Importance Of Accurate Product Costing For Business

Inadequacy of Traditional Costing Systems

Question 1

Costing is the function of assigning cost to different products produced or sold by the company on a reasonable basis so as to find out the total cost incurred to produce or to sell that product. In every profit-oriented business organisation, profitability of business majorly depends on individual profitability of each product dealt by it. Product costing serves as the foundation on which various critical decisions related to business are based (Al-Omiri & Drury, 2007).  Hence, generation of information as to how much does it cost to business to produce or to deal in particular item is of utmost information for the managers so that they can make informed decisions on the basis of such information. However, only availability of information product cost information is not merely important rather the accuracy of such information leads to the correct decision making for the business. Accuracy implies the efficiency of a firm to trace its actual business expenses through the costs of product and to the appropriate inventory values (Kee & Schmidt, 2000).

There are various reasons as to why accurate product cost information is important for the business. They are:

• Pricing decisions: When figuring out the selling price of the products in which the firm is dealing, the cost information plays the basic role as profit margin is added to the cost of production or procurement of the products to reach at the appropriate product price. The overall profitability of the firm depends on the quality of pricing decisions of its managers. If inaccurate cost information is used to determine selling prices, a business might have to suffer losses instead of profitability because huge competitive pressures on the business. Overstatement of product prices can make the business lose a large customer base and understatement of such prices could not even allow the business to recover the actual cost spent on producing or procuring something (Baxendale, 2001).
• Financial reporting: In order to prepare financial statements, especially income statements that depict the true profitability state of the business, determination of correct cost of goods sold is necessary. It could only be determined when there the cost incurred in production is accurately identified. If inaccurate cost information is used to prepare the income statements so as to allow the users of financial reports to undertake sound economic decisions.
• Product Replacement or Termination: In various organisation cost information is also used to evaluate the project’s feasibility for the business. While undertaking the decisions regarding the product continuance, product replacement or product termination, contribution margin of each product is calculated. In those situations accuracy of cost information is necessary because these decisions are generally one-time in nature and cannot be modified frequently. If incorrect contribution is determined using the inaccurate cost then it will lead to incorrect decision making by the managers (Fisher & Krumwiede, 2012). Further, the accuracy of the product cost information is necessary while assessing whether the firm should purchase a product from the outside market or it should manufacture it in-house.

Therefore, accuracy of product cost information is necessary for the managers to make relevant and necessary strategies for the success of business.

Traditional costing system is the system under which cost of a particular item is calculated by allocating of production overheads to such item using on the basis of quantum of consumption of production resources. Overheads are generally applied to different products on the basis of either the direct labour hours or the machine hours (Brierley, 2008).

In the given case study of Beztec Ltd which is engaged in the printer machines manufacturing business, traditional costing method is being used by the management to determine the cost of both the printing divisions i.e. Lexon Model Division and Protox Model Division. Production of printing machines generally involves more of machine-intensive work and hence the production overheads of the company are distributed to both the divisions on the basis of number of machine hours required to produce both the types of printers. Under the traditional costing, gross profit of Lexon Model is lower than the Protox Model. However, the method of allocation of indirect production cost is not appropriate on the basis of single overhead recovery rate in the given case due to involvement of multiple activities to produce the printers of different models. The production overheads of Lexon model and Protox model is calculated by multiplying the total number of machine hours used in their respective divisions with the common overhead rate. Due to this, the overall cost results are not found to be correct.

Use of Activity Based Costing

If in the given case, the management of Beztec Ltd uses the cost information generated through traditional costing technique for the decision making purpose to phase out a particular division then it will certainly lead to incorrect decision making.  Therefore, the company must implement such a management accounting technique of cost determination which is advanced and offers more realistic results (Charles & Hansen, 2008). Such technique could be activity based costing where the production overheads are allocated to the products on the most reasonable basis considering the practical aspect of all the activities involved in the production. Since, there are more than one activities required to produce the printers, the allocation of overheads must be undertaken using appropriate cost drivers related to the cost pool so as to provide decision useful information to the managers of the company (Askarany, Yazdifar & Askary, 2010).

