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Accountants and financial people are often faced with challenges on how to allocate overhead department costs to cost objects. However, the fixed nature of such costs complicates matters when allotting expenses in instances of fluctuating capacity utilization. In order to overcome this, a number of sophisticated costing methods have been developed in recent decades that help managers deal with issues of overhead cost allocation, processes which provide data for effective cost management.
Product costing is a methodology associated with managerial accounting, i.e., accounting intended to serve management in an operational context rather than to measure corporate performance as such, although, of course, any kind of cost accounting, including product costing, contributes to overall results.
This papers aims to present the procedure and techniques that might prove useful and beneficial for effective cost management to manufacturing business. This explains and compares the differences between traditional absorption costing system and activity-based costing.
Management Accounting Textbook (e.g. Kaplan & Atkinson 1989; Horngren & Foster 1991; Drury 1992) state that product costs are required for two purposes: 1) for financial accounting to allocate the manufacturing costs incurred during a period between cost of goods sold and inventorie; 2) to provide useful information for managerial decision-making requirement. Product cost plays a big role in pricing method. Most suppliers who are not strong enough in the market to dictate pricing, most are â€•price takersâ€- not â€•price makersâ€-, thus in order to avoid this scenario product cost have been the basis in cost-plus pricing method.
Product costing evolved in an environment of mass production in the second half of the 20th century as ever more managerial attention was focused on optimizing the production function. Traditional financial accounting approaches have been-and continue to be-based on measurements of fairly rough granularity. For determining corporate profitability, it is sufficient generally to track raw materials, labor, tooling, and energy inputs and to sum these into production costs. Pricing of different products, of course, necessitated finer distinctions so that costs associated with classes of products would be available as a basis for differential pricing. Closer attention to the costs of, for instance, low-, medium-, and high-end models of a vehicle or a device then proliferated "downward." The costing of composite products required costing of their components. In turn operations on each component might vary. Some might require more or less strength and hence heavier forgings; these in turn might need more or less additional machining. Some components could be attached mechanically, others had to be welded. These operations could be measured in time, time in dollars. A systematic analysis of how a product came to be, the inputs posted as received and then the operations performed on them individually estimated, produced the final cost of production from which receipts from sale of scrap would be deducted to get a net cost. Product costing evolved further from this point by assigning an appropriate percentage of total overhead and also measuring additional costs upstream-such as packaging, warehousing, and delivery to the ultimate buyer.
C) PURPOSE & VALUE OF FULL COSTING TECHNIQUES
Full Costing is a managerial accounting method that describes when all fixed and variable costs, including manufacturing costs, are used to compute the total cost per unit. Full costing includes these costs when computing the amount of money it takes to produce and distribute one unit of output. How firm expenses its production and distribution costs will impact the structure of internal income statements. Because all costs incurred to sell a product are included with cost of goods sold, the firm's gross margin will be lower under the full costing method than the absorption costing method.
In full costing, total costs are taken into account for product costing, inventory valuation and other allied important decisions. Full costing takes into account total costs. Full costing method absorbs all cost necessary to produce the product and to have it in a production costs. Full costing technique recognizes fixed overheads also as a product cost in addition to material, labour and respect: fixed manufacturing overheads are included in product cost under absorption costing; they are excluded under variable costing. Income statements for external reporting and for tax purposes are to be on a full costing basis. Managers have four fundamental areas using information concerning full cost of the business's products or services: first, having full cost information can help managers making price decisions; second, managers need information to help them make decisions that are aimed at getting the business back on course if plans are not being met; third, full cost information help managers to compare cost or assess relative efficiency; fourth, provide managers with information to assess performance and measuring income.
D) COMPARATIVE LITERATURE FOR ABSORPTION COSTING & ACTIVITY BASED COSTING
Comparative of Definition
Absorption costing overheads are apportioned to product cost centers. Each product cost center would then derive an overhead recovery rate, typically overheads per direct labor hour.
Activity-based costing (ABC) are analyzed into cost pools, with one cost pool for each cost-driving activity. The overheads are then charged to units of output, through activity cost drivers.
