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Management Accounting: Information for Decision-making

Management accounting information should comply with a number of criteria including verifiability, objectivity, timeliness, comparability, reliability, understandability and relevance if it is to be useful in planning, control and decision-making.
Explain the meaning of each of the criteria named above and give a specific example to illustrate each.
Give a brief explanation of how the criteria detailed in (a) might be in conflict with each other, giving examples to illustrate where such conflict might arise.
Question 2 : (Information for decision-making)
The overriding feature of information for decision-making is that it should be relevant for the decision being taken. However, decision-making varies considerably at different levels within an organization, thus posing a particular difficulties for the management accountant.
Describe the characteristics of decision-making at different levels within an organization.
Explain how the management accountant must tailor the information provided for the various level.
Question 1 (a) Management accounting information should comply with a various number of criteria including verifiability, objectivity, timeliness, comparability, reliability, understandability and relevance if it is to be useful in planning, control and decision-making. Below we are discussing about the criteria needed to achieve its natural reason which is for planning, control and decision- making.
The first criteria of management accounting information is verifiability. It means the ‘ability through consensus among measurers’ to ensure that the information represents the purposes and the right method of measurement has been used without any errors or bias. It also means that it is observable to outsiders, in the context of model of information. Verifiability refers to the ability of accountants to ensure that accounting information is what it is meant to be. The outsiders cannot see the accounting informations and the references to those variables in a contract between the two parties cannot be enforced by outside authorities. An example of verifiability is that of two accountants looking at the same information like inventory valuation and coming to similar conclusions. There are three key aspects in verifiability. The first aspect is consensus among observers. The second one is the assurance of correspondence to economic things and events. The third key aspect is direct verification versus indirect verification.
Besides that, objectivity is another criteria that is also another useful aspect in planning and making decisions. Most accountants these days rely on verifiable evidence. Example of verifiable evidence are invoices, delivery notes, receipts, physical counts or even financial statements. By practicing objectivity, it is now possible to compare financial statements of different firms with an assurance of reliability and also uniformity. In another words, when the management accountant is providing information to the top-level management, they should provide the accurate result without altering or changing anything so that the manager will be able to make a accurate decision without being influenced by anyone.
Moreover, Timeliness is one of the important parts for management to balance the relative merits of timely reporting and the provision of reliable information. Timeliness is concerned with having information to meet needs of decision makers before it loses its capacity to influence decisions. More accurate information may take a longer time to produce. Thus, to provide information on a timely basis, it may often be necessary to report before all aspects of management accounting transactions or any other event. Example, a firm may test-market a potential new product in a city. Despite a long wait for the accurate marketing report may cause a slight delay in the management’s decision to launch the new product nationally and the information will be useless to the decision making process. Thus, it is one of the managerial accountant’s role in the decision-making process which will decide what information is relevant to each decision problem and provide accurate and timely data. Not forgetting that it’s a conflicting criteria. Delaying information can significantly influence decisions and can “rob” information of its potential usefulness. Timeliness can have a direct impact on stock prices. Late reporting can represent “bad news” or a negative forecast. If the delay is great, it allows the opportunity for more information to be reported and to be supplied or maybe even speculated on by other sources.
The next criteria is comparability. This criteria helps us to compare the financial statement of an entity through time in order to identify trends in its financial position and performance. At the same time, this criteria also helps to evaluate and compare the financial statements of different entities. It provides information about a particular entity that can be compared with information about other entities and with similar information about the same entity for some period or some other point of time. For an example, the management accountant should prepare the accounting information in a consistent way using historical concept for every year so that it will be much easier for the company to make comparison with the past accounting information or related entities. The heads of the company must determine if they want comparability to be driven by the type of instrument or other factors such as management intentions and industry segments. For an example, financial service, software and also manufacturing.
Another criteria which is also needed is reliability. It is the quality of information that assures that information is reasonable free from any errors and are bias and faithfully represents what it purports to represent. It related to faithful representations and verifiability. An aspect in the context of reporting for financial instruments is the reliability of measurements including relevant disclosures about such reliability. For example, the staff has observed that many constituents seem to equate reliability with verifiability, not representational faithfulness. For purposes of discussion at this meeting, the staff plans to collect those sub-characteristics into three groups. The first one is, Faithful representation, including completeness and substance over form. The second one is verifiability, including precision and uncertainty. The last one is neutrality, including freedom from bias, prudence, and conservatism.
The second last criteria is understandability. It relates to the user’s perspective and financial informations that are useful. It could be increased by reducing complexities for users through reporting information that represents the underlying economics, or by reducing the number of alternative accounting methods applicable to a subset of asset. Informations that increases the understandability are definitely very useful. Understandability is known as when the users have a reasonable knowledge of business and economic activities and accounting and a willingness to know more the information with reasonable diligence. Information about complex matters that should be included in the financial statements because of its relevance to the economic decision making needs of users should not be excluded merely on the grounds that it may be too difficult for certain users to understand. For the example, management accountant should prepare the accounting information or summarize of the report and analysis that easily understood to the decision maker in order to let them easy to make final decision. One other noteworthy aspect of the interaction of the financial statements and Management Commentary is the understandability of the information provided in the financial reports. Understandability can be adversely impacted by placing related information in different parts of a report and not providing the user with a cross reference. If the IASB does add guidance on Management Commentary to its existing guidance on financial statement disclosures, this would provide an opportunity to better integrate related information.
