1. Introduction

Welcome to AIM 6202. Today’s discussion sets the stage for what will follow in the course. As managers, information is crucial for you to perform your job effectively. This course deals with the identification, collection and use of relevant information that a manager needs in order to perform various managerial tasks. We will begin by discussing the four types of managerial tasks.

All organizations, be it profit-seeking or nonprofit-seeking, have goals. In order to achieve these goals, managers in organizations indulge in a number of activities. They acquire resources, hire people and engage in an organized set of productive activities that will help the organization to achieve these goals. These activities can typically be classified into four generic types. They are called planning, decision-making, directing and controlling activities. Let me briefly explain what exactly I mean by each one of these types of activities.

Decision-making: Formally defined, decision- making is to choose the best option among the alternative options that are available to you.

What are planning activities? Planning activities involve developing a detailed set of operational and often financial descriptions of what needs to be done in the future.

The third set of activities that managers perform is to run the organization on a day-to-day basis. And this set of activities is what we call as directing activities.

The last set of activities in our list is called ‘controlling activities’. We started off by saying that organizations have goals and the managers want to achieve these goals with the use of physical and human resources. It is important for the managers to monitor, whether the organization is on the right path towards achieving its goals. If the organization is not moving in the right direction, managers have to make the necessary correction. This set of activities is referred to as ‘controlling activities’.

Let me provide you with a concrete example. Let's take the example of Disney. In the late nineties, the board of directors decided that Disney should undertake a capital intensive project in order to grow. They had lot of options. They could have expanded their theme park operations in the California or in Florida. They settled on the second option. Again they had to make another decision. They could have expanded the existing theme parks like Magic Kingdom or Epcot or MGM Studios or build a brand new theme park. Disney ultimately decided to build a new theme park and they called it "Animal Kingdom." Managers have to choose one option from among may alternatives and this is what we call as “decision making”.

Disney decided to build “Animal Kingdom” in Orlando. Now, this requires a lot of planning. Disney theme parks are always a nice blend of some reality as well as some fairyland tales. The managers kept the same formula for the new park too. They had to plan on the right mix between the “reality” themed attractions and “fairyland tales” types of attractions. The managers had to come up with a detailed description of all the rides and the attractions that should be built in the park, both in terms of physical resources as

1

well as in dollar terms. We would call such a plan as a “Capital budget” and we will discuss this later in the course.

What are the directing activities? Assume that the new park is built up and open to guests. How many employees are required on a week day morning or on a week end evening? How many buses need to be operated on a given day? What should be done if we are short of a bus driver? Someone needs to take care of all these aspects and make sure that all the operations go through smoothly. This is what I would call as “directing activities” which means running the organization on a day-to-day basis.

Finally, we come to the controlling activities. Assume that the park has been in operation for a few years. We would be interested in learning whether the company’s goal has been accomplished. Are the revenue and profits generated from the new park taking the organization in the right path to achieve the growth goals of the organization? In seeking to answer these questions, management is engaged in controlling activities, which means ensuring that the organization operates in the intended manner and achieves its goals.

As managers, you're expected to be engaged in these four types of tasks. In order to carry out the four types of managerial tasks effectively, you need information. And that's what this course is all about. Let us consider these four types of tasks in a little bit more detail, starting with”decision making”.

Decision making consists of four steps:

Step 1: Specify the decision problem, including the decision maker’s goals.Remember that the organization has goals and everything that we do, should

move the organization closer to achieving its goals. In other words, the decisions we make should help the firm to achieve its objectives or goals. Even with the same or similar goals, different individuals may differ in the factors they consider and the importance they attach to these factors. Understanding these factors that influence the decision makers’ goals and their relative importance is the first step in making effective decisions.

Step 2: Identify options.Usually there are numerous ways of achieving a given goal. If there is only one

unique way of doing things, then there is no decision to be made. By definition, decision making is choosing the best option among many alternatives. However, in some cases there may be very few options…as few as two. Alternatively, in some other cases, there may be a large number of options…as many as several hundred. Identifying all the available options is an important managerial task.

Step 3: Measure costs and benefits to determine the value of each option.There are both costs and benefits associated with each option. The desirability of

any particular option must be determined in the light of its costs and benefits. The net benefit of an option is the difference between the associated benefits and costs and can be

2

called the value of option. Even though, we often measure costs and benefits in dollars, keep in mind that the costs and benefits may be measured in non-monetary terms as well. Also, frequently, the measurement of costs and benefits is subjective and may differ across various decision makers. This may result in different value estimates for the same options for different decision makers.

Step 4: Make the decision by choosing the option with the highest value.Obviously, the best option is the option with the highest value to the decision

maker. After examining the costs and benefits of each of the options, the decision maker has the estimated value (or net benefit) for each option. Assuming that all the pros and cons have been taken into account, the option with the highest value is the most attractive option for the decision maker. So by choosing this option, you have made your decision!

