Category: Cost Accounting

Introduction

The October 2007 issue of Entrepreneur Magazine featured an article written by Patrick A. Casabona and Sylvia Gornik-Tomaszewski entitled: “Special Issue: Fair Value in Financial Reporting, Auditing and Tax Accounting” that compared the traditional method with the fair value model of cost accounting. It is an important issue about that is attracting a lot of debate presently all over the world.

Main body

Despite the fact that the fair value method is a newer, supposedly better method than the traditional model and enjoys the backing of major international accounting trend setters, there are many critics who contend that the traditional model continues to make more sense as compared to its new competitor.

The critics of the fair value method state that it lags far behind the traditional model insofar as the two most vital foundations of financial reporting are concerned – reliability and relevance. They underline their stance by blaming the fair value method as a significant cause of the Enron scandal² that shook the world as it shockingly exposed the excesses of businesses during the economically booming 1990s in the United States.

Critics have identified several major flaws in the fair value model of cost accounting that go to show it is not a totally reliable method.

First of all, even the most purposeful assessment of fair value conducted by a business organisation’s management will be incorrect to the degree that the many forecasts and presumptions are incorrect.

Secondly, unscrupulous management personnel can capitalise on the opinions and assessments utilized in the process to distort data and generate favourable results. For example, the DCF model’s assessment of cash flows can be manipulated to either overstate or understate amounts according to management’s wishes, or huge write-downs during a particularly poor performance period can be carried out.

Thirdly, irrespective of the intentions of management, the utilisation of Level 2 and Level 3 modes of measuring fair value as prescribed by SFAS No.157 of the FASB, generate figures that are problematic to verify .

Fourthly, it is understandable that any shift towards a fair value model could be incompatible with a principles-based accounting standards-setting procedure.

Lastly, assets that feature contractual cash flows are problematic to value. It is significant to note here that the SEC has acknowledged this particular deficiency in the fair value model by suggesting the provision of a variety of estimates in case of securities. The SEC’s admission gives rise to a potentially greater problem, namely, the difficulties that will arise while valuing assets that have no contractual cash flows.

Conclusion

In conclusion, despite the Entrepreneur Magazine article’s portrayal of the fair value method as much better than the traditional method of cost accounting, there is no doubt that the fair value model has a lot of drawbacks. It is foolhardy and dangerous to totally rely on a cost accounting method that can significantly precipitate massive accounting scandals such as the Enron fraud. Hence, until its drawbacks are properly circumvented and it is then properly and conclusively proved by the international accounting trend setting bodies that the fair value model is error-free and therefore worth adopting, it is highly recommended that business entities continue using the presently more trustworthy traditional cost accounting model.

References

Casabona PA, Gornik-Tomaszewski S. Special Issue: Fair Value in Financial Reporting, Auditing and Tax Accounting. Entrepreneur Magazine [serial on the Internet]. 2007. Web.

Krumwiede T. Why Historical Cost Accounting Makes Sense. Allbusiness.com [document on the Internet]. 2008. Web.

Differences in job order cost sheet

Manufacturing and services companies differ in a number of ways. The main difference is that manufacturing companies such as the Middleton Made Knives deal with the production of goods and services. Thus, at the end of the year, they have balances of the three categories of inventory (Bhimani et al. 231). These items are recorded in the balance sheet statement. In contrast, service industries lack balances of finished goods inventory at the end of the year. The job order costing system can be used by both manufacturing and service companies because it gives information on the cost of producing a job or a job lot. A job cost sheet is used by a company to record the costs of a specific job with an aim of estimating the total and unit costs of a finished job (McLaney and Atrill 231). The three main categories of costs in a job cost sheet are direct materials, manufacturing overhead, and direct labor.

