Farm Financial Standards Council

1
Farm Financial Standards Council

• Summer Symposium
• August 7-8, 2006

2
Farm Financial Standards Council

• Why am I here?
• My long-time interest in management accounting
• Don Gillings and Steve Hofing
• I would like to review briefly the basic concepts
  and framework related to management accounting
  information systems and then discuss the MA
  exposure draft report

3
My Primary Interests in Accounting

• Financial Accounting is the mother science of in
  financial reporting It is what we tell the world
  about our business (driven by GAAP)
• Management accounting is what we tell ourselves
  about our business (Also driven by standards)
• Managerial and Financial Accounting are
  intrinsically related
• However, Managerial Accounting systems typically
  (almost always) have the most impact on
  businesses
• My strong interest is MA makes me a bit biased
  toward MA
• Most of my business/consulting experiences have
  related to managerial accounting issues
• Many of the books I have authored are
  Managerial/Cost Accounting books
• I also use a lot of Management Accounting in my
  Forensic Accounting activities

4
The Impact of the Changing Business Environment
on Businesses and Accounting Information
Requirements

• Why management accounting? Why now?
• It is not business as usual anymore
• Intense Global Competition
• Virtually no business is immune
• Developing and maintaining management accounting
  systems becomes more challenging every day
• The more that is possible, the more that is
  expected
• The need to know is not a luxury, it is a
  necessity
• Ignorance is not bliss, and what you dont know
  can hurt you (even kill you)

5
Managers Must Utilize and Communicate Significant
Amounts of Business Information

• Accountants tend to be the gatekeepers of the
  organizations financial information
• But in a management accounting environment
  business (operations) managers should drive the
  content and nature of the MA information
• Information characteristics
• Relevant
• Timely
• Accurate

6
Management Accounting Provides Much Essential
Management Information

• Internal (management) reporting
• Driven by managements information needs
• All information must be cost justified and must
  satisfy the information needs of business
  managers which are often dictated by competitors
• When compared with external financial accounting
  reports management accounting reports tend to be
  more timely, more detailed, more decision
  specific and more user oriented

7
What Do Business Managers Need to Know?

• It depends but generally we need to know
  something about
• All product related costs, market profitability,
  customers profitability, business segment
  performance, and others business units
  information
• Management needs to understand
• Where and how it is making money
• Where and how it is losing money
• And understand the reason for the differences
• Cost behavior
• Incremental analysis, Flexible budgeting, CVP,
  controllability of costs, etc.
• Management can and should identify all relevant
  information that is essential to the effective
  and efficient management of the business

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Vital Truths About Managing Your Costs, Ames
and Hlavacek, Harvard Business Review, 1990

• In this article the authors state
• Over the long term, it is absolutely essential to
  be a lower cost supplier.
• To stay competitive, inflation-adjusted costs of
  producing and supplying any product or service
  must continuously trend downward.

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Vital Truths About Managing Your Costs, Ames and
Hlavacek, Harvard Business Review, 1990

• The true cost and profit picture for each
  product, for each product/market segment, and for
  all key customers must always be known, and
  traditional accounting practice must not obscure
  them.

10
What Should Management Accounting Systems Do For
An Organization?

• They should provide a framework for better
  decision making
• Scorekeeping information
• Alternative-choice decision information support
• They should facilitate the effective and
  efficient operation of the organization and
  provide insight into the intelligent use of
  scarce resources
• Accounting and in particular management
  accounting does not create economic reality
  instead it provides us with valuable information
  so that we can live within our economic reality
• Effective MA systems are the good guys

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Who Needs Management Accounting Information?

• The really big guys?
• All corporate organizations?
• Smaller operations?
• Arent there a lot of examples where
  organizations with limited management accounting
  systems are successful?
• The Glen Davis story

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Costs Are The Foundation Of Most Management
Accounting Reports

• Accounting information is not (or should not be)
  funny money
• Different costs for different purposes
• Not any cost for any purpose
• Different industries and different businesses
  within industries may require somewhat different
  management accounting information
• But the expected results are fundamentally the
  same, to more efficiently and effectively use
  scarce resources and manage the business

13
The Behavioral Nature of Accounting Reports

• Virtually all accounting information should have
  some impact on the behavior of business managers
• A key issue in financial reporting is to
  structure accounting and management reporting
  systems so that they induce favorable behavior
• Snoopy said, If you expect nothing you get
  nothing

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Accounting According to Clint Eastwood
(Accountings impact on the organization)

• The Good
• The system supports the goals and objectives of
  the company
• The Bad
• Neutral or slightly negative impact
• The Ugly
• Has a major negative impact on the goals and
  objectives of the company
• The effectiveness of most accounting systems is
  determined by the attitude of management and its
  desire to develop and utilize an effective MA
  system

