Traditional System Of Absorption Of Over Heads Accounting Essay

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Summarised Statement of Financial Position At 31 DECEMBER 20X9 LPG

£000 £000

Fixed assets 2,600

Current assets

Stocks 600

Debtors 900

Balance at bank 100

_____ 1,600





Capital and reserves

Ordinary share capital (£1



Preference share capital 200

Profit and loss account 800

Debenture stock 1,400

Trade creditors 800






Sales 6,000

Cost of sales (including purchases £4,300) 4,500


Gross profit 1,500

Administrative and distribution costs 1,160


Trading profit 340

Debenture interest 74


Profit before tax 266

Taxation 106


Profit after tax 160

Preference dividend 10


Profit available for ordinary shareholders 150

Ordinary dividend 10


Retained profit 140



ROCE = 10% 340/3,400 Ã- 100%

Profit margin = 5.7% 340/6,000 Ã- 100%

Asset turnover = 1.8 times 6,000/3,400

Gross profit margin = 25% 1,500/6,000 Ã- 100%

Return on owners' equity = 14.2% (266 - 10)/(1,000 + 800) Ã- 100%

Current ratio = 2 times 1,600/800

Acid test ratio = 1.25 times (900 + 100)/800

Debtors ratio = 55 days 900/6,000 Ã- 365 days

Creditors ratio = 68 days 800/4,300 Ã- 365 days

Stock turnover = 7.5 times 4,500/600

Earnings per share = 15p 150/1,000

Dividend cover = 15 times 150/10

Gearing = 47% (1,400 + 200)/3,400 Ã- 100%

Interest cover = 4.6 times 340/74


Profitability ratios:

1. Return on capital employed- The company showed a 10% return on capital, which is not good, but is inadequate because it exceeds the interest payment on bonds which is 5.3%.

2. Profit margin - This is very low at 5.7%. Net income varies widely from one sector to another; there is no need for more information on the performance of other companies to extract useful conclusions about the level of this relationship.

3. Asset turnover ratio - the overall efficiency of property sales. This is 1.8 times of LPG.

4. Gross profit margin - These is a more respectable 25% but, again in conjunction with industry averages indicate whether it is acceptable.

Return on owners' equity - Return on equity which is 14.2% depends on following three things.

- Investor expected return.

- Industry average.

- The return achievable in other ways of investment, e.g. building society.


A ratio of about 1:1 is generally regarded as indicating a reasonable level of liquidity. The current ratio is often more variable because of variations in the company needs to keep in stock. This suggests that the nature of business and LPG Ltd. stock levels above average are necessary, or that their inventory control procedures are poor. More information is clearly needed. The inventory turnover ratio may shed more light on this aspect.

Asset utilisation

Several ratios give some idea of management efficiency.

1. Asset turnover ratio -- Unfortunately, we can draw conclusions not have any information about the company and its effective management and more data is needed to compare reports of companies in recent years and reports of other companies for the current year.

2. Debtors ratio - LPG Ltd's number of 55 days is perhaps acceptable, as 60 days is

Habitually regarded as 'par' for a company offering normal credit terms of monthly

Payment for all its sales.

3. Creditors ratio - LPG Ltd pays its creditors on average in 68 days. It was after the period in which it draws its accounts receivable (55 days), it will help cash flow together.

4. Stock turnover ratio - This is equivalent to 7.5 times for LPG Ltd and is still difficult to reach conclusions on the character of isolation. It should be compared with other years for the company and other companies.

Investor ratios

1. Earnings per share -- LPG Ltd. Earnings per share from 15p. This should be compared with a profit per share of LPG be achieved by the year if the trend is positive or not.

2. Dividend cover - This is 15 times, a very safe earnings to dividend ratio.


1. The gearing ratio for LPG Ltd is 47%. Anything over 50% would most likely be considered as

Fairly high.

2. Interest cover - For LPG Ltd this is 4.6 times. This may be regarded reasonable.

Variance analysis:

Variance analysis is a tool of budgetary control by evaluation of performance by means of variances between budgeted amount, planned amount or standard amount and the actual amount incurred/sold. Variance analysis can be carried out for both costs and revenues.

Scenario for Variance:

Sufi cakes produce prepare cakes that are sold directly to the public. New Production (celebrity chef) has argued that companies should only use organic ingredients in the production of cake. Organic ingredients are more expensive, but must produce a product to improve taste and provide health promotion for customers. It was hoped that this would increase demand and allow an immediate increase in the price of cakes.

