Cost and Management Accounting - Literature review Example

Cost and Management Accounting Name Institution Course Professor Date Topic 1: Assumptions of CVP Analysis Abstract Managers in organisations are people tasked with making numerous decisions regarding the direction of the business. In performing these functions, they are helped by some management tools. One such important management tool is cost volume profit (CVP) analysis. It is a widely applied versatile tool in planning and controlling organisations functions. Various simplified assumptions must be taken into consideration before it can be a useful tool. It makes assumptions such as all products that are produced in a firm are sold and costs and prices are both known with certainty. In some cases, some of the assumptions in this model make it a difficult tool to be applied in real world settings. In fact, CVP analysis has been criticised for its simplified assumptions. Analysing the relationship that occur between cost, volume as well as profitability of services provided and products produced by a company are among the manager’s most important decision making tasks. Cost volume profit (CVP) analysis is a powerful tool for managers in organisations as they used it for planning and in undertaking various decisions in the firm. In fact, cost volume profit analysis is among the most widely and versatile application tools utilised by managerial accountants in helping managers took better decisions (Rich, Jones, Heitger, Mowen, & Hansen, 2011). However, CVP analysis is only useful when certain assumptions hold true. It is a technique that is based on some assumptions. CVP analysis may offer misleading results when one or more of its assumptions are absent. In this case, CVP analysis is a difficult method to apply in real world settings. This essay discusses the assumptions of CVP analysis that makes it a difficult method to apply in reality. Managers in a company hold important positions hence their decisions are significant to the firms’ success. The functions of the managers include estimating future costs, revenues and profits which help them in planning and monitoring operations (Needles, Powers, & Crosson, 2010). In performing these, managers want to realise operating profit for their firm rather than simply covering costs. CVP analysis shows the behaviour of revenues, costs and profits as volume changes is a tool that these managers use (Rich et al., 2011). Hence, it is natural to start analysis of CVP by finding the company’s break-even point in number of units sold. Profit is not achievable until break-even point is reached. Therefore, break-even point becomes a starting point for managers in planning future operations including earning of profit (Kinney & Raiborn 2012). CVP analysis is used in calculating the sales that are necessary in achievement of a target profit. Moreover, it also addresses other issues that include the number of units a firm must sell in order to break even, impact of price increase on profit and effect of fixed costs reduction on break-even point (Rich et al., 2011). It is useful for management to understand CVP analysis as it is important in profit and budget planning. In essence, CVP analysis explains effects of selling prices, sales volume, fixed and variable costs changes on the net profit (Arora, 2009). It is widely applied management tool used in planning and controlling organisations operations effectively. It is used by companies in reaching important benchmarks such as the firm’s break-even point. It is for this reason that recently established companies which typically have negative operating income (experience losses) considers their initial break-even point period as equally significant milestone in their operations. Nonetheless, CVP analysis has been frequently disparaged for using simplified assumptions such as ‘deterministic and linear cost and revenue functions’ as pointed out by Kee (2007, p. 478). In addition, it is criticized for focusing on single product as well as single-period analysis although it can be used for multiple products. There are several essential but necessary assumptions that are made in CVP analysis. The necessity of these assumptions makes CVP a difficult model to apply practically by managers in organisations. This is because some assumptions do not always hold true and applicable in real life situations. CVP assumes that costs and prices are both known with certainty (Mowen, Gekas, Hansen, Heitger & McConomy, 2011). In reality, companies rarely know fixed costs, variable costs and prices with certainty. Uncertainties and risk are part of decision making in business and it needs to be considered. Managers have to deal with uncertain nature of future costs, quantities and prices. Furthermore, a change in either of the variables usually affects the other variables value. A construction company for example does not know with certainty the costs of its machinery and equipment. This is because they depreciate with time. CVP analysis also assumes that fixed costs are constant in the entire period being considered (Pandey, 2009). This assumption is not valid in reality. If a company has no output, then it means that some fixed costs can be reduced or eradicated. An example is reduction of executives’ salaries or dismissal of some supervisors. In contrast, if a firm uses its idle capacity then incurrence of additional fixed