Management Accounting & Finance of Nokia and Carphone Warehouse - Essay Example

Accounting for Overheads Introduction The treatment of overheads has always been a very sensitive area in business. The method used will determine how comparable the cost of the business is with competitors. Costing systems and overhead allocation systems have given rise to many debates but these arguments have a positive element to them in that they allow for increased knowledge and understanding of the various methods in use. Some costing techniques are of the traditional management accounting systems while others are from the strategic management accounting realm. Traditional management accounting has come under increasing scrutiny and has been criticized on various grounds inclusive of the fact that it fails to provide information for strategic decision making purposes (Johnson & Kaplan, 1987; Bromwich and Bhimani, 1989; and Roslender and Hart, 2003). This suggestion was based on what some proponents of strategic management accounting saw as the inability of traditional management accounting to fulfill the information requirements that would contribute to the competitiveness of the organization in relation to its competitors as well as its long term performance. Part 1 A The importance of overheads in organizations According to Inman (2001) overheads relate to expenditure on materials and services which it is not economically feasible to identify with a specific saleable cost unit. Accounting for overheads is important to organizations because these are additional expenses that businesses incur that cannot be traced to a product or service but instead are expenses incurred in carrying out the operations of the business. These expenses include rent, heating and lighting, telephone, cleaning, stationery and other administrative expenses. In the case of Nokia the expenses incurred in operating the machinery, depreciation of equipment and other assets such as building associated with the production of the company’s products and other overhead costs such as light water and telephone are classified as factory overheads and are therefore included in production costs as part of the companies manufacturing costs. However, other overhead costs associated with selling and distribution, administration and finance are not included in the cost of the product but are charged as operational expenses in the company’s income statement. Nokia can determine how much it actually costs to produce a certain level of activity, the types of expenditure involved and their cost in relation to the volume of production. These costs can be used to compare with other companies who manufacture similar items. This will help them to establish a benchmark in terms of where they are in the industry as far as the level cost is concerned. In the case of Carphone Warehouse, the company provides a service which includes selling cell phones and other electronic items and repairing cell phones. The company does not manufacture anything and so the cost of the phones that it sells is the only cost of sales in the company’s income statement. The cost of repairing phones along with the costs of the service it provides are all included as operational expenses. Part 1 B The main features of the possible approaches to accounting for overheads There are a number of approaches to accounting for overheads. They include absorption costing and activity based costing (ABC). Absorption costing According to BPP (2009) absorption costing is a method of allocating overheads among the units that have been produced. The objective of this method is to include an appropriate share of the businesses total overheads in the total cost of the products that it produces. According to BPP (2001), the theoretical justification for using this method is that production overheads is included in the cost of production and should therefore be included in the cost of the products. The practical reasons for using absorption costing include the following: Valuation of stock – The valuation of the stock on hand is important because it is included in the statement of financial position and in order to derive the cost of sales figure in the income statement. In applying absorption costing closing stock would be valued at full factory cost (BPP 2001). Pricing decisions – companies want to add a margin to the full production cost of the product. This method is particularly suited to companies which do jobbing or contract work, where each job or contract is different and so a standard unit sales price cannot be fixed. The full cost of a product is hard to determine if absorption costing is not used (BPP 2001). Establishing profitability of different products – If a company sells more than one product it may be difficult to determine how profitable each product is unless overheads is allocated to each product on a fair basis. According to BPP (2001) this is a contentious argument. This approach consists of three stages, namely: allocation, apportionment and absorption The problem with this method is that it allocates too much overheads to high volume products and too little to low volume products. The fact is that the low volume products may be more complex to deal with in terms of the support services they require while high volume products may be simple to deal with. The problems with is approach to costing method has resulted in the development of other methods such as activity based costing. Activity based costing This approach to costing identifies an organization’s major activities and identifies the factors that drive costs. These factors are called cost drivers. Therefore the cost of lubricating oil to lubricate the machines to keep them functional would be one such cost. The cost of each activity goes to what is described as cost pools or cost centers. According to BPP (2001), these costs are then charged to products based on their usage of the activity. A products usage of an activity is measured by the number of the cost driver activities that it generates. According to Horngren et al (2000), the main features of this system are that: ABC creates much smaller cost pools which are linked to different activities For each of these activity cost pools a measure of the activity that is carried out is used as the cost allocation base. In that way each activity pool is related a narrow and more focused set of costs In some cases the costs in a cost pool can be traced directly to products or services. ABC is a strategic management accounting (SMA) technique. Simmonds (1981) defined SMA as “the provision and analysis of management accounting data about a business and its competitors, for use in developing and monitoring business strategy. This is what identifying cost drivers will allow Nokia especially and Carphone Warehouse to do. This approach is time consuming and therefore should only be considered where the benefits will outweigh the costs. In most manufacturing environments this method becomes crucial as it allows for a more advantageous method of obtaining costs that can be use for comparison