The major difference between absorption costing vs. activity based costing is the approach. Absorption costing allocates costs to product units, whereas activity based costing traces the costs of product units. Absorption costing helps ascertain the overall profitability or efficiency of the manufacturing system but fails to provide the real cost of individual product units. Activity based costing mirrors the functioning of the enterprise and contributes to strategic decision-making processes. ABC provides the real cost of individual product units and, thereby, helps identify inefficient or non-profitable products that eat into the profitability of other highly profitable products. ABC also helps price products equitably, allowing breaking down of product or service into sub-components or offering â€•top upsâ€- based on customer needs.
Previous Studies & Literature
Previous surveys (Schwarzbach, 1985 in USA; Ask and Ax, 1992 in Sweden; Theunisse, 1992 in Belgium; Drury and Tayles, 1994 in UK; O'Dea and Clarke, 1994 in Ireland; de With and van der Woerd, 1994, in Netherlands; Scapens et al. (1996) in UK; Drury and Tayles, 2000, in UK) have focused on the changes in management accounting practices that are taking place as a result of the changing manufacturing environment. Little evidence was found from these studies to indicate that either existing techniques are being adapted or new techniques are being implemented. The studies have reported that direct labour is the predominant method that is used to allocate overhead costs to the products though some respondents were dissatisfied with their product costing systems. Most of the surveys provide little insight into how companies compute product costs for decision-making.
A previous survey also (e.g. in the USA, Schwarzbach 1995; Howell et.al.1987; Hendricks1988; Emore and Moss 1991; Cohen and Paqiette 1991; and in the UK, Coates and Longden 1989; Bright et.al 1992) have focused mainly on the changes of management accounting practices that are taking place as a result of the changing manufacturing environment. Little evidence was found from these studies to indicate that either existing techniques are being adapted or new techniques are being implemented. Most of the studies, report that direct labor hours is the predominant method that is used to allocate overhead costs to products. Howell et. also reported that 54 percent of the respondents were dissatisfied with their product costing. However, apart from the Sweedish study, the surveys provide little insight into how companies compute product cost for decision-making.
A survey was undertaken (e.g. Occupied Territories of Palestine, Hajjawi 2009) which aimed to gather empirical evidence capable of providing an overview of current management accounting practices of manufacturing companies in Palestine. The survey describe and analyze the present state of, and trends of
development, in current cost accounting practices as a result of the aftermath of Palestinian second uprising crisis (September 2000 - November 2004). The findings indicate that product costs computed to meet inventory valuation requirements are widely used for decision-making and internal profit measurement. The majority of companies, however, used both full costs and variable costs for decision-making and findings suggest that product information is used in a flexible manner. The paper reports on the methods used by companies to compute full product costs and direct labour-based method were the most widely used overhead allocation based in production environment, and factory-wide rates. However, concluding sections suggest areas where further research is required
The academic literature regarding the use of MATs by companies in the west have centered on the issue as to whether or not the various MA practices are of any value to business practitioners. Scapens (1983) first discussed the apparent gap between the theory of management accounting as contained in the conventional accounting textbooks and the actual practice of those MA concepts by businesses. The argument was developed into one of the relevancy of management accounting to business operations in general by Kaplan and Johnson (1987). Again in 1988, Scapens (1988) called for research to generate a better understanding of management accounting practices. Dugdale (1994) surveyed 140 active members of the Chartered Institute of Management Accountants (CIMA) in Britain on their use of management accounting techniques and concluded that there does seem to be a gap between the theory and practice of MATs and techniques.
