Management Activity Based Costing - Research Paper Example

Variances and Activity Based Costing Economic activities require a guideline when being undertaken. The guidelines used include plans that are accompanied by budgets. The budgets outline the costs required to accomplish such economic activities, and the revenue to be realized. Dynamism in micro and macro environments causes actual results to be different from budgeted amounts. Drury (2008) explains that the difference is the variance. The statement below explains the variances for Geeta plc that produced Geeto product. This company budgeted to earn a profit of £ 18,393.3 but ended up earning £ 16,317. Income statement Item STD Q / H Actual Q/ H STD P £ Actual P £ Budgeted £ Actual £ Variance £ Sales Revenue 2,130 2,100 15 14.5 31,950 30,450 1,500 A Less cost of prod. Direct material L10 1,278 1,050 1.55 1.6 1,980.9 1,680 300.9 F L17 1,448.4 1,470 1.75 1.9 2,534.7 2,793 258.3 A Direct labour cost 497 525 7.2 7 3,578.4 3,675 96.6 A Variable production O/H 497 525 2.1 2.4 1,043.7 1,260 216.3A Fixed production O/H 497 525 9 9 4,473 4,725 252 A Total Prod. Cost 13,610.7 14,133 522.3A Profit 18339.3 16317 2022.3 A The variances have been calculated as follows; Sales revenue variance Selling price variance It is given by subtracting the actual selling price from the standard selling price at standard quantity (Drury, 2008). Selling price variance = (£15 - £14.5) * 2130 = £ 1,065A Sales volume variance It is given by the difference between the actual sold and the standard quantities at actual selling price Sales volume variance = £ 14.50 (2130 -2100) = £ 435A Sales revenue variance (SRV) = selling price variance + sales volume variance = £ 1,065 + £ 435 SRV = £ 1,500 A The value obtained is adverse (A) because the sales revenue budgeted decreased. Material cost variance It is made up of the material price variance and the material usage variance Material price variance It is the difference between the actual price and the budgeted price at the budgeted quantity. Material price variance for L10 = (£ 1.55 - £ 1.60) * 2,130 = £ 106.5A Material price variance for L17 = (£ 1.75 - £ 1.9) * 2,130 = £ 426A Material usage variance It is obtained by calculating the difference between the quantity used and the quantity for which, the budget was prepared. Material usage variance for L10 = £ 1.55 * (1,278 – 1,050) = £ 353.4F Material usage variance for L17 = £ 1.75 * (1,448.4 – 1,470) = £ 37.8A Material cost variance for L10 = £ 1.55 * 2,130 * 0.6 – £ 1,680 = £ 300.9F Material cost variance for L17 = £ 1.75 * 2,130 * 0.68 - £ 2,793 = £ 258.3A In the above material cost variances, L10 has a favorable variance because the cost incurred was less than the cost budgeted for whereas L17 has an adverse variance because the actual cost exceeded the budgeted cost. Labour variances Labour cost variance defined by Drury (2008) as the difference between the actual labour cost incurred and the budgeted cost. It is made up of labour rate variance and labour efficiency variance. Labour rate variance is the result of subtracting actual wage rate from standard wage rate at standard hours. Labour rate variance = (£ 7.2 – 7) * 525 * 2130 /2100 = £ 106.5F Labour efficiency variance It is given by the difference between the number of hours budgeted and the actual hours worked for at standard rate. Labour efficiency variance = (14 * 2130 / 60 -525) * 7.2* 2130 /2100 = £ 204.5A Labour cost variance = £7.2 * 14 * 2130 / 60 - £ 3675 = £ 96.6A Variable production overhead variance It is the difference in value of the actual and standard actual variable production. Variable production overhead variance = £ 2.1 * 14 * 2130 / 60 - £ 1260 = £ 216.3A Fixed production overhead variance = £ 9 * 14 * 2130 / 60 - £ 4725 = £ 252A Causes of variances The differences that result from expected results and actual results are caused by either the internal or external factors. A change may occur in the operating conditions of the business unit. Geeta plc experienced variances that may be explained by the following factors: Material price variance maybe caused by; Inflation. The rise in prices makes the prevailing market prices (actual prices) to be higher than budgeted prices. For example, Geeta plc purchased L10 at £ 1.6 per kg that was higher than the budgeted price of £ 1.55kg. Increase in the cost of transportation can also result to higher costs of inputs than what has been budgeted for. Material shortages Market forces make the prices of goods and services increase as soon as a shortage arises. This may be used to explain why the prices of raw materials increased. The price per kg increased from £ 1.55 to £ 1.6 for L10 and from £ 1.75 to £ 1.9 for L17. The price variance can arise as a result of a producer improving on the standard quality of raw materials. It has the effect of increased prices associated with rebranding. Material usage variance The employees may handle raw materials without care. Some raw materials become wastes if not properly used. This will make the producer use more materials than budgeted for. Geeta plc used more L17 than what was budgeted. On the other hand if employees handle materials carefully, wastes can be minimized and less than budgeted quantity will be used. This might be the case of L10 raw materials. The production of more or less quantity brought about by market demand can cause the quantity budgeted to differ with the actual quantity. Geeta plc budgeted to produce 2130 units but instead it produced 2100 units. The inefficiency in the manner in which, machines operate can cause material variance. Some machines may cause the input to be more than output (Lucey, 2002). The material usage variance can also arise due to machines being adjusted poorly. It affects the efficiency of the moving parts of the machines which, wastes raw materials.   