The aim of this report is to argue how management accounting systems function in the decision making processes in management activities, by taking the volume based overhead absorption and the activity based costing for an instance.
This report will comprise the introduction and evaluation of the volume based overhead absorption and the activity based costing, their function in decision making process, the distinctions between them, and an optimized suggestion of approach to this kind of accounting system. And the evaluation of these two management accounting approaches will be hinged on their effectiveness in decision making, including their objectives, strengths and weaknesses.
It is known that management accounting is an internal business function that includes the recording and reporting of a company's financial transactions. The accounting systems are supposed to support management in different business operations, providing analysis and support for different decisions and investments (Vitez, 2012). And the whole actions in a company, however, can be divided into several parts as designing, modeling, purchase, produce, marketing and delivering, and after sales services (Braun, et al, 2011). The financial accounting only requires taking the purchasing and producing periods into consideration when it comes to costing calculating, but actually, the whole six processes are supposed to be considered if the company need to earn profit. So here comes a significant question: how to define the cost. This question is the most basic one in managerial decision making, for it involves in many other activities such as pricing, cost volume profit analysis, budget volume variances analysis, and special order decisions.
The approaches used by management accounting to calculate the cost of goods is definitely different from financial accounting. This difference mainly exists in the allocation of overhead costing. For all the costs, it is easy to trace the direct cost into the products, so the main problem lies in the absorption of the indirect costs. Indirect costs are those that cannot be traced into specific products directly. This causes difficulties in establishing how much a product or service actually costs in total. Here there are two approaches to overhead costing: one is called volume based overhead absorption, which is a traditional absorption costing approach; the other is called activity based costing, which is a one put forward in the academic works in the late 1980’s and early 1990’s (Indirectcost. 2012).
The purpose of overhead absorption is to share out indirect costs, which is also called overheads, between the various cost objects, for example, products or services, on some appropriate basis. In this way we can attempt to establish the full cost, total absorption cost, of every item produced or service offered.
This traditional costing method often uses four steps to allocate the overheads.
The first step is to analyze the existing financial statements of last periods to re-distribute all the overheads so that they can be all divided into the departments that actually produce the products. For example, in a manufacturing company that produces tables, the two main production centers are assembly and painting, so all the overhead costs occurred during the process of administration, delivering, marketing and so on are supposed to be analyzed and eventually be allocated into the two producing centers: assembly and painting. In this step, the overhead allocation and absorption basis should be decided and the predetermined rates should be calculated separately. These rates will be used in the following steps.
The second step is to allocate the actual overhead costs happened in this period into the product centers basing on the overhead allocation and absorption basis and the predetermined rates. Now the overheads of administration, delivering, marketing and so on are zero and all the costs are split into two centers: assembly and painting.
Now we are now in a position to calculate the full (absorption) cost of each product. This will vary depending on how the business chooses to absorb, or to recover, the overhead costs, all of which are in assembly and painting center, into each product.
In practice, under the traditional methodologies, there are a huge number of different overhead recovery methods which can be applied. And the most often considered ones are two commonly used overhead recovery methods, one is based on labor hours and the other is based on machine hours used in the two production departments. So here it comes the third step, to allocate all the overhead costs into each single product by using the basis of labor hours or machine hours every product uses.
Finally, the forth step, add the direct cost to the allocated indirect cost then you can get the result of the full unit cost.