knowledge bank -applied learning

Abstract

The changing business environment of today which is symbolized by cross border flow of capital, technology and products has broadened the dimensions of accountability and performance. An increasing awareness of issues like ecological, economical and social sustainability has made it imperative for the accounting profession to adapt itself towards a substantive role in creating and enabling such development which does not impair the future.

Professional accountants are increasingly involved in the measurement, recording, reporting and stating assurance on sustainability issues. Sustainability permeates many aspects of any accountants work including the measurement of liabilities and impaired assets, the design and operation of management control systems, the identification and management of risk, the reporting and assurance of information and compliance with laws and regulations.

The two criteria which are frequently used by companies for reporting sustainability issues are the GRI Guidelines and the AA 1000 Framework. The GRI (Global Reporting Initiative) is a joint initiative of the US non governmental organizational Coalition for Environmentally Responsible Economies (CERES) and United Nations Environment Programme. GRI was established in 1997 with the objective of enhancing the quality, rigour and utility of Sustainability Reporting. GRI guidelines provide in-depth details on the reporting aspects of sustainability whereas the Account Ability’s AA1000 Assurance Standard is the dominant standard as far as assurance is concerned.

This article traces the history of sustainable development around the world, analyses the reasons which have contributed to the growing importance of sustainability reports and the role which professional accountants can play while preparing such reports.

The Stockholm Conference, 1972 and after…..

It was the Swedish Government, which took the initiative into bringing forth the problem of human environment on the agenda of the United Nations for the first time. Increasing awareness of serious negative environmental effects due to rapid development of science and technology, particularly after the Second World War, provided the general background to the Swedish initiative. These problems transcended national boundaries and cut across traditional administrative borderline. The notion of the growing interdependence between the nations, which resulted from these developments, stimulated the need of a new concept in global politics, is that of the oneness of our planet i.e. the fragile space ship earth. The stage was set for a new kind of international discussion, popularly known as Sustainable Development. Subsequent to the Stockholm Conference, World Conservation Strategy at Switzerland in 1980 prepared by the International Union for the conservation of nature along with the UN Environment programme and the World Wildlife Fund promoted the idea of sustainable development.

The concerns of the degradation of environment were common to all nations, but the approach to the solution of the problems was sharply divergent. The developing countries felt that the issues of environmental concerns were the luxury of the West and the rich, whereas for the developed nations environmental pollution and conservation of genetic and natural resources were prime areas of concern. It was at the Stockholm Conference that the former Prime Minister of India late Mrs Indira Gandhi in her famous speech stressed the need for linking environment with development at the global level. The United Nations appointed an environment commission, headed by Mrs Gro Harlem Brundtland, Prime Minister of Norway. This commission also stressed the need of integrating environment with development and termed the two as inseparable for future human survival. The Brundtland Report, as it is popularly known, defined Sustainable Development as “the development that meets the needs of the present without compromising the ability of future generations to meet their own needs”. This landmark report helped trigger an International Conference held by the UN General Assembly on issues concerning environment and development with the object of evolving a new global partnership for saving the earth planet and for sustainable development for the future. It was decided that the United Nations Conference on Environment and Development (UNCED) would be at the level of the Heads of State and Government, as a mark of importance of the issues involved. Hence, the UNCED was held at Rio de Janerio (Brazil) from June 3 to 14 1992. Another such World Summit on sustainable development was held at Johannesburg in 2002.

Industry and Sustainable Development

Business and industry have a key role to play in the global drive for sustainable development. In the run up to and since the Rio Earth Summit, business’s commitment to this goal has been apparent through many innovative initiatives launched by individual companies and business groups. Path-breaking private-public sector partnerships have also contributed significantly to the effort. The launch of many positive voluntary programmes, such as the ICC Business Charter for Sustainable Development and as described in the WBCSD’s (World Business Council for Sustainable Development) report "Signals of Change: Business Progress Towards Sustainable Development," indicates the broad agreement of industry worldwide to integrate sustainable development considerations into nearly every aspect of their day to day activities. Responsible entrepreneurial businesses are the driving force for sustainable economic development and provide the managerial, technical and financial resources to contribute to the resolution of environmental challenges.. Globally, the private sector is a primary source of employment creation, information, training, and capacity building. However, if the private sector is to make its full contribution to sustainable development, an essential prerequisite is a sound policy framework, both at the national and international level. Many challenges still remain and industry must continue to improve performance and keep stakeholders informed of its policies and practices.

 

Sustainability Report

Till date there is no international financial reporting or auditing standards dealing directly with social, environmental or sustainability accounting, reporting or auditing issues. One way of informing stakeholders about the progress, policies and practices related to sustainable development is through Sustainability Reports. Such a report is a stand alone, general purpose report issued by an organisation about its economic, environmental and social performance e.g. an environmental report.

Growing importance

Various global trends, such as the ones discussed below, have assumed significance over the past few years and have been instrumental in propelling the need of sustainability reporting by the corporate. 

Globalization: In a world characterized by massive cross border flow of capital and technology, the opportunities of creating wealth have increased multi fold. Alongside, there are concerns that such wealth may increase inequality amongst various social groups. While both governmental and non governmental organizations have a role to play in the globalization process, it is the corporate activity that remains its driving force. As a result almost all stakeholders including the corporate are seeking new forms of accountability, which may give some sort of a credible description of the consequences of the continuously expanding business activity across the globe.

Global governance: A border less global economy, which is being witnessed today, requires an equally borderless governing structure to help the private sector achieve goals which are socially, environmentally and economically viable. Various national and international institutions shall need to extend their capacity to govern such corporate activity. New models of international governance affecting areas such as green house emission, effect on ozone layer depletion or the emission of toxic pollutants, labour practices and the ever expanding financial standards signify the importance being given to global governance in the flat world of today. One of the common requirements from all these models is that of a high level of transparency.

Improvement in Corporate Governance: The recently witnessed Corporate Scandals like the ones of Enron and World Com has brought to focus the need of improving upon the existing corporate governance practices. It is now accepted that companies have a major role to play in the prosperity and continuous development of any society. whether it is economically or socially or for that matter environmentally.  In such a scenario the investors and all other stakeholders expect the highest standards of ethics, transparency, sensitivity and responsiveness from the corporate. The role of auditors is under scrutiny the world over and so is the behaviour of the board members. Today, corporate governance is being not only looked upon as a compliance activity but the dimension of its performance is being given the most importance. The importance of corporate governance can be understood by looking at the number of initiatives being taken by various institutions and organisations by way of issuing guidelines. Amongst the foremost are the Cadbury Commission, the Turnbull Report of the UK, the King Report in South Africa, OECD guidelines, the World Bank’s Corporate Governance forum and many others.

Emerging economies and globalisation: Countries like India, Brazil, Tanzania, China etc are facing the same globalisation, accountability and governance trends as those witnessed by the developed nations. Technology and capital is being transferred to such economies in a similar way as it was transferred amongst the developed nations in the last decade. This when coupled with very tightly linked supply chains across the world, increases the need of spreading common management practices and increasing accountability pressures into all segments of the value chain starting from research and ending with customer support. The emphasis of harmonizing accounting practices is on the forefront with similar progress being made towards social and environmental reporting.

Communication boon and rising expectations from organisations: The transfer of information today has re-characterised the history of human existence The use of internet and other high profile communication system has amplified the speed and force of feedback mechanism.  Consumers are today supported by more media coverage on sustainability issues and are hence more sensitive while evaluating companies. Such an unprecedented exposure has increased the expectations of the customers, consumers and other stakeholders in regard to sustainable activities of various companies. Today the risks of loosing brand image because of reasons related to sustainability are much more than the yester years. 

 

Governments involvement in sustainable reporting Although sustainable development had become a popular concept by the mid 90s, little was done to promote sustainability reporting. Today there are innumerable numbers of voluntary, statutory and regulatory initiatives taken in this regard. There is increasing talk of incorporating Non Financial measures in annual reports in almost all countries in the world including India. Narrative reporting appears to be there to stay. Some actions are propelled due to national and international requirements especially those related to social and environmental factors.

 

The pressure of financial markets: Financial industry is increasingly demanding sustainability reports. Such a demand has been primarily spurred by the growing demands of social and ethical funds among institutional and individual investors. “ The International Finance Corporation (IFC) a member of the World Bank Group, which is the largest multilateral source of loan and equity financing for private sector projects in the developing world , has made sustainable performance a basic criteria for the grant of any assistance.  IFC regularly monitors the environmental and social performance of projects in its investment portfolio. Also, the understanding of the relationship between sustainable activities and the value of the corporate is on the increase. Linkages between sustainability performance and key value drivers such as goodwill of the corporation, brand image and future asset valuation are influencing financial markets to adopt new tools for understanding and predicting value in capital markets:

·         Strategy - identification of relevant sustainability issues and stakeholder involvement.

·         Measurement and recording – measuring environmental benefits, costs and liabilities; management information systems for sustainability data; internal controls for sustainability issues; environmental cost and management accounting.

·         Management and interpretation – identification and appraisal of environmental threats and opportunities; incorporation of environmental and sustainability criteria into investment decisions; environmental management systems; managing environmental benefits, costs and liabilities; sustainability and codes of corporate conduct; responsible and sustainable supply chain management.

