Free Accounting Essays - Introduction to Accounting
1.0 Basic Introduction to Accounting
Accounting procedures play an integral role in strategic decision making process influencing both business and non-business entities. This decision making process have consequences not only over production, sales and employees but also over shareholder interests in the company. According to the Chartered Institute of Management Accountants (CIMA), the main aim of accounting is to provide financial information to users of such information.
Accounting can be classified into two segments whose main objectives may differ but collectively they tend to depict the financial position of the company to its internal and external users. The two segments can be classified as Management Accounting and Financial Accounting. Financial Accounting differs from Management Accounting in that they are summarised and prepared mainly for the external users of accounting information. The Institute of Management Accountants defines Management Accounting as a value-adding continuous improvement process of planning, designing, measuring, and operating both non-financial information systems and financial information systems that guides management action, motivates behaviour, and supports and creates the cultural values necessary to achieve an organisation’s strategic, tactical, and operating objectives.
CIMA defines Management Accounting as the process of identification, measurement, calculation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to ensure appropriate use of and accountability for its resources. An important contrast between the two segments of accounting is that management accounting is not mandatory in the sense that a company is free to do as much or as little as it likes and no regulatory bodies or agencies specify what is to be done, or, for that matter, whether anything is to be done at all.
The sole objective of management accounting is to provide the managers with a detailed analysis of the cost incurred and to assist them develop strategies to increase profits and reduce costs. Costing is a function which links both financial and management accounting. Without proper product cost information a manufacturing, wholesale or retail organisation would be unable to segregate the cost of sold and unsold outputs. Such segregation is essential to obtain periodic profitability measurement.
In this study, we are primarily concerned with management accounting and the strategies and techniques adopted and used in its estimation. We aim to look how superior is Activity Based Costing is to Traditional Costing and to what extent Activity Based Management is relevant to Management Accounting.
2.0 Cost Estimation Using Traditional and Activity Based Costing (ABC) systems.
In order to have a greater understanding of ABC systems and its significance it is essential that we assess traditional costing systems and look at the techniques adopted briefly. In doing so, we may be able to look at the merits and demerits of traditional method and the emergence of ABC systems as an alternate choice to the traditional costing system. Activity based Cost estimation has gained immense foothold in most company accounting systems largely due to its preciseness and accuracy. But such accuracies have come with question marks over its feasibility and complexities of identifying each and every activity.
Costing has remarkable influence over the product’s saleable properties in the market. Consumer’s purchasing powers have significant affect on the product life cycle. It is, therefore, necessary that manufacturers give importance to factors that influence the cost of a finished product not only from the point of view of selling but also from profitability, market share point of view. To do this, we need to look at the very early stages of production and work our way out to a stage where we may be able to list a list of reasons that leads to pricing of a product.
Traditional Costing System, also called Absorption Costing, is an inventory valuation and costing models that include all manufacturing costs - direct labour, direct materials, both fixed and variable manufacturing overheads. All manufacturing costs were considered as product cost regardless of whether they were variable or fixed cost. Thus, the main objective is to ensure all production overheads are absorbed into the total annual production costs.
Such accounting principles had technical flaws in the sense that it is largely inconceivable to fairly and justifiably divide the fixed costs between each of departments. Under absorption method price estimation looks deceptively simple. It just needs the company to compute its unit product costs, and then determine how much profit it wants and then set its selling price. It relies too much on forecast sales and management’s estimation of consumer perception on forecasted unit sales and the assumption that they are willing to pay whatever price the company decides.
Absorption costing was not designed for the modern automated technological environment. The traditional system accommodates all production overheads to be absorbed by all the production. In the past, overheads were only a small part of the total costs therefore it did not matter how mathematically accurate it is. But today, as suggested by Proctor, overheads often account for more than 50 % of the total costs. It is essential to estimate each cost contributing factor and look what activity gives rise to such costs.
In the days when traditional accounting practices were being formed and internationalised, the dominant industries were in the manufacturing sector. In a typical large manufacturing company, there would be large numbers of employees concerned with direct manufacturing and a much smaller number in the overhead departments In a situation where the direct labour costs could be as high as 90 per cent and overheads 10 per cent of total costs it was important to get some accuracy in terms of the hours, and therefore costs, of actually making components and assemblies. These discrepancies in cost estimation using traditional method are effectively corrected by another method called the Activity Based Costing (ABC).
