the importance and impacts of costing method on the process of managerial decision making

The cost accounting method that Minhnhat Company uses and its impacts on their decision making process .... This means choosing a cost accounting method can affect the decisions of manag

THE IMPORTANCE AND IMPACTS OF COSTING

METHOD ON THE PROCESS OF MANAGERIAL

DECISION MAKING

BY

LE THANH THUY

E0600122

BACHELOR OF BUSINESS (ACCOUNTING) HONS

HELP UNIVERSITY COLLEGE

THE IMPORTANCE AND IMPACTS OF COSTING METHOD ON THE

PROCESS OF MANAGERIAL DECISION MAKING

BY

LE THANH THUY

Graduation Project Submitted to the Department of Business Studies, Help

University College, in Partial Fulfillment of the Requirements for the degree of

Bachelor of Business (Accounting) Hons

JUNE, 2010

Declaration

I hereby declare that the graduation project is based on my original work except

quotations and citations which has been duly acknowledged I also declare that it has not

been previously or concurrently submitted for any other course/degree at Help University

or other institutions The word count is 12,295 Words

Acknowledgement

First of all, I am grateful to Dr Le Van Lien who gave lots of useful advices as

well as materials for this thesis And I would like to extent my thanks to Mr Minh,

manager and all of employees in Minhnhat Co., Ltd, who allowed and assisted me to

collect all of necessary information to finish this thesis My thesis can not be finished

without your supports

TABLE OF CONTENT

Declaration i

Acknowledgement ii

TABLE OF CONTENT iii

Abstract v

List of tables vi

List of figures vii

CHAPTER 1: INTRODUCTION 1

1.1 Introduction of topic 1

1.2 Issues 3

1.3 Issues expansion 4

CHAPTER 2: LITERATURE REVIEW 6

2.1 Managerial decision making process 6

2.1.1 Decisions in nature 7

2.1.2 What is decision making process? 9

2.1.3 What is accounting information? 10

2.1.4 Managers and management accounting 12

2.2 The importance and Impacts of costs accounting methods on decision making process of the managers using SWOTs and Porter’s model analysis 14

2.2.1 Absorption costing 15

2.2.2 Variable costing method 17

2.2.3 Activity based costing system (ABC) 19

2.2.4 The importance and impacts of accounting methods on managerial decision making process 21

2.2.4.1 SWOTs analysis and why managers should choose a suitable costing method or importance of these methods 21

2.2.4.2 Porter’ model with five factors which can affect the managerial decision of managers in term of cost accounting methods 24

Figure 1: Porter’s model with five factors 25

CHAPTER 3: RESEARCH AND METHODLOGY 29

3.1 Aims of the project 29

3.2 Research methodology 30

3.3 Data sources 30

3.4 Limitation 31

CHAPTER 4: CASE STUDY ANALYSIS 33

4.1 Introduction 33

4.1.1 Company’s background and mission statement 34

4.1.2 Operational structure 36

Figure 2: Operational structure of Minhnhat Company 36

4.1.3 Firm core business and competitive advantages 37

4.2 Differences when using different cost accounting methods 38

4.2.1 Incurred expenses during the period of 2008-2009 39

Table 1: Production of Minhnhat Company 39

Table 2: Direct material cost of Minhnhat Company 40

Table 3: Direct labor costs of Minhnhat Company 41

Table 4: production of Minhnhat Company 41

Table 5: Selling and administration expenses of Minhnhat Company 43

Table 6: Cost pool and activities measures of ABC method 44

Table 7: Total manufacturing overhead and selling expense during the year of Minhnhat Company 45

Table 8: Distribution of resources across activities costs pools of Minhnhat Company 45

Table 9: Distribution of resources across activities costs pools in $ of Minhnhat Company 46

Table 10: Activities rate of Minhnhat Company 47

4.2.2 Unit cost product using three methods to calculate 47

Table 11: Cost per unit of raincoats using variable and absorption costing 48

Table 12: Overhead cost per unit of adults’ raincoat and children raincoat using ABC method 50

4.2.3 A profit comparison using absorption, variable and ABC costing method to calculate 51

Table 13: Direct Materials and Direct Labor costs of Minhnhat Company 52

Table 14: Income statement of Minhnhat Company using ABC costing method 53 4.3 The cost accounting method that Minhnhat Company uses and its impacts on their decision making process 54

Figure 3: Income comparison between variable and absorption costing method: Income statements for 2009 of Minhnhat Company 56

