The Essentials Of Cost And Managerial Accounting - Case Study Example

The Essentials Of Cost And Managerial Accounting Table of Contents Table of Contents 1 Introduction 1 1. Concepts affecting the pricing decision 2 2. Role of standard costing and variance analysis 4 3. Advantages and disadvantages associated with ABC system 13 Reference 18 Introduction Manac plc is a multinational company engaged in production and selling of a range of electrical goods. The company has its production units in different part of the world and the products are being sold in different global markets. In the last few years the company has been unable to achieve its budgeted profit target. The finance department uses standards costing along with absorption costing method as strategic financial accounting tools. As per the board of directors, to make more profit, company should enhance the volume of sales, but this might not be the real cause for which the company failed to achieve its budgeted profit. To find the main cause behind lower profitability, a full review of variance was conducted to identify the areas which have not met the budgeted profitability 1. Concepts affecting the pricing decision The term price refers to the cost paid by the customers for availing particular goods or services. For the customer or consumer, the price paid for availing any commodity or service should be equivalent to the utility received from it. As per economics theory, the price of a commodity should be based on a demand and supply basis; the higher the demand, higher will be the price and vice versa. Its opposite for supply, higher supply results in lower price and vice versa (Hollander, 1997, p.237). For a buyer, the price is the cost paid for availing the benefit where as for the supplier price refers to the source of revenue. Price of a commodity plays an important role in generating sales so the seller takes great care while setting the price of the commodity. As per Brooks (1975) “Profit satisfaction is the main goal of industry today”. Economists are often of the view that an optimum price can be attained when marginal cost is equal to marginal revenue (Brooks, 1975). But in real life many other factors affect the price of a product. These factors can be segregated as internal factors and external factors. The internal factors are under the control of the company, as and when required these factors can be manipulated according to the management’s requirement. For example- Cost of the raw materials: when the raw material is available at lower price, the cost of production is low and hence the company can have good profit margin, even when the price is low (Washington State University & U.S. Department of Agriculture Cooperating, n.d.). Cost of labour: labour cost is a prime input for any production or service industry. The higher will be the wage rate of labour, the higher will be operating expenses and price of the product will moves up. Thus the price of product has to be kept marginally high to have budgeted profit margin (Thomas & Zanetti, 2008). Other facts of production: there are many factors of production which have direct effect on cost like availability of land, cost of facilities (example water electricity, fuel etc), cost of capital, availability of short term debts. Market share of the company: if the company has a larger market share that means they are the market leader so will have the power to set the price which will be followed by other competitors. The market leader, on taking advantage of economies of scale, can keep the price lower to elevate the barriers for new entrants. On the other hand when companies have to enter in the new market, they keep the prices as low as possible, but as soon as their market shares increase, they enhance the price to have better profit margin (Blanchard, 2005). Profit margin and cash flow state: if the company wants higher sale, it will set the price margin lower. Though profit margin will be lower per unit of product or service but due to huge volume of sale total profit will be high. This approach is applicable in those goods and services which are for mass consumption. For the goods and services targeting high profile customers, profit per units of goods and services should be higher, so price is marked quite high to have enough profit margin because the sales volume will remain low (BNET Editorial, n.d.). External factors are those factors which are not in the control of management and the company have to accept them as they are. Few examples of these factors are being discussed below: Elasticity of demand: if the product or service has elastic demand, then on increasing the price the total sales will decrease. The product that has inelastic demand, increase in price will result in higher volumes of sale and for the products which have unitary demand, change in price will not at all affect the company sales (Keller, 1989, p.99). Customers’ expectation: while purchasing a product or service, customers pay more attention toward the value as compared to the price. When customers have more expectation, they do not hesitate to pay higher price where as when expectation is low, they prefer to pay low price (Hill & O'Sullivan, 2003, p.158). Market competition: when a company set their product prices, the market competition is taken into consideration. When competition is high it’s not easy to change the price, but when company has monopoly in the market, they have ample possibility to monitor the product prices as per their requirement (Fabiani, 2007, p.205). 