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Management accounting is an essential mechanism for organisations in order to operate efficiently. This is because it gives organisations an indication of how to plan, control, measure and operate non-financial and financial information systems to enable effective implementation of their objectives. Management accounting was developed to measure performance for different organisational units; so they would become aware of what areas need further development and improvement.
Manufacturing organisations were the prime organisations to use management accounting, however, as major changes occurred, service organisations implemented management accounting. This was because these organisations became more complex as they started to introduce more services and customers became more demanding. Consequently, organisations needed more information to establish and plan functional strategies to make the right decisions on products/services and production costs.
Recently, organisations have developed new approaches to allocate overheads, as organisations have expanded their overheads represent a higher contribution of all costs. Organisations use these main methods of allocating their costs such as marginal costing ,absorption costing and activity based costing, which will be discussed on the latter.
Traditional costing systems such as marginal and absorption costing; have been developed when direct labour and materials were the most significant costs of a product. Businesses used these methods because they only produced small ranges of products, lacked of sophistication and products were produced in identical batches so they would be consuming similar amounts of costs.
Organisations used to allocate 5% indirect costs and 95% would be direct costs (Yu-Lee, Reginald, T. 2001). Hence, then this method was the appropriate for such organisations. On the other hand, nowadays overheads account most of the product's costs, and direct labour only represents 5%( Thacker, Chris, 2009). Therefore, overheads are not always fundamentally related to the volume drivers of labour or machine hours as this can distort products costs. As, different products require different labour and machine hours. For example, although the products are the same, some batches might take longer to make or the machine set up might take longer. When producing ice creams, different flavours might take longer as the machine will take longer to clean, as some ice cream flavours are thicker than the others. Consequently, these products although they are similar they incur different costs so their cost must be different so that all costs are recovered (Atkinson, A. et al).
Service and manufacturing organisations operate differently, especially on the way they approach overhead costs. For example, absorption cost systems ensure all manufacturing costs are absorbed into the products produced. However, non-manufacturing organisations do not have work in progress and finished good inventories. Therefore, defining the 'product' is more complex.
Historically managers in service organisations have not used management accounting as much as manufacturing companies. However, nowadays they are required to produce accounts in order to improve their efficiency and quality. This is because customers easily notice defects and delays which consequences can be severe such as customers choosing alternative companies and gaining bad reputation. Consequently, if companies have to create management accounts they become under pressure of having to minimise costs, improve quality and efficiency in their operations in order to analyse which one is profitable and eliminate the products/services that are making losses.
Marginal costing focuses on the contribution that individual products make to the overall fixed overheads and profit of a business. Under marginal costing, the product cost does not include overhead costs as they are dealt as period costs, so they are charged to the income statement. Unlike Absorption costing, this technique even if costs are variable or fixed they are allocated in the same way to cost of units produced. It does depend on the way the organisation operated, for example, if production remains constant and sales alter then absorption costing will create less change in the net profit. On the other hand, this method only draws attention on total costs so it is useless for management decision, planning and control.
Some of the advantages in using marginal costing, in short term all the relevant costs are included for decision making. On the other hand, in the long term it is more advisable to use absorption costing as fixed costs must be recovered through the sales if the business wants to continue. Marginal costing avoid arbitrary allocations of absorption as sometimes this becomes misleading for short term decision making. As absorption costing does not treat fixed costs as period costs, then even if sales are low, there is still a profit or at least costs have been included in product price so no loss is made. If marginal costing sales volume are declining but output is sustained, it gives warning in advance that such product/service might be making a loss. Absorption costing does help 'matching concept' of matching sales with the cost of sales of the same period, therefore, this method is good for planning (Weetman, P).
One of the absorption systems is job order costing which is implemented in departments that produce different jobs or batches and costs are accumulated by jobs. The other one is process cost systems which focuses more on assembly processes and continuos flow of production. Process costing assigns costs to the production processes and then to the products flowing through the process. The disadvantages of these methods is that they ignore the possibility that some activities might be benefiting from other departments. In practice, most organisations produce different products which have different machine set up costs, therefore, this can distort costs. Additionally, as these costs are estimated, the production level can be lower or greater than expected so overheads can be over or under absorbed. As most organisations produce a variety of products it is preferable to calculate separate rates for each department so that costs are more realistic. A blanket overhead rate can be only be useful if a batch of one same product is produced, if products consume similar amounts of service departments and if overheads are low.
Production systems have been accommodated to meet the changes of the marketplace, although in many organisations the internal management accounting systems have remained changeless. However, managers have become discontent with the traditional costing methods as they believed they were no longer appropriate in the modern organisational environment. Additionally, processes began to become more complex as a variety of products were introduced and some also having individual customer specifications. Therefore, it became difficult to use the traditional methods to allocate costs appropriately. Additionally, technology was another major driver as it resulted in increasing automation, so it enabled organisations to measure how long it took them and cost them to produce products/services.
Moreover, a new method of allocating overheads was developed by the Harvard Business School Professors Kaplan and Cooper (Amrik, S, et al 1998) known as Activity Based Costing. ABC is based on cost attribution to cost units on the basis of benefits received from indirect activities. Compared to the other costing methods it is a more radical and novel approach to cost analysis and cost management. Of course, this method can be efficient and helpful depending upon its effort and expertise that is put into the ABC design and application.