with competitors in the industry in order to gain a strategic position. Part 2 Comparison of the operating environments of manufacturing and Service organizations –Nokia and Carphone Warehouse Nokia is a manufacturing company that produces cell phones and other electronic items. In addition to manufacturing they also operate sales, distribution and administrative departments which carry out their related functions as suggested by their description. However, although these departments are operated in conjunction with their manufacturing operations, not all the costs are charged to production. It is only the direct and indirect costs that are incurred in the factory which are charged to the product. The cost of selling, distribution and administration is charged as operations expenses in the income statement. It must be noted manufacturing involves a number of processes and according to Horngren et al (2000) the management of some organizations believe that the facility sustaining costs should be allocated to the products and services of the business. These facility sustaining costs relates to administrative (utilities, office rent, etc.) and other expenses that are required to sustain the business Carphone Warehouse is a merchandising and service organization which sells cell phones and other electronic items to customers. In addition to selling the products they also repair similar items for a fee. There is no direct cost attached to selling and repairs. All of these costs are charged to the income statement as is the case with sales distribution and administration expenses. The company simply adds a profit margin to its products to determine the selling price. Part 3 The strengths and weaknesses of each overhead costing approach to Nokia and Carphone Warehouse The Strengths of Absorption Costing The strengths of absorption costing at Nokia is that it allocates overheads to the products it produces and so the company is able to value the cost of the goods that it sells and the cost of the goods that it has on hand. Absorption costing allows the company to calculate the full cost of production and thereby applying a margin for its profits It allows Nokia to establish the profitability of each product Carphone Warehouse The company may be able to apply absorption costing by allocating costs to departments. This application may be based on floor area for some items such as light or the number of staff in the department This service can be priced based on the number of hours spent repairing the items and the hourly rate of labour used but generally there is a set price for this kind of service and the number of repairs is not determined by Carphone Warehouse but by the requirement for the service by the customer. Customer service can be applied to merchandising based on the amount of time that it takes to explain to customer how certain gadgets are used. Weaknesses of Absorption Costing Nokia sell several different products, each of which uses varying amounts of direct materials, direct labor and other direct expenses. The time used to produce them is different and so applying an overhead adsorption rate based on labor hours or machine hours used or based on the volume that is produced is not a fair basis. Some items will therefore be over-priced and some under-priced. This can result in the company losing market share on the overpriced products Products make diverse demands on resources because of the differences in processes, complexity and batch size and so if too much overhead cost is applied products that do not require special attention, this will result in prices that are not competitive. complex products will appear to be very profitable since overheads is allocated based on volume while the simple products may appear to be losing money All or most indirect costs are normally identified as output unit level costs. Carphone Warehouse is just a merchandiser and service company. The merchandise is priced based on adding a margin to the cost of the products (inclusive of the cost of getting it to the required location for sale) it sells and the expected expenses involved in holding and storing the items until they are sold. Some products will move faster than others and so it does not make any economic sense to work out the overheads that relates to merchandising vis-à-vis repairs department as there will also be times when the repair personnel will not be occupied. Carphone Warehouse will charge the costs associated with repairs service to the repairs department based on some overheads allocation basis such as floor space. The company may not be able to recover the cost of hiring the repair personnel as hours on the job may not be consistent with the number of hours worked. The cost of employing persons in merchandising at Carphone Warehouse cannot be added to the cost of the products in the same way that it is done in a manufacturing company. Overheads are therefore charged to the department The activities in the repairs department may be more complex but the allocation may be based on the size of the department. The Strengths of Activity Based Costing At Nokia the activities involved in producing the product from ordering through to material handling, machining, assembly, production scheduling and dispatching will be used to determine the cost of the items. This is a more appropriate method because it takes into consideration the number of activities involved and not just the number of items produced as in the case of overhead absorption methods. Nokia will therefore be able to have a better idea of the true cost of its products and therefore the relevant profit margin that can be added to obtain maximum profits. Knowledge of the real cost of its products will help Nokia to be better able to compete with other industry players. It facilitates benchmarking as the cost of performing various activities in providing a service or product can be compared with competitors It supports performance managements and scorecards (valuecreatinggroup.com n.d.) It makes non-value added activities visible so that they can be rid of It is consistent with the way the work is done because the work involves activities It utilizes unit cost and not total cost as in overheads absorption It integrates continuous improvement programs in that by costing activities the management may seek to reduce activity cost since they now know the different activities and the cost of these activities which make up the full cost. ABC is easier to understand According to Horngren et al (2000) although ABC originated in manufacturing, it has also applicable to servicing and merchandising businesses. It can be used at Carphone to improve efficiency and satisfy customers. Repairs and customer service are key activities At Carphone Warehouse Activity –cost pools can be measured by calculating pools for repairs and customer service There will be different levels of complexity involved in repairing different items There will also be different levels of complexity involved in providing a service to customer in the merchandising department The company