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THE IMPORTANCE AND IMPACTS OF COSTING METHOD ON THE PROCESS OF MANAGERIAL DECISION MAKING BY LE THANH THUY E0600122 BACHELOR OF BUSINESS (ACCOUNTING) HONS HELP UNIVERSITY COLLEGE 28TH, JUNE, 2010 THE IMPORTANCE AND IMPACTS OF COSTING METHOD ON THE PROCESS OF MANAGERIAL DECISION MAKING BY LE THANH THUY Graduation Project Submitted to the Department of Business Studies, Help University College, in Partial Fulfillment of the Requirements for the degree of Bachelor of Business (Accounting) Hons JUNE, 2010 Declaration I hereby declare that the graduation project is based on my original work except quotations and citations which has been duly acknowledged. I also declare that it has not been previously or concurrently submitted for any other course/degree at Help University or other institutions. The word count is 12,295 Words. i Acknowledgement First of all, I am grateful to Dr Le Van Lien who gave lots of useful advices as well as materials for this thesis. And I would like to extent my thanks to Mr. Minh, manager and all of employees in Minhnhat Co., Ltd, who allowed and assisted me to collect all of necessary information to finish this thesis. My thesis can not be finished without your supports. ii TABLE OF CONTENT Declaration ........................................................................................................................... i Acknowledgement .............................................................................................................. ii TABLE OF CONTENT ..................................................................................................... iii Abstract ............................................................................................................................... v List of tables ....................................................................................................................... vi List of figures .................................................................................................................... vii CHAPTER 1: INTRODUCTION ....................................................................................... 1 1.1. Introduction of topic ................................................................................................ 1 1.2. Issues ........................................................................................................................ 3 1.3. Issues expansion....................................................................................................... 4 CHAPTER 2: LITERATURE REVIEW ............................................................................ 6 2.1. Managerial decision making process ....................................................................... 6 2.1.1. Decisions in nature ........................................................................................... 7 2.1.2. What is decision making process? .................................................................... 9 2.1.3. What is accounting information? .................................................................... 10 2.1.4. Managers and management accounting ......................................................... 12 2.2. The importance and Impacts of costs accounting methods on decision making process of the managers using SWOTs and Porter’s model analysis. .......................... 14 2.2.1. Absorption costing .......................................................................................... 15 2.2.2. Variable costing method ................................................................................. 17 2.2.3. Activity based costing system (ABC)............................................................... 19 2.2.4. The importance and impacts of accounting methods on managerial decision making process.......................................................................................................... 21 2.2.4.1. SWOTs analysis and why managers should choose a suitable costing method or importance of these methods. .............................................................. 21 2.2.4.2. Porter’ model with five factors which can affect the managerial decision of managers in term of cost accounting methods.................................................. 24 Figure 1: Porter’s model with five factors. .......................................................... 25 CHAPTER 3: RESEARCH AND METHODLOGY ....................................................... 29 3.1. Aims of the project................................................................................................. 29 3.2. Research methodology ........................................................................................... 30 3.3 Data sources ............................................................................................................ 30 3.4. Limitation ............................................................................................................... 31 CHAPTER 4: CASE STUDY ANALYSIS ...................................................................... 33 4.1. Introduction ............................................................................................................ 33 4.1.1. Company’s background and mission statement .............................................. 34 4.1.2. Operational structure...................................................................................... 36 Figure 2: Operational structure of Minhnhat Company. ......................................... 36 4.1.3. Firm core business and competitive advantages ............................................ 37 4.2. Differences when using different cost accounting methods .................................. 38 4.2.1. Incurred expenses during the period of 2008-2009 ........................................ 39 Table 1: Production of Minhnhat Company ......................................................... 39 iii Table 2: Direct material cost of Minhnhat Company ........................................... 40 Table 3: Direct labor costs of Minhnhat Company .............................................. 41 Table 4: production of Minhnhat Company.......................................................... 41 Table 5: Selling and administration expenses of Minhnhat Company ................. 