- Absorption Costing:
The objective of absorption costing is to include in the total cost of a product an appropriate share of the organisation’s total overhead or indirect costs. An appropriate share basically means that an amount which reflects the amount of time and effort that has gone into producing one unit of the product. Absorption costing is a method for sharing overheads among different products on a fair basis. In absorption costing all production overheads are incurred in the production of the organisation’s output and so each unit of the output receives some benefit from theses costs. Each unit of the output is therefore charged with some of the overhead costs. This can be explained by an example (Appendix 1). Absorption costing is used for inventory valuations, pricing decisions and for establishing the profitability of different products. There are basically three stages of absorption costing which are Allocation, Apportionment and Absorption. Overhead allocation is the process by which whole cost items are charged directly to a cost unit or cost center. Apportionment is a procedure whereby indirect costs are spread fairly between cost centers. Costs of service cost centers are apportioned to production cost centers. Absorption is the process whereby overhead costs allocated and apportioned to production cost centers are added to unit, job or batch costs.
- Marginal Costing:
Alternative to absorption costing method is marginal costing method. In marginal costing method only variable costs are charged and computed as cost of sales of the products produced. A contribution calculation is also done. Contribution is calculated as sales revenues minus variable costs. In marginal costing system work in progress and finished goods are calculated at marginal or variable production costs. Fixed costs in marginal costing system is treated as a period cost and charged in full to the profit and loss statement directly.
- Job Costing:
Sometimes production work is undertaken by an organisation according to the specifications of its customers. In job costing a job is a cost unit which mainly consists of a single order or a contract. According Drury (2008), job costing relates to a costing system where each job is unique in itself. The customer basically approaches the organisation and indicates the requirements for the job. The management then agrees with the requirement and then prepare a cost estimates for the job. Material, labor and overheads are computed and a profit margin is calculated. If the estimate is accepted then the job is scheduled for completion (Appendix 2).
- Activity-Based Costing:
Activity-Based Costing (ABC) is also an alternative costing technique to absorption costing methods. ABC basically involves the identification of the factors or the cost drivers which cause the costs of an organisation’s major production activities. Overheads are traced to products using transaction-based cost drivers for example no. of production runs, no. of orders received etc. Cost drivers for short-term costs are volume related. The procedure involve in ABC are as follows: Identification of organisation’s major activities, Identification of the factors which determine the size of the costs of an activity, Collection of the costs associated with each cost drivers into cost pools. Charge costs to products on the basis of their usage of the activity (Appendix 6).
Planning and Decision-Making:
Drury (2008) said that relevant costs and revenues are those future costs and revenues that will be changed by a decision. When taking short term decisions management has to take into account the relevant costs associated with the decisions. Relevant cost is an important concept and it helps the manager to only focus on those factors which affect the short-term horizon of the decision. Basically relevant costs are future cash flows arising as a direct consequence of a decision. Relevant costs are of three types: They are future costs, they are in cash, and they are incremental costs. Management takes many short-term decisions, these include make or buy decisions, further processing decisions, and outsourcing and shut down decisions (Appendix 3).
CVP Analysis:
Cost-Volume-Profit analysis is the study of the interrelationships between costs, volume and profit at various levels of activity. It is important for the management of an organisation to know the profit level and margin which can achieved if the certain production level is undertaken. CVP analysis also provide information related to the breakeven point (appendix 4) which is the activity level where there is neither profit not loss for the organisation. Moreover CVP analysis can provide information related to the amount by which actual sales can fall below anticipated sales without incurring loss. Other information related to CVP analysis is included in (Appendix 4).
Budgeting Process:
‘Planning is a very general term which covers the longer term strategic planning and shorter term operational planning.’ (Weetman, 2006). Budgeting process provide an efficient system through which managers can effectively plan and control various production activities within an organisation. A budget is a plan prepared by the management of an organisation of what the management is aiming to achieve and what are the targets it has set for itself for a particular accounting period. Budgeting process involve the identification of the principal budget factor which limits the overall production of the company. Sales budget is then prepared, production and non-production overheads budget is then prepared. Fixed budget is the budget which remains unchanged regardless of the production activity within an organisation. Flexible budget is a budget which is prepared for controlling purposes and designed to change as volume of activity changes.
