Advanced Management Accounting: Considering Different Forms of Costing - Assignment Example

BRIEFING PAPER By Date : Part A: Briefing Paper To: Board of Directors From: Manager Subject: Considering Different Forms of Costing Besides the basic methods of costing, there are a number of different forms of costing techniques that can be uses by management with each producing a different cost for the product. These differences in costs of a particular product when using the different forms of costing techniques is as a result of the exclusion and inclusion of certain components in product costs. The type of costing that a company chooses can result in substantial differences in costs and as such the management should be keen to choose a costing technique that will benefit the company. Therefore, a company should consider the various forms of costing techniques for the purposes of controlling costs and making some important managerial decisions. The generally-used forms of costing techniques include absorption costing, marginal costing, activity based costing, throughput accounting, target costing and environmental accounting. a) Absorption Costing Absorption costing is a technique of product costing that usually includes an appropriate share of a company’s total overheads in the total cost of a product, which are usually taken to entail an amount of overheads that reflects the effort and time that has been used in producing the product (Garrison, Noreen & Brewer, 2003). In arriving at the costs of the product using absorption costing an organization has to go through a three step-process involving allocation, apportionment and overhead absorption. The first step is allocation that entails a process where cost unit or cost center are identified and then those costs that are associated with each cost center are charged accordingly. Overheads clearly identifiable with costs centers are allocated to these cost centers but costs which cannot which cannot be identifiable to cost centers are allocated to general overhead cost centers. For example the cost of a warehouse security guard will be charged to the warehouse cost center but the heating and lighting costs would be charged to general overhead cost center. Under overhead apportionment an organization will start by sharing out of overheads within the general overhead cost centers between other cost centers using a fair basis of apportionment. After this stage of overhead apportionment, those costs that have been allocated to service cost centers are then apportioned to production cost centers including those that are directly allocated and the apportioned costs. Finally, absorption costing ends with absorbing those overheads that have been allocated and apportioned to production centers into the product cost using overhead absorption rates. An absorption basis is chosen merely based on common sense and a matter of judgment. There are no predetermined methods or rules involved but it is important that the basis chosen reflect the features of a particular cost center in order to avoid any anomalies. Under this method when calculating the cost of sales, those costs allocated and apportioned to non-production cost centers need to be deducted from the production cost. In terms of managerial decision making, absorption cost is less useful because there is no clear relationship between profits and sales volume meaning that if sales volume rises total profit will increase by the sum of the amount of overhead absorbed per unit and the gross profit per unit. Therefore, absorption costing is cannot be an efficient method of monitoring profitability. b) Marginal costing Marginal costing is a form of product costing that entails the allocation of expenditure to production of only variable costs that are said to directly arise as a result of production such as direct labour, direct materials, variable overheads to the production and other direct expenses (Kloock & Schiller, 1997). Fixed costs of production are not taken into account because production usually varies and may result in misleading results. This technique of costing emphasizes the difference between fixed costs and variable costs. Under this method, closing inventories are valued at the marginal or variable production cost unlike in absorption costing that charges inventories at their full production cost which includes absorbed fixed overheads. Therefore, if the opening and closing inventories differ, the profits reported for the accounting period under the two methods of cost accumulation will be different. However, in the long run, total profit for the company will be the same regardless of the method used because in the long run, total costs will be the same in both absorption costing and marginal costing. Marginal costing is considered to be more useful for decision making purposes in an organization unlike absorption costing that is required merely for an organization’s reporting to comply with the accounting standards. In the case of marginal costing, contribution usually changes as the sales volume changes. A rise number of units sold will lead to an increase in profits will by the amount of extra