A Big Portion of Managerial Functions - Coursework Example

MEMO The Board of Directors Management Accountant 6 November Topic: Costing Techniques & Budgeting Costing Techniques A big portion of managerial functions is to ensure the resources are used as efficient as possible to meet an organization’s objectives and goals. This management can use management accounting in order to evaluate and analyze organizational performance and hence assist in key decision making processes. A key element in an entity would be its costing approach that would affect how profitability is ascertained and how responsibility costs are evaluated. In this particular paper, activity based costing (ABC) and the more traditional absorption costing would be discussed in line with the company’s operation and their impact on costing compared and analyzed. The aim of this communiqué is help the board members to understand the basic concepts in costing and how the different approaches impact on the profitability of the company as a whole. Proper costing is necessary in order to make important decision such as the amount of productions that is required or the type of products that should or should not be produced. To begin with we shall first define the two different methods of costing Traditional or Absorption Costing Technique Berry limited has been using the absorption costing technique in costing its manufactured products. This particular technique is the simplest and time savings (Edwards, S., 2008). This method is also referred to as full absorption costing where all indirect costs are expensed to a specific products being manufactured. What is basically done is that all indirect overheads are apportioned based on the number of products made. The major assumption made is that all products consume the same amount of resources (Cokins, G., 2001).. This assumption is false with more complex products or in this particular case where there are more than one commodities being produced by the manufacture. The table below gives the cost per unit of each of the products using the absorption costing method Absorption Costing Method Units 20,000 16000 22,000 Direct materials 23.00 28.00 22.00 Direct Labour 30.00 36.00 24.00 Machine Hours 30,000.00 20,000.00 30,800.00 overheads 511410.8911 340940.5941 525048.5149 overheads per unit £ 25.57 £ 21.31 £ 23.87 Total Cost per unit £ 78.57 £ 85.31 £ 69.87 Total Cost £ 1,571,410.89 £ 1,364,940.59 £ 1,537,048.51 Table: Absorption Costing Method From the above table it can be noted that the overhead costs per unit are 25.57, 21.31 and 23.87 for the three products X, Y and Z respectively. In this particular costing the machine hours only were used as the basis for absorption of the overheads. This method is used when sufficient specific cost data is not available to give an indicative costing of each product. This method therefore would be misleading as it would lead to miscalculation of costs and hence there would be errors in determining the proper selling prices. The pricing policy for berry limited is cost plus a mark up and therefore if the wrong cost is obtained an inappropriate selling price would result also. Based on this disadvantage of the easier to perform absorption costing, the activity based accounting method was also proposed. Activity Based Costing Method. As explained above the traditional costing method usually allocates costs based on machine hours. But this method does not take into consideration other activities that are part of the production process and therefore would not be a good indicator of how much overhead is required to complete a single unit of a product (Baker, J. J.,1998). Activity based costing would enable the allocation of overhead costs based on different jobs and functions that have to be undertaken on a particular product such as ordering, transporting, machining and other general factory costs. The basic principle behing this method is the fact that commodities usually take several steps or activities that are followed in order to manufacture a particular product. These steps then are the ones that determine the amount of overheads incurred. In Berry limited an activity based costing system would be different from the original traditional costing system as shown in the table below; Activity Based Costing Method Product X Y Z Units 20,000 16,000 22,000 Direct Materials 23.00 28.00 22.00 Direct Labour (£12 per Hour) 30.00 36.00 24.00 Machine Set up cost (W1) 4.87 3.04 6.08 Machine Ordering cost (W2) 5.26 4.11 6.58 Machine Running Cost (W3) 7.80 6.50 7.30 General Facility Cost (W4) 6.71 5.60 6.25 Cost Per Unit £ 77.64 £ 83.25 £ 72.21 Total Cost £ 1,552,800.00 £ 1,332,000.00 £ 1,588,620.00 Indirect Production costs Cost pools £ Cost drivers Machine set up costs 280,000 Number of batches Material ordering costs 316,000 Number of purchase orders Machine running costs 420,000 Number of machine hours General facility costs 361,400 Number of machine hours –––––––––– 1,377,400 –––––––––– X Y Z Total Machine Hours 30,000 20,000 22,000 72,000 Batches 40 20 55 115 Orders 160 100 220 480 machine set up per batch ( W1) £ 2,434.78 material ordering cost per order (W2) £ 658.33 machine running costs per machine hour (W3) £ 5.83 general facility cost per machine hour (W4) £ 5.02 From the above calculations it can be noted that the key features of activity based costings are the activities or the steps taken by a product from raw material to when it is sold (Emblemsvaring, J. ,2003).. All these activities contribute to the overall cost of the product and hence the all these costs are taken into consideration. In this particular case of Berry limited the activities that have to be considered are machine set up costs, material ordering costs, machine running costs and the general facility costs. Impact of the costing techniques on Revenues X Y Z Activity based costing (ABC) 77.64 83.25 72.21 Absorption costing 78.57 85.31 69.87 Elasticity Elastic demand Elastic demand Inelastic demand From the table above a comparison of the cost per unit of the three commodities has been