2. Role of standard costing and variance analysis Standards costing system is used by for determining the standard cost for producing one unit of product or service (Finkler & Ward, 1999, p.88). Figure 1: Management control system followed in Standard costing system (Source: Oliver, L. 2000, p. 219) An organisation feels that if they know the standard cost of producing single unit, it will be easy for them to find out what will the total cost of production for the required units. So every time they will not have to work out the cost of production. The company segregates these costs and then allocate it to different responsibility centres. The total cost of production of a single unit is distributed under various sub-heads as direct material, direct labour and overheads incurred while producing the product. Other factors like selling and administrative cost should also be considered. The company tries to take these standards as the base while setting their budgets and it compares the actual cost incurred while production against them to find out variances. Variance can be segregated in three broad categories such as material variance, labour variance and overhead variance. Again these three types of variance can be further subdivided in terms of cost and quantity (TAMU, n.d.). Management tries to find out the prime cause behind such variation and then with the suitable solution, these causes have to be removed. Figure 2: Overview of Standard Costing System [Source: Drury, 2004, p.728] To understand how variance analysis can be beneficial in finding the major causes behind lower than target profit, a variance analysis of unit-X in Manac plc was conducted. Material Cost Variance: (Standard Cost - Actual Cost) * Standard Quantity Material Quantity Variance: (Standard Quantity - Actual Quantity) * Standard Rate Labour Rate Variance: (Standard Rate per hour - Actual Rate per hour) * Standard Hours Labour Efficiency Variance: (Standard Hours allocated - Actual Hours taken) * Standard Rate Variable production overhead variation: (Actual hours worked * standard variable overhead rate) - (Actual cost) Variable production overhead variance: (Standard variable production overhead cost of actual production) - (Actual hours worked * standard variable overhead rate) Variable production overhead total variance: (Standard variable production overhead cost of actual production) - (Actual cost) Fixed production overhead variance: (budgeted fixed production overhead) - (Actual fixed production overheads). Certain other overheads should also be determined like marketing cost variance, administrative cost variance and sales variance. For calculating all these variance the actual cost incurred has to be subtracted with the standard budgeted cost (Broadbent 2003, p.154). Management considers the variance favourable if actual cost incurred is lower than the budgeted standard cost. It is applicable for all the variance that has been determined above. More often, to get a clearer picture, management adopts different types of ratios. These ratios are presented below: Volume ratio: (Standard Hours Produced / Budgeted Labour Hour) * 100 Capacity ratio: (Actual Labour Lour Worked / Budgeted Labour Hours) * 100 Efficiency ratio: (Standard Hours Produced / Actual Labour Hours Worked) * 100 If management finds the values of ratios are greater than 100 percent, then they consider it favourable. On the other hand lower value of these ratios gives a signal that performance of the unit is below the standards and cost incurred is quite higher then standards (Lucey & Lucey, 2002, p.441). Figure 3: Variance analysis (Source: Drury, 2004, p.737) Using all these tools, variance analysis was conducted in Manac plc and the data were analysed. It was found that the company’s cost of production is much higher as compared to the standards set by management. Even the ratios provided unfavourable results giving the signal that management is unable to keep the operation costs within limits. Variance analysis of Unit-X is given below: Table 1 All the figures are in $   Standard cost per unit No. of units Standard cost Actual cost incurred Variance Direct material 50 12550 627500 620809 6691 Direct labour 9 12550 112950 139298 26348 Variable overheads 35 12550 439250 440202 952 Fixed overheads 10 12550 125500 125509 9 Selling and Marketing overheads 12 12550 150600 139660 10940 Administrative overhead 25 12550 313750 320051 6301 It was found that management has favourable variance value for material and selling & marketing overheads. The other cost components like direct labour, variable overheads and administrative overhead gave unfavourable variance value. When management analysed the real causes behind deviation, they came to know many hidden facts. For example to keep the cost of production low, the purchase department started using poor quality material as a substitute. When asked the caused behind this change, they said if they go for the standard materials, purchase cost will go too high and they do not have that much financial budget allotted for purchase. The top management is happy as the total cost of direct material has gone down, but on the other hand they are unaware of the fact that quality of their products is deteriorating. The variance analysis results showed that cost incurred on direct labour is too high as compared to the standard cost. While finding the real cause behind such deviation management came to know that within last few months labour rate has gone quite high in labour market. Due to entry of many new competitors the demand for skilled and semiskilled labour has gone high. Workers are constantly putting pressure to enhance their wages. The human resource department does not have that much allotted budget to fulfil labours’ demand and as a result a state of tension has developed between human resource department and labour group. This has reduced their efficiency, many a time they do not come to work and the management have to arrange the temporary workers as a substitute, so all this has resulted into high labour cost. The condition is same for other variable and fixed overheads as management neglected the inflation rate, changing government policies, unstable condition in international market and many other vital factors while finalising the standard cost for vital element of production. To keep the total budget under control, the marketing department tried hard to cut the cost on its selling and marketing activities. They believe the company already has a good market share and it is a well known name in international market, so there is no requirement for extensive advertisement and other sales promotion tools. Such cost cutting has negatively affected company’s competitive position in many international markets. The top management is unaware of the fact that many old customers have already shifted to other competitors which provides additional services to their customers. So as the company was relying heavily on standard costing, it never bothered to find out why the reasons for not attaining their desired profit targets. Variance analysis has many advantages, few of them are been discussed below: It is often used for determining which component of cost of sale is not performing as per the predetermined standards. Management can