2.1 Activity Based Management and Cost Estimation.
2.1.1 Activity Based Costing (ABC).
ABC system is based on activities linking organisational spending on resources to the products and services produced and delivered to customers. It uses activities for accumulating costs. Instead of assessing by how much each of these departments contribute to costs, ABC system starts by asking what activities are being performed by the service department sector. It focuses on Cost Drivers.
The process of estimating cost using the activity based costing method begins by first identifying the activities performed by the business. Once we can ascertain the activities, we then move on to calculate the total costs of each such activity over the financial period. As stated earlier, the activity method relies on cost drivers for each activity. We then calculate the cost driver rate, that is, the average costs of one occurrence of the cost driver. This process is then followed by assigning part of the cost of each activity to different products based on the extent to which each product has caused the activity to occur.
It is important to understand that not all overheads increase in proportion to the number of units produced. The traditional approach on the other hand assumes all overheads to be a contributing factor in all production, that is, they all increase as output increases.
Overhead Expenses
Activity Costs Pool
Other Costs drivers
Operating Machinery
Controlling Quality
Buying Raw Material
Cost Driver Rates
£ / Costs Drivers
£ / Machine Hour
£ / Inspection
£ / Purchase Order
£ / Costs Drivers
Number of Machine Hours
Number of Inspection
Number of Order
Times
Product Costs
Following is the chart representation of overhead cost estimation as per activity based cost estimation. We can determine the operating machinery activity costs by multiplying cost driver rates (£/Machine Hour) by the number of machine hours. Same can be done with many other activities. Using this strategy, we can identify each activity/activities and derive a precise and accurate cost for that activity/activities and its contribution to the overall product costs. However, it would be inappropriate to say that ABC is free from flaws. It requires major inputs from almost every area of the business – factory, warehousing, maintenance, purchasing, quality control etc. Some costs such as heating applies to more than one activity and to divide it amongst all the appropriate cost pools, some subjective method of apportionment, as in absorption costing, is for all logical reasons doubtful.
2.1.1a Identifying Cost Drivers.
The Cost Drivers is a quantitative measure associated with the workload of the activity. It typically should provide a good explanation of the behaviour of costs in the pool and should be identifiable with each product line for the final stage of product costing. One major flaw witnesses while selecting a particular cost drivers is that no historical date are generally available to undertake statistical testing of the relationship between the behaviour of costs in the cost pool and the cost driver itself.
To complete the operation of the system the cost driver rates are applied to the costing of product output. This costing system requires that cost driver must be able to associate itself with the specific products for e.g. the machine hour rate applied to Machinery Operation in the chart seen earlier. Another precondition is that the rate must be predetermined, that is, it must be based on estimated activity cost levels and cost driver volumes for the current period.
The major drawback associated with this rates estimation is that it needs constant monitoring and, if necessary, adjusting regularly. Such process comes with additional costs which can be captured by the final product costs.
2.1.1b Value Added or Non Value Added.
This is an essential component in the cost estimation technique under ABC system. As we have seen earlier, ABC system works towards reducing costs and increasing profitability. If we suppose that certain activity reduces costs to a certain extent, to what extent does that activity add value to the product from the point of view of the customers ? If the answer to this question is negative, we may very well say that it is non-value adding and efforts should be made to eliminate such activities. However, it is almost difficult to eliminate completely all those non-value added activities. Most organisations run up to 20 to 40 % of their total expenditure through non-value added activities.
Despite some of the drawback associated with ABC, most managers who have implemented find ABC far too superior to traditional costing system. To summarize ABC following are some typical benefits of Activity Based Costing are:
· It can accurately predict costs, profit and resources requirements associated with changes in the production volumes and costs of resources.
· It can track costs of activities and work processes.
· It can equip managers with cost intelligence to stimulate improvements.
2.1.2 Activity Based Management (ABM).
Activity Based Management refers to the actions managers take based on the information from an activity based accounting system to increase profitability. The action may represent operational improvements to high cost processes, changing product prices and product mix, and restructuring customer relationships. It aims at improving processes, particularly the processes performing batch and product-sustaining activities.
