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Jessup ltd was established in 1996 and the company is advertising and public relations business. The company specializes in outdoor advertising, production, printing, events, promotions services, road signs and banners. On the other hand Jessup ltd gives the best service to clients and helps expand, promote and develop their customer business. The company is run by four directors who are all advertising experts.
After 10 years the business environment has been change and the company has reached a stage where they need better management of the accounting function. So Jessup ltd needs a management accountant to solve financial and accounting problems in the business. Therefore strategic management accountant play a significant role in companies. They help companies to record, plan and control organization activities and advice the decision makers in correct ways.
On this report will explain the relevant information for the decisions making to the company have more understanding. In additional will also explain the benefits and problem of Activity based costing for the company use in activity.
2.0 STRETAGIC MANAGEMENT ACCOUNTING
Management accounting is internal trading building role accounting and finance professionals that work in organizations. (Bizcovering, 2009) Therefore management accounting is concern on provisions and accounting utilization of information for managers in organizations, it provide the inform business results that will be allow manager better prepare in their management and control functions. (Startups, 2010) On overall strategic management accounting is a type of management accounting.
2.1 Role of Strategic Management Accountants
The management accountant has become more important because a management accountant is valued business partners and directly support to an organization strategic gold. (Startups, 2010) Therefore management accountant work at the beginning of the accounting cycle they have to record, plan and control organization activities and advice the decision makers in private sector and public sector. It is use as features not present time tools. (Blurtit, 2006) In additional management accountant involve in financial, budget, costing and total quality management (TQM).
A management accountant has to record the financial transactions to ensure that companies have a good understanding of their financial situation, so that executive management can make knowledgeable decisions. (Osmond Vitez, 2010) Beside that management accountant is responsible in all financial resource that may be obtained with the company and how this resource can be allocated to other project that company have implemented. On other hand a management accountant also has to inform the management about the profits or lose when conducting a project. (Accountant Search, 2010) Moreover, conceptual framework had developed by International accounting standard Board (IASB) with the purpose of true and fair view in the financial statement is for management accountant to avoid the accounting scandal happen in an organization.
Beside that the role of management accountants also include budget.
Management accountants provide the budget is for Jessup ltd. (Osmond Vitez, 2010) On the other hand the remaining of the budget system is to help managers plan and control activities. The budgets are prepared often and those budgets can help to push workers and meet objectives of the business. (Oppaper, 2010)
The cost of products and service produced by the company is an important part of the responsibility of the management accountant. (Osmond Vitez, 2010) Management accountant able to help Jessup ltd to breaking down of cost or outflow of the function and process to smooth the business environment in each level of progress in the preparation of cost control and also recommendations to improve business productivity to collect maximum profit or success of the business. (Abel Konel, 2010) Job-order costing, activity-based costing (ABC) or processes costing are the costing methods that may include. (Osmond Vitez, 2010)
2.1.4 Total Quality Management
Management accountant must arrange well-organized management information systems to keep the business and operations in the latest whereabouts remain informatics tools, contributed to Total Quality Management (TQM) helps in making process decision at all levels of management of the specific industry. (Abel Konel, 2010)
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3.0 RELEVANT COST AND REVENUES
One of the basic propose of a manager is making decision. (Garrison and Noreen, 2000) Therefore, relevant costs understanding are importance once realize that there are many areas where relevant costs concept is used namely as to continue or discontinue or shut down decisions; pricing; accept or reject special order; limiting factor due to scarce resources and make or buy decision. In all state above, management needs enough relevant information and makes correct decision. So that manager need to understand what really is relevant cost. (Blogspot, 2009)
In decision making, cost and revenues can be classified according to whether they are relevant depend on the decision context. (Colin drury, 2005) The cost that meets the requirement of good management accounting information is 'Relevant costs'. (Docstoc, 2010) Relevant cost and revenue are future costs and revenues will be change by decision. (Colin drury, 2005) For example, Jeremy ltd produces table for £20 per unit. A customer make an order with 200 unit of table if Jeremy ltd accept it they will get £4000. The £4000 will be the revenues cost. However, to affect a decision a cost must be future cost and cash costs.