·         Reporting and assurance – preparation of internal and external sustainability reports; internal reporting of sustainability performance; communicating sustainability matters to management; the internal perspective on sustainability assurance; functioning of systems and codes;  preparation of external assurance.

 

Role of an accountant

Accountants are employed in a wide range of functional areas spreading across different industry sectors and have varied roles and responsibilities to perform. The following are some specific areas where the accountant’s involvement shall be mandatory to further the idea of sustainability reporting;

·         .Corporate Policies: Professional accountants working in business are frequently involved in framing company policies and developing business cases for action. While discharging their functions related to such roles and responsibilities, an accountant is ideally placed to mange the impact of sustainability issues in an integrated way. This can be extended to identifying, measuring and managing business risks. An accountant is suitably placed to provide some sort of an assurance that the proposed company policies are being implemented properly across the organisation. This can be done through the use of certain performance indicators to test the effectiveness of company’s policies and the reliability of related information.

·         SCM (Supply Chain Management): In the flat world of today, good Supply Chain Management is necessary for remaining competitive. This awareness has led many a company to introduce policies which minimise risk related to reputation and goodwill. With the need of more information, either regulatory or because of the pressure from customers, companies will fast realise their responsibility towards managing the supply chain. In this regard accountants will have a prominent role to play in the preparation and monitoring of the purchasing policies and the design and operation of management systems relating to the supply chain.

·         Stakeholder engagement: For stakeholder engagements to be effective, it is necessary that the information provided is reliable and trustworthy. The providing of such information shall at most of the times be the job of an accountant and in the process he shall need to work upon data relating to social, environmental and economic matters.

·         Benchmarking: An effective benchmarking system requires timely publication of information that is relevant, reliable and comparable. An accountant’s role in such an exercise is monumental as he has the necessary expertise to collect and present both financial and non financial data.  Also, an accountant’s expertise shall be useful in interpreting and analysing such collected information. Similarly, accountants working in business could also assist in raising the quality and credibility of the approaches adopted by the increasing number of benchmarking organisations.

·         Taxes and Subsidies: One of the major functional responsibilities of many an accountant relates to the area of taxation and subsidies. Accountants are expected to give advice on taxation of all forms and the expanding development of environmental taxes is of increasing importance to them. All taxes or subsidies given for furthering the cause of sustainability will be of paramount importance to the concerned accountants and the latter shall find himself to be in an ideal position to contribute to the development and implementation of business policy which promotes sustainability.

·         Tradable permits: Various tradable permits affect many a national jurisdiction and there is a challenging opportunity for professional accountants to contribute to the development of such policies at all levels including standards for accounting and reporting. For all those businesses which are affected because of such permits, there will be a compelling requirement of managing and accounting for ‘emission permits’, allowances and corresponding assets and liabilities. Needless to say, a professional accountant is the best suited for carrying out such an exercise.

·         Assurance: Accountants will increasing be involved in collecting, checking and interpreting information relating to environmental and social impacts. This will most likely affect those who are employed in the mainstream reporting role or in internal audit. Accountants shall provide assurance on internally communicated information on sustainability issues in order to provide the necessary confidence to the board in the reliability of the information.

 

Conclusion

Sustainability Reporting is an all encompassing paradigm in the way the Corporate Social Responsibility is going to shape and assume. Transnationalisation of companies have to address these issues in an equally responsible manner in their set up in developing countries. It is not only that the capital flows are important for companies, but the preservation of country’s ecological and environmental needs are also equally essential. The reporting of the activities which the company performs for maintaining sustainable development is a complex issue. Companies have to take the task and report on sustainability as a part of their financial statements. Accountants and finance professionals will have a major responsibility towards such reporting requirements. As the trend appears, sustainability reporting shall be amongst the major area of concern for the global corporate in light of the growing need to protect nature.

 



1. CASE STUDY
Limitations of Standard Costing and Flexible Budgeting
 
“We have been leaders in Picture Tube manufacturing from the last many years, however, it appears that frequent changes in government policies have been adversely  affecting us leading to a demand from the quality and production  personnel to abandon the age old budgeting and standard costing system which has been used so effectively in the past. The argument is simple that since we do not know in advance, as to what the demand in the market is going to be, we are in no position to budget production. Last year the budget forecasted a potential manufacture of 2000 17’ Picture Tubes; however, we ended up manufacturing nothing of that sort as there was no demand in the market. Blaming the marketing personnel is of no use as demand in the present day scenario is widely fluctuating specially with customers having multiple choices in both the Picture Tube sizes as well as quality parameters.  Critics argue that in the present business environment  there may be little use of budget related activities as they may not be able to provide us with any measure of our competitiveness in the industry. On the other hand, the accounting and finance personnel are vehemently opposed to the issue of abandoning the old concept as they feel that slight changes and modifications in the same may allow us to retain our effectiveness as well as help in enhancing efficiency. I understand that there was a proposal of changing our system to an Activity Based Costing methodology but the same was talked down upon because of the excessive costs involved.” Thyagrajan, the General Manager of Pele tube Electronics recalled issues, which were discussed during the last meeting chaired by President Shri Victor Nichole. 
Minutes of an internal meeting of managers of Peletube Eletronics ltd. 
DATE: November 09, 2012
TIME: 5.30 p.m.
VENUE: Peletube  Bhavan, Ghaziabad
PRESENT: Thyagrajan , General Manager; Devendra Bahadur, Sr Manager  (Marketing); Arvind Lakhotia ,  Sr Manager  (Finance); Shalab Kapur ,Dy General Manager  (Manufacturing); OP Singh  , Quality Control Manager 

Thyagrajan: Good evening to all of you. I have called this meeting to resolve an issue raised in the meeting held last month chaired by our honorable President Shri Victor Nichole. There was a proposal in the meeting of discarding the Budgeting and Standard Costing systems since, according to OP Singh, the reports generated by the same were inducing dysfunctional behaviour in our employees, so much so, that they would ultimately end up distancing us from our customers. The reasons, according to OP Singh were many and I would ask him to apprise you of the same. However, before we commence further with the meeting I would request you all to be futuristic in your approach as we are planning a quantum leap in our production in the coming years with talks in advanced stages with quite a few leading companies, which are engaged in the assembly of Televisions. Ideally, I would like to see a process built up so as to ensure timely production for timely deliveries along with minimal or even zero variances. Subsequent to achieving the same, we would perform both value engineering and value analysis for cost reduction purposes. However, since OP Singh raised the matter in the monthly meeting, I would request him to take a lead and share with all of your good selves the issues he has in mind, which he believes may be detrimental for Pele tube in the coming years.

