Conceptual Foundations Of Financial Reporting: Implementing ABC Costing

Background

Discuss about the Conceptual Foundations Of The Financial Reporting.

Sewing easy Ltd. Is the company which is in the business of manufacturing the sewing machines for the last 2 years. It has been producing mainly 2 models namely basic and advanced. Last year in 2017 the company made good profits and now they will be selling the same to the overseas buyer. However, the management of the company as well as owner of the business Sam Moroney are a bit confused about the fact that the buyer is only interested in buying the advanced model and not the basic model (Bizfluent, 2017). For the product costing purposes, the company has been using traditional costing method and using the machine hours to allocate all the indirect costs of production as the company did not wanted to implement a new costing system and incur expenses on account of that as the company was already earning heavily.

But the given proposal from the overseas buyer has put the owner and the business in some thinking and thereby now they are thinking of implementing the activity based costing system to find out the reason for the overseas buyer’s preference for the advanced model.

1. The product costing of the two models of sewing machine under the current traditional costing method is shown below. The basis of allocation or the cost drivers have also been shown in the table(Alexander, 2016).

The cost per unit of the two model of the sewing machines as per activity based costing has also been shown below:

The company has been selling the models of sewing machine at cost plus 20% under the current costing method and is willing to sell at the same price even now. The overseas buyer is willing to purchase only the advance model(Choy, 2018). The profit and loss account under the two scenarios has been shown below

1. Traditional costing being used for the product costing
2. Activity based costing being used for the product costing

From the above profit and loss account and the analysis, it is very clear that the overseas buyer is interested in buying only the other model because it is cheap as compared to the market (Dumay & Baard, 2017). The company when applies the traditional method, the cost of the advanced model is $ 981.28 per unit whereas when the company applies the activity based costing technique then the cost becomes $ 1001.78, now in both the scenarios the company is getting the model at the $ 1188.54. On the other hand if we analyse the cost per unit for the basic model under the traditional costing and the activity based costing, we see that the profit attributable under the latter system is much more than the former hence the buyer will be at loss purchasing the product at more than as compared to the market (Heminway, 2017).

Analysis

The above is one of the instances which shows the importance of the accurate product costing.

• This shows that if the products are being appropriately and correctly costed then the correct profit would be revealed and the business would not be losing the revenue as well as the customers.
• Also, the competitors would not be able to make use of the same and thereby increasing their sales. In case the correct costing is not being done, the business would not be able to take decision relating to the introduction of the new products in the market, removal of the old products from the catalogue as they are no more profitable and also not being able to decide when to increase or decrease the price of the product in the market(Goldmann, 2016).
• In case there is any project tracking related with the costing of the product then in the absence of the accurate costing, there would always be a deviation as compared to the expectation and the project tracking would all go wrong.
• If the company is planning for the project development meaning the introduction of the new product in the market basis the old product then the costing can be an invaluable resource therefore it needs to be accurate(Jefferson, 2017).
• Finally, if the product is not costed accurately, it gives rise to inefficiency and ineffective results in terms of budget, the income statement, the transfer prices and thereby the overall financial statements of the company.

1. We hardly see that the actual overhead costs and the applied overhead costs would match. It is usually the difference between the manufacturing overhead applied to the work in progress and the manufacturing overhead being actually incurred(Dichev, 2017). If the manufacturing overhead applied to the particular process is more than what is being actually incurred then the difference is being termed as over-applied manufacturing overhead. On the other hand, if the application of the overhead is less than what is being actually incurred then the difference is being termed as the under applied manufacturing overhead. The main reason of occurrence of the under or over application of the cost is due to overheads being applied at the predetermined overhead rate which is being computed in the beginning of the year and then being applied throughout the year but the actual overhead is usually different (Linden & Freeman, 2017). The over or under applied manufacturing overhead is usually the debit or credit of the manufacturing overhead account as the actual cost is being debited and applied cost is being credited to the account and based on the actual occurrence and work in progress respectively. At the end of the year, the debt balance show the under application whereas the credit balance shows the over application of the overheads. It can be dealt with in different ways mentioned below:
2. The balance of the manufacturing overhead account can be allocated to work in progress, cost of goods sold and finished goods account on the basis of the overheads being actually applied to all these accounts during the given year. The journal entry for the same has been given below:

When the overhead is under-applied

When the overhead is over applied

The second way of dealing with the under applied or the over applied is through transferring the entire amount to cost of goods sold account(Meroño-Cerdán, et al., 2017). The journal entry for the same is given below:

