CHAPTER ONE

INTRODUCTION

1.1   Background of study:

Calculating the cost of products or services remains a difficult exercise, especially in highly competitive environments where in order to guarantee long-term profitability, companies must ensure that their product and service costs should not exceed market prices (Hoozee, Vermeire, and Bruggeman, 2009).

However, also in the non-profit and public sector accurate cost estimations are crucial given the need to constantly prioritize spending and to minimize costs because of the limited resources and budget pressures (Linn, 2007; Sudarsan, 2006; Wise and Perushek, 1996).

Costing systems help companies determine the cost of a cost object such as a product or service. Direct costs such as direct labour and materials are relatively easy to measure and can be directly attributed to specific products or services. On the contrary, indirect costs such as marketing, depreciation, training and electricity are not directly attributable to a cost object. Indirect costs are therefore allocated to a cost object using an allocation approach.

An accounting system is an orderly, efficient scheme for providing accurate financial information and controls. Regulatory requirements and internal administration policies are key considerations in the design of an effective accounting system.

Thus, accounting systems show the books, records, voucher, and files and related supporting data resulting from the application of the accounting process. It involves the design of documents and transactions flow through an organization. The uniqueness of small and medium scale businesses calls for careful consideration in the design of accounting systems.

Small and medium scale enterprises are a vast majority of businesses found in variety of primary and intermediate production of the economy. These establishments have tremendous impact on the state and wellbeing of the nation in employment generation, as sources of national outputs and revenues, providing feedstock for large corporations. They may lack the sophistication to apply the detailed accounting processes, yet the value of accounting systems to these businesses is quite profound.

Cost accounting system is a framework used by firms to estimates the cost of their products for profitability analysis, inventory valuation and cost control. It’s also a process of collecting, analyzing, summarizing and evaluating various alternative courses of action. Its goal is to advise the management on the most appropriate course of action based on the cost efficiency and capability.

Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future. Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, information must be relevant for a particular environment.

Estimating the accurate cost of products is critical for profitable operations. Cost accounting is a type of accounting process that aims to capture a company’s costs of production by assessing the input costs of each step of production as well as fixed costs such as depreciation of capital equipment. But its primary function is to facilitate decisions making by managers. As a result, there is wide variety in the cost accounting systems of the different companies and sometimes even in different parts of the same company or organizations.

All types of businesses, whether service, manufacturing or trading, require cost accounting to track their activities. Cost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated during the industrial revolution’s, when the complexities of running a large-scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions.

In the early industrial age, most of the costs incurred by a business were what modern accountants call “variable cost” because they varied directly with the amount of production. Money was spent on lobour, raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes. Some costs tend to remain the same even during busy periods, unlike variable costs, which rise and fall with volume of work.

Over time, this “fixed cost” have become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control, storage and handling, plant supervision and engineering. In the early nineteenth century, these costs were of little importance to most businesses.

However, with the growth of railroads, steel and large-scale manufacturing, by the late nineteenth century these costs were often more important than the variable cost of a product, and allocating them to a broad range of products led to bad decision making. Managers must understand fixed costs in order to make decisions about products and pricing.

For example: A company produced railway coaches and had only one product. To make each coach, the company needed to purchase 30,000FCFA of raw materials and components, and pay 6 laborers 20,000FCFA each. Therefore, total variable cost for each coach was 150,000FCFA. Knowing that making a coach required spending 150,000FCFA; managers knew they couldn’t sell below that price without losing money on each coach. Any price above 150,000FCFA became a contribution to the fixed costs of the company.

If the fixed costs were, say, 500,000FCFA per month for rent, insurance and owner’s salary, the company could therefore sell 5 coaches per month for a total of 1,500,000FCFA (priced at 300,000FCFA each), or 10 coaches for a total of 2,250,000FCFA (priced at 225,000FCFA each), and make a profit of 250,000FCFA in both cases.

