TYPES OF COSTING SYSTEMS: A HYPOTHETICAL SCENARIO
This article was formerly captioned: "Types of Cost Accounting: The Case of A Manufacturing Company?"
Introduction
Types of costing systems employed in countries may differ from company to company. By
virtue of improvements in information technology, increased competition even at
a global scale, differing organizational structures, and the advent of new
management practices, the environment within which management accounting is practiced
appears to have been altered (Burns and Scapens, 2000). A partial reflection of
this changing landscape for management accounting is partly shown in a change in
its definition.
In
1981, the National Association of Accountants (now the Institute of Management
Accountants) defined management accounting as “…the
process of identification, measurement, accumulation, analysis, preparation,
interpretation, and communication of financial information used by management
to plan, evaluate, and control an organization and to assure appropriate use of
and accountability for its resources. Management accounting also comprises the
preparation of financial reports for non-management groups such as
shareholders, creditors, regulatory agencies, and tax authorities.” This
definition seems to view management accounting as a stand-alone tool to aid
management in the effective use of the firm’s resources.
In
2008, however, the Institute of Management Accountants (IMA), after 27 years
decided to advance a new definition of management accounting so as to factor in
various new developments in the field. The IMA newly defined management
accounting as “a profession that involves
partnering in management decision making, devising planning and performance
management systems, and providing expertise in financial reporting and control
to assist management in the formulation and implementation of an organization’s
strategy.” It would be observed that in this second definition by IMA,
management accounting is seen as a profession, indicating that it has evolved
or come of age to be no longer solely considered as a tool. This definition
also stresses the concepts of “partnership” and “organizational strategy.” This
is no surprise because, in modern times, strategy and partnerships have become
critical to the survival of many an organizations.
Management
accounting can be regarded as management-focused accounting. It is a field that
seeks to explore innovative ways to use financial data to improve management activity.
One of such innovative ways is the
creation of costing systems, which facilitates the allocation of costs to
products.
Costing
Systems Types: Backgrounds and Development
Costing
may be defined as the process or activity of deciding the costs sustained on different
types of inputs utilized in the firm and allocating these costs to various
products or activities of a concern.
Costing
has a number of uses for a firm. An example of this is the fixing of selling
price of products. Additionally, costing also enables analysis of costs and
profitability thereby facilitating investment decisions and cost control.
It is difficult to classify the
different available costing systems used in manufacturing or any other
industry. However, according to Al-Omiri and Drury (2007), costing systems may
be classified based on their level of sophistication with regard to the
assignment of indirect costs. According to them, both simplistic and
sophisticated costing systems can accurately assign direct costs to cost
objects. Hence, accurate indirect costs allocation is the trigger for the
innovation of costing systems. Accurate allocation of indirect costs is a dicey
issue in management accounting. Generally, direct costs in manufacturing firms
supersede indirect costs. This is supported by Al-Omiri and Drury (2007) who
observed that the average direct and indirect costs for all firms were 69% and 31%
respectively. Their data also showed that manufacturing units have a
significantly larger proportion of direct costs (75%) and financial and commercial
organizations have a significantly higher percentage of indirect costs (51%).
The
measure of a good costing system is significant accuracy in allocation of total
costs between total inventory and cost of goods sold (Cooper & Kaplan,
1991). There may be unfortunate consequences associated with an inaccurate
allocation of costs between products. Some offshoots of this situation are
improper pricing decisions, the stoppage of production of a profitable product
line and failure to take note of unprofitable product lines (Lamminmaki &
Drury, 2001). Incorrect pricing decisions happen when products are
significantly over-costed or under-costed, all because of inaccurate costing
systems.
The
fact is correct product pricing is so critical because it plays a vital role in
determining the success or failure of a product line. It is for this reason
that we have a number of costing systems. Some of these costing systems are:
Output costing, Job costing, Batch costing, Process costing, Absorption
costing, Marginal costing, Target costing and Activity-Based Costing (ABC).
