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This report is intended as a review of the different systems of accounting which involve pricing and costing decisions of products. The report provides for the models and concepts affecting the pricing decision of products and the managerial accounting systems of developing the cost of production and manufacturing. At present, since the company is utilising standard costing and absorption costing methodologies as part of the strategic management accounting principle, it is necessary to provide more information about these aspects and their limitations. One significant improvement over the past several decades over absorption costing system is the introduction of activity based costing and this is detailed in the following report along with its limitations. In the concluding sections of the report, the advantages and disadvantages which have been indicated in the main body of the report is summarised and irrational is developed for the adoption of the costing system for the organisation.
Generating the price of the different kinds of products and services of organisations is one of the important decisions in managerial accounting. The optimisation of the pricing depends on several situations based on a long-term or short-term approach considering the major influencing factors such as consumer demand, competitive action, cost of the raw materials, economic, political, legal, branding and even the strategic necessities of the organisation (Swamidass, 2000). Consumer demand plays an important role in setting the price of products and is relevant to the consumer perception about the quality required from the products along with the supply and demand characteristics at different time frames. The competitive action is one of the important aspects which affect the pricing decisions as it is necessary to develop the price of the product on a comparative basis to that of the products provided by the competitor’s (Wilks, Burke, and Avis, 2008). The pricing decisions is not only relevant in the case of managerial accounting or finance but is very much tangled with the marketing decisions of the organisation. In many situations the pricing is based on demand conditions and market forces but in several other situations the pricing is not market-driven and it is possible for an organisation to set the price based on the costing of raw materials and production. The essential factor in such kind of pricing decisions is to make a profit and hence the organisation must produce at a cost below the market price. In several market conditions both the market demand and the cost considerations are influencing on pricing decision.
Figure 1 – Setting prices
(Source – Wilks, Burke, and Avis, 2008, page 49)
Apart from the market-driven forces, economic, political and legal issues are also infringing on the pricing decisions. Certain laws must be endured to such as non-discrimination among customers and non-collusion. Certain products which are considered essential in the market are priced based on political considerations and the perception of the public which forces the political establishments to pressurise the organisations either based on regulation or other forces. The image of the organisation is also necessary to be considered during the pricing decisions and an organisation with high quality products and services may necessarily price the products consistent with the brand image (Avis and Killick, 2009).
While the above conditions are the major forces which are considered in general in any economic conditions which are affecting the pricing decisions, from the managerial accounting point of view there are several models and concepts which are utilised in setting the price of products. In the profit maximisation model there is necessarily a trade-off between setting a higher price and gaining a wide market share or increased number of sales based on the organisation’s total revenue curve (Kapil, 2008). As the price is increased for a product, there is the incremental reduction in the total number of quantities sold whereupon a point which is on the demand curve where the marginal revenues diminish which is based on the law of diminishing returns (Scarlett, 2008). There is an impact of changes in the price on the volume of sales which is described as the price elasticity and there are two conditions. The demand of the product is elastic if the price increase has a large negative impact on sales volume and vice versa (Horngren, 2008). The pricing decisions based on demand and marginal revenue curve are in fact very difficult to analyse without having adequate data about prices and market demand on a long-term basis (Drury, 2008). Within the profit maximisation model the marginal revenue and the marginal cost paradigm is not necessarily an essential condition in every market situation.
Figure 2 – Cost benefit trade-off in information production
(Source –Drury, 2007, page 151)
Managerial accounting can always be considered as a trade-off between the benefits derived from setting the price is based on accurate information and the cost of gaining such information. The above figure dictates the suitable approach in terms of cost and benefits when considering the cost of the information required for optimal and sub optimal pricing decisions (Drury, 2006).
The pricing decisions of organisations are also based on the time horizon and the short run pricing can be based on a one-time special offer based on seasonal conditions and adjusting the product mix and output volume in competitive market conditions. But according to Rajasekaran, (2006) many organisations prefer a longer term pricing horizon when the organisation have an adequate leeway in setting the price. One another consideration in utilising long-term rise in a pricing decision is because of the irrelevance of fixed costs based on time horizons and it is only through a long-term pricing model that a reasonable return on the investment can be gained. But as per Patra, (2006) short-term pricing decisions are opportunistic based on demand conditions.
standard cost can be considered as a parameter oratory determined cost and according to Needles Powers and Crosson, (2010) is the amount of an organisation perceives a product or the manufacturing process over a period of time and cost based on assumptions of efficiency, economic conditions and other influencing factors. It is determined based on estimations of the various elements of cost such as material, Labour and overheads over a period of time and is also used for controlling the cost of production and manufacturing and the sourcing of raw materials (Shah, 2009). There are several advantages of utilising the standard costing mechanism. One important function is in assisting the functions of management mainly relating to planning and controlling and also act as a criteria for performance measurement. It is supposed to reduce inefficiencies and provides for continuous monitoring of the wastage of resources. They are also used as a benchmark and in the process of management by exceptions were the concentration of the managers is required only when the standard cost are varying (Hilton, 2011). The most important function in performance is in the reduction of controlling the cost in terms of improving the efficiency.