compared. It can be noted that generally the activity based costing valued the cost of producing product Y and Z higher while the production of product X was lower as compared to using the absorption costing method. The pricing policy of the company is cost plus mark up and therefore there would be need to revise the prices based on the new costs. Product X was initially cost at £78.57 but the new ABC cost is £77.64 which imply that it was overpriced. Also product X had demand elasticity which imply that an decrease in prices would lead to an increase in demand. Putting these two together, the company can take advantage and increase revenues by decreasing the prices to reflect the new costs which would increase the sales volumes significantly and hence more revenue. Product Y was also overvalued and with the revised costs would mean that the products would be more profitable if the sales price was kept constant. However, if a decrease in prices would result into a higher sales volume then a reduction in prices should be proposed as a way of increasing sales revenue. Product Z on the other hand was undervalued in absorption costing and therefore needs to have a selling price that would reflect its actual value. The product had demand inelasticity which means an increase in prices would not affect the demand quantity. This therefore means the company can increase the prices of commodity Z to reflect the new costs and would eventually increase the revenue as the quantity remain the same but prices increase. Conclusion on the impact of costing techniques Based on the above discussion, the following points have been highlighted about the two costing techniques. Firstly, the traditional or absorption costing method where all the indirect overhead were absorbed based on machine hours did not accurately reflect on the actual cost of each of the three different product units. Also based on the multiple products being produced the activity based model was most suitable and would produce more accurate information for proper decision making. The activity based costing uses the steps and activities involved in each of the processes and hence the more accurate estimation of the costs. The costing techniques affect how the end products are priced since the pricing policy is cost plus mark up. Therefore the costs obtained during costing affects the selling price and hence the revenue. With the change in costing method there was need for re evaluation of the impact on the change in prices. Commodities that were inelastic are not affected by changes in prices hence changes can easily be implemented. However, those with elastic demand mean that increase in prices would reduce demand hence when increasing prices a lot of caution should be taken. 2. Budgeting Budgeting has been part of the normal practice in many entities ranging from for profits to not for profits to governmental organization. Budgets are a forecast tool that helps entities to plan for their future operations and activities (Khan, A., & Hildreth, W. B. ,2002).. They assist in resource allocation, planning for eventuality and also setting goals that align with the entity’s main goals and vision. Essentially a budget is a foreword looking tool that has to estimate future activities and transaction and hence ultimate caution needs to be taken to ensure accuracy and reliability (Dugdale, D., & Lyne, S.,2010).. This can be done through consultation and analysis by a management accountant with budgeting experience. Berry Limited plans to carry out a budgeting process and there are usually many reasons for carrying out the costly and time consuming process. Budges provide wealth of value for entities that operate effectively their budgeting systems. Budgeting helps in periodic planning of activities, it helps in controlling through fostering cooperation, communication and coordination, it also provide a framework in which performance evaluation can be done and lastly it can be a motivating factor that propels an entity to achieve its set out goals. In the paragraphs below, a discussion shall be done on the various functions budgeting can play in Berry Ltd and their implication on the overall financial performance. Periodic Planning Budgeting would be help the company to plan for their operation from period to period. This is important since as a business there are production needs that have to be met and sales targets to be set and implemented. All these activities need to be allocated resources and planned for. A well planed entity would be able to put aside sufficient resources to enable it meet its operational and tactical objectives. Planning involves setting goals and targets, putting timelines, allocating resources and assigning responsibility in a particular entity. This would set the vision that would steer the company for the planned period and help it focus. Control The control function of budgeting helps to foster communication, cooperation and coordination within the company. The various individual managers might make their plans but the company’s optimum plan requires a vehicle that would facilitate exchange of ideas among the various segments such as production, sales, administration, finance and logistics. The budget process acts as a way to review and control some process that could be redundant or counterproductive before the final budget is approved. Budgeting for Berry Limited Company would enable it to control its expenditure based on the level of activity and also control the scope of its production based on the various market forecasts. Performance Evaluation Once budgets are made, they are meant to be yardsticks in which the company would evaluate its performance(McCaffery, J., & Jones, L. R. ,2001).. The budgets therefore need to be realistic but too easy to be to achieved without effort and innovation. This brings about the question of who should set the targets. The dilemma here is that if the workers and direct supervisors set targets for themselves they would put them too low that they would easily achieve them and if top management