CHAPTER 5: CONCLUSION 57

References: 60

THE IMPORTANCE AND IMPACTS OF COSTING METHOD ON THE

PROCESS OF MANAGERIAL DECISION MAKING

BY

LE THANH THUY JUNE, 2010

Supervisor: Dr LE VAN LIEN

Abstract

In general, cost accounting method can be considered as the most concerning problem

with an organization Different costing methods will lead to different profit to a firm

This means choosing a cost accounting method can affect the decisions of managers

based on the empirical study of advantages and disadvantages of three costing methods

which are absorption, variable and ABC costing method Many people think that there

are no links between the managerial decisions and cost methods, but I think they have a

potential relationship As a result, I will use SWOT and Porter’s model to explore some

evidences about this connection After that, I make some recommendation about the

importance and impacts of cost accounting method on the managerial decision making

process

List of tables

Table 1: Production of Minhnhat Company

Table 2: Direct material cost of Minhnhat Company

Table 3: Direct labor costs of Minhnhat Company

Table 4: production of Minhnhat Company

Table 5: Selling and administration expenses of Minhnhat Company

Table 6: Cost pool and activities measures of ABC method

Table 7: Total manufacturing overhead and selling expense during the year of Minhnhat

Company

Table 8: Distribution of resources across activities costs pools of Minhnhat Company

Table 9: Distribution of resources across activities costs pools in $ of Minhnhat Company

Table 10: Activities rate of Minhnhat Company

Table 11: Cost per unit of raincoats using variable and absorption costing

Table 12: Overhead cost per unit of adults’ raincoat and children raincoat using ABC

method

Table 13: Direct Materials and Direct Labor costs of Minhnhat Company

Table 14: Income statement of Minhnhat Company using ABC costing method

List of figures

Figure 1: Porter’s model with five factors

Figure 2: Operational structure of Minhnhat Company

Figure 3: Income comparison between variable and absorption costing method: Income

statements for 2009 of Minhnhat Company

CHAPTER 1: INTRODUCTION

In this part, the structure of this thesis, an introduction about the topic as well as

relates issues to it will be covered This will create the whole picture about the ideas and

help the users easy to follow and link them to each other to figure out the potential

relationship between cost accounting methods and managerial decision making process

that the author mentioned in the abstract

1.1 Introduction of topic

A fire at the headquarters of the National Association of Accountants (NAA) in

1984 destroyed all information related to cost accounting aspect (Cunagin, C., & Stancil,

J., L., 1992) As a result, none accountants as well as historical researchers can ensure

and show evidences about the accurate time when the cost accounting methods are born

As Richard Vangermeersch, a leading accounting historian said ‘a problem in cost

accounting is that many such accountants feel that they have no past’ (1986) Therefore

even costing management accounting is not a new problem but its importance is just

focused and researched in the twentieth century

There are many methods to calculate the costs such as absorption costing method,

variable method, throughput accounting, and lean accounting and so on Each of method

will have different way to allocate costs As a result, with the same company, applying

two methods can lead to different decisions In order to make a managerial decision,

costing methods play important roles In fact, cost allocating can be considered as a

guideline for the managers to make better decisions By comparing annual reports,

managers can see which profitable products are as well as whether any costs are wasted

or used inefficient For some managers especially of the small company, absorption

costing might be the best costing method while it can deal with the conflicts of interests

between them and their companies Other managers think that if they use another type of

costing methods to reduce and allocate costs more efficiency will improve their

performance more than using absorption costing method However, this does not mean

with the same information or report, different managers will make the same decisions

This process is depended on capability of each person Therefore, to sum up, managerial

decision making process of managers is affected by many factors but in this thesis, only

impacts of cost accounting methods are discussed

This thesis is divided into five chapters as follow:

 Chapter 1: Introduction

 Chapter 2: Literature review

 Chapter 3: Research and methodology

 Chapter 4: Case study analysis

 Chapter 5: Conclusion

These five parts are not separated, they will be linked in order to express the ideas

that the author would like to share Chapter 2: literature review and chapter 4: case study

analysis will be the most important parts which focus on the theory and the fact in a real

case Chapter 1 and chapter 3 will considered as a background to create the general ideas

of this thesis And chapter 5 will conclude the findings after analyzing a real case

compare to the theory

1.2 Issues

Main ideas which are expressed in this thesis include the cost accounting methods

introduction, advantages and disadvantages of them and it impacts on the decision

making process of managers

As mentioned above, history of cost accounting method is necessary to know

especially for three methods that the author wants to focus: absorption costing method,

variable costing method and Activities Base Costing method (ABC) It is difficult to

ensure that which costing method is applied first because of lacking documents about

this But, for some historical researchers, absorption costing or traditional costing method

