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

Absorption costing is known as a traditional cost accounting, this method makes no distinction between fixed and variable costs; in this method, all manufacturing costs, both variable an

E0700060

BARCHELOR OF BUSINESS (ACCOUNTING) HONS

HELP UNIVERITY COLLEGE

MARCH, 2011

PHAM THI HOAI THANH

March 28, 2011

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ACKNOWLEDGEMENT

First of all, I would like to express my sincere appreciation to my supervisor, Dr Dao Thi Thu Giang who has guided me throughout this thesis Her constant guidance, insightful suggestions, and constructive ideas are the essential inputs and encouragement for me in order to complete this thesis

Next, I would like to acknowledge to manager and all of employees in Ha Tinh Medical Material Company who allowed and assisted me to collect all of necessary information for me to get this thesis done Without their contribution, I could not be able to gather much information for my research

Lastly, I would also like to extend my heartfelt gratitude to my friends for their continuous support, encouragement and contribution, which have been crucial during the presentation of this report

My thesis cannot be finished without your supports

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TABLE OF CONTENT

DECLARATION OF ORGINALITY AND WORD COUNT Error! Bookmark not

defined.

ACKNOWLEDGEMENT Error! Bookmark not defined

TABLE OF CONTENT iii

ABSTRACT vi

LIST OF FIGURES vii

LIST OF TABLES viii

CHAPTER 1: INTRODUCTION 1

1.1 Introduction of topic 1

1.2 Problem statement 3

1.3 Issues expansion 4

1.4 Structure of the research 5

CHAPTER 2: LITERATURE REVIEW 6

2.1 Managerial decision-making process 6

2.1.2 Decision making process 9

2.1.3 Accounting information and its role in decision-making process 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 SWOT model analysis 13

2.2.1 Costing methods ● Absorption costing 13

Figure 1: Absorption costing method 14

● Variable costing method 15

Figure 2: Variable costing method 16

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● Activity based costing system (ABC) 17

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

CHAPTER 3: RESEARCH AND METHODLOGY 26

3.1 Aims of the project 26

3.2 Research methodology 27

3.3 Data sources 28

3.4 Limitation 28

CHAPTER 4: CASE STUDY ANALYSIS 30

4.1 Introduction 30

4.1.1 Process of formation and development of the company 31

4.1.2 Facilities of the company 32

4.1.3 Company’s mission statement 33

4.1.4 Potention on production of the company 33

4.1.5 Potention on marketing of the company 34

4.1.6 Structure of Ha Tinh Medical Materials’ management structure 35

Figure 3: Structure of management team 36

4.1.7 Accounting policy adopted 37

4.2 Difference when using different cost accounting methods 37

4.2.1 Incurred expenses during the period of 2008 – 2009 37

Table 1: Total revenue for Vitamin A of Ha Tinh Medical Materials 38

Table 2: Direct material cost of Ha Tinh Medical Materials 39

Table 3: Direct labor cost of Ha Tinh Medical Material 40

Table 4: Manufacturing overhead cost of Ha Tinh Medical Materials 41

4.2.2 Cost of goods manufactured under absorption costing method and variable costing method 42

Table 5: Cost of Vitamin A using absorption cost and variable cost method 42

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4.2.3 A profit comparison using absorption costing and variable costing method to

calculate 43

Table 6: Cost of good sold for Vitamin A 43

Table 7: Gross profit for Vitamin A 44

Table 8: Variable cost of goods sold for Vitamin A 44

Table 9: Contribution margin for Vitamin A 45

Table 10: Difference between variable costing and absorption costing 45

CHAPTER 5: CONCLUSION AND RECOMMENDATION 47

5.1 Conclusion 47

5.2 Recommendation for calculating product cost of Ha Tinh 48

Medical Materials 48

REFERENCE……… 51

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THE IMPORTANCE AND IMPACTS OFCOSTING METHOD ON THE PROCESS OF MANAGERIAL DECISION MAKING