sets targets it might end up setting some unrealistic targets that cannot be achieved easily. Therefore, Berry Ltd would have to decide on how to set its targets which will form the basis for performance evaluation. A bottom up approach would be suitable where the production staff understand the capacity of the machines and ability of the operators better and hence would advice a realistic production figure. Also the sales teams need to set realistic figure given by salespeople who have targets that would align to the company’s. these targets have to be streamlined to ensure that the entire master plan serves all aspects of the company. Motivation Berry Ltd could use the budget as a tool for motivating its staff through a bottom up approach to budgeting. This is because a bottom up is a participatory budgeting process that would increase the motivation of the employees as they would want to meet targets that they participated in setting rather than targets that have been forwarded to them by the management. There would be a degree of ownership of the targets and hence the productivity would inherently be higher than expected. The management could also use targets to motivate the employees by offering bonus and other rewards for those who meet their productivity goals (Brody, P. J., 1995). Effective Budgets For Berry Ltd to have an effective budget it must ensure: That the budget is goal oriented so that it might steer the firm to achieve its goals and objectives. The major goal for Berry Ltd would be to maximize their shareholder’s value by being as profitable as possible The budget should be realistic as opposed to wishful thinking. A realistic budget would enable proper allocation of resources and planning of operations that would achieve results. An effective budget should be participatory as a way of instilling a sense of team play and cooperation. This is a motivating function of the budgeting process that Berry Ltd can benefit from. Through the budgeting process the management can use it to modify the behavior of employees to align with the vision, goals and tenets of the company The control aspect of the budget needs to be used effectively as ayardstick for the evaluation of performance and eventual improvement for the budget planning stages in consequent trading periods. Conflict of the various purposes of Budgets In summary, budgeting is basically a forecasting tool used by businesses to help plan, allocate resource, control, evaluate and motivate its employees. Therefore the tool serves more than one purposes that sometimes could be in conflict with each other. It is therefore needs to be a process of harmonization of the budgets to ensure that every element of the budget is satisfied. The budget conflicts mainly come from the people involved in the budgeting and the different expectations from an organization. In most instances, the employees would love to get the most earnings in terms of salaries for the least job done. On the other hand the management would love to get the most profits from the corporation and thus gain more bonuses at the end of the trading period. Therefore there is conflict with the managements needs for high profits with the workers need for high wages. A bottom up approach would involve more of the workers setting targets and management using those targets to monitor and evaluate performance (Omopariola, O. ,2002).. This approach can be very motivating to the employees but also frustrating to the management. This is because management are responsible for the overall strategy of the company and need to ensure that all activities are geared towards ensuring this goal is achieved. The best way to avert this conflict is to try and ensure that the company’s strategic direction and goal are well known to all the individuals in the company. This would assist them in the decision making process when doing their individual and departmental budgets best on their ability and innovation capacity. The production manager’s proposal of a bottom up approach could have been from his experience of how his team works and what motivates them. When the production is high then higher sales revenues are possible as the volumes increase. Therefore it means that when the production team are motivated to set their own targets they will feel compelled to actually fulfil them and hence it would result to better profit margins for the entire company. Also the process of budgeting from the bottom up would enable the management to understand the various underlying factors that may lead to better performance such as the needs and expectations of the companies. A bottom up approach leads to a win scenario for both the managers and the employees that are involved in the operation of the business. This therefore would lead to a better than expected financial performance and staff satisfaction. References Edwards, S. (Ed.). (2008). Activity Based Costing (Vol. Topic Gateway Series No. 1). CIMA. COKINS, G. (2001). Activity-based cost management: an executives guide. New York, Wiley. BAKER, J. J. (1998). Activity-based costing and activity-based management for health care. Gaithersburg, Md, Aspen. EMBLEMSVARING, J. (2003). Life-Cycle Costing Using Activity-Based Costing and Monte Carlo Methods to Manage Future Costs and Risks. Hoboken, NJ, John Wiley & Sons. http://www.123library.org/book_details/?id=5922. KHAN, A., & HILDRETH, W. B. (2002). Budget theory in the public sector. Westport, Conn, Quorum Books. DUGDALE, D., & LYNE, S. (2010). Budgeting practice and organisational structure. Oxford, CIMA Pub. http://site.ebrary.com/id/10378830. MCCAFFERY, J., & JONES, L. R. (2001). Budgeting and financial management in the federal government. Greenwich, Conn, Information Age. BRODY, P. J. (1995). Technology planning and management handbook: a guide for school district educational technology leaders. Englewood Cliffs, N.J., Educational Technology Publications. OMOPARIOLA, O. (2002). Government budgeting in Nigeria: principles, policies and practices. Ile-Ife, Nigeria, Obafemi Awolowo University Press. Read More