will have a better idea of where and how to reduce cost The weaknesses of Activity Based Costing at Nokia It will be time consuming to collect data on the activities especially in merchandising and distribution and so may not be worth the extra effort The weaknesses of Activity Based Costing at Carphone Warehouse Time consuming to collect data It may lead to decisions which are unfavorable for the business. The repair service may not be profitable but it will be a way of getting customers to come into the store so activity based costing may lead to a decision to scrap the department but this may result in less sales. Some departments act as feeders for other departments in a business. Part 4 The best approach for each organization The best approach for Nokia is to use Activity based system. The business that it is in requires it to know its cost of production to the “T”. The best way to find that out is through activity based costing. In this way it will know what activities add value and which activities are leading to a waste of resources. In using this method the company will be able to carry out value engineering and in so doing carry out continuous improvement in costs as well as design of its products. The best approach for Carphone is to use Absorption costing. It will be too time consuming to cost the various activities and it would not be as valuable to the company as it would be in a manufacturing environment, The company can monitor its business by deciding when it may need to reduce staff or hours of work of its employees where applicable. If costs are not adequately covered by revenue in certain locations the company may self to close those locations and concentrate on those that are profitable. All locations should be able to receive items for repairs but they may be sent to a central location in order to make the service feasible. Part 5 The potential uses for accounting overhead information by managers in both organizations Managers use accounting information at Nokia to decide where they can cut costs, which activities they can eliminate and what activities they can improve on without it increasing costs drastically. They can use it to make pricing decisions and to decide the product mix that they should produce. It can also be use to compare with other companies in the industry and for long term performance management. The companies can also use this information to determine what activities to outsource, that is make of buy decisions. Carphone Warehouse could also decide on outsourcing its repair services if this is not profitable. Nokia may also want to outsource some aspects of its manufacturing operations if it could be done cheaper by an external firm. If information on costs is not correct then managers will make incorrect decisions that are detrimental to the organization. Non-value added costs should be eliminated as soon as activities or cost drivers are identified. According to DeBusk (2008) traditional accounting systems like absorption costing do not support or pay attention on the elimination of waste. Eliminating waste is an important aspect of management and can be described as a common sense approach to doing business in this age of competition. Part 6 Ways in which managers can enhance their organizations by using management accounting information, including where relevant ratio analysis According to Hiromoto (1988) management accounting systems provide information for all aspects of an organization’s transactions. It covers all spectrums of the organization and represents an important source of information for decision making. Managers can enhance their organization by using management information to plan, direct, organize, and control the various activities in the organization. The information is also used to make strategic decisions on how to compete within the industry. If the management does not have this information on hand the company will not be able to compete effectively with other companies in the industry. Management is required to be informed of the cost of its competitors various activities so that they will know how their cost compares with the industry average. It is important that ratios based on profitability, asset management, liquidity and other ratios of significance to the business be calculated for comparative purposes. There is normally an industry average that the company should only allow itself to surpass if surpassing it represents a positive measure. It should therefore allow for regular review of budgets to ensure that targets are being met and that these are comparable to what its competitors are doing. Regular review of and updating of budgets is essential to the success of the company. The company should however, not just focus on budgets which is internal but at the competition which is external and seek to add value to its products. Nokia is in an industry where technology is changing rapidly and so it needs to be always focused on external information so that it can make internal changes in the way it does things. Some companies are now looking at target costing which allows them to set a target price for which they want to sell a product and then based on that price they arrive at a target cost. This, however, requires the implementation of strategies such as the Balanced Scorecard which will allow the organization to create value for its many stakeholders including customers, shareholders and employees. References BPP. (2009). F2 Management Accounting. 3rd ed. London, UK: BPP Learning Media Ltd. BPP. (2001). Financial Information for Management. London, UK: BPP Publishing Ltd. Bromwich, M & Bhimani, A. (1989). Management Accounting: Evolution not Revolution, Management Accounting: 67(9) p. 5-6. DeBusk, G. (2008). Straight Talk about Lean Accounting. Tennessee CPA Journal: Nov. 2008 p. 15-17 Hiromoto, T. (1988). Another Hidden Edge-Japanese Management Accounting, Harvard Business Review: (July/August) p. 22-26. Horngren, C.T., Foster, G. and Datar, S.M. (2000). Cost Accounting: A Managerial Emphasis. 10th ed. New Jersey, USA: Prentice Hall Inman, M.L. (2001) Costing basics for the 21st century. Student Accountant Magazine: December/January 2001. Retrieved: http://www.acca.co.uk/students/student_accountant/archive/2001/12/28472. 9th May 2011 Johnson, H & Kaplan, R (1987) Relevance Lost: The Rise and Fall of Management Accounting. Massachusetts: Harvard Business School Press Nokia (2010). Nokia in 2010. Retrieved: http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9ODc3ODV8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1. Last accessed 6th May 2011 Roslender, R. and Hart, S. J (2003) In Search of Strategic Management Accounting: Theoretical and Field Study Perspectives. Management Accounting Research: 14(3) p. 255- 279. Simmonds, K. (1981). Strategic Management Accounting. Management Accounting: 59 (4) p. 26-30 Value Creation Group. (n.d.). Activity Based Costing Advantages and Disadvantages. Retrieved: http://www.valuecreationgroup.com/activity_based_costing_advantage_disadvantage.htm. Last accessed 8th May 2011 Read More