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

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 28TH, JUNE, 2010 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 i 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 ii 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 Introduction of topic 1.2 Issues 1.3 Issues expansion CHAPTER 2: LITERATURE REVIEW 2.1 Managerial decision making process 2.1.1 Decisions in nature 2.1.2 What is decision making process? 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 iii 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 iv 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 v 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 vi 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 vii 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, 4.2.3 A profit comparison using absorption, variable and ABC costing method to calculate The main different between absorption and variable costing method is allocating the fixed manufacturing overhead costs (see figure 3) This will be more emphasized in the income statement of Minhnhat Company From the early part, cost per unit of products is calculated and inventoriable cost for the absorption costing method is $ 1.7 per adults’ raincoat and $1.395 per children’s raincoat This includes $0.17 as the fixed manufacturing overhead costs in production process In this statement, fixed manufacturing overhead costs are handled differently between absorption and variable method Under variable costing method, this can be considered as an expense for the production process of the year As a result, it is deducted directly to the contribution margin However, under the absorption costing method, this amount is treated as inventoriable costs in 2008 It means except the beginning inventories from 2008, a part of sold products will be included in the cost of good sold, the remaining will be remained as a part of ending inventories goods in the balance sheet Although the product unit cost under the absorption costing is higher than variable costing, operating income under absorption costing is still higher than variable costing This is because only a part of fixed manufacturing overhead costs are allocated in the cost of good sold using the absorption costing whereas, the whole amount of these costs are calculated as the incurred expenses for the financial year 51 Compare with absorption costing and variable costing, ABC costing method is more complicated Both direct materials and direct labor have to be recalculated into total even the cost per unit is still remained the same Table 13: Direct Materials and Direct Labor costs of Minhnhat Company ($) Direct materials Adults' raincoats 60,000unitsx2.2mx$0.4/m 52800 Children raincoats 40,000unitsx1.5mx$0.4/m 24000 Total 76800 ($) Direct labor Adults' raincoats 60,000unitsx1/3hourx$0.15/hour 3000 Children raincoats 40,000unitsx1/4hourx$0.1/hour 1000 Total 4000 Using this table costs, the income of Minhnhat Company will be computed as follow The income which is calculated under ABC costing method is much higher than the other two methods It is easy to see that cost of direct material and direct labor are remained the same, only manufacturing overhead and selling and administrative expenses of the company are reduced This means except unavoidable costs such as direct labor and direct materials which are affected by other factors like market, demand and supply, other expenses can be used more effectively if the managers know how to allocate them precisely By concentrating more in the activities and allocating costs efficient, not only costs are saved but also profitable divisions are focused With the same limited resources, the managers can produce more income for the company and enhance their performance 52 at the same time This is the reason why ABC costing method is becoming more and more popular in most of countries Table 14: Income statement of Minhnhat Company using ABC costing method ABC costing method Revenues Adults' raincoats 90,000unitsx$10 900,000 Children's raincoats 30,000units*$7 210,000 1,110,000 Direct costs Direct materials Direct labor 76800 4000 Process order overhead 41,438 Machine operation overhead 45278 (167,516) Indirect costs Supporting customers Income (19835) 922,649 In fact, it is quite difficult if we just lean on the theories But when applying them in reality, depending on their own advantages and disadvantages, managers’ decisions will be affected in different ways To understand more about this, the next part will express the impacts of each method in managerial decisions through the experiences that Minhnhat Company just passed away and the current costing system that they are using at this moment 53 4.3 The cost accounting method that Minhnhat Company uses and its impacts on their decision making process In the opinion of Minhnhat company’s managers, Mr Minh would like to use absorption costing method rather than variable costing method One of reason is because this method can increase the profit of the firm and his performance is also improved This is not only help the firm attracts more investments from potential investors but also solve the conflicts of interest between the shareholders and managers in term of judging the performance of the business Another reason for this is that absorption costing method is required in preparing the financial statements to investors Although raincoats are easier to maintain rather than other items, they still can be depreciated a little bit because of the fashion trend Like clothes, each year, old color will be replaced by another color As a result, even with the same appearance, price can be different based on the color