3.1 Two Main Principle of Relevant Cost
Relevant cost should be differing between among the available alternative. Future costs are relevant, past or committed costs do not affect the decision. (UOS, 2008) However cash costs are to be included and non cash cost should be ignore in the decision making process. For example, like depreciation which it is follows the rule of book-keeping. (Fao, 2010) Therefore relevant cost can be incremental cost, avoidable cost and opportunity cost.
3.1.1 Incremental Cost
Incremental cost also can refer to difference cost it can change and it difference in total cost among alternatives which is calculated to aid decision making. (Robert Scarlett, Bob Scarlett, 2007) Incremental cost must be compared with incremental revenues because it is to arrive at a decision. (Hubpages, 2010) For example, variable cost. (Robert Scarlett, Bob Scarlett, 2007)
3.1.2 Avoidable Cost
Deciding whether or not to discontinue a product is one of the situations which are necessary to identify the avoidable costs. Avoidable costs which are usually variable costs and sometimes may be a few specific costs that is the only cost which would be saved. For example, shutdown, divestment decisions and etc. (Freebookonline, 2010)
3.1.3 Opportunity Costs
Opportunity costs are the benefits of that sacrifice when one action is chosen, in preference to alternatives. The opportunity cost is the potential benefit foregone. (Accaglobal, 2010) For example, Zen has a full time job that cost him £80 per day while attending the job. He has to spend two days on house to take care of the sick father and the employer has agreed to give him the leave but without the pay. So the £160 in lost wages would be opportunity costs of taking the two days leave for take care of the sick father.
3.2 IRRELEVANT COST
Irrelevant costs and revenues are cost that should be ignoring it when making decision because they are not future cost. (Smccd, 2010) For example I sell an advertising board to A with the cost of £10000 and B also with the cost of £10000. So there is no irrelevant revenue, because get the same cost. There are some types of irrelevant cost which are sunk cost; committed cost; notional cost; historical cost and other assumption.
3.2.1 Sunk Cost
Sunk cost is something happen in the past that is not directly relevant in decision making. (Garrison and Noreen, 2000) On the other hand, sunk cost may result risk aversion.(Marcel Zeelenberg and Eric van Dijk, 1997) Beside that according to Robert Kee say that "economic theory state that it is no longer relating for decision making when fixed cost of capacity once achieved is sunk cost". (Robert Kee, 2008)
3.2.2 Committed Cost
Whatever decision is making now there will be a future cash outflow that will be incurred. For example, sign a legally binding contract. (scribd, 2010)
3.2.4 Notional Cost
Notional cost also can refer as imagining costs like create a cost that the company didn't have. For example notional rent. (Accaglobal, 2010)
3.2.5 Historical Cost
Historical cost is costs that happen in the past which is irrelevant for decision making but for prediction future cost this is the best available basis. (Csus, 2010)
3.2.6 Other Assumption
Other assumption has variable cost and fixed cost. All variable cost is usually will be relevant costs and all fixed cost is irrelevant for decision making. By the way fixed costs may only be fixed in the short term. (Freebookonline, 2010)
3.3 Relevant cost for material
Relevant cost for material will become current replacement cost unless material was bought but will not be replaced. On the other hand, the relevant cost will be higher of the following of their current resale value and the value they obtain if they were put to alternative use. Whereas in the event the materials have no resale value, they the opportunity cost will be nil. (Freebookonline, 2010) In table 1.0 below is show that use the following decision tree to determine the relevant costs for material. An example has show in appendix 2.0. As a result in appendix 1.0, Jeremy Plc would accept the order because the additional income of £5750 exceeds the relevant cost of materials.
Are materials already in stock?
Cost of purchase
Will they be replaced?
Contribution from alternative use
Will they be used for other purposes?
Net realizable value
Table 1.0 Relevant cost of material
Sources taken from: (Profitactionplan, 2008)
3.4 Relevant cost for labor
Determine direct labor costs which relevant to short-term decision depends on circumstances. The labor force is to be maintained in the short-term when a company has temporary spare capacity, so that the direct labor cost will be irrelevant for short-term decision making purposes. (Colin drury, 2006) However, if labor force could be placed to a utility alternative, hence the relevant costs are the variable costs of labor and associated variable overheads + contribution forgone from unable put it to alternative use. (Scribd, 2010)
In table 2.0 below show to determine the relevant costs for labor and the existence of spare capacity is a factor however it is same to material. (Profitactionplan, 2008) An example has show in appendix 2.0. As a result in appendix 2.0 Jeremy Plc can accept the new customer's offer because the revenue from completing work is £ 28,000. The relevant Costs of Materials: Opportunity cost is £1,500, labor of basic pay is £8,000. Opportunity Cost of losing other job is £18,000 and incremental cost of consultant is £2,200, so total up is £29,700. There has an extra profit to be earned by accepting the order is £1,700.