The last criteria is relevance. It is also very important in the planning, control and decision-making. Relevance is the capacity of informations that are needed to make a difference in a decision by helping the users to form predictions about the outcomes of the past, present and future events or even to confirm or correct prior expectations. Relevance may be represented by determining which values assigned to financial instruments allows user to make better decisions based on the information provided to them. Informations may be deemed more or less relevant based on which measurement basis is being used. Different decisions basically will require different type of data. For example, an analysis on a project should not have any information on indirect costs because it is not relevant for making decision of the project and should include any prime cost because it is relevant cost for the decision-making.
Question 1 (b) Management accounting information is used to satisfy the management needs. Those informations are useful for planning, controlling and decision making. However, these criteria also face conflict amongst one another. Conflict simply refers to the incompatibility or interference of one’s idea, event, or activity with another. In this case, the conflict between criteria will happen when satisfying a criterion affects another criterion being difficult to fulfill as they are in collision with each other. They are few types of conflicts involved. Below are the conflicts.
Relevance vs Reliability
Relevance and reliability are two important criteria which are needed while making a decision. However, often there are some conflicts occur because of these two conflicts, requiring a trade-off between various degrees of relevance and reliability. A forecast of a financial variable may possess a high degree of relevance to investors and creditors. However, a forecast necessarily contains subjectivity in the estimation of future events. Therefore, because of a low degree of reliability, generally accepted accounting principles do not require companies to provide forecasts of any financial variables. Reliability and relevance often impinge on each other. Reliability may suffer when an accounting method is changed to gain relevance and vice versa. Sometimes, it may not be clear whether there has been a loss or either on relevance or reliability. The introduction of current cost accounting will illustrate the point. Proponents of current cost accounting believe that current cost income from continuing operations is a more relevant measure of operating performance than is operating profit computed on the basis of historical cost. They also believe that if holding gains and losses that may have accrued in past periods are separately displayed, current cost income from continuing operations better portrays operating performance. The uncertainties surrounding the determination of current costs, however, are considerable, and variations among estimates of their magnitude can be expected. Because of those variations, verifiability or representational faithfulness, components of reliability, might diminish. Whether there is a net gain to users of the information obviously depends on the relative weights attached to relevance and reliability (assuming, of course, that the claims made for current cost accounting are accepted).
Comparability vs Consistency
Comparability is another important criteria for planning control and decision making. Comparability which enables users to identify similarities in and differences between economic phenomena should be distinguished from consistency; the consistent use of accounting methods. Concerns about comparability or consistency should not preclude reporting information that is of greater relevance or that more faithfully represents the economic phenomena it purports to represent. If such concerns arise, disclosures can help to compensate for lessened comparability or consistency.
Timeliness vs verifiability
Timeliness and verifiability is needed all times for decision making. Information is useful when it is timely. To be timely, the information must be available when needed to define problem or to be begin to identify possible solutions. Those criteria might conflict with verifiability. It is because when needed verifiability information, it may take time to calculate or to get it after production process is end. Verifiability is the useful information when it is accurate. Before relying on information to make decisions, it is important to ensure that the information is correct. For example, a production manager has to decide the actual amount of lychee to be used in produce of 10000 units of lychee drink. But, because of the time given is limited, he has to prepare the report to the top management by forecasting the amount of lychee that will be used. Although he has meet the criteria of timeliness, he is might not meet the criteria of verifiable. This is because, he did not use the actual amount of lychee that will be used. This might cause some problems to occur during the production process. The cost of lychee is lower or others factors. When the production has come to an end, he will be able to know the actual amount of lychee that was been used. So, there is a conflict between timeliness and verifiability.
Timeliness vs reliability
Another conflict is between timeliness and reliability. Information is said to be reliable when they incorporate all aspects of a transaction as well as other events in order to facilitate users in deciding on any issue regarding the latter. However, most of the times in providing timely reporting, those aforesaid transactions or events are never taken into account as it occurs after the report is prepared and thus impairing reliability. In interest of timeliness, the reliability of the information is sacrificed, every loss of reliability diminishes the usefulness of information and as time pass, and either the reliability of the information drops or increase accordingly. For example, the material supplier decides to supply only one of the Material A. Company Y is very interested and is capable to buy the Material A. The supplier is interested on selling the Material A to Company Y, but there is no contract signed between them. As time passes, the supplier received an offer from Company Z’s, with a higher price and shorter time compared to Company Y. Therefore, Material A is selling to Company Z and Y loses the Material A. Company Y is reliable on material supplier to get the Material A yet the supplier needed to sell the Material A in a shorter time to get the profit. So, supplier decides to sell it to Company Z. Thus, the criterion of timeliness is conflict with criteria of reliability.
