In an age of increasingly fast-growing business, where products and services are available to each provider, organizations need to continuously calculate and plan ahead in their daily business. Manac plc. is already firmly established in the international market and is producer and seller of standard electrical goods. The company uses standard costing and absorption costing as part of its approach to strategic management accounting. It is to be clarified why the organization does not generate the desired profit.. According to Brauchlin and Wehrli, the term strategy comes from the Greek mythology and is consisting of the word "stratus" = Army and "agein" = campaign. (1991, p.3) It becomes clear, that the development of strategies relating to business practices that are directed against competitors. Thus wrote more than 2,500 years ago the Chinese philosopher Sun Tzu Clavell „The general who wins a battle, did a lot of calculations in his mind before. The general, who lose the war, did not." (Clavell 1996, p.24)
This seminar paper deals with the topic, how to use strategic management accounting in Manac plc. to generate the best possible results for the company. Therefore following the previously used accounting methods will be closely examined and considered critically. Different models will be shown to determine whether more produced and sold goods mean a higher profit. The next approach is to review the role of standard costing and variance analysis in management accounting. Furthermore the advantages and disadvantages of introducing an Activity Based Costing system will be considered.
i)
Pricing decisions
Management decisions for achieving the company's goals are depending on multitude factors such as competition, marketing research, costumer behavior, cost, advertising, market saturation and sales promotion. (Gowthorpe, 2005, p.472) Therefore pricing decisions must be taken into account of many factors. In any case, it will be examined what models and concepts are available for companies and which are affecting the pricing decision. Each company works with models and concepts in order to calculate the right price for their product. (Tavella, Randall, 2000, p. 1-3) It is important to distinguish between long-term and short-term decisions.(Drury, 2009, p. 79 - 82) Long term means over several years however, short-term specifies a particular period, a quarter or a fiscal year. It is close, that Manac plc. does not work with the optimal system, due to the fact that the company does not generate the expected profit. There are many models of price determination, including perceived - value pricing, going- rate pricing, sealed - bid pricing, negotiated - pricing, pareto analysis, penetration pricing policy and full-cost pricing. Following two models it is important to examine more closely.
Target pricing
The target costing is due to its strong customer orientation less often an instrument of corporate-centered controlling, rather than a holistic management method which has proven strategic decisions in competitive markets. The target costing can be divided into four phases. In the beginning, had a closely look at the market, to find out what a product should cost to be still competitive. Furthermore, the customer preferences have to be considered. The second step is to defining the desired profit to be made on the product. (Drury, 2009, p. 353) At next, the desired profit has to be deducted from this target price to achieve the target gain. The last step is to compare costs and, as appropriate, adjust the estimate cost to actual. The formula:
Target Price - Desired Profit = Target Cost
Equations give us the allowed cost of the product. These costs should be compared with standard costs which are prognosticated by the company. The success factor in this method is, that at the beginning of the product-life-cycle, every employee must be kept to the budget. (Drury, 2009, p.352) Furthermore, the determination of preferences for a weighting of costs compared to the importance of various product attributes can be made. Thus, the company has the ability to see whether a product should be further developed (should be provided with more value) or whether it was even developed yet. Target costing aims to define the total cost a product causes in a company. (Drury, 2009, p. 353 - 354)
Example for Manac plc.
As one can see in the appendix (calculation one), for overall development, production, design and marketing the target cost is $8 per unit. ( expecting purchase of 50.000 units, 20% return in investment) These $8 target cost need to be broken into the different steps of production.
Usefulness of Target Costing
According to Hutt and Speh (2010, p.308) there are some advantages of target costing. Target costing already ensures proper planning with the first step of the product planning prior the production. The implementation of target costing begins on the market, with needs assessments and customer surveys, therefore companies which using target cost pricing are likely to be closer to markets than other companies. One of the main reasons of target costing, is probably the cost can be accurately calculated to individual cost drivers. Another positive feature would be that the cooperation between departments will intense Disadvantages are on the one hand the high expense of the exact calculation and on the other hand high willingness to cooperate. Furthermore the quality of the products may be suffered because during the manufacturing process only cheap components are processed.
