Management accounting.
Operating Statement for product RS8.
Discuss how the operating statement you have produced can assist managers in:
i) Controlling variable costs;
Variable costs are costs that vary in proportion to the activities of a company or business.
For example direct labor and overheads or conversion cost as they are referred to. Also the prime
cost is also a variable cost i.e. direct labor and direct material.
The operating statement contains the standards for quantities for sales, materials to be
consumed and direct labor. Management can use these standards to compare with the relevant
actual variable costs incurred. The variances noted in the operating statement can be used to
guide the management in identification of the causes of the differences and forms the basis or
foundation of investigation and suggestive corrective measures can be instituted based on the
analysis of the operating. Also decision making is easier when deciding the quantities to be used
to minimize variable costs.
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The operating statement enables comparison between budgeted expenditure and actual
expenditure on variable cost. It identifies areas of weaknesses in the production processes and
quantifies the losses involved. The variances can be helpful to managers in ascertainment of cost
and the activities that caused them. Accurate information can be obtained from the calculations.
The profit calculated shows the level of improvement and whether the objectives and targets of
the firm were achieved. When undertaking reconciliation of the actual and the budgeted
expenditure, the variances shows where the discrepancies occurred. This reduces the work load
of managers and provides essential information to the management. The variances are vital in
controlling the quantities been used in the production process. Depending on the nature of the
transactions the managers can calculate the levels of breakeven and the required rate of profits
margin.
The operating statement helps the management to break down the ideal standards and the
actual achievable targets in variable costs. The operating statement identifies the difference
between attainable variable cost targets and those that are not. The reasons that cause the
differences i.e between the standards and the actual results are also highlighted in the operating
statement during reconciliation of the actual and the difference.
The operating statement helps in controlling variable cost during standard costing as it
helps the management in setting realistic variable costs which is vital if the target cost are to be
met. For instance in the above operating statement the highest variance is found in material M7
standing at $294 (two hundred and ninety-four). The reason for this high adverse variance may
be because the budget was unrealistic or there is something unusual with the handling of material
M7. The management needs to investigate the cause of this variance.
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ii) Controlling fixed production overhead costs.
Fixed costs are company or business expenses that are not related or dependent on the
level of quantity of goods or services produced by the company. They include overhead and
other indirect expenses of operating a business. They tend to be periodical or time-related such as
salaries, security, marketing, administrative supplies or even rent payable monthly or quarterly.
Fixed expenses or costs are used to control the prices of products or services to maximize profits
to ensure appropriate returns and profitability the investment made. The operating statement
shows the comparison between the various production costs and their effect on the fixed cost. It
shows whether the fixed costs are economically viable and if the business is benefiting or
incurring losses. The operating statement analyses the fixed costs and their levels of profitability
and identifies areas that need improvement or the ones that can be totally removed. The fixed
costs in the operating statement helps the management in controlling and making economic
decisions that are informed and accurate which gives the investors a clear picture of the
company’s actual production cost. The operating statement gives justification for use of
expenditure which controls the production process.
The operating statement helps in controlling fixed costs as it shows real and actual fixed
costs against the standard fixed costs. These helps prevent unrealistic and unattainable targets
from being included in the standard budget. The variance of $315 in the fixed cost is high and
needs investigation as these are fixed costs and the variance need not be very high. The cause of
the major disparities or discrepancies in fixed costs is mostly extra overtime allowance allowed
on the employees. These should be countered by factoring this extra expense in the standard
budget in case there will be any need.
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Fixed costs can also be used to control income. They can be accurately used to measure
available income given a fixed expense. For instance, in a factory using electric power to
produce goods, the monthly power bill matches with the production department’s finished goods.
For a given period in specific industries, the power bill for running the factory is almost fixed,
monthly expenses are don’t vary but production can be matched to the electricity costs.
c) Mr. Ash has recently heard about Activity Based Costing (ABC) but is unsure what it
is and whether Ash plc could adopt this. You as the new management accountant
have been asked to provide Mr. Ash with information on ABC, so that he can make a
decision whether to introduce it into the company. Your answer should include an
explanation of ABC, what the method is intended to do, a comparison with the
traditional method and whether it would affect your calculations in part (a).
ABC costing technique is a process that applies costs and expenses to the activities that
cause them. ABC developed as result of the problems encountered in traditional costing method.
The following are the problems that were associated with traditional costing method and later
contributed to the growth of ABC which attempted to counter some of its weaknesses.
Traditional costing divides costs between variable and fixed expenses. However, time
scales that are applicable to many projects make this method redundant. Costs should be viewed
in terms of whether they are short term or long term since most strategic decision and plans are
based on time scales ranging between three to five years during which periods the costs may
become variable.
Over time, when the business grows and the complexities of management increase, and
costs become varied and diverse not overly because of increase volumes but because of the
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nature of diversity of its products the costs become complex and require sophisticated assistance
and support functions. When allocating costs in terms of volume, the product whose output is the
highest will receive the highest allocation level of apportionment. The product with fewer
volumes may take unequal amount of time and the material needed to set up, but the allocation
will be limited to a small proportion of the support cost. (Garrison, Ray, Noreen, Brewer, 2009)
Some costing methods are founded on financial costing method and systems and are
inappropriate for final decision making purposes. For purposes of inventory valuation, only
overheads related to production may be later absorbed into the cost of the product while
overheads from selling and distribution are ignored.
