Influence of ABC and Absorption Costing System on Profit Statement - Assignment Example

The influence of ABC and Absorption Costing system on Riptides’ Profit ment Task Introduction Management Accounting is a discipline that ensures the provision of critical information to the management team of the company to facilitate decision-making. The internal stakeholders consume the information prepared by the management accountants. Costing systems are part of the management accounting techniques that have been implemented in most companies for decades. The primary purpose of the costing systems in companies is to ensure that the cost of production, operation and other activities are determined and controlled. The management accountants extract cost information from past activities and incorporate the data into the company’s accounting system. The information is used to analyse the influence of the company’s undertakings on key accounts such as costs and profits. Therefore, it is fair to mention that the costing systems facilitate decision-making by providing critical information suitable for operation analysis. The common types of costing systems are the activity based costing and the absorption costing system. The paper will provide a profit and loss statement prepared using both the ABC and absorption costing system. In addition, a discussion will be included to explain to Riptide Plc’s manager that the ABC system provides extra information suitable for decision-making. Question 1 a: Conventional absorption costing system Let us determine the absorption rate for the two departments (machine and assembly department). The absorption rate for machine department = (overhead allocated to machine department/ machine hours) = (504,000/420,000) = $ 1.2/ machine hour. Therefore, the overhead cost per product is as below. XYI YZT ABW 1.2 *2 1.2*5 1.2*4 $ 2.4 $ 6 $ 4.8 The absorption rate for the assembly department = (overhead allocated to assembly department/ direct labour hours) = (437,000/530,000) = $ 0.8245/ labour hour. Therefore, the overhead cost per product is below. XYI YZT ABW 7*0.8245 3*0.8245 2*0.8245 $ 5.772 $ 2.474 $ 1.649 Table A: Total cost per unit Product XYI YZT ABW Variable 32 84 65 Overheads: Machine 2.4 6 4.8 Assembly 5.775 2.474 1.649 Total 40.175 92.474 71.449 Table B: Profit Statement Items XYI YZT ABW Total Revenue (price*units) 2,250,000 3,800,000 2,190,000 8,240,000 Expenses (cost/units*units) 2,008,750 3,698,960 2,143,470 7,851,180 Profit 241,250 101,040 46,530 388,820 Question 1 b: the Activity based costing Table C: The overhead costs per unit XYI YZT ABW Machining services = 0,85 0.85 100,000 = 85,000 0,85 200.000= 170.000 0,85 120.000 = 102.000 Assembly services = 0,6 0,6 350.000 = 210.000 0,6 120.000 = 72.000 0,6 60.000 = 36.000 Set-up costs = 50 50 120 = 6.000 50 200 = 10.000 50 200 = 10.000 Order processing = 4,875 4,875 8.000 = 39.000 4,875 8.000 = 39.000 4,875 16.000 = 78.000 Purchasing = 7,5 7,5 3.000 = 22.500 7,5 4.000 = 30.000 7,5 4.200 = 31.500 Total cost 362.500 321.000 257.500 Units 50.000 40.000 30.000 Overhead per unit = 7.25 8.025 8.583 Table D: Total cost per unit (variable cost + overhead) Product XYI YZT ABW Variable cost 32 84 65 Overheads 7.25 8.025 8.583 Total cost 39.25 92.025 73.583 Table E: Profit Statement Items XYI YZT ABW Total Revenue (price*units) 2,250,000 3,800,000 2,190,000 8,240,000 Expenses (cost/units*units) 1,962,500 3,681,000 2,207,490 7,850,990 Profit 287,500 119,000 -17,490 389,010 Question 1 c: Comments Profit statements have been prepared using the ABC system and the absorption costing system. In the process of making the profit statements, the costs incurred by Riptide plc when producing the three products have also been identified based on the two costing systems. Based Table F below, the cost per unit under the ABC system for product XYI, YZT and ABW are £ 39.25, £ 92.025 and £ 73.583. Under absorption costing, product XYI and YTZ cost more than the same products’ costs under the ABC system. However, product ABW cost more under the ABC than it costs under absorption system. Therefore, the differences in the cost of the products under the two costing systems are summarized in Table F below. Table F: difference in costs Product XYI YZT ABW ABC 39.25 92.025 73.583 Absorption 40.175 92.474 71.449 Difference -0.925 -0.449 2.134 Based on Table G below, the profits generated by the three products as determined using the ABC and the absorption system reveal that products XYI and YZT produced more profit under the ABC system than the profits generated by the absorption system with the exception of product ABW, which made a loss in the ABC system. The differences in the gains are shown in the Table G below. Table G: Differences in the profit levels Product XYI YZT ABW ABC 287,500 119,000 -17,490 Absorption 241,250 101,040 46,530 Difference 46,250 17,960 -64,020 Question 2: the managing director’s statement The managing director of Riptide plc is convinced that the ABC system is implemented based on fashion but not due to assertions that it is a source of additional information suitable for decision-making. It can only be said that the manager has not had a real-life encounter with the ABC