Management and Cost Accounting
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Management accounting is a branch of accounting that provides accounting information to managers in organizations. The information provided is thus used for making informed decisions in addition to acquisition of relevant information for managerial and control purposes. Information acquired in managerial accounting is usually different from other forms of accounting such as cost accounting or financial accounting. This is because the information is first, intended for managers in organizations to make sound decisions.
Second, information acquired in management accounting is forward looking other than being historical. Third, the information is confidential and specifically meant for management instead of the public. Fourth, information is computed with reference to needs of managers through the use of management information systems instead of financial accounting standards (Masha, 2007, 12). Management accounting involves the preparation of financial reports for creditors, shareholders, tax authorities and regulatory agencies.
Cost accounting on the other hand, is one of the most critical methods in management accounting which reflects the scope of management accountants. Traditionally, management accountants performed the duty of variance analysis. This reflected a systematic approach of comparing actual and budgeted costs of labour and raw materials used during production period. The essay paper addresses one of the most critical aspects of management and cost accounting in relation to allocation of costs and overheads. It is a particular matter that gives management accountants hard time when analyzing data in correspondence to overheads allocation. Bearing this in mind, it is important to look at traditional versus innovative practices that relates to actual and budgeted costs.
Most manufacturing firms still use variance analysis but this is accompanied with innovative techniques. Among the commonly recognized techniques include life cycle cost analysis and activity based costing (ABC). These techniques are usually designed in correspondence with modern business environment. Life cycle cost analysis technique recognizes that managers have the capacity to influence cost of manufacturing products at the stage of product life cycle (Heeley, 1993, 9). This implies that manufacturing costs are determined before design stage of the product is finalized and commencement of production stage. It is possible for managers to influence cost of manufacturing at this stage because small changes to product design leads to cost savings.
One major concern of managerial accounting is in the scope of production or manufacturing of products. Production involves successful directing of raw materials and other cost factors in the production process under close supervision of the managers. The production deals with placing hands on process and deals with tangible components of business such as assembly, inventory or fabrication among other steps. Managers focus their efforts on this specific area of production through application of relevant tools in support of production logistics. It calls for employment of techniques that sees movement of goods through the production process until such products reaches the final consumer. In other words, managerial accounting ensures that business model is operated in the right manner by minimizing on costs and maximizing on profits.
Managers seek to achieve high yields at minimal costs while maintaining quality standards. The production of products is a very complex process that requires making of informed decisions. This is because of the cost components that need to be maintained at a minimal level. The concept of cost accounting is featured at this stage of production whereby processing of raw materials to finished product is mandatory. Some of the mandatory production costs that need to be managed properly include direct materials, direct labour and manufacturing overhead.
Direct materials include all costs of materials used to produce a finished product. An applicable case is the manufacturing process of a computer which constitutes of the screen, plastic housing, mother boards, power cables and other components. Other minor materials are required in the process but these accounts for indirect materials. Direct labour costs include the gross amount paid to workers who are involved physically or directly in the production process. For example wages paid to a welder who fabricates bicycle frames in a bicycle factory constitute part of direct labour. However, in the production process employees from other factories are indirectly involved in the manufacturing process. This constitutes indirect labour which includes supervisors, maintenance personnel, security guards, or services of suppliers.
Manufacturing or production overheads are the other components of production costs that need efficient decisions. These include all costs of manufacturing apart from direct labour and direct materials. Some classes of manufacturing overheads include indirect labour, indirect materials, and factory expenses such as depreciation, maintenance, insurance, tax, repair or utilities. Manufacturing overheads also known as factory overheads are very difficult to trace in a finished product. However, these costs are relevant components of production and should be allocated appropriately.