Question 2(a) The process identifying problems and opportunities and resolving them is called as Decision Making. Decision making is intertwined with the other functions such as planning, coordinating and controlling. Decisions are made in order to change the company’s current status to a more desirable state of affair. Managers, teams, and individual employees make company decisions, depends on the scope of the decision and the design and structure of the organization. Organizations which have decentralized structures will delegate more decisions to teams and front-line employees. Programmability, uncertainty, risk, conflict, scope, and crisis are the characteristics of decision making.
Programmability is divided into two. They are programmed decisions and non-programmed decision. Programmed decision means identifying a problem and matching the problem with established routines and procedures for resolving it. Whereas, the non-programmed decision is the process of identifying and solving a problem when a situation is unique and there are no any previously established routines or procedures that can be used as guidelines.
Uncertainty also has two types. They are certainty and uncertainty. Certainty is the condition when all the information is needed to make a decision. However, uncertainty is the condition when the information available to make a management decision is incomplete.
Risk is the level of uncertainty as to the outcome of a management decision. Risk has positive and negative aspects too. Decision environment for risk vary depending on company size and culture. Those who work in entrepreneurial firm must be more comfortable with making risky decisions than those who work in large corporations with established procedures.
Next characteristic of decision making is conflict. It is always hard to get everyone to agree about what to do. Conflict over opposing goals, utilization of scarce resources, and other priorities are often characterized in decision making.
Decision scope is the effect and time horizon of the decision. The effect of a decision includes who is involved in making the decision and who is affected by it. The time horizon of a decision may range from a single day to five years or more. There are three different level of management. They are the top-level management, middle level management and the lower management. The top-level management takes the strategic decisions. The middle level management takes tactical decision. And the lower level management takes the operational decision.
The top level management who makes the Strategic decisions encompasses a long term perspective of two to five years and affect the entire organization. Top level managers, or strategic manager are also called senior management and executives. They are those individuals who are at the top one or two levels in an organization. Examples of top level management are The Chief Executive Officer (CEO), Chief Financial Officer (CFO), Chief Operational Officer (COO), Chief Informational Officer (CIO), President, Vice President, Chairman and Board of Directors. They have the long-term vision for the company. They are not involved in day-to-day tasks need to possess conceptual skill so as to set the goals for the organization as a whole. For example, Jerry Yang, the former chief executive of YAHOO, was criticized when a $44.6 billion acquisition bid from Microsoft failed under his watch. They frame the organizational policy. They are also responsible for mobilization of resources. They generally make large budgetary decisions for the company and are responsible to the shareholders and the general public. The success or failure of the organization rests on the shoulders of the top level management.
Middle level managers are those in the levels below the top managers. Middle level management makes Tactical decisions which have a short-term perspective of one year or less and focus on subunits of the organization, such as departments or project teams. Tactical decision is the mixture of strategic decision and operational decision. Example of middle management is General Manager (GM), Plant Manager, Regional manager and Divisional manager. Middle level managers are responsible for carrying out the goals set out by top management with setting goals for their departments and other business units. Tactical decisions, the medium term decisions about how to implement strategy, are delegated to middle managers. Middle management decisions might include marketing a new product, communicating with and managing lower management and determining what issues need to be addressed with top level managers. Each individual middle management department develops a strategy to meet its inner departmental goals.
Lower level management makes Operational decisions which cover the shortest time perspective, generally less than a year. Operational decisions, short term decision or also called administrative decisions about how to implement the tactics affect daily tasks and generally handled by lower level managers. They are often made on a daily or weekly basis and focus on the routine activities of the firm such as production, customer service, and handling parts and supplies. Office managers, shift supervisor, department manager, foreperson, crew leader and store manager, are responsible for the daily management of line workers. For example, supervisor may decide to reward the most productive employee with an employee of the month award, or offer incentives such as gift certificates.
The last characteristic of decision making is Crisis. Decision making during crisis is more challenging and difficult than under ordinary conditions. Making a decision in a crisis situation can make or break the career of a manager.
Question 2(b) A management accountant’s duty is to provide information to users who are part of the organization from various levels. However, different level of management has different information needs. Thus, a management accountant has to tailor the information for them.
The first step that should be taken before the management accountant provides any type of information is that he should be clear and understand the company vision as the top, middle and bottom management of an organization. The top-level management is responsible for the long term strategis plan with strategic decisions for about 5 to 10 years time. Therefore the top management will create a mission, which will consist of a more specific goal that unifies company’s efforts. So, the management accountant should prepare budgets for top management accountant to decide which projects have to undertaken to achieve the company’s goals. Budget is a strategic plan that details the action that must be taken during the following year. It also pinpoint the responsibility of achieving the budgets to respective managers inline the company policies. For example, management accountant prepare the imposed budgets to top management before imposed to middle management to achieve targets. In the top-level management, a management accountant should be responsible for all or a part of a company’s financial status, actions and transactions. The management accountant should also maintain budgets, perform financial analysis, build business strategies and also manage their relationships with investors and auditors.