OP Singh : Thank you Thyagrajan. In my opinion, Standard Costing and Budgeting have actually become a liability to our company. These systems are old and meant for an environment very unlike of what we are witnessing now. The basic objectives of these systems were that of controlling costs and evaluating performance of various Responsibility Centre managers. The environment prevailing during those times was not as competitive as now and we were amongst the very few organizations that had the capability of manufacturing Picture Tubes. A cost plus pricing approach was sufficient.  Competitors used our price as a benchmark for pricing Tubes produced by them. Our infrastructure was better than what was available with most organizations and to add to the advantage the promoters of our company had the latest technical knowhow available in the world: that too with first hand working experience. In fact, two of our promoters had been technically trained in the manufacturing process of Picture Tubes in the US. This led us to have a huge competitive advantage over others and in case you allow me to be blunt – we have milked our knowledge cow for perhaps too long a period. 
Thyagrajan : Yes , you are right. In fact, another founding Director of ours had worked in the UK with a Picture Tube manufacturing organization. During his tenure, he was responsible for the entire factory accounting and other commercial activities. I understand that Budgeting and Standard Costing systems implemented in our factory are similar to those implemented in that UK based company.  I believe that there have been a few changes in the system from what we did during the 1980s to what we do now. Perhaps Mr. Lakhotia may be able to tell us more as he has been associated with the company since its inception. 
Arvind Lakhotia : Change is a very subjective term . A change made in the Bill of Material is a change but also a result of intensive R&D effort. Similarly a change made in the relevant range assigned to any activity may , technically be termed as a change, however, it is most of the times due to the increase in efficiency, either concerted or otherwise, through a mere application of the learning curve. The word ‘improvement’ would be more appropriate in such situations. In this sense, I would not agree with respected Thyagrajan. In my opinion, there have been no changes in the systems we used in the 1980’s and the systems, which are in vogue today.  These systems have been giving excellent results since inception and similar systems are in fact being used the world over, even now. 
Thyagrajan: But OP Singh was so emphatic – in fact, according to him the system should be abandoned and replaced with an Activity Based Costing System.  Isn’t it , OP Singh? I distinctly remember your presentation during the meeting chaired by our President!
OP Singh : The system in vogue is managing events in isolation giving scant regard to the cross functional dynamics. I would go even further to claim that the systems are actually preventing management from taking proactive actions and in case this continues, it would certainly be detrimental in the long run. I for one believe that variations are bound to exist in any dynamic system and in case one wants to get a real picture, the measurement practices at our company need to be improved. I would give you specific examples but before that, it is essential to understand the complexities faced by our company today and appreciate the business environment changes, which have happened over the past many years.
As you are aware, we had established our plant in the early 80s and were pioneers in manufacturing Picture Tubes in India. There were only black and white Tubes made during those times and that too in a couple of sizes, 17” and 21”. Subsequently we diversified into the making of coloured Picture Tubes and added two more sizes, 19” and 27”. Later developments in the Television market pushed us into the making of Flat Surface tubes, which were in addition to the curved monitors made since long. We were able to survive because of the high quality human capital which existed in our organization who were good enough to adapt with the much needed technical changes happening globally. However, today, the paradigm is completely different with manufacturers from North America, Korea, Japan and China entering India to produce in our territories. In addition, with a drastic reduction in Custom Duties, both CKDs and SKDs can be imported at a very cheap rate .These when assembled turn out to be cheaper than what we produce at our plant; however, we have still managed to survive and profit because of the competitive advantage which I mentioned earlier. 
Let me come to specific instances, which I believe shall help everyone understand the point I want to make. Our Costing system computes a variance known as a production volume variance (PVV). An adverse PVV highlights the money, which we lose because of not utilizing the capacity to the full. An adverse variance is understood to be a lapse on the part of the production department. However, in the present circumstances where we have to produce only as per the demand in the market, the computation of PVV does not make sense. In case we continue doing so, the production personnel shall be forced to produce for stock, as they would be reluctant to have an adverse PVV reflecting negatively on their performance. The need of today is to produce in small quantities as per the market requirements and that to deliver the same on time. Capacity utilization is no longer the paradigm, especially post globalization where the competition is intense. Apart from locking up unnecessary funds in the Inventory, we also run the risk of obsolescence with frequent rapid changes being introduced in the product characteristics .    
Arvind Lakhotia : I agree with this, however, doing away with PVV may not be a solution. We can make PVV independent of performance appraisal and that be that. The computation of unutilized fixed expenses would certainly help in improving future performance. How do we know whether we can produce more than what we have in hand? PVV would be necessary. 
Shalab Kapur : Unutilized fixed expenses ! Uh!  This shall be of use in case we are measuring the fixed expenses properly. Let me give you an example. Salaries paid to the production personnel are a fixed cost in our budgeting and costing systems. A huge component of the PVV arises due to the same. However, with frequent changes in production schedules and the routing plans on the floor, a major portion of the production personnel’s time is devoted to Setup activities rather than actual production. The resources consumed during Setup are a part of the fixed salary component. Don’t you think it is wrong to call them fixed costs? This is one reason I advocate for an Activity Based Costing System. In case implemented, Setups would be treated as a distinct Cost Object and so the salary related to every Setup would become variable in nature. As we know, “the more we identify variability; the more precise we get in cost ascertainment”. 
Arvind Lakhotia : I agree with what Shalab is saying. In the present scenario, there is a need for redefining the fixed overheads. The finance department is already working in this regard with a proposal to identify resources consumed during a Setup and removing the same from the fixed cost component. Once this is done, the PVV would reflect the unutilized capacity in real terms. Setup costs would be concentrated upon separately with a view to control and gradually reduce the same. Removal of PVV as a parameter for performance appraisal plus the changes we propose in the computation of PVV shall help address the concern of Shalab. 
Devendra Bahadur: Perhaps we may be better off by removing the fixed cost component from the product cost. These costs are imputed, not traced and should be looked upon holistically. 
OP Singh : I am glad that we are working on this aspect. I agree with Devendra Bahadur that fixed costs are imputed and the same need not be a part of the product cost. Also, that Setups shall be treated as a separate Cost Object is welcome. The same would have been done in case we had an operational Activity Based Costing system. However, there are other issues that need to be taken care about. Let us take the example of the computation of Material Price Variance (MPV). The variance reflects the deviations in the raw material prices actually paid from the ones, which were established in the beginning of the year. This variance reflects performance of the Purchase department. Frequently, in order to get a favourable or a negligible adverse variance, the purchase people have resorted to buying in bulk as the same fetches them discount. However, this is against the basic need of our company. Buying in bulk may fetch us discounts but it also increases the risk of obsolescence of the raw material inventory. Imagine buying material for 17” Picture Tubes and having the same locked in Stores for years because of zero production. The inventory would go obsolete. Similarly, the use of MPV for performance appraisal can induce another type of dysfunctional behavior i.e. buying of poor quality raw material at cheaper prices, which would help reduce the MPV. Both these examples again focus on the limitations of Standard Costing and Flexible Budgeting.
Arvind Lakhotia : I agree with the first point you have made. Buying in bulk could reduce MPV but alongside, there is a risk of huge capital tied up in the inventory. This can be rectified at the time we establish standards. Perhaps the standard prices for material would have to be raised . However, I would not agree with the second point. According to me, in case the purchase department saves money by buying low quality stuff at cheaper rates to improve MPV, the same would be reflected in an extremely high adverse usage variance. In addition, the cost of quality would shoot up abnormally. We had understood this recently when the Solder purchased was not of good quality, because of which the usage variance at the floor had become extremely high. Variances are all interdependent and it is wrong to say that the costing and budgeting systems in our factory measure things in isolation. What is important is the way we interpret these variances.  We need to understand that our operations are volume related. Variances for volume related activities are controllable and in case we incorporate the kaizan approach while establishing benchmarks, we could have a continuously improving operational situation.  I would like to emphasise over here that the Finance department is looking into the matters raised by OP Singh and Shalab Kapur and the perceived anomalies shall be looked into and rectified very soon. We believe that all of us are working towards the same goal and hence any MIS implemented should be in line with the ultimate objective of our company. I am sure that you will agree that the rectifications, which I have proposed in today’s discussions, are acceptable and would go a long way in addressing the concerns.
Shalab Kapur : Yes, in case we exclude the fixed cost component from our cost sheets and treat them in totality , we would have made progress in the right direction. Also. there is a compelling need to change the standard prices of raw material since buying in small quantities shall certainly be more expensive than when we buy in bulk. Both these developments would go a long way in improving performance. I would recommend that we stop using variances as a stick to beat managers, rather we use them to improve future performance by rectifying past errors.
OP Singh : In a way, what Mr Lakhotia is proposing is to have a hybrid system which utilizes concepts of ABC and blend the same to the traditional approach. I have absolutely no problem with such a development but allow me to say that still the system would be historical in nature which by itself is a big shortcoming for decision making . I am sure you will accept that what we need is real time information rather than a historical analysis. 
Arvind Lakhotia : We are already in the process of  implementing Integrated Accounting . This type of a system is actually designed to provide real time information.  Once this is done, the Cost Accounting section would not need to wait for the Trial Balance to be prepared by us in Accounting for computing variances , specially those which concern Overheads. 
Thyagrajan : Thank you gentlemen. I think we have had an intellectually stimulating session with Mr Lakhotia proposing certain changes in the existing costing and budgeting systems in our company. Perhaps we should meet again, once the existing system is improved upon and see how the MIS generated is different and hopefully better. Thank you all for being in the meeting.

Questions

1. Do you agree with the statement that variance analysis induces dysfunctional behaviour?
2. Do you think variances should be used for performance appraisal?  
3. Should Pele tube Electronics abandon its existing Costing and Budgeting system?
4. How is Activity Based Costing different from traditional Costing?



COST &  MANAGEMENT ACCOUNTING IN THE 21ST CENTURY
 
ABSTRACT
The theory of traditional Cost and Management Accounting has been under severe criticism in the recent years. Professionals working in the industry and the academia world over have critically debated over the relevance of cost and management accounting for decision-making and product costing purposes. It is argued that while cost and management accounting was an important tool in the nineteenth century and before, its importance in terms of both scope and objectives has gradually declined during the 20th century with requirements of inventory valuation taking precedence over the decision making and strategic use of this important functional area. It is widely believed that the fall of the UK and the US industry during the 1980’s and the 1990’s was caused due to wrong Product Costing, which provided with misleading inputs to managers thereby resulting in wrong and detrimental decision making. 

The focus of this article is to review the current scenario from a historical perspective so as to help readers understand the need of the emergence of modern concepts like Target and Activity Based costing. The article considers four paradigms that cover the recent history of cost and management accounting in the context of both product costing and the determination of selling price.
The traditional framework (Paradigm 1 and 2)
Since the time of industrialisation, Cost and Management Reporting has always been the responsibility of either Cost or Financial Accountants or both. Apart from the statutory Balance Sheet, Profit and Loss Account and the Cash Flow statements, the Financial Accountants of companies would provide other detailed reports to the management using the same set of historical data. However allocation and apportionment of expenses over cost centres and finally their absorption on the Finished Product continued to be the responsibility of the Costing professionals. Many companies adapted the Integrated Model to combine the Costing and the Accounting functions and get real time information, which would be of greater use than the historical data provided by financial accounts. 
However, with the advent of financial audit (early 1900s) and its increasing importance ever since, product costing systems have increasingly concentrated on the production portion of the value chain as shown below,                             
RESEARCH                DEVELOPMENT                  PRODUCTION          MARKETING              DISTRIBUTION          CUSTOMER SUPPORT

This is understandable since during the first half of the nineteenth century and perhaps till a couple of decades later, manufacturing costs accounted for the bulk of total costs incurred by the industry. The reason being the lack of competitive markets resulting in less advertising and distribution costs coupled with very little marketing and customer support. Manufactures worked in a monopolistic or a near monopolistic environment with products having long product life cycles and so did not require to incurr large quantum of expenditure on functional areas like Research, Development etc. With most of the money being expended on the production function, reports provided by financial accountants for inventory valuation purposes gave enough information to the management about the majority of expenses being incurred by the company. The other costs incurred in the other than production functions of the value chain were considered discretionary and since the total quantum of such costs would not be huge, frequently they were excluded from decision-making purposes.  

