Management needs to take various decisions for which information is required on a host of issues. In this regards, costing and cost accounting become imperative as the price of the underlying goods and service that the company provides would be driven by the same. As a result, any company needs to be well versed with the various principles and techniques related to cost accounting. Another key aspect for organisational success is budgeting considering the control function that is serves (Wygandth, Kimmel and Kieso, 2009). In wake of this, the given report aims to highlight the three pivotal techniques related to cost accounting namely CVP analysis, activity based costing and absorption costing. Further, the given report also highlights how budgets tend to achieve control besides discussing the various operational budgets and the information contained therein.
Cost Accounting Principles & Techniques
For decision making, management tends to rely on the various cost accounting principles and techniques. Detailed analysis in this regards tends to improve the overall decision and thereby enable maximisation of profits. Some of the key techniques are discussed below.
One of the key techniques in this regards is CVP analysis or cost-volume-profit. It is a useful technique in order to determine the breakeven point and also the requisite production and sales for achieving a desired level of profit. However, a key requirement for the application of this technique is the classification of the costs as fixed and variable cost. This becomes critical since the variable cost tends to be impacted by the activity level which is not the case with fixed cost which does not vary with the level of output (Drury, 2006).
In relation to applying the CVP analysis, it is imperative the contribution margin which essentially takes the selling price and the variable cost into consideration. The contribution margin per unit is then used to cover the fixed cost and any profits which the firm may desire. For break-even analysis, only the fixed cost needs to be recovered from selling the items (Bhimani et. al., 2008).
Consider a manufacturing industry which produces jackets. The CVP analysis can be applied in the manner indicated below.
Assume that the unit selling price = $ 200
Unit variable price = $ 100
Hence, unit contribution margin = 200 -100 = $ 100
Take the annual fixed cost to be $ 40,000, hence the break-even unit sale = 40000/100 = 400
Thus, for the company to break even i.e. have no profit no loss, it should sell 400 jackets.
Now if a pre-tax annual profit of $ 40,000 is to be made, then the unit sales required would be = (40000+ 40000)/100 = 800
Further, the CVP analysis also plays a crucial role in determining the price at which orders are to be taken from clients. For instance, consider that the current capacity utilisation out of 2000 jackets is only 75% or 1500 jackets annually. A client approaches the company with an offer price of $ 120 for 400 jackets. The company should accept the same as the variable cost is $ 100 and also there is surplus capacity lying idle which would be used because of the order. The fixed cost would not be considered for the same (Petty et. al., 2015).
Activity Based Costing
Another key costing technique is activity based costing which plays a crucial role in cost determination especially where there are multiple products being produced. In traditional costing techniques, the overhead costs are directly linked with a direct cost such as direct labour or raw material so as to distribute the overheads costs across product lines. This system is often flawed as it leads to over costing of certain products and under costing of others. This further affects the pricing of these products which in turn can impact the sales and the respective competitive position of the company and also the individual products (Wygandth, Kimmel and Kieso, 2010).
In order to allocate the overhead costs, the ABC method tends to rely on identifying the respective activities related to the same. The cost driver for each of these individual activities are defined and linked to each of the products based on the underlying usage. As a result, this costing technique tends to complicated than the traditional costing which is straight forward. However, the initial effort involved in identifying the individual activities and respective cost drivers is worthwhile since it leads to accurate costing of products (Drury, 2006).
Consider that there are two varieties of jackets with high difference in selling prices but the overhead costs are applied on the basis of direct labour which does not vary much. However, based on ABC, it is found that the overhead costs related to high end jacket is twice that of the low end jacket. The same would then be used to determine the unit price of each jacket. Eventually, a mark-up would be applied on the final cost to determine the correct price. Thus, application of ABC enables the management to price the goods correctly and maintain the right product mix for profit maximisation (Heisinger, 2009).
Yet another technique which has utility especially for financial reporting and managerial decision making is absorption costing. This method tends to highlight the key components of product cost by segregating the same as direct and indirect costs. The product cost under absorption costing tends to include the raw material, direct labour along with the overhead manufacturing cost. It is essential to distinguish the absorption costing technique with the variable costing which tends to include only the variable costs. As a result, while the absorption costing tends to include the fixed manufacturing overhead as part of the product cost, the same is not included in the product cost as per variable or direct costing (Emmauel and Otley, 2010).
Absorption costing tends to impact the income computation. This is because in this costing technique the fixed manufacturing overhead cost are also taken as product costs and when sales are higher, then owing to higher in inventory, a part of this fixed manufacturing overhead cost would go into inventory cost. As a result, the inventory amount would swell by the absorption of partial fixed manufacturing cost while the overall product cost in the given year would be lowered leading to a boost to the net income (Bhimani et. al., 2008).
