COST AND MANAGEMENT ACCOUNTING: ZTC CASE STUDY
Introduction
Many books denounce financial priority over strategic issues because the latter is more long-lasting and carries more potential for growth than the former. However, working capital (e.g. solvency) of the firm is achieved through robust current cash and assets. On the other hand, the inability of the company to spend for the sake of its overall goal attainment may only position it on minimal gains. Due to this, this paper discusses the strengths and limitations of a value-creating and financially-supporting method called CAS based on the case attached in the appendix. It allows us to evaluate the boundaries of CAS in terms on how well it addresses financial and strategic issues.
Limits of Cost Accounting System
The appendix below shows how ZTC can benefit from a more accurate measurement of direct labor, direct materials and of course overheads. This can be achieved by using a certain cost accounting system (CAS). When CAS is installed, the most likely positive influence in the operations of the business is increased in profitability, improved in resource allocation and better managerial decision-making. However, these benefits are only attainable under specific conditions and the ability of the company to integrate CAS and other limiting factors to the extent of its effectiveness should be closely examined.
When CAS is implemented, it should be updated from time-to-time in an organized fashion because information is continuously acquired and can be used to include in the present CAS ( 1995 ). Such can result to a more dynamic and pro-active CAS. For example, the new policy of ZTC requires a tight annual cost control which may necessitate lesser use of electrical appliances (e.g. air-conditioning in certain parts of the company premises). Without the company updating its CAS, its overhead costs may obtain the projections of current years without reference to a tight electricity control. In effect, the quality of the current CAS is blemished.
The significance of CAS update has also implications to a more successful framework than totally replace the old with a new CAS. For its accounting department, a new manufacturing environment for ZTC is likely less affected compared to its manufacturing ( & 1993 ). In the contrary, CAS needs to be integrated and adjusted based on the operational changes of the company. The caution of this endeavor is to prevent the organizational culture of ZTC to be deflected by accounting adjustment. There should be harmony in case of culture shock after a change in manufacturing setting. Today, companies are aspiring to provide low-cost and high-quality products. This is a shift from the traditional one-sided strategy. As a result, the traditional way of accounting for overhead costs should be evaluated. For example, human resource requirements became more stringent which necessarily requires adjustment of direct labor due to higher salaries.
Simple adaptation is useful but drastic change in CAS structure can be destructive and unacceptable to the existing corporate culture (). Thus, resistance may ensue and strategic components of the company are at risk. In effect, accounting system must be change to measure the new values. CAS should be a follower to the manufacturing changes and be a diligent yardstick to control and account for cost and establish a reasonable profit. This is because, unlike the other departments in an organization, accountants are more in a reactive position (e.g. over-funded projects, costly acquisitions, expensive monetary incentives) which makes them form their own subculture away from the mainstream culture (). Due to this, adaptive and updating behavior of CAS should be in place to allow optimal benefit of an organizational strategy.
In the case of ZTC, its newly applied CAS is exposed to the adverse risk of recency effect ( 1995 ). It is a managerial mind-set in which the recently received information is given more weigh at times when there is information overload. In pricing, overhead costs can be understated or overstated negligibly if this theory applies. For example, ZTC has furnished a job quotation using the projected electric bill fees but decided to include the recently increased fees. Assuming that electricity is a primary component in carrying its business, the lack of “averaging” can lead to customer dissatisfaction due to abrupt increase in quote. In effect, its pricing is not really that effect when it customer relations is in focus.
Further, based on the case, ZTC has implemented records-keeping for works that are in-progress to organized and allocate cost at the end of every work. This can be applauded because records management has long been proved to be a tool to protect corporate assets and reduce business risk ( 1992). In analogy, financial assets (e.g. cash flows and revenues) and risk of not covering overhead and other costs are taken into consideration. However, the new CAS is no use to control customer bargaining especially when the latter is already embedded in the business history and current strategy (e.g. big customers, key partners, retailers). As a result, the records-keeping capability of the new CAS can undermine “personal transactions” between the president and vital customers. And because the president has the final decision in pricing, data in the records is revisable with just a simple guarantee from him.
