Necessity of Companies Having Accurate Product Costs - Case Study Example

Necessity of companies having accurate product costs Table of Contents page 3 2. Introduction page 4 3. Importance of accounting : page 5 4. Accounting conventions and the product costs : page 6 5. Conclusions : page 11 6. References : Page 12 Abstract Accounting is one of the core functions of an organization. It is absolutely impossible for an organization to function without an accounting department. Accounting helps an organization realize the financial status of an organization at a particular moment. Business strategies are often formulated with the help of the financial statements formulated by the accounts department. Accounting concepts and conventions can affect the fixing of price of a product or service. Only the accounts department knows about the actual cost incurred to the production of a good or commodity. Apart from the production cost and overhead costs also should be considered while determining the unit price of a product. Accounting conventions are not fixed. It depends on many parameters. These parameters might be changing periodically which in turn forces the organization to revise the price of their products periodically. Because of the fluctuating nature of accounting conventions, and the difference in accounting strategies adopted by different organizations, Kaplan (1988) concluded that Because of the conventions of accounting, most companies dont really know what their products cost. This paper critically evaluates the necessity of companies having accurate product costs. Introduction Accounting conventions are methods or procedures employed generally by accounting practitioners. They are based on custom and are subject to change as new developments arise (Business Definition for: accounting convention, 2009). In business nothing is fixed or independent and everything is related to each other. Production, planning, purchasing, sales, accounting like all the core departments of a business unit function by helping each other. For example, the costing of a product is usually done by the top management team. Only the accounts department knows about the raw material costs, production costs, transportation costs, overheads of the firm etc which needed to be considered while deciding about the unit price of the product. In other words, the top management needs the feedbacks from the accounts department in order to determine the unit price of a product. On the other hand, the price deciding entities mentioned above are not constant always. It can fluctuate based on different conditions in the market. For example, currently the steel and iron prices have dipped a lot. The Indian daily, “Financial Express”, reported that flat steel prices saw a fall of Rs 1,000 per tonne in the last two months. The paper also reported that the Steel Authority of India Ltd (SAIL), on Tuesday reduced its flat product prices again by about Rs 500 per tonne (The financial express, 2009). Under the above circumstances car manufacturers can reduce the price at present because of the less raw material cost. On the other hand the iron prices can increase any time and then the car manufacturers will again revise the prices of their vehicles. The exact prices or the price variations of raw materials are accounted by the accounts department based on which the unit prices of the finished good can vary. Importance of accounting Accounting is the language of business which provides information that will help an entrepreneur to make correct financial decisions. An accountant’s job is to give the information needed to the entrepreneur to run the business as efficiently as possible while maximizing the profit and keeping costs low (Label, 2006, p.4). Most of the people who don’t have much idea about the functioning of an organization may think that the accountants are simply doing the credit and debit calculations. But as per the current trends, accountants have significant place in an organization since they are the entity in an organization who know the exact financial climate of the organization. All the transactions related to the organization are brought in front of the accountant’s table from where these transactions attain proper shape. Managers use accounting in production, marketing, research and development and sales etc (Label, 2006, p.6). Even while fixing the price of a product managers or the top management team look for statistics from the accounts department. There are lots of variables which can affect the price of a product. Accurate pricing is essential for the smooth movement of the product in the market. Accounting people are the core entity which helps the managers in determining the price of a product. An organization needs to change the prices of their product or services quiet often because of the fluctuations in the market and accounting conventions. Accounting conventions is a common practice which is followed universally in accounting in order to record and present the accounting information of an organization (Accounting conventions, n. d., p. 38) Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead to a product, many manufacturers assign the expected or standard cost. This means that a manufacturers inventories and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product. Manufacturers, of course, still have to pay the actual costs. As a result there are almost always differences between the actual costs and the standard costs, and those differences are known as variances (Accounting Coach, 2009) Accounting conventions and the product costs “The most commonly encountered accounting convention is the "historical cost convention". This requires transactions to be recorded at the price ruling at the time, and for assets to be valued at their original cost” (Tutor2u, n. d.). Historical