Does spare capacity exist?
Nil cost unless overtime worked or extra labor hired, when cash outlay
Can extra employees be hired?
Cost of hiring
Contribution from alternative products which must be abandoned to create spare capacity
Table 2.0: Relevant cost of labor
Sources taken from: (Profitactionplan, 2008)
3.5 Relevant costs for overhead
In additional to calculating the relevant cost of material and labor, may also be required to calculate the relevant costs of overhead. Relevant costs of overhead are only those overhead that vary as direct result of a decision. (Profitactionplan, 2008)
4.0 TYPES OF COST SYSTEMS
Cost system classified as direct costing system, traditional absorption costing systems and activity based costing system (ABC). In here will discuss a little bit of traditional absorption costing and activity based costing, but more concentrate on ABC. (Colin Drury, 2006) ABC is one accounting theory which involves determines all business costs to every individual good or service provided. (Wisegeek, 2010) In order to determine the selling price of a good or service, Jessup ltd must include direct cost and indirect cost. Direct cost and indirect cost are similar as overhead cost. Direct cost is cost that involve in the process. However indirect cost is cost that can not involve in process. (UOS, 2008)
4.1 Traditional absorption costing
Traditional cost accounting methods designed around 1870 to 1920 and those day industry do not have automation is labor intensive and have low level of overhead costs compared to today. However, this altered quickly from 1960s and especially in 1980s. On other hand, traditional costing also can refer as absorption costing. (Emblemsvag, 2010) However, the traditional cost accounting method refer to allocates overheads cost to production departments. (AccountingCoach, 2010) The costs are allocated randomly base on the direct labor hours, or the production machine hours and other. (Differencebetween, 2010) In appendix 3.0 will show the example. As a result in appendix 3.0 the product of A and B is understated, so the product can sell very well but cannot make profit. In contrast product C is overstated so the product is no demand but make profit. This was show that the traditional method can be understated or overstated. So Activity Based Costing was created to provide more accurate cost.
4.2 Activity Based Costing (ABC)
Activity based Costing is a kind of costing system that could be used to determine costs more exactly. (Tiffany Bradford, 2008) Nowadays ABC systems are being taken by many manufacturing and service organizations. (Tzvi Raz and Dan Elnathan, 1999) ABC is a costing method that is designed to provide managers with information on fees for making strategic decisions and others that could affect the ability and hence "fixed" costs. (Garrison and Noreen, 2000) It is a new approach to determine overhead costs to product. (Pauline Weetman, 1996) Therefore ABC method refers to allocates overheads costs are based on activity not department anymore. By the way ABC system also used many cost drivers as absorption bases. (Colin Drury, 2006) Cost driver is a factor which causes of the cost of an activity performed in the value chain. (12manage, 2010) Below the table 3.0 is showed the steps in an ABC system.
Identify major activities which in an organization's.
Identify the factors which cause the cost of an activity. These factors are called the "cost drivers".
Collect the costs pool of each activity.
Tracking costs to activities, according to how the demand cost.
Table 3.0 Step in an ABC
Sources taken from (Pauline Weetman, 1996)
An example will show in appendix 3.0. As a result in appendix 3.0 the total production cost of product A is £248.88, product B £109.93 and product C £85.17. There is a big difference between using traditional costing and ABC method.