43 Table 6: Cost pool and activities measures of ABC method. ................................ 44 Table 7: Total manufacturing overhead and selling expense during the year of Minhnhat Company............................................................................................... 45 Table 8: Distribution of resources across activities costs pools of Minhnhat Company ............................................................................................................... 45 Table 9: Distribution of resources across activities costs pools in $ of Minhnhat Company ............................................................................................................... 46 Table 10: Activities rate of Minhnhat Company ................................................... 47 4.2.2. Unit cost product using three methods to calculate........................................ 47 Table 11: Cost per unit of raincoats using variable and absorption costing ....... 48 Table 12: Overhead cost per unit of adults’ raincoat and children raincoat using ABC method. ......................................................................................................... 50 4.2.3. A profit comparison using absorption, variable and ABC costing method to calculate. ................................................................................................................... 51 Table 13: Direct Materials and Direct Labor costs of Minhnhat Company ........ 52 Table 14: Income statement of Minhnhat Company using ABC costing method . 53 4.3. The cost accounting method that Minhnhat Company uses and its impacts on their decision making process ............................................................................................... 54 Figure 3: Income comparison between variable and absorption costing method: Income statements for 2009 of Minhnhat Company ............................................. 56 CHAPTER 5: CONCLUSION ......................................................................................... 57 References: ........................................................................................................................ 60 iv THE IMPORTANCE AND IMPACTS OF COSTING METHOD ON THE PROCESS OF MANAGERIAL DECISION MAKING BY LE THANH THUY JUNE, 2010 Supervisor: Dr. LE VAN LIEN Abstract In general, cost accounting method can be considered as the most concerning problem with an organization. Different costing methods will lead to different profit to a firm. This means choosing a cost accounting method can affect the decisions of managers based on the empirical study of advantages and disadvantages of three costing methods which are absorption, variable and ABC costing method. Many people think that there are no links between the managerial decisions and cost methods, but I think they have a potential relationship. As a result, I will use SWOT and Porter’s model to explore some evidences about this connection. After that, I make some recommendation about the importance and impacts of cost accounting method on the managerial decision making process. v List of tables Table 1: Production of Minhnhat Company Table 2: Direct material cost of Minhnhat Company Table 3: Direct labor costs of Minhnhat Company Table 4: production of Minhnhat Company Table 5: Selling and administration expenses of Minhnhat Company Table 6: Cost pool and activities measures of ABC method Table 7: Total manufacturing overhead and selling expense during the year of Minhnhat Company Table 8: Distribution of resources across activities costs pools of Minhnhat Company Table 9: Distribution of resources across activities costs pools in $ of Minhnhat Company Table 10: Activities rate of Minhnhat Company Table 11: Cost per unit of raincoats using variable and absorption costing Table 12: Overhead cost per unit of adults’ raincoat and children raincoat using ABC method Table 13: Direct Materials and Direct Labor costs of Minhnhat Company Table 14: Income statement of Minhnhat Company using ABC costing method vi List of figures Figure 1: Porter’s model with five factors Figure 2: Operational structure of Minhnhat Company Figure 3: Income comparison between variable and absorption costing method: Income statements for 2009 of Minhnhat Company vii CHAPTER 1: INTRODUCTION In this part, the structure of this thesis, an introduction about the topic as well as relates issues to it will be covered. This will create the whole picture about the ideas and help the users easy to follow and link them to each other to figure out the potential relationship between cost accounting methods and managerial decision making process that the author mentioned in the abstract. 1.1. Introduction of topic A fire at the headquarters of the National Association of Accountants (NAA) in 1984 destroyed all information related to cost accounting aspect (Cunagin, C., & Stancil, J., L., 1992). As a result, none accountants as well as historical researchers can ensure and show evidences about the accurate time when the cost accounting methods are born. As Richard Vangermeersch, a leading accounting historian said ‘a problem in cost accounting is that many such accountants feel that they have no past’ (1986). Therefore even costing management accounting is not a new problem but its importance is just focused and researched in the twentieth century. There are many methods to calculate the costs such as absorption costing method, variable method, throughput accounting, and lean accounting and so on. Each of method will have different way to allocate costs. As a result, with the same company, applying two methods can lead to different decisions. In order to make a managerial decision, 1 costing methods play important roles. In fact, cost allocating can be considered as a guideline for the managers to make better decisions. By comparing annual reports, managers can see which profitable products are as well as whether any costs are wasted or used inefficient. For some managers especially of the small company, absorption costing might be the best costing method while it can deal with the conflicts of interests between them and their companies. Other managers think that if they use another type of costing methods to reduce and allocate costs more efficiency will improve their performance more than using absorption costing method. However, this does not mean with the same information or report, different managers will make the same decisions. This process is depended on capability of each person. Therefore, to sum up, managerial decision making process of managers is affected by many factors but in this thesis, only impacts of cost accounting methods are discussed. This thesis is divided into five chapters as follow:  Chapter 1: Introduction  Chapter 2: Literature review  Chapter 3: Research and methodology  Chapter 4: Case study analysis  Chapter 5: Conclusion These five parts are not separated, they will be linked in order to express the ideas that the author would like to share. Chapter 2: literature review and chapter 4: case study analysis will be the most important parts which focus on the theory and the fact in a real 2 case. Chapter 1 and chapter 3 will considered as a background to create the general ideas of this thesis. And chapter 5 will conclude the findings after analyzing a real case compare to the theory. 