Activity Based Costing (ABC)
The major concern of this essay paper is about activity based costing technique which recognizes that manufacturing costs in modern factories are influenced by the amount of activities. In other words, the activities involved include the number of produced products within a month and idle time recognized as a result of production equipment. According to ABC technique, the driving force to effective control measures in production process is optimization on the efficiency of manufacturing activities. Activity based costing is also referred to as cause and effect accounting based on the transformation that a product undergoes before reaching its final stage (Innes & Sinclair, 1994, 351). One of the most significant aspects in production or manufacturing process is avoidance of any form of disruptive events.
The production process should be at minimal cost with a view of maximizing on profits. Major disruptive disruptions include machine breakdowns and failures in quality control. A manufacturing factory that aims at maximization of profits is deemed to consider these events other than focusing on reduction of raw materials costs. The common overhead in production process is direct labour which many accounting techniques put more emphasis on. On the contrary, activity based costing does not really emphasis on direct labour as one of the driving costs in production process. Instead the technique emphasizes on activities that lead to increase in costs during the manufacturing process. Major emphasis of activity based costing is production of a unit that results to a finished product and provision of services.
The production costs are assigned during the production process through consideration of certain techniques. One of the most relevant techniques is Activity Based Costing (ABC) which is considered when assigning indirect costs in the process of producing products and services. ABC is a modern technique of assigning costs during the manufacturing process which is more accurate than traditional approach of allocating overheads. The traditional method groups overheads and assigns them to products based on volume of output. The method allocated production overheads as direct labour cost, direct labour time and direct machine time in hours.
Activity based costing is considered as a cost accounting technique that produces more accurate product cost. Certain provisions about this method make it to be a reliable technique for allocation of indirect costs. Key among these provisions includes its development, process, activity categorization, features and benefits. In the scope of accounting, ABC is a method used to measure cost of producing products and performance of activities. ABC recognizes the fact of casual relationship of cost drivers to activities. It is used by managers to assign cost to activities on the basis of resources used.
Activity based costing systems applied in factories recognizes numerous activities that promotes production of goods and services. It is used to clearly expose a relationship that exists between expenses and activities that lead to generation of the costs (Bloom & Heynman, 1990, 7). Failure of the traditional overhead systems to assign costs accordingly led to implementation of activity based costing. The main emphasis was to clear make mangers understand factors that leads to existence of overheads. ABC was in addition adopted to do away with the problem of product cost subsidization which was evident in traditional costing system.
ABC is a critical method that produces accurate product costs and leads to better understanding of products profitability. It is a method which is in a position to allocate costs to products providing focus for improvement process. ABC is a reliable method of cost analysis in the production process and an effective tool that helps mangers to make strategic decisions. Activity based costing thus is an instrumental method used to create a better understanding about the relationship between cost and activities within an organization.
Features of ABC
The features of activity based costing makes the method one of the most outstanding technique in cost accounting that produces more accurate product costs. The first feature of ABC is that it identifies the resources used in production of products irrespective of the behaviour of individual costs in the short-run. Second, the characteristic feature of fewer fixed and given costs makes ABC produce more accurate product costs. Third, ABC systems create cost pools linked to different organization activities as compared to other techniques such as absorption coasting. Fourth, activity based costing traces more costs as direct and it seeks an absorption base which is a cost allocation consideration. The absorption base has an outstanding feature of cause –effect related with costs in a cost pool.
Development of activity based costing
ABC method has emerged in the recent years to enlighten managers about accurate cost information necessary for production purposes. The costing method facilitates evaluation of profitable products that need to be produced by an organization. Accurate estimation of bottom line figures is another outstanding feature of ABC method. Other considerations that led to development of ABC method include a decline in manufacturing industries, development of technology, increased rate in service industries, the need for a variety of products and increased level of overheads to total costs. The need for ABC method also is influenced by the fact that many organizations are not aware about the activities involved before the final product is produced.
