Exploring the range of costing methods

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In business, retail, and accounting, a cost is the value of money that has been used up to produce something and as producing and earning profit is the main intention of any business or accounting cost alone is the most important thing in any of the accounting field.

Cost: According to Lal, J. (2002) Cost is the amount of expenditure relating to a specific thing or activity. The specific thing or activity may be a process, job, service, product or any other activity. In other word Cost is the total spent for goods or services including money and time and labour.

Types of costs: Cost can be Direct and Indirect. The total of Direct cost is Prime Cost and the total of Indirect cost is Overheads.

Direct Cost: Costs those are directly attributable to the units of output. They can be divided into direct materials, Direct Labour, and Direct Expenses. Brammer, J. and Penning, A. (2001)

Product X

Direct Material 20

Direct Labour 15

Direct Expenses 10

Prime Cost = 45

Indirect Cost: Costs that cannot be directly attributed to the units of production. They are also referred to as overheads. In a manufacturing environment only the indirect costs relating to production are usually absorbed into the production cost. Brammer, J. and Penning, A. (2001)

Product Y

Indirect Material 15

Indirect Labour 10

Indirect Expenses 5

Overheads = 30

Prime Cost 45

Overhead 30

Cost Per Unit = 75

Cost Behaviour: Hansen, et al. (2009) states that Cost behaviour is the general term for describing how cost changes when the level of output changes. In other word cost behaviour is the relationship between cost and activity.

There are different types of cost behaviour and they are :

Variable Cost: Variable cost is a cost that varies directly with sales, such as raw materials, labour and sales commissions. It changes with a change in the volume of activity.

The diagram shows the way variable cost works and how it changes with the change in the volume of activity. In the diagram the horizontal line introduce the total number of unit and the vertical line introduce the total cost of production. As we can see from the diagram when the total unit is 5 the production became 10 so the cost per unit is 2. It's the same for 20 but the cost per unit stays the same. So the diagram makes it clear that variable cost changes with the change in the volume of activity.

Example: Example for variable cost could be The cost of temporary labour for a temporary staffing company.(More temps placed = more temps hired and paid.) and The cost of paper for a printing company. (More jobs printed = more paper used)

Fixed Cost: Fixed cost is a cost that remains relatively constant regardless of the volume of the operations. It doesn't change based on production or sales volumes.

The diagram above shows the way fixed cost works. In the diagram the horizontal line shows the total number of unit and the vertical shows the total cost of production. So as we can see when 10 units is produced the fixed cost is 20000 but from the diagram we also see that when the unit increases to 10 to 20 the fixed cost stays the same.

Example: As fixed costing is a never changing method the example of it would be:

Rent, Rates, Salaries, Accountancy costs, Most Marketing Cost

Semi-Variable Cost: A semi-variable cost is a cost that starts with a fixed cost and as the volume of the activity increases the cost also start increasing. It's an expense which contains both a fixed cost component and a variable cost component.

Here, when the total unit is 20000 the total cost of production is 140000 and the fixed cost is 70000. So the total variable cost stand (140000-70000) = 70000. So it could be said that (F.C+V.C) = S.V.C

Example: As the semi-variable cost contains both of the contents of fixed cost and variable cost, the example for it would be: Mobile phone calls, Sales commissions and salaries.

Stepped Fixed Cost: Stepped fixed cost is a cost that is relatively fixed over a small volume or range of activities but is variable over a large range or volume. This cost stays fix for a relevant range but as the range exceed the cost get increased.

In stepped fix cost when 40 units are produced the total cost is 80 but when the production increases and became 45 then the cost will also increase to Relevant Range (A+B) means 80+90 = 170. If the production of unit raise further up to 80 then the total cost will be Relevant Range (A+B+C) means (80+90+95) = 265. So it is clear that Stepped fix cost changes when the relevant range exceeds.

Example: An owner of a house have to pay 1000 rent having capacity of 7 people. So he have to pay the same till the capacity of people exceed from 7 but the owners family capacity is about 8, so by extra person the owner have to acquire another house on rent and because the owner intend to keep extra person in the house so by exceeding person the owner acquire a house and the rent went double by an extra person. So such a cost which is extended by a certain range is stepped fix cost.

Total quality management is a set of management practices throughout the organisation which ensure that the organisation is meeting or exceeding customer requirements. TQM strongly focus on process measurement and controls as of continuous improvement.

Total Quality Management: According to Brammer, J. & Penning, and A. (2001) Total Quality Management means that quality management becomes the aim of every part of an organisation. In other word TQM is an enhancement to the traditional way of doing business Naidu, NVR. et al (2006)

The Philosophy of TQM: The basic principles for the Total Quality Management (TQM) philosophy of doing business are to satisfy the customer, satisfy the supplier, and continuously improve the business processes. There are some principles of TQM which is part of its philosophy and those are

Satisfy the customer

Satisfy the supplier &

Continuous improvement

The philosophy of TQM is to do with the quality and the quality hierarchy explain it well.

