Costing Principles in Accounting and the New Activity-Based Costing Systems - Research Paper Example

Running Head: COSTING PRINCIPLES AND ACTIVITY BASED COSTING SYSTEMS Costing Principles In Accounting And The New Activity Based Costing Systems [Name of Writer] [Name of Institution] Costing Principles In Accounting And The New Activity Based Costing Systems Introduction Cost has been described as a forfeit of possessions incurred for a future gain or purpose. The possessions that are sacrificed are in the shape of cash or an equivalent of cash. A future benefit refers to assets such as inventory, apparatus, equipment, property, and intangibles. The expense for a future benefit that lasts simply during the present phase is a cost that is expensed. For instance, the cost of office provisions used in the present fiscal period is classified as an expense because it does not have benefits that carry over to future fiscal periods. A cost purpose is an action or product for that the total or unit cost is to be computed. A cost objective may be the product manufactured or the service delivered, or it may be a department, a course, or a function, all of that are referred to as cost centers. The cost axis is the least unit for that costs are mounted up for reporting and analytical functions. Job-order Organisations whose products or batches of products are treated as individual jobs use job-order costing systems. Airplane producers and parts suppliers for large manufacturing Organisations, such as tool and die shops, are examples of the users of this system. Process Organisations use process-costing systems with homogeneous products such as crude oil, chemicals, and grains. Both job-order and process costing systems function to build up unit costs of production, but since of the inherent disparities in the physical characteristics of the products the two methods vary. Actual Actual costing systems soak up actual direct material, actual direct labor, and actual company overhead into production costs. Normal Normal costing systems absorb actual direct materials and actual direct labor, but absorb estimated company overhead into production costs, by using a predetermined overhead rate. Standard Standard costing systems absorb standard direct materials, standard direct labor and standard company overhead into production costs. Standard costs are estimated costs that may have a close relationship with budgeted costs. Standard costing systems are widely used by manufacturing organisations. (Shank, 1993, 32-33) Absorption Costing The official statement of generally accepted accounting principles, demands that the assessment of inventories by manufacturing firms for external reporting include the full cost, that is, direct materials, direct labor and total company overhead. This system of product costing is called absorption costing or full-absorption costing. (Antos, 1998, 13-14) GAAP also requires that for external reporting actual costs should be used except where the estimated costs are not materially different from actual costs. Direct Costing Direct costing differs from full-absorption costing only in regard to one category of costs, fixed company overhead. Direct costing includes direct materials, direct labor, and variable overhead in the product costs. Fixed company overhead is charged directly to the accounting period. Ending inventory, therefore, never includes any fixed overhead. This system of costing has not been approved for external reporting purposes by GAAP, but may be used for internal purposes. Activity-Based Costing A management tool named activity - based costing (ABC) has turn out to be one of the more extensively clinch of new management styles over the period of the last ten years. Though its nucleus lies in cost accounting, ABC has engrossed the consideration of business managers in general, and has been the focus of researches in the Harvard Business Review and Fortune. Not simply is it a foremost subject matter in business, it has been accepted in parts of government like USA, such as the Department of Defense and the IRS. What commenced as effectively an accounting theme has broadened to the position where it influences virtually all aspects of a company, from manufacturing to marketing. In the early research about activity based costing, the focal point was on the primary notions - fundamentally "theory development." As the theory started to be put into practice, farther-reaching penalties were developed for example, necessitate redesigning performance assessment measures to replicate the new economics revealed by activity based costing. (Hussey, 1999, 15-16) As these annexes of the basic theory started to affect Organisations, academic researchers came to distinguish that reflective realization issues were arising. This in twirl has provided rise to a fragment of the activity based costing research on organizational change. There are two methods of classifying marketing costs. First is the primary account method that identifies the natural origin or subject of expenditure, such as salaries, rent, insurance, and utilities. This is the traditional method of classification used in financial accounting. Second is the activity base method, that identifies the activities, performed in the pursuit of cost objectives. The marketing objectives of obtaining demand (promotional) and servicing demand (physical distribution) include activities such as materials handling, advertising, market research, and order processing. Under the primary account method, costs that are collected in the natural expense accounts are divided into direct and indirect to be charged or allocated to each Service, territory or customer. This method follows traditional accounting procedures. Under the activity base method, all costs are directly traced or allocated to the specific activity. (Leahy, 1998, 2) A unit rate for each activity is developed in terms of the activity's cost driver, the principal cause of the cost incurrence. The objective of marketing cost analysis is to enable the accountant to produce data for management decisions, either by the analysis of the past or the projection of the