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The Role of Accounting in Business Management

Frank, the owner of the company is of the view that accounting is not very important for the company and accounting is all about deducting all expenses from the income. He finds no relevance to look at the cost before setting up the price he wants to set the price based on the price that has been set by his competitors. Frank has a very less knowledge about the cost accounting systems so somebody needs to provide him with all the information related to it. Before adopting the proper cost accounting in his company he should first know the advantages, uses and types of product costing system (Alex, 2012).

Product Costing System means recording all the expenses and incomes of the company. The income and expenses belonging to any department whether factory, administrative or selling should be recorded. This will give a clear picture to the accountant about the revenue and expenses of departments separately (Ball, 1984). It will help the department incurring huge expenses to identify where the money has been spent and keep a control over it. In case, there is any department whose income is considerably low then the reason should be found out and corrective measures should be taken. Product costing system helps in ascertaining profit and valuing closing stock and work in progress. Product costing system makes the preparation of cost sheet easier. The costing system is affected by the volume of production and therefore the company can easily determine the correct volume of goods that should be produced. It is necessary to record expenses only then Frank will be able to charge a profit on the goods as he needs to recover the cost incurred first.

Frank should know that there are two types of costing system and he should adopt such system after doing a detailed analysis. The following are the two types-

  • Job order costing: This type of costing system should be used where unique and different goods are manufactured in the organisation. All the expenses that are related to a particular job taken into consideration so that profit can be determined.
  • Process costing: In this type, the expenses incurred are divided as per the functions and processes. It helps to keep a track of cash flows from different departments and helps to reduce costs.
  • Hybrid costing system: Some companies use process as well as job costing when both are used simultaneously then it is known as hybrid costing.

The first work of Frank is to select an appropriate product costing system after the choice is made he needs choose a suitable cost allocation system. The cost allocation system are-

  • Traditional system- In this system of cost allocation, the management prepares a statement of budgeted overhead which is divided on the basis of per unit produced. This overhead rate is applied on the actual figure then when the production process is completed. If the recovery of the overhead is more than the overhead incurred then it the situation is called over recovery and when the expenses exceeds recovery then it is known as under recovery or under absorption of overhead.
  • Activity Based Costing- In this system, the cost is allocated based on the actual consumption that was made during a particular activity. To understand it better, let us take an example, the department that uses 30 hrs to do a job, the cost of that 30 hrs will only be allocated to the department. The actual figures of expenses incurred in a particular activity are taken into account in this system.

Product costing is a complex system but should be adopted by all the companies because ie helps to increase the efficiency of the working in an organisation. It helps to reduce the expenses and increase the profits. It helps the company to have relevant information that is required to take decisions as we know the success of the company is based on the decisions made by the management.

The following schedule is showing the cost of goods sold and cost of goods manufactured:

Particulars

Amount

Opening stock of raw materials

12000

Add: Purchases of raw materials

180000

Less:closing stock of raw materials

12000

Direct wages

182000

Prime cost

362000

Add:Factory overhead

Insurance

14000

Repairs and maintainence

8000

Land tax

4500

Factory buiding depreciation

8000

Factory equipment depreciation

16000

Work cost incured

412500

Add: Opening work in process

4500

Less: closing work in process

33500

Works cost

383500

Add: Administrative overhead

Administrative salaries

24000

Indirect labour cost

118000

General liability insurance

2400

Depreciation on office equipment

1800

Cost of production

529700

Add: Opening stock of finished goods

11000

Less: Closing stock of finished goods

16000

Cost of goods sold

524700

Add: Selling and distribution expense

Advertisement expense

12000

Sales salaries

90000

Travel and entertainment expense

14100

Cost of sales.

640800

WIP

Particulars

 Amount

Particulars

 Amount

To Bal b/d

           4,500

By Finished Goods

      3,33,000

To Raw Material

      1,80,000

By Bal c/d

         33,500

To Direct Labour

      1,82,000

      3,66,500

      3,66,500

Raw Material

Particulars

 Amount

Particulars

 Amount

To Bal b/d

         12,000

By WIP

      1,80,000

To Accounts Payable

      1,80,000

By Bal c/d

         12,000

      1,92,000

      1,92,000

Manufacturing Overheads

Particulars

 Amount

Particulars

 Amount

To Actual Overheads

      1,68,500

By Finished Goods

      1,56,000

By Bal c/d

         12,500

      1,68,500

      1,68,500

COGS

Particulars

 Amount

Particulars

 Amount

To Finished Goods

      4,84,000

By Bank

      4,84,000

      4,84,000

      4,84,000

Accounts Payable

Particulars

 Amount

Particulars

 Amount

To Bank

      1,84,000

By Bal b/d

         12,000

To Bal c/d

           8,000

By Raw Material

      1,80,000

      1,92,000

      1,92,000

Finished Goods

Particulars

 Amount

Particulars

 Amount

To Bal b/d

         11,000

By COGS

      4,84,000

To Overheads

      1,56,000

To WIP

      3,33,000

By Bal c/d

         16,000

      5,00,000

      5,00,000

Under the traditional system of costing, which is one of the systems for the allocation of expense there arises a problem of under and over recovery of overhead sometimes. The company has to treat them correctly so that they can ascertain the correct profits of the organisation.

Let us get our concepts clear about overhead and how they are charged. Overhead are the indirect expenses that the company has to bear during the production process. A predetermined rate based on labour hours, machine hours or direct material is charged from the customers. The rate that is charged from the customer is based on the estimated overhead and not the actual figures. When the actual information is available to us we can check the correctness of the overhead rate (Berman, Knight, & Case, 2013)..