ZTC is a closely-held and small corporation which makes it a potential customer-driven business ( 1985 ). In effect, all else equal, it is likely to make corporate polices flexible which necessarily undermines the usefulness of recording costs. This can be the reason why the new CAS is revised with little financial, human resource and managerial upheaval because the final determinant of decisions are the customers. Such tactic can also identify the planning rationale of the management in building the new CAS. On the other hand, measuring performance through record-keeping is very imminent. The effort given by individual employees, level of expended materials and new cost trends for the overheads are verifiable to obtain efficiency indicators.
When it comes to expertise in cost accounting, ZTC employee pool lacks the needed skill to maximize the benefits of the new CAS. The responsible accounting employee also does two tasks (e.g. records keeping and accounting) which can undermine emphasis on the cost management. In effect, the quality of advice he can provide the president would be in minimum. With the perceived improved process, the organization should not expect too much with the new CAS. There is no technology infused or skilled accountant integrated in the new system which only mitigate their problem on costing but far eliminated it. Its size is the foremost determinant of such minimal effort because the cost of a completed CAS overlaps its potential benefits. In the contrary, the learning curve of ZTC may not have enough experience to appreciate the full implementation of a CAS which made it more risk-averse.
Appendix
In its old cost accounting system (CAS), ZTC Sign Company failed to include overhead cost as well as accurate measure of labor costs when issuing quoted prices to their customers ( 1985 ). The president, who prices a job order, uses arbitrary values to cover overhead costs with regards to arrive at a profit. Such process is practical for ZTC because it is a small company which employs seven people. In the contrary, the company and the president cannot determine if the quoted prices really cover costs and provide profit due to lack of cost control particularly on overhead costs.
As a result, the company introduces a new system that would capture overhead costs in a more accurate manner ( 1985 ). There is a need to independently accumulate the overhead costs of each job so that customer will be charged at a “reasonable” price quotation. However, overhead costs such as depreciation, repairs, maintenance, heating and lighting cannot be allocated to specific jobs. This is aggravated by the fact that the management is only able to get such information at the end of an accounting month. In effect, the president would continue a subjective approach to pricing because quotation must be handed to customer before the work even started.
In view of this problem, the company used the overhead cost projection based on an annual basis ( 1985 ). The method might not be as accurate as it can be but considering the small size of the business it can be a practical as well as useful guide. In adapting the new system, the company does not want to increase the load of its accounting-secretary employee. It chose to undermine financial benefits of accurately capturing overhead head in favor of its human resources. This resulted in classifying overhead costs as cost of goods sold that are accumulated at the end of the accounting month. Coupled in this strategy, clock sheet (records direct labor costs) and material usage (records all materials used) are installed when a job order is on-going.
Conclusion
CAS has financial merits to obtain more accurate pricing. However, primarily due to the presence of customer approach and anonymity of accounting department, CAS is unable to surpass many strategy-related issues in decision-making, planning, control and performance measurement. This is because CAS can bring efficiency but less on profitability and growth. As reflected in ZTC’s minimal effort to support the new CAS, sustainability and persistence of system of costing is unshielded to the supremacy of other strategy-related issues (e.g. customer relations management). In the contrary, CAS is more relevant when a firm is very large, very known and very efficient. This would require less customer power (because they are diverse and numerous) and more pressure to use cost-related strategies (because cost is what makes most companies in an industry successful like in real estate).
ACTIVITY-BASED COSTING: PETERSON CASE STUDY
I. Activity-Based Costing (ABC) versus Traditional Cost Systems (TCS)
ABC is a support cost accounting methodology to TCS primarily due to the change in manufacturing products or execution of service of modern businesses (Internet, Value Creation Group). TCS is appreciated in the previous era characterized by operations that are labor-intensive, semi-automatic, with limited differentiation and with minimal overhead costs. However, as technology and expertise advances through time, ABC is developed to capture a more accurate estimation of costs that can result to better allocation resources and setting pricing strategies. ABC is able to show the connection of resources consumed and produced outputs leading to increase cost visibility and sound budgeting.