15
The Report Management Accounting Guidelines for
Agricultural Producers

• I think that the exposure draft addresses all of
  the key elements of effective management
  accounting systems that I discussed earlier
• I think the draft does an excellent job of
  describing the nature and character of the
  Management Accounting Guidelines project
• The report clearly describes the need for
  understanding costs and the role of an effective
  management accounting system in delivering
  relevant cost information
• The section on the basics of managerial
  accounting does a good job of describing and
  structuring the responsibility reporting
  environment
• The report also does a good job of tying together
  the concepts of levels of reporting and the
  relationship between internal and external
  reporting

16
The FSC Management Accounting Guidelines for
Agricultural Producers

• The report is pretty comprehensive and
  descriptive of most essential MA issues
• The section on managerial accounting issues for
  agriculture addresses some issues that are not
  necessarily managerial accounting per se but that
  have special meaning for agricultural businesses
• In some respects this material addresses the
  concept of external reporting vs. the reality of
  the situation

17
The FSC Management Accounting Guidelines for
Agricultural Producers

• The material on standard costs is good and well
  illustrated. I think this topic should be
  expanded to include a discussion of the values of
  standard costing systems and how they might be
  used to enhance performance in agricultural
  businesses
• Some key concepts such as cost behavior and
  activity-based costing (ABC) probably need more
  explanation and support in order for most users
  to apply them to their businesses
• Implementation of effective MA systems in most
  agricultural businesses will most likely require
  significant educational and technical support
  from others such as FFSC or other groups

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Comments for the FSC Management Accounting
Guidelines for Agricultural Producers

• There were not many comments to the exposure
  draft that took issue with the basic content or
  orientation of the report
• I agree with this position
• There were a number of comments that dealt with
  specific numbers or relationships
• There was one submission that proposed funding of
  an educational program to facilitate the
  implementation of the FSC MA Guidelines
• I dont want to comments on the merits of that
  particular proposal
• But I do believe that some form of educational
  support and technical support is crucial to the
  implementation and success of the MA program

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Five Important Issues to Think About

• Management accounting is a reality check not a
  cover up
• The numbers by themselves are not very important
  if you do not understand what they mean
• Inventoriable (traditional unit costs) must not
  cloud our understanding of all the other
  product-related costs that impact significantly
  on a products or business segments
  profitability
• Cost behavior is crucial to understanding and
  utilizing many management accounting concepts
• Activities drive costs and a solid understanding
  of Activity-Based Costing (ABC) systems is
  important in measuring, understanding and
  controlling costs

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(1) Management Accounting is a Reality Check

• Some external reports do not always reflect the
  current reality
• Tax depreciation may be quite different than
  actual depreciation, cash revenue or expenses may
  not reflect actual revenues or expenses, etc.
• Accrual accounting is essential to measuring
  performance
• Management accounting measurements and reports
  are intended to give a clear picture of the world
  in which you operate (and not through rose
  colored glasses)
• Sometimes Management Accounting confirms what we
  believe
• Sometimes Management Accounting paints a
  completely different picture than we thought
• Our goal should be to develop a management
  accounting system that gives us the most accurate
  and informative information that is possible to
  intelligently manage each component of our
  business

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(2) To be Effective Managers Must Understand
Management Accounting Information

• Merely having valid management accounting numbers
  will not automatically guarantee better business
  decisions
• A new software package by itself will not always
  deliver useful managerial information
• Mangers need to be able to interpret and
  understand the significance of the information
• The more you understand (MA) the better you can
  manage operations
• Management education is a key to success
• George knows cost behavior
• A little information can be a dangerous thing

22
Communications is a Process

• Communications components
• Speaking
• Writing
• Listening
• Understanding
• Feedback
• Others

23
How Do We Communicate Accounting/Financial
Information?

• Trusted Confidant MBA professional experiences
• Create dependencies
• Kiev, Ukraine experiences
• Are we communicating?
• Provide management with learning opportunities
• Successful business managers tend to have a clear
  understanding of accounting/financial concepts
  and consequences
• All business managers tend to be more effective
  when they have the ability to inform/
  discuss/persuade/ others about the impact of
  accounting related issues

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Why Is It a Challenge to Use or Communicate
Financial Information?

• Some managers just dont know much about
  financial information
• Some managers just dont want to know much about
  accounting (MBA Core majors discussed)
• Some managers think financial information is all
  a bunch of funny money
• Many accounting terms are used regularly in
  everyday life and we must overcome misconceptions
• Examples?
• The concept of cost, expenses, budgets, income,
  amortize, etc.
• It is always about the numbers?
• The numbers never lie?
• More revenue is always a good thing?
• More expenses are always a bad idea?