can be considered as the leader of cost accounting After that, variable costing was born

and later ABC is invented The same limited resources and costs, these three method lead

to different results as well as decisions Each method will apply a way to allocate costs

which differ with the other two methods Nothing can be perfect therefore these methods

contain both advantages and disadvantages to managers

Using SWOTs model, all of advantages and disadvantages will be judged fairly

SWOTs mean strengths, weakness, opportunities and threats This model is used popular

in management aspect Some people do not believe that SWOTs can be applied to

analyze in accounting However, accounting does not mean only work with numbers

especially with managerial accounting Managers also need ability to evaluate the

effectiveness and efficiency of the firms, the operation process and cost budget through

numbers Moreover, through this evaluating, it will be easier to see the importance of cost

methods on the decisions making process

Porter’s model is another management framework that the author uses in this

thesis Unlike SWOTs, this model will focus on five factors which can have significant

impacts on the decisions of managers which are new entrances, buyers, suppliers,

substitutes and rivalry competitors These will affect the cost available for the firms and

lead to changes in result when calculating costs using different methods Then, decisions

of managers can be changed also

1.3 Issues expansion

Theories are still theories if we can not apply them into the reality As a result, in

chapter 4, a real case of MinhNhat company – one raincoat manufacturers will be use to

analyze In this part, from the collected cost information of this company, absorption

costing method and variable costing method are applied In fact, this company prefers

absorption costing rather than variable costing method because the increasing trend in

profit can attract more investors But they had to turn into a new costing system which is

a combination between absorption costing method and ABC costing method from 2007

because of managerial wrong decisions during the use of absorption costing method

According to Mr Minh, manager of this company, applying absorption costing is

good for external reports especially for investor attracting purposes However, this can

lead to mistakes in internal control process As a result, a suggestion for a new system in

which variable and absorption costing methods coexists should be concerned by

accounting researchers

CHAPTER 2: LITERATURE REVIEW

Like the first part of introduction, this will provide information about managerial

decision making process and three cost accounting methods Understanding about the

decision making process in general and in costing management can help the managers

know what kind of information and how much of information do they need to make an

efficient decisions From this, a briefly introduction about the history, calculation and

contents of absorption costing method, variable method and ABC method will be

covered In the last of this chapter, SWOT and Porter’s model will be used to evaluate the

advantages and disadvantages as well as impacts of cost accounting methods on the

decisions of managers

2.1 Managerial decision making process

Every body has to make decisions Depending on different purposes of various

groups of people, decisions can be made differently in a specific circumstance In order to

understand what managerial decision making process is, this part will explain:

- What are decisions in nature?

- How many steps do this process involves?

- What is accounting information?

- And how the managers use this information?

2.1.1 Decisions in nature

Decision process could be considered as a study in which the decision makers try

to overcome distractions from both internal and external to identify and choose the best

alternatives for a certain problem in a specific circumstance

Every day, every second, we have to make decisions from small to important

things For example, in the morning, we decide which kinds of clothes we will wear

today; then we decide whether to have a breakfast at home or bring some things such as

an apple to the school then taste it in the break time or lunch More important than these

things, we decide our job in the future, salaries that we desire

With a limited resources and time, we could not do many works at the same time

As a result, making the best decision is very important which means it is not only suitable

with our ability but also can bring our best results (König, T.; Debus, M.; & Tsebelis, G.,

2010) According to most of people especially businessman, to make a good decision,

they need a lot of necessary information However, in fact, we could not wait until we

have enough information to make a decision For instance, we decide which major we

will follow in the university We can not wait until we have enough statistics about all

major to make a decision Although every student want to study a major which can help

them find a job better, they have to decide without thinking or planning so much

Depending on different people as well as knowledge and experiences, decisions

will be different (Engel, C.; & Singer, W., 2008) Generally, many people though that

they are only affected by their own decisions whereas their parents, friends, bosses and

colleagues’ decisions also affect them (Lucius, C., 2009) This can be minor or

significant influences based on the relationship between them For example, our parents

decide to live in countryside As a result, our appearances as well as our characteristics

and thinking will be different with other children who live in big cities This means our

decisions or other people’s decisions could affect the rest of our life by shaping our

attitudes and believes (Brunsson, N., 2007)

In some circumstances, decisions should be made by a group of people instead of

an individual (Egenhofer, C.; Kaczynski, P., M.; Kurpas, S.; & Schaik, L., V., 2010)

This is popular when teamwork is more and more important and developed nowadays

Some people think that this is not sufficient because of including lots of judgments as

well as estimations However, a person could not know every thing of various aspects;

more people can have better ideas if they know how to pass all of distractions such as

negligence and noise which is mentioned in the book named ‘Better Than Conscious?:

