Acounting and finance - Essay Example

1.0 INTRODUCTION: To efficiently administer the various functional areas and activities for which the manager is responsible and also to co ordinate these functions and activities within the overall framework of an organization is the two major purpose of an accounting system. Especially the management accounting systems contemplate to analytically measure and report all financial and non-financial information so that the managers can make fruitful and effective decisions to fulfill the goals of an organisation. Thus the focus of the management accounting is mainly internal reporting of the various activities. Modern day management accounting plays a very significant role in both planning and control decisions. Hence in the process of decision making the management accountant has to make a number of realistic and logical assumptions in arriving at an optimal solution for the problem on hand. For enabling the management accountant to take a stand on the various assumptions in the process of decision making, the cost of the product or service is a key element. Traditionally there are various methods of ascertaining the cost of a particular product or service. One of such methods is collecting the various cost elements and allocating them to the particular product or service which is known as unit costing. The other method by which traditionally the costs were determined is standard costing. 2.0 STANDARD COSTING-INEFFECTIVE TOOL UNDER CERTAIN CIRCUMSTANCES As outlined above one of the traditional ways of ascertaining the cost is to apportion a standard cost for each unit based on historical cost data. This system of ascertaining costs and base the managerial decisions has lost significance due to the fact that modern companies tend to have lower truly variable costs as against a very high degree of fixed costs. Also the equipments that are being used have become more complex and specialized and they form a very significant proportion of total costs. In addition organization with a wide range of products has processes which are common to several finished items making cost allocation irrelevant or meaningless. 3.0 ALTERNATIVE TO TRADITIONAL COSTING SYSTEMS-ACTIVITY BASED COSTING SYSTEM (ABC SYSTEM) An alternative to the traditional costing systems, modern day multi process business corporations adopt the activity based costing system which has proved a real tool in the hands of the managers for making proper business decisions. The activity based costing system is a refinement of the costing system in which focus is centered on the individual activities as the fundamental cost objectives. An activity in an organization may take the form of an event, task or unit of work with a specified purpose. To illustrate; the design activity, set up activity, manufacturing operations, shipping activity, distribution activity and administrative activity can form the basic key costing elements for the refinement of the costing system and thereby to arrive at the proper cost of a particular unit or service. ABC system aims at calculating the costs of the individual activities and assign costs to cost objects such as products or services on the basis of the activities undertaken to produce each product or service. 3.1 FEATURES OF ABC SYSTEM OF COSTING Fundamentally there are three distinct features of the activity based costing system: They are: 1. ABC system works by creating smaller cost pools linked to different activities. Traditionally organizations used to have single overhead cost pool related to several cost pools. 2. For each activity-cost pool ABC system aims to measure the activity performed and have this as the base. 3. In some cases costs in a cost pool can be identified and traced back to a particular Product or department or service and such kind of direct tracing of costs improve the cost accuracy as no assumptions are made to allocate the common costs. The logic behind the working of the ABC system of costing is that the more we create finely structured activity-cost pools, greater is the possibility to arrive at the accurate costing of activities, since the activities themselves are the cost drivers for the cost pools. 3.2. STEPS INVOLVED IN IMPLEMETING ABC SYSTEM OF COSTING Before analyzing the steps involved in setting up and implementing ABC system of costing one should understand the cost hierarchy which term signifies the categorisation of costs into different cost pools on the basis of the different types of cost drivers or cost allocation bases or different degrees of difficulty in determining the cause and effect relationships. ABC system basically use a four part cost hierarchy or categorisation namely: Output unit level costs, Batch level costs, product or service sustaining costs and facility sustaining costs. Based on these categories of costs the following steps are to be performed in effectively implementing the ABC system of costing: 1. Identify the chosen cost objects: this may be aimed at calculating the total cost of manufacturing and distributing certain products of the organization. 2. Identify the direct costs of the products: This step involves identifying the direct material costs, direct labour costs, maintenance and other costs directly associated with the product or service. 3. Select the cost-allocation bases to use for allocating indirect costs to the product or service-this step will involve selection of the individual activity associated with the product which will serve as the base for allocating the cost. 4. Identify the indirect costs associated with the each activity or cost allocation base -in this step the overhead costs incurred by the organization are allocated to the different activities as much as possible on the basis of the cost and effect relationship or the benefits derived from such activity. 5. Compute the rate per unit of each cost allocation base used to allocate indirect costs to the products. 