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Pricing is the value placed on what is exchanged. Price is a critical parameter in the modern-day business and has a strong impact on the firms' competitive ability. While price is the amount of money a consumer needs to give up in exchange of the good or service received, cost is the expense incorporated to manufacture a good or service. However, price influences total costs through its impact on quantities sold (Alford & Engelland, 2000).
An analysis of costing would be done on the basis of the learning in this course applied to my work at the previous organization ABC Foods, an agro-processing SME (small and medium enterprise) engaged in the production and distribution of milk and milk products.
TYPES OF COST
Cost may be defined as the amount of resources, usually measured in monetary terms, sacrificed to achieve particular objective (McLaney & Atrill, 2008:281). Costing should convey the objectives of the firm for eg. Increase in the shareholders' wealth and should differ from one possible result to the other i.e. the historic costs are irrelevant and future costs may vary.
Costs are classified into two main types:
Fixed Cost - The business expenditure which is independent on the volume of activity is termed as fixed cost. Variable Cost - This cost changes according to the volume of activity. At ABC Foods, the fixed costs are the rent, insurance, real-estate taxes, salaries and bank payments. The variable costs are labour, electricity, transportation and supplies such as animal feed.
Costs can also be categorized as:
Product Cost - The cost involved in producing or purchasing a product is called as the product cost. Period Cost - It is non- manufacturing cost which is not included in the cost of purchase or production.
Direct material (milk), direct labour (assembly line workers) and manufacturing overhead (indirect material and indirect labour, depreciation on plant and machinery, and utilities) are the product costs at ABC Foods. Marketing costs (depreciation of delivery van, advertisement, sales commission and cold storage) and administrative costs (depreciation of land and building, management costs like salaries and travel) are period costs.
TYPES OF COSTING SYSTEMS
Traditional Costing System
A firm's traditional costing system is often prepared to comply with the financial reporting requirements and often articulated with its general ledger system. This approach constitutes of three steps viz. accumulation of costs in production and non-production divisions, allocation of non-production costs to the production costs and allocation of the revised production division costs to various goods, services i.e. costs to be recovered from the customers.
However, this approach suffers from several drawbacks, one of the prime being the assumption that the plant would run at the installation capacity. Many firms, like ABC Foods, have hence embraced a new costing system which is explained in the following paragraph.
Activity Based Costing System
In contrast to traditional cost-accounting systems, activity based costing system initially accumulates the overhead cost for each of the firm's activity which is eventually assigned to the goods, services or customer which causes that activity. The most vital aspect of this system is activity analysis. Activity analysis is the process of recognition of suitable output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service.
Though activity based costing has its advantages, rather than replacement to the traditional costing, it was used to supplement traditional costing in ABC Foods due to the following reasons:
Traditional costing system assigns costs based on single-volume measures like direct-labour hours.
It is a convenient and cost-effective method of financial reporting compliance.
Since it was developed during the industrial revolution, overheads during that time were marginal in the total costing. (McLaney & Atrill, 2008: 373).
Traditional costing does not take into account the situation at the market place viz. competition, price-cutting, quality perception and bad debts.
Management decisions based on activity based costing give an insight into the design, production, marketing and distribution.
Due to the division wise focus, activity based costing provide better cost allocation information, and hence offers an advantage to the management to control them more effectively.
Following is the budgetary target for ABC Foods, however it is also important to note the assumptions.
The trade receivables from the retailers would increase by 10% owing to the increase in geographical spread of distribution which demands a credit period to the new retailers; so would the trade payables due to increase in procurement.
The Bank has accepted to disburse the loan on 1st April owing to completion of the documentation in the next month; this amount would be utilised in the expansion of the existing facility which would take 6 months for completion and the interest repayment would be done only by the year end in December 2010.
The old delivery van would be replaced in the month of Aug with the new one.
Order would be placed to the new plant and machinery in the month of May with an advance payment of 50% while the balance would be paid on erection and pilot run in October 2010.
The opening balance as on 1st March is considered to be 100,000 GBP.
Operating budget - It consists of
Financial budget - It consists of
Budgetary target does help the management in planning for future. However, in most circumstances the actual output may not be the same as the original budget. Hence corrective action needs to be taken for budgetary control to encourage the managers achieve the goals and objective of a firm.
The adverse variance of the actual output with reference to the original budget forces the management to take corrective actions. There are several reasons for the occurrence of variances; following is a brief of the same according to the type of variances:
Poor performance by sales team.
Worsening of the market condition as compared between the budgeted time and the actual sales.