Decision Making, the Human Mind, and Implications For Institutions’ of Eapen, G.,

(2009) When the globalization becomes a dominated trend, making the best decision

while still maintaining the Code of ethics is the most desired goal that all of businessman

especially investors want to achieve

2.1.2 What is decision making process?

In management, decision making process includes six steps which are

recognition of decision requirement, diagnosis and analysis causes; development the

alternatives; selection of desired alternatives; implementation and chosen alternatives;

and evaluation and feedback (Richard, L D., 2009) With the same meaning of making

decision process but shorter, there are only four steps that decision makers should

concern when they make decisions (Hoggett, Edward, & Merlin, 2006)

First step is establishing the goal With managerial accountants as well as

investors, different situations will lead to different decisions Based on available

resources such as time and capital, decision makers should know whether the decisions

they make could be the best alternatives This means is that determination is needed and

necessary to achieve the goals that we desired In case this is important, all of our values

as well as motives will be affected

Gathering available information is the second step There are various kinds of

information As a result, what kind of information do we need and how much of

information is needed are two important questions If we collect too much information,

our judgments and attitude can be changed and not wise any more Relevant information

can help us make better decisions with higher successful degree whereas irrelevant

information leads to distractions during our decision making process

After collecting enough and useful information, we have to think how many

alternatives available for our decisions In fact, we can not avoid uncertainty because

what we expect is in the future Therefore, we only can make the best decisions within

limited resources in specific circumstances

When we know what are available alternatives and their consequences, we have

to decide and make a plan which can help us achieve the outcomes we expect Although

this process has only four steps but it still reflects the nature of making decision process

This can help both accountants and investors have better thinking and judgment when

they face with any problems or opportunities

2.1.3 What is accounting information and its role in decision making

process?

Information plays an important role in making decision process as mentioned

above Thanks for the development of internet, accessing information becomes easier and

easier (Saaty, T., L.; & Vargas, L., G., 2009) But this does not mean all of information

are useful for our decision making process Overload of information, the motives and bias

of providers, remoteness of information and complex transactions make the decision

makers face a higher information risk possibility (Alvin, A.A.; Randal, E J.; Beasley; &

Mark; 2010)

Not many information could be considered as accounting information Nature

of accounting is identifying, measuring and recording all transactions of an entity,

therefore, accounting information must reflect actual financial events of that entity

(Romney, M., B.; & Steinbart, P., J., 2008) Although this information can not guarantee

the future events but it can help the decision makers reduce the uncertainties In other

words, historical records can be a useful guideline for both managerial and invested

decision makers From this, mater budget can be prepared to show the business goals of

the entity in the new period Additionally, through differences between the actual and the

budgeted numbers, decisions makers can adjust and drive the business into an effective

way

By comparing the effectiveness and efficiency of an entity’s performance year

to year, accounting information could provide a wide view to users about which activity

could their core business categories and how could they allocate the costs more precisely

(Hurt, R., L., 2009) All of this information will be updated and filed day by day

(Bagranoff, N., A.; Simkin, M., G.; & Norman, C., S., Ph.D CPA, 2009) As a result, if

the outcomes are not as decision makers’ expectation, an investigation will be

implemented to ensure whether a new decision should be made

Depending on specific needs and positions of users, accounting information can

be judged important or not For example, for some investors, profitability and earning per

share are key information when they decide to invest while others think it needs more

criteria such as CSR reports (Coenen, F., H., J., M., 2010) This means the same

accounting information can be important or not based on the knowledge as well as

precisely judgments of users

2.1.4 Managers and management accounting

Both internal and external users want to collect and use accounting information

probably As mentioned above, managers try to use the accounting information in order

to enhance the efficiency as well as the effectiveness of allocating limited resources

Comparing figures from year to year can draw a better picture about the running

business As a result, they will plan a master budget as a bench mark to evaluate the

performance of a business According to two authors, Atrill, P., & McLaney, E.,

depending on the requirements of decisions, managers may require daily, weekly or

monthly reports which are designed in differently forms and purposes (2009) For some

special accounting reports, internal auditors can be involved in verification process

Unlike managers, investors use accounting information in others purposes As a result,

they will access accounting information in different ways as well as types In this thesis,

managers will be the main users that we concern

Unlike reporting information which is reported to external users such as investors

and suppliers, management or managerial accounting tents to provide all of financial and

all of necessary information within an organization to managers to help them take their

responsibilities in planning, controlling and deciding activities (Tremmel, J., C., 2009) In

general, the common questions that perform the expectations and purposes of managers

include:

- What is the profit after taxes is being earned of our company?