What is Product Costing System?

It is possible that the pre determined rate may not match with the actual overhead rate then in such a case the company may have to face following two situations-

Over recovery- The situation when the overhead recovered from the customer is more than the actual overhead incurred. For example, the company recovered $ 10 per unit from the customers and it estimated that the total production will be 2000 units. Later, when the actual figures were ascertained it was found that $18000 was actual incurred. So, in this case the amount recovered from the customer is $20000 whereas the amount actually incurred is $18000.


Under recovery- Under recovery is just the opposite of over recovery. In under recovery, the overhead expenses incurred are more than the overhead recovered from the customer. Suppose, the actual overhead incurred is $20000 but the recovery from customers is only $17000. The difference of $3000 is the under recovery which is a loss for the company. 

There are different reasons for the under/over recovery of overheads. The under/over recovery should be treated as follows-

If the under/ over recovery happens due to the negligence or fault of the management then it should be transferred to the profits and loss account. The loss because of under recovery will be reflected on the debit side of the account whereas gains due to over recovery will be shown on the credit side.

If the reason of under/over recovery is seasonal variation then it should be carried forward to the subsequent years and adjusted accordingly.

Under/over recovery may also be the result of changes in the price level. In respect of goods that are already sold the amount of under/over recovery should be transferred to profit and loss account. But in respect of goods that are still lying in the stock, a supplementary rate has to be charged.

Supplementary rate can be calculated by dividing the amount of under/over recovery by the number of unit produced. 

If the under/over recovery is due to any other reason that is not stated above then it should be charged to profit and loss account.  

These two situations have an adverse impacts on the company because over recovery of the overhead increases the price of the goods sold which creates burden on the customers. So, there is a high chance of losing a market share and low demand of the goods. In the under recovery, the company is not able to recover the overhead to the full extent and so a part of the expense has to be borne by the company which results in losses. It is therefore very important for the company to choose its product costing system wisely and also use the cost allocation system in an efficient manner (Cafferky, & Wentworth, 2010).  

It has already been discussed earlier that there are two approaches of product costing system- Traditional costing system and Activity Based Costing System. The concept of traditional accounting system has already been explained in the earlier answer. Now, we will understand the concept of Activity Based Costing and also determine whether Frank should adopt this system in his organisation of not. 

Advantages of Product Costing System

Activity Based Costing is one of the cost allocation system in which the cost is distributed among various departments according to the service that has been used by them individually. This system should be adopted by the manufacturing concerns that produce different or unique type of products. The burden of these cost lie only on the departments who takes its benefits the other departments has no burden of such expenses. This system is very helpful in the determination of cost of individual departments. A company should first analyse this system properly before implementing it. He should know the various advantages as well as disadvantages of adopting this system in his company. 

The following are some of the advantages of Activity Based Costing. They are- 

This system helps the organisation to identify the unnecessary and wasteful expenditures. When it comes to the knowledge of the company that such cost that has incurred is wasteful in nature it tries to minimize such cost. This helps in saving money in the other process as well.

Activity Based Costing makes it easy for the management to carry ot product pricing. It helps in allocating cost to different departments. The cost per unit is easily determined and so the company can set the selling price after the addition of profit.

This type of costing is not only useful to the production department but also to the selling and administrative departments. So, it helps to minimise cost in the other departments also,

The Activity Based Costing system brings improvement in the business process. There is a clear picture of the stream in which the company needs to improve and the areas in which it has already shown improvements.

This system helps us to identify the cost behaviour and brings to the knowledge of the company whether such data are accurate and reliable or not.

This system of costing helps the managers to take the decisions wisely an promptly without any confusion.

There are many advantages in Activity Based Costing but there are some disadvantages as well-

If the total overhead cost holds a very small proportion of the total cost then it will not necessarily help the company to reduce the cost. Also, if the overhead is in relation to the volume there are very less chances that there will be cost reduction.

Activity Based Costing may prove to be expensive but once it is properly implemented the cost are recovered in the form of savings. A lot of supervision and guidance is needed for the initial implementation of this system. This system is also considered to be complex.

The measurement of the cost and the cost drivers is a difficult part. It becomes necessary to update the Activity rates cost.

Activity Based Costing is not beneficial for smaller firms but it is very useful to the large manufacturing concerns. The firms that follow cost plus pricing system can get full benefits of this system. However, if there are any firms who takes into account market based prices then ABC costing may not be favourable. The manufacturing environment and the technology used may also affect the application of ABC costing.

The time taken to implement this costing system is considerably more because it requires a detailed study and analysis of different departments and processes of the organisation.

The wrong data that is used as an input may cause great damage to the entire company. So, a special attention and awareness should be present among everyone in the organisation while maintaining the records. 

There may arise some difficulties in the selection of the cost drivers. 

The ABC costing system has been explained properly along with the advantages and disadvantages. As we can figure out the advantages suppresses the disadvantages this system should be implemented by Frank. The disadvantages relates to initial implementation only so we can figure out that although it will take time but it will be beneficial for the company in the longrun.

References

Alex, K. (2012). Cost accounting (1st ed.). Chennai [India]: Pearson.

Ball, W. (1984). A sense of direction (1st ed.). New York: Drama Book Publishers.

Berman, K., Knight, J., & Case, J. (2013). Financial intelligence (1st ed.). Boston, Mass.: Harvard Business Review Press.

Cafferky, M., & Wentworth, J. (2010). Breakeven analysis (1st ed.). New York: Business Expert Press.

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