The direct materials section of Middleton Made Knives will have entries of all items that are directly used in the production of knives. Some of the items that are likely to appear in this section are hardened steel blanks that are used to make the knife shaft and blade, wood for the handle, and packaging materials. In contrast, the direct material section of service companies differs across the industry depending on the type of services that are offered by an entity. It is worth mentioning that most service companies do not keep track of the direct materials that are used in the production process because they are insignificant (McLaney and Atrill 172). For example, in the case of accounting and law firms, direct materials are low-cost items such as papers. Most of these companies treat such items as overheads and not direct materials. Therefore, they are recorded under overheads. In some instances, service companies track the costs of direct materials, especially when they are significant. For instance, consider the case of electricians who performs repairs. They will charge for services rendered. Apart from that, they may also purchase some materials for carrying out the repairs (Brigham and Ehrhardt 210). In this case, they will keep track of the cost of these materials. Such items will be treated as direct materials just like the case of raw materials in the manufacturing industry. Another example is the total cost of producing a movie. Some of the direct materials that are often used are props, costumes, and broad sets (Bhimani et al. 231). These costs in most cases are quite significant and are always recorded in the direct material section. Therefore, the recording of items in the direct material section of a service company highly depends on the significance of the cost of items. However, the process of recording the information in the job cost sheet for the manufacturing and service industries is the same.

Examples of costs for Middleton Made Knives

As mentioned above, the other sections of the job order cost sheet are direct labor and manufacturing overheads (McLaney and Atrill 172). Some of the items that are recorded in these sections are discussed below.

Direct labor

This section basically records factory labor costs. In the case of Middleton Made Knives, the items in this section will comprise gross earnings of factory workers, taxes on payroll, and fringe benefits that are incurred by the company (McLaney and Atrill 172). The factory labor costs are allocated to the jobs based on the time tickets that are often prepared when the job is being executed. The time ticket records information of the employee, a number of hours worked, the job charged, and the total labor cost.

Manufacturing overheads

This section of a job order cost sheet accumulates the costs that are directly related to the manufacturing process. Therefore, they relate to the entire production and not a specific job. Some of the items that will be included are depreciation on factory building (if the company owns the building), rent, depreciation of factory equipment, salaries that are paid to supervisors in the factory, costs incurred by the factory quality control department, salary of factory maintenance employees, indirect factory supplies, cost of electricity, gas and water that is used in the factory, property tax on factory building, and cost of repairs and maintenance of machines and equipment at the factory (Weygandt, Kieso and Kimmel 169). These costs are blanket and cannot be assigned to a specific job based on the amount incurred. Therefore, there is a need to assign them to each unit produced. This process is at times challenging because there is no direct association between the overheads and the units produced (Weygandt, Kieso and Kimmel 163). To solve this problem, most companies often use predetermined overhead rates. It is worth mentioning that the costs that are not related to the manufacturing process are expensed and not added to the product unit cost. An example of such type of cost is an amount spent on sales and marketing.

Works Cited

Bhimani, Alnoor, Charles Horngren, Srikant Datar, and George Forster. Management and Cost Accounting, England: Pearson Education Limited, 2008. Print.

Brigham, Eugene and Michael Ehrhardt. Financial Management Theory and Practice, USA: South-Western Cengage Learning, 2009. Print.

McLaney, Evans, and Peter Atrill. Financial Accounting for Decision Makers, London: Financial Times/Prentice Hall, 2008. Print.

Weygandt, Jerry, Donald Kieso, and Paul Kimmel. Managerial Accounting: Tools for Business Decision Making, London: John Wiley & Sons Ltd, 2010. Print.

Any entrepreneurial activity is aimed at making a profit, increasing capital. Nevertheless, to get surplus value, organizations first need to invest something, and it is precise with these investments that the possible efficiency of business activity is limited. That is, it can be said that the costs are the determining factor for making a profit. That is why a cost control policy is so important in healthcare organizations.

The objectives of cost and financial result control are to provide timely, objective, and sufficient analytical information about the organization’s cost structure for internal and external users and to develop the organization’s control environment. In addition, the policy provides increased opportunities for the development of balanced motivation of production and management personnel and increased opportunities for applying various approaches to analysis. Finally, the convergence of the principles of production accounting and cost control through integrated management also appears as a goal.