Labour efficiency and rate variance Poor working environment as explained by Drury (2008) may cause workers to spend more than in performing their tasks. On the other hand, best working conditions can motivate the employees, and this can make the time taken in producing those units being less than the allocated time. Improper training of workers can make them spend more time in working with machines and producing goods than the hours planned for (Lucey, 2002). On the other hand, proper training and understanding of instructions enable the employees to produce goods using the minimum possible time. Installation of new machines gives the employees the hard time in adapting to the machine usage, and this can cause variation in expected results and actual results. Exit of employees from a company can make new incoming employees to lack experience of working fast. Lucey (2002) explains that the employee turnover can make labour variances arise. In the case of increased and urgent need in the business, the management will engage employees in overtime basis, and this will create labour variance. Lack of motivation in teamwork and incompetency in supervising the employees can allow the loopholes for them to take unnecessary longer time in completing certain tasks in the production process. The economic conditions in the labour market triggered by trade union negotiations may cause the wage rate to increase. This will make the cost of hiring labour force to increase, and this will result in labour variance. A relationship exists between the above variances. One variance can result in another arising. For example, increase in the price of raw materials leads to price variance. In order to minimize costs of production, the accountant responsible will put measures to reduce wastages in the usage of inputs. It will make the magnitude of the material usage variance change. Similarly, increase in demand will make the sales volume variance change. The enterprise’s management will draw a flexible budget to adjust the amount to produce. The available capacity may not allow them to achieve that. The management may engage employees to work overtime which, will change the hours budgeted for causing both labour rate and labour efficiency variance to appear. Activity Based Costing It is a method applied in the accounting system in charging overheads to cost centers. The overheads are incurred in service centers, and there is a need to reassign such costs to other departments. It is a modern approach, where projects are used as the means of allocating costs to production departments or products. It is carried out using the following steps as outlined by Drury (2008); Step one involves noting the activities of the company planning to use it. The production process may involve activities like material handling, making orders, assembling, dispatching, and setting up machines. Using ABC requires such activities to be identified in this stage. Step two involves associating the identified activities in step one with their cost drivers. Cost drivers as explained by Drury (2008), are the factors that cause the volume of any given activity change. In step three, the costs associated with the identified activities are summed up to constitute cost pools. These are total costs for each activity selected. Lastly, step involves the calculation of specific overhead absorption rates and using them to charge overhead costs to departments or products based on the activity associated with the product or department in terms of its usage. ABC is intended to provide a justifiable means of charging support costs to products. This is because of its advantages whenever it is applied in the absorption of overhead costs. Lucey (2002) outlines the following as some of the advantages of ABC; It gives realistic basis for charging overheads to the different cost centers and products. It is true that variable costs change in relation to the production activities. In the cases where variable overheads increase with an increase in the volume of activities, use of a single absorption rate to charge costs to products that involve the different number of activities becomes unrealistic. It makes some products to have more costs than their actual costs. It allows the cost accountants to set a profit margin that covers for the product cost and desired profit to be realized. It is because the approach has some accuracy in reassignment of the overheads. The higher the number of the activities involved, the higher the costs absorbed to the product. It allows the management to get a clear understanding of cost drivers, and means of controlling costs are put place. The management has the task of managing costs. A manager will avoid engaging in activities that are not critical in the production process so that least possible costs will be charged to the department he/she is assigned responsibility. Applying ABC will enable the management to consider the transaction based activities in determining cost drivers. In this case, the production volume is avoided that is unrealistic. ABC has also some disadvantages when used. They include; Production processes may occur in such a way that separating activities is not possible. Besides, several costs behave differently. It is the best process applicable to the overheads that assume direct linear relationship. The process is complex and expensive. It implies that firms intending to use the design but with financial constraints will not enjoy the advantages of the process. The method can only be applied successfully by highly trained accountants because it is highly subjective especially in identifying projects. Comparison of ABC and the traditional design Similarities Both methods use direct labour hours in charging overheads. ABC uses direct labour hours in absorbing overheads influenced by direct labour hours’ activities. Traditional method also uses direct labour hours in calculating the single overhead absorption rate. Both methods are applied by cost accountants in charging overheads particularly from service departments to product or departments. Differences ABC uses the volume of activities associated with the department or product rather than making volume based approach applied in the traditional design. It results in the application of different overhead absorption rates unlike the traditional that uses direct labour hours in charging overheads. ABC allows flexibility in tracing costs to several activities such as production processes, customers, areas under the responsibility of managers, and the product whereas the traditional approach make the process of doing the same impossible because of the use of a particular overheads absorption rate. The above information shows that ABC is better off than the traditional approach in calculating the rate required for overhead allocation. Mr. Bank should evaluate ABC based on the information above to make a decision on whether to apply it or continue with the traditional approach. In the calculations above, applying ABC will change the amount of overhead absorbed by the product. The cost accounting information used in the above calculations is for a single product. The method is used to charge overheads to products or departments. The calculations were to change if the products were two or more. It is because all the overheads will be absorbed by Geeto product only. References List Drury, C.2008. Management and Cost Accounting (7th edn.). London: South-Western. Lucey, T. 2002. Costing (6th edn.). London: Continuum. Read More