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Table of contents
TABLE OF CONTENTS
THE PARADIGMS OUTLINED BY FERRARA.
PARADIGM A THE ERA OF THE INDUSTRIAL REVOLUTION.
Cheap University Papers on Cost / management accounting - The 21st century paradigms
PARADIGM B THE ERA OF COST-VOLUME-PROFIT ANALYSIS AND DIRECT COSTING.
PARADIGM C THE ERA OF ACTIVITY- BASED COSTING.4
PARADIGM D THE ERA OF MARKET DRIVEN STANDARD COSTS AS OPPOSED TO ENGINEERING-DRIVEN STANDARD COSTS.5
THE CHANGE IN THE RELATIONSHIP BETWEEN COSTS AND SELLING PRICE HIGHLIGHTED THROUGHOUT THE 0TH CENTURY6
COMMENTS ON FERRARA'S THOUGHTS ON THE 1ST CENTURY PARADIGM8
The paradigms outlined by Ferrara.
Paradigm A The era of the Industrial Revolution.
The most important or the base of this paradigm was standard cost or the total cost per unit of output. When arriving the total cost per unit of output, almost all the costs including direct materials, direct labor, manufacturing overhead, and even marketing and administrative costs were accounted. As the final step of the process, to achieve the targeted or desired profit a target-selling price per unit was arrived. This was done by adding the desired profit or markup, to the total cost per unit. The bottom line of paradigm A was to achieve the projected costs per unit, to achieve the price (target selling price per unit) that would yield desired profitability.
Paradigm A Calculating and Using Unit Product Costs Ignoring the Distinction Between Fixed and Variable Costs
Manufacturing costs
Direct materials$00,000
Direct labor50,000
Manufacturing overhead450,000
Marketing and administrative costs500,000
Total$1,400,000
What volume of activity should be used to determine unit costs?
How should desired profit be determined?
Paradigm B The era of cost-volume-profit analysis and direct costing.
This introduces the distinction between fixed and variable costs, which ultimately leads to cost-volume-profit analysis and direct costing. The volume of activity issue relates mainly to fixed costs, because the variable costs per unit are determined by engineering standards and analysis techniques and many variable costs have become more fixed over time. In essence, the issue of volume of activity to divide by has become a larger issue as the relative amount of variable costs has diminished and the relative amount of fixed costs has increased.
Paradigm B Calculating and Using Unit Product Costs Using the Distinction Between Fixed and Variable Costs
Variable costs
Direct materials 1.00 per unit
Direct labor1.5 per unit
Manufacturing overhead.50 per unit
Marketing and administrative.5 per unit
Total.00 per unit
Fixed costs
Manufacturing overhead50,000
Marketing and administrative450,000
Total $800,000
Paradigm C The era of activity- based costing.
The activity-based costing (ABC) embodies two additional variable costs i.e. product complexity and product diversity, to develop a more accurate total cost per unit, which then improve the determination of selling prices and product mix decisions. There are three elements of variable manufacturing cost under ABC,
a.Costs that vary with units of product.
b.Costs that vary with product complexity, such as number of batches.
c.Costs that vary with product diversity, such as number of products.
Paradigm C Calculating and Using Unit Product Costs Using Activity-Based Costing
Variable costs
Direct materials$1.00 per unit
Direct labor1.5 per unit
Variable Manufacturing overhead
Variable with number of units.50 per unit
Variable with number of batches.40 per unit
Variable with number of products.5 per unit
Variable marketing and administrative.5 per unit
Total$.75 per unit
Fixed costs
Manufacturing overhead $ 175,000
Marketing and administrative 450,000
Total $ 65,000
Paradigm D The era of market driven standard costs as opposed to engineering-driven standard costs.
Paradigm D introduces using the selling price that the market will allow to help to determine the cost that the market will allow. Perter Drucker has referred to this concept as price-led costing opposed to cost-led pricing .In the cost-based pricing contracts, the market determines the price, and the role of cost is to help determine whether or not it is wise to enter the market or stay in the market. The target cost per unit is a market driven standard cost that has to be met if desired profits are to be achieved.