Let me introduce the concept of “opportunity cost” here. An opportunity cost is the potential benefit sacrificed when the choice of one action precludes taking another alternative course of action. Consider a simple example. Let’s say that you go to a restaurant. You have a choice of chicken or fish that you can order from the menu. The opportunity cost of ordering chicken is the foregone pleasure associated with eating fish assuming that you are just going to order one dish. Opportunity costs arise all the time in our daily lives. For example, the opportunity cost for a student to attend college full time is the potential salary that the student could have earned by going to a full time job instead of attending a college. If you have more than two options, then how would you measure opportunity cost? The opportunity cost of any decision option is the value to the decision maker of the best option from among the remaining options. Therefore, usually the value of the chosen decision option exceeds its opportunity cost.

This course is going to be of particular relevance to step number 3 in the decision making framework that I presented some time ago, namely measuring costs and benefits. The four step framework for decision making applies equally to decisions we make in our individual lives as well as in business situations. But there is one important difference. In organizational setting, managers and the organizations frequently have conflicting goals. Unless individual goals are aligned to organizational goals, the decisions made by individuals are not going to be optimal for the firm. In order to align the goals of individuals with the organizational goals, we need to have control mechanisms. We need to have policies and procedures put in place defining acceptable behavior of employees. There has to be monitoring which means enforcement of policies and procedures. We should have incentive mechanisms and constant performance evaluation feedback to make sure that the decision maker considers the organizational goals while making the decisions. We will see more of this in later lectures.

Let us now consider planning and control activities. Actually, these tasks involve decision making too! Remember that a plan is a blue print that specifies the requirements such as physical and human resources and their dollar equivalents for achieving a given goal. There are several decisions that need to be made before this blue print is prepared. For example, in a manufacturing organization typical planning decisions may include deciding on what products to manufacture, how best to make and deliver them to

3

customers and what inputs should be used to produce them. Control activities include keeping a watchful eye on everything we do with a particular focus on whether we are moving in the right direction to achieve our goals. I want to make two important points here:

1) Many decisions have aspects of both planning and control. Even though, I mentioned earlier about the four types of managerial tasks, in reality, it is often difficult to figure out where planning stops and controlling starts and vice versa.

2) The length of planning and control cycle can vary from a few minutes for a short term managerial task to even a few years for a long-term managerial task.

How does accounting fit into this decision framework? The principle role of accounting is to facilitate measurement, in particular, measurement of costs and benefits of decision options. Accounting information is useful to two types of decision makers: decision makers external to the firm and decision makers internal to the organization. Financial accounting is primarily focused on fulfilling the informational needs of parties external to the organization including current and prospective shareholders, lenders, investment analysts, unions, consumer groups and government agencies. On the other hand, managerial accounting is primarily meant to provide information for internal decision makers, namely managers at all levels of the organization.

Let us look at the conceptual view of accounting. Financial accounting provides the summary of all economic transactions between the firm and the external environment. The upper part of the diagram represents these economic transactions. The lower left hand part of the diagram represents the domain of financial accounting. The economic transactions are condensed into summary financial statements, as per GAAP regulations and certified by auditors. The lower right hand part of the diagram represents the domain of managerial accounting. In addition to financial data, non-financial data is also used to generate various managerial accounting reports that are fed to managers inside the organization.

How does managerial accounting differ from financial accounting? Look at the primary users. Ask the question: Who uses these accounting systems? We already discussed that managerial accounting is meant for internal users while financial accounting is meant for external users. Next ask the question whether there are any standards or regulatory requirements? Financial accounting information is produced as per GAAP guidelines and is subjected to auditing. There are no such requirements for managerial accounting information. Third, we can look at the level of analysis in both these accounting systems. What is the unit of analysis for presenting the reports? Financial reports are consolidated summary reports for the whole organization or at best, disaggregated to the level of segments. Managerial accounting reports are specifically tailor made for each decision making manager. Next, we can look at the characteristic

4

that is emphasized in collection and production of information in both financial and managerial accounting systems. Reliability and verifiability are extremely important for financial accounting reports and relevance often suffers at the expense of reliability. For managerial accounting reports, relevance to decision making is very important. Next, we can look at the frequency of reports. Financial accounting reports are produced at fixed intervals…yearly and quarterly. Managerial accounting reports are produced when needed and often at a much greater frequency. Finally, what kind of data is used to generate the reports from both these systems? Financial accounting reports are produced exclusively from past financial data while managerial accounting reports are produced using financial and nonfinancial data. The data includes both past as well as the estimated data for future.

Finally, I want to close today’s discussion with a brief comment about ethics. I don’t have to overemphasize the importance of ethical considerations in every aspect of decision framework. All of us are clearly shocked and dismayed by the seemingly endless stream of corporate scandals over the past few years. Many of these cases involve managerial mismanagement, some are characterized by ethical lapses and in some cases there are alleged criminal behaviors. One important lesson from these scandals is that not only is unethical behavior in business is wrong in a moral sense, but it also can be disastrous from the standpoint of the economy. The Sarbanes-Oxley Act of 2002 is the direct result of such corporate scandals. Keep in mind that ethical considerations play an important role in all managerial tasks such as decision making. Therefore it is important to remember the importance of ethical considerations in the design and implementation of managerial accounting systems.

5