Management Accounting System of Thomela Products Limited - Essay Example

Case Analysis of Thomela Products Limited Introduction: The case study mainly deals with the issue of introducing management accounting system in the firm and including adequate number of cost centers to it. After much controversy about the number of cost centers to be included in the management accounting system the chief accountant identified the cost centers on the basis of per unit product produced and how each cost center is related to one another in the entire production process. As it was an engineering company, the chief accountant successfully divided the manufacturing and service of the firm into four major cost centers like Fabrication, Assembling, Administration and Plant maintenance. He successfully included all the expenses and related each with one or more cost centers. The report will concentrate on providing a thorough investigation based on the seven vital issues that have been given. 1. Management accounting system does not necessarily relate to a whole new form of accounting system but it concentrates more on providing valuable information to enhance the effectiveness and efficiency of the business. (Johnson, Kaplan, 1991, p.4). It can be regarded as an extension given to the concept of cost accounting which helps in giving more economic information to the management helping them in decision making, policy formation, detect the major flaws on the business etc. According to the Anglo-American Council Management Accounting is defined as “the presentation of accounting information in such a way as to assist management to the certain policy and the day to day operation of an undertaking.” From the definition it is being understood that the financial data is basically processed and analyzed in a manner that the management can run business operation more systematically. Apart from business planning and policy formulation there are other certain objectives of this system. This system essentially is being used as a process of interpretation. Unlike cost accountancy it does not always identifies the cost element of the business but it is more dynamic in nature as it analyzes the data and reveals the vital information like where in the company is doing bad or good in its operational processes.( Johnson, Kaplan, 1991, p.4). These identifications in turn help in the decision making of any organization. In this case, the company Thomela though was making profits up to a certain level; there were difficulties in their activities and production, which were exposed when the market collapsed. Thus with the installation of the management accounting system, the company can identify the basic areas they are incurring more costs in the production process of their products. This will simplify the job, as when the activities are separately allocated to different cost centers, it will reveal in which cost centers the expenses are more and why is it so. So it will help in reforming and restructuring the budget of the company and in simplifying processes so that less cost is incurred. Thus we can see that this accounting system apart from giving basic accounting information also analyzes the cause and effect of any given expense and income. As mentioned earlier that management accounting system focuses on increasing efficiency of the entire process of business, and even more so it is objective oriented in nature. Whereas general accounting processes focuses on the strict norms and regulation details, this form of accounting tries to give valuable information of the system and it has no specific norms also. 2. There are certain issues and limitation of this system. The major reason for which Tom, who was the chairman and the managing director was objecting the idea of installing the management accounting system was the huge cost generally associated with it. As the company was loosing out on profits, installing a new system incurring a huge cost was not looking like a good idea for him. Also for a company who are more accustomed with the conventional style of accounting for years, needs a huge change in their mental setup and cultural aspects to accept this dynamic nature of the system. (Drury, 2001). There are certain other issues like; this system concentrates more on information giving rather than following strict accounting norms and so there could be biases on how such in formations can be dealt with. This tool definitely identifies the critical areas of concern, but an incorrect interpretation is always a threat. Wrong identification and taking actions on the plan will ensure certain downfall of the company. So this system is though intelligent but risky in nature. Also the system is in its phase of evolution, that means unlike cost accounting norms and regulation the strong base of management accounting system is yet to be established, it will even likely to take certain time as the process incorporates a huge lot of other aspects of the organization apart from just accounting. So the system becomes more complex and it will depend on the nature, number and choice of cost centers to determine the success. (Johnson, Kaplan, 1991) If the cost centers are too less, the simpler structure will fail to identify the minute areas where actually cost are being incurred, again if the number of cost centers are too many there are possibilities that the system might become complex. Before installation a proper balance has to be kept in mind. 3. There are costs which are being directly involved with the production process of any particular product. They are called direct costs or prime costs, these mainly includes the costs involved in direct material required, direct