4.2.1 Reason for development ABC
The direct labor and material costs accounting were the largest proportion of the costs because traditional cost accumulation system had only a narrow range of product and when overheads costs were only a very small fraction of the total costs. (CAT-ACCA resources, 2010) Recently activity based costing grew in popularity due to some factors specific. One of the reasons is increase in the number of support services. For examples: production scheduling, inspection hours and etc. Another one is increase in the overhead proportion of total costs. (CAT-ACCA resources, 2010) Beside that there is increase diversity products generated by a company and diversity customer requests. Lastly this method tends to be more complicated while in a company, some products are being produced in large groups other is being only in small groups (Activity Based Costing). Activity based costing would be continue to grow in usage as long as years due to this work scholars. (Articlesbase, 2008)
4.2.2 Benefits of ABC
During the late 1980s ABC appeared first in the academic literature. In 1990s it had reached the professional accountancy journals and at that time has already being use by a lot of company with progressive attitudes. (Pauline Weetman, 1996) The main benefit if introduce ABC into Jessup is the company will have greater understanding of product or customer profitability. (Valuebasedmanagement, 2010) With ABC, Jessup ltd might be control or manage costs with manages activities which become their basis by monitoring a sum key performance measure. (CAT-ACCA resources, 2010) Beside that ABC also can help the Jessup manager to analyze the cost. (Valuebasedmanagement, 2010) On other hand, ABC also can help the company to identification things that not giving extra value then forgone it. Whereas the system is also particularly with the performance management of departments employ the majority of human resources in the contemporary enterprise system. However this process also will allow Jessup ltd to implement priced strategies across another firm diagonal as business processes, channels supply networks and appreciation efficiently and optimum analyzed in this process. (Scribd, 2010) Lastly through ABC, accountants can now promote the future of the organization, not just in the last report. (UOS, 2008)
4.2.3 Problem of ABC
On above have showed the benefit of ABC but there are also have some problem of ABC. If Jessup ltd introduces ABC into company they will face the identifying of cost driver. The cost driver is not an easy task. Beside that overhead usual to a few cost pools which still need arbitrary method to apportion the costs. For example rent, rates and building depreciation. (CAT-ACCA resources, 2010) Although that, the implementation cost and time involved in data collection and obtain relevant apportion the costs. (UOS, 2008) On the other hand ongoing ABC system can be expensive when maintaining it but traditional costing method cheaper that ABC system. (Qfinance, 2010) Some manager will not approve to use the system because the system is very transparent and they want to keep several things out of the view of the owners of the company. (Scribd, 2010) sentence
4. 3Survey on Current Accounting Method in UK
In theory ABC system are good in manufacturing and service organizations but in practice according to Mohammed Al -Omiri and Colin Drury (2007) survey conducted in UK show that has 15% of organizations are using ABC system however another 85% of organizations are using other system. Base on the above survey, we can conclude that Jessup ltd is able to apply on ABC system because 15% of UK Company is applied.
Lastly this report will give directors much recognition in the role of strategic management accountant, relevant information and also will have much recognition on the benefits and problem of the ABC system. Beside that director has a huge responsibility on making a correct decision on whether to discontinuing a product line, segment or division, acceptance of a special order, limiting factor decision and make or buy decision. In decision making the directors not only need to consider in relevant information it also need to consider on qualitative factors. In additional Jessup ltd directors not just want to consider on which cost are relevant to decision making, it also need to consider which method are best for the company. Finally my advice is negotiating for Jessup ltd directors needs and can afford the cost, remembers that self-confidence and realisms will play an important part.
1.0 Relevant cost of material
Jeremy Plc has been approached by customer who would like a special job to be done for him, and who is willing to pay £20,000 for it. The job would require the following materials:
Total units required
Units already in stock
Book value of units in stock £/unit
Realizable value £/unit
Replacement cost £/unit
Material B is used regularly by Jeremy Plc, and if units of B are required for this job, they would need to be replaced to meet other production demand. Materials C and D are in stock as the result of previous over-buying, and they have a restricted use. No other use could be found for material C, but for unit of material D could be used in another job as the substitute for 300 units of material E, which currently costs £5 per unit (and the company has no units available at the moment).
Calculate the relevant costs of material for deciding whether or not to accept the contract.
In this case material A is purchased at the replacement cost of £5.50 per unit. For material B is used regularly and the company need to be replaced to meet other production demand. Therefore the existing stocks are 700 unit and a further 700 units will be bought to replace them. Relevant costs are 1,100 units at the replacement cost of £5 per unit. On the other hand 800 unit of material C are already in stock and 1,000 units are needed. So if used in the contract the 800 units will not be replaced because of restricted use and a further 200 units must be bought at £3.50. They could not be sold at £ 2.00 each if they are used for the contract. An opportunity cost of sales revenue forgone is the realizable value of these 800 units. Beside that required material units D are already in stock and will not be replaced. There is one opportunity cost use D in contractual because is alternative opportunities either sell present stock for £6 per unit (£ 1,200 in total) or avoid buying other (E material), which will cost 300 x £ 5 = £ 1,500. Since substitution for E is more beneficial, £1,500 is the opportunity cost.