However, manufacturing costs computed then were typically characterised by simplistic assumptions, with the use of ‘blanket’ overhead rates and simple labour overhead recovery bases being the common practice. This would result in wrong product costs, the detrimental effect of which was understood only during times of fierce competition and growth, beginning 1980s.

The traditional era of cost and management accounting
The traditional era of cost accounting can be divided into the following two phases;
• First half of the 20th century – Costs were classified as Direct costs and Manufacturing overheads. (Paradigm 1)
• Second half of the 20th century- Costs were classified as Direct costs, Fixed overheads and Variable overheads. (Paradigm 2)








DEBATABLE  ISSUES (Paradigm 1)
A Cost Sheet prepared in the first half of the 20th century would appear as follows;
Cost Sheet as prevalent in the first half of the 20th century (Paradigm 1)
(in Rs)
Capacity : --------- units
Description Total cost Direct Cost per unit Overheads per unit Cost per unit
Bill of Material Cost xxx xxx ------- xxx
Direct Labour xxx xxx ------- xxx
Manufacturing overheads xxx ------- xxx xxx
Marketing and administrative  overheads xxx ------- xxx xxx
Total cost per unit xxx
Add desired profit xxx
Desired selling price/unit xxx

There are two debatable issues which immediately cross ones mind on looking at the cost sheet drawn above. They are;
1. #What volume of activity should be used to project overheads so as to arrive at unit cost?
2. What should be the criteria to determine desired profit?
#possible answers to the volume of activity question, which needs to be addressed to determine the total unit cost, usually point towards expected volume or the capacity of the plant or the normal level of production.

 The answer to the second question is generally subjective. However, the use of ‘cost of capital’ concepts remains the most widespread. 

# In case one looks carefully at the Cost Sheets drawn above, it shall be clear that whose ever prepares the Cost Sheet has got enough information on the volume of activity to be conducted by the concerned company, because only if this information is available can one actually predict the amount of manufacturing overheads to be incurred in a future period. In a competitive market, one may safely argue, one can only know the volume of activity to be performed by having in his mind a tentative Market Price, strangely however, this is one of the primary objective of a Cost Sheet. Similarly the issue of desired profit, the calculation and computation of which is extremely subjective and hence debatable.

DEBATABLE  ISSUES (Paradigm 2)
As mentioned above, there are very subtle differences in the Cost Sheets prepared in the first half of the 20th century when compared to Cost Sheets made in the second half. Unlike the first half, Cost Sheets prepared during the latter period were characterised by the fixed and variable concepts. By doing so, they answered,* to a certain extent, one of the debatable issues mentioned during the previous era that is;
• Since variable cost of units is determined by engineering standards and other analytical techniques, they do away with the volume of activity question, which essentially then pertains to fixed costs.

A Cost Sheet prepared in the second half of the 20th century would appear as follows;
Cost Sheet as prevalent in the second half of the 20th century (Paradigm 1)
Capacity : --------- units
                                       in Rs                      
Description Total Cost Total Fixed Cost Total Variable Cost Fixed Cost per unit Variable Cost per unit Total Cost per unit
Bill of Material Cost xxx ------- xxx ------- xxx xxx
Direct Labour xxx ------- xxx ------- xxx xxx
Manufacturing overheads xxx xxx xxx xxx xxx xxx
Marketing and administrative  overheads xxx xxx xxx xxx xxx xxx
Total cost per unit xxx xxx xxx
Add desired profit xxx
Desired selling price/unit xxx

*The second half of the 20th century is popularly known as the era of ‘Cost Volume Profit Analysis’, in which the manufacturing overheads were segregated into fixed and variable. Whereas variable overheads could be identified with the production pattern with ease, the fixed overheads needed to be imputed over the products. This used to be done by identifying appropriate Cost centres and Overhead absorption rates. Fixed manufacturing overheads were initially allocated over the Cost centres and then finally absorbed over the output at the rates, which were pre-established.  The overhead rates were established considering the maximum output, which could be achieved by the specific cost centres as compared to the budgeted costs, which would be incurred for that level of activity. The result was that in case a company did not produce to potential, certain amount of these fixed overheads would not be absorbed over the products and hence remains unabsorbed. Such overheads were subsequently charged to the Profit and Loss Account and also provided the management with information about the productivity of the workers on the shop floor. However, Product Costing done on the basis of  imputing fixed costs gives approximate results and is only useful in case the product has a long life cycle in the market. In the present competitive scenario, where innovation is the rule of the day, product life cycles have shortened and the competition has increased amongst companies at an unprecedented level. Such a scenario requires companies to produce in small batches as   per customers requirements (implying higher raw material costs due to smaller purchases than before) , deliver quickly and efficiently (higher incidence of cost on the customer support and distribution functions of the value chain)and most importantly be prepared for product obsolescence Traditional costing may not be appropriate today as what it was when the market conditions were different. 

Activity Based Costing (Paradigm 3)
The debatable issue of volume of activity remained in the post 1940 era although it then concerned only the fixed overheads. As pointed out above, the concept of imputing fixed cost per unit had its own shortcomings. 

To a large extent, such anomalies are done away with the use of Activity Based Costing (ABC). A Cost Sheet prepared with ABC concepts is shown below;





Cost Sheet (ABC)
Variable costs per unit Rs
          Direct materials Xx
          Direct labour Xx
          Variable manufacturing overhead ;
             Variable with number of units Xx
          Variable with product complexity(number of                batches) Xx
          Variable with product diversity(number of products) Xx
Variable marketing and administrative Xx
Total variable cost per unit Xx
Fixed costs
Fixed manufacturing overhead Xx
Fixed marketing and administrative Xx
Total fixed cost per unit Xx
Grand total cost per unit Xx
Desired profit (mark up) Xx
Target selling price per unit Xx

 A careful study of the differences in the traditional Cost Sheets and the Activity Based Cost Sheet shows that ABC recognises two additional variable costs (reducing the fixed component) and is essentially designed to improve the accuracy of the total unit cost thereby impacting favourably the fixation of selling price. These two additional variable costs are as follows;
• Costs, which vary with product complexity, such as number of batches.
• Costs that vary with product diversity, such as number of products.
Although, there are many critics of ABC who contend that the technique is nothing but an improvement over the traditional concepts, it is easy to see how ABC would be a better tool during times when customers become demanding in terms of ‘features’ of products because of which companies have to cater to slightly different types of production processes for essentially the same product. The Textile Machinery and Picture Tube   industry in India faced such a situation during the mid 1990s when the government had allowed foreign companies to enter the Indian markets and the import duties on second hand goods, SKDs and CKDs were reduced drastically. Customers then had more choices; product diversity and complexity were the need of the hour. The benefits of ABC during such times are immense.   

Market driven standard costs (Paradigm 4)
Unlike traditional costing concepts where a target selling price is established after computing the cost of a product, paradigm 4 uses the selling price it believes the market will allow in order to determine the allowable cost. Hence, the allowable or target cost per unit is a market driven standard cost that has to be met if the desired profit are to be achieved. 
Cost per unit under paradigm 4 is computed as follows;


Target Cost Sheet (Rs per unit) 
Selling price (prevailing in a competitive setting) Xx
Less desired profit Xx
Target or allowable cost Xx

Hence in Target Costing what counts is the need to produce at an allowable cost. This idea may mean that now the distinction between fixed and variable components is immaterial. It also implies that in case one intends to continuously improve, this allowable target cost should be reduced over time. Such reductions shall need an empowered workforce because it is the one, which is nearest to the action and so in the best position to lead towards a path of continuous improvement.   

Conclusion
The scope and objective of cost and management accounting has changed over a period of time. New tools and techniques like ABC and Target Costing have been introduced, keeping in mind the changing economic environment, which has increased competition. Activity Based Costing is a substantial improvement over the traditional costing techniques because of its identifying more variability in expenses incurred in the production process. However, it is unable to do away with the contentious issue of computing the ‘desired profit’. In today’s competitive environment, Target Costing, with its emphasis on market driven costs is perhaps the best way to survive productively. 

References
1. Johnson and Kaplan - Relevance lost: the rise and fall of management accounting.
2. Cooper, R (1996) - Activity Based Costing and the lean enterprise: Journal of Cost Management.
3. William L.Ferrara, CPA, and Management Accounting (USA): Cost/Management Accounting: the 21 st century paradigm.




CASE STUDY

Investment Appraisal at Somgeets Pvt. Ltd.


The case deals with Investment Appraisal for a new business venture. The case is set in a small manufacturing and services company located at Mumbai. Students may assume for analysis purposes that profits made on sale of land shall be included along with regular income.