costs may be realised. In this case, the conclusion is that fixed costs are only constant over certain relevant range level of activity and increases in a step-wise manner (Pandey, 2009). Cost volume profit analysis evaluates the relationship between costs functions and products revenues which assist in evaluation of financial implications of a company. Kee (2007) explains that CVP analysis is used in assessing the implications of product pricing, mix as well as process improvement decisions. It is clear from these that it is a vital tool in the organisations but its assumptions make it almost impractical to be fully applied in real life situation. CVP analysis assumes that all the firms’ productions are sold (Hansen & Mowen, 2010). This implies that no change in inventory will be realised by the firm. In reality, not all products produced in a company are sold. For example, a company may undertake rigorous production in anticipation of selling them because of improved economic growth but changes in consumers’ tastes may prevent the firm from selling all its products. It then becomes difficult for companies to apply CVP analysis because one assumption does not hold. Companies typically divide their costs. CVP analysis assumes that costs can only be divided into fixed and variable components (Warren, Reeve, & Duchac, 2011). Example of fixed costs includes salaries, insurance and depreciation while variable costs are mainly costs of direct materials that are used in production of a product. It is difficult to identify costs as either fixed or variable. Some costs are easily identifiable as fixed such as rent of a building, or variable, such as direct cost of material. Some costs are classified as semi-variable costs because it contain element of both fixed and variable cost. These costs are difficult to separate (Pandey, 2009). Moreover, some costs are not easily determinable. For example, various methods of calculating depreciation exist and difficult for firms to determine which is the best method. Due to this, costs in a firm are classified by use of subjectivity and semi-variable element is ignored. It is important to point that failure by anyone to classify costs as either fixed or variable makes application of CVP almost impossible. Cost profit volume analysis is only approximation method at best under its assumptions (Lal, 2002). This is so because when prices, operating efficiency, unit costs or any of relevant factors changes, then modification of the overall CVP relationships and analysis are necessary. In addition, due to assumptions, data on costs are of little significance. CVP analysis is more of a short run method used for a single product but rarely do firms produce a single product. In a situation where there are multiple products, not all products have the same contribution margins and are produced in a variety of volumes with differing costs (Hansen & Mowen, 2010). Example is a firm that produces computer accessories. Contribution of a product like computer battery may not be same as contribution margins of computer screens. As a result, there is difficulty in getting the break-even point as neither cost curve or revenue curve are necessarily straight. Cost volume profit analysis is an important planning and control tool that shows how costs, revenue and profit fluctuates with volume as earlier explained. Additionally, CVP is a useful technique to management in cost control, budgeting and decision making (Lal, 2002). In spite of its usefulness, CVP assumptions render it a difficult tool to apply in real world setting in strict adherence to its assumptions. Modifications of some of its assumptions such as classifying semi-variable costs as either fixed or variable make it somehow easy to be applied. However, if all of its assumptions are to be followed strictly, then I agree to a large extent that application of CVP analysis in real life situations is difficult. Therefore, all assumptions as well as limitations should be vigilantly considered when preparation or interpretation of CVP analysis results is undertaken. Sets of CVP analysis that are based on different circumstances and assumptions may be prepared as a reflection of situations that prevails in different firms enterprises. CVP analysis ought to be revised in reflecting the changing situations when circumstances changes. In addition, it is necessary to have an updated analysis in order to make it a useful tool in budgeting, cost control, managerial decision making and profit forecast. References Arora, M.N 2009, Cost and Management Accounting (Theory, Problems and Solutions). Himalaya Publishing House, Mumbai. Hansen, D. R., & Mowen, M. M 2010, Cornerstones of cost accounting. South-Western, Cengage Learning, Mason, OH. Kee, R 2007, ‘Cost-volume-profit analysis incorporating the cost of capital.’ Journal of Managerial Issues, vol. 19, no. 4, pp. 478-493. Kinney, M. R., & Raiborn, C. A 2012, Cost accounting: Foundations and evolutions (9th ed). South-Western cengage Learning, Cincinnati. Lal, J 2002, Cost accounting (3rd ed). Tata McGraw-Hill Publishers, New Delhi. Mowen, M. M, Gekas G, Hansen D.R, Heitger D.L, & McConomy D 2011, Cornerstones of managerial accounting. Nelson Education, Toronto. Needles, B. E., Powers, M., & Crosson, S. V 2010, Financial and managerial accounting (9th ed). South-Western Cengage Learning, Mason, OH. Pandey, I. M 2009, Management accounting ; planning and control approach (3rd ed). Vikas Publishing House Pvt. Ltd, Noida. Rich, J. S, Jones J, Heitger D, Mowen M, & Hansen D 2011, Cornerstones of financial & managerial accounting. South-Western/Cengage Learning, Mason, OH. Warren, C. S., Reeve, J. M., Duchac, J. E., & Warren, C. S 2011, Financial and managerial accounting (11th ed). South-Western Cengage Learning, Mason, OH. Topic 2: Setting Prices for Service Organisations Abstract Setting prices is one of the important elements in marketing. Service organisations are concern with provision of services to various stakeholders. They set their pricing objectives which include maximisation of profits, sales. Different pricing methods are used in achieving these pricing objectives. In service organisations, applications of these methods are not straightforward in comparison with organisations producing products. Cost-plus pricing and target costing are among the most popular pricing related models used by service organisations. However, their application in setting prices for service organisations in a reliable manner is difficult as determination of the costs to be included in calculation of service price. Services have characteristics such as perishability and intangibility. In this case, their prices must be set in advance in avoidance of losses from the time lapse. Pricing is among the most important marketing mix element. Service firms have pricing objectives which act as a basis of providing directions for action. These pricing objectives range from maximisation of profits, sales, market share, to avoid pricing wars or achievement of social goals (Avlonitis & Indounas, 2007). In achieving these, organisations employ different pricing methods which are the steps that firms uses in arriving at the marketing decisions. It includes cost based pricing, competition based pricing or demand based pricing. Cost-plus pricing involve estimation of costs that are inherent in provision of a service and then a profit percentage is added in establishment of the price (Heisinger, 2009). This method is problematic to service organisations when they used it in setting their prices. It is difficult to determine which costs are to be included in calculation of the selling price. Furthermore, most costs in service sector are indirect in nature. This essay discuss the setting of prices in service organisations and difficulty in application of pricing related models such as cost-plus pricing and target costing in setting these prices. Organisations often set their prices based on competitors’ prices. Competition based pricing method is a pricing technique that set prices of services offered or products produced according to prevailing market average prices or similar to competitors price (Baker, Marn & Zawadi, 2010). Rarely do service organisations set their prices in satisfaction of the customers’ needs, that is, demand based pricing. Avlontis and Indounas (2009), in their research of various banks, shipping firms, medical services companies and insurance firms found out cost- plus and pricing in accordance with market average prices are the two pricing methods that are used and most popular with service organisations. It can be deduced from this study that customer based methods are not used mostly by service organisations. This may be due to difficulty in determination of the customers’ needs and demands. Another reason pointed out by Avlonitis and Indounas (2007) is that cost-plus pricing may be enabling firms in covering their costs and charge competitive prices which satisfy existing customers as well as attracting new ones. Once pricing objectives are developed by a firm, selection of pricing method in reaching these goals are selected. It may be an easy task for organisations that deal with products but some difficulties can be experienced by service organisations. Pride, Hughes and Kapoor (2011) explained two factors that are important to a firm before it can set prices. First, there must be recognition that the firm’s costs do not ultimately determines the service or product price but it is the market. Secondly, costs and sales that are expected can only be used in establishing the minimum price at which service is provided without incurrence of loss or selling of a product. Price is very important to any business. (Ng, 2007) asserts that it is only through price that a firm can generate revenue hence is crucial for survival of the firm. Arriving at the right price for a service organisation constitutes better profits but not getting it right could lead to disastrous consequences such as huge losses. Even though this is the case, arriving and setting the ‘right’ price by service organisations is a problem in itself. Purchasing a service is different from purchasing a product. Ng (2007, p.15) contends that the difference is ‘that services have two parts to the exchange that involves the firm- the purchase and the consumption’. In contrast, the state of consuming a product lies with the buyer as the company is not often present when consumption takes place. Example is a consumer taking a cold soft drink from a fridge that was bought days or weeks earlier. However, it is not possible for a service to be inventoried before consumption by the buyer because it has not already been produced (Ng, 2007). Therefore, service cannot be bought and kept by buyers until that time they desire to consume it. In