TCS has the assumption that cost items exhaust resources, base costing in volume-related drivers and highly influence by structure (Internet, Emblemsvag). On the other hand, ABC believes that cost is unmanageable that makes activity analysis more realistic. Another, ABC has cost basis on several stages and levels not merely on volume (e.g. unit level like direct labor hours) but also batch level (e.g. orders/ set-ups as in the case of Peterson), products level and facility level. Lastly, ABC is focused on organizational processes (e.g. quality control, packaging) rather than bureaucracy (e.g. departments like accounting, paint section, trucking). As a result, the organization can learn important information such as how to improve productivity and allocate resources efficiently.
II. Problems with the Existing System
The first problem of the existing system in Peterson is the tedious task of tracing the budgeted overheads of the six departments. This strategy is like an aggravation in the process of determining a more accurate approach to costing because the organization will have to trace overheads that are initially been budgeted. In the process of tracing, application of costs uses only direct labor hours (DLH) that tends to distort the impact of material costs (MAT), machine hours (MCH) and other overheads. The different cost driver rate per department also implies traditional cost system’s assumption of bureaucratic approach leading to a more labor-intensive framework which should not be the case because MCH in MC, PL and AS departments are very significant.
As DLH is continuously used by Peterson, profitability was declining as the firm introduced newer products such as GT102 and GT103. As a result, costing errors occurred when Peterson tried to relate particular product attributes to unit products (e.g. DHL) when in fact costs can be related to batches, families and other products of the company. Automation limited the effectiveness of DHL in costing because labor hours became smaller and the necessary overhead costs were substantially reduced. Dollar costs were decreasing while time cycles took over the cost pressure seen in batch-related drivers. The overly focus of management in controlling the variance figures also led the organization to execute misleading actions to achieve cost efficiencies which can adversely affected product quality.
III. How ABC overcomes this Problem
Cost drivers are allocated in the form of direct labor, materials and overheads (e.g. machines) but are individually allocated to departments. This is the result of focusing on departmental costing which undermine the presence of other activity-related cost especially the presence of overheads. The ultimate measure is the DLH which also minimizes the opportunity to measure other cost drivers present in other departments. ABC minimizes the problem by creating homogenous cost pools for each department and allocates them to the three products based on their cost drivers. As a result, there is a more accurate inclusion of necessary costs especially the overhead according to the activity precedents and significance. ABC drives the company to focus cost controls from contributing activities from their planning and actual production of products. The approach of ABC is that products utilize activities while activities utilize costs (Internet, Johnstark) which can promote integrative improvements to total quality management.
IV. Cost under Current Approach
(See Spreadsheet)
V. Activity Schedule
(See Spreadsheet)
VI. Profit per Unit under ABC (See Spreadsheet)
VIII. Measures to Improve Profitability
One measure is the inventory turnover as it may guide managers on how to detect problems in marketing or product quality. Inventory turnover can be seen in the order cost driver especially if Peterson would adopt flexible manufacturing systems such as lean and mean production. Another is the common-size analysis where overspending in one activity can be compared to the overall revenues and its contribution to the value of the firm. As a result, activities can be controlled to prevent excessive cost accumulation if it is proved to have minimal contribution.
Third asset turnover can show how efficient Peterson in using its assets that it can justify any large amount in cost drivers. When activities are inefficient, cost drivers can indicate the differences between production periods for comparison. Fourth, collection ratio (e.g. debtor and creditor days) can protect the working capital of Peterson and prevent it from going bankrupt. In this ratio, cost drivers can indicate how the company must prepare to borrow at times of crisis to be able to continue activities without delay or any disruption. Alternatively, Peterson can compare the contribution (e.g. outputs) of each activity to the total value of the firm and hence can prioritize in times of recession.
IX. Limitations of ABC Approach
Like other costing methods, ABC is not compatible to all firms with dissimilar structures and strategies (e.g. in labor-intensive industries or those having limited products) (, 2002). Another is the problems and difficulties that may arise in its adoption by a first-timer where costs and human resistance impede integration, therefore, results to several costing failures and even operational delays. Lastly, ABC does not have all theoretical support and sometimes conflict with other well-established accounting principles that many practitioners are limited and even anxious in using the technique. Many protagonists in costing are also emphasizing that all techniques are within the boundaries of individual risk and cost preferences of firms such that product cost distortions may be seen as normal variances that firms must confront.
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