instantly make a rough assumption that for producing certain units of a specific product what will be total cost of products. The variance gives a cause to find out the real problem that lies in the process. It is a simple technique and management can easily understand the results. It helps in setting the breakeven point. It assists management in finalising prices of different products and services (Lynch, 1983, p.269). The variance analysis process does have certain limitations associated with it which has been discussed below: It fails to give reason behind variances in the different component of cost of sales. If a variable provide favourable variance, it does not means the cost has been handled properly by the management. Certain variable are common and does not make much change in total cost of production, but variance analysis undertakes them at each and every time. These results might misguide the management. It only shows what has happen till now, but fails to provide information regarding future affect of such variation (Anthony, 1972, p.437-438). While the management uses variance analysis and standard costing techniques, they should be aware of these limitations. This will help them in interpreting the reports in much affective way and to solve the problems which lead to variations. 3. Advantages and disadvantages associated with ABC system Absorption costing system is a traditional form of costing where the full cost of production (direct material, direct labour and factory overheads) are absorbed and transferred to the products or services. Management does not differentiate between fixed cost and variable cost and they directly charge them on the total output. Absorption costing is the most conventional approach for cost accounting in manufacturing firms. As per GAAP, the books of accounts, profit & loss account and balance sheet of a company should be prepared following total absorption method (Rachlin & Sweeny, 1996, p.94). Activity Based Costing (ABC) determines the cost associated with performing an activity. The management gathers information regarding specific costs related with different activities. First of all the cost centres are to be determined and then the total cost is distributed within them. Management gets a clear picture regarding the cost centre and incurring level of cost; attention is paid mainly on the variable overheads (Shim & Siegel, 1998, p.225-336). At present Manac plc is using absorption costing system for management accounting purpose, but this system is suffering from certain loopholes. Due to these loopholes the management have failed to achieve their profit targets. A variable analysis was conducted to find out how different cost elements are performing. After the analysis, management planned to shift from absorption based costing system toward activity based costing system. Such change has certain benefits like- Different cost centres can be indentified and management will have a clear understanding how much cost does different activities are incurring (BBA Hons European Management Hakan Goektuerk, 2007, p.10). Management will have a chance to find out which activity can be substituted or should be modified to reduce the overall cost of production (BBA Hons European Management Hakan Goektuerk, 2007, p.10). It results in more realistic overheads allocation and the chances of cross subsidisation can be reduced. At present Manac plc has production units in many locations situated in different parts of the world. So ABC system will bring uniformity and transparency in the costing process (BBA Hons European Management Hakan Goektuerk, 2007, p.10). After implementing ABC system, management will be able to identify the changing nature of different activities. Hence there will arise an opportunity to take proactive decision (BBA Hons European Management Hakan Goektuerk, 2007, p.10). But there will be certain disadvantages associated with ABC, few of them are discussed below: ABC is an expensive process; hence the net profitability of the company will reduce further. Often, it is very difficult to get all the necessary information and data required for ABC process (Jiambalvo, 2007, p.208). It requires a lot of managerial time, so the management might feel pressure on them (Crowther, 2004, p.178). ABC is a more complex system, as the size of company increase it becomes difficult to manage ABC system (Bendrey et al., 2003, p.147). ABC can only be used by the management for assisting in decision making process, but for making final reports as per GAAP, company has to follow traditional costing systems. Before taking any major decision regarding the change of cost accounting system, management should seriously undertake the advantages as well as the disadvantages of the ABC system over Absorption system. Conclusion After conducting the variance analysis, the management of Manac plc came to know about many loopholes in their presently used costing method. Standard costing is a common technique and it has certain benefits also. On the other hand standard, standard costing often results in non-realistic budgets. Using the standard costing management tends to underestimate the change in prices, inflation rate fluctuation, changing economical and political scenario and instability in international markets. So often the standard price set by the management does not match with actual costs and results in variation. To hide variation, the management might try to use unethical means like using raw material of poor quality, employing efficient labour to reduce labour cost, cost cutting in marketing and advertising budget or compromising with other essential expenditures. All such camouflaging can suppress the information for shorter phase of time, but in long run the business is sure to suffer a lot. The management has decided to shift from Absorption Costing system to ABC system, so management has made a comparison between both these costing systems. The analysis indicates, though ABC has certain disadvantages, but in the long run management will be benefited as they will have more flexibility in the cost control process, they will be able to set more realistic cost and profit targets and hence it will succeed in achieving the budgeted profit levels. Reference Anthony. 1972. Management control systems. Tata McGraw-Hill. BBA Hons European Management Hakan Goektuerk. 2007. 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