- What resources are available?

- Do they have CSR reports?

- Should we invest and produce in these products?

It is difficult to satisfy all of investors’ needs Therefore, by disclosure the

financial statements, managers will try to release and provide general information about a

corporation fairly among investors

Reducing risks and enhancing wealth can be considered as dominated trends for

most of managers (Proctor, R., 2009) As a result, no managers want to decide while they

have not got enough information Figuring out the differences between pieces will be

harder than looking at the whole picture and comparing although it can minimum the

risks of the organizations Therefore, collecting accounting information from annually

reports might be a good way to draw a conclusion This will let mangers broaden their

point of views and have better judgments during their decision process Moreover, too

much and to detailed accounting information will lead to overload the information and

affect managers’ attitudes and a misstated decision can be made

However, no one can ensure that all of information provided by the corporation is

accuracy and objectively Sometimes, to get a higher profit and a better performance,

managers and accountants can cook the numbers Therefore, investors need helps from

the third party – external auditors to maintain the fair and objectivity of accounting

information which are given by the managers

2.2 The importance and Impacts of costs accounting methods

on decision making process of the managers using SWOTs and

Porter’s model analysis

Generally, cost accounting is the way to calculate costs and price of the products

It can be used to help managers understand the costs of running a business (Weygandt, J.,

J.; Kimmel, P., D.; & Kieso, D., E., 2009) The appearance of larger business scales

needs another costing method to use In the early industrial age, investments in the direct

labor, direct materials and manufacturing overhead costs which are included in variable

cost now can be considered as directly guide for deciding costs and price of products

However, after a long time of using variable costs, accounting scientists figured out that

some cost such as maintenance, tooling, production control, purchasing, quality control,

storage and handling, plant supervision and engineering are remained the same during the

business period without concerning the volume of work (Shim, J., K., Ph.D.; & Siegel, J.,

G., Ph.D.; 2009) As a result, they are called ‘fixed costs’ Over time, these costs are

more and more important However, until the twenty-first century, its importance is

identified clearly (Stenzel, C., & Stenzel, J., 2002)

There are many types of costing accounting methods such as absorption costing

method, variable costing method, ABC method, throughput costing method, lean costing

methods, etc (Vanderbeck, E., J., 2009) But in this thesis, only the first three methods are

analyzed

By applying different costing accounting method, decisions made by managers

will be diversified As a result, in the last part, SWOTs model will be used to analyze

This means in this part, strength as well as weaknesses, opportunities and threats of each

method will be analyzed in order to evaluate the impacts of each method on the

managerial decisions making process

2.2.1 Absorption costing

It is quite difficult to identify the time that absorption cost is invented This is

because all of related and important documents of cost accounting were lost in a fire at

the headquarters of the National Association of Accountants (NAA) in 1984 (Cunagin,

C., & Stancil, J., L., 1992) However, this method can be consider as an origin of other

latter cost accounting methods such as variable costing and ABC costing And this is also

known as traditional costing method

According to this method, both variable costs and fixed costs are calculated as

inventories’ costs (Horngren, C., T.; Datar, S., M; Foster, G.; Rajan, M.; & Ittner, C.,

2009) In other words, administration expenses such as marketing and research and

development costs also are parts of manufacturing costs Therefore, this method is also

called full costing method A unit of production cost includes direct material; direct labor

and manufacturing overhead costs and only a part of the fixed manufacturing overhead

cost is allocated along with the variable manufacturing overhead cost (Balakkrishnan, R.,

Sivaramakrishnan, K., & Sprinkle, G., 2008) Like the definition of absorption costing

method, a unit product cost can be calculated by added the total variable manufacturing

overhead costs including direct material, direct labor and variable manufacturing

overhead costs with the fixed manufacturing overhead costs (McWatters, C.;

Zimmerman, J., L.; & Morse, D., 2008) This amount will be treated as cost of good sold

on the income statement Similarly, ending inventories will be carried forward to the next

period on the balance sheet For example, to make an ice cream, a company has to pay

$11 which is included $1 of material, $2 per hour of hiring an employee, $3 of variable

manufacturing overhead and $5 of fixed manufacturing overhead costs Generally, fixed

manufacturing overhead costs per unit can be calculated by dividing the annually fixed

manufacturing costs to the number of produced products For instance, in this case, this

company produces 10,000 ice-creams annum with the fixed manufacturing cost is

$50,000 As a result, fixed manufacturing cost will be $5 ($50,000/10,000units)