The Activity-based costing (ABC) method is widely used due to several advantages compared to traditional accounting methods, which imply that resources for all types of products are consumed in proportion to their output volumes. ABC in health care organizations has been suggested to be capable of addressing costing challenges (Keel et al., 2017). However, it has some drawbacks, and it is not a panacea for all accounting and reporting problems. American scientists Cooper and Kaplan developed the Activity-based costing method more than three decades ago, which was adopted in one department and at first and is now widely used (Berg & Madsen, 2020). The basic principle of calculating the cost is the division of costs into direct and indirect and the attribution of both types of costs to finished products. As a rule, there are no problems with the distribution of direct costs in practice since they can be directly attributed to the cost of a specific cost object.

The advantage of using ABC is to determine how the overhead is used more accurately. If the company considers the cost of production by this method, organizations can get more detailed information on compliance of business expenses with industry standards. McBain et al. (2018) point out that “health organizations need valid information on condition-specific costs and patient outcomes to make informed resource allocation decisions and cost–benefit trade-offs” (p. 16). The ABC method is an excellent feedback tool for measuring the current cost of specific services if the management is striving to reduce costs. It also gives an idea of all the costs associated with the internal work of the organization. Managers can see what costs can be reduced if they resort to outsourcing.

Cost management should be part of the overall enterprise management system. Making disparate management decisions and not following the cost control policy leads to the fact that the cost management system works inefficiently. In addition, the incompleteness and untimeliness of providing data on costs is the reason for the formation of erroneous indicators of the value of costs and cost, ignoring factors that affect the number of costs. High labor intensity and high costs for implementing ABC in the organization may cause the rejection of this policy.

These indicators are interrelated: as a rule, when minimizing the cost of implementation, the complexity of the process increases, and vice versa. In addition, certain time costs will be required: in large institutions, it may take about a year to implement the methodology; in small companies with relatively simple processes, the implementation can take much faster. However, non-compliance with this policy can lead to significant losses and inefficiency of work.

With increasing competition, organizations should be able to assess the profitability of the services offered realistically. The ABC system focuses attention and contributes to a better understanding of the factors that affect the costs of the budget and its management. Furthermore, the ABC system is related to all overhead costs, and therefore it takes managerial, financial accounting to a higher level, beyond the traditional boundaries of the production process. In addition, by controlling the distribution of cost carriers, healthcare organizations can also control the level of costs.

The ABC system can help in cost management as many costs are caused by interaction with customers; in classical cost accounting systems, this is not considered. For example, organizations may have trading relations with specific customers at a loss but do not know about it since the costs are not analyzed by a method that can assess the actual situation. The ABC system can be used together with the analysis of profitability by customers to determine with greater accuracy and reliability the amount of profit received from servicing certain groups of customers, thus improving the efficiency of patient care. Unintended consequences may be that the costs of implementing this accounting method may exceed the benefits received. In addition, sometimes the ABC system is introduced because it is fashionable and not because managers will use it to teach practical management information.

For an enterprise whose business process consists of many operations, the ABC method for calculating the cost is preferable. Its use will allow making more effective decisions in the field of marketing strategy, the profitability of services because it makes it possible to control expenses at the stage of their occurrence. This is why this method is one of the best ways to solve the problem of cost control. However, it is essential to create a reliable system at the enterprise that will allow getting the necessary information at a reasonable price. The current system should also be periodically reviewed and revised to decrease its usefulness over time.

References

Berg, T., & Madsen, D. Ø. (2020). The historical evolution and popularity of activity-based thinking in management accounting.Journal of Accounting & Organizational Change, 16(3), 401-425.

Keel, G., Savage, C., Rafiq, M., & Mazzocato, P. (2017). Time-driven activity-based costing in health care: a systematic review of the literature.Health Policy, 121(7), 755-763.

McBain, R. K., Jerome, G., Leandre, F., Browning, M., Warsh, J., Shah, M., Mistry, B., Abnis I Faure, P., Pierre, C., Fang, A., Mugunga, J.C., Gottlieb, G., Rhatigan, J., & Kaplan, R. (2018). Activity-based costing of health-care delivery, Haiti.Bulletin of the World Health Organization, 96(1), 10-17.