6. Compute the total indirect costs allocated to the products 7. Compute the total costs of the products by adding all Direct and Indirect costs assigned to them. One of the key features of the ABC system is that this system identifies all costs used by the product or service irrespective of the nature of the costs whether they are variable or fixed in the short run. The second important feature is the identification of cost hierarchy, as cost hierarchy greatly facilitates the allocation of costs. In ABC system, emphasis is put on arriving at the total cost first and the unit activity cost is arrived at by dividing the total costs by the number of units of the respective activity. 3.3 ILLUSTRATION: The following illustration strives to show the collection of unit cost on the basis of ABC system: ALPHA CORPORATION is a company manufacturing lenses for the rear lamps of automobiles. Products are: Simple lenses S3 and Complex lenses CL5. The illustration Provides data for the simple lenses coded S3.. PART A: BASIS OF ALLOCATION OF INDIRECT EXPENSES The indirect cost pools identified by the company and the indirect cost allocation bases are: ACTIVITY BASE TOTAL OF ALLOCATION INDIRECT COST $ 1. Design activity 100 parts/square foot 450,000 $4500 per sq. foot 2. .Setup activity 2000 set up hours 300,000 $150 per set up hour 3. Manufacturing operation activity 12750 molding machine hr 637,500 $50/molding m/c hr 4. Shipping setup activity 200 shipments 81,000 $405 per shipment 5. Distribution activity 67,500 cubic foot 391,500 $ 5.80 per cubic foot 6. Administration activity 39,750 direct labour hrs 255,000 $6.4151 per labour hr PART B: PRODUCT COST USING THE ABC SYSTEM Description of Cost and Total cost Cost Per Unit The quantity of activity used Total Cost/60000 (being the no of lenses) Direct costs Direct Material $ 1,125,000 $ 18.75 Direct Labour 600,000 10.00 Other direct costs 120,000 2.00 Total Direct Costs 1,845,000 30.75 Indirect costs Design activity cost 30 sq.foot x $ 4500 135,000 2.25 set up activity cost 500 set up hours x $150 75,000 1.25 Manufacturing operation Activity costs 9000 molding m/c hrs x $ 50 450,000 7.50 Shipping set up activity 100 shipments x $ 405 40,500 0.67 Distribution activity 45,000 cubic foot x 5.80 261,000 4.35 Administration activity 30,000 direct labor hrs x $ 6.4151 192,453 3.21 Total Indirect costs 1,153,953 19.23 Total Costs (direct + indirect) $ 2,998,953 $ 49.98 4.0 UTILITY OF ACTIVITY BASED COSTING SYSTEM: The Activity based costing information is being used by the corporations to make decisions on pricing, product mix and cost management decisions. Basically the Activity based costing system leads to Activity Based Management to enable to take quicker and efficient decisions on pricing and product mix situations, cost reduction and process improvement situations, designs and for planning and managing the various activities of the company. 5.0 LIMITATIONS OF ACTIVITY BASED COSTING SYSTEM: Although there are significant merits in using the ABC system, the system is not left with some serious limitations which makes the companies to rethink about introducing this costing system The principal limitations are: 5.1 MORE DETAILED ANALYSIS: The main costs and limitation of ABC system are the details and measurements necessary for implementing the system. Even a simple ABC system requires the management to identify different cost pools or activities and allocate the total indirect costs to those defined activity. These measurements are expensive and prove costly to the management. The activity cost rates are to be reviewed very often and updated. This involves lot of detailed working and costs. Very detailed ABC systems are costly to operate and difficult to understand. 5.2 POSSIBILITY OF ERRORS When the activity based cost pools are to be determined and costs are allocated to those bases there are possibilities that errors may occur in measuring the activities. Such errors may vitiate the very purpose of the detailed costing system and will end in wrong decisions being made on the basis of erroneous cost allocations. When measurement errors are large, activity cost information may be misleading. 5.3 COMPLEX ALLOCATION PROCESS With a detailed working of the activity based cost pools, often it becomes difficult to maintain a simple approach to the costing data and information. During such times, the companies are forced to use substitute allocation bases for which data are readily available rather than the preferred allocation bases. It may also result in the operation staff to have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services. 6.0 USING THE COSTING DATA BASED ON ABC SYSTEM FOR DECISION MAKING One of the pertinent questions is that whether the costing data evolved out of the system of Activity based costing can be used for decision making and if so what is the degree of reliability of such costing information in decision making process. Considering the limitations of the ABC system as detailed in 5.0 above, the costing data in larger organizations evolved from the activity based system of costing are bound to have certain degree of unreliability. In the management accounting reasonable and logical assumptions to certain critical factors are unavoidable and this analogy extends to the cost collection under ABC system also. Hence the collection of costing information and data is bound to have a fair degree of assumptions being made. This is true especially while deciding on the cost hierarchies and the allocation of indirect costs to such cost pools which necessarily needs a certain amount of assumptions. How far to rely on the costing data for major management decisions is a question to be decided based on the individual issues on hand and how it affects the profitability or growth of the company. Since some information is basically needed to arrive at any management decisions, it would be better to rely on the costing data and information collected on the basis of Activity based costing system which provides a reasonable degree of accuracy, although the collection and allocation of costs prove to be more detailed and expensive. REFERENCE LIST Horngren, Foster, Datar c 2002, Cost Accounting A Managerial Emphasis, Prentice-Hall of India Private Limited, New Delhi, India. Read More