Variance can be considered as the difference between the actual cost than the standard cost and the lesser amount of variance indicates higher levels of efficiency and is a tool used in controlling the cost (Coombs, Hobbs and Jenkins, 2005). The analysis of variance involves the computation of individual variances and the termination of the causes of variance. In the case of an organisation where products are manufactured the computation of material, Labour and overhead variances are conducted an analysis of the causes of variances are evaluated in order to enhance the efficiency and performance (Smith, 2011).
Figure 3 – Example for different variances constituting material variances
(Sources – Chadwick, 1998, page 210)
Variances represent the deviations of actual performance from standard performance. From the theoretical concepts there are two types of variances which are favourable and unfavourable. The material cost variance is the difference between the standard costs of material is for a specified output and the actual cost. In the above figure of the different aspect of material cost variance is provided. Similar is the case of labour variance and overhead variance. Variance is not only related to production and manufacturing operations but also with respect to sales (Khan and Jain, 2009).
Although the concepts of standard costing and variance analysis have been derived from the disadvantages caused by historical costing, there are certain limitations for the standard costing system also. According to Atrill and McLaney, (1994) under practical considerations the variance analysis is developed on a short-term periodical basis and is once again historical in nature which can only be corrected after the variation has occurred. Another aspect of the management’s concept of working to certain set of standards is the limitation imposed on the employees where the morale might suffer. The focus of the management should be on continuous improvement and enhancing the efficiency in order to survive in the market conditions. In order to so it is necessary to evaluate the trend of variances of the standard costing and develop a continuous improvement process rather than just meeting the standard cost. The other limitations of standard costing is that the system of costing request a high degree of skill and also may not be suitable for all types of firms. On another disadvantage is that the fixing of responsibility of not attaining the cost standards is not properly defined. The market conditions may not always favour the standard costing system as the prices of the input material is make change over the time horizon and also it is not practicable to be applied for non-standard products (Coombs, Hobbs and Jenkins, 2005).
Organisations utilise the measurement of variances in order to evaluate the performances after decision-making which provides for enhanced learning and continuous improvement. Although variance is considered as a lagging measurement, Lucey, (2003) have suggested that they are an early warning system which indicates the existence of potential problems and opportunities. Variance analysis also provides for the development of packages for achieving performance improvement over a future period but according to Lynch, (2001) it is necessary to consider that the cause of variance could be multiple and there could be external factors affecting the variances of the costs and prices.
The concept of variable costing and absorption costing systems are utilised for pricing decision there the variable costing is the method of costing that separates the variable manufacturing cost from fixed manufacturing cost (Swamidass, 2000). When the variable costing system is utilised only the variable manufacturing costs are allocated to the products and is included in the cost of inventory valuation. The way you will costing system is also called as marginal costing or direct costing and it is necessary to consider all the variable cost in order to determine the contribution margin which is the amount of sales revenue left after all variable expenses have been deducted (Wilks, Burke, and Avis, 2008). In the case of socks and costing it is necessary to allocate all the manufacturing cost which are both fixed and variable to the product and unsold inventory. There is no separation of the fixed and variable costs.
In the case of absorption costing, the fixed manufacturing overheads are necessarily located to the products which are included in the valuation of inventory whereas in the case of variable system only the variable cost are assigned to the products and the fixed costs are essentially considered as period cost and written off in the profit and loss account (Avis and Killick, 2009). In the case of absorption costing system only the amount of fixed overhead incurred during a particular period of time is considered in the fixed overheads. In several business situations it can be seen that there is variation in the sales of the products due to seasonal demand conditions the variable costing systems developed fictitious loses but the advantage of absorption costing system since all the fixed overheads are deferred and is only included in the close of the inventory, is recorded as an expense and hence during the period when the production is phased up in order to cater to the demand conditions at a future period, the loses will not be reported. An important consideration of providing any costing information to the market is that they will influence the share prices and hence it is necessary for both the internal and external information are in alignment. As the top management of any organisation has a preference for the reporting profitable measures on a sustained basis, absorption costing systems are utilised. In the case of production exceeding that of sales, the absorption costing system would be reporting higher profits whereas the variable costing system will only show higher profits than the sales exceed the production. But it is to be noted that the total profit of an organisation will remain the same over a period of time in both the systems.
