Absorption Costing for Welsh Company - Weaknesses and Strengths, Job Order Costing, Process Costing - Case Study Example

Absorption Costing By of Table of contents Introduction…………………………………………..3 Absorption costing……………………………………3 Job costing order……………………………4 Process costing………………………………5 ABC Approach………………………….…...6 Weaknesses and strengths…………………………......7 Absorption costing in the public sector………………...8 Conclusion ……………………………………………..9 List of references……………………………………….10 Essentially absorption costing refers to the means through which all the manufacturing costs are engrossed by units produced. This implies that, the cost of a finished unit in inventory will include direct materials and labor, and both fixed and variable manufacturing overheads. It is notable that, absorption costing is the most preferred method for external reporting as per the Generally Accepted Accounting Principles (GAAP). Absorption costing is fundamental in tracing the variable costs of production and the fixed costs attributed to the production of the product (Riahi, 2001). It is imperative to note that, absorption costing is dissimilar from the other costing methods since it takes into account fixed manufacturing overhead (the counting expenses ) such as factory rent, utilities and amortization (Riahi, 2001). Absorption costing forms three different types of costing, which include job order costing, process and ABC costing. Job order costing Considering the job order costing, the costs are assigned to the product in Batches or lots (Avis & Killick, 2009). Job order method is used in companies that offer bespoke or distinctive products or services. It is common in service industries that, serve customers with inimitable needs. Such services may include tracing of the number of hours spent on each individual client’s account (Avis & Killick, 2009). Fundamentally, the manufacturing cost categories include direct materials, direct labor and manufacturing overhead. All these jobs are counted as inventory until the good or product is sold. It is essential to note that, the job order cost system requires the manufacturing costs recorded in a document called the job cost sheet. This sheet provides a detailed record of the cost incurred to complete a specific job. Consider the following illustrations that, indicates how three kinds of manufacturing costs are allotted in a job order cost system. Direct materials job cost sheet Direct Labor manufacturing overhead Fixed overhead rate It is noticeable that, direct materials and direct labor costs are allotted to jobs differently than manufacturing overhead costs. For instance, the direct costs, requires keeping of track of the costs of specific jobs with a set of records referred to as the source documents. Essentially a source document is a hard copy document similar to the receipt issued after payment (Horngren, Datar & Rajan, 2012). However most companies use paperless system where information is stored in electronic databases. On the other hand, manufacturing overhead comprises of the costs that cannot be directly traced to particular jobs. It is imperative to note that, on assigning these jobs, accountants should use a predetermined overhead rate based on some secondary allotment measure and cost driver. The material requisition form refers to the form that lists the quantity and cost of the direct materials used in a particular job. This is normally done before materials are used on a job. The fundamental purpose of this form is control the physical outflow of materials from inventory and into production. Similarly, a direct labor time tickets refers to a source document that shows how much time a laborer spends on a range of jobs per week. On the other hand, job cost sheet is a document that gives a summary of all the costs incurred on a specific job. Process costing Process costing refers to a costing method where all costs are accumulated for each stage of production and the cost per unit of product is ascertained at each stage of production. This is done by dividing the cost of each stage by the normal output of the stage under consideration. Continuous production, homogeneous products, standardized process, and process-wise collection of costs characterize process costing (Gietzmann & Monahan, 2003). Process costing is advantageous since it helps in the preparation of tender and quotations. In addition, it enhances accurate costs. However, the cost obtained at each process is only historical, which is not beneficial for effective control. More over, the work in progress is normally done on the estimated basis, which leads to inaccuracy in total cost computations. ABC approach ABC costing refers to a costing approach, which allots resource cost objects such as products and services or customers based on the performed activities for the cost objects. The fundamental aspect of this approach is that firm’s products and services are assigned to activities based on the activities that are resource consumption drivers. In addition, the costs are assigned to cost objects based on activities performed for the cost objects (Learning & Teaching, 2002). It is noticeable that, ABC recognizes the direct associations amid the resource costs, activities, cost drivers and cost objects in allotting costs to activities and then to the cost instruments. It is imperative to note that, ABC assigns factory overhead cots to cost instruments such as products by identifying the required resources and activities as well as their outlay and quantity needed to produce the output. It is notable that, ABC approach incorporates an activity, a resource consumption cost driver and an activity consumption cost driver to complete the system cycle. A firm is able to determine the resource costs consumed by activity centers per a unit of an activity. Then the firm assigns the cost of an activity obtained to products by multiplication of the cost of each activity with the amount of the activity consumed by each of the cost instruments (Learning & Teaching, 2002). In case Welsh government needs to adopt ABC approach, it requires a process of three stages. These stages include, identifying of the resource cost and activities. This stage requires conducting of a research analysis to facilitate identification of specific resources costs and activities of Welsh government. The second stage entails the assignment of the resource costs to activities by direct tracing or evaluation and the last stage