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COPYRIGHT 2001 JAI Press, Inc.
If accurate product costing, more flexible capacity use, and better information for strategic planning and decision making appeal to you, ABC is the supplement to use with traditional accounting methods.
Understandably, entrepreneurs and owners of small firms are not likely to give much thought to an accounting system during the planning or implementation phases of their business. The business plan forces them to deal with pro forma financial statements that are properly integrated to assist bankers and venture capitalists in evaluating the venture.
Soon after start-up, however, these entrepreneurs and small business owners will be faced with the need for an accounting system to meet the ongoing information needs of the investors, the lenders, and the various authorities that will tax the income of the business. An accounting system that meets those needs is one that is governed, to a great extent, by the demands of the Financial Accounting Standards Board (FASB), in the case of information provided to investors and lenders, and by the Internal Revenue Service, in the case of information provided for income tax purposes.
Accounting systems designed to meet the needs of investors, lenders, and income taxing authorities often fail to provide the managerial accounting information necessary to operate the new venture. In particular, they do not provide the information needed to accomplish the very important tactical and strategic planning and decision making that will be critical to success.
Traditional Accounting Systems
The term "traditional' is used to describe the accounting system designed primarily to meet the needs of investors, lenders, and income tax authorities. Such a system is characterized by absorption costing. Absorption costing takes its name from the manner in which inventory is valued for reporting on the balance sheet and the cost of goods sold is valued for reporting in the income statement--in other words, the manner in which products "absorb" cost as they are manufactured.
It is based on the assumption that as a product is manufactured, it absorbs the costs of the direct materials that become a part of it, the labor used in making it, and the overhead costs associated with its production, which include depreciation on the machinery and the facilities, supervisory costs, heat and electricity, and many other costs related to operating the firm. The assumption behind absorption costing is that these expenses are necessary for the product to be manufactured, so each should attach itself to, or be absorbed by, the product being manufactured.
Absence of Marketing and Distribution Costs in Product Costs
Using absorption costing, the product costs include only the costs of manufacture, not those of marketing and distribution. Traditional accounting regards marketing and distribution costs as having been expensed during the accounting period in which the costs are incurred, rather than including them in the cost of items in the ending inventory. Thus, if the entrepreneur or small business owner were to ask the accountant for the cost per unit of each type of product made, the accountant's answer would most likely be expressed in terms of absorption costing and would include only manufacturing costs. The omission of marketing and distribution costs could be particularly misleading if they run high compared to a product's manufacturing costs. The cost profile of many consumer products includes marketing and distribution far in excess of the cost of making the product. Such could easily be the case for mass-market convenience products, such as foods, health care items, and so on.
Some companies have dealt with the omission of marketing and distribution costs in product costing by allocating fixed marketing and fixed distribution costs to products based on the relative sales dollars contributed by each product. However, that method assumes that the marketing and distribution effort associated with each product is appropriately measured by the product's sales--an assumption often revealed to be inappropriate. Newly introduced products often have low sales volumes but require intensified marketing and distribution efforts. Standard, high-volume products may not require a commensurate marketing and distribution effort.
The Distortion Caused by Absorption Costing
The manner in which manufacturing overhead attaches itself to the product also causes distortions in product costing. Unlike direct material costs, which tend to vary in direct proportion to the number of units manufactured, factory overhead is most often a fixed cost. Manufacturing overhead is incurred in the form of depreciation expense or supervisory salaries. If production volumes are lower in one accounting period, manufacturing overhead is not likely to be lowered commensurately, or even at all. This inclusion of both direct costs (direct materials) and fixed costs (factory overhead) causes a product costing distortion that has the potential of misleading an entrepreneur or owner/manager trying to run a small business.
On the other hand, if the owner of a small service firm were to ask the accountant for the cost per unit of each type of services produced, the accountant would probably be at a complete loss as to how to respond. This is true because service firms typically have no cost accounting system to attribute costs to each of the various services provided.
To demonstrate the distortion caused by absorption costing, it is necessary to use a simple example in which a new venture manufactures two products using four different machines. The cost of raw materials for each product and the amount of time each product requires of each machine are indicated in Table 1.
We shall assume further that the costs associated with the factory are $6,000 per week and include the wages of the machine operators, the depreciation on the machines and buildings, supervisor salaries, and the electricity to power the...
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