Management Accounting Issues - Assignment Example

?Management Accounting Management Accounting (a) Determine the profit per unit of each product using the current overhead absorption system based on labour hours. Profit per unit = Selling price – (direct costs + overhead cost) Baltic Rural Delta Material 109 91 124 Direct Labour 37.5 67.5 45 Production overhead 51.34 92.41 61.60 Total 197.84 250.91 230.6 Selling Price 217.25 287.85 325.00 Profit per unit 19.41 36.94 94.40 Total (S.P X Budgeted Production) (19.41 X 1250) = 24262.5 (36.94 X 2000) = 73880 (94.40 X 3750) = 35400 (b) Determine the profit per unit of each product using an activity based costing approach. Budgeted Production 1250 2000 3750 Baltic Rural Delta Material 109 91 124 Direct Labour 37.5 67.5 45 Production overhead 145.88 71.67 41.15 Machine set-up 36.19 18.10 3.62 Machine maintenance 27.69 20.77 27.69 Purchasing 41.00 20.5 8.2 Material handling 41.00 12.3 1.64 Sales 217.25 287.85 325.00 Profit (loss) - 75.13 57.68 114.85 Total -93.9125 115360 430687.5 (c) In not more than 1,500 words prepare a report for the management of Armstrong Ltd which must include the following: i An analysis of the profitability of the different products using the two different methods of apportioning overheads, and the reasons for the differences in product profitability. You should refer in your answer to parts (a) and (b) of the question which should be included in the appendices to the report. In the absorption costing system, all the three products seem to have made a substantial profit (BALAKRISHNAN, SIVARAMAKRISHNAN, & SPRINKLE, 2008, pp56-67). The key issue with absorption costing systems is with timing; fixed manufacturing overhead costs are charged against revenue when units are sold. As seen in (a) above, all manufacturing overhead costs are included in the calculation of product unit cost. This forms the basis of the costing system in absorption costing. All of a product’s manufacturing costs, both variable and fixed, are said to be ‘absorbed’ by the product. Under absorption costing, a certain amount of fixed manufacturing overhead cost is applied to each unit of output. As with the case in (a) above, under absorption costing unit manufacturing cost included direct material, direct labour, applied variable manufacturing overhead and applied fixed manufacturing overhead. Consequently, when each of the units is sold the fixed overhead cost per unit is included in the expense ‘Cost of goods sold’ as shown in the tables above (BALAKRISHNAN, SIVARAMAKRISHNAN, & SPRINKLE, 2008, pp56-67). Therefore, apportioning overheads using absorption costing is profitable for all the three products. On the other hand, we can include only the variable manufacturing costs in product unit cost and to treat fixed manufacturing overhead as a period cost i.e. as an expense on the income statement as the case in (b) above. This system is known as variable costing also known as direct costing. We will now examine affects profit determination (BHATTACHARYYA, 2011, pp45-100). Fixed manufacturing cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost (LUCEY, 2003, pp78-89). Under variable costing, all variable costs of production are included in product costs. Thus if the company sells Baltic at 217.25 unit of product, only 217.25 will be deducted as cost of goods sold, and unsold units are carried in the balance sheet inventory account at only 217.25. This realizes a loss of 75.13. This is a result of excluding fixed production costs when costing yet they are part of the total production costs. With variable costing, the total amount of fixed manufacturing overhead cost is expensed in the current accounting period, irrespective of how many units were produced and sold. Unit manufacturing cost, therefore, includes only variable costs i.e. direct material, direct labour and applied variable overhead. When variable costing is used, it is necessary to divide the total amount of manufacturing overhead into its variable and fixed components by using a cost analysis technique like the High-Low method. It is important to bear in mind that variable costs change in total in direct proportion to changes in the level of output (or the level of the cost driver such as direct labour hours or machine hours) but on a per unit basis they remain constant (BHATTACHARYYA, 2011, pp45-100). Therefore, the difference between the number of units produced and the number of units sold allows us to make the following two statements: 1. When production is greater than sales, absorption costing profit will be greater than variable costing profit, because some of the fixed manufacturing overhead cost incurred in the current accounting period is held in an inventory (asset) account under absorption costing, whereas under variable costing the total amount of the current period’s fixed manufacturing overhead is expensed (BALAKRISHNAN, SIVARAMAKRISHNAN, & SPRINKLE, 2008, pp56-67). 2. When production is less than sales, absorption costing profit will be lower than variable costing profit, because some of the fixed manufacturing overhead costs incurred in the previous accounting period will be included in the current period’s cost of goods sold, in addition to all of the current period’s fixed manufacturing overhead costs. Under variable costing only the total amount of the current period’s fixed manufacturing overhead costs is charged against revenue—the previous period’s fixed manufacturing overhead costs were expensed in the previous period (Donald John 2012). ii Your comments on the views of the three directors, illustrating your points where ever possible by reference to parts (a) and (b). The sales director is just incorrigible towards accepting new ideas. In as much as he understands that the gains of introducing activity based method of attributing overhead costs to products by far exceeds the costs, he is still against it. It is either he is incompetent or he fears such introduction would point out irregularities in his work. The production director is very positive. He perfectly understands that the benefits of implementing an activity-based costing system, he is unwilling to part with the traditional approach. He further has fears in investing into this method much as the benefits exceed the costs of implementing the new approach. The accountant seems to understand the efficiency in using activity based costing in determining overhead costs. He asserts that this approach considers more cost centres, assigns different cost drivers and as a result resources consumed by cost units are more accurately measured. iii Your recommendations to the management of Armstrong Ltd, as to whether or not you think activity based costing is appropriate for Armstrong Ltd A variable costing income statement is particularly useful for short-term decisions, such as whether to make or buy a component, and for pricing – especially when variable selling and administrative costs are included. Under variable costing, profit is a function of sales. The classification of costs, as fixed or variable, makes it simple to project the effects that changes in sales volumes and prices have on profit. Managers find this useful for decision making. For many decisions, variable costs provide a good measure of the incremental costs that need to be assessed. Also cost volume profit analysis requires a variable costing format for the income statement. However, fixed costs are an important part of the total cost of running a business and must be carefully managed. Variable costing provides a useful perspective of the impact that fixed costs have on profits by bringing them together and highlighting them, instead of having them scattered throughout the statement (BHATTACHARYYA, 2011, pp45-100). On the other hand, in the modern business environment, with a high level of fixed manufacturing overhead, a relatively small percentage of manufacturing costs may be assigned to products under variable costing. Also, in the longer term a business must cover its fixed costs too, and many managers prefer to use absorption unit cost when they make cost-based pricing decisions. Some argue that fixed manufacturing overhead is a necessary cost incurred in the production process so that when fixed costs are omitted the unit cost of the product is understated and profit per unit is overstated. However, absorption product costs include unitised fixed overhead, which can result in sub-optimal decisions, especially as fixed costs are not incremental costs in the short term. With variable costing, fixed costs are not ‘unitised’, but instead are included in total on the income statement as an expense in the period in which they are incurred. This avoids the costing inaccuracies that can arise from incorrect forecasts of production levels and the amount of fixed cost per unit. With variable costing, a product’s unit cost does not change with changes in production levels. As a result, variable costing is preferable for managerial decision making (BHATTACHARYYA, 2011, pp45-100). Bibliography BALAKRISHNAN, R., SIVARAMAKRISHNAN, K., & SPRINKLE, G. (2008). Managerial accounting: models for decision-making. Hoboken, N.J., Wiley. LUCEY, T. (2003). Management accounting. London, Continuum. BHATTACHARYYA, D. (2011). Management accounting. Delhi, Pearson. Read More