Management Accounting for Business

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368904 MANAGEMENT ACCOUNTING FOR BUSINESS

TERM 2 2015

Individual Written Assignment

PEDRO AND HIS PEANUT BUSINESS

Contents

1. Introduction        

2.1 The rationale of Webb's build up of full costing        

3. The disadvantages of absorption costing method        

3.1 The shortfall of absorption costing        

3.1.1 Reducing expenses on business segments        

3.1.2 Confusion of costs in inventory        

3.1.3 Unsuitable used in service industry        

3.1.4 Opportunity cost in decision making        

3.1.5 Unsuitable for unstable peanut selling        

4. Mark’s narrow perspective on management accounting        

4.1 The purpose of management accounting        

4.2 The roles of management accounting        

5. Conclusion and recommendation        

Reference        

1. Introduction

Petro wants to start a peanut business in his bar, however, Mark has some thought and suggestions about it. After careful reading of the case, the questions are answered in this assignment. The first part is focused on the explanation and analysis towards the rationale of Webb's build up of full costs. The second part examines the disadvantages of absorption costing based on the literature reviews to criticize Mark’s advises. The third part illustrates the main purpose and role of management accounting, and points out the Mark’s narrow perspective. The fourth part presents conclusions and suggestions.

2. Absorption costing

Ray, Eric and Peter (2012) state: “Absorption coting treats all manufacturing costs as product costs…and allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing costs (p.230-231).”

A fished unit cost is going to include direct materials, direct labor and both variable and fixed manufacturing overhead, which means absorption costing method is covering all of the manufacturing costs no matter it is fixed or variable costs. In other word there is no need to divide the manufacturing overhead into two components, variable and fixed attribute. Because the fixed manufacturing overhead is going to allocate to the product costs, all of the costs related to fixed costs are going to allocate along with direct labor, direct material and variable manufacturing overhead.

2.1 The rationale of Webb's build up of full costing

The rationale for Webb’s build up of the total costs is that the fixed overhead cost relates to “the expenditure for rent, heat light equipment, depreciation, decorating, wages of the cook and waitress”, which is the cost beyond or under direct material and direct labor used in peanuts production. When each bag of peanuts is purchased from the suppliers, these costs should be calculated and expensed legitimately. Now Pedro has already got 50 bags, which means that the sales are less than inventory. Hence these fixed costs will end up with keeping in inventory so long as fixed overhead is expensed in proportion to production, which means these fixed overhead costs will not covered by sales until they are sold in the following period. This is why when Pedro said he wanted to throw this business away, but Mark told him that he probably could not afford to face the $6,252 annual overheads loss.      

When each bag of peanuts was sold, the $5,112 overhead costs will be transferred to cost per unit sold. Meanwhile, the worth of $1,000 1 square foot of counter space also counts to general overhead cost, which will be transferred to the cost of peanut inventory. Therefore, Mark adopted absorption costing method and the rationale of build up the full cost of selling peanut is to measure the complete cost. General manufacturing overhead include fixed and variable attribute, even fixed manufacturing overhead is not easy to allocate to per bag of peanuts sold, but still, this component is a cost of that particular unit level. Hence, these costs should be allocated to production. That is why Mark said if Pedro wanted 16 cents per bag profit he would have to charge $1.60 even though “No-one will buy them”. Again, the logic here based on Mark’s thoughts relates to the method of absorption costing usage, which causes the suggested price per bag of peanuts.  

3. The disadvantages of absorption costing method

The cost accounting system of absorption costing is taking the fixed and variable overhead costs into cost of goods produced. Each finished inventory unit cost involves the same portion of overhead costs. Businesses normally use this method on their income statement while it still has some disadvantages (Taylor, n.d.). The discussion and judgment towards Mark's advice as follows:

3.1 The shortfall of absorption costing

Based on the literature reviewing, the examiners focused on comparing the advantages and disadvantages about marginal costing and absorption costing method, which gives the following conclusion:

“The main disadvantage of absorption costing method is that it does not provide any useful information for decision making (Kaplan Financial Knowledge Bank, 2012)”. Because absorption costing emphasizes on the total cost, the detailed costing attribution in terms of fixed and variable overhead costs were ignored. Therefore, when it comes to decision-making, managers are going to rely on their own intuitive judgments.    

Further, since each unit of production includes same portion of fixed manufacturing overhead costs when business is adopting absorption costing method, as additional units were produced, the same calculating procedure takes into account. However, these are not just net operating income but also revenue opportunities. (Taylor, n.d.)  

If 50 bags of peanuts per week were sold and variable overhead cost allocates to per bag was $2.02 (this is an assumption, because in this case, it is not clear how the variable manufacturing overhead costs are allocated in the spreadsheet), and fixed overhead costs are $19.23 per week (In this case: the peanut rack takes up one square foot of counter space, which is worth $1,000 a year), absorption costing will allocate $0.38 to per bag of peanut for a total cost of $2.4 per bag. If Pedro had an opportunity to sell another 5 bags of peanuts at $2 each unit, absorption costing makes it look like it is in a loss of $0.4 per bag. However, as matter of fact, it is making $0.4 per bag because there is only variable cost but no fixed cost added by selling 5 more units.