Analysing different Costing Procedures and Techniques

Category: Accounting

With regards to the costing technique it can be seen that the accounting technique used has been firstly to apportion all of the restaurants overheads equally. This ensures that each individual segment of the business has its costs equally distributed throughout all the other production and service areas within the business. Factors such as materials, wages and prime cost are all included in order to find the overhead absorption rate, and it is this that is used in order to work out what costs should be apportioned to each area. This particular type of accounting practice will create an absorption costing statement at the end of the year as apposed to a marginal one.

When looking at the example, we can see that the accountant has used an absorption costing technique in order to ensure that all of the businesses fixed costs are covered. Furthermore absorption costing is the only type of accounting which meets the international accounting standards; one of the main reasons for this is that using this technique prevents factors such as stock from being undervalued.

In addition, we can see how Hugh has built up the cost of these peanuts and that is isn't just a case of calculating the cost of the profits. For example Hugh has charged extra losses from the Kitchen, this may well be due to the fact that selling the nuts will in fact decrease the potential income to the kitchen as people eat the nuts instead. The counter space also has its costs charged to the peanuts as if it has a peanut stand on it, then there is no room to sell other goods. On the other hand though factors such as heating and light have been taken into account, which could be argued as to weather or not they should, and if so what proportion of the costs should be allocated. On top of all this the initial cost of the peanuts and the stand to display the peanuts has been included, but if done this way then these costs haven't actually been apportioned, just charged to the cost of the peanuts.

Upon building the price, Hugh has taken into account the contribution cost received from each bag of peanuts and then worked out how much the overheads are going to be. From this he has worked out apportioned overheads are greater than any contribution, so the selling price has to rise accordingly so as not to run at a loss and hence this is why Pedro would be forced to sell at $2.64 a bag, as compared to the 40 cents which the sales man claimed, however depending on the way that the costs are added up (be it absorption or marginal) both these amounts could arguably be correct.

Question B - Explanation of Procedures

These absorption costing techniques are necessary for a number of reasons. Firstly is that they are the only costing type officially accepted under the international accounting standards, as well as being the only costing type accepted by Inland Revenue (and thus is a legal requirement) when making decisions on how much tax to pay as factors such as levels of stock are never undervalued. Furthermore absorption costing helps to show less fluctuations in net profits in businesses where sales may vary from one month to the next but yet production stays the same. Also, absorption costing ensures that each part of the business takes its fair share of the overheads, but at the same time giving management the choice over what percentage of overhead goes where, meaning smaller departments can pay less each year than the larger ones, this also can lead to manipulation regarding the contribution factors if selling more than one item, so for example in Pedro's case although the nuts have to be sold at $2.64, if the costs were absorbed differently where bigger factors such as the kitchen or bar took a larger portion of the overheads then he would be able to sell the nuts at a lower price, whist still absorbing all the overheads involved. However with regards to overheads factors such as heating and light are also factored into the selling cost of the products. Where as if the accounting was done in a different format, such as marginal costing for example, these costs would just simply have been removed from the profit figure in the Income statement.

Question C - Relevance of Procedures

When looking at the price Hugh has come up for selling the nuts, it is questionable if he has used the correct accounting procedures in creating the value. As mentioned, absorption costing is the only certified method; however the process of creating an answer can be quite different. For example it is not stated at what percentage the costs have been absorbed by different parts of the business, if the peanut stand is taking as equal a share of the costs as say the kitchen or bar then it would be unreflective on the contribution factor per packet of nuts sold. Furthermore there are factors to consider such as the bar space, in Hugh's totalling of the cost he has assumed that without the nut stand there, that area of the bar would be constantly in use, this may well not be the case. As such it should have been worked out what the contribution factor per packet of peanuts sold was and then had the appropriate overheads apportioned to it. This way the selling price would still have been reasonable to the consumer and the costs that were there would have been absorbed by the other sections, or even removed for not being totally relevant.