Output
Costing
Output
costing also refers to unit costing or single costing. In this costing
technique, costs are accrued and examined under varying elements of cost used
in making the product. Cost per unit product is then determined by dividing the
total cost by the quantity of units produced. This costing technique is
preferably used when a manufacturing company is producing a single product en
masse by continuous production process manufacturing. The units of output are
homogenous (The Institute of Company Secretaries of India, 2012).
This
system of costing was developed for steel making firms, breweries, cement
works, mining companies, brick making concerns, and so on, whose business
activities involve the production of a homogenous product.
In
this system, incurred expenditure comprises costs on material, labour and
direct costs, works and administrative expenses and direct costs. Indirect
costs associated with making the product is spread over periodic intervals
based on estimates. However, selling and distribution expenses, though indirect
costs, are not considered during product costing under this costing system.
Job
Order Costing
Job
order or job costing may be defined as a system of costing in which the
elements of cost are accrued individually for each job or work order embarked
on by a firm. Industries involved in production or render services against
specific orders use job costing.
This
system of costing is employed in Job Order Industries, such as engineering,
construction, shipbuilding, furniture making, and machine manufacturing, where
the production depends on the requirements of the customer. Job Order
industries are unique in that, production is not continuous but rather
production depends on the quantum and specification of the order received from
customers. As a result, each job has the potential to be different from the
other.
In calculating the cost of
the job, direct costs are charged to the job directly as they can be traced to it.
Using some appropriate basis, indirect expenses i.e. overheads are charged to
the job.
Batch Costing
Batch costing is a variant
of job costing system. Here, costs are accumulated for definite batches of
homogenous products ordered for manufacture. A batch is a cost unit that
consists of a discrete, readily distinguishable group of product units, which
maintain its distinct identity throughout the production process. The output of
batch consists of a number of units and it is not economical to determine cost
of every unit of output independently. In batch costing, cost per unit is
calculated by dividing total batch costs with total batch units. Total batch
cost is calculated by adding cost of materials per batch, labour cost per
batch, and other expenditures per batch.
In batch costing, products
lose their separateness as they are manufactured in a continuous flow. This
system of costing is used in manufacturing firms producing readymade garments,
toy making companies, as well as tyre and tube making companies.
Process Costing
Process
costing is a system of costing under which total costs are accrued for each
stage of production or process, and the cost per unit of product is determined
at each separate stage of production by dividing the cost of each process by
the standard output of that process.
In
process costing, costs accrue process-wise. Both direct and indirect costs are
accrued in each process. The entire cost of each process is divided by the
normal output of that particular process in order to calculate cost per unit of
that process. Under this system also, the products are homogenous. Process
costing is applicable in the sugar-manufacturing industry.
Absorption Costing
Absorption
costing is also known as full costing or traditional costing and it is commonly
used for external accounting reporting. Absorption costing is a process of assigning
the variable costs of production and the fixed costs of production to the manufactured
product. Job order costing and process costing can be classified under this
type of costing system.
Marginal
Costing
Under
the marginal costing system, product costing is determined by assigning
variable costs of production to the product. These variable costs are overheads
as well as selling and distribution costs. All the fixed costs associated with
a production period are charged to that period’s profit and loss account.
Marginal
costing is also known as direct costing or variable costing. It involves
classifying product costs as variable
and fixed. Variable costs may be defined as those costs that fluctuate in connection
to the variations in the production volume. Fixed costs, for the reporting
period (never in excess of a year), were constant and wholly unaffected by alterations
in the volume of production (Chandra and Paperman, 2012). In marginal costing,
product costs comprises only the direct material and direct labor costs plus
the variable portion of the overhead costs.
Fixed costs are excluded and allocated
to the income statement as a period expense. In a nutshell, under marginal
costing only the variable manufacturing costs alone are considered worthy of being
inventoried and they are harmonized with sales when the product is sold. The fixed
costs of manufacturing are never inventoried. Thus under this system, the
income of a firm depends, as it ought to, on sales and not on production that
is stored in inventory.
