Report Gives a Detailed Explanation of Management Accounting

Question: This Report Gives a Detailed Explanation of Management Accounting? Answer: Introduction Product costing is a methodology which associates itself with managerial accounting. This type of accounting is designed to help management in operations and not measure corporate performance. Thou, like any other cost accounting, product costing help in contributing to the overall results. It is used for determining the cost of production of an unit by studying all the resources used for its creation. Product costing helps us to identify cost components which can be handled in a specific order to take out cost from the product by redesigning, reengineering, purchasing, retooling, packing and other different interventions by the management. It is a traditional method of costing so it has certain inadequacies. Activity Based Costing (ABC) is a method of costing which identifies the activities in an organization and then allocates the cost of each of those activities with resources to all the products and services according to the actual compensation. With the help of ABC, a company estimates the cost elements of its products, activities and services. ABC not only identifies but also eliminates certain products and services which are not profitable and lowers the price of the products that are overpriced. It also identifies and eliminates products and services which are not effective and allocates processing concepts that leads the same product at a better yield. In our report, we will learn about product costing and ABC individually, and then compare both of them by applying them to the case of Frank Burgesss, New Age caravans and seeing which turns out to be a better option. Body Product costing evolved in the latter half of the 20th century, during the environment of mass production as more managerial attention was given on making the best use of production function. To derive corporate profitability, it is necessary to keep a track on raw materials, energy inputs, labor, and tooling and add them to derive production costs. Pricing of different products helped in finer variations and the costs of these products would be useful as a basis for differential pricing. It has certain limitations as it a traditional way of costing. Measurement Problems In product costing a lot of importance is made on representing all costs, including those that do not come to mind immediately, this is why ABC is more popular and useful. Measurement is rather easy even if it is complicated in the production process. For example, problem arises in appropriating the capital costs of the equipments to individual products that go through it and this also includes costs of suppose liquids and lubricants which are used in machines to make them function better. Other complexities for product costing are measuring the costs of developing good relations with supplier and also warranty service, which does not come to mind immediately but long after the sale is made. The main problem with product costing is that overheads can be under or over applied. We will see the causes and reasons for it, citing proper examples and see methods of how reconciliation can be done for the same. Under or over application of overheads The overhead rate is predetermined before the start of the period and is based on an approximate data; the overhead cost that is applied to work-in-progress can vary from the overhead cost that was actually sustained during the period. This difference between the preliminary estimates of overhead cost to work-in-progress and the actual overhead cost of the period is called under or over application of overhead. Example- If we look at Frank Burgesss, New Age Company we see that overhead rate was based on 60000 direct labor hours to be worked for the year and $1800000 in overhead costs. This comes to 1800000/12=150000 a month. But for the month of April, 5200 labor hours were recorded and the employees were paid $35 an hour, which sums up to 182000. So according to the problem the labor hours were under applied. Methods of reconciling over and under applied overhead cost In case there is over or under application of overheads, then it can be dealt in two ways: By allocating the difference between work-in-progress accounts, finished goods account and the cost of goods sold account. By shifting the difference completely to the cost of goods sold account. Cost Sheet for the month of April PARTICULARS $ Amt. ($) Opening Stock of Raw Materials 12,000 (+) Purchases of Raw Materials 160,000 (-) Closing stock of Raw Materials 12,000 Direct Materials Consumed 160,000 Direct Labour 182,000 Prime Cost 342,000 Add: Factory Overhead Expenses Depreciation on: Factory Building 8,000 Factory Equipment 16,000 Indirect Labour Cost 118,000 Insurance - Factory 14,000 Repairs Maintenance - Factory 8,000 Land Tax - Factory 4,500 (+) Opening stock of WIP 4,500 (-) Closing stock of WIP 33,500 -29,000 Works Cost 481,500 Add: Office Administrative Overhead Expenses Administrative Salaries 24,000 General Liability Insurance 2,400 26,400 Cost of Production 507,900 (+) Opening stock of Finished Goods 11,000 (-) Closing stock of Finished Goods 16,000 -5,000 Cost of Goods Sold 502,900 Add: Selling and Distribution Overhead