systems (except activity-based systems, as will be described in Chapter 11) do not provide adequate information about those cost objects. For example, in a project-based business, published financial reports do not provide cost and revenue information about each project, but instead report information about salaries, rental, office costs etc.

Businesses may adopt a system of management accounting to provide this information for management purposes, but rarely will this second system reconcile with the external financial reports because the management information system may not follow the same accounting principles described earlier in this chapter.

The requirement to produce financial reports based on line items, rather than cost objects, is a second limitation of accounting as a tool of decision-making.

The notion of cost is also problematic because we need to decide how cost is to be defined. If, as Horngren et al. defined it, cost is a resource sacrificed or forgone, then one of the questions we must ask is whether that definition implies a cash cost or an opportunity cost. A cash cost is the amount of cash expended


(a valuable resource), whereas an opportunity cost is the lost opportunity of not doing something, which may be the loss of time or the loss of a customer, equally valuable resources. If it is the cash cost, is it the historical (past) cost or the future cost with which we should be concerned?

For example, is the cost of an employee:

ž the historical, cash cost of salaries and benefits, training, recruitment etc.

paid? or ž the future cash cost of salaries and benefits to be paid? or ž the lost opportunity cost of what we could have done with the money had we not employed that person, e.g. the benefits that could have resulted from expenditure of the same money on advertising, computer equipment, external consulting services etc.?

Wilson and Chua (1988) quoted the economist Jevons, writing in 1871, that past costs were irrelevant to decisions about the future because they are ‘gone and lost forever’. This is a difficult question, and the problematic nature of calculating costs may have been the source of the comment by Clark (1923) that there were ‘different costs for different purposes’.

This, then, is our third limitation of accounting: what do we mean by cost and how do we calculate it?

Conclusion This chapter has described how an accounting system captures, records, summarizes and reports financial information using the double-entry system of recording financial transactions in accounts. It has also identified how the principles underlying the accounting process can present limitations for managers in using financial information for decision-making. This has a particular effect in relation to cost, which as we will see throughout Part II is crucial for non-financial managers.

In this chapter we have also identified three particular limitations of accounting

that result from the domination of the scorekeeping function:

ž the exclusion of the wider human, social and environmental costs from those reported by accounting systems;

ž the focus on line items rather than cost objects, despite the latter having more meaning for planning, decision-making and control; and ž the problematic notion of defining cost as historic, future or opportunity.

Each of these is taken up in subsequent chapters.

References Clark, J. M. (1923). Studies in the Economics of Overhead Costs. Chicago, IL: University of Chicago Press.

Horngren, C. T., Bhimani, A., Foster, G. and Datar, S. M. (1999). Management and Cost Accounting. London: Prentice Hall Europe.

Wilson, R. M. S. and Chua, W. F. (1988). Managerial Accounting: Method and Meaning. London: VNR International.

Management Control, ManagementAccounting and its Rational-EconomicAssumptions

Management accounting needs to be understood as part of the broader context of management control systems. In this chapter, we describe the theoretical background of management control and management accounting and its most recent developments: non-financial performance measurement and strategic management accounting.

Management control systems

In his seminal work on the subject, Anthony (1965) defined management control as:

The process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of the organization’s objectives.

Management control encompasses both financial and non-financial performance measurement. Anthony developed a model that differentiated three planning and

control functions:

ž Strategy formulation was concerned with goals, strategies and policies. This fed into ž Management control, which was concerned with the implementation of strategies and in turn led to ž Task control, which comprised the efficient and effective performance of individual tasks.

Anthony was primarily concerned with the middle function. Otley (1994) argued that such a separation was unrealistic and that management control was ‘intimately bound up with both strategic decisions about positioning and operating decisions that ensure the effective implementation of such strategies’ (p. 298).

Building on Anthony’s earlier definition, Anthony and Govindarajan (2000) defined management control as a process by which managers at all levels ensure that the people they supervise implement their intended strategies (p. 4).


Berry et al. (1995) defined management control as:

the process of guiding organizations into viable patterns of activity in a changing environment... managers are concerned to influence the behaviour of other organizational participants so that some overall organizational goals are achieved. (p. 4)

Ouchi (1979) identified three mechanisms for control:

ž the market in which prices convey the information necessary for decisions;

ž bureaucracy, characterized by rules and supervision; and ž an informal social mechanism, called a clan, which operates through socialization processes that may result in the formation of an organizational culture.