BY PHAM THI HOAI THANH

vii

LIST OF FIGURES

Figure 1: Absorption costing method

Figure 2: Variable costing method

Figure 3: Structure of management team

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LIST OF TABLES

Table 1: Total revenue for Vitamin A of Ha Tinh Medical Materials Company

Table 2: Direct material cost of Ha Tinh Medical Materials Company

Table 3: Direct labor cost of Ha Tinh Medical Materials Company

Table 4: Manufacturing overhead cost of Ha Tinh Medical Materials Company

Table 5: Cost of Vitamin A using absorption cost and variable cost method

Table 6: Cost of good sold for Vitamin A

Table 7: Gross profit for Vitamin A

Table 8: Variable cost of goods sold for Vitamin A

Table 9: Contribution margin for Vitamin A

Table 10: Difference between variable costing and absorption costing

Cost accounting is the process of accounting for cost, which begins with regarding and classifying costs and ends with the preparing periodical statements and reports for

ascertaining and controlling costs Today, cost accounting may be defined as the process

of measuring, analyzing, computing, and reporting the cost There are different cost

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accounting methods that managers can choose and help them to make better decision in the future These methods are absorption costing, variable costing, activity-based

costing, throughput costing, etc Absorption costing is known as a traditional cost

accounting, this method makes no distinction between fixed and variable costs; in this method, all manufacturing costs, both variable and fixed are treated as product costs with non-manufacturing costs, for example, selling and administrative expenses, being treated as period costs Therefore, it is not well suited for cost volume profit

computation, which is important for good planning and controlling So absorption

costing method might be the best costing method for the small company However, there are some managers and accountant think that using another method might better than using absorption costing One of these reasons might because the activity-based costing

is a modern accounting system, which segregates expenses based on specific activities and then allocated the cost among individual items based on volume of activity, so this method can reduce and allocate costs more efficiently Different managers will not make the same decision with the same information and report so making decisions will depend

on each manager’s philosophy In fact, decision-making process is influenced by many factors but in this thesis, we will put only intention on the importance and impact of cost accounting methods

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1.2 Problem statement

As mentioned above, main ideas of this thesis are related to cost accounting methods, their advantages and disadvantage, as well as their impact on the decision on making process of managers

In management accounting, cost accounting is that part of management accounting which establishes standard and actual cost of operations, processes, departments or product and the analysis of variances, profitability or social use of funds Managers use cost accounting information to make their decision making to reduce a company’s costs and improve its profitability As a form of management accounting, cost accounting need not follow requirement of GAAP, because its primary users are internal managers, rather than external users, and what to compute is instead decided pragmatically

Cost accounting includes many methods but in this thesis, there are three cost

accounting methods that the author wants to focus: absorption costing method, variable costing method, and activity-based costing method The absorption costing method seemed as the earliest of cost accounting After that, variable costing method was

invented Using traditional cost accounting methods is difficult for companies with complex processes and manufacturing practices; therefore later activity-based costing method was created out of the need to overcome these difficulties by dividing

production into its core activities Depending on each case that manager will choose best cost accounting method for their company, however nothing can be perfect, and each method contain both advantages and disadvantages

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SWOT analysis is a strategic method for identifying business’s strengths and

weaknesses, and to examine the opportunities and threats in the wider environment of a project or a business venture (market, industry, global situation) Using SWOT model, all of the advantages and disadvantages of each cost accounting method will be judged fairly This method often uses in management aspect, the managers applied SWOT model to evaluate the effectiveness and efficiency of the companies, cost budget, and operation process Analyzing cost accounting methods follow SWOT model, managers will be easier to see the importance and impact of them on the decisions making process

accounting method on decision-making process of managers

The chapter 4 will introduce about Ha Tinh Medical Materials Company, and then from the collected cost information of this company, absorption costing method and variable costing method will be applied

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1.4 Structure of the research

In this thesis, there are five chapters as follow:

