Importance of accurate product costing and problems with traditional costing
Management Accounting has become an integral part of any business organisation. Management Accounting helps in determining the overall cost of production accurately so that pricing strategies can be prepared for a particular product. One of the most important factors that should be considered while assigning a price to particular product service is apportionment of overhead cost. Overhead cost are the costs that are not directly related to production of particular goods and services. For example, cost of delivering goods for whole organisation cannot be directly apportioned to a particular product as deliveries conducted for whole organisation. In such cases various apportionment methods are used for dividing overall overhead cost to each of the product manufactured by the company. There are various methods through which such apportionment can be done (Weygandt, Kimmel and Kieso, 2015). This report is focused on activity based costing for apportionment of overhead cost. Activity based costing is a method which identify the various overhead activities and cost is assigned on the basis of these activities. Apportionment in activity based costing is based on relationship between three major factors cost, overhead activities, and product under production. Activity costing method is currently used by various organisations as it represents more accurate overall cost of production as compared to other traditional methods (Noreen, Brewer and Garrison, 2014).
The level of competition in business market is increasing day by day. Business organisation working in industry is facing competition from domestic organisations as well as International organisations. Therefore it can be said that globalisation has increased the level of competition in local market and international market. In such a competitive business environment, it is important that proper costing and pricing methods are used by organisation for their product and services (Dopson and Hayes, 2016). It is very essential for any organisation to track its cost accurately so that accurate profits determined from each of their products. Determination of accurate cost and profit will help in determining which product to produce more and which product to divest from the business.
Determination of accurate cost also helps in assigning the selling price for product and overpricing or under-pricing of any product can be have negative impact on business organisation. If the products are overpriced and the demand of the product will decrease and it will affect overall profits earned by the company. If the products are under-priced then profit margins of the company will decrease and it would not be able to complete with other organisations in competitive business environment. Therefore it can be said that accurate product costing will help in profitable existence of business in market (Hilton and Platt, 2013).
Problems with traditional costing methods
In today’s business environment, it is important that all organisations keep a competitive edge in their business operations as compared to other business organisations. Costing methods adopted by business organisation can act as a competitive edge for a particular business organisation. Accurately measurement of cost can result in better implementation of cost available to the company. In addition to that there are various laws that are implemented for setting predatory pricing strategies. Predatory pricing strategies are the strategies that are used by business organisation to drive competition out of market by lowering their own prices charged from customers. If a company states in the court that such pricing were charged due to inaccurate costing methods then it would not hold up in the court. Therefore it is important to conduct accurate product costing so that additional costs like legal fees can be avoided (Garrison et.al, 2010).
Traditional costing method are the methods of apportionment of overhead cost in which only one factor for apportionment of cost is used i.e. either machine of labour hour. Majority of the organisations by adopting this method but it has various disadvantages that resulted in inaccurate pricing of product and services. According to the traditional methods, there is only one factor on basis of which overhead cost can be apportioned (Zimmerman and Yahya-Zadeh, 2011). This will definitely result in inaccurate pricing of product and services. Following are some of the limitations of traditional costing method that shows that it is not apt to use this costing method in current business environment-
- Traditional costing methods rates i.e. machine hour rate and Labour hour rate can be used for valuation of closing stock or apportionment of cost but it should never be used for making important strategic decisions for business. The strategic business are implemented for a period of three to five years and labour hour and machine hours cannot be estimated for a long period of time (Miller-Nobles, Mattison and Matsumura, 2016).
- In current business environment majority of the work is done through automation. In such scenario it would not be effective to use labour hour rate as the number of labourers in the organizations are very limited.
- Apportionment of indirect cost in case of traditional costing methods is very difficult because it does not considered that the factors that are considered in modern costing methods. For example, delivery charges for the company cannot be apportioned on the basis of labour hour incurred by the driver (Langfield-Smith et.al, 2017). On the basis of labour hour rate, delivery charges will be apportioned on an equal basis as equal time is given by driver of the truck. But in reality it should be apportioned on the basis of distance travelled by delivery truck to make them available to next location.
- Traditional costing method only considered the factors up to the process of manufacturing goods and services and labour hour or machine hour incurred after the product is manufactured is ignored.
Cost driver rates are calculated by dividing the total cost of particular activity by number of such activity undertaken in the process of production of goods and services. Cost drivers for Beztec Limited are calculated in the following table-
Total cost shows in traditional costing method is very different from the cost calculated as per ABC costing method. Total cost of manufacture for production of Lexon is lower in ABC costing whereas cost of producing Protox is very high. ABC costing methods should be considered more accurate as compared to traditional costing method as it apportion the cost on the basis of activities that are more relevant than machine hours and labour hours.
It can be evaluated with the help of above profitability statement that the profits calculated in traditional costing methods does not represents the actual profits incurred by individual products. Aggregate profit generated from production of goods would be similar but individual profit from both of their products is totally different in ABC costing method as compared to traditional costing method. in case of Lexon, total profit per unit as per traditional costing method is only 71.5 per unit but ABC costing method shows that generated by the product is 128.55. It was the traditional costing method was presenting profit 78% lower as compared to what it should have been. On the other hand in case of Protox, profit were highly overestimated in case of traditional costing method. Traditional costing method shows a profit of $107 per unit but as per ABC costing method this product has incurred a loss of $121 per unit. Strategic decisions in relation to this product to be made on the basis of ABC costing method as it represents more accurate results (Noreen, Brewer and Garrison, 2014).