In this chapter we are concerned with management control as a system (a collection of inter-related mechanisms) of rules.

Simons (1994) also took a broader view of management control systems in his

description of them as:

the formal, information-based routines and procedures used by managers to maintain or alter patterns in organizational activities. These systems are both pervasive and unobtrusive, but are rarely recognized as potentially significant levers of organizational change. (p. 185) Simons described the actions taken by newly appointed top managers attempting revolutionary and evolutionary strategic change, all of whom used control systems to overcome inertia; communicate the substance of their agenda; structure implementation timetables; ensure continuing attention through incentives; and focus organizational learning on strategic uncertainties.

Simons (1990) developed a model of the relationship between strategy, control systems and organizational learning in order to reduce strategic uncertainty. The model is reproduced in Figure 4.1.

Research by Simons (1990) found that the choice by top managers to make certain control systems interactive provided signals to organizational participants about what should be monitored and where new ideas should be proposed and tested. This signal activates organizational learning.

We can distinguish systems for planning from systems for control. Planning systems interpret environmental demands and constraints and use a set of numbers to provide a ‘common language which can be used to compare and contrast the results obtained by each activity’ (Otley, 1987, p. 64). These numbers may be financial (resource allocations or performance expectations). They are represented in accounting and in non-financial performance measurement. Otley et al. (1995)

noted that:

–  –  –

Figure 4.1 Process model of relationship between business strategy and management control systems Reprinted from Accounting, Organizations and Society, Vol.

15, No. 1/2, R. Simons, The role of management control systems in creating competitive advantage, pp. 127–43, Copyright 1990, with permission from Elsevier Science.

Control systems are concerned with feedback control, in which ‘the observed error is fed back into the process to instigate action to cause its reduction’ (Otley, 1987, p. 21). By contrast, planning systems are also concerned with feedforward control, ‘because it is only an expected error that is used to stimulate the control process’ (p. 21).

We can consider the management planning and control system as a single system in which both feedback and feedforward are concerned with reducing the performance gap (Downs, 1966). Downs defined this as ‘the difference in utility [an individual] perceives between the actual and the satisfactory level of performance’ (p. 169). According to Downs, the larger the gap, the greater the motivation to undertake more intensive search.

We can show this diagrammatically in Figure 4.2.

Feedforward is the process of determining, prospectively, whether strategies are likely to achieve the target results that are consistent with organizational goals.

Feedback is the retrospective process of measuring performance, comparing it with the plan and taking corrective action. The two systems need to be integrated as a management control system as they share common targets, the need for

–  –  –

corrective action to be reflected either in goal adjustment or in changed behaviour, and the allocation or utilization of resources (i.e. budgeting and budgetary control, which are covered in Chapters 14 and 15).

According to Anthony and Govindarajan (2001), every control system has at

least four elements:

1 A detector or sensor that measures what is happening.

2 An assessor that determines the significance of what is happening by comparing it with a standard or expectation.

3 An effector (feedback) that alters behaviour if the assessor indicates the need to do so.

4 A communication network that transmits information between the other elements.

This can be represented in the diagram in Figure 4.3.

There are five major standards against which performance can be compared (Emmanuel et al., 1990):

1 Previous time periods.

2 Similar organizations.

3 Estimates of future organizational performance ex ante.

4 Estimates of what might have been achieved ex post.

5 The performance necessary to achieve defined goals.

Hofstede (1981) provided a typology for management control: routine, expert, trial-and-error, intuitive, judgemental or political. The first three are cybernetic and these are described in this chapter. Non-cybernetic controls are described in Chapter 5.

–  –  –

A cybernetic control process involves four conditions (Berry et al., 1995, originally

published in Otley and Berry, 1980):

1 The existence of an objective that is desired.

2 A means of measuring process outputs in terms of this objective.

3 The ability to predict the effect of potential control actions.

4 The ability to take actions to reduce deviations from the objective.

However, Otley and Berry (1980) recognized that:

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