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Nowadays, performance measurements of manufacturing organization play a significantly crucial role in assisting strategic decision as well as development direction making. As a major element of performance measurement, the option of costing system has an important influence on the prosperity of business. When the use of appropriate costing system can improve production efficiency and ensure the strategic decision in right direction, the utility of wrong costing system will lead to destructive economic consequence for business. Since last century, the efficiency of traditional costing systems to deal with changes in manufacturing practices have been primary concerned. As the outcome of industrial economy age, the implication of traditional costing systems is based on the production process involving high proportion of direct cost such as machine and labor costs. (Mishra and Vaysman, 2001) However, with the development of digital economy, the role of support service has been enhanced, while the direct cost level of total production cost has been diminished in present business environment. Compared with traditional methods, some advanced contemporary notion of costing techniques are introduced such as activity based costing and total quality management as well as just-in-time theory. (Bhimani, 2006) Due to the significant difference between traditional and contemporary techniques, it has attracted lots of discussion concerning the relevance of traditional costing system to current business environment. This essay aims to indentify the reason why the traditional costing systems compared with contemporary techniques become inappropriate for current business environment by analyzing two representative traditional cost-management tools: absorption costing and standard costing.
The relevance of absorption costing system
Since the early of last century, the traditional costing systems have been introduced to manufacturing practices. It is a well-known fact that they usually involve volume-based cost driver which is suitable for the production process during industrial age, and the information provided focus only on internal operation management due to high collection cost. (Johnson and Kaplan, 1987) However, with the coming of information and digital age, the relevance of traditional cost management tools have been attacked since last decades because of increasing requirement of external competitive information.(Wilson and Chua,1993) Moreover, the emergency of new advanced contemporary cost management techniques also makes the future of traditional costing systems in the predicament.
As one of major conventional costing systems, absorption costing method involves the utility of volume-based overhead absorption bases such as labor hour and machine hour. In other words, all manufacturing costs are allocated to products while non-manufacturing costs are directly charged from profit and loss statement. Although majority accounting authoritative bodies have approved the use of absorption costing, yet there is still a lot of criticism around it. (Baxter, 2005)
Primarily, absorption costing method combines different cost drivers into unit cost rather than indicating the true cause of overhead. (Vercio, 2008) Thus, it is difficult to identify where cost saving in overheads can be made for long term reduction of cost. Then, the blind reduction of overhead costs is more likely to induce a decreasing in the quality of products in many cases, which destroys the customer loyalty eventually. Moreover, due to the advanced techniques involved in production process, the direct cost may just be a fraction of total cost with high-efficiency manufacture. (Drury,2008) In other words, the traditional cost drivers such as labor hour or machine hour are not regarded as the major components of production overhead in current business environment. Thus, the utility of absorption costing will probably lead to misleading and inaccurate measurement of product costs. Besides, it is possible to result in improper pricing and sale mix decisions owing to under or over estimation of product cost.
Due to above problems about absorption costing system, the possible solution is to employ activities based costing (ABC) with the assumption of cause and effect relationship between activities and cost. Compared with traditional absorption costing system, the major advantage of ABC is to highlight the true cost centre of the overheads by using the activity cost pools. (Drury, 2008) Hence, some managers have began to awake that the use of ABC is more relevant to current changes than absorption costing in manufacturing practices since 1980s because it is helpful to eliminate the cross subsidization problem and improve sale mix decision. (BjÃ¶rnenak and Olson, 1999)
However, In fact, it is costly and time consuming to build up an ABC system instead of the traditional one, because it normally involves complicated process and great amount of employee training, and the new system will be worthless if there is any error involved in overall process. Thus, the traditional absorption costing system is still prevalent in practice because of several advantages to the business. (Mishra and Vaysman, 2001) On one hand, according to this measure, fixed cost will be deferred and recorded only in the period of incurring sale as an expense. Thus, absorption costing avoids fictitious losses being reported and provides a logical profit calculation. (Drury, 2008) On the other hand, in order to be accordant with the measure employed by financial market to evaluate general management performance, senior management may prefer internal profit reporting system to follow the external financial accounting absorption costing systems. By this way, it is to reduce the potential impact of the accounting information from external report on share price, and the managerial bonus linked to external evaluation report is also to encourage the use of absorption costing as internal reporting system as well. (Drury, 2008)
The relevance of standard costing system
As to traditional standard costing system, it involves to record the production cost at standard per unit, then identify the adjusting entries by comparing with the known actual cost. Thus, standard costing is considered as an appropriate tool for production efficiency and cost control with the information provided from adjusting entries over a period of time. However, dissenters insist it is not appropriate for contemporary business environment with following criticism.
