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Second question: Comments on various statement made by Oven, Rooney and the Chair person (in italics) and their implication for management accounting within the company.
1.Rooney replied that 'profits had declined because August's production was significantly less than the average monthly volume because August was a holiday period when many of the production staff took their annual holiday entitlement. The reduction in production staff resulted in production overheads being under-absorbed, and this under-absorption of overheads resulted in additional fixed overheads, compared with July, being assigned as costs within the August profit statement'.
From what Rooney said, the decline of profits is mainly due to large amount decrease of production in August because of the holiday period. And the amount of production in August was less than average monthly volume, so it incurred under-recovery of production overheads, which is recorded as an expense in the current accounting period (Drury, P64) and in turn leaded to reduction in profit.
According to UK Statement of Standard Accounting Practice on Stock and Work in Progress (SSAP 9) and the international accounting standard on inventories (IAS2), the allocation of overheads in the valuation of inventories and work in progress needs to be based on the company's normal level of activity and that any under- or over-recovery should be written off in the current year. Under- and over-recovery of overhead is not allocated to products. Also as mentioned above, under-recovery is recorded as an expense in the current accounting period whereas an over-recovery is recorded as a reduction in the expenses for the period (Drury, p64).
2. Owen(manager) stated that 'surely if there is a significant increase in sales this should be reflected in an increase in profits.'
3. . Rooney showed the statements as in Appendix 1 to Owen who responded 'now that is what I expect from an accountancy system. I knew that the performance was better in August than July and this is what is reflected in the variable costing profit statement. I propose that we replace the absorption costing system with a variable costing system.'
Generally, it is common sense that people sell more and earn more profits. But as more and more complex modern business is, the more complicated accounting system people use, so it may occur some counterintuitive accounting phenomenon, say, increase in sales can lead to declined profits if we use absorption costing system to allocate fixed overhead costs to products.
The reason is that after we allocate fixed overhead costs to products, profit is determined by two variables, sales volume and production volume, so the correlation between profit and sales is not simply linear. However, under variable costing system, profit is a function of sales volume only, assumed selling price and cost structure not changed (Drury,p147).
So it is right that profit increases as sales increase when we use variable costing system, but it is not true under absorption costing system.
The mathematical model for profit fuctions below can make the argument above more logical.
Variable costing operating profit= ucm -Qs-FC
Absorption costing profit= ( ucm - ufmc) Qs + (ufmc - Qp) - FC
Qs: Number of units sold ucm: contribution margin per unit
ufmc: pre-determined fixed manufacturing overhead per unit of output
Qp: number of unites sold
FC: total fixed costs (manufacturing and non-manufacturing) (Drury¼Œp147)
However when production equals sals, the profit would be the same for both method, when production exceed sales, the absorption costing system will show higher profit, when sales exceeds production, variable costing system will show higher profit.
It seems variable costing system cope better with the common sense that sales in August increase so correspondingly profit should be higher than in July. But no matter variable costing system or absorption costing system, they both have drawbacks and advantages. It will be discussed in the following section.
4. This proposal was also supported by Rooney, who opined 'The obvious advantage is that this approach would avoid the need to allocate manufacturing fixed overheads to products. This process is time-consuming and many of these allocations are arbitrary and have the potential to distort the profit margins on individual products. Now I think on it variable costing is also preferable for controlling fixed overhead cost because fixed overheads are separately reported rather than absorbed as a product cost'.
It is indeed that variable costing system has many advantages for internal management purpose and decision making.
Like Rooney said variable costing system avoid arbitrary allocation of fixed overhead and distort of profit margin.
When making short term decisions, the cost information based on the seperation of fixed and variable costs are very useful and relevant. That means variable costing system highlights the analysis of variable and fixed costs.
'Variable costing system removes from profit the effect of inventory changes' and that is why under variable costing system it is intuitive that profit increases as sales increases and also, because of this variable costing can avoid the manipulating of inventory level and profit in short term by managers, 'which means managers can no longer defer deliberately some of the fixed overhead allocation by unnecessary increasing stocks over successive periods.' (Drury,p149)
'Variable costing avoids fixed overheads being captialized in unsaleable stocks'(Drury,p149)
However, although variable cositng is good for internal management, auditors and exteranl investors do not concern decision relevance of product cost information but whether the inventory information is unbiased and auditable (Lucas, 2000) and whether the information can be used for inter-company comaprison. And many companies need to raise fund form stock markets, so they adopt absorption costing system in order to be consistent with external reporting and meet the legal requirements. Besides, absorption costing can make managers be more aware of fixed costs when making sales budget and setting price because cost of individual product already contain allocated fixed cost. The question whether to use absorption costing or variable costing or both will be discussed below.