On April 16th 1853, a locomotive pulling 14 carriages and 400 people left what was then Bombay to a 21-gun salute and trundled to Thane, 34 km (21 miles) away. This particular journey marked the beginning of the Indian Railways. The network grew fast. Some of it was built by the British Raj, some by the princely states, such as Bikaner and Jodhpur, which retained their notional independence. Many of the network’s main trunk routes were laid by private companies under schemes that would now be described as “build-operate-transfer”/”build-operate-own-transfer”(BOT/BOOT). It was during those times that Somgeets Pvt Ltd (SPL) was incorporated with specific objective to manufacture and lay ‘Tracks’. After independence, the product mix gradually diversified from only ‘Tracks’ to ‘Tracks’, ‘Wheels’, Doors and ‘Lock Handles’ (LH). Supplies to parties other than the Railways were substantial and growing. The company also expanded into services and gradually but steadily increased its presence into Railway Catering. By 2000, manufacturing accounted for only 30% of sales. However, SPL was still known for its high quality manufacturing and reliable customer service. In 2000, the company bid on an Indian Railway contract to supply 1Lakh ‘Lock Handle’s’ a year for five years. SPL bid Rs 25 per ‘Lock Handle’ fixed for five years. Somesh, president of the company, wanted to grow his manufacturing base and felt sure that the contract was a good way to restart a relationship with the government that had been dormant for the last many years. The Railway order would allow SPL to bring about 30 steady jobs to the sea coast area and reactivate a factory which had been shut down in 1981 when SPL lost a contract to supply ‘Wheels’ to the Northern Railway division. The factory was located on a 5 acre land on a sea shore site near the Taj Hotel. The Plant was fully depreciated on SPL’s books; except for the Rs 10,000 cost of the land purchased from its owner who was migrating to the then newly founded Pakistan. The company had turned down Rs 9 Lakh offer for the land in 1995 from a property dealer. Somesh had no idea about the price of land today but he did not bother as the land was not for sale, anyways. If the bid of SPL was to be accepted by the Indian Railways, SPL would need to invest substantially in infrastructure. In this regard, Somesh had projected Rs 5 Lakh expenditure to renovate and refurbish the factory building and grounds. He also estimated an expenditure of Rs 8 Lakhs to buy equipment which would be required to manufacture ‘Lock Handles’ and of Rs 4.25 Lakhs for working capital which would be released at the end of the project. He planned to borrow 50% of the total requirement from banks and to use the balance from SPLs cash reserves.. A 10 year loan at 10% interest was readily available for the said purpose. The life of the equipment was estimated as 5 years whereas the building was expected to survive the next 10 years. In normal circumstances, the investment would last much longer but Somesh wanted to be conservative in his financial projections. If the five-year contract was not to be renewed, Somesh estimated zero salvage value for all infrastructures (building and equipment). ‘Lock Handles’ were specifically meant for the Rail Wagons and had not much demand elsewhere. 

The first year income statement for the project was estimated as follows: 
Sales : Rs 25,00,000(Rs 25 per LH) 
Factory Cost HS Steel Rs 10,00,000(Rs 10 per LH) 
Direct labour Rs 4,00,000 (Rs 4 per LH) 
Other Material Rs 1,00,000 
Indirect Cost Rs 2,50,000 
# Depreciation Rs 2,10,000 
Factory Profit Rs 5,40,000 
# The Company would use straight line method of depreciation for tax purposes. 

Shipping expenses were to be borne by the Railways. No incremental selling and administrative expenses were foreseen.
Somesh estimated Taxes to be 35% of profit. According to Somesh’s estimate, his cash costs would probably grow 4% each year because of inflation. The Railway procurement officer with whom Somesh was dealing with expressed serious interest over the offer mainly because of the fixed price per unit for 5 years as proposed by SPL. According to him, the price quoted was very competitive especially because of zero escalation as projected in the bid. He asked Somesh to submit his 5- year financial forecast. Somesh was unsure of what was needed of him and so he approached his Finance Director, Geetika, for necessary advice. She suggested that SPL needs to prepare cash forecast for the proposal and then compute the “IRR”,”NPV” and “Payback” for the project. According to Geetika, 15% cost of capital was a reasonable estimate and the company would continue as a going concern in case such returns were possible. Geetika had special concern for the land value to be used for the project. She felt that the land cost should be included somehow in the analysis but was not sure how. Market estimate for the land at the sea coast was Rs 15 Lakhs but a comparable property in an industrial suburb nearby had sold recently for only Rs 3 Lakhs.

Questions 

1. You are required to prepare a cash flow forecast for the abovementioned project. 

2. Compute the NPV, IRR and Payback. 

3. Do you think that the proposal is a good deal for the Railways? 

4. Is it a good deal for SPL?


Click To Answer



CASE STUDY
Accounting and Finance 



Spiritual Dimension

 




 





Synthesized Case Study
The Case Study is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case has been compiled on the basis of the applied working experience of the Author. The Author has worked extensively with Telecom organizations in a managerial capacity.





Spiritual Dimension 
 




Summary of the Case
The last two decades have witnessed large scale corporate scams thereby highlighting the need of ethical behaviour by employees for sustained profitability. Since almost all these scams have the involvement of the accounting, finance and audit functions , the need of imbibing ethics in this important discipline has  been felt by one and all. The case study “ Accounting and Finance- Spiritual Dimension” looks into one such scenario where incongruent behaviour of employees of the organisation has become a cause of concern to the management. In a meeting called by the Managing Director, managers across functions deliberate upon the specific issues with the objective of arriving at workable solutions. Discussions range from the roots of accounting and finance in the spiritual domain to its modern day applicability through established principles and practices.   

Learning objectives
 The understanding of basic concepts and principles like  Distinct Entity, Accrual, Measurement etc. 
 The understanding of Responsibilty Centers.
 Advantages and Disadvantages  of Standard Costing and Budgeting as management tools for control.
 The allocation of Joint Costs and the implication of such allocation on employee behaviour.

Keywords
Disinct Entity ,Accrual, Liability, Ethics,Manifested Soul;Agency Conflict; Scandals, Joint Costs, Inventory, Standard Costing;Budgeting;Production Volume Variance;Material Price Variance; Volume Based Production; Dysfunctional Bahaviour; Goal Congruence; Fixed Expenses; Performance Appraisal; Overheads; Usage Variance; 

JEL Codes
M14,M41,L63





The Spiritual Dimension
 “As all of you are aware, the last two decades and more have been characterized by corporate scams which have led to certain stringent measures been taken by those in the policy making arena. In fact, radical changes in various laws including listing agreements, accounting, audit etc has become a continuous process across the world. The effectiveness of additional legislation for controlling frauds is debatable especially in a case where existing laws are stringent. Rules and principles are important but no matter how many new rules are put in place, an efficient and effective performance outcome would only be possible in case each of us works ethically. We have been having yoga and meditation classes for the past five years and the practice has become quite popular; however, it is a matter of concern that many of us are still not being able to control our desires, with actions frequently cutting our Self.  As you would recollect, one of the immediate responses our company had, post Enron debacle was that of setting up a whistle blowing facility. Today, all Responsibility Centre’s have an exclusive physical facility, used by employees for informing management about unethical doings in all operations. We did this in 2003 and there was nothing serious reported until recently. However, the last two years starting April 2013 have been painfully different. There has been a flurry of communiqués pointing towards incongruent behavior amongst our employees. Complaints are across Functions and most of the issues appear to be arising because of employee self-gratification. In addition, we have had reports of some misdoing in the Accounting section, which has gone unreported by our auditors .The complain concerning the accounting function was the one which I received in April 2012 and ever since there has been a continuous increase across functions. I am in no way suggesting that the accounting and finance functions are to be blamed for all wrong doings, however, I am singling them out because it is my firm belief that  a smart and ethical team of accountants and finance professionals would  prevent or at least detect, any irregularity, be it intentional or unintentional. How much does one gain from such unprincipled behavior? Why do so many of us indulge in the same? What should be the measures, which we need to adopt?  We all need answers to such questions. Only a week back I had put across these sentiments to your Yoga Guru, Acharya Shashiendra. I am grateful that the Acharya has agreed to be with us in this meeting. I am sure you know a lot about him but how many of you know that the Acharya was a practicing Chartered Accountant prior to taking Sanyasa?” Shri Gautam Kalsi, Chairman and Managing Director of Vinkas General Carbon Ltd, a leading solid-state electronic component manufacturer, briefed senior employees prior to the commencement of the scheduled meeting.   

Minutes of an internal meeting of managers of Vinkas General Carbon  ltd. 
DATE: November 09, 2015
TIME: 5.30 p.m.
VENUE: Vinkas  Bhawan, Noida. India

PRESENT: Acharya Shashiendra, Yoga Instructor and Spiritual Guru; Gautam Kalsi, Chairman and Managing Director; Rahman Ghazi, Senior Manager  (Marketing); Shyam Banerjee ,Senior Manager  (Finance and Accounts); Shalabh Kapur , General Manager  (Manufacturing); Vincent Tophoff, Quality Control Manager. 

Gautam Kalsi:  Good evening to all of you. I have already briefed you about the reason behind this meeting. Post Enron and the other many corporate accounting frauds like WorldCom, Xerox, Sunbeam etc, there has been a universal call for the need of more ethical behavior by the corporate. Millions of people have lost their lifetime savings because of frauds played upon them by a few individuals. . How does one prevent such unfortunate happenings? Surely, stricter laws and their effective enforcement would make things better. Vincent was telling me about a research, which concludes that post Enron; managers are now adhering to laws more closely due to the social and political changes, not due to a shift in moral thinking. This is worrying, especially in cases of developing countries like India where there are enough loopholes in the legal system that can be exploited by those who want to make it through shortcuts. Laws could be effective only to the extent we want them to be. We can go on making laws but there will be many who would find ways of breaking them and very often, the latter would prevail. I would request Vincent to brief you about the research he had mentioned to me. It sounds interesting. 