In middle management, they are responsible for developing and carrying the tactical plans to accomplish the organization’s mission. Tactical plans specify how company will use resource, budgets and people to achieve company goals within its mission. In this level, management accountant will use various methods to decide the profit with minimum production costs. Profit volume analysis is one of the methods to calculate changes in cost and sales in determine the profit. Management accountant will calculate breakeven point where the level of sales of company needs to achieve at zero profit. After that, management accountant also prepared the report on scare resources which the supply of resources is limited by define the limit factor. Then, management accountant will produce the product that give higher contribution per limiting factor and take considerations of qualitative factors before final decisions is made. Final decisions is means whether to make or to buy the decision. It is situation where an organization is given a choice to produce by own resources or pay other organization to make the product. After management accountant prepare the information in form of cost volume profit, limiting factors analysis and decisions about activities either to buy or to make, middle management have to decide, carrying the tactical plans and delegating the responsibility of jobs to the operational management. In a summary, the types of information that a management accountant should tailor to middle-level management is like preparing financial statements, assess internal controls, supervise accounting staffs, complete and review tax returns and also help to manage the general ledger.
Lower lever management is responsible to carry the operational plans where it is related to day to day plans in producing products or services. For example, management accountant will determine the economic order quantity for lower management to know the amount of inventory they should reorder order to minimize ordering cost and holding costs. Therefore, lower level management will order the maximum order. In the lower level, the types of informations a management accountant should tailor are receivables and payrolls, financial statement and compliance audit, help in the budget department and also prepare reports for the controller’s department.
Question 2(c) An example of a typical management decision is Strategic Decision. Strategic Decision would normally be taken at first level which is top management.
A top management approach is one where an executive, decision maker, or other person or body makes a decision. This approach is disseminated under their authority to lower levels in the hierarchy, who are, to a greater or lesser extent, bound by them. For example, a structure in which decisions either are approved by a manager, or approved by his or her authorized representatives based on the manager’s prior guidelines, is top to bottom management. Top management translates the policy (formulated by the board-of-directors) into goals, objectives, and strategies, and projects a shared-vision of the future. It makes decisions that affect everyone in the organization, and is held entirely responsible for the success or failure of the enterprise Strategic decisions are broad based, qualitative type of decisions which include or reflect goals and objectives. Strategic decisions are non quantitative in nature. Strategic decisions are based on the subjective thinking of management concerning goals and objectives.
Besides that, there are impact of mergers and acquisitions on top level management.
Impact of mergers and acquisitions on top level management may actually involve a “clash of the egos”. There might be variations in the cultures of the two organizations. Under the new set up the manager may be asked to implement such policies or strategies, which may not be quite approved by him. When such a situation arises, the main focus of the organization gets diverted and executives become busy either settling matters among themselves or moving on. However, the decision maker must be well equipped with a degree or must have sufficient qualification to solve the problems that arises.
Knowledge of management accounting is needed by the decision-maker to come out with relevant information. A part of that, there might be an impact on tax because of this decision made. The information provided not only for the inside people but also for the external people such as shareholders or supplier.
On the other hand, top management will practises non-routine concept for all the activities held. Non-routine is known as nonrecurring decision such as the following to accept or reject a special order; to make or buy a certain part, to sell or process further, or to keep or drop a certain product line or division. In these types of decisions, the decision maker must have knowledge of relevant costs and contribution margin.

Valuation Methods of Inventories: Advantages

The subject of this paper is the valuation of inventories. We have looked at the rules of the International Financial Reporting Standards (IFRS) and Dutch rules. The Dutch rules can be dividend in Title 9 of Book 2 of the Dutch Burgerlijk Wetboek (BW) which is a part of the Dutch law and the recommendations made by the Raad voor de Jaarverslaggeving (RJ) which are giving a interpretation of the Dutch law, but which are not a part of the Dutch law.
The research question of this paper is:
Which valuation methods of inventories are allowed or not and what are their advantages and disadvantages?
Before we are starting with this question we tell you about the general lay out of the different rules and standards in chapter 2. In chapter 3 we will explain the methods based on the historic cost price. This chapter tells you about costs of purchase, costs of conversion and methods to assign costs. We will explain the differences between fifo, lifo and hifo. Chapter 4 deals with fixed transfer price. Chapter 5 describes the fair value (or actual value). Chapter 6 describes one interpretation of fair value, namely the replacement value. Chapter 7 describes net realizable value and the difference with fair value. Chapter 8 will tell you in short about the selling price.
At the end of this paper in chapter 9 we will give our opinion about which methods should be used.
