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The traditional method of costing relied on the arbitrary addition of a proportion of overhead costs on to direct costs to attain a total product cost. In contrast to traditional cost accounting systems, ABC systems first accumulate overheads for each organizational activity. They then assign the costs of these activities to products, services or customers causing that activity. In comparison with traditional methods, costs will be allocated in different proportions, so highlighting unprofitable products that should either be improved form the range.
This type of costing system usually allocates costs based on a single volume measure, such as direct labour hours or machine hours. While using such a basic volume measure to allocate overheads as an overall cost driver, this approach seldom meets the cause-and-effect criteria desired in accurate cost allocation. Traditional absorption costing has become increasing inaccurate as the relative proportion of overhead costs has risen. This distortion of costs can result in inappropriate decision making. (Drury C, 2004)
1.2 Back ground of the Pomodoro Clothing Company Limited
The Pomodoro Clothing Company Limited is UK's medium Scale organization supply brand women garments in many countries in Europe like England, Scotland, Wales, Spain, Greece, Italy, France and Northern Ireland. Pomodoro Clothing Company first came and established in London, UK, in 1992. Pomodoro has been successful since its establishment in London, UK.
The Pomodoro Clothing Company Ltd. has developed with full departments comprising of: administration, human resources, design, quality control, accounts, production and marketing. The total numbers of employees in the company is now almost 80 people. Account manager use traditional full costing method which has caused some serious problems in decision making and overall performance of the company
Many indirect costs are relevant for decision making;
Product decisions are not independent.
Direct information system is required to identify unprofitable products.
Traditional costing system allows overheads to be related to products in rather more arbitrary ways producing.
Traditional costing system gives less accurate product costs.
(Source: Pomodoro Clothing Company Ltd.)
1.3 Aims and Objectives of the Research Study:
1.3.1Aims of the Research Study
Primary Aim: is to show how ABC system gives the new approach to product costing, pricing decision and how performance of overall business can improve of Pomodoro Clothing Company compare to Traditional Absorption Costing system.
Supplementary Aim: ABC systems have the litheness to provide special reports so that management can obtain decisions about the costs of designing, selling and delivering a product. The key aspect is that ABC focuses on accumulating costs via activities, whereas traditional cost allocation focuses on accumulating costs within practical areas.
1.3.2 Objectives of Research Study:
Main aim of the company to achieve annual growth rate of 12% in next year.
To determine new product pricing system and improve overall business performance.
Assigning the cost of activities to products according to product's demand.
Assigning costs to cost pools for each activity
1.4 Significance of the study
The report will help me develop through and in-depth understanding of my MBA subjects in Finance such as Strategic Financial Issues and Management and Cost Accounting. The report will also help me develop understanding of the importance of ABC system to the Pomodoro clothing company in particular and to other organizations in general. As well, the project report will combine all the knowledge I have gained in the MBA programme to design the ABC system which gives new approach to product costing, pricing decision making and profit gain for Pomodoro clothing company. In addition, this project report will help me in future when I work in financial sector or any management position in any company or be an entrepreneur.
Chapter 2. Literature Review:
The literature on ABC collected primary from books in the areas of cost management accounting, finance and management, which will be compared to project based documentation of case study research. The primary aim of the literature search is to help researcher to develop an effective guide on ABC system and their back ground, comparison with traditional costing, benefits and limitations.
2.1 Background of ABC system:
The concepts of ABC were developed in the production sector of the United States during the 1970s and 1980s. In the beginning ABC focused on manufacturing industry where technological developments and productivity improvements had reduced the proportion of direct costs but increased the proportion of indirect costs. In 1988 Cooper and Kaplan described ABC as an approach to solve the problems of traditional costing systems. These traditional costing systems are often unable to determine accurately the actual costs of manufacturing and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products. (Holzer and Norreklit, 1991)
2.2 Definition of Activity based costing:
The concept of ABC was first defined in the late 1980s by R. Kaplan and W. Burns. There is a recent definitions of ABC by Chartered Institute of Management Accounting(CIMA) are quiet impressive for understanding the concept of ABC system.
Activity based costing (ABC) is an 'approach to the costing and monitoring of activities which involves tracing resources consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.'(CIMA Official Terminology)
2.3 Comparison of traditional costing and ABC
Traditional costing system usually allocates costs based on a single volume measure, such as direct labour hours or machine hours. While using such a simplistic volume measure to allocate overheads as an overall cost driver, this approach seldom meets the cause-and-effect criteria desired in accurate cost allocation. This method of costing has become increasing inaccurate as the relative proportion of overhead costs has risen. This distortion of costs can result in inappropriate for product costing and pricing decision.
In contrast to traditional cost accounting systems, ABC systems first accumulate overheads for each organisational activity. They then assign the costs of these activities to products, services or customers (referred to as cost objects) causing that activity. The initial activity analysis is clearly the most difficult aspect of ABC. Activity analysis is the process of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service. The main advantage of ABC is that it minimises or avoids distortions on product costs that might occur from arbitrary allocation of overhead costs.
2.4 Benefits of ABC system:
ABC provides a more perfect method of costing of products and services.
It allows for a better and more comprehensive understanding of overheads and what causes them to occur.
The Availability of cost driver's rates can be used as an input into the design of new products and modification of existing ones.
It makes costly and non-value adding activities more visible, so allowing managers to focus on these areas to reduce or eliminate them.
