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Reflective Report for Integrated Business Decision


Discuss the argument :‘It is now widely accepted that conventional cost accounting distorts management view of business through unrepresentative overhead allocation and inappropriate product costing.’

Student number: 100081665 Word count:1449

Onat, Anitsal and Anitsal (2014, p.149) defined doing business as an art of getting most profit with the limited resources. Companies usually maximum their profit by increasing price or deducting cost. When there is a constraint of price, cost management became extremely important. Cost accounting traces, records and analyses the costs of products or services which are produced by businesses and activities, by applying accounting and costing principals. Meanwhile, cost accounting also encourages the measurement of performance, productivity and quality of product (Heather, 2008). Many people argue that traditional cost accounting is not accurate enough compared with recent cost accounting, since it does not allocate overhead typically and not calculate product costing appropriately. Absorption costing is a representative of conventional costing method, which full allocated manufacturing overhead into inventory units produced (Gupta, Pevzner & Seethamraju, 2010). While activity based costing (ABC) is a kind of modern costing method that provides cost information to managers, which allows them to make strategic and other decisions. It is a method that allocates overhead according to cost drivers and hence useful to management that pays attention to activities (Seal, Garrison & Noreen, 2012). This essay will discuss this argument by introducing these two method briefly and then explain the merits and necessity for ABC. An example might encourage the understanding of the difference between two method and the accuracy of ABC method.

There is no denying that traditional absorption costing is of great importance of cost measurement. In the past, most companies produced a small range of products and direct cost are usually much more higher than indirect cost. So absorption costing usually chooses a cost driver such as direct labour hours or machine hours and then allocates overheads based on predetermined overhead rate(BPP, 2014). In this case, the value of over-absorbed or under-absorbed overhead was not that important (Vercio, 2008). The application of absorption accounting is relative simple, cheap and easy to explain to stakeholders. It calculates full product cost by adding direct cost and a percentage of production overheads by means of overhead absorption rates (Kaplan,

no date). Recently, however, financial markets require top managers to carry out reliable and flexible business strategies, which aim at competitive advantage. To achieve and sustain competitive advantage, a rapid technical adjustment, large investment, sales flexibility, after-sales service and so on are needed. In this new environment, conventional costing method may show an incompletely correct information on product cost. The increase of the overheads or decrease of relative share of costs such as direct labour hour will lead to a high overhead absorption rate easily without considering the sophistication of activities. ABC was born in this complicated environment and helps managers to get a more accurate and comprehensive insights into creating value (Kalicanin and Knezevic, 2013).

As the name shows, activity based costing allocates overheads based on activities. ABC plays an important role when activities cause cost and influence consumption. There are two important terms which can encourage the understanding of ABC. According to BPP (2014), cost driver is the elements that determine the size of an activity’s costs or the cause the cost of an activity. And cost pool is the total cost allocated to an activity (Onat, Anitsal & Anitsal, op cit, p.151). Kapic (2014) stated that there are four fundamental steps to allocate cost according to ABC method: First, identify an organization’s major activities that consume resources; Second, identifying cost drivers, related to activity; Third, collect the cost of each activity into cost pools; And fourth, calculate overheads of products on the basis of their usage of the activity. From these four steps, it can be seen that unlike absorption costing in which overhead pooled by departments, ABC sets up separate cost pools and could avoid the reapportionment of service department. Meanwhile, ABC identifies cost drivers such as number of production runs and number of orders as absorption bases which makes it more closely related with the causes of overhead costs. Since ABC focus on the nature of cost behaviour, it will provide a meaningful product cost. Also, the reason why ABC is very popular nowadays is that it is the only method which recognized that plenty of overhead costs come out of the various and complicated operations (BPP, op cit). Another important point is that ABC provide a good understanding for

managers to learn what drives overhead costs. So it can be easier for managers to monitor each activities and to decided how to manage these activities to have a lower cost (Weetman, 1999).

One example from BPP (2014) might encourage a better understanding of the deference between traditional absorption costing and ABC and the importance to apply ABC method:

Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost data for the period just ended are as follows. Output units Number of production runs in the period Material cost per unit $ W X Y Z 10 10 100 100 2 2 5 5 14 20 80 20 80 Direct labour hours per unit 1 3 1 3 1 3 1 3 Machine hours per unit

Direct labour cost per hour is $5. Overhead costs are as follows. $ Short-run variable cost Set-up cost 3080 10920

Production and scheduling cost Material handing cost

9100 7700 30800

Using a conventional absorption costing approach and an absorption rate for overheads based on either direct labour hours or machine hours, the product costs would be as follows. W $ Direct material Direct labour Overheads[W1 ] total Units produced Cost per unit 950 10 $95 3050 10 $305 9500 100 $95 30500 100 $305 44000 200 50 700 X $ 800 150 2100 Y $ 2000 500 7000 Z $ 8000 1500 21000 Total $ 11000 2200 30800

Using activity based costing and assuming that the number of production runs is the cost driver for set-up costs, production and scheduling costs and materials handling costs and that machine hours are the cost driver for short-run variable costs, unit costs would be as follows.

W $ Direct material Direct labour Short-run variable overheads[W2] Set-up costs[W3] Production and scheduling costs[W4] Materials handling costs[W5] 4280 Units produced Cost per unit 10 $428 1100 1300 1560 200 50 70

X $ 800 150 210

Y $ 2000 500 700

Z $ 8000 1500 2100

Total $ 11000 2200 3080

1560

3900

3900

10920

1300

3250

3250

9100

1100

2750

2750

7700

5120 10 $512

13100 100 $131

21500 100 $215

44000

Workings and summary will be shown in Appendix.