It is used in conjunction with activity based costing to improve processes and reduce costs. Taking ABC into consideration, managerial activities can be categorized into two distinct managerial objectives – Operational ABM and Strategic ABM. Operational ABM sets aim at reducing the cost of activities and to increase capacity by improving efficiency. It begins by possible improvements to existing processes and allocating resources to carry them out. The next stage is to monitor the results of each such activity. The results are generated by ABC which can then be used to verify and reduce spending on operational activities. The divergence or variance between the actual and anticipated resource consumption would suggest whether or not strategy have materialised or not.
Strategic ABM, on the other hand, aims at increasing the demand for high profitability activities and to decrease the demand for low profitability ones. Activity based costing, largely due to its individualistic estimation, can provide information on the profitability of individual products and customers. For example, this allows marketing manager to develop strategies to market distinct sales mix towards more profitable products and more profitable customers.
Assessing both these ABM objectives, we can summarise that, it is aimed at profitability by reducing cost and also to eliminate those activities that are least required or those that have least impact over the product’s overall production stage and in the final marketing and sales stage.
2.1.2a Superiority of ABC/ABM over Traditional Costing system and its significance to Management Accounting.
Very briefly, we assessed how discrepancies in the traditional costing in terms of allocating overhead costs to outputs rather be assigned or traced to output. Following are some points that will highlight the accuracy and preciseness of Activity based Management -
1. It provides visibility in the way costs flow through the business.
2. It establishes the links between activities and those factors, internal or external, that drive the level of activity up or down.
3. It eliminates the false divide between direct costs and overheads.
4. It ignores gross margin and uses accurate product and customer contributions as the basis for comparing product and customer profitability.
5. It exchanges the stilted definitions of value-added and non-value-added for sensitive categories that highlight the subtle impact of internal process failures and external customer behaviour.
3.0 Critical Appraisal and Conclusion.
The development of ABC as a precise accounting principles have been due to many interrelated reasons. Flexible manufacturing systems, total quality management, wide range of products, more customisation and faster and more reliable response to customers have all contributed to its emergence. These factors led many firms to change the structure of cost estimation.
Activity based costing and management have been increasingly used in relation to marketing activities and customer profitability. The scope of ABC systems have spreads its accuracy from manufacturing to service, banking and insurance companies. It is also described as an efficient system that helps to integrate non-financial and financial performance measures.
Research by Cobb, Innes and Mitchel (1992) has highlighted some discrepancies with ABC and ABM. Setting up of the system and data collection and the amount of work required to gather such information on each and every activity are the most common problem. It requires time to select and identify most cost drivers as it may involve managers spending time to identify potential non-value adding inputs, resources and cost drivers. It has also been suggested that as careful consideration is given to each activity, it often leads to identification of too many drivers which is cost prone and they (drivers) tend to increase in numbers. A selected activity cost pool may not be in sync with the organisation cost structure. For example, Purchasing activity may be found in purchasing, production, stores, administration and finance department which may make it difficult to identify the clear ownership of the activity.
And as suggested earlier, some cost drivers such as heating are used over variety of activities and it would not be sensible to mathematically divide such cost drivers. Even if we could, what are the parameters to be considered while differentiating drivers such as heating over a variety of activity ?
Despite these short comings, the main benefits of ABC and ABM are different product costing, greater visibility of overheads, emphasis on activities crossing departmental boundaries, improved understanding of overhead cost behaviour by managers, control and reduction of overhead costs by eliminating or reorganising activities, increased resources for core or value added activities. To sum it up Activity Based Costing approach is worth considering for all organisations where overheads are a significantly percentage of the total costs.
References and Bibliography.
Anthony A. Atkinson, Robert S. Kaplan, S. Mark Young, Management Accounting, Fourth Edition, International Edition.
Garrison, Noreen, Brewer, Managerial Accounting, Eleventh Edition.
Ray Proctor, Managerial Accounting for Business Decisions, with Contribution from Nigel Burton and Adrian Pierce.
Kaplan and Cooper, Cost and Effect: Using Integrated Costs Systems to Drive Profitability and Performance, 1998, Harvard Business School Press, Boston.
David Ashton, Trevor Hopper, Robert W. Scapens, Issues in Management Accounting. Chapter 6 – Activity Based Costing.
Websites:
http://www.saferpak.com/abm_articles/Basics%20of%20ABM%20Word.pdf
http://www.12manage.com/methods_abc.html