Product Idea

The proposed product is a Cordless Hooded Hair Dryer that can be charged at home and carried for traveling purposes without the hassle of finding an appropriate charging outlet. The new hairdryer will also have an operating battery life of 24 hours. The company will use a third-party manufacturing site for the production of this new product. It is expected to break through the fierce competition in the electronics industry and achieve growing sales.

Cost Estimates

There are two types of costs involved in the production of the new hairdryer including fixed and variable costs. Fixed costs include administrative salaries, marketing, and R&D expenses related to the new product. Table 1 provides details of these fixed costs.

Table 1. Fixed Costs.

The company will incur $530,000 per annum with no sales. Therefore, it is crucial that it makes sufficient sales of its hairdryer that could cover these fixed costs and generate a profit.

Variable costs include the cost of components and third-party manufacturing charges per unit. Table 2 provides estimates of these variable costs.

Table 2. Variable Costs.

The total variable cost is $23 per unit which will be used to determine the company’s contribution margin and its ability to attain the break-even level.

Selling Price

The selling price of the new hairdryer will be based on the cost-plus-margin strategy (Drury, 2013). Moreover, the prices of similar hair dryers of other companies are reviewed and incorporated in the pricing decision. However, the company aims to disrupt the market by introducing a technologically advanced cordless hairdryer that gives the best results at a comparatively lower price than its competitors. The company’s existing hair dryer models with a cord are sold for between $35 and $40 on Amazon. Therefore, the price of this new product will be higher than its existing products. The company will set a profit margin of 150% and the selling price in the U.S. will be calculated as follows.

Selling Price = Variable Cost x (1 + Profit Margin)

Selling Price = $23 x (1 + 150%)

Selling Price = $57.50

Expectations of Growth and Potential Profit

The hairdryer market has been growing over the last ten years or so without any slowdown. Consumers are willing to pay for high-quality products that offer new and better features. Therefore, it could be stated that the demand for new models is unlikely to weaken. However, market conditions are challenging as competitors such as Dyson, Philips, and Panasonic have a strong market hold and share (ReportBuyer, 2018). Conair expects to achieve sales of $2.5 million in the first year and achieve a growth rate of 20% in the next two years. Variable costs are expected to increase by 2% and fixed costs will increase by 5% as well. The company’s sales and profit projections for this new product are given in Table 3.

Table 3. Sales and Profit Projections.

Conclusion

It could be concluded that the new product will generate a profit for Conair. It is proposed that the company should use a third-party manufacturer to avoid high fixed costs. The estimation of variable costs and selling price indicates that the new product will have a high contribution margin.

References

Drury, C. (2013). Management and cost accounting (4th ed.). Berlin, Germany: Springer.

ReportBuyer. (2018). Global hair dryer market 2018-2022. Web.

Reverse Engineering of a HairDryer. (2014). Parts and functions. Web.

Introduction

Direct costing, which is also known as variable costing has been used most predominantly as an alternative to absorption costing over the last 70 years.

Even though absorption accounting, as suggested in accounting textbooks, must be employed in preparing income tax reports, financial statements as well as in defending pricing models, a number of times, variable costing has served the same purpose up to and including defending the price practices.

It is claimed in some quarters of the corporate world that, some companies are shifting to variable costing to achieve some form of consistency between the way decisions are made since it relies on variable costing and the way these decisions are reported by financial accounting systems.

This paper will therefore try to compare and contrast absorption costing and variable costing, giving details of the advantages of the latter and weaknesses of the former. It will also endeavor to explore the reasons why absorption costing is preferred despite its weaknesses (Schiff, 1987, p. 36-39).