system. Therefore, his statement is unrealistic for the following reasons. First, it is important to understand the basics underlying both the costing systems. Traditional absorption costing method bases the cost driver on the production volume. Due to that basis, the production costs determined using the method does not capture all the variables in the production process. Therefore, various management practitioners are of the view that the costing system provides in accurate cost estimation. To be specific, the absorption costing method assigns the production costs to the products on the basis of either the machine hours or labor hours or both. It is important to not that in the production process, not only the machine and labor hours are the cost drivers but also other activities. Due to that, the absorption costing system is said to provide distorted cost estimations (Jones 2014, pp. 1-7). Principally, the cost of production are assigned directly to the products under the absorption costing system instead of assigning the costs to activities involved in the production process, then to the respective units to determine per unit cost of production. The process would require the assignment of the overhead costs to various activities in the production process, which are then allocated to the products based on overhead absorption rate as determined using the cost drivers. Therefore, under the method, a reduction in the overhead cost does not mean the identification of the specific cause of the cost; rather it is a general cost reduction. That means, the costing method does not provide information suitable for formulating long lasting solutions to the minimization of the production costs. On that note, it is easier for a manufacturing firm to compromise quality in the name of minimizing the production cost (Stevenson, Barnes & Stevenson 1993, pp. 2-8). Suffice to mention, the traditional absorption costing system assigns the production cost to products based on the indirect cost drivers. That is, there is no certainty whether the determined cost drivers are the actual cost drivers when manufacturing batches of products. The cost assignment procedure is based on the idea that the total cost of producing multiple products are divided by the total units to obtain the cost of producing one unit. In other words, the cost of production, under the system, is generated by all the units produced. What if product XYI needed one more additional process for the completion of its production process than product ABW? It would therefore, mean that that the cost of the additional process when manufacturing product XYI would shared among the three products even though there is no direct cause-effect relationship between the cost and the other two products. The absorption costing system has several steps listed below (Pierce, B. & Brown, R. 2006, pp 2-15). The identification of the indirect production costs. The estimation of the indirect costs of production for a period (daily, monthly etc.). The selection of a cost driver that generates the costs (labour hours or machine hours or both). The determination of the overhead absorption rate (the total cost of running machine/the total machine hours etc) The application of the overhead costs based on the identified overhead absorption rate (Pierce, B. & Brown, R. 2006, pp 2-15). It has been determined that the main issue with the traditional costing system is the basic idea. The method assumes that the products are the cost generators. That is, when products are manufactured, the costs are entirely related to the products. The assumption makes sense when the direct costs are determined with accuracy. However, it is false to assume that all the production costs are generated by products when factoring the possibility of indirect costs. That is, the production costs that are not directly generated by the units produced (Pierce, B. & Brown, R. 2006, pp 2-15). Second, currently, a lot of management accountants have increased their reliance on the activity based costing. The ABC bears the name of the most accurate costing system in the modern world. The management accountants who perform various critical roles in an organization use the ABC to improve the approach to managing activities that form the core of the manufacturing process, not to mention the supplementary activities. It can be said that the ABC facilitates the roles of the management accountants since it provides additional information suitable for accurate decision-making (Letza & Gadd 1994, pp. 2-9). For example, in the above calculations, there are two methods used to determine the cost and profits generated by products XYI, YZT and ABW. Under the traditional absorption costing system, the cost departments are the machine and the assembly department. The costs are allocated to the three products based on the absorption rates determined using the cost drivers (machine hours and labour hours). On the other hand, the activity based costing system has provided additional information regarding the production of the three products. That is, the set-up costs, order processing costs, and purchasing costs. The set of information provide costs that are part of producing the three