Summary of relevant costs:
Material A (900 x £5.50)
Material B (1,100 x £5)
Material C (200 x £ 3.50) plus (800 x £ 2.00)
Proceeds of sale
Sources taken from http://free-books-online.org/accounting/cost-management-accounting/decision-making-contd-relevant-costs/
2.0 Relevant Cost of Labor
Jeremy Plc has been making a machine to order for a customer, but the customer has gone into liquidation, and there is no prospect any money will be acquired from the winding up of the company. Costs incurred to date in manufacturing the machine are £ 45,000 and progress payments of £10,000 had been received from the customer prior to the liquidation. The sales department has found another company willing to buy the machine for £ 28,000 once it has been completed. To complete the work, the following costs would be incurred.
Materials: These have been bought at a cost of £ 5,500. They have no other use, and if the machine is not finished, they would be sold for scrap for £1,500.
Further labor costs would be £8,000. Labor is in short supply, and if the machine is not finished, the work force would be switched to another job, which would earn £28,000 in revenue, and incur direct costs of £10,000 and absorbed (fixed) overhead of £ 8,000.
Consultancy fees £3,500. If the work is not completed, the consultant's contract would be cancelled at a cost at £1,300.
General overheads of £8,000 would be added to the cost of the additional work.
Jeremy Plc has to decide whether the new customer's offer should be accepted or not?
Costs incurred in the past or revenue received in the past cannot affect a decision about what is best for the future because they are not relevant. Costs incurred to date of £ 45,000 and revenue received of £10,000 is past and should be ignored.
Similarly, the materials price paid in the past is irrelevant. The only relevant cost of materials affecting the decision is the opportunity cost of the revenue from scrap which would be forgone - £1,500.
Contribution forgone by losing other work £ (28,000 - 10,000=18,000) on the other hand, labor costs required to complete work of £8,000 opportunity costs and the relevant cot of labor is £26,000.
Cost of completing work £3, 500, Cost of canceling contract 1,300 so the incremental cost of consultancy from completing the work is £2,200.
Absorbed overhead is a national accounting cost and should be ignored. Actual overhead incurred is the only overhead cost to consider. General overhead costs (and overhead absorbed alternative serve labor generation) should be ignored.
Relevant costs is £29,700
Sources taken from http://free-books-online.org/accounting/cost-management-accounting/decision-making-contd-relevant-costs/
3.0 Activity based costing
Jeremy ltd produces three types of product using broadly the same production methods and equipment for each. Currently a conventional product costing system is used although an activity based costing system is being considered.
The following are information related to these three products:
Material cost (£ per unit)
Hours required per unit
Labor is charged at a rate of £9 per hour. Currently the production overheads are recovered on a machine hour basis at a rate of £35 per machine hour.
In preparation of implementing an ABC system the following analysis was conducted:
Costs relating to machinery 30
Costs relating to material handling 25
Costs relating to inspection 25
Costs relating to set-ups 20
Total production overhead 100
A B C
Number of movements of materials
75 10 35
Number of inspections
400 300 300
number of set-up
200 400 200
Calculate the costs per unit for each product type by using traditional costing method and ABC system.
Traditional Costing Method
OAR= Total budget overhead cost ÷ Total machine hour
Total overhead= 35 Ã- 16000
Product costing per unit
o/h cost @ machine hour
Total production cost per unit
Cost Driver rate
Costs Relating to Machinery (CRTM) = 168000÷16000 = £10.5
Costs Relating to Material Handling (CRTMH) = 140000÷120 = £1166.67
Costs Relating to Inspection (CRTI) = 140000÷1000 = £140
Costs Relating to Set-Up (CRTSU) = 112000÷800 =£140
Activity based costing: overhead analysis
No. of inspections
No. of Set-up
Total O/H cost
No of unit produced
Total O/H costs per unit
Product costing per unit
Total O/H cost per Unit
Total production cost
Comparison of two methods
Traditional absorption costing system
Activity based costing system
Overstated / Understated