Management Accounting - Report Example

PART B MANAGEMENT ACCOUNITNG – AN OVERVIEW WITH EMPHSIS ON THE CHANGING NEEDS OF PRESENT DAY COSTING SYSTEMS TO AID MANAGEMENT DECISIONS BY ELIMINATING THE FLAWS OF TRADITIONAL COSTING SYSTEMS 1.0 INTRODUCTION: The design of a management accounting system should be guided by the challenges being faced by managers. There are four important themes on which the managers have to concentrate to ensure success in their decisions affecting managerial planning and control functions. They are: 1. Customer focus – the challenge facing managers is to consider and continue investing sufficient but not excessive resources in customer satisfaction so that profitable customers are attracted and retained. 2. Key success factors – the operational factors like cost, quality, time and innovation are the important factors which a management accountant has to focus relentlessly. 3. Continuous improvement - the managers have to consider the continuous improvement projects undertaken by the competitors to aim and get an edge over the competitor’s activities. 4. Analysis of value chain and supply chain – treating each of the business functions in the value chain as an essential and valued contributor and integrating and co-coordinating the efforts of all business functions in addition to developing the capabilities of each individual business function. For effectively administering the foregoing themes and to provide the most value in performing their problem-solving, scorekeeping, and attention-directing roles employ a cost benefit approach, the managers should give full recognition to behavioral as well as technical considerations and use different costs for different purposes. Modern day management accountants are faced with the problem of inadequacies in the traditional costing systems and are constantly on the lookout for newer methods of collecting and allocating costs to different products/services. 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 is known as unit costing. 2.0 UNIT COSTING - AN INEFFECTIVE COSTING SYSTEM IF NOT INTERPRETED AND UTILISED PROPERLY A UNIT COST also called AVERAGE COST is computed by dividing some amount of total costs by the related number of units. The units might be expressed as hours worked, packages delivered or automobiles assembled. Unit costs are frequently used in financial reports. However for many decisions, managers should take a straight forward analytical approach and think in terms of total costs rather than unit costs. Consider the following example: The data relate to a manufacturing plant of cellular products: Assumptions: For year 2004 Fixed Costs US $ 10,000,000 Variable costs @ $ 60 per unit of phone assembled US $ 30,000,000 Total costs US $ 40,000,000 Assuming that the fixed costs and variable costs for the next year 2005 remain unchanged the following are the budgeted costs for 2005 at different production levels: UNITS VARIABLE TOTAL TOTAL TOTAL UNIT PRODUCED COST/UNIT VARIABLE COSTS FIXED COSTS COSTS COST 100,000 $ 60 $ 6,000,000 $ 10,000,000 $ 16,000,000 $ 160 200,000 $ 60 $ 12,000,000 $ 10,000,000 $ 22,000,000 $ 110 500,000 $ 60 $ 30,000,000 $ 10,000,000 $ 40,000,000 $ 80 800,000 $ 60 $ 48,000,000 $ 10,000,000 $ 58,000,000 $ 72.5 1,000,000 $ 60 $ 60,000,000 $ 10,000,000 $ 70,000,000 $ 70 A plant manager who used the 2004 cost of $ 80 per unit would underestimate actual total costs, if for year 2005 the total output is below the year 2004 level of 500,000 units. If the actual volume in 2005 is only 200,000 units due to some factors on which the company has no control, actual costs would be $ 22,000,000. Using the unit cost of $ 80 times 200,000 units predicts $ 16,000,000 which underestimates the actual total costs by $ 600,000 ($ 22,000,000 actual cost minus $ 16,000,000). An over reliance on unit cost in this situation could lead the plant manager to have insufficient cash available to pay costs if volume declines to 200,000 units. For decision making the managers should think in terms of total costs rather than unit costs. 3.0 ACTIVITY BASED COSTING SYSTEM (ABC SYSTEM) and ACTIVITY BASED MANAGEMENT AS AN ALTERNATIVE TO TRADITIONAL COSTING SYSTEMS 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. Having analysed the fundamentals of ABC system, like features, steps involved in implementing the system, finding out the indirect cost allocation for the different activities as cost drivers in Part A of this assignment, the following describes various other systems and tools of costing in relation to ABC system. 