Management Accounting: Methods of Costing - Case Study Example

Methods of Costing Introduction Sustainable profitability is the core objective of every business operation. In order to achieve this aim, firms tend to focus on expense minimization and revenue maximization as the basic principle of business operation. However, certain promotional expenses like advertisement expenses or designing expenses can hardly be reduced as they have become inevitable strategies to confront with the modern competitive market. Hence, curtailing luxury costs associated with business performance is the advisable alternative. At the same time, entrepreneurs must also make sure that cost curbing does not affect the quality and accuracy of products or services rendered. “Costing is a powerful tool that helps managers to discover the true costs of products” (Ledgerwood & White 2008, p.317). Relying on the given case of the building firm “Home improvements and Extensions Ltd” we can consider different constructive costs. Types of costs A firm may incur various types of operational costs during the course of their day to day business operations. In order to design situational business strategies and thereby fit the organizational interests into the persisting demand conditions, every corner of operational costs has to be essentially identified by a firm. According to Truett & Truett (2008), a firm may experience different types of costs such as ‘historical costs, opportunity costs, fixed costs, variable costs, incremental costs, private costs, and social costs’ (p.223). The explanations and reasons of variations of these costs are described below with suitable examples from construction industry. Historical cost: It is the cost incurred by the firm during the course of their operations for which the firm has either paid completely in the past or promised to pay in future. Historical cost is recorded in the books of accounts of the firm and is used for the preparation of income statement at the end of the financial period. It includes rent and interest payments, wages and salaries to the labors, and cost of raw materials. Historical cost may vary according to the market demand for the services of the construction firm. Opportunity costs: It is the implicit cost incurred by the firm if the business had employed to next best opportunity. Although opportunity cost is an imaginary cost, it is necessary for calculating the net income from operations. Implicit salary income to the directors and implicit interest income on capital are some of the examples for opportunity costs. It may fluctuate according to management strategies and accounting practices followed by the firm. Fixed costs & Variable costs: The former does not vary in connection with volume of output in the short run but the latter does. Fixed cost includes depreciations and salaries of permanent employees of the building firm. On the other hand, variable costs exactly change with level of output or operations of the firm. Transportation expenses can be an example for the same. Incremental costs: Sometimes management undertakes additional activities during the conduct of business in order to maximize the profitability of the organization. In a building firm, it gradually decreases when company reaches a good position; but after this limit, incremental cost increases since additional cost elements are to be applied at that position in order to get into the next level of business. E.g. Construction of new facilities. Private costs: It is the sum total of historical costs and opportunity costs incurred by the firm so that it varies in accordance with these costs. Social costs: It includes private costs plus any additional costs imposed on the society by firm’s operations. Hence it is determined by the volume of private costs and effects of firm’s operations on the society. Air, water, and noise pollution are some of the examples of social costs in a construction industry (ibid pp.223-226). Need for different costing methods Although construction industries had started implementing costing techniques many years ago, it was inefficient as they considered total cost at the completion of the project as project cost. In this strategy, no provision was made to identify the losses incurred during the conduct of the project. The project manager can determine the weak part of the operations only if he employs up-to-date costing techniques. The proper knowledge about the pros and corns of the project enables the manager to form appropriate strategies that would improve the remaining part of conduct. Similarly this valuable information will help the firm to organize their next venture more efficiently. Moreover, the management will be able to detect the superfluous expenses; and thus the earnings from operation can be maximized. In addition to this, a well developed costing method will assist the contractor to plan his next project on the basis of recently prepared cost sheet. Operation of different costing methods According to the performance nature of the firm, there are large numbers of costing methods in use. They are illustrated below. Unit costing: If a firm produces identical units of a same product, then unit costing tool can be applied. E.g. Production of bricks. Batch costing: When the production involves a number of processes, the costs can be allocated to each process by the employment of batch costing. E.g. Production of jam. Job costing: In some concerns, each job is considered as an individual process and thus costs are allocated to each job. In case of manufacture of large number of machineries, job costing is the best technique to prepare cost statement. Contract costing: This method is used when the work is carried out in agreement with specific orders, and which is of long duration. E.g. construction industry. Process costing: In this method, when the firm continuously produces homogeneous products; it distributes costs to the products with the assumption that each product consumes material, labor and power equally. Eg. paint manufacturing. In addition to this, there are many other costing methods in practice according to the type and need of the organization. Advisable costing method Although there are number of costing techniques in practice, contract costing would be the most appropriate tool for the Home Improvements and Extensions Ltd. Since it is a building firm, it undertakes works on contract basis and probably takes more than one year for completion of a project. To illustrate, a construction contract is performed on the basis of a contract deed which involves all relevant information regarding the contract