labor and labor hour costs, and also the direct machine costs which are being used. Now for any single unit produced, there are other accessory costs also being associated with the production of a single unit. These are called overheads. As this particular firm is more of a manufacturing concern for truly evaluating the cost of manufacturing, the factory overhead is to be considered. When this factory overhead is included, it is called that the absorption of that particular overhead. In the case study demonstration in the Appendix 3 is being given, for calculating the prime manufacturing cost of one unit of “Flowcel”. Here only direct costs associated with material, labor and machines are being considered while evaluating the manufacturing cost of one unit Flowcel. It should be noticed in this case that any manufacturing process would generally involve only two cost centers. They are assembling and fabrication. So for the process of absorption of factory overheads into the cost element we should include those expenses which are associated with these two cost centers as factory overheads. These expenses could be indirect material expenses, indirect wages and supervision, power, vehicle expenses, depreciation of plant and machinery. These are the other factor apart from the prime factors which determines the cost of one unit Flowcel. These overheads are included as they are the direct factory related overheads. So by the new method, the manufacturing cost of per unit Flowcel will include expenses like direct materials, direct labor, direct labor hour required, machine hours required along with the other overheads mentioned above. The incurred overheads are absorbed on the basis that these expenditures contribute to the manufacturing cost of the product. The factory overhead costs would be determined by dividing the total budgeted costs divided by the capacity of production for that particular product. The budgeted above mentioned overhead costs are: indirect material= (8000+ 5000) = 13000 UK pound. Now for indirect wages and supervision= (60000+20000) = 80000 UK pound, power= (140000+110000) = 250000 UK pound, vehicle expenses= (12000+ 6000) = 18000 UK pound, depreciation of plant and machinery= (50000+ 40000) = 90000 UK pound. These are the budgeted costs for the overheads which when divided by the capacity of production of Flowcel would give the overhead costs per unit of the product produced. 4. Now by the absorption of the factory overhead new elements of expenses would be added. So for calculating the manufacturing cost of unit of Flowcel we get the following information: Direct materials: Fabrication 10 Assembling 5 = 15 Direct labor: Fabrication (210) + Assembling (350) = 560 Direct Labor Hours: Fabrication (35) + assembling (80) = 115 Machine hours required: Fabrication (30) + Assembling (45) = 75 Indirect material =13* Indirect wages and supervision =80* Power = 250* Vehicle expenses= 18* Depreciation of plant and machinery = 90* (* here the production of Flowcel is assumed to be 1000 units per time period and all the capacity is being utilized for the production of Flowcel only). So the total manufacturing cost after absorption of factory overheads = (15+560+115+75+13+80+250+18+90) = 1216 UK pound. So we see the entire expense including the factory related overheads for manufacturing one unit of Flowcel is given by 1216 UK pound. This figure denotes all the expenses which directly or indirectly contribute to the production of Flowcel. So to extract the exact cost for the company in producing one unit of Flowcel the factory overheads are being included. 5. Now if we compare the two methods by which manufacturing costs have been calculated we will find a huge difference. This is due to the inclusion of the factory overhead costs. Previously to calculate the cost for producing one unit of Flowcel, the prime costs were considered. They were direct material and direct labor who contributes directly to the production of the product Flowcel. But it does not give a clear picture in the management accounting system. For any decision to be made the management should gather all the relevant information. In this design of management accounting system, the cost centers considered are only four, and also if only the prime costs of production are considered the management might not get a clear picture about the things which are going wrong in the system. So a broader base of the cost element should be considered to incorporate those overheads which are related to the factory space. This method will help the management somehow to identify the critical factors which are increasing the cost of production. Including only the prime costs which are directly related to the production of Flowcel, the manufacturing cost of unit of the product comes to only (direct labor+ direct material) 575 UK pound, where as when all the related overheads are included the cost of production for one unit Flowcel comes to 1216 UK pound. There is difference of (1216 – 575) UK pounds = 641 UK pound for only one unit of Flowcel produced. For 1000 units its amounts to 641000 UK pound, which is relatively a large amount considering the expenses of the company. This amount would have otherwise been neglected, if the factory overheads would have been included. 