Question 2: Rates of Overhead Allocation

Activity Pool	Overheads		Lexon	Protox	Total	Rate
Soldering Cost	$    1,165,725.00	No. of Solder Points	1333125	433125	1766250	$       0.66
Shipment Cost	$    1,064,250.00	No. of Shipments	18225	4275	22500	$    47.30
Quality Control	$    1,534,500.00	No. of inspections	63225	23963	87188	$    17.60
Purchase Cost	$    1,176,120.00	No. of orders	90113	123727	213840	$       5.50
Machine Power Costs	$          71,280.00	Machine-hours	198000	18000	216000	$       0.33
Machine Set up Costs	$        928,125.00	No. of set-ups	18000	15750	33750	$    27.50
	$    5,940,000.00

Activity Pool	Lexon’s  Cost Drivers	Amount	Protox’s Cost Drivers
Soldering Cost	1333125	$                    879,862.50	433125	$      285,862.50
Shipment Cost	18225	$                    862,042.50	4275	$      202,207.50
Quality Control	63225	$                1,112,753.62	23963	$      421,746.38
Purchase Cost	90113	$                    495,621.50	123727	$      680,498.50
Machine Power Costs	198000	$                      65,340.00	18000	$          5,940.00
Machine Set up Costs	18000	$                    495,000.00	15750	$      433,125.00
Total Production Overheads		$                3,910,620.12		$  2,029,379.88

	Lexon	Protox
Sales	$  23,760,000.00	$                7,524,000.00
Total cost of goods sold	$  13,678,620.12	$                6,636,179.88
Gross Profit	$  10,081,379.88	$                    887,820.12
GP % (Gross Profit/Sales)	42.43%	11.80%
GP Per Unit	$                420.06	$                            147.97
ABC Costing
GP Per Unit	$                420.06	$                            147.97
Traditional Costing
GP Per Unit	363	376.2

Working:

	Lexon	Protox
Direct materials	$    5,491,200.00	$                3,854,400.00
Direct production labor	$        475,200.00	$                    277,200.00
Machine	$    3,801,600.00	$                    475,200.00
Total direct	$    9,768,000.00	$                4,606,800.00
Total Indirect	$    3,910,620.12	$                2,029,379.88
Total cost of goods sold	$  13,678,620.12	$                6,636,179.88

Question 5:

APES 110: Code of Ethics for Professional Accountants is the code designed and framed for the Australian accountants who are holding professional accounting degree as recognised under the prescribed regulations (Armstrong, Ketz & Owsen, 2003). All the certified accounting professionals are required to follow this code of ethics while engaging in the provision of professional services to their client or to the employing organisation so as to bring dignity to the institute. The said code requires the professional accounts to act in the best interest of the public by following certain principles such as confidentiality, integrity, objectivity, professional behaviour and professional competence and due care in the professional practices (APES 110).

Management accountants of the companies are also one those professional accounts that are required to adopt the code while providing the management accounting services to their clients. In the given case study of Beztec Limited, Sue Smith is the management accountant. As a professional management accountant, Miss Smith is entrusted with the responsibility of performing its professional services in the best interest of company and not in the particular interest of any particular party, be it be a CEO of the company or someone else (APES 110).

It has been observed that Steven Kay, the CEO of Beztec Limited is earning considerable portion of bonuses as a part of performance based incentives, on the basis of revenues and profitability of both the divisions of the company. It is evident from the case study that Beztec is currently using the system of traditional costing and on the basis of the results extracted from this system, the top management of the company is proposing to phase out the Lexon Model because of its lower reported profitability than the Protox Model. However, management accountant has used the activity based costing for the purpose of appropriate overhead cost allocation. The decision to use ABC as the cost allocation technique is taken by Miss Smith out of the knowledge and competence in the areas of technical standards of the given field (Anderson, Hesford & Young, 2002). The results obtained using ABC method are not acceptable to the CEO of the company because of their belief that there will be significant reduction in their incentive compensation as ABC technique is favouring Lexon Model more than the Protox Model. Therefore, the CEO has suggested Miss Smith to make alterations to the results of ABC technique.

Ethical Principles for Professional Accounts

In this case, it is the duty of Miss Smith as a professional management accountant to apply the principle prescribed in the code of ethics. As per the principle of objectivity, Miss Smith must apply the professional judgement without any biasness or conflict of interest (APES 110). Further, it is her ethical duty to professionally behave in this case by avoiding to accept the suggestions of CEO of the company which are purely based on their personal interests and are prejudicing the interest of the employing organisation i.e. Beztec Limited, as a whole.  Miss Smith must refuse to accept the suggestions of CEO of the company and must forward the results of activity based costing technique to the further management levels. The application of ABC will provide the managers with more realistic and accurate information on the basis of which such significant decisions can be undertaken in the more informed manner (Qian & Ben-Arieh, 2008).