When the overhead is under applied

When the overhead is over applied

ABC system is acronym for the Activity based costing system. It is one of the innovative and correct method allocating the costs based on the cost drivers(Trieu, 2017). It is one of the costing methodology which identifies the various activities within an organization and then allots the cost based on the different activities to the given products and services as per the per unit consumption. It shows the relationship between the costs, activities and the products and services and using this relationship allocates the indirect overheads to the products less arbitrarily as compared to the traditional methods (Visinescu, et al., 2017). There are generally 2 categories of cost allocation one being transaction drivers which show how many times a process has been repeated or activity occurred and the other being duration driver which shows how much time a particular activity has taken. It has a number of benefits which are mentioned below

1. More accurate method of costing of the product and services
2. It enables correct pricing decision as well as when to introduce a new product in the market.
3. It helps in the effective management of the overhead costs and reduces the non-value adding activities thereby helping the mangers to eliminate the redundant activities.
4. It also contributes in product and customer profitability analysis
5. It helps in tracing the activities for the given cost object and also in tracing of the overhead costs(Sithole, et al., 2017).
6. It helps in better decision making by the mangers as more accurate data is present to see what product and activities to be focused upon to improve the profitability.
7. ABC analysis involves pooling of the costs, identification of the cost drivers and range of applications. Thereby it can help the company in identifying the spare capacity if any help in the reduction of the cost.
8. It helps the service industry mostly to allocate its cost as there are no direct cost drivers which can be used to allocate the overheads(Werner, 2017).

Along with the benefits, ABC costing also comes with the some limitations as well which has been listed below:

1. It is quite expensive to implement as it needs to be driven as a separate activity all together and an extra manpower may be required. It is also complex as compared to the other processes and traditional costing systems.
2. There may also be several difficulties in the selection of the cost drivers and assignment of the common costs(Vieira, et al., 2017).
3. It may be that beneficial to the smaller firms as they may not require this level of technology. Furthermore, it is beneficial to those who use cost plus mark-up method for pricing but not for those who using the market price based method.
4. If the amount of the overheads is small, then the ABC costing analysis may not be of much use(Raiborn, et al., 2016).
5. It is not a substitute to the monthly profit and loss statements, neither should it be used to prepare the profit and loss account.

References

Alexander, F., 2016. The Changing Face of Accountability. The Journal of Higher Education, 71(4), pp. 411-431.

Bizfluent, 2017. Advantages & Disadvantages of Internal Control. [Online]
Available at: https://bizfluent.com/info-8064250-advantages-disadvantages-internal-control.html
[Accessed 07 december 2017].

Choy, Y. K., 2018. Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, p. 145.

Dichev, I., 2017. On the conceptual foundations of financial reporting. Accounting and Business Research, 47(6), pp. 617-632.

Dumay, J. & Baard, V., 2017. An introduction to interventionist research in accounting.. The Routledge Companion to Qualitative Accounting Research Methods, p. 265.

Goldmann, K., 2016. Financial Liquidity and Profitability Management in Practice of Polish Business. Financial Environment and Business Development, Volume 4, pp. 103-112.

Heminway, J., 2017. Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and Organic Documents. SSRN, pp. 1-35.

Jefferson, M., 2017. Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland. Technological Forecasting and Social Change, pp. 353-354.

Linden, B. & Freeman, R., 2017. Profit and Other Values: Thick Evaluation in Decision Making. Business Ethics Quarterly, 27(3), pp. 353-379.

Meroño-Cerdán, A., Lopez-Nicolas, C. & Molina-Castillo, F., 2017. Risk aversion, innovation and performance in family firms. Economics of Innovation and new technology, pp. 1-15.

Raiborn, C., Butler, J. & Martin, K., 2016. The internal audit function: A prerequisite for Good Governance. Journal of Corporate Accounting and Finance, 28(2), pp. 10-21.

Sithole, S., Chandler, P., Abeysekera, I. & Paas, F., 2017. Benefits of guided self-management of attention on learning accounting. Journal of Educational Psychology, 109(2), p. 220.

Trieu, V., 2017. Getting value from Business Intelligence systems: A review and research agenda. Decision Support Systems, Volume 93, pp. 111-124.

Vieira, R., O’Dwyer, B. & Schneider, R., 2017. Aligning Strategy and Performance Management Systems. SAGE Journals, 30(1).

Visinescu, L., Jones, M. & Sidorova, A., 2017. Improving Decision Quality: The Role of Business Intelligence. Journal of Computer Information Systems, 57(1), pp. 58-66.

Werner, M., 2017. Financial process mining – Accounting data structure dependent control flow inference. International Journal of Accounting Information Systems, Volume 25, pp. 57-80.

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