Product Costing System Types: An Analysis

Introduction

History

Systems for costing products

I. Conventional Costing

A. Job Costing

B. Process Costing

C. Batch Costing

Strengths and Weaknesses of Conventional Costing

II. Costing based on activity

Weaknesses of ABC

Time-Driven Activity-Based Costing

Relevance of Costing Systems – Modern Organisations.

Conclusion

References

Introduction

Management accounting, as defined by the Chartered Institute of Management Accountants is “the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by the management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources.” It assists managers in their job of enhancing shareholder and customer value through efficient and effective utilization of resources within the organization. (CIMA official terminology, N.D)

In the latter half of the 1980s, despite the rapid evolution of the business world, the management accounting methods remained the same. Cost control methods provide a clue to the difference between the traditional and new practices in management accounting. Cost accounting can be described as the primary method employed in management accounting. However, typically, management accountants employed variance analysis to evaluate the actual costs of raw materials and labor employed in the production process with budgeted costs. Costing systems are used in management accounting to assign costs across different cost items.

Production Costing refers to the method of analyzing and listing all costs are incurred during the manufacturing and selling of a product. This includes everything from purchasing raw materials and the costs of shipping the finished product to retail. In the current business climate, it is widely regarded as the most important factor in the process of evaluating and developing business strategies. According to John A Lessner indicated in the Journal of Accountancy “In today’s hotly-competitive business environment, accurate product costing has been critically important to business survival.”

History

The practices of costing products have changed in the last 50 years. In the past, it was calculated as just the overall manufacturing costs. In the latter half of the ’50s, direct costing was introduced for the purpose of separating variables from fixed costs. There was however no tangible connection between the product and consumed resources, as they were both distinct entities. (Wilson, Frank C, 1991)

New concepts and practices were developed in the 1980s to address the demands of modern diverse structures. In the early 1980’s, Activity Based Costing (ABC) was developed to improve the distribution of manufacturing overhead costs, and later to include costs that are not related to manufacturing. (Hongren et al, 2006)

Systems for costing products
I. Conventional Costing

Conventional Costing methods were used more than 60 years ago. employed a costing system based on volume including budgeting, variance analyses, and accountability accounting to satisfy the requirements of management in traditional manufacturing settings. The costing method was followed, for example, volume-based measurements like hours of work or the value of labor dollars to assign indirect costs. They were a good way to allocate expenses in the 1920s but did not work in the modern manufacturing facilities in the 1980s.
(Ali, 2006)

A few of the various traditional costing methods used included:

A. Job Costing:

In this kind of method of budgeting and costing object is several units of a specific product or service referred to as”jobs. Each requires different kinds and quantities of resources. Job Costing systems assign costs to different production tasks that differ in a significant way. For jobs that require direct materials, direct labor is monitored to their costs and is recorded until the finalization of the task. Costing of the job is typically done in conjunction with a particular task, or in the case of a project that is distinct.
(Horngren et al 2009)

B. Process Costing

It is the Chartered Institute of Management Accountants (CIMA) defines process costing as “The method for costing is applicable when products or services result from the result of continuous or repetitive activities or processes. Costs are averaging over units that are produced over the course of the time”. Costing by the process is appropriate for manufacturing facilities that produce a homogeneous composition of their products, and in which production runs continuously. The cost of the product is summed across the number of units made.

Some of the important Jargons employed for Process Costing are: (Lang field (Lang field Smith 5th edition, 2009)

1. Weighted- Average Method
2. First in First out (FIFO).
3. Last In First Out (LIFO):

C. Batch Costing:

A collection of manufacturing processes in one unit, that includes all Manufacturing, Direct, and Labor costs that occurred in one batch.

Strengths of Costing as a method of costing (Liaqat Ali, 2006)

1. Utilized to assign manufacturing overhead costs to products by using a Volume-based cost driver.
2. Direct material cost and direct labor costs
3. NonManufacturing Cost is not attributed to specific products.
4. Strong correlation between O.H. Cost and the cost driver to ensure the cost of the product is accurate.
5. It is measured in terms of the volume of production, in the number of units produced.

The weakness of Conventional Costing techniques (Liaqat Ali, 2006)

1. They are not able to provide the right data to facilitate learning and development.
2. The strategies used to assign the cost of products and services weren’t precise.
3. Direct labor-based processes were not suitable for manufacturing environments.
4. The variances were not understood by employees on the front line and they don’t encourage an integrated view of the process within the company.
5. There isn’t any immediate, tangible link between consumption and product costs.
6. Traditional costing ignores the functions of processes that use input resources and create output products or services

II. Costing based on activity

Costing based on activity; a method that was developed in the mid-1980s in order to improve the way manufacturing overheads are allocated to the products… The system determines the costs of each activity and assigns costs to cost items such as products and services in relation to the activities required to make each item and service.
Barrett Richard (2005) states the ABC’s strength is: ABC is defined as:

1. It allows for more accurate pricing of services, products, and distribution channels, as well as customers.
2. ABC system offers a good return to businesses. It lets you analyze the costs and concentrates on the lucrative sector that enhances the profits of the business.
3. Through the web-based applications in ABC users of information are able to refresh the data in accordance to their specific needs. The managers can access reports on their desktops and make better decisions in their areas of control.
4. Projects that adopt the ABC methods tend to be more rational than they were previously.