Assume the annual fixed manufacturing cost = $ 40,000
Also, assume that the annual sales of jackets amount to 30,000 units with 10,000 units as the inventory. Hence, unit fixed manufacturing cost = 40000/40000 = $ 1
Thus, fixed manufacturing cost to the tune of $ 30,000 would be reflected in the P&L while the remaining $ 10,000 would be reflected in the inventory. As a result, the net income before tax would be inflated by that amount. Therefore, the usage of costing system becomes pivotal and needs to be considered by the management.
Budget & Budgetary Control
Budget is commonly used in almost every organisation across the globe. It may be defined as the estimated income and expenditure for a given entity during a defined period which is usually an year but may be less also. The universal utility of budget may be attributed to the key function that it serves. Besides other purposes, one of the key utilities of budget is in relation to budgetary control. Through budget typically the finance is allocated to various departments and projects. Hence, the top management can establish control by clearly communicating the priorities of the firms by allocating requisite financial resources to key strategic areas and projects while ignoring the financial needs of the less important projects and departments (Petty et. al., 2015). Also, control is not only limited to the stage of budget formulation but it is also witnessed at the time of performance evaluation. This is because the budget tends to provide estimates of the potential review. At the end of the review period, a comparison is drawn between the estimated performance and the actual performance. The performance of managers is done in this regards and hence there is better alignment between corporate, departmental and individual objectives. Hence, the use of budget ensures that the top management is able to ensure that the priorities of the staff align with that of the top management which is considered symbolic for organisational interests (Wygandth, Kimmel and Kieso, 2010).
It is imperative to note that budgets can also cover various key functions and not necessarily limited to the organisation as a whole. The various budgets which tend to deal with particular functions are known as functional budgets. The discussion of these budgets is carried out below (Drury, 2006).
Sales Budget: This is one of the core budgets which need analysis between periods along with products. The budgetary sales projections are made taking into consideration the past sales trends and the current demand, economic situation and likely price of the product. This is prepared by the sales manager considering the past trends, present scenario and likely future developments. This captures both the unit sales as well as the sales revenue which may be expected (Wygandth, Kimmel and Kieso, 2009).
Production Budget: This is done post the preparation of the sales budget as the core objective of this budget is to determine the production necessary in order to meet the sales. It needs to consider the current level of inventory, current capacity and future estimates of sales so as to outline the likely production requisite in various months or quarters (Kinney and Rainborn, 2012).
Raw Material Budget: This is linked to the production budgets as based on the production estimates only, the raw material procurement would be done. Further, the estimated waiting period along with the pricing trends would also be considered while determining the likely purchases of raw material to fulfil the estimated production (Seal, Garrison and Noreen, 2012).
Direct Labour Budget: In order to carry out the estimated budgetary output, this budget tends to list down the direct labour requirements. The estimates are reached considering the hours worked or output produced by one worker and considering the average wage rate which would provide an estimated wage bill that should be expected for the project output production (Bhimani et. al., 2008).
Manufacturing Overhead Budget: This pertains to the indirect expenses that are incurred as part of the manufacturing processes. These are isolated in three different sub-types namely the fixed, variable and mixed. This classification is important so that these can be predicted correctly keeping in mind their exact association with the output level. These tend to estimate the likely overheads cost which would arise for the given time period (Petty et. al., 2015).
Master Budget: This is the budget which tends to summarise the various functional budgets that have been discussed above. Thus, it is not limited to a particular aspect but takes into consideration the various operational aspects and hence can provide an estimate of the expected profits. Further, this is prepared once the other operational budgets have been approved by the concerned authority (Emmauel and Otley, 2010).
The use of the above operational budgets is critical so that the master budget can be prepared which essentially provides a summary of the estimated operational and financial performance. Also, the operational budgets allow evaluation of individual departments pertaining to each operational aspect thereby identifying the outperformers and the underperformers through variance analysis. Further, rectifying measures could be taken based on the same and also rewards can be distributed to operational heads (Heisinger, 2009).
Based on the above discussion, it is apparent that the various cost accounting techniques tend to play a critical role in the organisational success. The CVP analysis helps in understanding the fixed and variable costs while analysing the requisite sales for achieving any given desired profits. The profits reported can be impacted by the costing method determined which has been demonstrated through the use of absorption costing. Further, the activity based costing is a key technique in order to allocate the indirect costs especially when there are multiple product lines. This in turn allows for competitive pricing without which the organisational success is quite difficult. Also, a crucial role in organisational success is played by budget which acts as an effective tool for control. Besides, there are various operational budgets which tend to highlight the estimates for the respective operations and summaries in the form of master budget.
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