The basic concept of absorption costing is that the production overheads are spread over the unions would use but the disadvantage is that the overheads may be under or over absorbed when the estimation of the costs do not match with the actual cost. In order to smooth out the limitations of the absorption costing system the activity based costing is introduced where the costs are collected on the basis of the activities which consume resources and overheads are allocated to product on the basis of appropriate cost drivers (Scarlett, 2008). The different steps involved in activity based costing is the identification of the cost drivers, the collection of the cost pools, calculation of the levels of activities and the rate and the final allocation. The advantages are that the cost is reflecting the complexity and diversity of the manufacturing process and the derivation of the prices are realistically reflecting the various sources used for the manufacturing. A significant improvement over absorption costing is that the activity based costing is able to allocate responsibility and significantly reduces the arbitrary introduction of cost absorption (Horngren, 2008). But since the activity based costing is a complex method there is no realistic cost per unit measurement and in many situations not all the product costs are driving the prices. During inventory build-up for a seasonal variation of demand the profits are distorted similar to that of variable costing (Drury, 2006). But according to Needles Powers and Crosson, (2010) the activity based costing is suitable for the costing of products when the overheads of production are significantly higher comparing to that of the direct cost. Moreover activity based costing can be utilised or non-standardised production systems and products and hence cater to the different types of products with their varying levels of diversity.
The different studies conducted by researchers all activity based costing indicates that organisations are able to derive benefits due to the adoption of management at a cost rather than providing for the accuracy of product cost (Shah, 2009). According to Hilton, (2011) a significant advantage of activity based costing is that it is able to perform the managerial functions of continuous improvement and monitoring and as per the views of Khan and Jain, (2009) the concept of resource consumption is utilised. The consumption of a resource only occurs when the raw materials and even the overheads are utilised for the production of products or services and the raw material is talked as inventory is not considered in the product cost allowing for better management of pricing decisions. Although the concept of resource consumption can be utilised only for direct and tangible measurements, according to Atrill and McLaney, (1994) the utilisation of overheads for production also can be considered as resource allocation for each product segment and hence is able to derive a significant improvement over absorption costing system. According to the views of Swamidass, (2000) the introduction of activity based costing systems is in accordance with the development of the production process by utilising various technological systems such as computer-aided manufacturing and design which are intense resources needed to be incorporated in the costing of products. Significantly Lucey, (2003) have identified through empirical measurements that activity based costing systems provides for the maximisation of efficiency of the manufacturing process, reducing the wastage of resources and the optimisation of allocation of costs and its utilisation to derive effective decision-making. From the principles of activity based costing, the managerial concept of activity-based management has been derived and is considered as a part of the total cost management system. Organisations are able to better manage inventory and consider the various aspects of production enhancement since all the activities are differentiated on the basis of the manufacturing of products or services. Moreover the indirect expenses of production are also considered in the activity based costing system which is not included in the traditional forms of costing.
The above report provided a glance of the different aspects of management accounting, where the initial discussion centred on the models and concepts adopted and affecting the pricing decision of products. Further the concept of standard costing and variance analysis is evaluated and their limitations identified. A comparison study of activity based costing and absorption costing system have been developed in an elaborate basis considering the complexity of the systems.
When analysing all the different aspects related to activity based costing, which is considered as significantly complex even though providing for an effective measurement of performance and the costing of the various activities, it is recommended that the present system of absorption costing along with the standard costing and variance analysis be continued for the organisation. The main rationale for the continuation of absorption costing and standard costing is that the company is manufacturing and selling a range of standardised electrical products were in the variation in the raw material prices, demand conditions and inventory is minimal. Activity based costing is utilised in order to effectively monitor the different activities involved in the manufacturing of products and considerably when there is a significant level of diversity of the products and production systems. Since Manac Plc. is manufacturing the electrical goods using standardised production systems which have a very insignificant variance coupled with insignificant levels of change in the raw material and their prices, activity based costing system may not be able to provide any significant advantage from that of the present absorption and standard costing system.