Expenses Advertising Expense 12,000 Sales salaries 90,000 Travel and entertainment (sales) expenses 14,100 116,100 Cost of Sales 619,000 Above we have prepared the cost sheet for Frank for the month of April. We start by adding purchase of raw materials to the opening stock of raw materials and deducting closing stock of raw materials. We then add direct labor to get the Prime Cost as $342000. We then apportion all the expenses of the factory. After adding the opening stock of work-in-progress and subtracting the closing stock we get Works cost as $481500. We then come to the office and administration and after allotting all the costs we get cost of production as $507900. Then we add and deduct the stock of finished goods and get cost of goods sold as $502900. Then we apportion the expenses of selling and distribution and get the cost of sales as $619000. In the raw materials ledger we have balance brought forward of $12000. In the credit side we have accounts payable of $160000. In the debit side we have the prime cost consumption of $160000 and $12000 is carried forward to the next month Finished Goods Account To Balance B/f 11000 By COGS A/c 502900 To WIP a/c 481,500 (Consumption) To Ofc Admin Exp. A/c 26400 By Balance c/d 16000 518900 518900 In the finished goods account we have a carried forward balance of $11000. In the debit side we add the work-in-progress amount of $481500 along with expenses of the office and administration which is $26400. In the credit side we have the consumption of $502900 and a balance of $16000 is carried forward. WIP Account To Opening WIP 4,500 By Finished Goods A/c 481,500 To Prime Cost a/c 342,000 (Cost of Production- Balancing Figure) To Manufacturing O/hs 168,500 By Closing WIP 33,500 515,000 515,000 In the debit side of the work-in-progress account we have the opening stock of WIP, we then add prime cost of $342000 and manufacturing overheads of $168500. In the credit side after subtracting the closing WIP we get the balance figure of $481500 which is the cost of production which will be transferred to the finished goods account. Cost of Sales Account To Finished Goods A/c 502900 By Sales A/c 619000 To Selling Distn Exp A/c 116,100 619000 619000 In the cost of sales account we have finished goods of $502900 and then we add selling and distribution overhead of $116100. In the credit side we have sales of $619000. Account Payables A/c To Bank A/c 180000 By Balance B/f 12000 (Payments made) By Raw Materials A/c 160000 (Purchases for April - Balance) By Balance c/d 8000 (Advance paid) 180000 180000 Debit side of the account payable account has payments made of $180000 and in the credit side we have advance payments of $8000 and the balance brought forward of $12000. The remaining balance of $160000 is the purchase of raw materials for the month of April Manufacturing Overheads Account To Actual Overheads 168500 (Refer Cost Sheet) By WIP A/c 168500 168500 168500 In the debit side of the manufacturing overheads account we have the actual overheads of $168500 and in the credit side we have WIP of $1685 Activity Based Costing (ABC) Activity Based Costing (ABC) is the methodology for the accurate distribution of overhead to the items that use it. It gives us a targeted reduction of overhead. We will see the process flow of ABC. Process Flow of Activity Based Costing (ABC) Identify Costs: Identifying the costs that we want to allocate is the first step of ABC. This is one of the most important step of ABC, as we would not want to waste time on broad project scope. Load Secondary Cost Pools: the second step for ABC is creating cost pools which will provide services to other parts of the company, and not costs which directly support a companys products and services. Administrative salary and computer services are certain examples. These costs should be later allocated to cost pools which are directly related to it. Depending on the nature of costs and their allocation there might be many secondary cost pools. Load Primary Cost Pools: Creating cost pools which are related directly with the production of goods and services is the basic requirement for creating primary cost pool. A separate cost pool for separate product lines is very common. Research and development, advertising, procurement and distribution are such costs. Cost pools can also be created at the batch level, so assignment of costs can be done based on batch size. Measuring Activity Drivers: Collection of information about activity drivers which are used to distribute costs in secondary cost pools to primary cost pools, and also allocating costs in primary cost pools to cost objects. As it is expensive to collect activity drive information, so we use activity drivers. Allocating Costs in Secondary Pools to Primary Pools: We can use activity drivers apportioning the costs in the secondary cost pools to primary cost pools. Charge Costs to Cost Objects: Using an activity driver we can distribute the contents of each primary cost pool to cost objects. It is mandatory to have a different activity driven for each cost pool. In order to allocate costs, we should divide the total cost in each cost pool by the total amount of activities in the activity driver; this will give us the cost per unit o the activity. Then using the activity