Vincent Tophoff: The research, which I had mentioned, suggests that there has been a change in the attitude of management towards ethics and ethical behavior. The research was conducted both prior and post Enron convictions with the same set of questionnaires being distributed to approximately 1000 participants. Decision-making options were purposely linked to areas of conflicting interest. The research concludes that post Enron employee decision making has certainly improved; however, the change is not due to changes in the conscience but rather due to fear of conviction. On the other hand, results from the pre conviction study concluded that business executives’ decision-making was inclined towards the alternative providing maximum benefit even if the doing defied existing rules of law and society. Prior to the conviction of Enron executives, business scandals without real consequences had little impact on behavior. 

Rahman Ghazi: I agree. The highly visible conviction of Enron executives is the reason behind this shift. Strict legal enforcement can work wonders. The companies concerned have felt the heat with some of them closing down while others seeing their goodwill deteriorate. However, market downsizes only the ones who are exposed, not all. A few people going to jail does not mean that justice has been done. I agree with the CMD, accountability in the purview of the legal framework can make a difference; however, there is no substitute for ethics and morality. 

Gautam Kalsi: A developed country is different from the ones, which are developing, and the majority of people live in the latter. Take India’s example. How many people have gone to jail because of bad corporate governance? As far as I know, the figure was nil, prior to the Satyam fraud.  Some would argue that it is incorrect to generalize the wrongs done by a few, on all; however, we need to remember that these few are those who have evolved the wrong way and in case society does not take note, there will be many more like them in the making.  There is something called God fearing which, is entirely missing. I wonder what Acharya would have to say in this regard. 
                                                                                                                                                                                                                            Acharya Shashiendra:  Thank you Gautam and good evening to all of you. It is sad that there are such serious loopholes in our legal framework and this is something that needs rectification. All of us need to work on it collectively as any individual alone cannot do it. However, the moral quotient is in our individual hands. Gautam used the word God fearing, which perhaps is being harsh on Him. With the type of compassion, which He bestows upon all of us, the word God fearing might not be appropriate. He is there to help and protect us, not feared. However, this said we also need to understand that all of us are subject to various scientific laws , internally as well as externally , which lay down certain principles and rules to be followed, not doing which may result in various types of worries, both short term as well as long term. Perhaps that is the reason why this word God fearing has become so popular. Doing the right thing because of fear is different from doing a right because of honest Intent. Right and Wrong can be done at all levels, however, many a times, debates and discussions on corporate scams frequently center upon senior officials like the CEO and CFO and the buck is conveniently passed. 

Gautam Kalsi :  I agree. Also, immorality is different from being illegal. I am glad Acharya brought up the moral quotient issue. In case you recollect my thoughts prior to the meeting, I had used the word incongruent behavior. I did this because of certain complaints, which I received through our whistle blowing system. Let us take the example of our monthly MIS. We compute variances in our operations to understand where we are going wrong in order to rectify errors. However, there have been reports that our purchase department is not shy of buying low quality material in order to gain a favorable material price variance. The action could easily be attributed to an error of judgment and thereby escape any reprimand, however, the consequences could be disastrous. In my opinion, making such compromises may be possible without any apparent harm to the concerned individual, but it certainly is an immoral action.

Vincent Tophoff: These harmful repercussions may not be noticeable in the short run, however, in the end; they shall certainly affect the profitability of our company and the well-being of all stakeholders. You have pointed out just one anomaly whereas actually there are many instances of such practices. In my opinion, one of the very important reasons for this unethical behavior is the costing and budgeting system monitored by the Finance and Accounting department. We all know that variance reports are important tools used for performance evaluation and the fear of adverse variances forces managers to compromise. That is the reason why, in spite of adopting Total Quality Management(TQM),we rarely have adverse production volume variances or for that matter adverse material price variances. As you are aware, the TQM setup requires us to produce as much as we plan to sell and buy raw material in quantities, which are, just suffice for intended production. However, in case you look at the production figures or the raw material purchase figures you would not find any difference in quantities produced or bought now as compared to the pre TQM scenario.  

Shalabh Kapur: I will not agree to this. You are trying to find fault in the fact that my workers work efficiently and utilize full capacity. This is ridiculous. How can you blame someone for working? Moreover, our production quantum is a function of the marketing and sales budget and we produce as per plan.   

Vincent Tophoff: Mr. Kapur, please do not take it as blame and what I have said is not ridiculous either. I understand that after the implementation of TQM, the marketing department is relooking at the sales budget every third month and providing information about the changes online. In such a dynamic scenario, how would you explain the massive build up in inventory this year? Is it not a fact that your profitability increases with increase in production? In addition, the more you produce, the lesser is the adverse production volume variance. 

Shalabh Kapur: You need to understand the dynamics under which my department works. We produce multiple products in the same production set up. Many of our products are jointly produced with a few being classified as by-products. This is unlike the yester years when we used to produce only a few types of rectifiers. Today, we have diversified into Thyristors, Diodes, Transistors, ICs and other electronic components. One major reason for the inventory build up is the Joint nature of production. Take the example of Rectifiers. A production run of a typical batch of Rectifiers yields multiple quality products having different characteristics and sales value. The initiation of a batch of products yields 5-6 different quality finished products. Only if the sales department aligned their budget with batch characteristics the inventory would be minimal. The second reason why inventory piles up is that all Joint Products carry different profit margins and hence the neglect of the lower end. Neither of the two reasons have anything to do with my department. We produce, as per sales requirements and in the process if we utilize capacity, I see no harm. The product once produced would inevitably be sold, in case not today, then maybe later. As far as increasing profitability is concerned, I would like to clarify that I am not the right person to answer your question. The language of accounting has always been so confusing e.g.  I have never been able to understand how profits happen to be liabilities to a business or how are overheads allocated over my department in our monthly MIS.  Maybe, Shyam could educate us on the impact of all this on the commercial front. Also, is it not surprising that almost all the corporate scandals which have happened in the past and because of which we are all sitting over here today, are because of the wrong doings of the accounting and finance function? The same department generates the contentious MIS. Enron and its likes would never have happened had the accounting and finance functions been more moralistic in their approach. 

Rahman Ghazi:  Shalabh has problems with all, be it Accounting, Finance, Marketing or Sales. Let me clarify that production scheduling is the job of the production, planning and control department (PPC) whereas demand is not in our hands.
Gautam Kalsi: Coordination would certainly be of use. Both sales and production are facing the challenge of variables, which are not controllable at their end. The raw material used in the production of semiconductor devices is perhaps more sensitive to environment than the demand of our products in the market. However, Shalabh has raised an important issue of the role of accounting and finance functions in almost all reported corporate scams.  I was reading about the various corporate frauds, which have happened during the past two decades. All of them have the active involvement of the accounting and finance function. The waste management scandal of 1998 involved the increase in asset life base to decrease depreciation. Arthur Anderson was found guilty. The World Com scandal involved the reporting of fake earnings, again by the accounting department. Here the line costs were capitalized rather than being expensed. The Health Scot scandal again involved the fake increase in earnings, yet another involvement of the accounting function. I can go on and on. The bottom line is the involvement of the accounting and finance disciplines in all these wrong doings. Only if morality had prevailed, such wrong doings would never have happened. 

Shyam Banerjee: In my opinion and as mentioned by Vincent, apart from being immoral, incongruent actions are detrimental to the profitability of any company in the long- run.  Low quality products could erode our goodwill, which is a result of decades of hard work done by all of us to reach this position. Surely, none of us would like to see all those efforts going waste, only to allow someone gain a favorable variance .When we produce more than what we can sell; the extra production reduces the adverse volume variance thereby increasing profitability. The finished goods that should not have been lying with us consume a substantial portion of the fixed expenses and hence an increase in the bottom line. In a scenario like ours where a majority of responsibility centers are profit centers, Vincent’s statement makes a lot of sense. However, characterizing all scams as accounting and finance functions wrongdoings would  perhaps be going too far. In case one goes in depth, the role of the accounting and  finance function is not pioneering, i.e. it has not been one of a creator. The founder CEO and Chairman initiated the waste management swindle. CEO Bernie Ebbers affected the World Com fraud. Similarly, the Health Scot scandal happened because of the involvement of its CEO Richard Scrushy. The accounting and the finance functions were mere facilitators of wrongdoings by others; however, there is no doubt that all damages were avoidable if auditors and accountants had stood their ground.

Shalabh Kapur:  The accounting and audit functions are those of a watchdog. If the protector and the savior get involved in facilitating wrong doings, there may be no alternative for improving. I have heard people talk about the role which accounting and modern day finance plays in promoting the worst type of capitalism.  In addition, this language needs to be more transparent and easy to understand. Acharya, you are a qualified Chartered Accountant. What are your views of this function?