On the income statement, cost of good sold in this example will be $110,000

(10,000units x $11/unit) Continue with the example above, assume that this company

still remains 1000 ice-cream as ending inventories at the end of the year; $5,000 will be

assigned as ending inventory value on the balance sheet under this costing method By

this way, the higher ending inventory value will lead to lower expenses and higher net

operating income (Drury, C., 2007) If in the next period, these inventories can be sold;

fixed manufacturing overhead costs will be included in the cost of good sold This is

called fixed manufacturing overhead cost released from inventory

In conclusion, this means under absorption costing method, a part fixed

manufacturing overhead costs will be allocated as cost of good sold on the income

statement The remaining will be assigned to unsold goods and carried forward to the

next year on the balance sheet

2.2.2 Variable costing method

Since the fire at the headquarters of the National Association of Accountants

(NAA) in 1984, it is difficult to identify exactly the period that this method is applied

However, most of accounting historians think that this method is the follower of the

absorption costing method Sometimes, this method can be referred as direct costing or

marginal costing method

Unlike absorption costing method, variable costing method focus on costs which

are vary with the quantity of products These include direct material, direct labor, and

variable manufacturing overhead Under this method, fixed manufacturing overhead costs

are not calculated in the production costs (Horngren, C., T.; Datar, S., M; Foster, G.;

Rajan, M.; & Ittner, C., 2009) It will be treated as a part of the period costs or expenses

on the income statement As a result, the fixed manufacturing costs will be excluded in

the cost of good sold

To calculate a unit of product cost, the number of products will be multiply with

the total variable cost including direct material, direct labor and variable manufacturing

overhead which are assigned for each unit of product For example, to make a toy car, it

takes $3 to buy material, $4 per hour to hire an employee and $5 for variable

manufacturing overhead costs The total cost allocated for a toy car will be $12 per car

($3+$4+$5) During a year, this company sells 6,000 cars As a result, the unit product

cost will be $72,000 ($12/car x 6,000cars) This means on the income statement, costs of

good sold will be equal $72,000 In case this company remains 300cars as ending

inventory, the amount of $ 3,600 (300units x $12/car) will be performed on the balance

sheet as the value of the ending inventory

Under this method, the total amount of fixed manufacturing overhead costs will

be treated as an expense of the current period Compare with absorption costing method,

it is easy to see that ending inventory calculated by this method is lower This reflects the

differences between assigning a part of fixed manufacturing costs with total variable

manufacturing overhead costs and allocating only variable manufacturing overhead costs

to ending inventories (Drury, C., 2006) Therefore, the difference in net operating income

reported between these two methods can be explained By higher values of ending

inventory, net income under absorption costing is increased whereas this is opposite with

variable costing method

Variable costing method only calculate the variable manufacturing overhead costs

into production costs, all of fixed manufacturing overhead costs are treated as expenses

on the income statement This leads to a lower income as well as ending inventory’s

value on the balance sheet compare with using absorption costing method

2.2.3 Activity based costing system (ABC)

In three costing methods which are emphasized in this thesis, this is the latest but

the most popular method This is the best tool for refining a cost system Instead of using

broad averages for all costs objects, ABC method allocate costs of sources based on the

need of each cost object such as products, services and jobs (Cooper, R., & Slagmulder,

R., 2005) For example, a simple lens needs 1hour to make while a complex one takes

2hours to make As a result, costs can not be allocated equally between these two items

By this way, ABC costing method provides accountants better measurement of indirect

costs which are used by different cost objects Additionally, it also can be applied in case

that the indirect costs are shared by various kinds of costs objects

A little bit different with two methods above, costs in ABC costing can be divided

into four levels Output unit level costs is the first one which is useful in case to

calculated the cost of activities performed on each individual unit of products or services

Increasing in the number of products or services will lead to enhancing amount of costs

which are allocated to those products or services Unlike output unit level costs, batch

level costs deals with a group of products or services’ activities costs In general, a

company can decide how many items can be included into a batch Then, costs will be

allocated into batch instead of each individual unit like in output level The third level of

costs is product sustaining costs which only focused on supporting costs for individual

product or services This level does not concern the numbers of units as well as numbers

of batch of individual products or services Facility sustaining costs is the last level of

ABC costing method Differs with the other costs, this traces costs which are supporting

costs for the whole even these costs can not be traced in individual products or services