Cost-plus pricing
According to Bhimani (2012, p.369) cost-plus pricing or also known as markup pricing, is another model for a company to determine the price of a product. In this relatively simple method first calculate the cost of the product subsequently adding a percentage on top of that price to get the selling price to the costumer. (Drury, 2009, p.109)
Usefulness of cost-plus pricing
This method is often used in highly standardized products, as quality production volume and sales volume largely remains the same. (www.thesmallcompanyblog.com) A proof for that cost-plus pricing is not a suitable method for Manac plc. The company is indeed a manufacturer of standard electro articles, but must rather go with trend at the market. Electrical items must be constantly evolving and therefore it is difficult to standardize the products. In addition, the model tends to be too foreign customers because it does not require customers or market analysis. Taking all these facts into considerations one can say that the choice of a pricing model depends on many factors. A company has to consider which is profitable and useful for itself.
ii)
The role of standard costing and variance analysis
Standard costing
Chadwick (2002, p. 280) defines standard costing as follows: " A standard cost is a predetermined target cost designed to provide a benchmark against which to measure actual performance. The setting of a standard may involve consideration of: quantities, prices, rates of pay, qualities and a detailed review of all the relevant factors. Standards can be set for selling prices, and the elements of cost, i.e. materials, labour and overheads." It follows, therefore, that the standard cost are set for a specified period. After this period the predetermined standard cost are compared with the actual cost, this difference is designated as variance. According to Broadbent and Cullen (2003, p. 149) likewise the standard cost are closely related to budgeting. The standard cost system provides the calculated cost an organization needs to prepare the budget. In this connection it is important to know the difference between standard cost and budget. "Budgets deal with total costs and standards deal with unit costs.", as Broadbent and Cullen mentioned. (2002, p.166) A company can uses both for their planning, budgetary control and standard cost control. However, standard costing is only really suitable for an company, if the organization "are built up from repetitive process." (Broadbent and Cullen, 2002, p.166) That means, if the work processes are easily seen through, like the following illustration shows. The work input and work output belongs together and the exchange of information is guaranteed.
Fig 1. Control using budgeting and/ or standard costing
Feedback
Variance analysis reports/statement
Compare with actual
Management action
Plan (the budget or standart)
Standard costing in Manac plc.
As mentioned above standard costing is useful in organizations where most of the operations are repeated. Furthermore, ideal standards are difficult to realize and as consequence tend to be demotivating for employees. Nevertheless, Broadbent and Cullen point out, ideal standard can work as long-term goals as well. (2002, p. 150) Manac plc. has to adapt their products with the latest technical standards. Consequently Manac plc. needs to calculate their cost again and again and therefore standard costing could be the reason why Manac plc. does not generate the expected profit because their cost system does not live up to expectations of the organization. Another point is that it is only useful, if the company actually produces all their products in a standardized procedure and the processes within the organization are repeated.
Variance analysis
As mentioned earlier, variance analysis compares actual costs with budgeted costs and analyses the difference. According to Chadwick (2002 , p. 282) there are two types of variances, namely favourable variance and adverse variance. Favourable means, the actual costs are lower than the budgeted cost, whereas adverse means, that the actual costs are higher than the budgeted costs. For sales revenue or profit budget, favourable means actual revenue or profit is greater than budgeted sales or profit, by contrast, adverse means that actual profit or sales is lower than budgeted revenue or profit. Find in the appendix a brief example of this topic. (Calculation two)
As calculation two shows, the first row which is needed to calculate is sales revenue. The budgeted revenue was five hundred dollars and the actual sales six hundred dollars. This is a variance of one hundred dollars favourable, because the company earned more revenue than expected. The profit is composed of sales revenue (green circle) minus costs (red circle).
Key areas which contribute to the overall profit
This indicates that how a company has to deal with variances depends from whether they are adverse or favourable. For example adverse cost variance may occur when the prices of raw materials increase or employees demand pay rises or even when the rent increase. The purchasing power of customers, increasing competition and the amount of disposal income are also factors for revenue variances. However, adverse variances could be improved by finding cheaper suppliers or the demand increase.