accounting cost values an asset based on the price paid at the time of its acquisition. In the example, mentioned above, consider a car manufacturer (Say Ford) has purchased iron before the iron prices started to dip. On the other hand their competitor (Say Toyota) might have purchased iron after the price dip happened. In this case, Toyota will able to reduce the price of their vehicles whereas Ford may face losses if they reduce the prices of their vehicles in order to compete with Toyota. Thus Ford might be forced to stick with the same old prices for their vehicles because of the historical cost convention. Monetary measurement is another accounting convention. Non-monetary items like workforce skill, morale, market leadership, brand recognition, quality of management etc. may not come in the list of accountants (Tutor2u, n. d.). For example, Microsoft is one best examples of monopoly at present. They have recently released their latest Windows operating system version Windows 7. There is no competition for Windows 7 at present. No completion for Windows 7 is not even in the distant vicinity. In the absence of any competition Microsoft will be able to set the price of their Windows 7 at their own will. The consumers cannot neglect Windows 7 even if the price beyond their grasp because of the necessity of such an operating system in the current world. In other words, Microsoft would be able to set a much higher price for their product than what the Microsoft accountants set for the product based on the actual spending on the development of the Windows 7. Thus, market leadership, monopoly, and brand recognition like non-accountable terms helped Microsoft to set a higher price for their product. Separate entity is the third accounting convention which can affect the cost of a product. It ensures that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business (Tutor2u, n. d.). Some business entrepreneurs ask their organization to add their personal expenses also with the company expenses. For example, Suppose Bill Gates asks Microsoft to include his and the direct board member’s personal expenses also with the company account. In such case, the Microsoft accounting people would be forced to increase the price of the Windows 7 even further up. Realization is the fourth accounting convention which can affect the product pricing decisions. It determines whether a revenue or expense has occurred so that it can be measured, recorded and reported in the financial reports. In general, revenue is recognized along with the associated expenses when an exchange has taken place, the earnings process is complete, the amount of income is determinable, and collection of amounts due is reasonably assured (Accounting concepts, n. d.). Suppose India has imported certain nuclear reactors from America two months before when 1 dollar value was equivalent to around 50 Indian rupees. Now, 1 dollar = approximately 46 Indian rupees. If India is paying for the imported goods now, they need to pay less because of the destruction in dollar value at present. In other words, suppose the deal was agreed for $100000 (100000 x 50 = 5000000 Indian rupees) two months before. Now at the time of realization, India needs to pay only 4500000 Indian rupees (100000 x 45 = 4500000 Indian rupees). Materiality is the fifth convention which states that the significance of an item should be considered in order to determine, what is reported. (Bean counter, n. d.). In other words materiality is a judgment about the significance of a product to a user. For example, a computer operating system is essential for a computer user whereas an OS may not be significant to a person who doesn’t have a computer. A person with a computer may purchase Windows 7 even if the cost was too high whereas a person without a computer may not bother about the price of Windows 7. So materiality of product can affect the decision making of the pricing of a product. Consistency is another accounting convention which can affect the pricing of a product. Accounting standards are undergoing changes over a period of time because of the changing technologies and new concepts in business. For example, globalization has drastically changed the whole traditional business concepts. Accounting also has changed a lot because of globalization and changing business principles. For example, method of charging depreciation and valuation of unsold goods are some of the consistent accounting principles followed by a business man year after year (Accounting conventions, n. d., p. 38). But the norms followed for valuing such goods may change over a period of time. For example, some accountants value the price of the unsold good based on the value of it at the time of production whereas some others value the price of unsold goods based on the price of those goods at the end of the year when they take the inventory of unsold goods. Conservatism is another entity which can be considered as an accounting convention. “Accounting conservatism will recognize all probable losses as they are discovered and most expenditure as they are incurred (Investopedia, 2009). Conservatism is based on the principle that Anticipate no profit, but provide for all possible losses” (ACCOUNTING CONVENTIONS AND STANDARDS, n. d p.38) Most of the Businesses sell goods for cash and credit. It is not possible for the business people to recover some credits given. Such credits would be written off at the end of the year. Even if it is written off it should be accounted. It is evident that a business man loses some amount while writing off the credits. At the same time, these written off credits may force the business man to increase the price of his products in order to recover his lost amount. Thus, conservatism can also affect the pricing of a product. Conservatism convention works based on the