The main advantage of ABC is that it minimises or avoids distortions on product costs that might occur from arbitrary allocation of overhead costs.
It supports other management techniques such as continuous improvement, scorecards and performance management.
2.6 Limitations of ABC
ABC is a relatively new technique and the potential problems may appear only over a longer period of time. The initial activity analysis is clearly the most difficult aspect of ABC. Activity analysis is the process of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service.
Chapter 3. Research Methodology
This project is a case study report where I will use Pomodoro clothing company and its costing system, pricing system and decision making policies as a case. I will combine both literature review and my own real world knowledge of this topic and my work experience at Pomodoro clothing company to write this report, using my previous work experience, annual financial reports and staff feedback of Pomodoro clothing company to identify the problems in decision making and profit gain.
3.1 Type of research and research method
According to Saunders (2006) the methodology is one of the most significant parts of the research making process. I will use Exploratory research here which often relies on large sum of secondary data research such as reviewing available literature and/or data, or qualitative approaches such as informal discussions with managers (Saunders 2003) like it will be the case in this project.
Qualitative researcher typically relies on four methods for gathering information:
Participation in the setting,
In depth interviews,
Analysis of documents and materials.
3.2 Researcher philosophy:
(Saunders, 2003)" Deductive approach owes more to positivist and the inductive approach to philosophies, the deductive approach owes more to positivism and inductive approach to interpretive". After considering all concepts, it became evident that this research project would have to fall within interpretive philosophy as it required analysis of qualitative data inductive approach.
3.3 Sources of data collection
Data will be collected from two main sources:
3.3.1 Literature reviews will be used to come up with the ABC system for decision making and profit gain comprising of internet articles or journals, books, newspaper or magazine articles and thesis on ABC system.
3.3.2 Internal documents like annual financial reports and interviews with managers and staffs will provide information for the case study portion of the report. The interviews will be based on the procedures in the guidelines issued for the project and will follow the ethical procedures for this kind of research, that is, interviewees will sign the Research Consent Form in the guidelines that certifies they have given informed consent to the research.
3.4 Sampling of the research
For this project, the non probability convenience sampling technique will be used. The convenience sampling attempts to obtain a sample of convenient elements (Malhorta, 1999). The researcher is the one who primarily selects the sampling units. By the way, "often, the respondents happen to be in the right place at the right time" (Malhotra, 1999).
In the case of this project, the criteria for choosing the sample of documents, the company chosen fits perfectly to the subject and, most of all, the researcher is an employee of this company. This convenience technique is the least expensive and the least time consuming of all sampling techniques. Convenience samples can be used in exploratory research to "generate ideas, insights or hypotheses" (Malhorta, 1999).
3.5 Method of Data Analysis
The data collected will be grouped into qualitative and quantitative data. This is to avoid data volatility and ensure efficiency in the analysis of the data. Excel will be used to generate the output. The output would be drawn from collected data and using calculations for product pricing of Pomodoro clothing company ltd. by activity based costing compared to traditional absorption costing. This would be a means to interpret the analysed data and draw a specific result to research questions.
In conclusion, it is important to emphasize that this research relies on multiple sources of data interpretation and therefore the risk of it being invalid at results will be reduced nominally. However, a reasonable attention will be given on all the above issues to ensure that errors and inconsistencies are minimized throughout the research.
Chapter 4 Research Findings
The purpose of this chapter will to explain findings and results come out from this research, to present ssresults; I will use different literature to compare with the multipurpose secondary data and documentation of implementation project. Using this research, the chapter indicates details come out from analyzing qualitative database of traditional costing system of the company.
After having gathered the needed information we are now going to analyse it and come out with our discovery of the study. Due to the fact that raw data cannot be considered useful for decision making purposes, it is indeed necessary to present data in a more useful manner to ensure easy understanding to prospective users. In this respect, therefore, this chapter purport to present data collected from the field for the research work in order to avoid misleading. Thus, the chapter seeks to use appropriate analytical measure to package raw data as to foster easy understanding of the field data.
The members of the senior management team of Pomodoro clothing company Ltd. discussed the introduction of a new product (embroidered woollen coat) to the company's range of high quality women garments in October 2009. A major agenda item was pricing. The account manager had given much thought to pricing policy and one of his concerns was that of dealing with the recovery of overhead within a full cost pricing policy. The discussion centred on the traditional method currently in use. So, I compared and contrasted Traditional costing method with ABC, which re-examines the problem that has faced accountants for decades; that of allocation and absorption of overhead.
5. Expected outcomes, schedule and table of contents
At the end of the project, I will come up with the best result of using activity based costing (ABC) for Pomodoro Clothing Company ltd which are also appropriate for other companies. There some specific learning objectives in that I aim to achieve:
How ABC is important in the development of the objectives of the company.
How Traditional costing systems misleading the decision making
How ABC is affect the success of the company
How ABC improve the profit margin of the company
The Expected schedule of the project report that I am to achieve is as below:
Project proposal Submission
Project literature searching and reading
First draft of the Project
Review of the project
Final submission of the project
The table of contents of the report will be something like:
A brief history of the Pomodoro Clothing Company, its aims, objectives and achievements
4. Key Processes of the case study
A brief explanation of how the data was collected for the case study.
Identify and explain four stages involved in designing ABC systems
A description of the ABC Cost hierarchy
A description of the ABC profitability analysis
5. Key learning
A model of ABC system for Pomodoro clothing company and comparison with existing traditional full costing system.
Possible recommendations and future benefits