such as contract price, time for completion, and quality of work etc. Under this technique project cost is estimated on the strength of historical or past cost. Similarly, the firm may assign some specialized works to sub-contractor, which needs additional costing practices. In addition to this, heavy investments and expenses are involved in a project contract (Gupta, Sharma & Ajuja 2009-10, p.337). Likewise each project is diverse in nature and needs separate cost estimation which necessitates the employment of contract costing. Similarly, all expenses incurred in a contract are of direct in nature. Therefore, any other costing techniques including job costing method cannot be efficiently applied in the case of a building firm. It can be illustrated using an example. The various estimated project expenses of a building firm on the basis of historical data are given below. Direct material- $50000, direct wages- $8000, work site O/Hs-72000, office and administration O/Hs- $32000, promotional and transportation O/Hs- 47000, and others- $20000. Assume that profit margin is 25%. A cost sheet is necessary to show the total estimated project cost. Cost sheet Particulars Amount Direct material Direct wages Work site O/Hs Office and administration O/Hs Promotional and transportation O/Hs Others Total cost 50000 8000 72000 32000 47000 20000 2,29,000 Although we got the total estimated project cost as $2, 29,000, it is not the cost for customers. It is only the cost incurred by the firm, so an appropriate margin of profit must be added to the construction cost to provide price quotation to customers i.e.; Quotation price = estimated cost + (estimated cost ×fixed profit percentage) =2, 29,000 + (2, 29,000 ×25%) =286250 Stock valuation Stock valuation of materials in building firms is a difficult task since they are bought at different times for different prices and are used by different employees. The application of FIFO (First In First Out) and LIFO (Last In First Out) covers the issue of stock valuation to some extent. Under the FIFO system, materials purchased first are issued to the construction department firstly; whereas LIFO technique issues last purchased materials first. In my opinion, it is better for the firm to adopt FIFO stock valuation method because it will safeguard the interest of the firm in a better way than LIFO method will do. It prevents materials from decay since it facilitates the flow of goods efficiently. On the other hand, cost of goods sold includes cost of older units and it will not match with latest revenue. However the remaining materials in the stock by the end of the year will probably be the products purchased lately because of the FIFO method. Consider the following events occurred in a building firm. 1/5/2010- received 250 units @ $50 (consider opening balance Nil) 13/5/2010- received 100 units @ $12; and issued 50 units Date Receipts Issues Balance 1/5/2010 250 50 12500 250 50 12500 13/5/2010 100 12 1200 250 100 50 12 12500 1200 13/5/2010 50 50 2500 200 100 50 12 10000 1200 Stock on 31st May 2010 can be computed as follows 200 units @ $50= 10000 100 units @ $12=1200 $11200 The firm indicates a stock of building materials worth $11200 on 31st May 2010. Market forecasting tools Forecasting is a powerful tool to analyze future market demand conditions and it includes qualitative as well as quantitative methods. Qualitative methods try to research tastes and preferences of the customers through a sequence of interviews and questionnaire methods at different phases. It would not always provide desired outputs if the people passively respond to the program. On the other hand, quantitative market research methods such as online surveys and telephones surveys make efforts to discover market demand for a particular product (Garcia-Diaz & Smith 2008, p.42). Online surveys are the most suitable method for the firm to get customer feedback and thereby market interests since now a day, majority of people have access to internet. Similarly, it is a less time-consumable method both for the firm and customer. In addition to this, it is the least expensive method available for a firm to conduct market survey for their newly launching product. Similarly telephone survey is also an effective method in order to discover potential customers for a long time. It is a more practical method as people would be willing to respond to the promotional phone call on the ground of nobility. The major disadvantage of these methods is the lack of reliability and accuracy. Similarly these techniques fail in the case of illiterate and busy persons. However, the exercise of electronic sources for the purpose of demand forecast would help the firm to skip from the cumbersome task of tabulation and interpretation. It also saves from the risk of random sampling. Annual report of Hindustan Construction Company Particulars 2009 2010 Turnover 3518.32 3862.97 Profit after tax 125.35 81.44 (Source: moneycontrol.com, Hindustan Construction Company) Suggestions for improvement Competition is tough in the construction world today; and only those building firms with outstanding infrastructural designs can run a sustainable business. So the firm must acquire qualified and experienced engineers in order to earn a good stature in the construction industry. “Home improvements and Extensions Ltd” can conduct campus interviews in order to discover innovative talents. Similarly the company can minimize operating costs by way of reducing wastage. Proper control must be exercised over the employees in order to accomplish the optimize use of materials. In addition to this, an efficient internal control system should be established with intent to manage systematic functioning of the organization. Similarly, the firm has to be careful about the timely completion of contract work they undertake, which would add value to its services and thereby enhance its reputation. Moreover, firm’s architectural concepts must be apt to the current market situations. References Guptha, SP, Sharma, A & Dr. Ahuja, S 2009-10, Cost Accounting Semester=III, Rahul Jain- V.K. (India) Enterprises, New Delhi. Garcia-Diaz, A & smith, JM 2008, Facilities planning and design, Prentice Hall, Upper saddle River. Hindustan Construction Company, Directors Report, Money Control.com. accessed 26 Nov 2010 http://www.moneycontrol.com/annual-report/hindustanconstructioncompany/directors-report/HCC Ledgerwood, J &White, V 2006, Transforming microfinance institutions: Providing full financial services to the poor, World Bank Publications, Washington. Truett+Truett, 2008, Managerial Economics, John Wiley & Sons, New Delhi. Read More