General laws and standards
The use of IFRS is for the consolidated statements of listed companies. All other companies in the Netherlands can opt for the application of IFRS or Dutch Law in Title 9 of Book 2 of the BW and the rules which were made by the RJ. [1]
IAS 2 (IFRS)
IAS 2 sets out how to deal with inventories. Paragraph 6 defines inventories as follows:
Inventories are assets:
held for sale in the ordinary course of business;
in the process of production for such sale; or
in the form of materials or supplies to be consumed in the production process or in the rendering of services. [2]
IAS 2 is not applicable for all kinds of inventories. Work in progress arising from construction contracts, including directly related service contracts, financial instruments and biological assets related to agricultural activity and agricultural produce at the point of harvest has their own IAS.
IAS 2 paragraph 9 prescribes that inventories must be measured at the lower of the cost and net realizable value. This leads to a requirement for impairment test. Paragraph 10 prescribes that the costs of inventories shall contain all costs of purchasing, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Paragraph 6 prescribes that the net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
Book 2, Title 9 of the Burgerlijk Wetboek (Civil Law of the Netherlands)
The Dutch Law defines in article 2:369 BW about the next four types of inventories:
Commodities and consumable supplies;
Work in progress;
Finished goods and goods for trading;
Prepayments on inventories. [3]
Article 2:384 lid 1 BW allowed the purchase price, the manufacturing price and the actual value to use for valuation of the inventories. Article 2:384 lid 7 BW gives an own regime for financial instruments, other investments and agricultural inventories.
In the “Besluit Actuele waarde” the rules of Book 2 title 9 are further explained. [4]
Raad voor de Jaarverslaggeving
The Raad voor de Jaarverslaggeving (RJ) gives the following definition of inventories:
Assets which are held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.
The RJ prescribes in rule 220.301 RJ that inventories must be valuated based on the cost-price or the lower market value or actual value.
220.201 RJ defines when an inventory item has to be recognized. The inventories are only assets if it is probable that the future economic benefits in according to the assets will be for the company and the costs of the assets can be solid measured.
Comparing the rules
The definition of inventories is the same in IAS 2 and the rules of the RJ. Book 2 BW is applicable on every type of inventory. IAS 2 is not applicable for every type of inventory. Excluded inventories have their own IAS. Actual value is allowed in the Dutch rules, but not under IAS 2. There are not any differences between the Dutch BW and the RJ about valuation techniques. This is logical, because the RJ has to deal with the Dutch BW.
Historic cost price
Although there is much criticism about his system, this one of the most used method of valuation of inventories. When you think of historical cost, you immediately think about costs of purchase. But that are not the only costs. Think of transport costs, administrative costs, taxes and other cost. Factories even have cost to complete the products. We call these costs of conversion.
Costs of purchase
Costs of purchase are not only the price paid for the product. There are more costs that you have to pay. For example import duties, administration cost and shipping cost. Value added tax can be recoverable by the entity from the taxing authorities [5] . These taxes are therefore no costs and cannot be added to the inventory. All other costs that are directly related to the product can be added to the inventory (according to IFRS).
It is important that also revenues from discounts are deducted from the total costs of purchase.
We shall make an example. Let assume there is a company in the Netherlands. They want to buy oranges in Africa. The oranges normally costs 2 euro per kg, but the company gets a discount (because they buy a large quantity). They cost now €1,50 per kg. The company buys 500kg. Value added tax is €0,50 per kg (based on the discounted price). To ship the oranges to the Netherlands there are costs: €100. The company also needs to pay import duties: €50,-.
The costs of purchase can be determined as followed:
Price: 500kg x €2,- = 1,000
Discount (500kg x €0,50) = (250)
VAT (500kg x €0,50) = (250)
Shipping cost = 100
Import Duties = 50
Cost of purchase = 650
Note that you really pay €900,- in total. But 250 will be returned to you by the tax authorities.
Costs of conversion
Costs of conversion are the costs that occur when a manufacturing entity makes products out of raw materials. You do not only have the raw materials. Think of the machines in the factory and employees. These are examples of direct costs. But they are not the only costs. There are many costs that cannot be directly linked to a product: administration, electricity, depreciation of machinery and so on.
But which costs should you assign to the product (and inventory). This is a topic that is very much discussed in management accounting.
There are basically 4 types of methods to allocate costs to the products. Throughput costing, direct costing, absorption costing and activity based costing.
Throughput costing
Throughput costing traces the least amount of cost to the inventory. Throughput costing only assigns only the direct costs. These direct costs are based on unit-level. This is an advantage because otherwise managers would have an incentive to overproduce [6] . Managers do that because you are able to lower the average cost per unit when you produce more. We shall give an example:
A company produces 10.000 products. 5000 products will be sold.
Fixed costs are $ 50.000 and variable costs are $ 1 per unit.
Selling price = 15
We assume that there is no beginning inventory.
We can see that in this example the profit is much higher under absorption costing. In this example is the production higher than the actual sales. Note that if the production is equal to the sales, there would be no difference. If the production is lower than the sales, you need to have a beginning inventory and profit under absorption costing is lower. This is because you take a part of the last years fixed cost and takes that this year. So it looks like throughput costing is a good system because you can’t steer the profit, but it violates the matching principle. That is why this method is not allowed for external reporting purposes.