contribution earned. In addition, fixed cost expenditure under marginal costing is constant meaning that this method gives an accurate overview on the effects of changes in sales volume on the company’s cash flows and profits. c) Activity Based Costing Activity Based Costing is form of costing that aims at identifying the factors that cause the costs of an organization’s major activities and using it as a basis of apportioning overheads to products (Drury, 1992). The major ideas behind activity based costing include activities cause costs and producing products creates demand for the activities. The method recognizes the causal relationship between cost drivers and activities through which it assigns indirect cost to products. An activity based costing system operates as follows: identify an organization’s major activities; identify the cost drivers that cause change in the cost of an activity; collect the costs associated with each cost driver into cost pools and charge overhead costs to products based on their usage of the activity measured by the number of the activity’s cost diver that each product generates. Activity based costing assigns a company’s overheads to products in a more logical manner that the traditional approach of absorbing costs. Manufacturing overhead costs are apportioned to products based on the number of the activity’s cost diver that each product generates. The following example illustrates the costs and their possible cost driver. Costs Possible Cost Driver Ordering costs Number of orders Material handling costs Number of production runs Production scheduling cost Number of production runs Dispatching costs Number of dispatches d) Throughput Accounting Throughput accounting is a principle-based approach that is in sympathy with the just-in-time philosophy aimed at providing managers of an organization with decision support information that will help to improve profitability (Corbett, 1998). It follows the concept that a manager has been provided with resources including buildings, labor force and capital requirements and he should use these resources to generate sales revenue. Taking into consideration such a scenario, the most appropriate financial objective is to maximize throughput, which is the sales revenue less direct material cost. Throughput accounting brings change to the way an organization views revenue recognition, profitability and cost by focusing on improving cash flows, increasing revenues and providing capacity. It shifts the emphasis of decision making to maximizing throughput and profitability from the conventional managing costs and budgets. It drives the decisions of management to improve the constraint’s efficiency so as to maximize profitability by ensuring that the organization’s resources support the constraint. Through analyzing the effect on cost and throughput, it provides a way to measure productivity improvement efforts. e) Target Costing Target costing is a technique of costing that entails setting a target cost that is calculated as a difference between the competitive market price and a desired profit margin (Ansari, Bell, Klammer & Lawrence, 1997). It is a system in which an organization plans in advance the product costs and profit margins that they want to achieve for a particular product. If the company cannot manufacture a product at these levels, then it cannot go ahead with the project. Target costing is an important managerial tool that monitors the product throughout their product life cycle towards helping a company achieve consistent profitability. The target cost is calculated by starting with a market based price and subtracting a desired profit margin. Considering the price of a product is set to be $ 17,950 and the company requires an 8% profit margin. The target cost is calculated as $ 17,950 – (8% x $ 19,950) = $ $ 16,514. f) Environmental Accounting Environmental accounting is a technique of accounting that entails identification of the company’s resource used and measuring of costs of the company associated with the impact on the environment (Odum, 1996). These costs may include environmental fines, taxes and penalties, waste management costs, pollution prevention technologies and costs to radiate contaminated sites. However, since business accountability is very complex, environmental accounting is an important aspect of an organization. It may act as a useful way in which a company can help discharge its accountability to the future generations and to the society. In addition, it adds strength to the accountability of a company to shareholders. It also helps as a key measure for encouraging the internal efficiency of operations. Part B: Dribbles Ltd a) Calculation of Ratios for Dribbles Ltd 1) Operating profit percentage Operating profit percentage = Operating profit x 100% Revenue Operating profit percentage 2012 = £ 914 ÷ £ 9,485 x 100% = 9.64% Operating profit percentage 2013 = £ 1,042 ÷ £ 11,365 x 100% = 9.16% 2) Return on capital employed Return on capital employed = Earnings before Interest and Tax x 100% Capital Employed Return on capital employed = EBIT / (Equity + Non-current Liabilities) x 100% Return on capital employed 