3.1 ACTIVITY BASED COSTING SYSTEM AND DEPARTMENT COSTING SYSTEMS Companies very often find it convenient to have costing systems that have the feature s of ABC systems such as multiple cost pools and multiple cost allocation bases –but that do not emphasise individual activities. Many companies have evolved their costing systems from using a single indirect cost rate system to using separate indirect-cost rates for each department like design, manufacturing, distribution etc or sub departments like machinig, and assembly departments within manufacturing. This is done so by the companies because the cost drivers of resources in each department or sub department differ from the single, companywide, cost allocation base. ABC systems are a further refinement of departmental costing system. Using department indirect-cost rates to allocate costs to products results in the same product costs as activity cost rates if 1. a single activity accounts for a sizable fraction of the department’s costs or 2. significant costs are incurred on different activities within a department but each activity has the same cost allocation base or 3. Significant costs are incurred on different activities with different cost-allocation bases within a department but different products use resources from the different activity areas in the same proportions. Where any one of the above three conditions holds, it is enough to use department indirect-cost rates rather than activity rates which pose difficulties in collecting and allotting. 3.2. ACTIVITY BASED COSTING IN SERVICE AND MERCHANDISING COMPANIES Although ABC systems can prove effective in manufacturing companies the utility of the system of costing in service and merchandising areas have many applications. The general approach to ABC in service and merchandising areas is similar to that of applying the costs to the various activities as cost drivers. Here costs are divided into homogeneous cost pools and classified as output-unit-level, batch-level, product or service sustaining, and facility sustaining costs. Such cost pools correspond to the key activities in manufacturing companies. Costs are allocated to products or customers using activity drivers or cost-allocation bases that have a cause and effect relationship with the costs in the cost pool. Service and merchandising sectors also have to confront the problems of measuring activity-cost pools and identifying and measuring allocation bases which shortcoming is inherent in ABC systems. 3.3ACTIVITY BASED COSTING AND VARIANCE ANALYSIS: ABC systems classify costs of various activities into a cost hierarchy –output-unit level, batch level, product sustaining, and facility sustaining. The basic principle and concepts for variable and fixed manufacturing overhead costs can be extended to ABC system. By batch level costs we mean the resources sacrificed on activities that are related to a group of units of products or services rather than to each individual unit of product or service. The variances are calculated on the basis of comparison of actual costs and budgeted (flexible) costs of the individual activity as a cost pool. For illustration purposes the variances in respect of setup costs which are batch level costs in a manufacturing company are calculated by using the following formula: Note: The flexible budget variance for setup overhead costs can be subdivided into efficiency and spending variances: Variable setup overhead efficiency variance = (Actual units of variable overhead cost allocation base used for actual output – Budgeted units of variable overhead cost allocation base allowed for actual output) X Budgeted overhead rate. Variable setup overhead spending variance = (Actual variable overhead cost per unit of cost allocation base – Budgeted variable overhead cost per unit of cost allocation base) X Actual quantity of variable overhead cost-allocation base used for actual output. 