 Chapter 1: Introduction

 Chapter 2: Literature review

 Chapter 3: Research and methodology

 Chapter 4: Case study analysis

 Chapter 5: Conclusion

In this thesis, five chapters will be linked each other in order to express the ideas that the author would like to share Chapter 1 and chapter 3 will consider as a background to crease the general ideas of this thesis Chapter 2 will focus on the theory of cost

accounting method and chapter 4 is a real case, playing a supplementary role for chapter

2 And last but not least, chapter 5 will conclude the findings after analyzing a real case compared to the theory, and some recommendations for the company

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CHAPTER 2: LITERATURE REVIEW

Chapter 2 will provide information about managerial decision-making process, and introduce about the history, calculation and contents of absorption costing, variable costing, and activity-based costing method Understanding managerial decision-making process and cost accounting methods can help the managers know what kind of

information and how much of information they need to make efficient decisions After that, SWOT model will be applied to evaluate advantages and disadvantages of each cost accounting method

2.1 Managerial decision-making process

People make many decisions every day Decisions can be made in different ways

depending on different purposes of various groups of people Therefore,

decision-making is a reasoning or emotional process which can be rational or irrational, can be based on explicit assumptions or tacit assumptions However, managerial decision making process can be only understood through four parts They are:

 Decision in nature

 Step in decision-making

 Role of accounting information in decision-making

Decision process could be associated from internal and external information and people need to choose the best alternative for a good result

Making decision is very important and everyone make many decisions everyday For example, we decide what to buy for our family when going to supermarket; we decide what kinds of sports for good health In another case we make another difficult decision

to go such as we are surrounded by the fire: to jump through the windows and risk to killing yourself or to wait the firemen and risk being burned to death if they come too late? What should we do? This is an important decision for us at the moment More important than these cases, we have to decide what kinds of job in the future to earn a lot

of money

Our business or the affairs in our life is experiencing development and growth, we are often faced with difficult decisions We need to choose among many decisions; it is not possible for us to do everything that we would like to do because time and resources are always limited In fact, our actions will have long reaching consequences, and will affect the lives of others Sometimes the pressure of having to act forces us to make a decision that we may regret later Sometimes this pressure causes us to waver and miss an

opportunity For example: the representative of the UN and the general who commanded

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the UN forces had been unable to make up their mind about the need for an air force support and 7000 people were badly slaughtered

There may be different styles associated with the way in which people make decisions,

or certainly that we seek different information with which to make us decisions In general, we ourselves, parents, children, sisters, friends, and bosses could affect our decision, besides that following the research of a variety of aspects of decision making, the decisions depend on sex, politics, consumers, economy, etc Women tend to take decisions based on emotive factors, they tend to consider the opinions of others and weigh them up in relation to their own understanding of a decision and its causes and effects However, men tend to learn towards an instant solution and can be wary of clouding issues by opening them up to too much discussion Men tend to look at the rights of the individuals involved and make what they intend to be fair and just

decisions

In business, decision-making is an important of business success Decisions are based on

a foundation of knowledge and sound reasoning can lead the company into long term prosperity, conversely, decisions that are made on the basic of flawed logic,

emotionalism, or incomplete information can quickly put a business out of commission Sometimes the managers could not know every thing of various aspects, therefore when

it works, collective intelligence does come up with better solutions than could

individuals

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2.1.2 Decision making process

Decision-making is usually defined as the act of making up your mind about something However, the process of decision-making is not as easy as it sounds There are certain important decisions that you have to make that have the ability to change the course of your life Thus, it is important to take decisions in a systematic way, so that the decision you make has high chances of being successful (Proctor, R., 2009)

According to Hoggett, Edward, & Merlin, 2006, decision-making consists of four main steps, such as, establishing goals, gathering available information on alternatives,

determining consequences of alternatives and choosing a course of action

The first step and arguably the most important step in the decision-making are

establishing goals (or what are we trying to achieve?) It is a primary importance that we should first determine or specify our task; we must identify each situation in which a decision is needed and determine the goals we wish to achieve Depending on then values, motives, desires, and different situation help us have different decisions

Once a decision maker has established the goal, it is necessary to gather available

information on alternatives In this step, we determine what information we need as information can help change our attitudes, beliefs or expectations Gathering information before making a decision helps managers get a better handle on the uncertainties

We can gather some kind of information that we are prepared to making a choice There are: what is relevant and what is not relevant to the decision? What do you need to know before you can make a decision or that will help you make the right one? Who knows, who can help, who has the power and influence to make this happen (or to stop it)?