driver, we allocate the cost per unit to the cost objects. Formulate Reports: For management consumption we can convert the results of the ABC system. The management will get a full cost view of the results generated by each region. Acting on the Information: Reducing the number of activity drivers used by individual cost object is the most common management practice of ABC. This will reduce the overhead cost. We will now see the benefits and limitations of Activity Based Costing (ABC). Uses of ABC Activity Costs: ABC is designed to trace the cost of activity, to see if it is in line with industry standards. ABC is also an excellent feedback tool for cost reduction, as it measures the outgoing cost. Customer Profitability: Product costs as we know are the costs incurred for individual customers, but along with that there is an overhead component also, like product return handling, high customer service levels, and cooperative marketing. ABC system will be able to manage these additional overhead costs and state the customer which is earning the company a reasonable profit. This will lead the company to turn away unprofitable customers, and focus on customers giving the company the largest share of profit. Distribution Cost: A company uses different distribution channels to sell its products in the market, like retail, internet and distributors. The cost of maintaining a distribution channel is overhead, so the company can determine which distribution channel is using overhead, it can then drop unprofitable channels and change how distribution channels are used. Make or Buy: ABC gives the company an inside of each and every cost associated with the manufacturing of the product, so it can determine which costs can be eliminated if an item is outsourced, and also costs which wont be outsourced. Margins: If the company properly allocates overhead using the ABC system, it can decide on the margin of various products, line of products and entire subsidies. This will be useful to determine where to position the resources of the company for earning largest margins. Minimum Price: Product pricing is based on the price which is common in the market, so the marketing manager should have an idea of what the cost of the product is, so that the company doesnt lose money on every sale or every alternate sale. ABC is useful for determining which overhead costs needs to be included in its minimum cost; this will depend upon the conditions in which the product is being sold. Production Facility Cost: It is quite easy to separate overhead cost at plant-wide level, so it gives the company to compare the cost of the product between its different facilities. Limitations of ABC Cost Pool Volume: ABC system provides high quality information but only after using large number of cost pools. The more the cost pools, more the cost of managing the system. Installation Time: ABC is difficult to install, every year installations has to be maintained if a company attempts to install it in all its product lines and facilities. For such installations, it becomes hard to maintain a high level of management and budgetary support during the months when the installation is being done. Multi Department Data Sources: An ABC system sometimes requires data input from multiple departments. The more the number of departments involved in this system, the more the risk that the inputs might fail. Reporting of Unused Time: If the company asks it employees to report the division of time on various activities, the employees have a tendency to report the time on unused activities as 0%. Thou there will be a large amount of unused time in anyones work for the day as it involve breaks, meetings among employees and with other people and also playing games on the phone, etc. Employees hide activities like this by apportioning time to other activities. These false or inflated numbers gives rise to misallocation of costs in the ABC system, sometimes by great amount. Separate Data Set: An ABC system cannot be made up from the information from a single general ledger. It requires various different databases and gets information from separate sources. It is quite hard to maintain this extra database, as it requires extra bit of staff time and also needs a separate budget. Conclusion After the discussion of the broad range of issues we come to a conclusion that a single product company with stable stock levels, both traditional and ABC methods will yield the same results, but for a multi-product company the allocation of costs can make a huge difference on the profitability of the product or service. The methods popularity is inverse to the data processing cost. ABC follows a difficult path in some organizations, and we can see its usefulness declining over time. It is important to construct a highly targeted ABC system, which will be reasonably cheap and will produce critical information. Installing a large and comprehensive ABC system, will be expensive, will be more resistant, and will be more likely to fail. Usually ABC would work best in an environment where we huge number of machines and products and the processes are not easy to sort out. In our report Frank Burgesss, New Age Caravans sells rugged but luxury range of caravans. 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