principle of showing minimum profit to the external world. “If profit shows more than actual, it may lead to distribution of dividend out of capital. This is not a fair policy and it will lead to the reduction in the capital of the enterprise” (ACCOUNTING CONVENTIONS AND STANDARDS, n. d p.38). Thus conservatism put a strong control over the profit statement in accounting. ‘Product pricing decision makers’ may tend to follow the balance sheet produced by the accounts department with the help of the above mentioned conservatism, which may force them to put higher prices. For example, conservatism tries to show low profit on papers even though the actual profit might be much more than the one shown in the paper. This low profit on paper may force the ‘Product pricing decision makers’ to increase the price of their product to increase the profit. Accounting conventions is one of the major variables in the pricing of a product. It can affect the costing of the product in many ways; sometimes positively and sometimes negatively. It is impossible to avoid accounting conventions while determining the price of a product. At the same time, it is not possible to fix the price of a product base on the accounting conventions alone. Reputation or brand value of a company plays a vital factor while fixing the price of a product. For example, Sony is charging around $ 700 for a Liquid Crystal Display (LCD) Television “Bravio” series of size 32 inches. On the other hand Samsung is charging around $ 500 only for the same sized LCD television. In other worlds, Sony is charging more because of their better brand value. If, Sony is considering only the accounting conventions, they can also sell the Bravia LCD series for around $ 500. In that case, millions of dollars Sony spent for developing the brand value will be wasted. So an organization cannot depend heavily on accounting conventions while fixing the price of their product. Even companies that once had systems adequate for financial reporting may now have inadequate systems because of acquisitions of new divisions or companies. Usually, the financial systems in the different operating companies will be independent of and inconsistent with each other. They likely make different assumptions about the way factory and indirect costs assigned to products for inventory valuation (Kaplan & Cooper, 1998, p.12) The over emphasize of accounting conventions in the price determining process, has forced Kaplan to make such a comment that most of the companies doesn’t know the actual cost of their products. The decision makers often may not consider all the variables while fixing the price of their product. In some cases they may tend to put higher prices than the actual deserving prices whereas in some other cases, manufacturers give fewer prices to their products than it actually deserves. Conclusions Accounting is one of the core areas of every business organization. The importance of accounting has been changed a lot in the current business scenario. Accountability is an accepted slogan in each business functions at present. Accounting is governed by certain conventions and concepts which can affect every decisions related to it. Product pricing is one of the major areas in business which has heavy dependence on accounting conventions. Conservatism, materiality, realization, monetary measurement, historic cost conventions, consistency etc are some of the accounting conventions which can affect the product pricing which forced Kaplan (1988) to conclude that Because of the conventions of accounting, most companies dont really know what their products cost. References 1. Accounting concepts, (n. d.), Retrieved 05 December 2009 from http://www.cpd.ogi.edu/MST/capstone/AccountingConcepts.pdf 2. ACCOUNTING CONVENTIONS AND STANDARDS, (n. d), , Retrieved 05 December 2009 from http://www.nos.org/srsec320newE/320EL3.pdf 3. Accounting Coach, (2009), Standard Costing, Retrieved 05 December 2009 from http://www.accountingcoach.com/online-accounting-course/30Xpg01.html 4. Accounting conventions, ( n. d), Retrieved 05 December 2009 from http://docs.google.com/viewer?a=v&q=cache:XoU4uKwe_wAJ:nos.org/320courseE/L-4%2520ACCOUNTING%2520CONVENTIONS.pdf+define+accounting+conventions&hl=en&gl=in&sig=AHIEtbRyA-ymUQdbD_IEZ0noQLWXqqnBSg 5. Bean counter,(n. d.), Financial Reporting and GAAP, Retrieved 05 December 2009 from http://www.dwmbeancounter.com/tutorial/theorybook.html 6. Business Definition for: accounting convention, (2009), Retrieved 05 December 2009 from http://www.allbusiness.com/glossaries/accounting-convention/4942643-1.html 7. Investopedia, (2009), Accounting Conservatism, Retrieved 05 December 2009 from http://www.investopedia.com/terms/a/accounting-conservatism.asp 8. Kaplan Robert S. & Cooper Robin, (1998), Cost & effect: using integrated cost systems to drive profitability and performance , Harvard business school press, http://books.google.co.in/books?id=SP4ziJkv3yQC&pg=PA342&lpg=PA342&dq=Kaplan+accounting+conventions&source=bl&ots=vdq1dNs43q&sig=FEbXZ2A2sRoo4QFf5DZ_KDV9wRk&hl=en&ei=vPEZS8vGCs-LkAXHn9nhAw&sa=X&oi=book_result&ct=result&resnum=7&ved=0CBwQ6AEwBg#v=onepage&q=&f=false 9. Label Wayne, (2006), Accounting for Non-Accountants: The Fast and Easy Way to Learn the Basics, Publisher: Sourcebooks, Inc.; 1 edition (June 1, 2006) http://www.amazon.com/Accounting-Non-Accountants-Fast-Learn-Basics/dp/1402206577/ref=sr_1_1?ie=UTF8&s=books&qid=1259923590&sr=8-1#noop 10. Tutor2u,( n. d.), Accounting concept and conventions, Retrieved 05 December 2009 from http://tutor2u.net/business/accounts/accounting_conventions_concepts.htm 11. The Financial Express, (03 December 2009), Steel makers fail to cash in on auto sector demand, Retrieved 05 December 2009 from http://www.financialexpress.com/news/Steel-makers-fail-to-cash-in-on-auto-sector-demand/549202/ Read More