The ultimate aim of any cost accounting system is to find out true cost of a product in a diversified and scattered organization. For this purpose, new techniques are coming up while old techniques are being improved.
The latest development is ABC-EVA approach which takes into account all costs and expenses for working out true cost of a product. Once true cost has been ascertained, the next phase is accountability of the managers and regional heads. If they have done well, they would be rewarded else warned or penalized for improvement of their performance.
In order to do so, the key activities of any large company are decentralized or turned into semi-autonomous units. In responsibility accounting terminnology, these units are referred to as responsibility centres and include:
- revenue centers,
- cost centers,
- profit centers and
- investment centers.
Along with responsibility, there comes a concept of controllability which says that “a manager should only be held responsible for those aspects of performance that he or she can control.”
Responsibility accounting has a number of advantages such as: (i) it provides a way to manage an organization that would otherwise be unmanageable. (ii) It enables higher level managers to concentrate on strategic planning and policy making and (iii) It motivates lower level managers and workers.
At the same times, there are certain disadvantages like it turns an organization into “functional silos” where individuals concentrate on their own jobs and ignore the organization as an entity.
A case study
Orient Industries Ltd is operating three units: (i) Toys, (ii) Garments and (iii) Sweets. These products are sold all over the country. For planning and control, the company has divided its operations into three regions; (i) Karachi, (ii) Lahore and (iii) Peshawar.
Product wise profitability
Clips from Board Meeting, a little funny
In a recent meeting, the board expressed its dissatisfaction over results for year ended December 31, 2009. It was observed that the Toys Unit has sustained an operating loss which may increase when necessary adjustments are made for Rs.820,000 shown as un-allocated expenses. The board asked for a report on each product and on each region.
Karamat Raja, the management accountant, was asked to prepare necessary working papers containing income statements both on product lines and regions.
Raja held necessary discussions with other managers for finding out some basis for distribution of Fixed costs and expenses over products and regions. There being various basis, it took a long discussion spread over a week to arrive at the following parameters:
- Fixed manufacturing overhead costs should be allocated to both product and regions on the basis of percentage of the variable costs to total variable costs.
- In case of depreciation, units produced may be treated as cost driver.
- S&A Expenses may be applied to regions if these could be traced directly and the rest on the basis of total sales or production as the case maybe.
Gathering information for Resports
Meanwhile, Raja collected some more information to preparation of income statements both on product and area basis.
Once the requisite statements are complete, these would be discussed by the management committee with necessary recommendation and placed before the board for a final decision which may involve dropping a product line or closure of some outlets in some regions.
product wise contribution margin
CROSS TAB - contribution margin
COMMENTS ON THE PERFORMANCE
The contribution margin by all product is in positive. However, contribution by Toys making unit was rather low and may turn into losses when a part of the fixed costs (Rs.2,060,000) is allocated to this unit. At this point, the management should investigate:
- The possibility of increase prices of toy products or possibility of increase volume even if the prices have to be reduced.
- This would, in turn, depend upon the elasticity of demand for such products. ( If elasticity is low, reducing price would not increase quantity and overall operation would be rendered unprofitable.)
CROSS TAB - operating profit
When a cross-tab of profitability is studied, it is observed that toys have done miserably in all respect. Of the areas, Peshawar has been in the red for two out of the three products. The management should investigate:
- Cutting variable costs in toys by re-engineering and changes in the layout. (Variable cost cannot be reduced, without change in technology, except where there is some undue wastage. Variable Cost is a formula cost and its reduction may bring about a deterioration of quality.)
- The management may discontinue the manufacture of toys and concentrate on other product lines that are profitable. However, closing toy-making unit would not wipe out the loss of Rs.176,112 as it is after absorving a portion of fixed overheads (24% of total or Rs.496,112).
- It may also be looked into if adopting Activity Based Cost would show better result in case of toys unit. In traditional accounts, the distribution of overhead is based on volume or value and may not present a true picture. ABC changes all resources used into activities performed and allocate costs on the basis of activities or benefits taken.
- The income statement by area shows Peshawar as a loser. The management may investigate behavior of S&A expenses in this area besides increasing sale of other lines which make high contribution to profit. In other words, the product-mix may be improved in favor of Peshawar to make it a viable territory.
Glossary KEY TERMS
Returns on Investment, Operating profit divided by Investment
Well performing, giving positive results
Closed or abondoned project or plant or section
Operating but in the wrong direction like doing something against the policies of own organization
Generally Accepted Accounting Principles
The common set of accounting principles, standards and procedures that companies use to compile their financial statement
Same as Profit and Loss accounts
Profit or production achieved with the efforts and guidance of managers
Economic Value Added
Econoic Value Added
Same as RI wih certain adjustments. It shows economic profit
A section or department where only collection are made like fees collection in a university.
Operating income minus cost of funds
Difference between standard overhead costs and actual overhead costs
Raw Material Variance
Difference between standard raw material costs and actual raw material costs
Difference between standard labor costs and actual labor costs
A department or organizational function whose performance is the direct responsibility of a specific manager.
A part of a company is treated as an autonomous unit where a manager is allowed some discretion in incurring capital expenditure and peerformance of the centre are watched by the RoI
A segment of an organization for which revenues, costs and profits are separately calculated and a manager appointed to control the segment
A section or department of a firm which is only incurring costs like accounts department. It performance is compared with budgeted costs relating to that department. On the one hand, there are budgeted costs for account department and, on the other and, there are actual costs to compare with.
A system of accounting that segregates revenues and costs into areas of personal responsibility in order to monitor and assess the performance of each part of an organization.
Planning and Control
Management techniques based on four phases: set standards, get results, compare and take action, if required
Economic Performance is an extention of financial performance where shadow prices are used instead of market prices and interest and depreciations are ignored.
Sujit Dutta on June 17, 2017:
Excellent... good for the students
vijayakumar on May 13, 2011:
hello sir, i want to do phd on responsibility accounting practices. what is your suggestion
jasmeenflora on March 26, 2011:
Great things you’ve always shared with us. Thanks. Just continue composing this kind of post. The time which was wasted in traveling for tuition now it can be utilized for studies. Thanks for this knowledgeable blog.
ASIF JAMAL from Islamabad on March 18, 2010:
sir, its more helpful for us to knw the all area of our courses(MBA) and also helpful for the all management people
its need of time that u should have core knowledge and with the help for on line distance learning helpful for the new gernation.
hafeezrm (author) from Pakistan on March 18, 2010:
Thanks Rufi and Harris_1 for your comments.
haaris_1 on March 18, 2010:
Very nice hub. Great and substancial information.. Thanks for sharing.
Rufi Shahzada from Karachi on March 18, 2010:
That is explained so well. Thank you very much for spreading knowledge...