1.2. Issues Main ideas which are expressed in this thesis include the cost accounting methods introduction, advantages and disadvantages of them and it impacts on the decision making process of managers. As mentioned above, history of cost accounting method is necessary to know especially for three methods that the author wants to focus: absorption costing method, variable costing method and Activities Base Costing method (ABC). It is difficult to ensure that which costing method is applied first because of lacking documents about this. But, for some historical researchers, absorption costing or traditional costing method can be considered as the leader of cost accounting. After that, variable costing was born and later ABC is invented. The same limited resources and costs, these three method lead to different results as well as decisions. Each method will apply a way to allocate costs which differ with the other two methods. Nothing can be perfect therefore these methods contain both advantages and disadvantages to managers. Using SWOTs model, all of advantages and disadvantages will be judged fairly. SWOTs mean strengths, weakness, opportunities and threats. This model is used popular 3 in management aspect. Some people do not believe that SWOTs can be applied to analyze in accounting. However, accounting does not mean only work with numbers especially with managerial accounting. Managers also need ability to evaluate the effectiveness and efficiency of the firms, the operation process and cost budget through numbers. Moreover, through this evaluating, it will be easier to see the importance of cost methods on the decisions making process. Porter’s model is another management framework that the author uses in this thesis. Unlike SWOTs, this model will focus on five factors which can have significant impacts on the decisions of managers which are new entrances, buyers, suppliers, substitutes and rivalry competitors. These will affect the cost available for the firms and lead to changes in result when calculating costs using different methods. Then, decisions of managers can be changed also. 1.3. Issues expansion Theories are still theories if we can not apply them into the reality. As a result, in chapter 4, a real case of MinhNhat company – one raincoat manufacturers will be use to analyze. In this part, from the collected cost information of this company, absorption costing method and variable costing method are applied. In fact, this company prefers absorption costing rather than variable costing method because the increasing trend in profit can attract more investors. But they had to turn into a new costing system which is 4 a combination between absorption costing method and ABC costing method from 2007 because of managerial wrong decisions during the use of absorption costing method. According to Mr. Minh, manager of this company, applying absorption costing is good for external reports especially for investor attracting purposes. However, this can lead to mistakes in internal control process. As a result, a suggestion for a new system in which variable and absorption costing methods coexists should be concerned by accounting researchers. 5 CHAPTER 2: LITERATURE REVIEW Like the first part of introduction, this will provide information about managerial decision making process and three cost accounting methods. Understanding about the decision making process in general and in costing management can help the managers know what kind of information and how much of information do they need to make an efficient decisions. From this, a briefly introduction about the history, calculation and contents of absorption costing method, variable method and ABC method will be covered. In the last of this chapter, SWOT and Porter’s model will be used to evaluate the advantages and disadvantages as well as impacts of cost accounting methods on the decisions of managers. 2.1. Managerial decision making process Every body has to make decisions. Depending on different purposes of various groups of people, decisions can be made differently in a specific circumstance. In order to understand what managerial decision making process is, this part will explain: - What are decisions in nature? - How many steps do this process involves? - What is accounting information? - And how the managers use this information? 6 2.1.1. Decisions in nature Decision process could be considered as a study in which the decision makers try to overcome distractions from both internal and external to identify and choose the best alternatives for a certain problem in a specific circumstance. Every day, every second, we have to make decisions from small to important things. For example, in the morning, we decide which kinds of clothes we will wear today; then we decide whether to have a breakfast at home or bring some things such as an apple to the school then taste it in the break time or lunch. More important than these things, we decide our job in the future, salaries that we desire. With a limited resources and time, we could not do many works at the same time. As a result, making the best decision is very important which means it is not only suitable with our ability but also can bring our best results (König, T.; Debus, M.; & Tsebelis, G., 2010). According to most of people especially businessman, to make a good decision, they need a lot of necessary information. However, in fact, we could not wait until we have enough information to make a