Importance Of Accurate Costing For Business Management

Traditional Costing System

There are various methods that are under process by the accountants and the book keepers to make a proper management of the financial aspects of the business. One such method is known as the traditional costing system. It is an accounting method under which the profits are predicted by taking into account the cause and effect relationship of the direct as well as the indirect costs of the business (Mahal and Hossain, 2015).

Costing is generally termed as an activity of breaking the costs into the individual units and the individual report is prepared in detail to identify each cost carefully. The basic ideology behind the analysis of the costs is there overall impact on the net profit of the company and taking immediate and the necessary steps to improve the position. The two major methods used are the traditional method, activity based costing method one more new method that have been introduced is the proration method for the purpose of allocation of the overhead cost. The analysis of the costing is necessary as helps in the decision making and ease down the complex transactions into the simpler ones. It’s necessary of the business to recognise the potential costs and the benefits associated with them and if the business fails it results into the sub optimal decisions ultimately. Also performing the cost analysis helps in giving an opportunity to the management to dive into the specifics of the particular funds required to spend on the product. The act of defining and the identification of the costs is a technical one and it reduces time and energy of the employees (Bennett and James, 2017).

Traditional costing is the method where the cost of the overhead is calculated by loading the percentage of the total overhead costs to the particular and the significant component. The percentage so arrived is generally the percentage of the machine hours as compared to the overall percentages and therefore the machine hours are treated as the base for the purpose of the calculation of the factory overhead (Xu, Frankwick and Ramirez, 2016).

The first table represent the calculation of the cost per unit of the Sewing Easy under the traditional method. For the purpose of the calculation of the overhead costs the machine hours are made as the base and thereafter the figure of the overhead calculation is arrived at 60 and 80 respectively for the basic as well as the advanced model (Cooper, 2017).  

Calculation of cost per unit under activity-based costing method

Further the second table displays the cost per unit taking into consideration the cost of the direct labour materials per unit and the labour per unit (Patiar, 2016).

Calculation of cost per unit under activity based costing  method
Particulars	Basic Model	Advanced Model
Direct Material cost per unit	350	580
Direct Labor cost per unit	175	280
Overhead costs per unit	52	120
Other operating Expenses		383500
Operating Expenses per unit		240
Total cost per unit a	577	1220

The ABC system is the system of the accounting that is based on the activities which can be bifurcated into the events, task, the small goals or setting up of the machines and the products used for the designing of the finished goods. This system of costing is used to target the product line, the earnings off the company, the service pricing. This system helps the organisation to shift their focus mainly on the pricing and the strategy required to maintain the costs which are grasped in the better manner (Patiar, 2016).

Under the ABC system an activity is also considered as the transaction cost or the key element or the cost driver which acts as the allocation base. There are certain example of the cost drivers such as the quality inspections, the orders in number for the purpose of the production, the maintenance requests, the machine set ups and the power consumed by the company to produce the goods and the services (Pitel and Alioshkina, 2016).

Under the activity based costing model the selling expenses, the office rent and the interest expense are also included. Also for the purpose of calculating the overhead rate the company assigned the costs on the individual basis or rather say on the basis of their respective key drivers and the elements. For example the inspection overhead is calculated on the basis of the inspection rate. Similarly the same formula is applied for the Assembly, Production scheduling and machine set up (Tsai, 2016).

Under the activity based costing the total overhead rate that has been calculated is $52 for the basic model and $120 for the advanced model. The observations also state that the company is earning profit while using the activity based costing method more.

Traditional Costing System
Sewing Easy
Income Statement
For the year ending 31st March 2017
Particulars	Advanced Model
				Amount
Sales				1944166
Cost of goods sold
	Direct materials		928000
	Direct labors		448000
	overheads		503012
Total Expenses			1879012
Gross Profit			65154
Net Income			65154

Activity Based Costing System
Sewing Easy
Income Statement
For the year ending 31st March 2017
Particulars	Advanced Model
				Amount
Sales				1944166
Cost of goods sold
	Direct materials		928000
	Direct labors		448000
	overheads		575801
Gross profit			1951801
Total				-7636
Net Income			-7636

After analysing the calculations and the situations the main ideology behind accepting the advanced model is that under the traditional product costing the cumulative costs are taken into consideration and thus it reduces the price of the advance model in the traditional based costing system. Further under the activity based costing system the overall loss is also suffered by the company and hence the overseas buyer accepted the idea of the advanced model because of the low price. Whereas in reality the correct method of calculating is the activity based costing method that gives the transparent idea of the individual costs (Plank, 2018).

Importance of accurate product costing

For any company the authenticity and the accuracy of the financial statements is the most important factor not only from the point of view of the managers but also from the point of view of the investors and the shareholders. The accurate product costing helps the investors to take the important decisions in deciding whether the funds invested by the investor are in correct direction or not. The accurate product costing helps in determining the impact of the budget where the costs are budgeted for the future on the basis of the current costs. Furthermore, the income statement is also dependent upon the cost of goods sold and the selling price of the product as well (Schram, et al 2015). This gives the true and fair view of the costs to ascertain the original position to the investors investing in the company. The assets and the inventory are also affected by the implications of the accurate product costing and moreover if the product costs are not calculated correctly the value of the inventory will be inaccurate. This will distort the calculation and the picture will not be transparent henceforth, these are the several reasons that determine the importance of the accurate product costing. The accurate product costing will not only help in enhancing the financial position of the business but also helps in having the competitive advantage over the competitors (Stark,  2015).