However, cost accounting can be traced to the early parts of the 17thcentury. The earliest reference of cost accounting can be seen in Robert Loder’s Farm accounting, (1610-1620). However, the Industrial Revolution in the 18thcentury brought about extensive mechanization of production system resulting in large scale production.

Some efforts were made in UK and USA to install factory cost system as far back as 1805. According to J.L. Nicholson (1913), the cost of manufacturing, the distribution of establishment charges, the commercial organization of the factories’ accounts and their principles and practices were fully understood and explained on how huge losses are incurred due to less effective use of cost management in the factories.

The findings of Horngren and Foster (1987) in their survey found that there is some recognition that the accounting system choices depends on the physical productivity characteristics of the firm. Therefore, the physical processes of production are the keys to the design of cost accounting in large, medium and small enterprises.

An examination of Standard Introductory Text on Operations Management by McClain and Thomas (1985) and Schmenner (1987) reveals a general agreement that production control system can be classified on the basis of process characteristics and demand characteristics.

McClain and Thomas (1985) further classified production system into dependent and independent demand, job shops (batch flow processes), and multistage manufacturing. This is not actually common in small and medium sized businesses due to the inability of acquiring a professional accountant.

1.2 Problem Statement:

The place of sound accounting and internal control systems in any business, irrespective of its scale, cannot be overemphasized. A vast majority of small-scale businesses cannot afford the complexity of a detailed accounting system even if they would have. Hence, the existence of single entries in their books and in some cases incomplete records (Wood, 1979; Onaolapo, et al., 2011). Some major issues have surfaced in recent years concerning the inadequacies of most of the cost accounting systems.

Critics state that the future of many businesses depends on proper cost accounting and advocate major revisions in both cost accounting concepts and systems. Even the most sympathetic supporters of cost accounting recognize that companies need to take steps to make the cost information more timely and useful.

Writers have been critical of “present-day” cost accounting, some as far back as the early 1980s. They reported that cost accounting systems are inadequate to meet management’s needs, especially regarding product costs. Kaplan has been a prominent critic and pointed out that there are problems with product costs (1984), use of cost accounting information for performance measurement (1983), and weaknesses in capital investment decisions (1986).

Traditionally, cost accountants had arbitrarily added a broad percentage of analysis into the indirect cost. In addition, activities include actions that are performed both by people and machine. However, as the percentages of indirect or overhead costs rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all products.

For example, one product might take more time in one expensive machine than another product—but since the amount of direct labour and materials might be the same, additional cost for use of the machine is not being recognized when the same broad ‘on-cost’ percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.

Goldratt (1983) called attention to the distortion of profits through excessive allocation of “value-added” costs to inventory. Edwards (1985) maintained that cost accounting is not bad, just misused; however, Edwards and Heard (1984) agreed that there are several issues to resolve through the joint efforts of accounting and other management functions.

Miller and Vollmann (1985) called overhead costs “the hidden factory” and pointed out that these costs were increasing, often caused by increased transactions, not product costs. More recently, writers proposed new cost accounting systems such as activity-based costing (Cooper et al. 1992; Beischel 1990; Turney 1991), lean accounting (Maskell and Kennedy 2007; Drickelhammer 2004) and resource consumption accounting (RCA) by van der Merwe and Keys (2002)

ABC is based on George Staubus’ Activity Costing and Input-Output Accounting. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.

Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently, managers were making decisions based on inaccurate data especially where there are multiple products.

Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity.

In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products which will help in solving the question of “the effects of cost accounting system on the performance of small and medium sized enterprises”. As a result of the above problems, one cannot refrain from asking some pertinent questions in order to have answers to resolve the problems.

1.3 Research Questions

1. What is performance of small and medium sized enterprises?
2. What role does cost accounting system play in the product costing of SMEs?
3. What are the impacts of the cost accounting system?
4. What is the relationship of cost accounting system and enterprise’ performance?

Check out: Accounting Project Topics with Materials