In order to compute cost of products using ABC method, seven steps should be

followed First of all, numbers of products which are produced and chosen as cost objects

should be identified For example, in 2010; Thien Long Company produced 40,000

standard pens and 10,000 special pens Next, all of direct costs such as direct material,

direct labor and manufacturing overhead will be identified by Thien Long Company

Then, depending on ways of allocating indirect costs, related activities and cost allocation

bases will be selected This not only helps the company identify the number of activities

costs pool but also ensure the reliability of data and measure For instance, activities

could be design, machine operations, shipment and distribution After listing all of

activities, indirect costs will be assigned based on each cost allocation base in the fourth

step In some companies, these costs are allocated depend on the analysis of the cause

and effect relationships such as set up hours and set up activity costs The fifth step is

computing the unit rate of each cost allocation base This will be useful when accountants

compute the indirect costs allocated to the product in the sixth step Finally, all of indirect

and direct costs will be added as total costs of the products

In fact, this method is more complicated than absorption costing and variable

costing method It takes more time and money to carry out But, it is more useful for

managers in allocating and using limited resources effectively and efficiency

2.2.4 The importance and impacts of accounting methods on managerial

decision making process

In order to find out the importance of different cost accounting method on the

decision making process of managers, SWOTs and Porter’s model analysis are necessary

By this way, we can evaluate why managers choose to absorption costing method,

variable method and ABC costing methods and how could these methods can help them

improve their performance in the eyes of Board of directors as well as investors

2.2.4.1 SWOTs analysis and why managers should choose a suitable costing method or

importance of these methods

Compare with variable costing method and ABC costing method, absorption

costing method is easier to apply and carry out Without differentiation between variable

and fixed costs, managers will not be confused when prepare both internal and external

reporting and performance evaluation Moreover, this deals with the conflicts of interests

between managers and investors1 In some case, in order to make the performance look

good, managers can take actions with the numbers of inventories which are reported on

the balance sheet to the investors Applying absorption costing method will prevent them

from doing such kind of guilty activities However, the weakest point of this method is

that in case managers want to enhance the operating income of a business over a specific

period of time, they only need to increase the numbers of productions even there is no

customers’ demand for those additional products (Bowhill, B., 2008) As a result, this can

be considered as an opportunity for this method Small especially new companies can use

this method to attract more investments from potential investors without any pressures to

consuming a huge amount of products (Marsh, C., 2009) But, this also can put the

business into a threaten position when the values of inventories are depreciated day by

day if it can not be consumed Additionally, for experienced and expertise investors, they

can be afraid of the future of the business when the ending inventories are increased

Unlike absorption costing method, variable costing method divides fixed costs

and variable manufacturing overhead costs separately As a result, cost for a unit of

products will be lower than calculating by absorption method This will be convenient for

managers when they want to apply the costs volume profit analysis to evaluate the

effectiveness of the business (Eldenburg, L., G.; & Wolcott, S., 2004) Moreover, for

fixed costs which are performed directly in the income statement, managers can see the

effectiveness in using and allocating costs per period and figure out the contingent

changes in the number of these costs Additionally, the operating income that calculated

by variable costing method does not affect by changes in the numbers of inventories This

can be considered as advantages when a company maintains a high amount of high

depreciate inventories And most of changes in variable manufacturing costs can lead to

influences in the cash flows statement However, we can not deny some of disadvantages

that this method can bring to an entity when accountants apply it One of the biggest

problems that this method has to face is generally accepted accounting principles

(GAAP) In most of countries in the World as well as in America, absorption costing

method is required for external reports As a result, if accountants use this method to

report, the financial statements will not be accepted

Generally, ABC costing method is only useful for managers in allocated costs as

well as the profitability of products and potential customers This can be helpful in

showing the wasting or inefficient allocating costs during the productions As a result,

managers can identify the best way in order to improve the values of the products while

reducing the costs (Kaplan, R., S.; & Anderson, S., R., 2007) Moreover, this method also

provides the product unit costs instead of the total costs Therefore, it can help managers

understand and supervise the costs flows easier Additionally, it can be considered as a

mirror of how the business works and facilitates a benchmarking for managers to

compare with other different companies and organizations with each other to get a better

decision However, this method needs lots of capital and time to implement Managers

should be trained before using this method As a result, not many organizations want to

apply and maintain this method so much Moreover, as mentioned above, traditional or

absorption costing method is still preferred in evaluating the performance And this

method is not conformed to the generally accepted accounting principles (GAAP) As a

result, when an entity wants to use this method, they have to establish two cost reporting

systems-internal and external costs reporting system Managers will need more time to

adapt and harmonize these two systems to ensure that they can work well Furthermore,

ABC costing method includes lots of costs which are related to the products, customers

and other cost objects (Hansen, D., R.; Mowen, M., M.; & Guan, L., 2010) Therefore,

when the managers want to make decisions based on this method, they need to know

which costs are relevant costs for their decisions at hand This can be known as

misinterpreting between the data of costs and decision making process of managers