Unavailability of product or service due to the manufacturing issues.
Direct material variance
Poor performance by the procurement division leading to the higher cost of purchase than the one intended in budget.
Change in the market condition which affects the rate to be hiked at the actual time of purchase compared to the one incorporated in the budget.
Low grade raw material or flaw in the machinery leading to higher rate of morsel.
Poor performance by the operations division leading to higher wastage of raw material.
Poor supervision by the line managers.
Less skilled (accounting to higher wastage or less productivity) or highly skilled (forcing higher wages) than required.
Inefficient personnel division.
To counter all these variances so that the objective of the firm is achieved, a programme of corrective actions should be implemented. Following are the possible recommendations:
Senior management should communicate to all its employees about the seriousness of the variances and that management decisions would be based on these periodic variances reports.
Allocation of responsibilities for specified business area to each of the managers would make them more accountable.
Budget targets should be SMART - Specific, Measurable, Achievable, Relevant, Timely. While unrealistic targets seem to de-motivate the managers, it could be recommended that managers themselves make contribution towards setting up of targets.
MIS reports to be fixed on a shorter periodic interval viz. monthly, so that corrective measures could be taken immediately. The format of these reports should mandatory contain the variances which would highlight the direction in which the business is moving.
Managers need to prove by their actions to eradicate the adverse variances, if any so that a favourable variance is reflected in the subsequent report.
The budget seems to motivate managers since the existence of budgets gives the direction and sets the guidelines for achieving the targets. The targets could be demanding, yet achievable, since such targets motivate the managers. It is also imperative for the management to take into account that the managers participation n target setting may lead to setting of easy targets for achievement or higher ones to impress on the face. Either of these would lead to disaster since it would not help to achieve the aims and objectives of the firm.
VALUE CHAIN ANALYSIS
The value chain is the linking sequence of activities, through the three phases of the product life-cycle from research and development to after-sales activities (McLaney & Atrill, 2008: 390). This approach seeks to control costs while recognising the concept of total life-cycle. The objective of any firm is to maximise its value thereby producing wealth for the shareholders. In a value chain, value is added in each of the link by an individual activity. Each of the links is expected to add value to the good or service thereby offering a value added product to the end user. It is crucial for the management to identify the weak links that do not add value to the good or service thereby cutting down the cost on that division or possibly abolishing the entire division by probable ways like outsourcing. In recent times, value chain analysis seems to be gaining popularity due to its application in management accounting.
"The Ernst and Young survey of management accounting practice in the US, conducted in 2003, revealed that 27 percent of respondents use value chain analysis extensively, with a further 47 per cent considering the technique in the future." (Ernst and Young, 2003)
At ABC Foods, veterinary doctors were employed for the health and safety of the animals. They used to conduct a routine check-up of the cows and administer the drugs periodically. However, the management found that this is a weak link in the operations division. The doctors were deployed from their job and the same work was outsourced to them with a fee-based compensation. This proved to be beneficial for the firm since both the doctors needed to work only for a full day in a month. Since the doctors were not adding value while in job, the elimination of that link was probably a sensible decision.
Also, the operations division was seen to deliver product i.e. liquid milk with the bacteria count just at par with the thresh hold level. Using the value chain analysis, the management concluded that special efforts were needed to improvise the product quality with the regard to the above mentioned parameters. Operations division worked closely with the inbound logistics to make sure that the raw material, milk reaches the chilling plant in the least possible time once the cows are milked. Their endeavour resulted into the milk being sold at a premium price due to the lowest bacteria count in the Indian market.
USE OF ACTIVITY BASED COSTING
Activity based costing has become an integral part of the modern day business since it is more user friendly and presents with the information which helps in effective budgetary control.
Activity based costing allows firms to collect information about the operating expenses. In this model of accounting costs are assigned to activities like planning, designing or manufacturing; these activities are associated with several goods and services offered by the firm. This helps a firm to understand the profitable verticals in its business and also focuses on the loss making ones which requires corrective actions. Managers collate the data needed for creation of a budget which creates awareness about various expenses for the effective functioning of a firm. In contrast to the theory of constraints which offers the short term solutions, activity based costing is claimed to be more effective when it is used over a period of time.
As Douglas Hicks as said "any small or midsize organization can develop an ABC system. It doesn't require a great commitment of time or financial resources. Nor does it require the implementation of special software integrated into the general ledger-although for larger organizations that may be a benefit. It requires only that management view its operations through 'the lens of ABC' and create a model that will enable it to measure costs in accordance with that view."