Another consideration is the fact of evaluating how activities costs are consumed. For instance, advancement in technology as is applied in both manufacturing and non-manufacturing sectors has seen many companies abandon traditional cost accounting. Other considerable reasons for development of ABC include deregulation of markets, increased levels of global competition, measuring of costs appropriately which leads to making of right decisions, and complexity of organization’s activities (Cooper & Kaplan, 1998, 99). In addition, it is argued that traditional cost accounting leads to overestimation of costs for high volume products while underestimating low- volume. Considering this in mind it therefore, reflects the reason for development of activity based costing.
Activity based costing process
The use of ABC method by managers when assigning indirect costs calls for consideration of four main processes. These steps are relevant in the production process and make activity based costing produce more accurate product costs. The processes include identification of activities, determination of cost drivers, creation of cost pools and trace to products. First, identification of the activities is based on certain principles and concepts. This involves considering that production activities consume resources. The identification of activities calls for help from involved staff and involves managerial judgment. Other major considerations include familiarity with aspects that are not directly linked to the organization and consideration of support activities. Core activities involved in production of products and services identified at this stage include material handling, set-ups, quality control, assembly and purchasing.
Determining cost drivers is the second process of ABC method which is applied to establish the factors that influence the identified activities at stage one. This step is a quantitative measure which helps to improve efficiency during the production process. The activities that lead to generation of costs during the production process are known as cost drivers. Choosing the cost drivers is a very involving task which requires judgment (Major, 2007, 16). For example the cost drivers for administration is labour hours, purchasing is number of purchase orders, customer inquires is the telephone minutes, and machine set-ups is number of set-ups.
The third stage is creation of cost pools which work under one assumption that organization’s activities are similar across the pool. This stage is very important in allocation of indirect overheads as it leads to creation of cost pools for each activity. Creation of cost pools for each activity helps organizations to find opportunities for improving their practices. This however, has its advantage in that it leads to reduction of production costs.
The fourth stage includes assigning costs of activities to products by determining cost driver rates and then applying the rate to products. The rates are determined through the use of budgeted activity and allocation is done in relation to usage of activities and demand of products. Assigning costs of activities to products thus is done through dividing activity cost by cost driver volume for the stipulated period. For example, total administration costs divided by labour hours is a good illustration on how costs should be assigned to products.
Categorization of activities
Categorization of organization’s activities is a relevant consideration that makes ABC an outstanding method in allocation of costs. Organization’s activities are categorized into first, unit-level activities. This category of activities is associated with the production process and occurs each time a u nit of a particular product is produced. This means that there is usually a direct relationship between unit-level activities and the units produced for example labour hours. A second category is product-sustaining activities which supports the production of different products in a given product line. Examples in this category include updating of products or any kind of technical support engaged in the production process.
A third category is batch-level which involves all the activities that are performed any time a batch is produced. The costs incurred at batch-level activities are usually fixed but to some extent they vary with the number of batches produced. The final category is facility-sustaining activities which includes the joint activities that are used to sustain the production process. Examples of facility-sustaining activities include accountancy, administration, lighting, or market research (Bhimani, 2003, 22).
Merits of ABC
Activity based is applied in the modern world of technological development hence producing more accurate product costs. First, ABC leads to improvement in decision making which leads to proper allocation of production costs. Second, ABC mainly focuses on important activities that lead to improvement in production process. Third, it is a method that creates an environment for greater understanding of overheads. Fourth, ABC method can be used by a number of organizations as it results to product profitability and proper pricing models.
The essay paper has addressed key issues relating to managerial and cost accounting specifically the production process and techniques applied to assign costs. It is clearly evident that cost accounting is a constitute part of managerial accounting. Production of products is a very extensive process that involves a number of costs. It is the role of managers to minimize production costs with a view of maximizing on profits.
The allocation of production costs calls the use of different techniques and the outstanding method in this essay has been activity based costing (ABC). The shortcomings of traditional cost accounting system and advancement in technology among other factors have led to adoption of ABC method by many organizations. Its characteristic features, advantages, categorization, process and development thus is considered as the major reasons that makes ABC produce accurate product costs.
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