Direct (or variable) costing
In this system all variable manufacturing costs are allocated to the inventory. All other costs flow into the expense of the current period. The variable manufacturing costs include direct material, direct labor and variable overhead. Variable overhead can be for example the electricity needed to operate machines.
Absorption costing
In absorption costing all of the manufacturing cost (fixed and variable) capitalized in the inventory. As we mentioned earlier, this means that the cost will not be an expense until the product is sold. The only costs that are taken at cost when incurred are selling and administrative costs. This is the system that is mostly used for external reporting. This is because it is aligned with the matching principle. Today, this system is now increasingly used also for internal reporting.
But as mentioned earlier, this system has a great disadvantage that it might encourage a manager to overproduce.
Activity based costing
Activity based costing is invented to improve traditional costing systems. The system provides more accurate product costs. You have to first assign costs to activities and then to goods and services based on how much each good or service uses the activity.
You can say that activities consume resources and products consume activities
You can determine the cost of goods and service in four steps:
Step 1:
Search for activities that are related to the company’s products. You need to make a list of activities and classify them as unit-level, batch level, product level, customer level or facility level. There are varies ways to do this:
You can use the top-down approach. The organization use specials ABC teams of people at the middle-management or above. Advantage of this method is that generating the activity dictionary is quick and inexpensive. [7]
You can also use the interview or participative approach. In this method you interview operating employees. So you have to rely on their knowledge.
And last but not least you can use the recycling method. In this method you have to reuse documentation of processes used for other purposes.
Step 2:
Estimate the costs of the activities that you identified in step 1.
Step 3:
Calculate a rate for each of the activities that you indentified in step 1.
For example machine cost is caused by hours it is used. So you need to calculate a rate per machine hour used.
Step 4:
Assign the activity cost to the product. For instance: measure how much hours you used and calculate total cost assigned to the product. Do this for all of the activities.
As you can see it is a very time-consuming and therefore expensive method. But you get the advantage of detailed information. Therefore a company needs to evaluate whether the extra information has a higher value than the costs.
As you can see, fixed costs are included in this system to. The system treats all costs as variable.
ABC is not used for external inventory valuation, but for decision-making purposes. This is because selling and administrative costs are also included. Activity based costs are therefore also not charged to the inventory accounts.
That’s why most of the companies that use the ABC method have an IT-system. This system is separate from the companies accounting system used for external reporting.
Normally the process of identifying is done once per year, or when changes are made in the production process.
Main difference with other costing systems is that other costing systems the manufacturing costs are allocated to products on the basis of production volume related measurement such as direct labor hours. ABC uses both production volume and non-production volume related bases. In ABC an attempt is made to assign all costs to products including engineering, marketing, distribution and administrative costs [8] .
Methods to assigning costs
Historical cost price is only a valuation at first recognition. For subsequent measurement you have different methods for assigning costs to inventory on sale.
Fifo
We begin with fifo. Fifo means first in first out. According to this method you assume that items that were first purchased are first sold. This is not literally. This method makes more sense in businesses where actually the first purchased products are first sold. This is the case in for example a supermarket. In this method the remaining inventory comes near to replace value. Because the inventory is valued for the price that you have paid last time. If this was not a long time ago, this last price is the replace value.
When products decrease in prices (deflation), fifo gives a lower income. This can be an advantage when you have to pay tax. But when there is inflation, fifo gives a higher income.
LiFo
Lifo means last in first out. It is basically the same as fifo, but in this method you assume that the last purchase goods are first sold. When goods do not have an expiry date this is a method that makes sense. For example think of a warehouse full with steel. You grab the first one you can reach. Steel will not decrease in value over time. It is a lot more work to grab the last one. In that way you actually first sell the product that you bought last.
When you use lifo, the cost of goods sold comes near replace value. This is because you use the newest purchase cost. But the inventory is valued according to the oldest products purchased. When there is inflation, lifo gives a lower income. This gives an advantage when for example you have to pay tax.
Collective LiFo (periodic LiFo)
In collective LiFo, the amount of inventory is determined periodically by conducting a physical count and multiplying the number of units by a cost per unit to value the inventory on hand [10] .
This makes a difference with normal LiFo. This difference can be best explained with an example:
A company buys on 1/1 500products á $1,50
Buys 1/4 200products á $1,60
Sells 1/5 600products
Buys 1/7 300products á $1,40
Sells 1/9 200products
LiFo:
When the company sells on 1/5 the purchase cost of that 600products are:
200 x 1,60 400 x 1,50 = $920,-
There are 100products left in the inventory with the worth of $1,50 each= $150,-
When the company sells on 1/9 the purchase cost of that 200 products are:
200 x 1,40 = 280.
Total costs of purchase for the period = 280 920 = $1200
The worth of the inventory on the end of the period = 100 x 1,40 100 x 1,50 = $290
Collective Lifo:
This time we do not look at when the company sells, but only at the end of the period. At the end of the period there are 800 products total sold (800 200).