Decision-Making under Risk and Uncertainty:
Techniques which reduce the uncertainty are as follows: Market researching, Conservative approach, worst/most likely/best outcomes estimates and pay-off tables. Pay-off tables identify and record all possible outcomes in a given situation. In order to reduce risk probabilities and expected values are calculated. Expected values indicate what an outcome is likely to be in the long term with repetition. There are also certain rules for making decisions under risk and uncertainty e.g. Maximin, Maximax, and Minimax regret. Sensitivity analysis can also be undertaken.
Pricing Decisions:
Other than costs there are also other things which have influences on the price of the products an organisation produced. Pricing decisions is one of the most important decisions a manager takes into account. There are various strategies through which a manager can take decisions regarding the price of the product. There is cost-plus pricing, marginal cost-plus pricing, market skimming pricing, market penetration. Some more strategies and details related to pricing strategies are in Appendix 5.
Performance Evaluations and Feedback:
Performance evaluations or performance measurement aims to establish how well something or somebody is doing in relation to a plan. There are financial performance indicators i.e. profit, sales, costs, cash flows etc. and non-financial performance indicators. Basically, performance evaluations provide information related to the direction of the managers for short-term and long-term directions. Performance measures are devised by the management to reward behavior and direction of the managers that maximises the corporate good.
Conclusion:
Management accounting can help managers make correct budget and decision through its process by choosing good cost measure techniques, using C-V-P and brilliant pricing strategies.
Bibliography:
Drury, C. (2008) Management and Cost Accounting (7th Edition), Thomson Learning, London.
Weetman, Pauline. (2006), Management Accounting: An Introduction, p 4, p 7, Pearson Education Limited, Edinburgh.
Appendices:
Appendix 1:
Suppose that a company makes and sells 100 units of a product. The prime cost per unit is 6 and unit selling price is 10. Production overheads costs is 200 and admin, selling and distribution costs are 150, the profit can be calculated as follows:
Sales (100 units * 10) = 1000
Prime Costs (100 * 6) = 600
Production overheads = 200
Admin, Sell, Dist = 150
(950)
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Profit 50
In absorption costing, overheads costs will be added to each unit of product.
Prime cost per unit 6
Production overheads (200 for 100 units) 2
Full Factory Costs 8
The profit would be calculated as follows:
Sales 1000
Factory Cost of sales (800)
G/P 200
Admin, Sell, Dist (150)
Net Profit 50
Appendix 2:
Information related to Job 12345, which is being carried by a company are as follows:
Department A Department B
Direct Materials 5000 3000
Labor 400 Hours 200 Hours
Labor Rate 4 4
Production overhead per hour 4 4
Admin etc 20% of full production cost
Profit Margin 25% of sales price
Sales price 20800
Department A B Total
Sales Price 20800
Direct Materials 5000 3000 (8000)
Labor 1600 1000 (2600)
Production Overhead 1600 800 (2400)
Overheads (2600)
---------
Profit 5200
Appendix 3:
Short-Term Decisions are as follows:
- Make or buy:
In a make or buy decision with no limiting factors, the relevant costs are the differential costs between the two options.
- Outsourcing:
The relevant costs and decisions relating to operating of internal service departments or the use of external services are the differential costs between the two options.
- Further Processing:
A joint product should be processed further past the split-off point if sales value minus post-separation costs is greater than sales value at split-off point.
- Shut Down:
Further operating costs of the department and the savings from the shut down of the department should be matched.
Appendix 4:
Breakeven Point:
Total Fixed Costs/Contribution per unit.
The contribution to sales C/S ratio:
Contribution required to breakeven/ C/S Ratio or Fixed Costs/C/S Ratio.
Margin of Safety:
Margin of safety is the difference in units between the budgeted sales volume and the breakeven sales volume. It can also be expressed in amount as well.
Appendix 5:
Pricing Strategies are as follows:
- Cost-Plus:
Sales price is calculated by computing the full cost of the product and then adding a percentage mark-up for profit.
- Marginal Cost-Plus:
It involves adding a profit margin to the marginal cost of production/sales.
- Market Skimming:
Price skimming involves charging high price when product is first launched.
- Market Penetration:
It involves charging low price when the product is first launched.
- Complementary Product:
Price charged by taking into account the goods that tend to be bought and used together.
- Product-Line:
Offering of sales of products which are related to each other.
- Volume Discounting:
Volume discount is a reduction in price given for larger than average purchases.
- Price Discrimination:
It is the practice of charging different prices for the same product to different groups of buyers.
- Relevant Cost:
Orders are charged according to its relevant costs.
- Minimum Pricing:
It involves determining the price at which the firm would make a breakeven.
Appendix 6
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