TQM is all about building quality from the start and making the quality everyone's concern and responsibility. For higher-quality goods and services most of the consumers are willing to pay a premium. Organisations which employ TQM philosophy believe that any product or service can be improved. This improvement could be better performance, reduced cost and higher reliability.

The Aims of TQM: TQM has a simple objective which helps it to achieve its aims and goals.

The main objective of TQM is Do the right things, right the first time, everytime.

TQM has some particular aim to fulfil and those are:

Making the organization market and customer focused.

Guiding the organization by its values, vision, mission and goals set through strategic planning processes.

Changing the organization from function focused to customer focused, where customer priorities come first in all activities.

Making the organization flexible and learning oriented to cope with change.

Making the organization believe in and seek continuous improvement as a new way of life.

Creating an organization where people are at the core of every activity, and are encouraged and empowered to work in teams.

Promoting a transparent leadership process to lead the organization to excellence in its chosen field of business.

Cost of Quality: According to McCormick, K. (2002) Cost of quality is a tool that has been used in many industries, usually within a total quality management or performance improvement programme.

There are four types of cost categories into which quality costs fall: Prevention Costs, Appraisal Cost, Internal Failure Cost and External Failure Cost. It is useful to split quality costs into these categories, for there are so many subcategories that it can be difficult to track them all without this method of organization.

Prevention Cost: Prevention costs are the costs associated with preventing mistakes and faulty output. They include the costs of:

Design improvements, to reduce number of rejects

System improvement for services

The development and maintenance of quality control equipment

The administration of quality control

Training employees in quality control and new methods of working

Appraisal Costs: Appraisal Costs are the costs associated with assessing quality. The include the costs of:

Inspection of goods inwards and raw materials received

Inspection of work in progress

Performance testing of finished goods

Appraisal of the quality of services

Internal Failure Costs: Internal failure costs are the costs of mistakes within the organization and they include the costs of:

Investigation and analysis of failures

Re-inspection

Losses due to scrapping sub-standard goods or selling them at lower prices

Losses due to faults in the raw materials purchased

Production delays

Reviewing product design and specification after failures

External Failures Costs: External failure costs are the costs of mistakes which result in sub-standard products or services reaching the external customer. They include the costs of:

Running a customer complaints department

Liabilities in relation to faulty products

Repairs and replacements

Loss of customer loyalty

Balanced Scorecard: Balanced scorecard is a Performance management tool that recapitulates an organization's performance from several standpoints on a single page.

Balanced Scorecard is the new synthesis created by the collision between the irresistible force to build long-range competitive capabilities and the immovable object of the historical-cost financial accounting model Kaplam & Norton (1996)

The 4 Perspective of Balanced Scorecard: The balanced scorecard system of Kaplam and Norton is a strategic approach and it helps organization to translate a company's vision and strategy

1. Financial perspective

2. Customer perspective

3. Business process perspective

4. Learning and growth perspective

The Financial Perspective: Kaplan and Norton didn't disregard the traditional need for financial data. Providing timely and accurate funding data will always be a priority for the managers. With the implementation of corporate database processing can be centralised and automated. But the point is that an unbalanced situation with regard to other perspective was lead by the present emphasis on financial issues. Perhaps there is a need to include financial data, such as risk assessment and cost-benefit.

The Customer Perspective: The philosophy of recent management shows that there is an increase in realization of the importance of customer satisfaction and focus in any company. There are some leading indicators which show that if company doesn't satisfy customer needs they might go to another supplier. Poor performance from this perspective could prove dangerous. Though the current situation is good but in future customers should be analyzed.

The Business Process Perspective: The perspective of business process refers to internal business process. The managers can see how their business is running by the measurement based on this perspective. It will also show the managers whether its product and services is need to the customers. These metrics should only be design by the persons who knows the processes very well. Two kinds of business processes could be identified in addition to the strategic management processes and they are

Mission-Oriented Processes

Support Processes

Learning and Growth Perspective: The perspective of learning and growth includes employee training attitudes and corporate culture related to both individual and corporate self-improvement. People are the main sources in a knowledge worker organization. In today's world it has become important for knowledge worker to learn continuously. Sometime government agencies find it difficult to hire new technical workers. Kaplan and Norton said that learning is something more important than training; it includes things like tutors and mentors within organization.

The integration of these four perspectives into a graphical image makes things more appealing

A budget is a financial document which helps people to project their future income and expenses. A budget process may be prepared by individuals or by companies to know whether the person/company can continue to work with its projected income and expense

Budget: According to Kemp, S. & Dunbar, E. (2003) Budget is a plan that which includes the money you will spend and when you will spend it. In a simple word budget is a plan of incoming and outgoing monies.