this case, inseparability of production and consumption complicates further the value that needs to be charged on a service at the point of ‘production’ which impact heavily on how service should be priced at the time of ‘purchase’. For example, a person that seeks the services of a divorce lawyer purchase in advance the service but price of this service may be uncertain. This is because it depends on whether there is existence of amicable settlement or the case is brought before a court. Another example is mortgage service which is purchased in advance but the price (in this case interest rate) may change at any point of the mortgage period. Such differences impact on how pricing of a service should be done even using the most popular pricing related models such as cost-plus pricing and target costing. Cost-plus approach in pricing and target costing are the most popular and widely used models by both service and non-service organisations in setting their prices. Cost-plus is a pricing technique that involves addition of a mark-up to the product or service total cost in arriving at a selling price (Burke & Wilks, 2006). This selling price determines the profit of the service provided when an individual providing the service has the ability of determining the service price. When an organisation sets the price, that price is often a function of the service cost. This is the typical approach of cost-plus pricing. It is a simple method of calculating the price of a service by organisations. However, the technique has its limitations. Cost-plus ignores the demand side (Weygandt, Kimmel, & Kieso, 2009). Furthermore, this approach poses problems to service organisations having high fixed cost. For service organisations such as airlines, telecommunication or transportation, the large portion of their costs is made up of sunk fixed costs with variable costs being very small. For example, housekeeping services and utilities that are consumed in one night spent in a hotel room only constitutes the variable cost. It is clear from this that application of cost-plus pricing method based on variable costs will not be useful. Pricing in service organisations appears to be a complex issue than in organisations producing products. Furthermore, pricing is a dynamic process as economy, consumers taste, innovations, and actions and reactions of competitors continually changes forcing re-appraisal of prices (Association of Certified Chartered Accountants, 2011). For service organisations that seek profits, revenues must be exceeding costs. It is therefore imperative to set a price of a service that exceeds the costs in order to generate the profit. Although this aim is clear to all organisations, setting this price is a problematic in itself. Nankervis, Miyamoto, Taylor and Milton-Smith (2005) contend that the costing in service sector should be forward-looking. This can only be achieved if the methods used in costing such as target costing and cost-plus pricing has no flaws and can be applied without much difficulty in service organisations. Target costing is a method of pricing involving identification of price at which a product or service will be competitive in the market, definition of desired profit to be generated on a product and target cost is computed by subtracting from competitive market prices the desired profit (Siegel & Shim, 2006). In this approach, market determines prices. In service organisations, finding the market price for a service may be difficult. Services provided by different organisations are not the same and so they priced their services differently. For example, an airline may have different prices for their services depending on factors such as quality of service, customers loyalty or type of service provided (such as low-cost or otherwise). Due to such factors, application of target costing in setting prices for service organisations becomes difficult. Services have perishability characteristics meaning that they cannot be stored after it has been produced. This means that organisations sell a service before it is produced or given. This gives rise to two consequences in setting prices by service organisations. First, a firm must sell all its services because it will perish. For example, a movie theatre must attempt to sell all its movie tickets as it will not be of any value after the movie has been shown to the audience. Secondly, pricing of services need to be advanced pricing (Ng, 2007). In this case, a company must either manipulate supply in matching the demand or manipulate demand so as to match supply. In concluding, to some extent, I agree that setting prices for service organisations are difficult and exacerbated further by the limitations pose by popular pricing models such as cost-plus pricing and target costing. Target costing and cost-plus pricing have some drawbacks. This makes their application by service organisations in determining reliably the cost of service provided a difficult task. In cases where there are high fixed costs in services such as hotels and airlines, marginal costs are negligible hence not affected by demand since all costs that are used in producing the service have been sunk. References Association of Chartered Certified Accountants (2011). BUSINESS STRATEGY AND PRICING, Accessed on 17 September 2014, > http://www.accaglobal.com/content/dam/acca/global/pdf/sa_feb11_P3_strategy_pricing.pdf Read More