Packwell Limited: Analysis of Costing System

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Executive Summary

The objective of having an efficient costing system is to arrive at the cost and profitability of the individual unit of product or service manufactured. The system also enables the managers to have a close monitoring of the performance of the divisions by comparing the actual results with the budgeted costing figures. This will facilitate the executives to take the necessary corrective action wherever required or to change the policies of the company if it is essential. An efficient costing system thus assists the management in their functions of planning, coordinating, and controlling the activities of the individuals and the overall performance of the firm. This paper presents an analytical review of various aspects of the costing system of Packwell Limited.

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Introduction

The present day business environment is so complex and competitive that increased use of automated production processes and advanced technological equipments are the order of the day. With every new development in the technology, the obsolescence of the products and processes has increased which has resulted in the shortening of the life cycle of the products. Just as it happens in the communication industry, any product is used only for a few years until the time it is replaced by new and updated products made out of innovative technological developments. The management of the firms has to take into account the rapid technological changes the market undergoes to remain competitive. This necessitates the managers to have a thorough understanding and appreciation of the costs involved in different phases of the production cycle of a product in order to maximize the earnings of the firm. Thus, stiff competition in the international markets, adoption of innovative technological changes and improved production systems have necessitated radical changes in the management accounting systems being followed by different manufacturing companies to remain globally competitive. Application of an efficient management accounting coupled with regular financial accounting will enhance the overall performance of the organization. This paper analyzes the contribution of management accounting including different aspects of an effective costing system in general. In addition, this paper also presents a report on the different components as they are applied to Packwell Limited.

Importance of Financial Accounting and Management Accounting

Financial accounting helps the business organizations to make sound financial decisions concerning the conduct of their businesses. Accounting covers the maintenance of books of accounts for recording the financial transactions of any business and the preparation of financial statements for any specific period from such recorded transactions. Thus, the important purpose of financial accounting is to prepare financial statements based on books of accounts maintained which will contain detailed information about the financial performance of the organization. Investors, creditors, banks, and tax authorities often refer to the financial accounting statements of the companies to make their decisions for various purposes. Management Accounting measures and reports financial and non-financial information that helps managers make decisions to fulfill the goals of an organization. Management accounting focuses on internal reporting. It differs from the financial accounting which measures and records business transactions and provides financial statements for the information of investors, government regulators and other external parties (Horngren et al 2002). One exclusive advantage with the management accounting is that it encompasses performance measurement. Performance measurement encompasses the establishment of budgets, which take into account the financial goals of the business. Alignment of the organizational goals, with the goals of the individual members of the organization becomes the primary responsibility of the management accountant.

Different Types of Costs

A cost represents the resource foregone by a firm to achieve a particular business or other objective. Cost is the monetary value to be paid for acquiring specific goods and services. Cost accumulation and cost assignment are the two stages that are identified with a typical costing system. While cost accumulation is the process of collecting cost data using some organized system of accounting, cost assignment is the process of tracing the accumulated costs to a specific cost object and allocating the accumulated costs to a specific cost object. In order to assess the profitability of a product or a particular customer cost may be assigned to the respective product or customer. Based on the relationship of the cost to a particular cost object, the costs may be differentiated between direct and indirect costs.

The costs related to a particular cost object are ‘direct costs’ which can be traced to the particular cost object. For example, the costs of the can or bottles in which a soft drink is packed can be described as direct costs. The main feature of direct costs is that it should be possible to trace such costs to a specific cost object in a cost-effective way. Indirect costs on the other hand are those costs, which are related to a specific cost object; but such costs cannot be traced back to the specific cost objects in a cost-effective way. For example, the cost of quality control of any product being manufactured will be an indirect cost as it will be difficult to trace the cost to specific product(s).

Costs associated with the products or services can be classified into variable and fixed costs based on cost-behavior patterns. Cost, which changes in total in proportion to the total level of activity or volume is described as variable cost. For example, the cost of steering wheel purchased for manufacturing automobiles is an item of variable cost, as the number of steering wheels to be bought varies in direct proportion to the number of automobiles manufactured. On the other hand, fixed cost is one, which remains unaltered over a specific period, irrespective of any change in the related level of activity. Costs are classified as fixed and variable based on their relation to specific cost object and in relation to a given period. For example, the leasing and insurance costs in respect of the manufacturing plant of an automobile manufacturer will be classified as fixed cost as these costs remain unchanged over a period.

Average Cost (AVCO) Method of Stock Record Maintenance

The stock record of Packwell Limited for the month of June 2009 is presented below.