The purchase cost of that product can be calculated as follows:
300 x 1,40 200 x 1,60 300 x 1,50 = 1190
The worth of the remaining inventory = 200 x 1,50 = $300
As you can see this makes a difference of $10. In this example it is not that much. But think of a company that buys and sells every day. In that case the difference can get much bigger.
Collective Lifo is a good example of a periodic method. Lifo is a perpetual method. As you saw in the perpetual method the inventory are updated each time a transaction involving inventory takes place. In the periodic method the amount of inventory is determined by conducting a physical count [11] . Unfortunately despite the advantages, this method can only be used for homogeneous products.
The perpetual method is a much more time consuming method. Therefore the cost is higher. But this method has advantages. You can get anytime you want information about the cost of purchase and the value of the remaining inventory. Therefore management can make better decisions. Because of the better control that you have, you will immediately see differences in stock. These differences can come from multiple reasons, for example they can be stolen or spoiled. Management can examine why there is a difference and can take action.
Hifo
Hifo means highest in first out. In this method you assume that the goods with the highest value will be sold first. In this case the company records the highest cost of goods sold as possible. Therefore, this method decreases your income. This is an advantage for companies, because they have to pay less tax or have less attention from for example environment associations or government. For example shell will not make too much profit. Otherwise government would raise taxes because it is polluting for the environment to produce oil. The cost for having this attention is called political cost. You need to minimize that cost.
This method can also be Lowest in, First out. It works the same way. Only in this way you maximize your profit. This can be an advantage for managers whose income is dependent of the profit.
Average costing method
The inventory is based on the average costs of all products. This can be a weighted average; this is the average of a period. The average can also be a moving average. In this case the average is changed every time the company buys new products or when there is a purchase return. This method makes the assumption that all products are homogeneous. Therefore it makes sense to use it in companies that have homogeneous products. The method has the advantage that is very easy to apply.
Because it is an average, you eliminate unusually high or low materials prices. This can help for better or stable cost estimates.
Fixed transfer price (Dutch: vaste verrekenprijs)
When purchase prices changes a lot it is very time consuming to register individual purchase price. It is even more time consuming when a company has a lot of transactions. That is why a fixed transfer price can be used.
The fixed transfer price is based on a fixed purchase price plus cost of purchase and cost of inventory.
At the beginning of the period, an average purchase price, average purchasing cost and average inventory cost is estimated.
Because it is an estimation, there will be differences in the real cost and the estimated cost.
The difference must be recorded on a separate account called: price differences at purchase. [12]
An example:
Company Bert sells chairs. The fixed transfer price is $ 200,-.
This price consists of:
Purchase price $ 160
Purchasing cost 10
Inventory cost 30
$ 200
The company buys 50 chairs for a total price of $ 8200. The following journal entry has to be made:
Inventory $ 10000 (50 x $ 200)
Price differences $ 200
a/ revenue purchasing department $ 500
a/ revenue inventory department $1500
a/ creditors $8200
Price differences are only based on the difference between expected purchasing price and real purchasing price. Therefore price differences is 8200 – (50 x 160) = 200. In this case the difference is an asset, because you actually paid more than the worth in your inventory. But sometimes you evaluate your inventory to high, because actual price is lower.
For example:
Company Bert buys 50 chairs for total price of $ 7800.
Journal entry will be:
Inventory $10000
a/ revenue purchasing department $ 500
a/ revenue inventory department $1500
a/ creditors $7800
a/ price differences $ 200
You can see that inventory did not change. That’s why FTP has the major advantage that inventory is easy to valuate. You can immediately calculate how much units you have (Inventory divided by FTP).
When you sell your products the sale will be calculated on actual price. The difference will disappear.
For example you sell 40 chairs of the 50 chairs you bought. You sold them for $400,- per chair. Journal entry will be:
Cash 40 x $ 400,- = $16.000
a/ Sales $16.000
Cost of goods sold (8700/50) x 40 = $ 6960
Price differences = $ 1040
a/ inventory 40 x 200 = $ 8.000
Cost of goods sold is valuated at actual price (in this case). This can also be on average price.
The remaining price difference only consists of the 10 remaining chairs in inventory.
If they are sold too, the price difference is 0 again.
Price differences are a correction on the inventory. When you use average cost price you create a special situation. Because then price differences are not only a correction on the inventory but also on the cost of goods sold. Therefore you have to make a distinction between price differences that go to the balance sheet and that go to profit and loss account, at the end of the period.
Fair value (or actual value)
Paragraph 6 of IAS 2 gives the following definition of fair value for inventories:
“Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.”
How works the fair value accounting method?
Fair value isn’t laid in one conception. The basis of fair value is that the value of an asset or liability is the value for what the asset can be traded between well informed, independent parties which want to do the transaction. The best indication of fair value is the quoted price on an active market. But not every asset has a quoted price on an active market. If an active market isn’t available, than you can look to the last transaction. This is just a good indication if the economic situation has been the same. At least you can use valuation techniques to determine the valuation. Other fair value conceptions are value in use and replacement value. [13]
Is the fair value accounting method allowed for inventories?