In order to avoid the decreasing in profit year to year, Minhnhat Company wants to apply absorption costing method to maintain the profit as well as their position in Vietnamese market and in the investors’ eyes However, to ensure that business is running effectively and efficiency, another internal report system is also created This is co-existed with the external reports system which means absorption costing method In the opinion of Mr Minh, the effectiveness of using costs is not reflected accuracy through the absorption costing method For example, if Minhnhat Company only produces raincoats for adults, this will be easier to calculate, but in case they produce more than one product, it will be difficult for both the accountants and managers compare and evaluate the efficiency level of using the limited 54 resources Moreover, if looking at the income statement, the manager might think that they reduced the expenses during the year without any doubt that whether those costs are saved or not As a result, they also apply ABC costing method to evaluate the performance of the business as a whole since 2007 Before applying the system with two types of financial reports, Mr Minh, manager of Minhnhat Company only focused on increasing the number of ending inventories in order to gain more investments Then, when the color taste of the market changes, inventories of this company depreciated and had to be sold off Luckily, this loss does not affect the financial situation of Minhnhat Company so much Since adding another financial report system, wasting costs is reduced while the quality of products is increased This leads to an improvement in the financial situation of the company and attract more investors as well as customers 55 Figure 3: Income comparison between variable and absorption costing method: Income statements for 2009 of Minhnhat Company 56 CHAPTER 5: CONCLUSION Cost accounting methods is still an arguable problem while its importance can not be denied Although most of data to establish this thesis is secondary data, it can be considered as a link between different points of views It is difficult to figure out the history of cost accounting methods as well as the number of costing methods which are used However, the most popular methods are absorption costing method, variable costing method and ABC costing method Each of them serves the managers’ decisions in different ways First of all, cost accounting methods can affect the managerial decisions of managers Absorption method can be considered as a leader for cost accounting This method is applied popularly It helps to increase the profit of the firms rapidly by producing more goods and maintain them as ending inventories For special items and low depreciation rate such as raincoats and wine, absorption method may be the best choice to improve the performance of the managers However, this method can not broaden the vision of managers about costs allocating As a result, it will lead to wrong decisions in management as Mr Minh, manager of Minhnhat Company did Unlike absorption costing method, variable method focuses on the direct costs which are allocated directly to the cost object As a result, cost per unit of product will be lower than absorption method and it is useful for managers to apply the cost volume profit analysis For example, mangers might know which products can contribute grosser margin to focus on But the income calculated by this method is lower than absorption 57 method; therefore performance of managers might be underestimated The last method is ABC costing method It not only helps the managers allocate cost effectively but also enhance the performance of managers in the long term Compare with the other two methods, this can not be applied for short term strategies The case of Minhnhat Company can express clearly the consequences of managerial decision making process using different methods It is easy to see that the income which is calculated in absorption costing is higher than in variable costing method As a result, it leads to a wrong managerial decision According to Mr Minh, in the past, when they applied the absorption costing method, they only concerned about the quantity of products without observed the reactions from the market as well as the customers Abusing the advantages of this method made the company in troubles Like fashion, color of raincoats is also changed while one of absorption method’s characteristic is carrying a part of production costs as ending inventories in the balance sheet Therefore, old color raincoats would be sold out with lower price and created a loss to the company In order to operate the business well, Minhnhat Company needs a reports system which can attract more investors and allocating the costs effectively at the same time After experiencing this loss, Mr Minh, the manager of this company suggested a new system in order to avoid the wrong decisions as much as possible but still use the advantages of absorption costing method With the approval of the Board of directors, this system is applied from 2007 ABC costing method was chosen to carry on as an internal reporting system This means absorption costing method and ABC costing method will coexist Absorption method will be used as external report because of its 58 higher profit number while variable 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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. .. RESEARCH AND METHODLOGY 3.1 Aims of the project One of questions that the author wondered from the beginning of this thesis is whether any connections between the managerial decision making process and. . .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,