An alternative Hugh could have used would have been that of marginal costing, that being only where direct costs are recorded. This means that the fixed costs of the business will not have been charged to Pedro's nut investment, it could be argued that this was the approach that the salesman took when selling Pedro the nuts in the first place. By accounting in this way all fixed costs are written of into the income statement. By doing this it allows management or indeed Pedro in this case to see the direct action of the sales upon profit for the year particularly as marginal costing identifies the relationship between the cost, the price and the volume of the goods sold.

There are numerous disadvantages involved here which Hugh no doubt took into consideration when coming up with his valuation. To start with, marginal costing focuses on historical data, where as management are looking at decisions for the future and as such previous sales cannot guarantee future forecasts. Furthermore, the fixed costs are removed which although is an advantage when looking at contribution factors of the goods sold, they do still have to be paid for so if not took here then they need to be removed from the profit figure at some point, and it is because of this that marginal costing is not an accepted form of accounting under the international accounting terms and in this country the Inland Revenue. As well as this there is the issue with what are fixed and what are variable costs, any mistakes made between them will cause the final figures to be distorted and as such the stock valuations will be incorrect, hence by having a set standard upon accounts it ensures some level of accuracy.

Question D - Discuss that the sole purpose of accounting is covering costs, profit and happy shareholders.

This statement could be argued in different ways. For example it could be criticised that the sole aim of accountancy is so that accurate records are kept regarding either a business or company over a period of time and can be compared to previous years to judge how well they are doing as well as acting as a log to keep records of all income and expenditure. The area in which the accounting is being used also plays a key part. For example, financial accounting keeps records of the costs and produces an income statement and a statement of financial position at the end of the financial year in order to reflect the performance of the business and analyse a profit or loss. Management accounting on the other hand focuses upon the fixed and variable costs as well as the contribution factor of any product made. The reports are also generated more frequently so that management can make quick decisions when necessary.

On the other hand it could well be argued that accounting is simply to ensure all costs are covered, profit is made and the shareholder knows about it. Hence one of the reasons that there are International accounting standards. By making a standard way in which the financial reports are created they allow for easy cross comparison when analysing performance. Furthermore the structure of the report helps to show a standard variation of "Profit" which has to include all of the fixed costs, where as if created in a marginal accounting statement for example the fixed costs would be shown elsewhere and value of stock would also have been built into the profit figure. This is where Hugh came up with his figures in the example by incorporating all of the fixed costs into the sales of the goods and thus reducing their positive contribution. When Pedro had been sold the nuts the sales man had failed to include any costs as a direct consequence of selling the nuts such as sales area, and negative externalities of buying the nuts instead of a proper meal. Thus creating an incorrect analysis of profit.

It could also be argued that these reports are simply to inform the shareholder, and by some means this may be true. It gives them an indication on the business performance; profit after tax and of cause most importantly the amount of dividend they will receive. It is also useful to potential shareholders when looking at where they want to invest their money. Hence why dividends are stated in the statement of financial position but also in detail in an equity statement.

There are many other reasons accounting is important however, such as the fact it is a legal obligation by the Inland Revenue and in order to conform to the companies act. It also provides a useful tool for suppliers to access the risk of weather or not they will be likely to receive their payments on time if they decide to trade with the perspective business.

Furthermore, management accounting is very important despite the fact it has no use to informing the shareholder, nor does it always conform to accounting standards. Its main is aim is not that of an end user reading the report but for that of management itself. The reports look at past financial performance but also that of likely performance for the future. The report also leads to the production of budgets so that companies can control how much they are spending. The fact that there is no set time limit on when management accounting reports have to be created means that they can be produced as little or as often as management sees fit. In addition to this is what the different types of accounting look for. Management accounting looks at the direct and indirect costs involved in the business which is what of cause caused the argument between Hugh and Pedro in the example, management accounting focuses upon factors such as labour costs and raw materials and builds them all up in order to work out a level of contribution per product created. Financial accounting on the other hand simply looks at the costs over the year.

Therefore it can be seen that accounting is indeed to ensure all costs have been covered, the business has made a profit and that the shareholders can see this. However accounting is also about so much more than that. Its about the analysis during the year, decision making and looking forward into the future of the business as well as the past as well as numerous other factors all ready mentioned, and because of all these reasons it may be a good idea for Pedro himself to invest in a new accountant if he believes that accounting consists of only three aims.