Profitability under ABC costing
Steven, CEO of the company, has suggested Smith not to disclose the ABC costing results to Headquarters as it would result in closure of Protox product. CEO of the company has also stated that ABC costing method used by Smith is not representing actual profitability as this analysis does not include all the activity conducted by the organisation. In the opinion of Smith, calculations done in ABC costing are very accurate and it represent actual profitability from both of the products. Smith is of the opinion that Steven does not want to disclose actual result as his bonus is based on divisional profit.
According to APES 110 code of ethics, there are certain characteristic that should be possessed by accountant while discharging his or her functions such as integrity, objectivity, professional competence and due care, confidentiality and professional behaviour (Accounting Professional and Ethical Standards Board (APESB), 2013). In the given scenario it is clear that product manufactured by the company Protox is not profitable for the organisation. Smith is confident that her calculation is accurate and relevant to the given case. Therefore top management and shareholders of the company and total right of evaluating the actual profitability generated from each of their products and services. Whether manufacturing of Protox would be continued or closed is not relevant and Smith should report the profitability statement prepared by her as per the principles of ABC costing.
Predetermined overhead rates are calculated at the starting of the financial year and applied on the budgeted expenses or activities. There are various reason that can result in over or under absorption of overhead cost. Here are some of these reasons-
- Error in estimation of overhead expenses at the start of the year can result in under or over absorption.
- Error in estimation of total machine hour or labour hour worked in a particular time period (Oseifuah, 2018).
- Selection of wrong method of absorption can also result in over or under absorption of overhead expenses.
- Seasonal demand and supply of product and service can also result in over or under absorption as it would result in wrong estimation of total expenses and revenue.
- Change in estimated production capacity of the company can also result in inaccurate absorption of overhead expenses. for example if production capacity of the company is increased buy installation of new machinery then total cost will also increase which will ultimately result in under absorption of overhead expenses (Stefano and Casarotto Filho, 2013).
Three ways to dispose the amount of over/under applied overhead costs
- Over and under absorption of overhead cost can be written by management in profit and loss account as an expense or income.
- Difference in actual overhead cost and estimated overhead cost can also be carried forward to next financial year and adjusted against over or under absorption in that financial year (Dale and Plunkett, 2017).
- Management can also use supplemental rate for the treatment of under and over absorption
Conclusion
It can be concluded that cost management accounting is very essential for internal purposes of the company. Results depicted from cost accounting are very important in taking various strategic decision in relation to production of goods and services. Cost accounting should be given same importance as financial accounting as both of these accounting are important in their own manner. This report has focused in traditional costing and method and Activity Based costing method for apportionment of overhead cost in the organisation. In the given scenario it is suggested that ABC costing should be used as it is more suitable according to the nature of business.
References
Accounting Professional and Ethical Standards Board (APESB), 2013. APES 110 Code of Ethics for Professional Accountants.
Dale, B.G. and Plunkett, J.J., 2017. Quality costing. Routledge.
Dopson, L.R. and Hayes, D.K., 2016. Managerial accounting for the hospitality industry. Wiley Global Education.
Garrison, R.H., Noreen, E.W., Brewer, P.C. and McGowan, A., 2010. Managerial accounting. Issues in Accounting Education, 25(4), pp.792-793.
Hilton, R.W. and Platt, D.E., 2013. Managerial accounting: creating value in a dynamic business environment. McGraw-Hill Education.
Langfield-Smith, K., Smith, D., Andon, P., Hilton, R. and Thorne, H., 2017. Management accounting: Information for creating and managing value. McGraw-Hill Education Australia.
Miller-Nobles, T.L., Mattison, B. and Matsumura, E.M., 2016. Horngren’s Financial & Managerial Accounting: The Managerial Chapters. Pearson.
Noreen, E.W., Brewer, P.C. and Garrison, R.H., 2014. Managerial accounting for managers. New York: McGraw-Hill/Irwin.
Noreen, E.W., Brewer, P.C. and Garrison, R.H., 2014. Managerial accounting for managers. New York: McGraw-Hill/Irwin.
Oseifuah, E.K., 2018. Activity based costing (ABC) in the public sector: benefits and challenges. Management, 12, pp.4-2.
Salem, M.S.E. and Mazhar, S., The Benefits of the Application of Activity Based Cost System-Field Study on Manufacturing Companies Operating In Allahabad City–India. OSR Journal of Business and Management, 16(11).
Stefano, N.M. and Casarotto Filho, N., 2013. Activity-based costing in services: literature bibliometric review. SpringerPlus, 2(1), p.80.
Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2015. Financial & managerial accounting. John Wiley & Sons.
Zimmerman, J.L. and Yahya-Zadeh, M., 2011. Accounting for decision making and control. Issues in Accounting Education, 26(1), pp.258-259.
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