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Stock Record Card for June 2009
Receipts Issues Balance
Date Qty
Kg
Cost
per kg £
Total Cost £ Qty
kg
Cost
per kg £
Total
cost £
Qty
kg
Total £
Balance 1 June 6,000 12,000
10 June 12,000 2.60 31,200 18,000 43,200
16 June 8,000 2.40 19,200 10,000 24,000
20 June 1000 3.50 3,500 11,000 27,500
29 June 6,000 2.50 15,000 5,000 12,500

Under this method of stock valuation, the issues of raw materials to production are valued at an average figure. As compared to the ‘First in First Out” (FIFO) method, and ‘Last in First Out’ (LIFO) method, the average stock method values the stock as at the end of the accounting period at average cost for inclusion of inventory figure in the balance sheet. Under this method the issues of materials valued at average cost represents the cost of sales chargeable to the profit and loss account.

The average cost is calculated by adding the different prices at which the materials are purchased during the period and dividing the total value by the number of units purchased. Despite showing the average value of the year-end stock, this method of costing has a shortcoming in that it obscures the fact that the quantities purchased in each batch may not be the same. Therefore, to avoid this problem, the company uses a weighted average cost. Even the weighted average costing has a disadvantage in that an average needs to be calculated every time there is a fresh delivery. Another issue is that the average calculated based on the weights may not represent the actual price paid for the purchase of materials (Pizzey, 1989, p 47). For example, the issue of 6000 Kg on June 29 is issued at a price of £ 2.50 per Kg, whereas the previous purchase is £ 3.50 per Kg.

Direct and Indirect Labor Cost

It is advisable to have the direct labor hours and costs distinguished by jobs or processes at each stage of production processes. This distinction is to be made from the time the labor is employed in the first department or process until the process is completed and the material transferred to the other department. It is the normal practice to account for indirect labor costs such as costs incurred on supervisors, clerical and other administrative staff in terms of hours or days of work. The cost of maintenance labor is assigned to the production departments to which the supporting staff provides the service, based on an acceptable percentage basis. “Factory workers who divide their time between direct and indirect labor time have their hours of indirect labor shown on their daily time tickets”. (Blocker, 2007, p 166) The direct and indirect labor of Packwell Limited is shown in the following table.

Calculation of Direct and Indirect Labor Costs
Basis Hours
worked
Normal
Rate/Hour £
Overtime
Rate/Hour £
Normal
Wages £
Overtime
Wages £
Total
Wages £
Normal Hours 350 8.00 2,800.00 2,800.00
Overtime at One and a half time wages 60 8.00 4.00 480.00 240.00 720.00
Overtime at double time wages 40 8.00 8.00 320.00 320.00 640.00
Total 450 3,600.00 560.00 4,160.00

From the table it can be observed that the total labor cost for producing 18,000 type ‘X’ pharmaceutical bottles during June 2009 is £ 4,160 of which £ 3,600 is to be charged as direct labor and the total overtime wages of £ 560 is to be charged as indirect labor as per the policy of the company.

Allocation of Overhead Costs

“In cost accounting, production overhead costs are allocated within a period through the use of allocation bases or cost drivers to products or services.” (Kinney & Raiborn, 2008) Overhead costs represent those expenses, which cannot be conveniently associated with any specific product or activity. In contrast to the materials and labor, overheads are invisible costs related to a finished product. However overhead is an important input in the production process like material cost or labor costs. The controlling of overhead costs is a difficult task for the managers and an efficient controlling of these costs requires constant attention of the managers. It is also important to understand the basis of apportioning the overhead costs for implementing any change in the production process.

Apportionment of Overhead Expenses
Fixed Overhead Basic of allocation or apportionment Total cost
£
Plastics Molding
£
Plastics Extrusion
£
Maintenance
£
Insurance of machinery Net book value of fixed assets 24,400 14,640 7,319 2,441
Rent and rates Square Meters Occupied 58,800 32,340 23,520 2,940
Indirect labor cost Number of Employees 191,600 89,413 76,640 25,547
Total 136,393 107,479 30,928
Maintenance 15,557 12,371
274,800 154,950 119,850

The basis of apportionment is determined based on the nature of overhead expenses. For apportioning the insurance costs, the net book value of fixed assets is assumed the proper basis as normally insurance charges are paid taking the book value of assets as the basis for calculating the premium amounts. In respect of the rent and rates the square meter occupied by the respective departments is considered as the basis for apportionment, since the rent is usually fixed on a per square meter basis. For apportioning the indirect labor costs, even though the budgeted costs can be taken as the basis, it would be more realistic to apportion the indirect labor on the number of employees in each department.

Product Cost based on Marginal Costing

There are various systems of costing like job costing, batch costing, process costing, contract costing, marginal costing, standard costing and activity based costing (ABC) that are being used by different companies based on the nature of the activities of the companies concerned. Each system of costing has its own merits and demerits that determine the usefulness of the costing system that is practiced by the company.