involves assigning of activity costs to cost instruments based on the apposite activity consumption cost drivers (Kimmel, Wygandt & Kieso, 2011). The final stage requires the mangers and accountants of Welsh government to carry out a careful analysis to determine the proper activity consumption cost drivers. A number of benefits and limitations are attributed to ABC approach. Some of the benefits include, gaining of better profitability measures through accurate and informative product costs and this leads to more accurate product and customer profitability. More over, ABC serves as a better decision-making instrument. This is attributed to the accuracy levels of measurement of the driving costs. In addition, this approach facilitates process improvement through provision of accurate and adequate information that aid in identifying weak points in the process (Young, 2003). On the other hand, ABC is limited in ambiguous cases of activity or resource consumption, which makes it difficulty in finding the specific activity that causes a specific cost. In addition, the costs of the products and services identified by ABC system may omit some costs associated with the products or services, however, GAAP require them to be treated as period cost (Polimeni, 2000). This element renders ABC inadequate. Similarly, ABC system is expensive and time consuming when developing and implementing it. For instance, ABC requires an average of twelve months or more for successful development and implementation. Weaknesses and strengths of absorption costing Absorption costing recognizes the importance of fixed costs in production. In addition, this method is used to prepare financial accounts and it helps in showing less fluctuation in net profit when production remains constant but sales fluctuates. More over, the stock value fluctuation distorts the stock valuation (Lere, 2006). On the other hand, this method is limited in a number of ways, which includes, reduced the practical utility of cost data for control purposes due to a highly arbitrary aspect of apportionment. More over, in this method all the fixed cost is not charged against the revenue of the year in which they are incurred. Instead the fixed cost relates to the opening stock is charged to the current year. This forms an aspect of unsound practice. Under absorption, costing collection and presentation of cost data is not beneficial for decision-making. This is because the process of allotting the product cost a sensible share of fixed overhead obscures cost volume profit association (Lere, 2006). Under absorption costing, behavioral pattern of costs is not highlighted consequently utilization under marginal costing are likely to go unnoticed in absorption costing. Similarly, absorption costing often deals solitary with production costs and ignores selling and administration costs. Absorption costing does not provide an expedient basis for making such computations (Horngren, 2001). The major rationale is to provide cost information for stock estimation and the capacity of reported profits. It is imperative to note that, the decision maker requires knowing that will remain unaffected. Absorption costing in the Public sector Absorption costing is appropriate in the public sector organization s because it serves as a modern method of cost management in service industry (Lucey, 2002). The appropriateness of this method in the public sector is attributed to the aspect of assigning the resources to activities and actions to cost objects based on the expenditure estimates. In this context, the mangers of Welsh government need to have an explicit idea on the application of the actual cost of the processes, operations and departments since they form the foundation of their budget (Lucey, 2002). Similarly, absorption costing is more fitting and appropriate in the public sector organizations because it easily fits with the accounting systems applied. In addition, this method supports performance management and scorecards (Lucey, 2002). In summary, the Welsh government should appreciate the use and the continuing use of absorbing costing because of the mentioned reasons. It is noticeable that. Majority of the public sector organs of the Welsh government embrace the absorption costing because of the pricing, marketing and adverting. Conclusion The absorption costing is highly recommendable for the managers of the Welsh company because of the said benefits (Gox, 2008). Absorption costing for instance, absorption costing recognizes the importance of fixed costs in production. In addition, this method is used to prepare financial accounts and it helps in showing less fluctuation in net profit when production remains constant but sales fluctuates (Izar & Hontoir, 2000). More over, the stock value fluctuation distorts the stock valuation. In this context, ABC approach remains the most appropriate type of absorption costing for managers of Welsh government to put in use. ABC approach enhances the gaining of better profitability measures through accurate and informative product costs and this leads to more accurate product and customer profitability (Gox, 2008). More over, ABC serves as a better decision-making instrument. This is attributed to the accuracy levels of measurement of the driving costs (Rachlin, 2007). In addition, this approach facilitates process improvement through provision of accurate and adequate information that aid in identifying weak points in the process. References AVIS, J., & KILLICK, J. (2009). Performance Management 2010 Edition. Oxford, Elsevier Science. GIETZMANN, M. B., & MONAHAN, G. E. (2003). Absorption versus direct costing: the relevance of opportunity costs in the management of congested stochastic production systems. Champaign, University of Illinois at Urbana-Champaign. GÖX, R. F. (2008). Strategic transfer pricing, absorption costing and vertical integration. Magdeburg, Univ., Fak. für Wirtschaftswiss. HORNGREN, C. T. (2001). Introduction to management accounting. Englewood Cliffs, N.J., Prentice Hall. HORNGREN, C. T., DATAR, S. M., & RAJAN, M. V. (2012). Cost accounting: a managerial emphasis. Upper Saddle River, N.J., Pearson/Prentice Hall. IZAR, R., & HONTOIR, J. (2000). Accounting, costing, and management. Oxford, Oxford University. KIMMEL, P. 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Techniques of management accounting: an essential guide for managers and financial professionals. New York, McGraw-Hill. Read More