decision. For instance, we decide which major we will follow in the university. We can not wait until we have enough statistics about all major to make a decision. Although every student want to study a major which can help them find a job better, they have to decide without thinking or planning so much. Depending on different people as well as knowledge and experiences, decisions will be different (Engel, C.; & Singer, W., 2008). Generally, many people though that 7 they are only affected by their own decisions whereas their parents, friends, bosses and colleagues’ decisions also affect them (Lucius, C., 2009). This can be minor or significant influences based on the relationship between them. For example, our parents decide to live in countryside. As a result, our appearances as well as our characteristics and thinking will be different with other children who live in big cities. This means our decisions or other people’s decisions could affect the rest of our life by shaping our attitudes and believes (Brunsson, N., 2007). In some circumstances, decisions should be made by a group of people instead of an individual (Egenhofer, C.; Kaczynski, P., M.; Kurpas, S.; & Schaik, L., V., 2010). This is popular when teamwork is more and more important and developed nowadays. Some people think that this is not sufficient because of including lots of judgments as well as estimations. However, a person could not know every thing of various aspects; more people can have better ideas if they know how to pass all of distractions such as negligence and noise which is mentioned in the book named ‘Better Than Conscious?: Decision Making, the Human Mind, and Implications For Institutions’ of Eapen, G., (2009). When the globalization becomes a dominated trend, making the best decision while still maintaining the Code of ethics is the most desired goal that all of businessman especially investors want to achieve. 8 2.1.2. What is decision making process? In management, decision making process includes six steps which are recognition of decision requirement, diagnosis and analysis causes; development the alternatives; selection of desired alternatives; implementation and chosen alternatives; and evaluation and feedback (Richard, L. D., 2009). With the same meaning of making decision process but shorter, there are only four steps that decision makers should concern when they make decisions (Hoggett, Edward, & Merlin, 2006). First step is establishing the goal. With managerial accountants as well as investors, different situations will lead to different decisions. Based on available resources such as time and capital, decision makers should know whether the decisions they make could be the best alternatives. This means is that determination is needed and necessary to achieve the goals that we desired. In case this is important, all of our values as well as motives will be affected. Gathering available information is the second step. There are various kinds of information. As a result, what kind of information do we need and how much of information is needed are two important questions. If we collect too much information, our judgments and attitude can be changed and not wise any more. Relevant information can help us make better decisions with higher successful degree whereas irrelevant information leads to distractions during our decision making process. 9 After collecting enough and useful information, we have to think how many alternatives available for our decisions. In fact, we can not avoid uncertainty because what we expect is in the future. Therefore, we only can make the best decisions within limited resources in specific circumstances. When we know what are available alternatives and their consequences, we have to decide and make a plan which can help us achieve the outcomes we expect. Although this process has only four steps but it still reflects the nature of making decision process. This can help both accountants and investors have better thinking and judgment when they face with any problems or opportunities. 2.1.3. What is accounting information and its role in decision making process? Information plays an important role in making decision process as mentioned above. Thanks for the development of internet, accessing information becomes easier and easier (Saaty, T., L.; & Vargas, L., G., 2009). But this does not mean all of information are useful for our decision making process. Overload of information, the motives and bias of providers, remoteness of information and complex transactions make the decision makers face a higher information risk possibility (Alvin, A.A.; Randal, E. J.; Beasley; & Mark; 2010). 10 Not many information could be considered as accounting information. Nature of accounting is identifying, measuring and recording all transactions of an entity, therefore, accounting information must reflect actual financial events of that entity (Romney, M., B.; & Steinbart, P., J., 2008). Although this information can not guarantee the future events but it can help the decision makers reduce the uncertainties. In other words, historical records can be a useful guideline for both managerial and invested decision makers. From this, mater budget can be prepared to show the business goals of the entity in the new period. Additionally, through differences between the actual and the budgeted numbers, decisions makers can adjust and drive the business into an effective way. By comparing the effectiveness and efficiency of an entity’s performance year to year, accounting information could provide a wide view to users about which activity could their core business categories and how could they allocate the costs more precisely (Hurt, R., L., 2009). All of this information will be updated and filed day by day (Bagranoff, N., A.; Simkin, M., G.; & Norman, C., S., Ph.D. CPA, 2009). As a result, if the outcomes are not as decision makers’ expectation, an investigation will be implemented to ensure whether a new decision should be made. Depending on specific needs and positions of users, accounting information can be judged important or not. For example, for some investors, profitability and earning per share are key information when they decide to invest while others think it needs more criteria such as CSR reports (Coenen, F., H., J., M., 2010) . This means the same 11
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