Objectives of Budgeting: Managers have a responsibility for achieving the objectives of the operation. A strategic plan will set out overall objectives and goals of a business and such kind of plan helps any organization to define the type of business. The management team is usually the reason for the preparation of budgets. Any operational are which is seen as essential to achieving the operational objective will have a specific budget. The number of budgets prepared in an organization is depends on the specific needs of management. The accounting system of the operation provides the information of what happened in the past and give a view to managers to keep track of whether or not they are meeting their current budgets. Only the budget from the past is not enough for managers they also need the financial information to provide expectation for the future. So it can be said that budget is an expectation of what managers agrees is achievable within the immediate future and are mostly expressed in financial terms.

Budget Committee: Budget Committee is basically a Cabinet Sub-Committee which is responsible for considering all Budget related matters and making appropriate recommendations to Cabinet.

Roles of Budget Committee: The roles of budget committee's are:

Establish reviews and financial policies and how those policies are implemented.

Make an understandable budget process for members of the committee and the larger community.

Make strenuous efforts to optimize the limited financial resources available to achieve the goals of the company.

Review the company's capital budget to make decisions and recommend the allocation of available funds.

Take action when the financial reports prepared for management review shows significant deviations.

Types of Budget: Budget is divided into different types. Each type has some different sub-points of its own. Normally budget can be divided into 4 parts and those are:

Incremental Budget: Incremental budget is a budget which is prepared using a previous period's budget or actual performance as a basis with incremental amounts added for the new budget period.

Incremental budget is stable and the change in this budget is gradual. The system of incremental budget is simple to operate and very easy to understand and the simple nature of the budget helps managers to operate departments on a consistent basis. On the other hand incremental budget lacks incentive for developing new ideas. If there's no incentive to reduce cost the budget may become outdated and can no longer relate to the level of activity or type of work being carried out.

Zero Based Budgets: Zero based budget is a budget which requires every level of management to start from zero and estimate budget data as if there had been no previous activities in their unit.

Zero based budget forces budget setters to examine every item and develops a questioning attitude. Based on previous year's figures zero based budget also prevents creeping budgets. In zero based budget managers are encouraged to look for alternatives but the problem with zero based budget is it is a very complex time consuming process and here short term benefits may be emphasised to the detriment of long term planning.

Activity Based Budget: Activity budget funds necessities to continue an agency's approved ongoing activities. The way the agency provides services this budget doesn't really include significant changes. The development of this budget is at the very beginning of each biennial budget cycle.

Activity budget can identify opportunities for improvement and cost reduction and it relates costs to performance data. Activity budget also enables assessment of processes that are effective in serving customers but this budget requires and accounting system that records at the needed level. This budget is also very time consuming and it requires detailed project plan.

Rolling Budget: It's a plan which updates continuously in order to stabilize the budget time frame while the actual periods covered by the budget change. A future period is added to budget at the end of each period (month, quarter or year)

The main advantage of a rolling budget is that it should prevent a variance arising from external and uncontrollable circumstances. This gives a more powerful meaning to the variances, which remain. They are fully attributable to management effort. Rolling budgeting system is very hard and time consuming.

Behavioural Aspects of Budgeting: The way in which budgets are administered impacts on their effectiveness in helping to achieve an organisation's goals. The budget in any company has a dual role of being a forecast of the year and a yard stick of managerial performance. Schiff, M. And Lewin, A. (1978)

It can also be argued that by using the budget to measure managerial performance there is an attempt to use it as a tool for control. If this is linked with a reward and/or punishment system There is a general tendency for managers to distort the information they pass on to their superiors, so that the unfavourable items are under-emphasised. Lamberton, G. And Harvey, D. (1991) Such distortion of information is undesirable and counter-productive. Some organisations use sanctions and punishment to encourage adherence to budget. The use of sanctions and punishment is synonymous with an authoritarian style of management.

The behavioural aspects:

Maintain supportive and cooperative relationship with staff

The use of punishment (authoritarian style) tends to encourage attempts to beat the system.

Padding the budget means overestimating costs and/or underestimating revenue

Participation in the budgetary process tends to result increased productivity and satisfaction

There are some advantages arises from participation and those are:

Improved communication

Greater understanding of the factors involved

The opportunity to thrash out problems at budget meetings before the budget is set

Increased acceptance of the budget

Improved commitment

Other factors affecting behaviour:

Dysfunctional behaviour may be caused by the following budgetary problems.

Budget targets that are perceived by employees as too difficult to attain will result in resentment and a feeling of stress.

Budget targets that are perceived by staff as too easy to achieve do not provide a challenge and may lead to a slipshod performance by staff.

Managers may experience a loss of autonomy by being hemmed in by the budget and not having sufficient flexibility to use their own initiative.

Managers may become narrow minded, focusing only on their own department, and create disadvantages for the organisation as a whole.

The emphasis on financial goals to the detriment of non-financial goals may have a debilitating effect on the organisation.

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