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After gathering available information to help us determine the alternative available, then the third step is determining consequences of alternatives This step is the stage when we have to assess each alternative we have come up with We have to find out the

advantages and disadvantages of the information At this stage, we can also select out the information’s that is thought unfeasible or not serve our goal

The final step deals with choosing a course of action Once we have gone through the previous 3 steps, after taking the alternatives available and the consequences of those alternatives into consideration, we must choose a course of action and start to make the goals that we wish to achieve realistic

2.1.3 Accounting information and its role in decision-making

process

The need for a decision arises in our life and business because we are faced with a problem and alternative courses of action are available, and we need more information when making a decision Therefore the information plays an important role in deciding which option to make decision process In business, accounting information is needed before a decision is made

Accounting is concerned mainly with identifying transactions and recording the

financial history of the transactions of an entity; therefore a major focus on accounting information is on actual financial events, not on future events (Hogget, Edward, & Merlin, 2006) Although accounting information is not future events, this information is

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used often as a guide to future estimates of the different alternative consequences The managers of the business will want to know what things are being done so they need this information in order to make plans for the future; they then need more updated

information in order to check whether actual performance is on target

Accounting information is also very useful in providing decision makers with

information about the outcomes or results of their decision (Hoggett, Edward, & Merlin, 2006) Accounting information could be used by internal and external decision maker, such as managers, investors, creditors, customers, etc before it can be regarded as useful

in satisfying the need of various user groups, accounting information should satisfy the following criteria: understandability, relevance, consistency, comparability, reliability, objectivity

Firstly, accounting information is understandability, which means the expression, with clarity of accounting information in such a way that it will be understandable to users – who are generally assumed to have a reasonable knowledge of business and economic activities

Secondly, it is relevance that means accounting information must help a user to form, confirm or maybe revise a view in the context of making a decision For example:

following accounting information of the business, we can understand their financial condition, and can make decisions like: investing or not, lending money or not?

Next, other criteria of accounting information is reliability which means the accounting information in reports is truthful, accurate, complete, and capable of being verified All

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of accounting information will be updated and filed day by day It is necessary

information for a potential investor

Finally, accounting information is prepared and reported in a standard way In other words, it is not biased towards a particular user group or vested interest

2.1.4 Managers and management accounting

In business, managers (as internal decision makers) require special-purpose financial reports to help in planning and controlling the operations of an entity (Hogget, Edward,

& Merlin, 2006) Following Hoggett, Edward, and Merlin in 2006, the manager need answers to some questions as:

 How much profit is being earned?

 What product should be produced?

 What resources are available?

 What is the most efficient production process?

 What will be the effect of increasing or decreasing selling price?

 How much is owing to outsiders?

 Will cash be available to pay debts as they fail due?

 What are the comparative effects of owning or leasing facilities?

In order to answer theses and many other questions, managers must base on a lot of information systems processed by different sciences; one of them is management

account

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Management accounting (also referred to as managerial accounting) is a specialized set of accounting concerned with focusing on internal needs of businesses, they provide financial and other information to all levels of management (as managers, chief

sub-executive officers, general managers, and account managers) in an organization to assist them to carry out their planning, controlling, decision making responsibilities

Management accounting has a function to prepare special purpose reports for internal users, which are financial budgets, sale forecasts, performance reports, cost of

production reports and incremental analysis reports

The activities of management accounting are cost behavior and cost volume profit relationship, decision making through incremental analysis, capital budgeting, budgeting for financial planning and control, flexible budgeting for performance evaluation, the determination of manufacturing costs and costing systems, and accounting and reporting for business segment operations