Sufi Cakes liability standard operating system based on cost differences attributed to specific individuals. Individual administrators receive a bonus when net favorable variances are granted. The new approach of the cake to organic production was introduced in early March 2009, following a decision by the director of the new production. There have been no changes in that time to the standard cost card. The variance reports for February

and March are shown below (Fav = Favourable and Adv = Adverse)

Manager responsible Allocated variances February March

Variance $ Variance $

Production manager

Material price (total for all ingredients) 25 Fav 2,100 Adv

Material mix 0 600 Adv

Material yield 20 Fav 400 Fav

Sales manager

Sales price 40 Adv 7,000 Fav

Sales contribution volume 35 Adv 3,000 Fav

Production manager is shocked that he seems to have lost all hope of a new bonus system. Sales Manager believes that the new cakes are excellent and staff delighted with the progress.

In April 2009 the following data applied:

Standard cost card for one cake (without adjustment for the organic ingredient change)

Ingredients Kg $

Flour 0·10 0·12 per kg

Eggs 0·10 0·70 per kg

Butter 0·10 1·70 per kg

Sugar 0·10 0·50 per kg

Total input 0·40

Normal loss (10%) (0·04)

Standard weight of a cake 0·36

Standard sales price of a cake 0·85

contribution per cake after all variable costs 0·35

In April the budget for production and sales was 50,000 cakes. Actual production and sales was 60,000 cakes in

that month, during which the following happened:

following essentials are used Kg $

Flou 5,700 $741

Eggs 6,600 $5,610

Butter 6,600 $11,880

Sugar 4,578 $2,747

Total input 23,478 $20,978

Actual loss (1,878)

Actual output of cake mixture 21,600

Actual sales price of a cake $0·99

All cakes produced must weigh 0·36 kg as this is what is advertised.

Sufi Cakes operate a just in time stock system and holds almost no inventory.

Calculations of variance

Material price variances

Ingredient Actual price/kg Standard price/kg Actual (AP - SP) x AQ Adverse or Favourable

Quantity kg MPV

Flour 0·13 0·12 5,700 57 Adverse

Eggs 0·85 0·70 6,600 990 Adverse

Butter 1·80 1·70 6,600 660 Adv

Sugar 0·60 0·50 4,578 458 Adv


Total 2,165 Adv


Material mix variance

Ingredient Act mix Std mix Std price Variance Adv or Fav

Flour 5,700 5,870 0·12 -20

Eggs 6,600 5,870 0·70 511

Butter 6,600 5,870 1·70 1,241

Sugar 4,578 5,870 0·50 -646

------- ------- ------

Totals 23,478 23,478 1,086 Adv

------- ------- ------

Material yield variance

Actual yield 60,000 cakes

Standard yield (23,478/0·4) 58,695 cakes

Difference 1,305 cakes

Standard cost of a cake (W1) $0·302

Yield variance (1,305 * 0·302) 394 Fav

Sales price variance

Act price Standardd Price Act volume (AP - SP) Adv or Fav

* Act Vol


Cake 0·99 0·85 60,000 8,400 Fav

Sales volume contribution variance

Actual volume 60,000 cakes

Budget volume 50,000 cakes

Standard contribution 0·35

Variance (60,000 - 50,000) * 0·35 = $3,500 Fav


Standard cost of a cake

Ingredients Kg $ Cost

Flour 0·10 $0·12 per kg 0·012

Eggs 0·10 0·70 perkg 0·070

Butter 0·10 $1·70 per kg 0·170

Sugar 0·10 $0·50 per kg 0·050

Total input 0·40 0·302

Normal loss (10%) (0·04)


Standard weight/cost of a cake 0·36 0·302

variance analysis.

Production manager

assesing the two leaders is difficult in this situation. In a production manager traditional sense has seriously increased in March after the transition to organic ingredients. It has a net negative cons his department $ 2,300 per month.

No adjustment to the rules that have been taken to switch to organic farming. Director has not only bought organic, has also changed the combination increases the contribution of more expensive ingredients. This may have contributed to increased sales of cakes. However, the decision to go organic has seen sales of business improvement. We are told that the cakes should taste better, and that customers can understand the health point of view. The production, however, shared none of the favorable variance in sales that result. If we assume that the sales performance improvement decision in full production manager to change the ingredients, the net profit for the favorable variance is $ 7,700.

The production manager does not seem to work in the original standard, in February, indicating an efficient service. In fact, it has earned a little extra this month.

Sales manager

A change in the ecological idea must be to customers. Would probably need a change of marketing and customer-specific conisations. The sales manager will probably feel he has done a good job in March. One wonders, however, are entirely responsible for all differences in favour. The transition to organic farming has undoubtedly contributed to the sales manager and in February, appears to have not met their objectives.