Kaplan and co (2007) describe the weaknesses of ABC as follows:

1. ABC is more time-consuming to gather data and is laborious worthwhile to implement. The collection of data that is not stored in any software program is a laborious task. The information used in ABC are abstract and hard to authorize
2. It is not a value driver and it is merely a correlation and other parameters that constitute value drivers.
3. It cannot be quickly adapted to evolving circumstances. It is suitable to the particular situation in the purpose for which it was designed.
4. It doesn’t consider the potential of capacity that is not used, which makes it theoretically wrong.

Time-Driven Activity-Based Costing

The Time-Driven ABC is the redesigned version of the traditional ABC system. Professor. Robert Kaplan known as the founder of ABC has developed a revolutionary method to overcome the shortcomings that plague the traditional ABC Systems. Time-driven ABC is more precise than conventional ABC. Surveys that are costly and time-consuming are eliminated in the time-driven ABC. (Kocakulah Mehmet C et al,2009)

Relevance of Costing Systems – Modern Organisations.

ABC gained popularity in the early 1980s. At the time, this was a service that was only accessible to large scale industries because the price of installation was quite expensive i.e. the price range was between $150,000 and 175,000, in the same time, it was a lengthy and lengthy process that took approximately 6 months to complete the installation. Also, it requires the assistance of experts since the construction was extremely expensive and required skilled hands.

In the past, the smaller companies and medium-sized firms could not even think of adopting a system like this because it was too costly for them, which could affect their viability. Because the conventional system was reasonably priced and easily implementable, small and medium-sized businesses have no other choice to go with the traditional system.

As time passed, technology advanced at its speed, the software that we’re able to compute the ABC system was easily accessible for smaller companies at a cost that was affordable for the smaller firms. The software was extremely user-friendly and its implementation was simple. ABC assists smaller companies in areas of computation costs related to activities that are not value-added. This allows them to run their business in a more efficient manner compared to large-sized firms. ABC’s use ABC assists smaller businesses in growing their efficiency and increasing their competitiveness on the market and, in turn, assists in improving the standards that allow them to stay ahead of the international competition

Conclusion

ABC opens up a new perspective for the manager despite the intractable issues that arise. ABC is useful to all companies regardless of size. The benefits of ABC are that it allows accurate pricing of goods. Utilizing an ABC system allows the business to adapt to the evolving market, and aids in identifying profitable as well as non-profitable areas.

References

  • Langfield– Smith Thorne Hilton 2009, Management accounting 5E. McGraw-Hill Australia Ltd
  • (Horngren.T, Datar.M, Foster 2009, Cost Accounting 13th E ,Pearson Prentice Hall Upper Saddle River New Jersey 07458
  • Liaquat Ali (2006), ‘Applications of Contemporary Management Accounting Techniques in Indian Industry, pages 1-4 , retrieved September 19,2009 from world wide web http://www.managementparadise.com/forums/principles-management-p-o-m/56145-applications-contemporary-management-accounting-techniques-indian-industry.html
  • Mehmet C Kocakulah, James Bartlett, Marvin Albin (2009). Journal of Cost Management, ‘ABC FOR CALCULATING MORTGAGE LOAN SERVICING EXPENSES’ 23(4) 8, retrieved September 25, 2009 from world wide web http://proquest.umi.com.elibrary.jcu.edu.au/pqdweb?index=2&did=1821682251&SrchMode=3&sid=1&Fmt=4&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1254219418&clientId=20960&aid=1
  • Richard Barrett (2005). Business Performance Management Magazine, “Time-Driven Costing: A Bottom Line of ABC’ ABC’ 3(1) 35, downloaded September 20, 2009 via the internet
    http://proquest.umi.com.elibrary.jcu.edu.au/pqdweb?index=6&did=889357501&SrchMode=1&sid=12&Fmt=4&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1254225861&clientId=20960
  • Robert S Kaplan, Steven R Anderson (2007). Journal of Cost Management, ‘THE INNOVATION OF TIME-DRIVEN ACTIVITY-BASED COSTING’ 21(2) 5, retrieved September 20,2009 from world wide web http://proquest.umi.com.elibrary.jcu.edu.au/pqdweb?index=7&did=1253867281&SrchMode=1&sid=10&Fmt=4&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1254224103&clientId=20960
  • Wilson, Frank C. “How modern is your company’s costing system?” Textile World, 1991 Retrieved September 25, 2009 from world wide web http://www.answers.com/topic/product-costing
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