6. “Introduction of New method while evaluating the manufacturing cost of the products” The management accounting system of Thomela Products Limited deals with four major cost centers. They are Assembling, Fabrication, Administration and Plant maintenance. All the expenses which the company incurs can be directly related to these cost centers. Among these four cost centers; Assembling and Fabrication are related to manufacturing activities. So when the manufacturing costs have to be calculated the expenses related to these two cost centers are considered. Previously the cost for one unit of Flowcel was calculated on the basis of the prime costs which are related to it. The expense which are being incurred directly and only while making the product was considered. But it does not give a complete picture. The idea behind the management accounting system is to extract relevant information about the business and the operation. To determine the cost of a product the more parameters have to be included because the process is large and many costs are being incurred at certain levels behind the eyes of the management. A true concrete picture is what the management deserves. So while calculating the cost of production of one unit of Flowcel, the factory related costs have to be incorporated to identify the entire expenses which are related some how with the production of Flowcel and other products. Inclusion of the factory related cost will ensure that a comprehensive picture comes out of the system. The management can scrutinize carefully the change in the manufacturing costs and what are the contributing factors which are leading to this change. This new method will serve as more of an information generating system. While designing the method it was kept in mind that the only those cost elements which are actually related to the production of Flowcel should be considered because addition of too many cost elements, would make the process complex and redundant. The overheads related to the entire value chain of the product produced are being considered in this new method. This would necessarily mean that only the costs incurred in the factory space where the product is being produced have to be considered. So in this case cost elements like indirect materials, which mostly indirectly contributes to the production, indirect wages and supervision, power, which is very essential cost element, vehicle, for the transportation of raw materials and plant and machinery depreciation expenses are being considered. As we can see that apart from direct labor and direct materials these elements do contribute to the production of Flowcel. These costs though look minute in nature but eventually they add up to huge costs which are often disregarded while calculating the manufacturing costs. The management would not realize the main areas where costs are being incurred if these costs are excluded. Specially expenses like power contributes hugely for even one unit production of a product. These are some crucial parameters which the authority must throw some light upon before taking serious cost cutting measures, which is now a demand for the company. In this stage the company should focus on the main elements where in for cash is being drained and as the company is entirely an engineering concern manufacturing related costs should be given prime importance. So by this new method of absorption of factory overheads in the manufacturing cost would help the management to determine the areas and act accordingly. 7. For a small engineering company like Thomela the main focus always lies only in generating profits, and many times they neglect the operational aspects and fail to identify the cost incurring areas of pain for the company. As long as their products are being sold in the market they remain satisfied with the operations. But the pinch is being felt when the market collapses and the economy goes down. In this kind of scenario companies who operate in lower cost margins excel. But in this case it seemed to be quite the opposite. Though the company was age old they failed to identify the main cost incurring areas in the operations which made them suffer a lot. That is the reason the chief accountant of the company tried to introduce the management accounting system in the company which would help them to identify the areas on which they are lacking. But the environment and the culture which was present in the company opposed the introduction of such system. This was due to the fact that the culture prevalent in the company wanted to stick to the traditional form of accounting and this system looked much more complex to them. They were doubtful about the effectiveness of the system and how well they themselves could interpret the results and act accordingly. It was this doubt in their minds which prompted the chief accountant to devise a simpler system with only four cost centers in them. He realized that inclusion of more cost centers would make the process very difficult to grasp for the management. So he successfully connected all the relevant expenses with the cost centers and calculated the manufacturing costs of the product. It was necessary from his part to show to the management about the facilities which one gets from such accounting system and how the managers can actually get useful information from the system. Judging the conditions given in the case study it was very urgent for the company for the introduction of the system otherwise failing to identify the important cost incurring areas would have led to the company’s downfall. References: 1. Johnson HT, Kaplan RS. (1991). Relevance Lost: the rise and fall of management accounting: Harvard Business Press, New York 2. Drury C. (2007). Management and Cost Accounting: Cengage Learning EMEA, UK 3. Emmanuel CR, Otley D, Merchant K. (1998). Accounting for management control: Cengage Learning EMEA, UK 4. Siegel JG, Shim JK. (2006). Accounting handbook: Barron’s Educational Series, New York 5. Belkaoui AR. (2001). Advanced management accounting: Greenwood Publishing Group, Westport Read More