When using absorption costing method, total overheads ($30800) are allocated based on total direct labour hours (440 hrs), which comes out an absorption rate of &70 per direct labour hour. Since the company only use one hour to produces product W and Y

for each, the cost per units is only $95. On the other hand, the company produces product X and Z using a higher labour hours (3 hours for each), so the cost per unit is much more higher that product W and Y ($ 305 per unit). While using activity base costing, short-run variable cost is allocated by machine hours and other activity costs are allocated by production runs. Although the labour hour required by product X is only one hour, it requires the same production runs with product X (2 production runs) in the period, which equals 0.2 run for each unit. However, producing 100 units of product Y and Z only require 5 production runs, which equals 0.05 for each unit. Since producing one unit of product W and X need 4 times of production runs than producing product Y and Z. As a result, product W and X have a higher cost per unit. Since product X requires the highest direct machine hour and number of production runs per unit, it has been allocated the highest overheads.Compared with activity costing, absorption costing leads an under-absorbed overheads among product W, X and Y and over-absorbed overhead for product Z. This means the process of producing product W, X and Z requires more activities and product Z requires less activities. It also under allocates overhead costs to less complex products W and Y since just 1 hour work need per unit but over allocates overheads to more complex products X and Z in particular (BPP, op cit, pp.259-260). From this example, it can be seen that traditional absorption costing gives a wrong information because it directly allocate overheads based on direct labour hours and do not relate them with activities. As a result, traditional absorption costing emphasizes high labour consumption product and might ignore highly important product which costs less labour hours. By contrast, ABC pays more attention to value and value-adding activities rather than on the volume or required labour hours of the activity (Onat, Anitsal & Anitsal, op cit, p.150).

Activity based costing method is really useful in many industries nowadays. Take services industry for example, this costing method makes sure that the resources are well consumed and are available for customer segments where paying are higher. Meanwhile, demand and supply can be controlled better, especially in complicated

service activities that require a high fixed cost (Onat, Anitsal & Anitsal, ibid, pp.165-166) . The method is not only suitable for the most popular industry in 21st century — services industry, but also suitable for flexible manufacturing industry. Manufacturing industries can get several benefits by using ABC method which include supporting the costs of new elements, using cost to control part manufacture and evaluating performance for various activities (Rezaie, Ostadi & Torabi, 2008, p.1065).

To summarize, when the primary driver is volume or labour, traditional absorption costing can be used since it is simpler and cheaper to implement and easy for outsiders to understand. However, in this complex business environment where production overheads count for a high proportion and overhead resources used by products varies, ABC is particularly useful. This method avoids the reapportionment of service department and provide meaningful product costs since it links overhead costs closely to the causes of costs. Also, it gives managers a clear understanding about how to manage activities to avoid unnecessary costs. Though there are some disadvantages of ABC for instance, it is impossible to allocate all overhead costs to specific activities, the choice for activities and cost drivers may be inaccurate and it is complex and costly (Gowthorpe, 2011), its significant role in modern business cannot be denied. It can be applied to lots of industries, not only services industry, but also manufacturing industry.

Bibliography

Gowthorpe, C. (2011) Business Accounting & Finance. 3rd edn. Andover: Southwestern Cengage Learning.

Gupta, M., Pevzner, M. and Seethamraju, C (2010) ‘The Implications of Absorption Cost Accounting and Production Decisions for Future Firm Performance and Valuation’, Contemporary Accounting 10.1111/j.1911-3846.2010.01030.x. Research, 27(3), pp. 889-922. Doi:

Heather, N. (2008) Research Starters Business. Online Edition.

Kaplan

(No

date)

Marginal

and

Absorption

Costing.

Available

at:

http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Marginal%20and%20ab sorption%20costing.aspx (Accessed at: 11th March 2015)

Kalicanin, D. and Knezevic, V. (2013) ‘Acitivity-based Costing as an Information Basis for an Efficient Strategic Management Process’, Economic Annals, 58(197), pp. 95-119. Doi: 10.2298/EKA1397095K.

Kapic, J (2014) ‘Activity Based Costing’, Business Consultant, 6(32), pp. 9-16.

Onat, O. K., Anitsal, I. and Anitsal, M. M. (2014) ‘Acitivity Based Costing in Services Industry: A Conceptual Framework for Enterprenuers’, Entrepreneurial Executive, 19, pp. 149-167.

Rezaie, K., Ostadi, B. and Torabi, S. A. (2008) ‘Activity-based costing in flexible manufacturing systems with a case study in a forging industry’, International Journal of Production Research, 46(4), pp.1047-1069.

Seal, W., Garrison, R. H. and Noreen, E. W. (2012) Management Accounting. 4th edn. Maidenhead : McGraw-Hill Higher Education.

Vercio, A. (2008) ‘Full Absorption: The Good, the Bad, and the Ugly’, Journal of Corporate Accounting & Finance, 19(3), pp. 51-55.

Weetman, P. (1999) Management Accounting: An Introduction. 2nd edn. Harlow: Pearson Education Limited.

Appendix

Workings: [W1] $30,800 ÷440 hours = $70 per direct labour or machine hour [W2] $3,080 ÷ 440 machine hours = $7 per machine hour [W3] $10,920 ÷ 14 production runs = $780 per run [W4] $9,100 ÷ 14 production runs = $650 per run [W5] $7,700 ÷ 14 production runs = $550 per run

Summary: Product Conventional costing unit cost $ W X Y Z 95 305 95 305 ABC unit cost $ 428 512 131 215 Difference $ +333 +207 +36 -90


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