Many studies to date have been conducted, describing MA practices of businesses. In the USA by Ernst and Young (2003), the UK, (Abdel-Kader and Luther 2006 and 2008; Bhimani 1996; Burns et. al 1996, 1999), Ireland (Clarke 1997), Australia (Chenhall and Langfield-Smith 1998), New Zealand (Lamminmaki and Drury 2001) and South Africa (Weweru et. al 2005). Clarke (1997) in his study of the costing systems of large manufacturing companies in Ireland concluded that there is a significant gap between theory and
practice. He also classified the companies as indigenous Irish versus subsidiaries of multinationals, by industry, by annual sales and by the number of products produced, however he made no attempt to statistically analyze results related to these various corporate characteristics. Chenhall and Langfield-Smith (1998) surveyed 140 large Australian manufacturing companies and found that traditional management accounting techniques were more widely adopted than recently developed techniques. They called for a better understanding of the factors that influence adoption of MATs, particularly the newer ones and mentioned that â€•some â€žwesternâ€Ÿ innovations may not be developed readily in various European countries because of cultural and historical differences in the development of costing systems.â€-
A case study (e.g. Norway, Bjørnenak 1997) which focuses on the diffusion of Activity-Based Costing (ABC) in Norway. A conceptual framework from general diffusion theory is adopted to structure a tentative model to describe the diffusion process. The study is based on a questionnaire survey, incorporating data from 75 of the largest manufacturing companies in Norway (a response rate of 57%). The findings show that a large number of companies have adopted ABC as an idea, i.e. they have implemented ABC or plan to do so (40%). Different variables related to cost structure, competition, existing costing system and product diversity were tested for their relation with ABC (planned or actual) adoption, but only cost structure was found to be statistically significant. Companies which had knowledge of ABC were significantly larger than the others. However, size did not significantly discriminate between adopters and non-adopters within the group with ABC knowledge. The source of information on ABC is also examined and the empirical data indicate a diffusion process that takes a contagious form and points out the importance of institutional influence.
A survey (e.g.UK, Innes & Mitchell 1995) which contains the results of a 1994 survey of activity-based costing (ABC) in the U.K.'s largest 1000 companies. The survey was designed to ascertain the adoption rate of ABC in these companies, the specific application of ABC, the views of users on the success and importance of ABC, the views of non-ABC users on ABC and the possibilities for future research. The results indicate that although ABC is now used by a significant number of large companies its impact is often restricted in scope and it has also been rejected by a sizeable number. The majority of companies have still to come to a decision on its use. Among users it is applied throughout all of the core areas of management accounting. There is thus potential for considerable growth in its adoption among non-users. It is an on-going development which gives considerable opportunity for researches interested in change to pursue work on this topic in a variety of the sub-areas of management accounting.
A case study (Tornberg, Jamsen and Paranko 2002) which aims to investigate the possibilities of activity-based costing and the modeling of design, purchasing and manufacturing processes in providing useful cost information for product designers. The hypothesis was that activity-based costing and process modeling might provide an effective tool for the evaluation of different design options. The study was conducted in a large Finnish manufacturing company. First, the most costly items of one product's sub-assembly were studied in order to identify the activities needed to produce the items and to calculate their activity-based costs. Second, the processes, in other words the activity chains, were modeled with graphic flowcharts from product design, purchasing, and manufacturing departments. Finally, the applicability of activity-based cost information and process models to product designing practices was tested. The results of the study suggested that activity-based costing and process modeling provide a good starting point in heading toward more cost-conscious design. This way the designers learn the relationships between the activities performed in the organization and their associated costs. The development of a parametric cost estimation model based on activity-based costing and process modeling provides a challenge for future research.
A research (e.g. Greece, Kohen et.al. 2005) aims at examining the rate of adoption of ABC by Greek companies that belong to all three sectors of the Greek economy, i.e. manufacturing, retail and services, as well as investigating the reasons that influence a firm's decision to change its current cost accounting system.
An empirical survey via questionnaires was conducted during 2003 on a sample of 88 Greek leading companies and four company categories were identified in respect to their perceptions towards ABC (ABC adopters, ABC supporters, ABC deniers and ABC unawares). Furthermore, evidence presented that firms that have implemented ABC (ABC adopters) have experienced multidimensional management facilitating benefits from the system. However, the adequacy of resources was found to be the variable that is positively and statistically correlated with the majority of problems encountered during ABC implementation process. Evidence shows that the possibility of future ABC adoption is related to the degree of satisfaction from the currently used cost accounting system. Companies that do not intend to adopt ABC (ABC deniers) were found to be more satisfied with their existing cost accounting system in comparison to ABC supporters.