By using activity based costing it can provide many benefits for organisations as it gives more accurate production line costs especially when non-volume related overheads are greater than the other costs; and various different product are manufactured. Furthermore, ABC is more adjustable to determine costs by cost objectives rather than like the other methods, which analyse costs by processes, customers and so on. Also, ABC provides a more reliable indication of how volatile production costs are in the long run so that managers can plan ahead more successfully. Additionally, ABC provides crucial financial and non-financial information, which are beneficial measures for cost management and performance assessment at operational levels. Managers are also able to identify and understand how costs behave and are then able to improve cost estimation.
Although, the ABC system has been described as an efficacious and more logical method of allocating overheads it has not been implemented in many organisations. According to a survey conducted in 1990 by the British Chartered Institute of Management Accountants (CIMA) ABC Working Group involving both manufacturing and financial services sectors concluded that only 6 per cent of those firms introduced it and 9 per cent had rejected ABC ( Innes and Mitchell, 1991a). Therefore, this is showing how not many organisations actually implement it although the ones that do use it do believe that it achieves the following five goals: gives more accurate product costing, better cost management, better cost control, better allocation of overheads and more accurate cost information.
Many organisations reject the ABC system due to the following problems; it is time consuming having to install the ABC system, especially for small companies. Also, in order to implement this system successfully, an organisation must posses of a suitable accounting staff, who knows exactly how the system works in order to be able to select the suitable cost drivers. Additionally, if some organisations are using the traditional methods then they are unlikely to introduce a new system as managers might lack of innovation experience and have doubts about the efficiency of ABC system. Organisations believe the main disadvantages of ABC are that is it costly and it required change to the organisational structure.
If activity based costing is successfully implemented then it can be beneficial for the organisation, especially if it has a variety of processes and if it produces products/services to customer's specific requirements. This is so that organisations can react quickly to deliver the correct value preposition to their customers. Nonetheless, what ever method is used, cost dynamics continue to be the same. Even the if most accurate approached is utilized variances still occur due to cost types being different and self-supporting.
An example of a case study about a company known as MelCo, although the company's overall profit margins were increasing their number of customers were declining. This was because the company was not aware of the areas that contributed the highest profit margins as they were using traditional accounting systems (Amrik, S. et al. 1998, pg. 140). Therefore, this is highlighting how if they used ABC they would have had sufficient information in order to determine which areas contribute more and less profit. So MelCo could be making the adequate pricing decisions and their profit could have been higher.
Furthermore, some organisations are required to apply the job order costing, in order to bid on jobs before the customers decide to place an order. This way they estimate the costs for each job and then a mark up rate it added to the final product price. Therefore, this is done to that organisations make sure profit is made. It is beneficial approach as even if they estimate the costs by doing this they make sure all costs are included on the products so no loss is made.
Nonetheless, the contingency theory argues that there is no allocation approach that is appropriate to all organisations. Fisher (2005) contrasts contingency with situation-specific and universalists models (Paul Collier, M. pg 238). Explaining how control systems are created due to the different characteristics that make up each organisation. Additionally, these control systems also depend on the circumstances a business is going through. For example, Fisher found some variables which alter the control systems, such as the industry and business size , diversification and structure. On the other hand Clark (1923) believed that there is 'no correct usage' explaining how cost information can be used in different ways relying upon the business conditions.
Heinz Ltd. is a manufacturing organisation that produces grocery products and only operates in three different locations (Appendix 1). I believe Heinz should be using process costing as the absorption system as their units are produced in identical batches . Consequently, it would be simple to calculate the costs as it divides the cost of stocks by raw materials, work in progress and finished goods ( Appendix 2). Therefore, their total costs could be divided equally to each product as they are all identical batches. Heinz could be also using a hybrid of job order and process costing, so thy could design job order cost sheets to record costs to units produced in the batch and number of machine hours spent.
As Tesco Ltd. is providing financial services, marginal or absorption costing would be difficult to apply as defining the 'product' would be more complicated. I believe the best approach that Tesco Ltd. could implement is ABC as accountants would develop a better understanding of the banking operations. Therefore, this would enable the financial control department to support information on the different processes to reinforce the credibility of the financial figures. Furthermore, as financial services offer many services from loans to bank accounts, so many comprise of different common costs so the list of products can be indistinctive.
To conclude, I believe each organisation differs so there is no ideal allocation method as it depends on the size of the organisation, in which sector is operating and other factors. However, I believe for most manufacturing organisations that produce similar products should implement traditional costing approaches. In addition, I think ABC if successfully implemented it can be beneficial for the organisations as it gives more accurate costs so it enables managers to make the right decisions. On the other hand, ABC should be only put in practice if the organisation has the suitable accounting staff who knows how this system works.
- Amrik, S; Walter W.C. (1998) Activity Based Costing in Manufacturing: Two Case Studies on Implementation, Integrated Manufacturing Systems Journal, 137-147
- Atkinson, A. Kaplan, R, Matsumura, E & Young, S. Management Accounting 5th Ed. Pearson, Prentice Hall International Edition, Chapter 4, pg 135
- Collier, P, M. Interpreting accounting information for decision making , Accounting for managers 3rd Ed. Accounting decisions Chapter 13
- Inees, J and Mitchell,F. (1991) Activity Based Costing Management: A Case Study of Development and Implementation, Chartered Institute of Management Accountants, London
- Thacker, Chris, 2009, Cost Management ( Concepts and Definitions) [Lecture to Accounting in its Organisational Context, Nottingham Trent University] 20th October
- Weetman, P. Management Accounting: Overhead Costs, Prentice Hall, Financial Times, chapter 4 pg 118
- Yu-Lee, and Reginald, T. (2001) Explicit Cost Dynamics: An alternative to Activity-Based Costing NY,USA: John Wileys and Sons, Incorporated, pg 112