Absorption costing vs. Variable costing

Definitions

Absorption costing, also known as the traditional costing is a commonly accepted accounting principles for external reporting. It entails all the tools of manufacturing, variable and fixed overheads as well as direct materials and labor. It refers also to full costing. Variable costing on the other hand, entails only the variable tools of manufacturing , that is, variable as well as direct labor and materials (Schiff, 1987, p. 36-39).

Compare

Both absorption costing and variable costing can be used preparing financial statements, income tax reports as well as in defending pricing practices. Variable costing has been used for the past 70 years as an alternate to absorption costing even though their differences widens when it comes to analysis.

Contrast

While absorption costing includes all manufacturing tools, variable costing excludes fixed manufacturing overheads. In this regard, absorption costing does not differentiate between variable costs and fixed costs thus cannot be used in (CVP) Cost Volume Profit analysis; on the other hand, variable costing which does differentiate between variable costs and fixed costs is much suited for (CVP) Cost Volume Profit analysis.

Moreover, variable costing is undesirable for peripheral reporting as never complies with the prerequisites while absorption costing does. Variable costing does not consider fixed costs in analysis, absorption costing does (Schiff, 1987, p. 36-39).

Advantages of Variable costing

Variable costing has several advantages, for instance; it reveals the relationship the exits between volume, price and cost. When applying variable costing, changes in the inventory does not affect profit, also, it is employed in CVP analysis, pertinent in decision making, identifies fixed costs and when in use, changes in production volume have no effect on the income (Wink & Corradino, 2010, p. 49-54).

Weaknesses of Absorption Costing

In as much as absorption costing is acceptable for external reports, it does have some limitations, these includes the fact that; It cannot be relied on for planning, control and decision making since it emphasizes on the total cost, which includes both fixed and variable costs.

In addition, since it emphasizes on the total costs, the manager’s emphasis lies on the total cost, leaving out the relationships that relates profit, cost and the volume.

In essence, the manager is left to use his own intuition in making such decisions. This is not quite appropriate, as the manager does not use concrete materials to make decisions. It however, complies with the external reporting perquisites unlike variable costing(Schiff, 1987, p. 36-39).

Why Absorption Costing is used despite its weaknesses

In comparison to variable costing, absorption costing seems to have much more weaknesses, but as it turns out, it is still the more preferred of the two.

This is mainly because, according to accounting books, absorption costing fully complies with the requirements for external reporting, something that does not go well with variable costing. It therefore remains that absorption costing is used since its presentations can be reported externally (Wink & Corradino, 2010, p. 49-54).

As entailed in the accounting principles, which regulates the requirements for external reporting, both fixed and variable costs are required for incorporation in the inventory, mainly to prepare the inventory for application as is intended.

This usually incorporates an acceptable proportion of manufacturing overhead incurred as the inventory is manufactured. Furthermore, variable costing treats as period costs, all fixed manufacturing overhead (Schiff, 1987, p. 36-39).

Conclusion

Absorption costing encompasses all the tools of manufacturing while variable costing ignores fixed costs. Variable costing ignores fixed costs in analysis although it is useful for Cost Volume Profit analysis. Absorption costing on the other hand is not utilized in analysis of Cost Volume Profit hence, does not give their interrelationship (Schiff, 1987, p. 36-39).

In as much as variable costing boast of several advantages such as its usefulness in planning, control and decision-making, among others, it does not comply with the requirements for external reporting and therefore remains as an alternative use for absorption costing, which is the most preferred and acceptable.

Absorption costing also has a number of weaknesses that includes its inability to be used for CVP analysis, among others. It is therefore imperative to note that the two costing methods are important and should be applied where possible, with clear regards to their importance (Wink & Corradino, 2010, p. 49-54).

Reference

Schiff, M. (1987). Variable Costing: A Closer Look [2]. Management Accounting, 68(8), 36. Retrieved from ABI/INFORM Global. (Document ID: 652509).

Wink, G., & Corradino, L. (2010). INCOME INFLATION: ABSORPTION COSTING VS. VARIABLE. Journal of the International Academy for Case Studies: Special Issue Number 1,49-54. Retrieved from ABI/INFORM Global. (Document ID: 2243561401).