IAS 2 doesn’t prescribe fair value as a valuation method. The RJ allows the use of fair value for valuation of inventories in 220.301 RJ. Art. 2:384 lid 1 BW allows the use of fair value. [14]
IAS 2 gives an explanation of the conception of fair value, because it explains that net realizable value may not equal to fair value minus selling costs.
Article 8 of the “Besluit Actuele waarde” explains that you can use the replacement value for inventories, besides the agricultural inventories. If the gain value is lower than the replacement value, than you have to use the gain value. If it is probable that the inventories will be replaced, than you have to use the gain value. For agricultural inventories which are valuated by actual value, you have to use the realizable value.
220.331 RJ describes if the inventories will be valuated by the actual value and that is probable that the inventories will be replaced, than must the actual value be based on the replacement value or the lower realizable value. 220.332 RJ says if the inventories will be valuated by the actual value and it is not probable that the inventories will be replaced, than must the actual value be based on the realizable value. The replacement value and the realizable value will be explained in another part of the paper.
What are the advantages and disadvantages of fair value?
The general advantages of fair value accounting for inventories are:
More transparency
Providing more information (about the market prices)
Financial reports are less subject to ‘earnings management’. [15]
Disadvantages are:
Fair value accounting can be expensive. Implementation and maintenance of a fair value accounting system will cost time and resources.
Fair value accounting for inventories is allowed by the RJ and the BW, but not by the IFRS. This can be confusing for some companies.
We think that it will be good if the Dutch rules and the IFRS will be the same, because this makes it more clear for the companies if the allowed or not to use fair value accounting for inventories. We don’t think that fair value must substitute the other methods, because for some companies is it not easy to measure the fair value.
Replacement value
There are two variances of the replacement value method: replacement value with a normal inventory and replacement value without a normal inventory. First we will give an example of the replacement value with a normal inventory: base stock value (ijzeren voorraadmethode). After this example we will explain the replacement value without a normal inventory. The function of the replacement value method is inventory valuation.
Replacement value with a normal inventory
How works replacement value with a normal inventory?
An example of replacement value with a normal inventory is the use of a base stock.
The base stock is the inventory which the company needs for a continued process of the company. The base stock can exist of a physical inventory and an economic inventory. The economic inventory consists of the physical inventory plus the orders and minus sales which are not delivered. The company has a price risk on the economic inventory. [16]
The company can valued the base stock by the next three values:
The price paid in the past;
Or the lower buying price on the balance date;
Or the lower net realizable value on the balance date.
The base stock is valued by an established price. It is possible that the actual inventory differs from the base stock. There are two types of differences: a manco or a surplus. There is a manco when the actual inventory is lower than the base stock. The difference between the actual inventory and the base stock has the company to buy as soon as possible and must be valuated by the using the replacement value. The replacement value is the price which the company has to give if she buys today the inventory to solve the manco.
There is a surplus if the actual inventory is higher than the base stock. The surplus must be valuated by using the minimum valuing rule. The company has to use the lowest of the following values:
The last paid price (Fife method);
Buying price on balance date;
Selling price on balance date.
The reason of this rule lies in the prudence principle. [17]
This system doesn’t take into account changes of the value of money. The system is used to determine the profit which can be pay out. [18]
There is a profit on the selling on e. of 50 (e-/-b) and a profit on the selling on f. of 50 (f-/- 0,5c). The total profit is 100.
Is it allowed to use the replacement value with a normal inventory?
IFRS doesn’t allow the use of the replacement value with a normal inventory. In the Netherlands has the Hoge Raad decided that the base stock method still acceptable is for the calculation of the taxable profit. [19]
220.204 RJ says that a method which uses the economic inventory can’t be a basis for valuation. 220.301 RJ prohibits methods which are using a “normal inventory”; one of these methods is the base stock method. The reason behind this idea is that the balance has to reflect the physical inventory.
What are the disadvantages of this method?
A disadvantage of this method is that it is difficult to make a definition of ‘the normal inventory’. Another disadvantage is that you have to deal with results of price speculation. The use of a normal inventory method leads to differences between the physical inventory and the normal inventory. This is sometimes confusing. [20]
Replacement value without normal inventory
The second method of using replacement value doesn’t know a normal inventory.
How works replacement value without normal inventory?
Replacement value is the value which you have to give if you want to replace your asset for another asset with the same economic value. [21]
If the price of the inventory increases you make a revaluation reserve with the same value as the price increasing.
An example:
Company Y has 1000 pieces as inventory. Every pieces has she has bought for 5 euro. The price increases to 6 euro. The company has to make a revaluation reserve for 1000 euro. (1000 x €1) [22]
If the replacement value of the inventory decreases, than you must the change deduct from the revaluation reserve. If the revaluation reserve isn’t big enough, than you must the decrease subtract directly from the profit- and loss account. [23]
When is it allowed to use the replacement value without normal inventory?
IAS 2 doesn’t allow the use of the actual value, and implicit the use

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