Marginal
costing as a costing system is simple to operate in that cost of materials,
direct labour costs and sales commissions, which are the main variable costs,
are all relatively easy to trace to specific products.
However,
one of the key challenges with this costing system is that variable production
overheads – indirect costs - are difficult to identify. These overheads alter
with the level of manufacturing activity. The cost of some overheads, such as
machine lubricants, disposable tools, some machine maintenance activities will
probably change as output changes.
Target
Costing
According
to Ansari et al. (2007), “target
costing is a system of profit planning and cost management that ensures that new
products and services meet market determined price and financial return.” This
idea is conveyed in the following simple equation: Target Cost = Target price -
Target profit.
The
target price and target profit are regarded as independent variables that are
externally defined by competitive forces in the product and capital markets.
Whilst what customers are willing to pay determine prices, what financial markets
anticipate as a return from that specific industry define profit. The dependent
variable is cost, which implies that a firm has to manage its cost to meet the
external constraints imposed by the product and financial markets in which it
operates.
According
to Ansari et al. (1997), Baker
(1995), Butscher & Laker (2000), and Gagne & Discenza (1995) target
costing is a critical system for firms that are doing business in competitive
environments and are characterized by short product life cycles. There are five
factors that influence the adoption of target costing (Cooper & Slagmulder,
1997): intensity of competition, nature of customer, product strategy, product
characteristics, and supplier-base strategy.
Activity
Based Costing (ABC)
According
to Gosselin (2007), ABC is a two-stage cost accounting technique that apportions
indirect costs to products, services, or any other cost objects. It involves
the identification of significant activities and the assignment of indirect
costs to these activities based on the way these activities consumed resources.
For
example, a product that needs a large amount of warehousing will be assigned
warehousing costs in accordance with this consumption. In contrast, traditional
cost accounting systems tend to allocate costs in accordance with volume
drivers such as direct labour hours.
Activities
represent all the actions performed to convert, and to support the conversion
of, materials, labour, technology, and other resources into outputs. Under this
system of costing, the focus is on why the costs were incurred instead of where
(Gosselin, 2007).
Analysis
of Costing Systems Based
on Type of Company being Investigated
The
manufacturing company under investigation is one that makes different models of
cars using the discrete-part and assembly manufacturing technique. This company
has several departments within its organization that are involved in the manufacturing
process. The company serves an international market and has a number of strong
competitors in its auto industry. For the purpose of this discussion, let us
call the company XYZ Motors.
Currently,
XYZ Motors uses the marginal costing technique to fix selling prices of its
automobiles. What this means is that the company charges only its variable
manufacturing expenses to the product and spreads its fixed costs in terms of
fixed overheads and the like over a reporting period. As good as this costing
system may be in Auto internal reporting and gives a better reflection of the
true price of a product as compared to traditional absorption costing, it however
seems to be oblivious to market, financial and technological forces influencing
XYZ Auto’s industry. The marginal costing system does not seem to seek to identify
or understand the factors that drive the variations in XYZ Auto’s variable
expenses. Perhaps this is because within this costing system there is no in-built
mechanism that facilitates this.
This
is where target costing comes in. Under target costing, cost price of XYZ Auto’
product can be determined as a function of the price people are willing to pay
for the product (target price) and, what investors or financial markets expect
as a return from that industry (target profit). Hence, this type of costing
system considers both market and financial forces in the determination of the
cost price of a product. Target costing is common among Japanese car
manufacturing companies. A limitation within this costing system, however, is
that it fails to consider the drivers, such as significant activities, which
influence the internal environment of XYZ Autos.