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The product cost per batch of Microwave containers using the marginal costing technique is shown in the following table.

Description Total Cost £ Cost per Batch £
Direct Materials Cost 160,256 250.40
Direct Labor Cost 251,008 392.20
Total Variable Cost 91,520 143.00
Marginal Cost 502,784 785.60
Total Fixed Cost 136,960 214.00
Total Cost 639,744 999.60

Marginal costing is defined as the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written off in full against the aggregate contribution (Tutor2u, n.d.). Balance of sales revenue after deducting the marginal cost is denoted as contribution.

Advantages

  • Marginal costing is a simpler method of costing and under this method there can be no carrying forward of including some percentage of the current year’s fixed expenses in stock valuation.
  • Managerial decisions on changed scenarios of sales and production planning is greatly facilitated by marginal costing to enhance the returns from the business.
  • With the tools of breakeven analysis and cost-volume-profit, marginal costing facilitates a meaningful analysis of short-term financial planning of the firm. The method also helps a comparison of the financial performance of the firm over different products or divisions. This helps the management to improve the areas of deficiency.

Limitations

Despite the above advantages, marginal Costing has certain limitations. They are:

  • It is a cumbersome process to separate the costs into fixed and variable elements. This difficulty may lead to inconsistent results sometimes.
  • Stock and work-in-progress often get under-valued under marginal costing. The separation of fixed costs from the stock valuation tends to vitiate the profitability of the firm. Such separation also affects the presentation of a true and fair view of financial position of the firm, as the status may not be transparent.
  • Since the fixed overheads are mostly estimations, instances of under-absorption or over-absorption may creep in the financial system.

Job Costing

“Job costing is the process of tracking the expenses incurred on a job against the revenue produced by that job.”(Snyder, 2009) In case where the production is undertaken based on the specific requirements of a customer order and the jobs are capable of being identified separately, job-costing system can be adopted. In this method, cost is accumulated in respect of individual jobs to calculate the total cost and the resulting profitability. Job costing facilitates the comparison of job cost with estimates and such comparison reveals the efficiency of the individual jobs and the system facilitates the measurement of exact profit or loss on each job. The disadvantage of job costing is that it will be a cumbersome process to identify and allocate the indirect costs for each job.

Process Costing

In respect of products, which are manufactured by the application of a series of processes in which the end-products of one process becomes the raw material for the other process, process costing system becomes useful. “By adding a component or undertaking some operation each process will make its contribution to the completed article. Each one of this series of operations or processes forms a natural cost centre for the accountant.” (Pizzey, 1989)

The main advantage of process costing is that the firm will be able to find out the inefficiency of the individual processes. The disadvantage of this costing system is that there are too many assumptions involved in process transfer costs.

Standard Costing System

“A standard cost for one unit of output is the budgeted production cost for that unit. Standard costs are calculated using engineering estimates of standard quantities of inputs, and budgeted prices of those inputs.” (Caplan, 2007) While the standard costing system is recognized as, a sensible method to compare budgeted overheads to actual the system also lacks in some respects. The variances being identified under standard costing are too aggregated and setting standards is often a complex process. This makes the standards arrive at a very last stage and hence the standards may not actually be used to control the variances in time. Standard costing assumes the existence of a very stable production environment. Hence, the standard costing system may not find itself attuned to the changed manufacturing environment. The standard costing system has its focus concentrated much on the cost of the materials and labor with the sole objective of cost minimization. The system does not concentrate much on the quality of the product, improvement of customer service, and other major contemporary issues, which are more technology based. This is making standard costing system out dated to fit the present manufacturing environment.

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Conclusion

For the manufacturing company under study job costing system can be identified as the appropriate system of costing. Under job, costing the cost object is an individual unit, batch, or lot of a distinct product or service called a job. The product or service is often custom made. Because the products and services are distinct, job-costing systems can accumulate costs by each individual product, service, or job. In a job costing system, the company accumulates costs incurred on a job in all parts of the value chain like Research and Development, design, manufacturing, marketing, distribution, and customer service.

Reference List

Blocker, J.G., 2007. Essentials of Cost Accounting. New York: Read Books.

Caplan, D., 2007. Management Accounting Concepts and Techniques. [Online] Web.

Horngren, C.T., Foster, G. & Datar, S.M., 2002. Cost Accounting: A Managerial Emphasis. New Delhi: Prentice Hall of India Private Limited.

Kinney, M.R. & Raiborn, C.A., 2008. Cost Accounting: Foundations and Evolutions. New York: Cengage Learning.

Pizzey, A., 1989. Cost and Management Accounting: An Introduction for Students. London: Sage Publications.

Snyder, S., 2009. An Overview of Job Costing. [Online] Web.

Tutor2u, n.d. Marginal Costing. [Online] Web.

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