Relevance Lost: The Rise and Fall of Traditional Costing - Essay Example

? Relevance Lost: The Rise and Fall of Traditional Costing Word Count: 1996 Words The traditional costing system had been a very common cost accounting system used during the 19th century. This report discusses the rise and the common use of the traditional costing system within many different manufacturing organizations. The report focuses on the different costing systems such as absorption costing, standard costing and the variable costing system, illustrating both the strengths and the flaws of these costing systems. The basic aim of this entire report is to discuss the rise and fall of the traditional costing system with a focus on the reason as to why the traditional costing system provided a vague picture of the product cost. The report also addresses all the issues and the comments passed upon by the senior management officials of JM Ltd while they were being interviewed. Finally the report elaborates the use and advantage of Activity Based Costing and provides an insight as to the suitability and usage of Activity Based Costing system for manufacturing organizations as compared to the traditional costing system. Introduction Costing is defined as “The establishment of budgets, standard costs and actual costs of operations, processes, activities or products; and the analysis of variances, profitability, or the social use of funds” (Lucey, 1996). With an end to the barter system, money became an important consideration. The introduction of money as a medium to purchase and sell any product or service led to issue of costs. Initially, the manufacturing companies were concerned and affiliated with the with the traditional costing approach in order to ascertain the costs of the manufactured products but later this focus also shifted towards the service industry as well whereby many different service providing organizations used traditional costing principles in order to value their provided services (Kapil, 2011). Problems faced by JM Ltd The cost accounting system is an integral part of an organization which helps in understanding and reviewing the internal financial system. Jarmurph Ltd follows the traditional costing system. The company was founded in 1988 when the traditional costing system was at the peak of its usage and was very much popular amongst manufacturing companies. Manufacturing companies used to value and ascertain the cost of their products using traditional methods such as marginal or absorption costing. Marginal costing is the process through which the variable costs of any particular product are attributed to the cost unit s and the fixed costs are written off against the net contribution. Absorption costing on the other hand absorbs all the costs of a particular product without distinguishing between fixed and variable costs. Unlike marginal costing, absorption costing absorbs the entire costs of a product in the total production costs (Lucey, 1996; Dorf 1994). The issues and the problems existing within JM Ltd have been considered separately as follows: Chief Accountant’s Issue The concepts underlying within JM Ltd are old school and they need proper up gradation in order to understand the complex environment in which the company operates. The chief accountant for JM Ltd believes that there fixed costs do not change; hence there is no use of trying to reduce such costs as they would not get reduced. This concept is not true as fixed costs vary in the long run and they do not remain constant. This can be easily illustrated by the fact when analysing the fixed cost with respect to the number of units produced. If for e.g. the fixed costs of producing 4000 units of any particular are $8000 (Fixed cost per unit would be $2) than these would definitely vary if 5000 units are produced, leading to a reduction in the fixed cost per unit (i.e. $1.6). This is a common misconception that lies within the traditional costing system, people tend to consider that if the proceed generated from an incremental sale is more than the marginal cost, it would lead to cover the fixed cost and eventually make a profit. This concept is only true when the fixed costs tend to be fixed in nature but this is not the scenario as the fixed costs do not remain constant and fixed in the long run and they keep on changing (Mohan et al, 2003). Besides this issue, a single driver is used within JM Ltd in order to allocate costs. This concept and the use of a single driver to allocate and ascertain costs would have been only successful when the company had only 15 product lines. The company currently offers more than 300 products and this makes the manufacturing environment more complex and this makes it difficult to ascertain the proper product costs. A single driver i.e. Direct Labour Hours used within JM Ltd ignores the changes being brought upon in the overhead costs and the process activity. This as a result produces an average result and this average result creates further ambiguity and distorted information with respect to the product costs. The traditional costing system has the tendency to understate the profits of products which are high volume related and if this costing system is used with respect to specialized products, it tends to overstate the profits. This may be the case with JM Ltd whereby the “EventAir” seems to be generating good profits and the other products are deemed to be losing out with respect to profitability (Geri et al, 2005). Another problem that seems evident within the company is the use of Direct Labour as the overhead allocation rate. This overhead allocation rate may not be the correct one considering the fact that the production system has moved from being labour intensive to machine intensive, hence if the machine hours are used as an overhead allocation/absorption rate, it would comparatively give a better view and understanding about the costs of the different products manufactured within the company (Woolf, 1985; Drury, 2008). Production Director’s Concern According to Ellen Stockdale, the production director, the production process within the company seems to work at the optimum level. The only issue that she thinks is worth any consideration is the accounting system. The production director is of the view that the accounting system within the company is not reporting the correct picture of the costs of the company. With a reduction in the use of labour and an increase in the machine usage for the production, the company has moved up its direct labour to other areas of production. Hence it would seem inappropriate to value “EventAir” through the traditional costing method as the product goes through several production setups and different steps and it would not be suitable to assign all overhead costs of such a complex product using the direct labour hours. This is one of the reason that the product “EventAir” is not being properly valued and the accounting system used within the company clearly under values the products because the traditional costing system does not account for other indirect cost with the product itself, rather the indirect costs are totalled up and are absorbed using the direct labour hours (Wisner, 2009). Marketing Director (JM Ltd) Bid Although the company has been using advanced technological procedures and processes in order to manufacture the products within their company, the company is unable to reduce their costs. This is not because the company is performing below par, it is obviously because the company’s costing system is not able to attribute the cost to their respective products and it is because of this reason that the company would have tendered at cost, thinking that they would win the contract, but they did not. This is because the JM Ltd’s traditional costing system would have over rated the costs attributable to protective