Acharya Shashiendra: There is nothing wrong with the profession – what needs to be changed is the attitude of people who are responsible to manage. You will be surprised to know that all the basic concepts on which accounting and finance have been built upon have their roots in traditional religious texts, be it Christianity or Islam or the other Eastern religions .I shall restrict myself to  the Indian  scriptures , known as the Vedas and Upanishads  as I  have been reading them since long. These scriptures subscribe a three-fold structure to the Human Being; the Soul, the Manifested Soul and the Body. The Soul, as understood in them is a part of God while the Manifested Soul is similar, not same. The Body serves as a vehicle for this manifested Soul, which gains strength through the doing of virtuous deeds thereby qualifying to obtain a better Body in the next life. This process repeats until salvation i.e. a stage where the subtle differences between the manifested Soul and the Soul disappear. Desires of the Body that frequently conflict with the needs of the manifested Soul are the hurdles we need to cross. These desires are like liabilities that need to be controlled while a human body makes efforts to perform virtuous deeds for strengthening its manifested Soul. In-born and acquired abilities are used for performing such deeds. Compare this simple three-fold understanding with foundations of Accounting and Finance. Similarities are striking. Let me enumerate them.

One - Separation of Company from its Owners is similar to the separation of the Soul with the manifested Soul. 

Two - The Going Concern concept that treats any Company as continuing in the future is similar to the concept of an eternal Soul.

Three- The objective of wealth maximization or value creation is parallel to the objective of helping the manifested Soul evolve through controlling unholy desires and performing good deeds.

Four- Similar to employees striving to maximize the wealth of the owners the Body operates as a vehicle to achieve the salvation objective of the manifested Soul.  

Five - Just as gains in Owners Capital are measured through the computation of Profits, the evolution of the manifested Soul is measured through the performance of virtuous deeds and vices.

Six - The accrual concept of accounting is inbuilt in the measurement of a Body’s performance e.g. carry forward of virtues and vices from previous lives determine many unexplained inborn abilities and weaknesses in human bodies.   

Seven - Similar to Agency Conflicts in Business, our Body requirements are frequently subject to conflicts with the objective of the manifested Soul. 

Eight - Increased market capitalization of a Business is similar to an evolved manifested Soul; the former facilitates expansion while the latter would help acquire a better Body. 

Rahman Ghazi: That is interesting. Although not exactly the same, similar concepts are understood in Islam where virtuous deeds could help the Soul evolve in order to qualify for Jannat or Heaven. In the belief of Kiraman Katibin, two angels residing on either shoulder of humans record all good and bad deeds. 

Vincent Tophoff: The concept of Soul and the Body being distinct from each other is quite popular and believed by a majority of the world’s populace except perhaps those who would qualify as atheists. In Christianity, we have similar concepts however; we distinguish the Mind from the Body. In addition, neither Christianity nor Islam accepts the concept of reincarnation. 

Acharya Shashiendra: The concept of reincarnation is perhaps the split off point. A majority of people in the East believe that an evolved manifested Soul either merges with the Soul /God (Salvation) or otherwise gets entitled to a better Body , the latter facilitating the process towards Salvation, whereas ,the benefits of Virtues are slightly different in the other systems of thought. However, before this split off, the concept of Body, Soul, Virtues and Vices remain common, with minor aberrations. What gets interesting is that just like the Distinct Entity concept; the concept of Measurement, Accrual and Appraisal become inevitable in the spiritual dimension. 

Gautam Kalsi: Concepts of the Soul get even more interesting in case one reads contemporary quantum mechanics. Many scientists world over are burning midnight oil to understand the possibility of the physical existence of a Soul which is beyond the dimensions of Time and Space.  However, not all amongst us are inclined towards spirituality or for that matter even religion. Ethics need to be driven in from an early age. I remember being taught Moral Science in school with separate classes and exams devoted to the subject.  

Acharya Shashiendra: Spirituality is a subject, which has no end -we can go on and on.  Teaching of Moral Science or Religion is not in our hands. Authorities responsible for the development of curriculum of schools and colleges have to take this decision. Of late, there has been a huge thrust towards the inclusion of ethics in professional accounting and financial courses. Maybe it helps future professionals. However, what makes me particularly happy is the fact that post Enron; all have understood the necessity of Enterprise Governance. . Laws pertaining to conformance are useful, but until performance is evaluated and accountability fixed, Corporate Governance has no meaning. 

Gautam Kalsi: Performance evaluation is fundamental to good governance, however; the benchmarks we make should be realistic and achievable. In case we have shifted our policy towards TQM and JIT we need to look at the Variance Reports accordingly. Maybe it is time that we revised our standards twice in a year; I understand we only do it once as of now. In addition, we could have benchmarks for Inventory. Let incentives be linked to the average value of inventory held. I would request Shyam to suggest me a proper mechanism. Alternatively, we could charge a fixed percentage of the value of inventory as an expense- this may help, as our production floors are all Profit Centers.  

Shalabh Kapur: In a TQM scenario, I do not see the reporting of Production Volume Variance of any use. It puts unnecessary pressure on my department. If standard material prices would be realistic, I am sure the quality of Raw Material would never deteriorate. That would take care of both abnormal material usage and price deviations. The Cost of Quality would also come down. 

Shyam Banerjee: Variance Analysis is a very useful tool for volume-based costs. I agree with Shalabh that the doing away of the computation of PVV would be of help. However, since over 70%  of our costs are volume based, I would suggest the continuation of Standard Costing and Budgeting. .In addition, the other measures suggested by Mr. Kalsi would certainly facilitate goal congruence amongst employees. As far as different profit margins of Joint Products are concerned, I would like to submit that costs attributed to products are for inventory valuation purposes and nothing stops any one of you from adopting the RSV method. Today, we are in a ‘multiple costs for multiple purposes’ era. 

Gautam Kalsi: These measures would take care of the Costing and Budgeting dilemma; however, what is of equal concern to me is an over invoicing issue, which has gone unnoticed by both Accounts and our Auditors. How do we prevent such unwarranted happenings?

Shyam Banerjee: Permit me to say that the issue had come to our notice quite sometime back. An internal enquiry resulted in the sacking of an employee who had been personally benefitting from such deals for long.   The over invoiced figure of the transaction, which happened this year, has been corrected in our books and the amount in dispute has been recovered from that employee. This is the reason why Auditors have been silent in this regard. However, that this practice escaped our notice for such a long time is worrying and as a precautionary measure for the future, we have strengthened internal controls and internal checks to counter such manipulations. 

Gautam Kalsi: I am glad that it finally came to our notice and that our Accounting and Finance section has immediately taken corrective action. I am sure that a good internal control system could help check such malpractices in the future. . I would request all of you to give your suggestions and recommendations on issues discussed today.  You will all agree that the discussions have been useful. Perhaps, we would need to meet once again for finalizing the course of action. Let me once again thank Acharya for spending his valuable time in this meeting and enlightening us about the spiritual dimensions of accounting and finance.  Thank you all. Have a good day.


QUESTIONS
1. Why do finance and accounting professionals consider profit to be a liability? 
2. What are the objectives of financial management?
3. “Standard Costing and Budgeting promote dysfunctional behavior” Do you agree?
4. Do you agree with Shalabh that Accounting and Financial Management promote the worst type of capitalism? 
5. Differentiate between enterprise governance and corporate governance.
6. What is the significance of the statement ‘multiple costs for multiple purposes’? 
7. Do you think that the use of RSV method would be useful for Vinkas General Carbon Ltd?




















Click To Answer


The Joint Cost Issue at Vikas Hybrid Pvt Ltd

The case relates to a Himachal Pradesh based company, which was a pioneer in the manufacturing of solid-state electronic components. The case highlights certain Joint Cost problems, which the company faced while producing multiple products out of the same manufacturing process. The case was worked upon in the mid 1990’s at the Baddi plant in Himachal Pradesh. However, figures used in the case have been changed to maintain company’s privacy. 

 Joint production processes are common in the agriculture industry, the food manufacturing industry, the chemical industry and many others. Examples may include a poultry plant, an oil refinery, a sugar plant , a milk-processing unit and many others.

About Vikas Hybrid Ltd 


Vikas Hybrid Pvt Ltd is a leading manufacturer and supplier of high-quality application specific standard products within the broad discrete, logic, and analog semiconductor markets. Diodes serve the consumer electronics, computing, communications, industrial, and automotive markets. Diodes' products include diodes, rectifiers, transistors, amplifiers and comparators, power management devices, including LED drivers and linear voltage regulators. The Company`s corporate headquarters, logistics centre, and India’s sales office are located in Delhi, India. Design, marketing, and engineering centres are located in Bangalore, India; Taipei, Taiwan; and Wolfsburg, Germany. The Company`s silicon rod fabrication facilities are located in Baddi,(HP) accompanied with two other factories , one of which is exclusively built for the manufacture of rectifiers  , an important product of the company accounting for more than 30% of total cost of production.


This particular factory initiated work in 1992 as professional manufacturer of all kinds of rectifiers. In the past years, by keeping the principle of "Satisfying Customers with Excellent Quality and Superior Services", the company has obtained very good reputation all over India and elsewhere in the world. 


Rectifier and its characteristics’ 

1906 was one of those years that would shape the world for years to come, although few people, if any, realized it at the time. In October 1906, Greenleaf Whittier Pickard (the grandnephew of the poet John Greenleaf Whittier) received a patent on a method for receiving radio signals that included a silicon point-contact diode. {U.S. Patent 836,531 was filed on August 30, 1906 and issued November 20, 1906}. The seed of thought of the use of silicon for controlling waveforms was probably born then, the tree came into being much later. Development in the theory and practice relating to the family of diodes(rectifiers included) has been rather slow.   Although people didn't know for long how point-contact diodes worked, it didn't stop them from manufacturing and using them.  