Every organization is a bundle of activities, be it productive or
non-productive, and these activities consume resources. A number of activities
go into the making of a product. In companies, like XYZ Autos, that manufacture
different models of cars, it is likely that the amount of resources consumed by
the activities that dovetail into the making of these cars will vary
significantly. The purpose of activity-based costing therefore is to determine
the costs of products by firstly identifying significant activities (comparable
to identifying binding processes in throughput accounting below) and assigning
indirect costs to these activities based on the way these activities consumed
resources. Additionally, activity-based costing (ABC) solves the limitation of
marginal costing in that ABC focuses on why
the costs were incurred instead of where.
Moreover,
within every organization, there are constraints that may affect its operations.
These constraints may be binding or non-binding. Binding constraints limit the
organization’s objective, whilst non-binding constraints do not affect the
value of the objective function (Verma, 1997). Throughput accounting is a vital
measurement and decision-making tool that is based on Eliyahu Goldratt’s Theory
of Constraints (TOC). The Theory of Constraints
can be defined
as a management approach that centers on improving bottleneck processes to constantly increase the performance of manufacturing operations
(Verma, 1997). This means that throughput accounting is not a costing system
but rather a management system. In simple terms, throughput accounting is that
management approach that identifies critical processes or activities and
optimizes them to contribute maximal yield to the objective function. In fact, Throughput
accounting alters a business’ internal perspectives on revenue recognition, costs
and profitability and thus alters the figures used for decision-making – basically
changes the Management Accounting.
Throughput
accounting seeks to find answers to the following three questions relevant to a
manufacturing organization: (1) what to change? (2) to what to change to?; and,
(3) how to cause the change? It is in the finding of the answers to these
questions that increase in profitability of companies is triggered by
throughput accounting.
Recommendations
In
the light of rapidly changing business environment and afore-running analysis, XYZ
Autos need to design costing system(s) that not only prevent price distortion
but also responds to changes in the business environment. Flexible costing
system is the way to go, knowing that the auto industry is heavily influenced
by market as well as technological forces. In management accounting, it is not
unusual these days to have organizations design a costing system based on the
nature of their products, operations, and level of costing information usage
because most modern management accountants now consent to the precepts of
contingency theory, which can be abridged as ‘choose the most appropriate
method for the purpose’ (Gosselin, 2007).
The
technology of production has developed rapidly and in a manner that carries noteworthy
implications for product-costing methods. Technological advances have resulted
in machine capital constituting an increasing proportion of total cost and
direct labor constituting a declining proportion of total cost (Gosselin, 2007).
This
development indicates that overheads constitute an increasing proportion of
total cost (Cooper & Kaplan, 1991). As a result of the declining
significance of processing costs (especially labor) in the overall cost
structure, using volume-related processing costs such as labor as the yardstick
for allocating overhead costs is becoming increasingly inappropriate. Worsening
this overhead-allocation problem is the growing range of products to which the
overhead cost is to be assigned.
It
is therefore recommended that an integrated approach be taking towards the
selection of a costing system for XYZ Autos because no single costing system
fully captures all the costing concerns of a business. The fact is the choice
of a costing system depends on the purpose for which it is intended (Shields,
1997). To increase profitability of the firm, throughput accounting is
suitable; for rapid respond to changes in the business milieu to ensure
competitiveness, target costing is the best; and, as XYZ Autos becomes more
complex and the proportion of indirect costs increase, Activity-Based Costing
(ABC) is the most preferred. The thing with ABC is that there is little
evidence in documentations that signify a direct link between a change to an
ABC system and increases in either shareholder value or firm profitability (Kennedy
& Affleck-Graves, 2001). However, other studies indicate that combined with
other improvement initiatives like target costing and throughput accounting ABC
increases the value of a firm (Krumwiede, 1998). This kind of strategy ensures
more accurate/activity costs.
Conclusion
There is no single cost system that fully reflects all
the variabilities influencing the operation of a manufacturing company. A good
costing system should be able to reflect changes in both internal and external
environments of the company.
The best costing system for XYZ Autos is an
Activity-based Costing only if it is used in conjunction with target costing
and throughput accounting.
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