future. In large organisations, the cost accounting activity may be performed within the marketing division by a marketing controller. Such an accountant may report to the manager of the marketing division and the controller of the corporation as a whole, having a staff relationship with the one and a line relationship with the other. In a small company, the accountant should be prepared for the analytical tasks that marketing cost accounting calls for, even though the greater part of the accounting duties lies elsewhere. Types of expenses do not determine marketing costs; most of the categories of expense encountered in service are also encountered in distribution. However, certain types of costs typically relate only to marketing, namely, Salaries and wages of market researchers, Service value analysts, artists and photographers, and others engaged in advertising and publicity Salaries and expenses of salesmen and commissions on sales Printing advertising materials Entertaining customers Rental of space Packing, shipping, and postage on advertising materials as well as Services Gifts and other promotional items Transportation by land, water, or air Credit and collection salaries and expenses Rent of storage for finished Services The process of marketing activity - based cost analysis involves the following steps. 1. Define the marketing cost objectives, such as Service lines, territories, and customers, and identify the activities that are involved in accomplishing the objectives. It is likely that costs will be accumulated in traditional departments rather than in activities or functions. The materials handling activity may be a marketing function even though it is physically located in the company and charged to a service account. 2. Define the output of the marketing activity. This is not always measurable in terms of number of Services. For example, the output of an advertising department may be information provided, inquiries received from new markets, or number of readers of material published as well as goods and services delivered. 3. Determine the cost drivers that are most likely to cause variability in each activity. In developing the cost drivers, relate the incurrence of the natural costs to the activities performed that may be the outputs of the individual cost center. Shipping department costs may be expressed as per piece shipped or per ton/mile of Service delivered. Billing costs may be expressed per line of invoice typed or per bill mailed. 4. Identify all relevant direct marketing and non-marketing costs that are traceable to the marketing cost objective. Traceable service, engineering, and administrative costs may be considered relevant depending on the purpose of the analysis. 5. Based on the cost drivers selected, allocate the activity costs to the major marketing cost objectives, such as Service lines, territories or customers. (Caplan, et. al, 2005, 1-3) This procedure serves as the framework for decision-making. In studies of actual company practices, more Service lines are added or dropped because of the personal attitudes or prejudices of a top executive than for any other reason. This activity - based analysis provides the objective evidence for adding or dropping Service lines or territories. The illustration 1 shows the calculation of the profitability of Service lines by territories using the activity - based costing approach. The previously described procedures are followed in principle. These procedures are as follows. 1. Identify the activities, such as, advertising, selling, order filling, shipping, warehousing. 2. Accumulate the direct costs and separate them into variable and fixed categories. 3. Determine the basis of variability (cost driver) for each activity. These three steps are illustrated as under. Activity Cost Driver Selling Gross sales, orders received, or salesmen's calls Order filling Number, weight, or size of units ordered Shipping and warehousing Units shipped Credit and collection Number of invoice lines 4. Calculate the activity's unit costs. The unit cost of each activity is determined by dividing the total activity cost by the basis of variability selected. Where conditions justify the practice, the unit cost can be used as the basis for budgeting and for the establishment of standards in a standard cost system. (Brimson, 2002, 1-2) 5. Perform a marginal cost analysis. The accumulation of direct costs and the allocation of indirect costs to marketing cost centers enables management to assign total cost responsibility to each marketing activity. However, the identification of total costs does not always provide relevant information for specific decisions concerning such important functions as salesmen's performance and territorial profitability. (Miller, 2001, 59-63) For example, salesmen are tempted to select Services, customers, and territories that yield them the greatest personal commissions, not those that yield the highest profit margins to the company. Only by applying margin analysis will the company be able to determine profit contribution by Service lines, territories, or other major marketing objectives. Bibliography Antos, John & James A. Brimson, (1994). Activity-Based Management for Services Industries, Government Entities, & Nonprofit Organizations, New York: John Wiley, Brimson, A. James, (2002). Handbook of Process Based Accounting, Leveraging Processes to Predict Results, AICPA. Leahy, Tad, (August 1998). Beyond Traditional Product Costing, Controller Magazine. Caplan Dennis, Nahum D. Melumad, Ziv Amir; (2005). Activity-Based Costing and Cost Interdependencies among Products: The Denim Finishing Company, Issues in Accounting Education, Vol. 20. Pp 1-3. Chatzkel L. Jay; (2003). Knowledge Capital: How Knowledge-Based Enterprises Really Get Built, Oxford University Press, and pp 41-59. Hussey R.; (1999). A Dictionary of Accounting, Oxford University Press, pp 13-21. Miller J. Gerald, W. Bartley Hildreth, Jack Rabin; (2001). Performance Based Budgeting, Westview Press, pp 67-79. Shank, John K. and Vijay Govindarajan, (1993), Strategic Cost Management, New Tool for Competitive Advantage; Boston, Free Press. Read More