In absorption, the basis used is often the labor hours even though the direct labor forms a
small margin of total cost.
The following are the stages that are involved in activity-based costing: a) identification
of the activities and causes of overheads expenditure. b) Adjustment of the system of accounting
to make cost be identified and collected by activity instead of the cost-centers. c) Identify what
causes the changes in activity’s costs. (Cost drivers). d) Establish the size and volume of all the
cost drivers. e) Calculate and confirm the rates of cost drivers by division of the activity’s cost by
its cost driver’s volume. f) Establish the volume requirement of each cost driver by the product.
g) Calculate the overheads attributable and related to each product by multiplication of steps (e)
and (f).
There are certain jobs under traditional system that may be over-costed because of their
high volumes. This is due to the reason that costs are based and allocated in terms of machine
hours. Small jobs that are difficult to quantify are under costed because they use fewer machine
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hours. This is because additional costs are incurred which are related to short-run production and
are not wholly reflected in the costing system of the company.
Cost drivers are activities that generate and cause costs not the cost themselves. There are
processes that add value and while others do not. Those that don’t add value should be removed
or reduced substantially without causing any affect on the product. Variable costs that are short-
term may be identified and allocated based on machine hours, direct labor hours, or direct
material cost using the volume-related cost. Expenses like electricity may be apportioned by the
driver’s variability and driven according to machine hours. The nature of transactions carried out
by the staff of the support department determines the relevant cost drive. Examples of cost
drivers include the orders of goods inwards that drives the department of goods inwards. Also the
number of runs undertaken by the production department drives several other items like the
inspection, set-up department and production cost scheduling. The quantity of dispatch orders
drives the major costs of the department of goods outwards.
When the cost drivers have been identified, each is designated and assigned as a cost
center and allocated all the costs associated with it. For example, the costs associated with the
cost center in the goods outward department are divided by the number or quantity of goods
outwards to determine the rate of charge-out. For instance, costs were identified and determined
to be $5000 and 1000 items were sent, then $5 would be the charge out rate per item.
Advantages of ABC
Managerial control is enhanced by the identification of costs that are related to the
activities that caused them. Performance measures can be derived from cost drivers besides cost
measures. When budgeting within the support departments the information provided by the
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identified costs from the cost-drivers is very useful and precise. The provision made when
costing the information in cost allocation is viewed more positively and with confidence by the
line managers than originally viewed in traditional costing as ABC overcomes most of the
historic problems associated with traditional costing. When comparing with traditional methods,
cost are allocated accurately in different proportions hence highlighting products that are not
profitable and which should either be done away with or improved.
Disadvantages of ABC.
ABC is still a new a technique and its potentials and weakness are still being weighed.
More investigation, research work and analysis are still being undertaken in real-life situations.
One thing that is not clear and still needs clarification is its impact on staff and managerial
behavior, its effect on staff motivation and attitude towards its general application. The
transitional period from traditional costing methods to ABC might be met with hostility
especially in large and organized corporations where change is viewed negatively. The smaller
and innovative firms may successfully implement because of their willingness to embrace
change positively and with less negativism. (Velmurugan, 2010)
The impact and effect of ABC on the profitability and the reduction in cost is still not
clear. Its successful implementation depends on the accuracy and the goodwill of the cost
accountants. The information generated from the cost activities are historic and care should be
exercised when using such information for future strategy. Problems encountered in the initial
process of implementation emphasize the cause of the costs in the change process. When the cost
drivers are not obvious, it may lead to wrong identification and the results may be disastrous as
the whole system will be inaccurate. The reporting of ABC overrides traditional measures of
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control when defining the overall responsibility. Care must however be taken to ensure the
allocated costs to a cost center are manageable and can be controlled effectively by the
concerned manager
The operating statement would be affected in many ways if traditional based costing
approach was adopted and used in this question.
The traditional costing methods such as the absorption or marginal costing methods may
have affected the above calculations in the following ways. a). Overheads are ignored as sunk
costs in marginal costing i.e. they must be paid notwithstanding the level of production. This
inflates the profit and the products are not allocated overheads and may be difficult to recover the
set selling price. These makes the company incur losses and eventually may run out of business.
In absorption costing products are allocated all the overheads. The company must
allocate and also apportion all service overheads to the production department. The allocation of
costs is done arbitrary and may not reflect accurately on the activities that are responsible for the
cost. A product may show a loss in its operation because of the allocation when it should be
showing the contrary.
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Garrison, Ray H; Eric W. Noreen, Peter C. Brewer. Managerial Accounting . McGraw-Hill
Irwin. (2009)
Khan, M. Theory & Problems in Financial Management. Boston: McGraw Hill
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Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective
.Harvard Business School Press, (1987).
Staubus, George J. Activity Costing and Input-Output Accounting (1971)
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Vance, D. Financial analysis and decision making: tools and techniques to solve
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(2003).
Velmurugan, Manivannan S. “The Success and Failure of Activity-Based Costing
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Systems.” Journal Of Performance Management 23.2 (2010): 3-33. Business Source Complete.
Web. 15 Mar. 2012.