E) DISCUSSION & CONCLUSIONS
We can see that there is a basic philosophical difference between the traditional and ABC approaches. The traditional approach views overheads as rendering a service to cost units, the cost of which must be charged to those units. ABC, on the other hand, views overheads as being caused by activities, and so it is the cost units that cause these activities that must be charged with the costs that they cause.
Comparing absorption costing vs activity based costing, activity based costing improves the quality of management accounting information, especially in large and multi-product operations where conventional overhead allocation methods such as absorption costing may produce misleading results. Absorption costing, however, remains more suitable for small firms and enterprises with homogeneous products or services. The problem underlying the traditional costing systems is that for most overhead activities, the proportions of the activity actually consumed by a specific product, does not universally correspond with a single cost driver. This holds true for most modern companies where products are produced by a combination of manpower and technology. The traditional cost accounting model employs a volume-based driver, such as direct labor hours or machine hours for the assignment of all manufacturing overhead costs. The conventional cost accounting model ends up with a cost of goods sold based on absorption costing and includes only product costs as defined in financial accounting.
Activity based costing is a different approach and improves control of overheads by a cost/cause relationship, that are activity and cost. The system is flexible enough to relate costs to customers, processors, management responsibility and not just products. Whilst activity based costing is not a perfect science it does offer a sense of financial pragmatism to the wider management process. The initial premise that activity analysis can highlight waste (non-value adding) and bureaucracy (secondary or support activities), activity based techniques have been used for straightforward cost reduction, process improvement and re-engineering, benchmarking, performance measurement and a variety of related exercises including activity or priority based budgeting. Activity based costing forces the manager to investigate fixed costs very closely. It therefore helps management to identify areas of inefficiency as well
as recognize costs which we could have been conceived fixed but, which are in fact, variable or semi-variable to specific products.
As per surveys and studies, the full costs are widely used because decision-relevant costs are only appropriate for undertaking special studies that require decisions on product introduction, abandonment or pricing, once specific products have been identified. Kaplan (1990) has argued that a product costing system is required that reports average long-term product costs derived from activity-based costing (ABC) systems. The product costs reported don't provide information that can be used directly for decision making. Instead, they report attention-directing information by highlighting those products that require more of detailed special studies. Full product costs used for decision-making are derived from product systems that were designed to meet financial accounting requirements (Drury, 2007). These systems were designed decades ago, when most companies manufactured a narrow range of products and direct labour and material costs were the dominant factory costs. Overhead costs were relatively small and the distortions arising from inappropriate overhead allocations were not of significance. Information processing costs were high and it was therefore difficult to justify more sophisticated methods of tracing overheads to products. Companies now a day produce a wide range of products and overhead costs are of considerable importance, and a simplistic overhead allocations can no longer be justified, particularly when information processing costs are no longer high nor a barrier to introducing more sophisticated systems. It is against this background that ABC has emerged (Cooper and Kaplan, 1991). It is important that a product costing system generates a reasonably accurate estimate of the resources consumed by each product.
Planning involves making decisions. Decisions are arrived at by: (1) recognizing that a problem or an opportunity exists, (2) identifying alternative ways of addressing the problem or opportunity, (3) analyzing the consequences of each alternative, and (4) comparing the consequences so as to decide which is best. Accounting information is useful especially in the analysis step of decision-making process (Devine et al., 2004). This implies that special studies should be undertaken when the need arises, such as when specific products have been identified that require pricing or abandonment decisions. The decision-relevant approach focuses on whatever planning time of a given situation is considered appropriate for the decision-maker. As competition in the marketplace increases and manufacturing systems become more complex, accurate product costing is desirable within the management decision process. Activity-based costing can improve product cost accuracy, but still requires the allocation of service departments where reciprocal services exist. A wide range of methods can tackle this issue, but the reciprocal process for allocating service departments explicitly recognizes all reciprocal service relationships, resulting in accurate allocation.
Gain an understanding of the basic concept of activity based costing
Activity Based Costing versus Traditional Costing
Activity Based Costing with worked example to compare with Traditional Costing
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