Primarily, this costing system only focuses on the internal-oriented cost control, which may mislead and misdirect management decision making as it neglects the importance of external market-oriented cost factors such as quality and flexibility. ( Atkinson and Kaplan, 1998)
Secondly, in order to pursuing low cost, the bulk buying and the supplier changes will be encouraged with traditional measurement of material price variance, as it pays little attention on quality and delivery which play considerably crucial role in customer satisfaction in current fiercely competitive economic environment. This measure is also considered to hinder the successful utilization of Just-In-Time (JIT) and Total Quality Management (TQM) which highlight the need for long term strategic partnerships with a few stable suppliers to provide timely delivery of quality materials for the sake of minimizing inventory cost. (Drury, 2008)
Besides, owing to the emphasis on labor and machine efficiency variances based on standard costing, over-production may be encouraged and excessive inventories will become a burden of business. Differently, the notion of JIT may be helpful to overcome the problems with the aim of eliminating waste and enhancing efficiency.
Moreover, management may tend to excessively stress the volume based overhead allocation rates rather than the total product cost so that the overhead cost is inaccurately estimated and high cost activities are hidden. The core problem is that the true cost drivers are not identified like the situation in absorption costing. Hence, the implication of Activity Based Management (ABM) is the reasonable solution with building up the â€œcause and effectâ€Â relationship between business activity and cost. ( Atkinson and Kaplan, 1998)
In addition, the traditional way only blindly highlights the improvement of department efficiency rather than the overall efficiency of value chain with allowance for tolerable levels of waste and quality variations. As a result, this induces the loss of cost saving opportunities, non-value added and cost inefficient activities. Conversely, the concept of JIT and TQM emphasize the reengineering the whole process in order to improve performance maximally.
Furthermore, current market environment changes so rapidly that there is great need of real time information for ensuring proper control measurement taken. But, it is believed that periodic financial variance reports cannot provide sufficiently meaningful and timely information, and hinder the control action in a JIT and the continuous improvement schedule based on TQMâ€™s philosophy.
However, although there are many criticisms mentioned above, standard costing system is still useful to modern business with appropriate changes. Instead of using attainable performance, the utility of demanding is able to encourage continuous improvement. Moreover, instead of being used to cost control and performance evaluation, standard cost and variance analysis also can be regarded as usable tool for tracking cost of inventory and maintaining a database for decision-making in order to improve cost efficiency as well as to maintain flexibility to changeable market environment. Besides, standard costing can be employed in conjunction with target costing for the sake of determining the cost gap.
In conclusion, due to the changes in manufacturing practice and economic environment during last decades, the implication of traditional costing systems has been in the predicament with the rise of new advanced management accounting techniques. Although there are many criticisms surrounding the traditional costing system because of some theoretical limitations, it is still relevant to the current business practice due to the advantages compared with contemporary techniques and continual improvement. The evidence from literatures also suggest the employ of the traditional costing systems as significant tools for performance management is because they can avoids fictitious losses being reported and present higher profit in accounting report than other contemporary management accounting techniques. (Mishra and Vaysman, 2001; Drury, 2008) Moreover, In fact, it is costly and time consuming to build up a new technique system such as ABC instead of the traditional one, because it normally involves complicated process and great amount of employee training, and the new system will be worthless if there is any error involved in overall process. As a result, some practitioners prefer keeping traditional management accounting methods to taking adventure though there is obvious theoretical advantage of new methods. Therefore, although the traditional costing systems have been behind the times and inappropriate for present manufacturing process in the aspect of theoretical base, yet it still cannot say that the traditional costing systems are irrelevant to current business environment absolutely when the implication of them still play an importance role in current real business world.