Question 6:

Yes, use of a predetermined overhead rate for the purpose of allocation of overhead cost would most probably lead to over or under allocation of overhead costs. Under or over absorption of overheads occurs in case of use of traditional costing approach in the business. The reason for the same is that under traditional costing method overheads are allocated to different items by applying the overhead recovery rate to machine hours or labour hours. As the recovery rate is determined prior to the commencement of actual production process, the actual overheads do not practically match with the budgeted or applied overhead. This causes the under-over application of overhead costs. Overheads are said to have under- applied in the situations where the value of budgeted overheads are lower than the value of actual overheads incurred in a particular period. This situation is technically termed as under-application of overheads. However, overheads are said to have over applied when the value of budget overheads exceeds the value of actual overheads. This causes the problem of over-application of overheads.

Both the amounts of under-application and over-application of overheads are required to be adjusted to the costing records at the close of accounting period so as to provide accurate cost details to the managers. The adjustment of under-applied or over-applied overhead is called as disposition off such overheads (Weygandt, Kimmel & Kieso, 2015). There are several ways by which under-applied or over-applied overheads can be disposed-off. These methods are discussed as below:

In case where the difference between the amount of actual overheads and budgeted overheads is material enough, it must be allocated to the different accounts on the proportionate basis. The accounts that are required to be adjusted in this case are Work in progress account, finished goods account and cost of goods sold account. The reason of selection of these accounts is that they are comprised of all the production overheads for the given period. The allocation of balance amount can either lead to increase or decrease in their amounts depending on the situations i.e. under-application or over-application of overheads (Hansen, Mowen & Guan, 2007).

However, when the amount of difference between the actual overheads amounts and applied overheads amount is not significant enough, it must be adjusted through the cost of goods sold account. It is used because it is a product’s account which contains maximum quantum of manufacturing overhead of a specific period. If there is under-application of overheads, then the balance is adjusted by debiting the COGS account and crediting the production overhead account whereas when there is over-application then the balance is adjusted by crediting the COGS account and debiting the production overhead account. The managers must ensure that the balance in the production overhead account is Nil after making the above adjustments (Hongren, et. al., 2010).

It is totally upon the discretion of managers whether to consider a difference as material or immaterial. Materiality is the aspect of information which influences the user’s decision. However, the first method is found to be more realistic in nature in the practical world.

References:

Accounting Professional and Ethical Standards Board (APESB), 2013. APES 110 Code of Ethics for Professional Accountants.

Al-Omiri, M. and Drury, C., 2007. A survey of factors influencing the choice of product costing systems in UK organizations. Management accounting research, 18(4), pp.399-424.

Anderson, S.W., Hesford, J.W. and Young, S.M., 2002. Factors influencing the performance of activity based costing teams: a field study of ABC model development time in the automobile industry. Accounting, Organizations and Society, 27(3), pp.195-211.

Armstrong, M.B., Ketz, J.E. and Owsen, D., 2003. Ethics education in accounting: Moving toward ethical motivation and ethical behavior. Journal of Accounting education, 21(1), pp.1-16.

Askarany, D., Yazdifar, H. and Askary, S., 2010. Supply chain management, activity-based costing and organisational factors. International journal of production economics, 127(2), pp.238-248.

Baxendale, S.J., 2001. Activity-based costing for the small business: A primer. Business Horizons, 44(1), pp.61-61.

Brierley, J.A., 2008. Toward an understanding of the sophistication of product costing systems. Journal of Management Accounting Research, 20(s1), pp.61-78.

Charles, S.L. and Hansen, D.R., 2008. An evaluation of activity-based costing and functional-based costing: A game-theoretic approach. International Journal of Production Economics, 113(1), pp.282-296.

Fisher, J.G. and Krumwiede, K., 2012. Product costing systems: Finding the right approach. Journal of Corporate Accounting & Finance, 23(3), pp.43-51.

Hansen, D., Mowen, M. and Guan, L., 2007. Cost management: accounting and control. Cengage Learning.

Horngren, C.T., Sundem, G.L., Stratton, W.O., Burgstahler, D. and Schatzberg, J., 2002. Introduction to Management Accounting: Chapters 1-19. Prentice Hall.

Kee, R. and Schmidt, C., 2000. A comparative analysis of utilizing activity-based costing and the theory of constraints for making product-mix decisions. International journal of production economics, 63(1), pp.1-17.

Qian, L. and Ben-Arieh, D., 2008. Parametric cost estimation based on activity-based costing: A case study for design and development of rotational parts. International Journal of Production Economics, 113(2), pp.805-818.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2015. Financial & managerial accounting. John Wiley & Sons.