5. The Board Chairperson expressed concerns about adopting the variable costing system. She said that 'with the variable costing system business would be undertaken at margins that exceeded variable costs but that may not provide a sufficient contribution to covering fixed costs or generating sufficient profit'.
The argument that variable costing system may not priovide enough profits to cover fixed cost in long run is not approriate. On one hand, if a pricing decision only depends on variable cost and ignore fixed cost, it is no wonder that sales revenue would not have enough margin to cover long run fixed cost. But that is the fault of managers not the variable costing system. On the other hand, people argue that if a company uses absorption system, the cost of every product contains allocated fixed cost, will make sure in long run all fixed cost will be covered. However, this is not the whole picture. It is indeed that managers may be more aware of fixed cost if they use absorption costing system when they draft the plan of sale budget. But in reality it is still possible that the company fail to achieve the budget goal and thus fail to cover fixed cost. (Drury, p149) For example, assume that a company has a production line where fixed costs are $ 500,000 and it can normally produce 50,000 units, thus fixed overhead rate is $10 per unit. If variable cost per unit is $15 and selling price is $35 and the company sell 20,000 units, so the revenue is 700,000 (35-20,000) and total cost is 800,000 ( 500,000 + 15-20,000). Therefore total sales revenue fail to cover total cost. In words, if managers pay enough attention to fixed costs and if they achieve the goal in their budget, no matter variable costing or absorption costing system can both provide useful information for pricing determination and cover long term fixed costs.
Now consider a more complicated case. When managers make a plan of sales budget of price setting, they need to take account into opportunity cost, say, what is the cost of best alternative use of their labour. In such a case of pricing and furthermore, product mix decision, absorption costing system could be 'useful and intellectually defensible' (Baxter and Oxenfeldt, 1961). Because in real life, it is not easy to know clearly what is the alternative of job X when a price must be put on it and the best estimate of opportunity cost is therefore the average contribution per labou hour (Lucas, 2000). So during the process of setting price and determining opportunity cost, 'absorption costing can serve as proxies for the opportunity cost of using the firm's capacity resurces on a particular job or product' (Baxter and Oxenfeldt, 1961).
6.In addition, she drew attention to the fact that 'external financial reporting required that profit statements and inventory valuations should be based on absorption costing. Therefore it would be necessary to operate both variable and absorption costing systems - one for internal profit measurement and the other for external profit measurement. The results reported by the two systems may differ and result in confusion if the systems reported significant differences in profits'. She argued that managers should focus on the same profit measure that financial markets use to evaluate the company. Finally, she drew attention to the fact that although the net profit in August was higher with the variable costing system if the profits for July and August were added together the absorption costing system showed the same profits.
Now Arcane Company face a common problem, which many other companies also struggle in, that is after nearly 100 years development, where should management accounting go or say how to define the function of management accounting nowadays? Wheteher it should 'become subservient to the needs of exertenal financial reporting' (Lucas, 2000) or it should focus on its original function of internal reporting, controlling and decision making.
On one hand it is legal requirement, like SSAP 9 and IAS 9, that companies need to use absorption costing system for external reporting. Because auditors and exteranl investors do not concern decision relevance of product cost information but whether the inventory information is unbiased and auditable (Lucas, 2000) and whether the information can be used for inter-company comaprison. In addition, thousands of companies need to raise fund in stock markets, so many of them adopt absorption costing system and it is inconsistent and confused and high cost to use two methods of inventory valuation, so the results is 'absorption costing still predominates' (Lucas, 2000).
On the other hand, the fact that ' variable costing provides more useful information for decision-making', 'variable costing removes from profit the effect of inventory changes', 'variable costing avoids fixed overheads being capitalized in unsaleable stocks' (Drury, p148) shows variable costing may be better for internal reporting, especially when management need profit and inventory information frequenly and shortly, say, monthly interval.
So it seems reasonable that Acrane Company use two costting system, absorption costing for external reporting and variable costing for internal reporting. However, as mentioned above, it would incure unnecessary cost if the company use two system and managers would feel confused when face two different results. But there is one very important ponit that people shoul be noticed. On an annual basis, the differences of stock level and profit index between variable and absorption costing system are not significant. As a chairperson, she needs to think in a bigger picture and consider long term strategy and she was right to pay more attention to the annual interval instead of monthly interval, so it would be acceptable if she finally make a decision to use absorption costing system.
Furthermore, according to Horngren (1977, p502) and Kaplan (1977, p52), the cost allocations linked to managerial behaviour, and thus absorption costing system can reduce arbitary use of perquisite by managers (Zimmerman, 1978). Because under certain assumptions, ' an agent's discretionary spending on per-quisites can be reduced by a luump-sum tax'( Williamson, 1964) and 'cost allocations can act as a lump-sum tax' ( Zimmerrman,1978).