4.0 ILLUSTRATION The following illustration strives to show the calculation of product cost in a company where the manufacturing costs are calculated using ABC system UNIVERSAL CORPORATION is a company manufacturing personal computers. Products are: Desk point and Provalue and the illustration provide data for the product Provalue... PART A: BASIS OF ALLOCATION OF INDIRECT EXPENSES The following table summarises the activity cost pools, the cost driver for each activity and the cost per unit of cost driver that the company uses as an allocation base for each indirect manufacturing cost pool are: MANUFACTURING DESCRIPTION OF COST COST PER UNIT ACTIVITY ACTIVITY DRIVER OF COST DRIVER Ordering and Placing orders and receiving Number of orders $ 80 per order Receiving components Testing and Testing components and Testing-hours $2 per testing hour Inspection final product Rework Correcting and fixing Re-work hours $ 40 per re-work hour Errors and defects The other assumptions are: 1. Direct Material costs per unit of Provalue are $460 2. Direct Manufacturing labour-hours required to manufacture Provalue equal 480,000 (3.20 direct manufacturing labour-hours per unit of Provalue x 150,000 units) at a cost of $ 20 per direct manufacturing labour hour. 3. Direct fixed costs of machines used exclusively for the manufacture of Provalue total $11,400,000 representing a capacity of 300,000 machine hours at a cost of $38 per hour each unit of Provalue requires 2 machine hours. Hence the entire machining capacity is used to manufacture Provalue (2 machine hours X 150,000 units = 300,000 machine hours. 4. Number of orders placed to purchase components required for the manufacture of Provalue is 22,500 at a cost of $80 per order 5. Number of testing hours used for Provalue is 450,000 (150,000 units are tested for 30 hours per unit) at a cost of $2 per testing hour. 6. Number of units of Provalue reworked during the year is 12,000 (8% of the 150,0000 units manufactured) Each unit requires 2.5 hours of rework for a total of 30,000 hours ( 12,000 X 2.5 hours) at a rate of $40 per rework hour. PART B: MANUFACTURING COST USING THE ABC SYSTEM Description of Cost and Total cost Cost Per Unit The quantity of activity used Total Cost/150,000(being qty produced) By the provalue Direct Manufacturing costs Direct Material $ 69,000,000 $ 460 150,000 units x $460 Direct Labour 9,600,000 64 480,000 hours x $20 Direct Machining costs 11,400,000 76 300,000 m/c hrs x $38 Total Direct Mfg costs 90,000,000 600 Indirect Manufacturing costs Ordering and Receiving Costs 22,500 orders x $ 80 1,800,000 12 Testing and inspection costs 4,500,000 hours x $2 9,000,000 60 Rework costs 30,000 hours x $40 1,200,000 8 Total Indirect costs 12,000,000 80 Total Costs (direct + indirect) $102,000,000 $ 680 PART C: PRODUCT PROFITABILITY OF PROVALUE USING VALUE CHAIN ACTIVITY BASED COSTING Total Cost cost per unit Per 150,000 units 2 = (1)/150,000 (1) (2) Revenues $150,000,000 $1000 Cost of goods sold Direct Material costs 69,000,000 460 Direct manufacturing costs 9,600,000 64 Direct machining costs 11,400,000 76 Indirect manufacturing o/h costs 12,000,000 80 Total Cost of goods sold 102,000,000 680 Operating Costs R&D costs 5,400,000 36 Design costs of products/processes 6,000,000 40 Marketing costs 15,000,000 100 Distribution costs 3,600,000 24 Customer-service costs 3,000,000 20 Total operating costs 33,000,000 220 Full cost of the product 135,000,000 900 Operating Income $ 15,000,000 $100 6.0 USING THE COSTING DATA BASED ON ABC SYSTEM FOR DECISION MAKING – ACTIVITY BASED MANAGEMENT SYSTEM The utility and limitations of using ABC system are discussed in detail in Part A of this assignment. One of the major advantage of ABC system is that it helps evolving an Activity based Management system (ABM). ABM describes management decisions that use activity based costing information to satisfy customers and improves profitability. Although ABM has many definitions, the prominent ones are PRICING AND PRODUCT MIX DECISIONS, COST REDUCTION AND PROCESS IMPROVEMENT DECISIONS AND PRODUCT DESIGN DECISIONS. An ABC system gives management insight into the cost structures for making and selling diverse products. As a result management can make pricing and product mix decision thereby improving profitability of the business in the complex competitive environment. Manufacturing and distribution personnel use ABC systems to focus on cost reduction programs and efforts put in this direction greatly benefits the company on the long run. Managers set cost reduction targets in terms of reducing the cost per unit of the cost allocation base in the different activity areas. Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can then work with their customers to evaluate the costs and prices of alternate design choices. REFERENCE Horngren, Foster, Datar c 2002, Cost Accounting A Managerial Emphasis, Prentice-Hall of India Private Limited, New Delhi, India. Read More