Traditional System of absorption of overheads

Traditional systems of cost accounting often allocate costs based on simple measures such as the number of hours of direct labor, direct labor or machine hours. Using a single unit as a single cost factor is rare to find cause and effect desired criterion for allocating costs, it offers a relatively inexpensive and convenient to comply with financial reporting requirements.

The traditional approach to cost sharing system consists of three basic steps: the costs accrue in the production or the production Department, the Department does not share the production cost of production departments and distribute the result (revised) costs ward production of various products, services or customers. The costs of this traditional allocation approach suffers from a number of deficiencies that may lead to distorted costs for decision making. For example, the conventional move towards of distributing the cost of unused capacity on products. Thus, these products will be charged the resources not used. To correct distortions, many companies have adopted various systems of cost allocation approach known as activity costs (ABC).


Unlike traditional systems of cost accounting, ABC systems first accumulate costs for each business organization, and assign activity costs to products, services or customers (cost objects), resulting in this activity. As expected, the most critical aspect of the CBA is the analysis of the activity. Business analysis is the process of identifying appropriate measures production performance and capital and their effects on the cost of developed a good or a service. Considerably, as considered in the next section evaluates the activity is the basis for addressing the distortions inherent in traditional systems of cost accounting.

ABC systems are not inherently limited by the principles of the requirements for financial reporting. By contrast, ABC systems have the inherent flexibility of ad hoc reports to facilitate management decisions on the costs of activities to design, produce, sell and deliver company goods or service. At the heart of this elasticity is that the emphasis on the accumulation of ABC cost systems through several key activities, while the distribution costs traditionally focuses on the accumulation of costs by business unit. By highlighting on definite activities, ABC systems provide greater cost allocation, especially when costs are caused by drivers who do not cost depending on volume. Even so, traditional cost accounting continue to be used to meet the needs of conventional financial reporting. ABC systems continue to supplement, not replace, traditional cost accounting.


In most cases, sufficiently strong traditional cost accounting system measures the direct costs of goods and services such as equipment and labor. Accordingly, the ABC implementation generally focuses on indirect costs, such as manufacturing overhead and selling, general and administrative expenses. Given this objective, the main objective of implementing ABC to reclassify most if not all indirect costs (as indicated by the traditional cost accounting) that the direct costs. As a result of these reclassifications, the precision of the cost has risen sharply.

According to Ray H. Garrison and Eric W. Noreen, there are six basic steps required to implement

an ABC system:

1. Identify and define activities and activity pools.

2. Directly trace costs to activities

3. Assign costs to activity cost pools.

4. Calculate activity rates.

5. Allocate costs to cost items using the activity rates and activity method previously determined.

6. Set up and hand out management reports.


While ABC systems are quite complex and costly to implement, Charles T. Horn Branch, Gary L. Sundem and William O. Stratton that many industries of manufacturing and nonmanufacturing are the adoption of ABC systems for a variety causes:

1. Accuracy margins for different products and services, and customer ratings, more and more difficult to achieve given that direct work quickly replaced by automated equipment. Therefore cost, a common entity (indirect costs) becomes the most important part of total costs.

2. Since the rapid changes in technology and reduce the life cycle of the product, companies do not have time to change prices or costs are paid, when detected.

3. Companies inaccurate cost measurements tend to lose the offer, as products more expensive due to hidden losses undercoated products, and are not aware that activities are not cost effective.

4. As the costs of information technology are decreasing, the price has developed systems and ABC also decreased.

Zero based budgeting

Zero-based budgeting is a technique for planning and decision making, which faces the working process of traditional budgeting. In the traditional supplementary budget, departmental managers justify only increases the budget in previous years and what has already been spent is automatically sanctioned. No reference to the previous level of expenditure. In contrast, the zero-based budget, each department works extensively reviewed and all expenditures must be approved not only increases. Zero-based budgeting requires the budget request must be justified in every detail of every division leader of the zero-based. Zero-base is indifferent to whether the total budget is increasing or decreasing.

The term "zero-based budgeting" is sometimes used in personal finance to describe "zero-sum budgeting", the practice of budgeting every dollar of income received, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward.

Zero budgeting also refers to the identification of a task or tasks, then the financial resources to complete the task regardless of the current resource.

Advantages of zero based budgeting:

1. efficient allocation of resources, since it is based on the needs and interests.

2. Leadership positions to find an inexpensive way to improve operations.

3. Identification of financial statements overstated.

4. useful service departments, where production is difficult to identify.

5. Increases staff motivation by providing greater initiative and responsibility in decision making.

6. More communication and coordination within the organization.

7. Identify and eliminate redundant and obsolete assets.

8. Identify opportunities for outsourcing.

9. Force cost centres to identify their tasks and their relation to overall objectives.