products. Therefore, the ABC system certainly provides extra information to the management team (Chea, A.C. 2011, pp. 1-5). Management accounting is concerned with the delivery and clarification of the information needed by management at all levels for the following purposes: first, to enhance the formulation of the organization’s policies. Second, to facilitate planning of the organization’s activities in the long-term, medium-term and short-term. Third, to ensure that the organization’s activities are under control. Fourth, to enhance the decision-making process. Last, to improve performance evaluation (Nur Haiza & Hoque 2010, pp. 2). Third, like mentioned above, the activity based costing system facilitates the role of the management accountants by providing additional information suitable for decision-making. Management accounting involves the following procedure: information identification, measuring, data analysation, and communication. The transmission of the information is necessary to enhance informed decision-making to facilitate the achievement of the organization’s objectives (McMullen, Sanchez & Stout 2011, pp. 1-2). It is the obligation of the management accountant to ensure the implementation of the process mentioned above. The role of the management accounting and the management accountant are to plan, organise, control, direct, communicate and motivate (McMullen, Sanchez & Stout 2011, pp. 1-2). Planning is the primary function of the management by means of which the managers decide the goals to be accomplished and the course of actions to be followed to deliver the goals. Planning gives the managers warning of possible future risk and, therefore, motivates them to make an informed decision (De Loo, Verstegen & Swagerman 2011, pp. 1-3). Control is the process that involves the comparison of the actual performance and the planned to identify any possible deviation from the budget. The corrective measure is implemented in the event a deviation is identified. Controlling can be defined as the process of compelling the actual events to conform to the planned events. The management accounting enhances the process by providing performance evaluation reports that compare the actual performance with the expected result for each responsibility center (Yazdifar & Tsamenyi 2005, pp. 1-5). Organization involves the establishment of the structure within which the required activities are to be performed and the assignment of responsibilities to the respective parties. Organizing involves the creation of decision units such as department, sections, and branches. In this case, the management accounting is expected to provide information on the performance of each of these departments (Johnston, Brignall & Fitzgerald 2002, pp. 2-7). Motivation involves the process of influencing human behavior so that the employees identify with the objectives of the corporation and make decisions that enhance the achievement of goals. It has been determined that the employees can be motivated by budgets and performance reports produced by management accountants. However, the objectives can only be a source of motivation when they are challenging but feasible in reality. Communiation is the role that ensures that information is passed from one individual to another or from one department to another. The management accountant enhances the communication process by maintaining an efficient system of communication. The management accounting information system is an example of an efficient information system. Conclusion Based on the above analysis, the traditional absorption costing system assumes that both the direct and indirect costs of production are generated by the produced units. On the other hand, the ABC system identifies cost departments and cost drivers, thus assigns the production costs based on the activities undertaken. It has been proven that the ABC system provides additional information suitable for decision-making. Consequently, the ABC system complements the role of the management accountants. List of References Chea, A.C. 2011, "Activity-Based Costing System in the Service Sector: A Strategic Approach for Enhancing Managerial Decision Making and Competitiveness", International Journal of Business and Management, vol. 6, no. 11, pp. 3-10. De Loo, I., Verstegen, B. & Swagerman, D. 2011, "Understanding the roles of management accountants", European Business Review, vol. 23, no. 3, pp. 287-313. Johnston, R., Brignall, S. & Fitzgerald, L. 2002, "The involvement of management accountants in operational process change: Results from field research", International Journal of Operations & Production Management, vol. 22, no. 12, pp. 1325-1338. 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Stevenson, T.H., Barnes, F.C. & Stevenson, S.A. 1993, "Activity-based costing: An emerging tool for industrial marketing decision makers", The Journal of Business & Industrial Marketing, vol. 8, no. 2, pp. 40. Yazdifar, H. & Tsamenyi, M. 2005, "Management accounting change and the changing roles of management accountants: a comparative analysis between dependent and independent organizations", Journal of Accounting & Organizational Change, vol. 1, no. 2, pp. 180-198. Read More