Variance limitations
From the previous title it is now obvious that the variance analysis is a good method to identify negative variances in specific divisions. It is also important to know about the limitations of the variance analysis. According to Broadbent and Cullen (2003, p. 157) variances arise because the already used original standards are no longer compatible with the requirements of the environment. The consequence is often outdated and not exact results of the variances. Variances can occur in any area of a company, for example material variances, material price variances, total material variances, labour efficiency variance or variable overhead variances. In a large organization like Manac plc. it is therefore very difficult to determine the exact cause of variances. Due to this case the analysis takes a large temporary and administrative effort (Drury, 2009 p. 296 - 297). As in the previous chapter already shows, variances are exposed to external influences like competition and changes in selling prices. For this reason they may not easily controlled by the management. According to Broadbent and Cullen (2003, p. 157) the latest point of criticism of standard variances are the cooperation with just-in-time productions. They argued, that companies -also produce just in time-, are dependent on long-term contracts with their suppliers and therefore price fluctuations are not important. As a result one can say that variance analysis is a good identification of different divisions and tasks that overturn their budget. The major problem is the amount of time it takes to establish actual costs.
iii)
Activity-Based costing
Comparison of traditional and ABC systems
As already analyzed in the previous chapters, organizations need to calculate the cost for a product, in order to know for what price it can be sold. According to Drury (2009, p. 162) there are two different methods for cost assignment. On the one hand there is direct costing, and on the other hand absorption costing, which Manac plc. already use as part of its approach to strategic management accounting. As the name implies, direct costing is a method that only takes the direct costs into account. Also, this means all incidental costs, also known as indirect costs are not assign to cost objects. The assumption is, that one can see exactly where direct costs accrue and therefore they are easily to assign, whereas indirect costs are not. (Drury, 2009, p. 162) Furthermore it was also argued, that direct costs are easy to handle and therefore relevant for decision-making. The implementation of a direct costing system is a simplistic process. Basically, the company has to identify those costs, which can assign to a specific cost driver, assistance with a suitable data processing system.
Absorption costing systems denominates a system, which considered both, direct and indirect costs. Indirect costs (or overheads) are usually common to several cost drivers. To assign them, one need cost allocation. This denominates a process, which is used when a direct system does not exist to assign costs for a quantity of cost objects. (Drury, 2009, p. 162) Absorption costing should ensure that all costs are covered and able to be assign to a product. It needs to be considered, where the differences between these standard system and ABC system are.
Two stage allocation process
Both systems are based on the same fundament. Both are using two-stage allocation. However, the traditional system distributes the cost of so-called "production and service departments". (Drury, 2009, p. 188) Whereas the ABC system uses plenty of different activity-based cost centers, namely activity cost pools. In other words, traditional systems assign cost to products or cost objects, by contrast ABC systems assign costs to activities. This is the second stage of the two stage allocation, to assign costs from cost centers to products or cost objects. This topic will be considered in more detail in the next chapter.
Designing ABC Systems
According to Drury (2009, p.188) the "ABC systems use many different types of second stage cost drivers, including non-volume based drivers", such as the number of purchasing activity, purchase or of production runs for production scheduling. Whereas traditional systems are tend to use a smaller number of second stage allocation, such as direct labor hours or direct machine hours, also called volume-based cost drivers. As already mentioned in the above section, the ABC costing is based on a so-called two stage allocation. These can be divided into four steps to design an ABC system. To consider this, following an illustration will show the four steps of designing an ABC system, likewise the differences between the procedure of a traditional overhead cost allocation and activity-based costing.
Fig. 2 Contrasting activity-based costing and traditional overhead cost allocation ( Weetman, 1999, p. 751)
Traditional overhead cost allocation Activity-based costing
Like Drury (2009, p. 196) mentioned, the first two steps belong to the first stage of the two stage allocation, whereas the last two steps belong to the second stage. It is obvious, that the designing and therefore the implementation of an ABC system is more expensive than the implementation of a traditional cost system. The appendix contains two calculation examples of ABC costing and traditional costing.