Rectifiers are used in power supplies to convert alternating current (AC) to direct current (DC), a process called rectification. Rectifiers allow electricity to flow in only one direction.  Rectifiers are in reality diodes, the latter being the electrical version of a valve and early diodes were actually called valves.

Electricity uses up a little energy pushing its way through the rectifier, rather like a person pushing through a door with a spring.  This means that there is a small voltage across a conducting rectifier. It is called the 'forward voltage drop'.

When a reverse voltage is applied a perfect rectifier does not conduct, but all real rectifiers leak a very tiny current of a few μA or less. All rectifiers have a maximum reverse voltage and if this is exceeded, the rectifier will fail and pass a large current in the reverse direction; this is called 'breakdown'/blockage.


The quality concept

The end user primarily assesses the quality of a rectifier by two distinct characteristics viz the swiftness of response in blocking current reversals and the maximum voltage level the rectifier can withstand. However, engineers at the factory are not aware of any method that could be used to produce rectifiers having exact specific characteristics. It has been noticed that every batch produced differs from the other although the conditions in which the manufacturing is done is the same for all batches. In addition, the characteristics of rectifiers within a batch are significantly different. It has been empirically seen that over a period concerning several production runs the distribution of rectifier characteristics resembles a normal distribution.

The production process


Silicon is used as the intrinsic semiconductor, to which the proper dopants are added. A dopant, also called a doping agent, is a trace impurity element that is added to silicon (in very low concentrations) in order to alter the electrical and physical properties of the product. Typically, the production process is initiated with a batch of 60 silicon rods being heated in a furnace with a temperature of around 1400 degree Celsius. The dopants are added in the same process. In case one alters the quantity of dopants one could bring about significant changes in the characteristics of the ultimate product. However, it is difficult to predetermine the exact quality of rectifier, which shall be produced with some standard quantity of dopant added to standard amount of silicon. It has been noticed that the enhancement of one characteristic is accompanied with a reduction of some other quality. In fact, it is extremely difficult to get exact quality of the finished product because a small variation in the temperature of the furnace and variability in gas distribution could alter substantially, the final product characteristic.

Once the silicon rod is heated in the furnace and dopants added, the following process of production is followed;

1. Each silicon rod is cut into 2,000 silicon chips , each approximately the size of a small pebble possibly as big as a black hole.

2. Every chip is subsequently placed between two metallic cylinders and compressed between them.

3. The above mentioned is then enveloped in a glass sleeve which is then heated in order to form the desired bond with the silicon chip.

4. Silver and copper wires are attached after which the finished product is painted and marked with the product name. 

It has been noticed that only 50% of the 1,20,000 chips initiated in production reach step 3. Out of the ones so processed, only 33.33% are saleable as part of the regular product line. 5,000 rectifiers are produced below quality and are sold in the market as seconds. Marketing efforts are not needed to sell these seconds and they are not assigned any inventory value.

Data relating to Cost of Production is given below;


 

Annual Costs (Rs)

Batch Costs(Rs)

Direct Material 1,27,500

Direct Labour   81,600

Variable Overheads 1,17,300

Total 3,26,400 × 20# 65,28,000

Non variable costs## 16,32,000

Factory Overheads## 20,40,000

Total Manufacturing Costs 1,02,00,000


# Production of rectifiers is done in batches approximating 20 Nos in a year.

## Allocated to N Series rectifiers based on direct labour.


ACCOUNTING ISSUES: HOW TO ACCOUNT FOR JOINT COSTS


Direct material and Direct Labour are costs, which can economically and feasibly be traced to the ultimate product, the N series rectifiers. However, Indirect Costs popularly known as Overheads are not directly assignable and hence need to be allocated. It is popularly understood in the industry that a detailed absorption cost per unit is required for decision-making and inventory valuation purposes.

In the case of silicon rectifiers, different quality finished products are created because of differing impurities (dopants) and variable temperature in the furnace. These different quality rectifiers have different sales value; however, the cost to produce them is “Joint”. This implies that Vikas Hybrid has no mechanism to match any of the costs with any of the individual component produced in one batch. Concisely, all costs are incurred to produce rectifiers with varying electrical and physical characteristics.

Allocation of Joint Costs at Vikas Hybrid can be done by any of the following two popularly known techniques;

1. All Joint Costs are divided by the total number of saleable units produced during the process. The method is known as the average or physical unit method. Such a method shall normally yield a different Gross Profit percentage because different quality rectifiers are sold at different sale value.

2. Joint Costs are assigned to units based on their relative sale value e.g. in case Jont Costs incurred for producing products A,B and C are Rs 1,000 and the sale value of the products is Rs 500, Rs 300 and Rs 200respectively , the allocation of cost to “B” is 30% of Rs 1000 or Rs 300 and so on. In this particular method the Gross Margin percentage of all the products remain the same. 


THE DECISION MAKING DILEMMA


The following table provides a list of the sales price and present inventory levels for the N series rectifiers. The projected annual sales and production are also shown. The breakdown of the products in each batch is similar.

TABLE

Product Blockage Maximum Voltage Annual Sales Orders Sale Price per unit (Rs) Current Inventory Annual Production in units

N71 .30 -.79 200 1,05,000 20.40 3,000 95,000

N72 .80-1.25 300 1,35,000 30.60 10,000 1,15,000

N73 1.26 – 1.75 400 1,05,000 35.70 10,000 95,000

N74 1.76 – 2.30 500    35,000 40.80 10,000 55,000

N75 2.31 – 2.80 600    20,000 51 2,000 40,000

4,00,000 35,000 4,00,000

 

(Note : As mentioned earlier, a  typical batch of rectifier produces approximately 5,000 units of the lower quality rectifiers known as Seconds. These rectifiers are not assigned any inventory value and whatever revenue is generated through their sales is credited to miscellaneous income. At present 65,000 such rectifiers are in stock. The demand for such rectifiers is extremely price sensitive. At present Vikas Hybrid sells these rectifiers at a rate of Rs 12.75 per unit.) 


Geetika , a Chartered Accountant had just begun a six months training programme at the Baddi factory of Vikas Hybrid. She was summoned by her immediate senior, Arvind, who called her attention to a order of  6,000 units of series N71 rectifiers. The inventory level of N71 was not sufficed. Since customers were perfectly OK with units that met their needs or exceeded them, Vikas Hybrid could also deliver from the other units of the N series. However, customers were not willing to pay extra for the higher characteristics.

Arvind asked Geetika to decide from amongst the following options;

1. To fill the order with N72 rectifiers.

2. To initiate a fresh batch of production so as to fulfil the order with N71.

3. To turn down the order because of lack of stock.

The fresh batch of production was an extremely good idea, however, it would entail the production of other units along with, thereby increasing inventory. Since Arvind’s performance was evaluated as a function of the “profits generated less inventory carrying cost”, he was not too eager to adopt the second option. Also there was a chance of this increased inventory getting obsolete. All along, Arvind had maintained inventory levels of one months sale as according to him a turnover ratio of 12 times was an appropriate balance between stock outs and excess investment.

Another matter which Arvind discussed with Geetika was an offer which had recently been received from a electrical manufacturing company to buy 4000 units per month of the N series seconds rectifiers at a price of Rs 7.65 per unit. The company was willing to sign a yearly contract for the same. Arvind told Geetika about his discussions on the same with the production manager. Apparently, the production manager was dead against the order maintaining that the price offered was throw away and would not even recover the out of pocket expenses of Rs 16.32 per unit in the production process of the same. According to him, it was silly to lock an order, which would not even recover the variable costs incurred. Arvind , however, was deeply concerned over the growing inventory levels, even though they were carried at zero inventory value. He asked Geetika whether she agreed with the production manager that it was naive to sell seconds rectifiers at Rs 7.65 per unit. According to him, it represented pure profits as seconds inventory was assigned zero value by the cost accounting department.

Another problem which Arvind shared with Geetika concerned a one time Indian Navy  request for bids on1,00,000 units of   N74 rectifiers. The Indian Navy  had asked for a cost plus bid, however, Arvind was not sure about what constituted  cost. Delivery was to be made uniformly for a period of eighteen months at about 5,500 units per month. Although Vikas Hybrid was not dependent on the government, the concerned work on a prestigious new Indian Navy system would certainly enhance its Goodwill.


Questions

1. Assuming zero opening inventory, how should Vikas Hybrid assign the production output (4,00,000 units) to the sales orders (4,00,000 units)?

2. Calculate per unit cost of the series N rectifiers in case an average costing system is used.

3. Calculate per unit cost of the series N rectifiers in case a relative sale value costing system is used.

4. Compute revenue, cost and profit if the order of 6,000 units of N71 was accepted for immediate shipment? Computations need to be done using both physical unit costing and relative sale value costing systems.

5. What should Geetika advise regarding the order of the electrical manufacturing company?

6. Discuss the behavioural implications of using the physical unit method and the relative sale value methods of costing systems?

7. Give your opinion on the price and manufacturing strategy for the Indian Navy contract?



Click To Answer