2012 = £ 914 ÷ (£ 9,813 + £ 1,220) x 100% = 8.28% Return on capital employed 2013 = £ 1,042 ÷ (£ 10,268 + £ 3,675) x 100% = 7.47% 3) Current ratio Current Ratio = Current Assets Current Liabilities Current ratio 2012 = £ 4,926 / £ 1,508 = 3.27 Current ratio 2013 = £ 7,700 / £ 5,174 = 1.49 4) Gearing ratio Gearing ratio = Long-term debt + Short-term debt + Bank overdrafts Shareholders equity Gearing ratio 2012 = (£ 1,220 + £ 1,508) / £ 9,813 = 0.2780 Gearing ratio 2013 = (£ 3,675 + £ 5,174) / £ 10,268 = 0.8618 5) Trade receivables collection period Trade receivables collection period = Average accounts receivable x 365 days Annual sales Trade receivables collection period 2012 = £ 2,540 / £ 9,482 x 365 days = 97.7 = 98 days Trade receivables collection period 2013 = £ 4,280 / £ 11,365 x 365 days = 137.5 = 138 days 6) Asset turnover Asset turnover = Sales Revenue / Total assets Asset turnover 2012 = £ 9,482 / £ 12,541 = 0.7561 Asset turnover 2013 = £ 11,365 / £ 19,117 = 0.5945 b) Analysis of the performance of Dribbles Ltd Ratio analysis is a technique use by companies to evaluate the relationship among the items in the company’s financial statements. It usually focusses on three major aspects of the business that include profitability, liquidity and solvency. The analysis on the results of Dribbles Ltd will be based on these three key aspects. Profitability The key ratios that evaluate the profitability of a company include profit margins, return on capital employed, pay-out ratio and asset turnover. Dribbles Ltd had an operating profit margin of 9.64% in 2012 and 9.16% in 2013. Due to the increase in sales revenue by 19.82% in 2013 we expect the profit margins also to increase and as such the decrease in the operating profit margin in 2013 shows a worsening performance for the company. The return on capital employed in 2012 was 8.28% but in 2013 it decreased to 7.47%. The decline in return on capital employed does not also fair well for the company and as such it should consider looking for ways to maintain or improve this ratio. Dribbles Ltd recorded an asset turnover of 0.7561 in 2012 that later decreased to 0.5945 in 2013. Similarly, this decline is a point of concern for the company. The pay-out ratio is calculated by dividing the cash dividends paid to shareholders by the net income. In 2012 Dribbles Ltd had a pay-out ratio of 0.2247 (£ 120,000 / £ 534,000) in 2012 and 0.2087 (£ 120,000 / £ 575,000). Investors will want to know why the pay-out ratio dropped. Liquidity The key liquidity ratios include current ratio, acid test ratio, trade receivables collection period and inventory turnover ratio. The current ratio for Dribbles Ltd in 2012 was 3.27 but in 2013 it drastically reduced to 1.49. Although the current ratio for both years is above the generally recommended level of 1, the massive decrease shows a weakening performance for the company. On the other hand, the acid test ratio for 2012 was 1.68 (£ 2,540 / £ 1,508) and 2.84 (£ 4,280 / £ 1,508) in 2013, which shows an improved performance. In 2012 Dribbles Ltd had a trade receivables collection period of 98 days while in 2013 it had a trade receivables collection period of 138 days. This increase in the trade receivables collection period of shows a decline in performance of the company. In 2012, the inventory turnover ratio was 3.59 (£ 8,568 / £ 2,386) but reduced to 3.02 (£ 10,323 / £ 3,420) in 2013. Although the decrease is small it still shows a decrease in performance in terms of liquidity. Solvency The key ratios that evaluate the solvency of a company include gearing ratio, debt to total assets ratio and times interest earned ratio. The gearing ratio for 2012 was 0.2780 while in 2013 it was 0.8618. This means that in 2013 the performance went down because the gearing ratio increased. On the other hand, the debt to total assets ratio was 0.2175 [(£ 1,220 + £ 1,508) / £ 12,541] in 2012 while in 2013 it was 0.4629 [(£ 3,675 + £ 5,174) / £ 19,117]. This increase means that the percentage of assets provided by creditors has increased which is bad for the company. The times interest earned ratio for 2012 was 41.55 (£ 914 / £ 22) and in 2013 it was 12.86 (£ 1,042 / £ 81). The decrease shows a decline in the solvency of the company. In summary, after analysing the performance of Dribbles Ltd in terms of profitability, solvency and liquidity of in 2013 was worse when compared to the performance in 2012. The contract the company signed resulted in an increase in the revenues of the company but overall it led to poor performance meaning that the company needs to reconsider this position. References Ansari, S. L., Bell, J., Klammer, T., & Lawrence, C., 1997. Target costing. Irwin/McGraw-Hill. Corbett, T., 1998. Throughput accounting. Croton-on-Hudson, NY: North River Press. Drury, C., 1992. Activity-based costing (pp. 273-288). Springer US. Garrison, R. H., Noreen, E. W., & Brewer, P. C., 2003. Managerial accounting. New York: McGraw-Hill/Irwin. Kloock, J., & Schiller, U., 1997. Marginal costing: cost budgeting and cost variance analysis. Management Accounting Research, 8(3), 299-323. Odum, H. T., 1996. Environmental accounting. Wiley. Read More