2.2.4.2 Porter’ model with five factors which can affect the managerial decision of

managers in term of cost accounting methods

In the last part of this chapter, the impacts of using different costs accounting

methods on the managerial decision making process of managers will be analyzed by

Porter’s model This model based on five factors which can affect the decisions of

mangers when they decide any problems or issues of their companies

Figure 1: Porter’s model with five factors

Source: http://www.caneval.com/images/pictures/fiveforcesmodel.jpg

There are five factors which can affect the managerial decisions: new entrances,

buyers, suppliers, substitutes and rivalry competitors Most of people think these five

factors can not be relevant to the costing methods However, in the author’s opinion, they

are potentially related to the applying the cost accounting methods

New entrants can be considered as one of threats to an existing entity Almost

managers want to persuade investors that they can get high returns when they invest in

any projects of the business Therefore, they will be more concentrated on maximizing

the potential core businesses and products which can provide high profits as well as

others ratios such as earning per share, current ratios, and etc This means in order to

defeat the existing companies, new comers just need to increase their profit number in the

income statements However, attracting customers from earlier organizations

is not as easy as it seems So, managers of these new-comers tents to use the

absorption costing method to increase the number of the ending inventories as well as the

profit of the organizations as mentioned above This not only can be considered as a

strategy of the new comers to attract the investments from investors in short term periods

but also helps them avoid directly competitions with earlier and bigger organizations

Moreover, in case that other company wants to use other methods such as variable

costing method and ABC costing method, those companies can face troubles with the

policies of the generally accepted accounting principles (GAAP) Consequently, both

managers and organizations can be beneficial from these decisions

However, when the globalization becomes the dominated trend, buyers and

suppliers are combined in various ways As a result, for managers, they will use variable

costing method and ABC costing method as an internal tool to manage the business and

make these become the differences to distinguish with other companies (Simms, J.,

2008) This can change the decisions of the investors If the companies still remains a

large amount of ending inventories but managers can convince the investors that they

have enough facilities as well as controlling ability to maintain the values of the ending

inventories which is one for weaknesses of absorption costing method, investors might be

very happy Consequently, investors may re-evaluate the effectiveness and efficiencies of

the business and invest to that business Similarly, with variable costing method and ABC

costing method, investors can judge the operating ability of managers and the future of

the business Compare with using absorption costing method, variable and ABC method

can provide a better cost comparison among various departments to managers and turn

their decisions in a different way (Cokins, G., 2009)

The same as the appearances of new entrants, the substitutes is another threat

which can damage the existence of a business Generally, some managers think that

lower products price can help the business compete with other competitors easier, so they

will choose the variable costing method to allocate the costs This provides lower costs

which are assigned to each product units As a result, the price for each unit of product

using this method will be lower than using absorption costing method This can be good

for customers but lead to a suspected thinking in the investors’ attitudes They can

underestimate the value-added of the products In the worst case, investors may reject

investment invitations from these organizations This means in the positions of managers,

sometimes lower production costs might be not a good enough chance to attract

investments Therefore, using absorption costing or ABC costing can be more attractive

to investors These can be considered as an assurance for the quality of the products and

development in the future of a business In fact, these two methods helps managers

decide which are the core competences of the business and how could they improve those

strengths

Although absorption costing method is required in the generally accepted

accounting principles (GAAP), using variable cost and ABC costing method as internal

reports can reverse the decisions of the mangers Especially with rivalry competitors in

the same industries, most of managers can understand that absorption costing method can

the best way to maximize profits of the companies without pressure of selling products

They need another way to differentiate their business with other Therefore, besides of

applying only absorption costing method, they can show the internal financial statements

using the variable or ABC costing method By this way, they can show the investors how

they run a business, whether the performance is effectively and efficiency or any wasted

resources are existed

In conclusion, three costing methods above can have impacts on the decisions of

mangers in different ways in specific circumstances In some situations, absorption

costing method can be the best one in maximizing profits whereas it can be the worst one

if the managers can not convince the investors that they have enough abilities and

facilities to manage and maintain the values of those ending inventories Similarly,

variable costs provide a lower cost per unit of products but can make the investors

underestimate the quality of productions and operating process In the position of a

manager, all of decisions should be discussed seriously before making if this method is

applied to ensure that both managers and organization can benefit from those decisions

ABC method is good to show the details as well as the ways of allocating costs of

products but it is difficult for managers to identify the potential relations between these

costs to make a suitable decisions Therefore, when using this method, managers should

be sure that they have ability to make decisions through incremental analysis