2.2 The importance and impacts of costs accounting methods

on decision-making process of the managers using SWOT

Therefore, absorption costing is also referred to as full costing In other words,

absorption costing is the cost of a finished unit in inventory, which will include direct materials, direct labor, and both variable and fixed manufacturing overhead in cost of good manufactured

Figure 1: Absorption costing method

incurred

Work in process inventory

on Balance

Sheet

When goods are 

finished

Finished Goods Inventory

on Balance

sheet

When goods are  sold

Cost Of Goods Sold

For example, Company A produces and sales shoes, to make shoes, during 2009, this company produced 200,000 units and 199,500 units were traded Manufacturing costs for 2009 was as follows: the direct material cost was $100 per unit, the direct labor cost was $100 per unit, variable manufacturing overhead cost was $100 per unit, and fixed manufacturing overhead cost of $80 per unit In this example, variable manufacturing cost per unit produced can calculate by direct material plus direct labor plus variable manufacturing overhead $300 ($100 + $100 + $100) Therefore, total inventory cost per unit produced was variable manufacturing overhead cost per unit produced plus fixed

As a consequence, using absorption costing method, the amount of cost would be treated

as cost of good sold on the Income Statement, ending inventories will be carried forward

to the next period on the balance sheet, and this costing method is used for external reporting

 Variable costing method

As absorption costing method, variable costing method is a method of inventory costing

in which all-variable manufacturing costs (such as direct material cost, direct labor cost, variable manufacturing overhead cost) are included as inventory cost However, in Variable costing method all fixed manufacturing costs are excluded from inventory costs

incurred

Work in process inventory

on Balance

Sheet

When goods are 

finished

Finished Goods Inventory

on Balance

sheet

When goods are  sold

Expense

on Income Statement

500 shoes as ending inventory, and the amount of $150,000 ($300 per unit x 500 units) will be reported on the Balance Sheet as the value of the ending inventory

Under variable costing method, all of fixed manufacturing overhead costs are treated as

an expense of the period so ending inventory under this method lower than ending inventory under absorption costing method Therefore, net operating income reported by

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Variable costing method is lower than reported by absorption costing method

Continuing with example above, operating income is $40,000 (500 units x $80) higher under absorption costing method compared with variable costing method

Difference from absorption costing method, variable costing method is used for internal management only There are: inventory valuation and income determination, relevant cost analysis, break even and cost volume profit analyses, and short term decision-

 Activity based costing system (ABC)

Around 1870 – 1920, those days industry was labor intensive, there was little bit of automation, the product variety was small and the overhead costs in companies were generally very low, so traditional costing method was relevant to use However, in the 1980s from the increasing lack of relevance of traditional costing method, many

companies have found that this system tends to assign costs to products based on an arbitrarily developed average rather than the actual resource usage therefore Activity-Based Costing (ABC) arose

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In this thesis, of all three costing methods analyzed; this method is the latest but the most popular method today Activity-based costing is a commonly used approach to improve

a traditional costing method

ABC refines a costing system by identifying individual activities as the fundamental cost objects, note that an activity is an event, task, or unit of work with a specified purpose - for example, designing products, setting up machines, operating machines, and

distributing products (Charles T.Horngren, Srikant M.Datar, George Foster, Madhav Rajan, Christopher Ittner, 2009) Today, an increasing number of companies around the world are using ABC system due to these implementation cost ABC systems first

calculate the costs of individual activities and then assign costs to costs objects such as products and services on the basis of the mix of activities needed to produce each

product or service (Charles T.Horngren, Srikant M.Datar, George Foster, Madhav Rajan, Christopher Ittner, 2009)