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(3) Managers Must understand all Product-Related
Costs

• Production costs are assigned to inventory and
  often receive the spot light by management
• But there are many other costs related to
  products that determine the profitability of
  products or other business segments
• Tracing all product or segment related costs is
  essential to assessing and understanding segment
  profitability

26
Understanding the Value Chain

• As products move through the production, sales,
  and distribution process, value is added
• We must be able to track the value added at each
  function and the costs associated with each of
  those functions
• We must seek to avoid/minimize non value added
  activities (and associated costs)

27
(4) Cost Behavior is essential to Understanding
Management Accounting

• There are many reasons why managers may want to
  know about cost behavior in their business
• 1) For use in many different types of
  cost-volume-profit (CVP) analyses.
• 2) For use in flexible (dynamic) budgeting
  activities.
• 3) For use in standard costing, in particular,
  MOH variance analysis.
• 4) For use in determining Manufacturing Overhead
  (MOH) application rates.
• 5) For use in assessing the controllability of
  costs

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Common Types Of Cost Behavior

• Fixed Costs Costs that fundamentally are not
  driven by changes in volume
• Variable Costs Costs that change directly and
  proportionately with the volume of activity
• Mixed Costs Costs that contain both a fixed and
  a variable component
• Others

29
Cost Behavior Assumptions

• Relevant Range Cost behavior estimates are
  usually based on the analysis of historical
  costs. If cost behavior characteristics are
  projected outside of the observed range of
  activities, the projections may not be accurate.
• Time assumption As time passes, the business
  environment changes, and cost behavior may
  change as well.

30
Determining Cost Behavior Patterns

• Costs categories do not automatically fall into
  one of the cost categories described above
• For example lease costs can be fixed, mixed, or
  variable
• If you have not done some careful analysis of
  cost behavior for this situation, you probably do
  not really know much about it
• Understanding cost/volume relationships can be
  very important
• Hospital financial managers example

31
Cost Behavior Estimation Methods

• Most organizations have very little cost
  information that is captured and reported by type
  of cost behavior pattern. Therefore, cost
  behavior patterns must be estimated using logical
  and effective analytical methods.
• Experience
• Plotting cost data
• High-low method
• Regression/correlation method

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Challenges Relating To Cost Behavior Estimations

• When managers analyze accounting data to
  determine cost behavior they must understand the
  impact of a variety of issues on the results that
  occur
• Cost pools
• Allocations
• Timing Issues
• Entity Issues
• Accounting Policies
• Legal Issues

33
(5)The Role of Activity Based Costing (ABC)

• ABC is intended to provide more accurate cost
  data than traditional measurement systems
• First applied to product costing (MOH)
• Now used more extensively in costing upstream and
  downstream activities
• Why is it used here?

34
Activity-Based Costing

• ABC is a widely used and accepted method of
  accurately assigning the costs of activities to
  their appropriate cost objective.
• It is commonly believed by the accounting
  profession that ABC is a very effective cost
  measurement methodology for tracing costs to the
  activities that drive the costs
• Activity based (ABC) costing system first traces
  costs to activities and then to products (or
  other cost objectives).
• The underlying assumption is that activities
  consume resources (resulting in costs) and that
  products (or other cost objectives), in turn
  consume activities (and their related costs).
• An ABC costing systememphasizes direct tracing
  (of costs) and driver tracing exploiting cause
  and effect relationships
• By linking the cost of activities to their
  outputs, such as products, services, customers,
  and projects, ABC results in an accurate
  determination of the cost of goods and services

35
Where Does This Leave Us?

• What are your thoughts about these or other
  issues?
• What issues would you like us to discuss?
• Questions?

36
Standard Costing

• Standard costs are carefully predetermined costs
  and quantities used as criteria for measuring
  performance.
• Comparisons with Budgeting
• Standards are more detailed and provide a better
  framework for timely performance measures.
• Budgets typically more effectiveness oriented and
  standards are more efficiency oriented.

37
Reasons for using Standard Costs

• Cost Control.
• Convenient timely framwork for measuring
  performance.
• Useful in setting external and internal prices.
• Make managers more cost conscious.
• Used in Management by Objective (MBO) systems.

38
Steps in a Standard Costing System

• The first step is to create or set standards
  for each activity management wants to use
  standards. Usually there is a standards setting
  committee of organization.
• Because of changing environmental issues, the
  standard setting process is a continuing
  activity.
• The second step is to accumulate or measure
  actual costs for the period.
• The third step is to compute variances by
  comparing actual costs with standards.

39
The Analysis Of Variances Is A Process Designed
To Answer The Questions

• What is the amount of the variance?
• Why did the variance occur?
• This is the most important component

40
TOTAL VARIANCE

• DIRECT DIRECT
  MANUFACTURING
• MATERIALS LABOR OVERHEAD
• Material Price Labor Rate
  Two-Variance Method
• Variance Variance
• Material Quantity Labor Efficiency
  Three-Variance
• Variance Variance Method

41
Timing of Variance Measurement and Reporting

• - Sooner is better than later.
• - Cost/benefit is a key issue

42
DISPOSING OF STANDRAD COST VARIANCES

• Small Variances Charge or credit to Cost of
  Goods Sold
• Large Variances Spread to the appropriate
  accounts that are impacted by the variance.