Replacement of current absorption costing system
It is now apparent, that traditional systems are easier to implement, cheaper and therefore most companies use traditional cost systems. (Drury, 2009, p. 163) As contrast," ABC systems tend to be sophisticated". (Drury, 2009, p. 165) The more accurate and sophisticated the system, the more complicated and higher costs for the establishment. It is always the question of cost versus benefit. One of the main advantages of the ABS system is that it provides a detailed listing and allocation of product cost, these in turn are important for decision- making. Thus, the overheads are allocated to the product, if product costs seem to be too high, then it can be controlled by controlling the individual cost factors. (Weetmann, 1999, p. 758) In other words, ABC systems make it easier to react by identifying the details. Attention to the disadvantages. The problem with this method is that it is relatively rare to find in practice and therefore only a few experience reports do exist. Likewise ABC systems require a detailed accounting records and a specific cost coding system to allocate cost firstly to cost pools and from there correctly to products. Another point that Weetman (1999, p. 758) responds is that ,"no allocation mechanism can produce accurate results unless the cost item which is being processed is of high reliability and its behavior is well understood." However Drury (2009, p. 200) represents the opinion, that ABC systems are able to define costs in detail and that it is easier to deal with them. He pointed out, the main issue is to know about the companies goals and to adapt the system to the appropriate nature of the organization. Due the fact that, it is useful to replace the absorption costing system because Manac plc. is in high competition and secondly they offer a huge range of products. These are reasons that Drury (2009, p. 200) mentioned about the usefulness of ABC-systems in organizations. Specifically, this will be discussed in the final summery.
Final summery
Manac plc. does not generate the expected profit. In this financial report different models and systems are considered critically to identify the main issue for the organizations those areas which have not met budgeted expectations. The company need to adapt to the market and therefore Manac plc. need to change the current calculation system to generate more profit. To do this, the organization has to spend a huge amount of money for the implementation of an ABC system. After the establishment the company is able to identify the main cost factors. Standard systems are not made for companies with a high level of competition. No industry is evolving as fast as the technology sector. Even standard items must be developed every day. A detailed insight of the cost drivers is useful in order to plan more accurately and budgeting. Furthermore a detailed statement of costs can also help to find investors for new products as they have accurate insight into the company's calculation. Manac plc. must adjust to the fact that the implementation of the new system takes time and also the desired success will only become clear after the successful establishment. If the organization will replace the absorption costing system with the more exactly ABC system, it will generate the expected profit by identifying the main costs due to consideration overheads and allocation to products. More sales means not more profit.
IV
Bibliography
Books
Bhimani, A., Horngren, C., Datar, S., Rajan, M. et al. (2012) Management and Cost Accounting. 5th ed. Edinburgh: Prentice Hall, p.369 - 378.
Brauchlin, E. and Wehrli, H.-P. (1991) Strategisches Management. München, Wien: p.3.
Broadbent, M. and Cullen, J. (2003) Managing Financial Resources. 3rd ed. Oxford, Amsterdam, Boston, London, New York, Paris, San Diego, San Francisco, Singapore, Sydney, Tokyo: Butterworth Heinemann.
Chadwick, L. (2002) Essential Finance and Accounting for Managers. Harlow, London, New York, Massachusetts, San Francisco, Toronto, Son Mills, Sydney et.al: Pearson Education, p.280-281
Dinger, H. (2002) Target Costing. München, Wien: Carl Hanser Verlag, p.7-17.
Drury, C. (2009) Management Accounting for Business. 4th ed. RR Donnelly, China: Brendan George, p.353.
Clavell, J. (1996) Die Kunst des Krieges. München
Gowthorpe, C. (2005) Business Accounting and Finance for Non-Specialist. 2nd ed. London: Thomson Learning, p.476 - 478.
Hutt, M. and Speh, T. (2010) Business Marketing management: b2b. 11th ed. USA: Cebgage, p.308.
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Tuinstra, J. (2001) Price Dynamics in Equilibrium Models - The Search for Equilibrium and the Emergence of Endogenous Fluctuations (Advances in Computational Economics). 16th ed. Massachusetts: p.28.
Weetmann, P. (1999) Financial & Management Accounting An Introduction. 2nd ed. London: Pearson Education Limited.
Internet
www.strategienet.de (2012) Was ist Strategie?. [online] Available at: http://www.strategienet.de/wasist.html [Accessed: 11.11.2012].
www.thesmallcompanyblog.com/ (2011) 4 Pricing Mistakes You Need to Stop Making. [online] Available at: http://www.thesmallcompanyblog.com/TheBlog/2011/01/4-pricing-mistakes-you-need-to-stop-making/ [Accessed: 24.11.2012].
www.wirtschaftslexikon.gabler.de (2009) Controlling. [online] Available at: http://wirtschaftslexikon.gabler.de/Definition/controlling.html [Accessed: 11.11.2012].
Figures
Fig 2
Weetmann, P. (1999) Financial & Management Accounting An Introduction. 2nd ed. London: Pearson Education Limited, p.751.
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