headwear and body wear products thus leading the company to bid at a higher rate whereas they should have made a lower bid. This has been an issue that has been clearly reported by the Marketing Director of JM Ltd (Daly, 2002). Reporting issues to the Chairman (JM Ltd) The company has been performing well with respect to its manufacturing processes. The company has complex manufacturing procedures such as CAD and CAM and these processes are necessary for organisations such as JM Ltd which have a diverse product line. The only problem that has been a major concern within the company is that the company has relied too heavily onto the traditional costing systems. It would have been understood when the company used traditional costing techniques such as absorption costing, marginal costing and standard costing system when they were formed. These traditional costing systems would have portrayed and reflected proper results when JM Ltd only had 15 different products but these traditional costing techniques become less effective when a company enhances its product line. JM Ltd’s current product line has crossed over 300 products and it is because of this reason that the traditional costing techniques cannot properly value the products because of the shift to machine intensive and more technological production methods (Myers, 2009). It would be clearly appropriate for JM Ltd to introduce Activity Based Costing within their company. This new method would align with the complex and the diverse nature of manufacturing and products prevailing within the company. This method would help the company towards proper reporting of product costs and would further lead the company to focus on those areas which are costly and are less profitable. After adopting the ABC costing technique, the company would be able to point out towards those products which are in fact loss leaders, but on the contrary, they are being reported as profitable (Akyol et al, 2005). “Activity-Based Costing (ABC) is a cost accounting method used for understanding product, service and customer cost and profitability” (Mihut et al, n.d.). Unlike traditional cost allocation methodologies, the ABC system provides better and meaningful information which can be used by the company to price a particular product and also determine the profitability of that particular product. The issues that are usually encountered within the traditional costing techniques are that the company overhead costs such as indirect costs are assigned with respect to an activity’s direct costs, this technique seems clearly biased as any specialised product would not only use the same material and labour as that of a standard product but it will also consume additional overheads such as other costs of inspection, more quality checks (same as the one with respect to “EventAir”) (The Economist, 2009). Under the ABC system, the cost drivers would be ascertained. Cost drivers are considered to be those factors that change the cost of any particular activity (Cokins, 2001). These cost drivers would be used in order assign costs to products with respect to the usage of those activities. Conclusion and Recommendation Proper implementation of the ABC system requires a thorough detail of the production system and this information usually lies with at the discretion of the production director i.e. Ellen Stockdale in JM Ltd (Ayvaz et al, 2001). The production director seems really keen in providing all the necessary information as she totally believes that the technologically advanced production methods employed within JM Ltd (such as Computer Aided Manufacturing) would never lead to inefficiencies within the production system. According to her, the accounting system needs some change and this change would definitely be achieved by proper implementation of the ABC system. Many commentators strongly believe that proper implementation of the ABC system would definitely lead to greater cost reduction and severe elimination of wastages (Steadman, 2008). The basic problem that lies within JM Ltd is the use of traditional costing system and this can only be corrected if ABC systems can be implemented within the company. The company’s diverse product range and the complex environment in which it operates makes it necessary for the company to follow an advanced costing system such as the Activity Based Costing system (Drury, 2008). Although there have been many reported failures of the adoption of the ABC system, if properly implemented, it can result in enhancing competitiveness and profitability of a company like JM Ltd. Reflective Statement Questions Explanation 1. What did I learn from producing the coursework? e.g. about myself, the subject, my research techniques, my planning and time management skills, my motivation etc. The coursework helped me in getting an insight towards the different costing methods and gave me a better understanding of the traditional costing method and the activity based costing method. The entire paper led me to search for different publications, articles and books throughout the internet. I also accessed online library in order to find different books and articles published on the above mentioned costing issues. I had to plan my entire paper beforehand because of the lengthy nature of the paper and the fact that I would have to search for many different sources throughout the internet. I gathered all the necessary information and later on used it to draft my paper. 2. What problems did I encounter when completing the assignment (if any)? e.g. with resources, with the teaching strategies adopted, with the level required. It seemed really difficult at first to gather the entire necessary information but once I got hold of the information, the most difficult part was to properly structure the paper. It was really difficult to use all the aspects found within the information and answer the question. The information was found abundantly and it seemed a problem while structuring the paper properly. 3. What would I do differently next time and what would have enabled me to do a better job? I would like to structure my paper in a much better way the next time I complete the paper, though I think that I have done fair but I wanted to prepare the report in a much better way. Besides the structuring, the information gathered, was not properly analysed because of the excessive load of information. I would definitely want to skim the best information from the entire data that I collect in order to provide a much better paper next time. 4. When completing the assignment, which learning outcomes did I find easiest / perform best at? (you may give reasons for this) The easiest and the best performing learning outcomes were to understand, explain and relate traditional costing methods with that to the scenario. The flaws of the traditional costing systems were clearly linked to the scenario hence making it easy to understand the issues with the traditional costing systems 5. When completing the assignment, which learning outcomes did I find most difficult / perform worst at? (you may give reasons for this) The structuring of the report seemed to be the most difficult part within the entire report. The excessive data gathered on the subject matter led to confusion as to how the entire data should be properly utilized within the report. 6. Do I honestly believe that I have performed to the best of my ability? I sincerely think that I have performed to the best of my abilities in writing the paper, though I think that the structure of the report may be a bit weak but the information gathered in order to answer the question was immense and this led to the major confusion as to which information should be incorporated within the report and which should be excluded. Bibliography ABDUL KHALID, S. 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