According to Cooper, R., & Slagmulder, R in 2005, there are four steps that are used to determine the cost of goods and service under ABC method The following briefly summarizes those four steps Firstly, identifying and classifying the activities related to the company’s products is step one The activities related to the company’s products included activities in all areas of the value chain (such as product design, production, marketing, distribution, etc.) As activities are identified, they are classified a cost

hierarchy as output unit level costs, batch level costs, product-sustaining costs, and facility-sustaining costs Output unit level costs are the costs of activities performed on each individual unit of a product or service Overtime, additional units of output

produced will lead increase the cost of activities of running the automated molding

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machines, so machine operations costs (such as the cost of energy, machine

depreciation, and repair) are output unit level Batch level costs are the costs of activities related to a group of units of products or services rather than to each individual unit of product and service, and setup costs are batch level costs Product sustaining costs are the costs of activities undertaken to support individual products or services regardless of the number of unit or batches in which the units are produced Facility sustaining costs are the costs of activities that cannot be traced to individual products and services but that support the organization as a whole The general administration costs (including top management compensation, rent, and building security) are facility-sustaining costs The second step is estimating the cost of activities that identified in step one Estimate the costs of specific activities that cause costs, which are for both human resources (such as employee labor for production and machine maintenance), and physical resources (such

as the cost of machinery and building occupancy) Then calculate the total cost of each activity Next, calculate a cost driver rate for each activity The activity cost data from step two is used to calculate a cost driver rate that the company can use for assigning activity costs to goods and services And the final step is assigning activity costs to products The cost driver rates prepared in step three are used to assign activity costs to goods and services

In fact, ABC has been called one of the most important management innovations the last hundred (Emblemsvag, 2000) In comparation with Traditional costing method, it is really the difference between them; there are three major differences Firstly, under traditional costing method it is assumed that cost objects consume resources whereas under ABC method it is assumed that cost objects consume activities Secondly, ABC

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uses cost drivers at various levels while traditional costing mostly utilizes volume

related allocation bases And finally, traditional costing is structure oriented whereas ABC is process oriented

For example, company A produces two products, product X is a low volume item, which requires certain activities such as special engineering, additional testing, many machine setups, and it is ordered in small quantities Another product is product Y, this product is

a high volume product, and it runs continuously, requires little attention and no special activities In this example, if company A used traditional costing, it might allocate all of overhead to products based on the number of machine hours Although product X did demand lost of engineering, testing, and setup activities but product X did not have many machine hours so it will have little overhead cost allocated In contrast, product Y will be allocated an enormous amount of overhead but it demanded little overhead activity Under traditional costing methods, the result will be a miscalculation of

manufacturing overhead cost of each product Beside that, ABC method will overcome this shortcoming by assigning overhead on more than the one activity, running the machine Under ABC method, product X will be assigned some of the costs of special engineering, special testing, and machine setup Product Y will not be assigned any cost

of special engineering or special testing, and it will be assigned only a small amount of machine setup

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2.2.2 The importance and impacts of accounting methods on

managerial decision making process

Using different cost accounting methods might leads the managers make difference decision in their business Because, basing the same accounting information but the different method might provide different result In some case, this method can give the profit but in another it might give loss, so the manager must work careful to find out the best accounting method for their business On the other hand, SWOT analysis is useful technique for summarizing the external environmental factors SWOT stand for

strengths, weaknesses, opportunities and threats The framework was described in 1969

by Edmund P Learned, C Roland Christiansen, Kenneth Andrews, and William D Guth in “Business Policy, Text and cases” The external analysis identifies opportunities and threats whereas the internal analysis defines the firm’s strengths and weaknesses By understanding that information a firm can better leverage its strengths, correct it

weakness, capitalize on opportunities, and deter potentially threats Thus, SWOT

analysis would help managers in find out the right strengths and weaknesses of each method, besides gets the right opportunities and threats for their business when they choosing apply any method

When a company using absorption costing method sells inventory, both the fixed and variable costs associated with production of that inventory are deducted on the income statement as cost of good sold The unsold units still carrying all fixed and variable overhead and production costs remain on, or are capitalized, on the balance sheet as inventory (Garrison, Noreen, & Brewer, 2008) In fact that long term decisions require