Management Accounting for Business

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3.1.1 Reducing expenses on business segments

Mike (n.d.) argued, higher predetermined overhead rate is going to reduce expenses in the income statement, which resulted in “over absorption”. (Mike, n.d.)

Therefore, another shortcoming of absorption costing resulted in the wrong decision-making is “skewing the results of decisions made to discontinue business segments (Kathy, n.d.)”. Because the fixed overhead cost allocates to each unit level, in this case, Mark suggested “move to a building with cheaper rent, wash the windows ever other week, don’t have soap” due to the overwhelmed operating expenses for peanut business. However, peanut business is not a main business. Bar and restaurant belongs to service industry, if the supplementary services are not meet the consumers’ expectations, cut the expenses would become the worst decision-making.

3.1.2 Confusion of costs in inventory

According to Kathy (n.d.), “businesses use absorption costing to determine the value of the ending inventory and cost of goods sold (Kathy, n.d.)”.

So long as absorption costing allocates fixed manufacturing overhead to the inventory peanuts, there is no cost of each bag before they were sold. For example, if there were 50 bags of peanuts inventory in the first week and $0.38 fixed overhead allocates to each bag, 40 bags of peanuts were sold, $15.2 fixed overhead would be taken in the first week, which is showing as the inventory cost in the income statement. However, this is supposed to be the cost as long as the peanuts were sold.

This situation consistent with what Kathy (n.d.) stated further, “absorption costing would discourage profitable business…due to the company evaluates each business opportunity using absorption costing as its base cost…but the rejected business may contribute additional profits (Kathy, n.d.)”.

Mark suggested selling the peanuts as $1.60 per bag in order to make 16 cents per bag profit. However, this is not the situation that would make the business profitable. Staying in 40 cents or lower than $1.60 per bag could be a much better pricing decision if adopting other costing accounting system, such as variable costing.

3.1.3 Unsuitable used in service industry

Deo (n.d.) summarizes that, except providing useful information for managers to make pricing decision, absorption costs will always be “arbitrary to some extent”. He explains that the method of cost allocation in services industry is always involves some “drawbacks and areas”.

As discussed earlier, why Mark told Pedro he should not shut down the peanut business due to the annual overhead already incurred. However, selling peanuts in the restaurant is just a supplementary activity. It would not be the main business Mark runs. Even though he was not suggesting to deny the business, but may be he should, because his suggestion is based on the calculation of revenue whether above or below the absorption costs. Therefore, absorption costing is not suitable used by service business and supplementary business like this case.

3.1.4 Opportunity cost in decision making

Ray, Eric and Peter pointed out, “For purposes of making decisions, the concepts of differential cost and revenue, opportunity cost, and sunk cost are vitally important…opportunity cost is the benefit that is forgone when one alternative is selected over another (Ray et al., 2012, p.47).” In this case, Petro is paying $100 for the rack. Rather than buying a rack as an investment for the peanuts business, he could stay in the counter business. Instead, counter business income would forgo, which is the opportunity cost of buying the rack.

Therefore, instead of making decisions based on absorption costing system, understanding cost classifications is much more helpful in providing useful information. Then, Petro would have a much reliable data-driven answer to decide whether stay in or throw way this peanut business.

3.1.5 Unsuitable for unstable peanut selling

Taylor recommended that to calculate and reflect the true cost of units sold in absorption costing would have an important precondition, which is each period should produce and sell the same and steady amount of units. (Taylor, n.d.)

In this case, the sales and production of peanuts are not the same for each week, sometimes the volume of peanut sales could increase or decrease, the operating costs change accordingly. Thus, the overhead costs will fluctuate with the output, no matter if it is fixed or variable overhead costs. However, because fixed overhead cost is constant, which means the level of output does not affect them, so absorption costing does not reflect a very clear and detailed figure of how costs generated.

4. Mark’s narrow perspective on management accounting

It is not just like Mark said “The sole purpose of accounting is to ensure that all costs have been covered, the business made a profit and that shareholders know about it”. Because here we consider Mark is not just an accountant, he is actually playing a role in management position, which is a very important role of this business. He should be responsible for planning, controlling and effective decision-making activities in this business. In other words, he is not just providing financial reports and emphasizing the results of past activities to the external groups. Instead, providing important information to the internal groups and help management activities perform better is what a managerial accountant needs to do (Ray et al., 2012,p230). If he was just “ensure all costs have been covered and the shareholders know about it is made a profit”, the role and purpose of management accounting was misunderstood by him.

4.1 The purpose of management accounting

Management accountant should understand how to implement strategy through planning, budgeting and forecasting (Marino, n.d.). Therefore, not only financial reporting should be measured, but also nonfinancial part.

In this case, Mark should put himself in a managerial accounting position, where the goal of management accountant is clearly made. He applies his professional knowledge to provide useful information to Pedro and help him make smart decisions. If this complementary business of selling peanut will add value to this restaurant, then how to measure the risk behind it? If this business was not going to add any value for this restaurant business, information provided by management