The accounting includes the wide range of the terms and two such terms are the actual overhead and the applied overhead. The actual overhead of any company can be termed as the factory costs of the indirect nature that have been incurred or spent for in reality. This includes all the overhead costs except the direct material and the cost of the labour. Few examples of the costs that are under the category of the actual overheads are Equipment maintenance, factory insurance, factory utilities, production supplies, factory rent, factory property taxes. There may a slight difference between the actual overheads and the applied overheads which is based on the standard rate of the overhead (Vaxevanidis and Petropoulos, 2018).

Applied overhead is the overhead under the method of the costing. Applied overhead can be termed as the fixed charge assigned to a production job or department within a company. In contrast to the general overheads the applied overheads have the equal importance. The applied overhead can be displayed by the best example of the depreciation and insurance (Accounting Coach 2018).

Actual overhead and applied overhead

From the point of view of the management the applied overheads is considered as the standard part of the financial planning and the analysis method. In order to serve and facilitate the better capital budgeting decisions the review of the applied overheads is necessary and crucial for the management. For the purpose of the calculation most of the industries make use of the standard rate rather than bifurcation of the same (Popesko, Papadaki and Novák, 2015).

Further the actual overhead and the applied overhead is different from each other at the end of the day because since the future overheads along with the machine hours cannot be judged with the certainty and in relation to this the actual hours of the machine will not occur in the uniform manner therefore there will always be the difference between the actual as well as the applied overhead.

In  addition to this if the overheads that are assigned more than the actual amount than the overheads are termed as the applied overhead otherwise the case is the reversal case. As and when the cost of goods is calculated the amount it is in excessive nature it can be termed as the under applied overhead.

There are few methods to deal with the situations where there are under and the over applied issues.

• The first method allows the transfer of the amount to the next financial year.
• The second method the journal entry is passed and the amount is transferred to the profit and loss account.
• A supplementary rate is considered against the standard rate.

			300000	210000
	Account balance				Account balance
	before Proration				After Proration
Work in progress	60500	3%	9073	6351	75924
Finished Goals	90000	4%	13497	9448	112944
cost of goods sold	1850000	92%	277431	194201	2321632
Total	2000500		300000	210000	2510500

Proration method of the costing is the method of costing where the overheads are based on the actual overheads of the firm. With the use of this method the sum of all amounts is charged to the project of the overhead (Detek, 2018). The prorated overhead percentage rate is calculated on the basis of the total amount of the work in progress, cost of goods sold and the finished goods sold. Rest the amount is bifurcated on the basis of the allocated and the applied overhead (Manunen, 2013).

References

Accounting Coach (2018) What is the difference between actual overhead and applied overhead? [online] https://www.accountingcoach.com/blog/dfifference-actual-overhead-applied-overhead [Accessed on 15th January 2018].

Bennett, M. and James, P., 2017. The Green bottom line: environmental accounting for management: current practice and future trends. Routledge.

Cooper, R., 2017. Target costing and value engineering. New York: Routledge.

Detek, (2018) Proration Method of Overhead Allocation [online] Available from https://help.deltek.com/Product/Vision/7.6/oa_proration_method_of_overhead_allocation.html [Accessed on 18th January 2019]

Mahal, I. and Hossain, A., 2015. Activity-Based Costing (ABC)–An Effective Tool for Better Management. Research Journal of Finance and Accounting, 6(4), pp.66-74.

Manunen, O. (2013) An activity-based costing model for logistics operations of manufacturers and wholesalers, International Journal of Logistics, 3(1), 53-65.

Patiar, A., (2016) Costs allocation practices: Evidence of hotels in Australia, Journal of Hospitality and Tourism Management, 26(1), pp.1-8.

Pitel, N.Y. and Alioshkina, L.P., (2016) ABC analysis as a tool of optimization of marketing management of export-led enterprises, New York: Springer.

Plank, P., 2018. Introduction. In Price and Product-Mix Decisions Under Different Cost Systems (pp. 1-5). Springer Gabler, Wiesbaden.

Popesko, B., Papadaki, Š. and Novák, P., 2015. Cost and reimbursement analysis of selected hospital diagnoses via activity-based costing. E+ M Ekonomie a Management.

Schram, D.J., Kohn, C.F., Ashare, S., Maldonado, J., Rieske, D.W. and Rasavong, L., SC Johnson and Son Inc, 2015. Accurate Product Placement. U.S. Patent Application 14/104,896.

Schram, D.J., Kohn, C.F., Ashare, S., Maldonado, J., Rieske, D.W. and Rasavong, L., SC Johnson and Son Inc, 2015. Accurate Product Placement. U.S. Patent Application 14/104,896.

Stark, J., 2015. Product lifecycle management. In Product Lifecycle Management (Volume 1) (pp. 1-29). Springer, Cham.

Tsai, W.H., (2016) Activity-based costing model for joint products, Computers & Industrial Engineering, 31(3), pp.725-729.

Vaxevanidis, N. M., and Petropoulos, G. (2018) A literature survey of cost of quality models, Journal of engineering, 6(3), pp. 274-283.

Xu, Z., Frankwick, G.L. and Ramirez, E., 2016. Effects of big data analytics and traditional marketing analytics on new product success: A knowledge fusion perspective. Journal of Business Research, 69(5), pp.1562-1566.