This creates a series of new issues,
a.The total cost per unit must not exceed the target cost if the desired profit is to be attained.
b.For continuous improvement, the allowable or target cost per unit must be reduced over time.
c.The work process may have to be changed in order to reduce costs.
Paradigm D -The 10s and Beyond The Era of Market-Driven Standard (Allowable) Costs
Selling price (giving competitive setting)xx
Less desired profitxx
Allowable or target cost per unitxx
The change in the relationship between costs and selling price highlighted throughout the 0th century
At the beginning of the century i.e. during paradigm A, a total cost per unit was derived by adding all the costs involved in the production process, and the selling price was determined by adding the desired profit to total cost per unit. Later on during paradigm B a variable cost per unit was derived, and based on the volume of activity a fixed cost per unit was derived, and then adding those together a total cost per unit was derived. The selling price was determined similarly as paradigm A. When considering the paradigm C, with the help of two additional variable costs i.e. product complexity and product diversity, which help to determine the activity of production, a total cost per unit, was derived. Ultimately using the said activity based total unit cost the selling price was determined. Hence when considering the relationship so far between the cost and the selling price, firstly total cost per unit was determined and based on that the selling price was derived.
Towards the end of the 0th century that is during paradigm D we can clearly see that this trend has been changed. No longer was a total unit cost developed in order to determine the selling price, but instead a market driven selling price and a market driven standard cost was used. When elaborating on this it was believed that the selling price was allowed or determined by the market, and based on that we determine the cost that the market will allow. Therefore in order to attain desired profits a market driven standard cost has to be achieved.
Lets look at an example Ingram, R.W., et al (001, pp.15-16)
You are selling leather balls. Your variable (also known as direct) cost per leather ball is $10. Your weekly admin and warehousing expenses total to $000 (your fixed costs). You are currently selling 500 leather balls per week at a sale price of $15. Your Sales are therefore $7500. Your direct costs total to $5000, leaving you $500. After you deduct your fixed costs you have a $500 profit.
Your competitor is selling leather balls at $14. In order for you to stay in the market you have to compete with you competitor. Therefore you decide to drop your price to $14. How can you earn a $500 profit at new price? There are two options available
1.Reduce the variable cost by $500.
Well your basic sales are now 500 x $14 so are now worth $7000. When you reduce the fixed cost of $000 the balance amount of $5000 include the profit and the variable cost. In order to earn a profit of $500, the variable cost should be reduced to $4500.
.Increased the volume of sales.
Suppose your costs remain the same, so on sales of 500 leather balls you are now breaking even. However, your fixed costs are already covered within that $7000, so each additional leather ball you sell will add $4 (14 minus 10) to your profit. To exceed $500 profit, you need to sell 500/4+1 leather balls = 16. So if your price drop to $14 brings in more than 15 new sales you will make more money!
Comments on Ferrara's thoughts on the 1st century paradigm
For the 1st century paradigm Ferrara suggests a combination of paradigms C and D. When considering the present world market we have to accept the fact that it is intensely competitive. Therefore the "market driven selling price "which embodies by paradigm D cannot be ignored. Also he states continuous improvement is a necessity. I agree with afore said facts, because the present world market is an oligopoly and open market. Therefore if you are to stay in the market and achieve desired profits, it is a must you achieve the allowable cost permitted by our competitors.
Further he says to use the ABC method introduced during paradigm C to determine the actual cost. With the help of activity based costing we can achieve the market allowable cost more organisely and methodically. Thereby using product complexity and product diversity we can analyses the production process and reduce production cost.
1. Ferrara recommends a combination of Paradigm C and D.
.Paradigm D is compelling as markets often determine prices and allowable costs to achieve the market price.
.Paradigm D alone is not sufficient; however, because there must be an ex ante and ex post assessment of costs. This is role for ABC from Paradigm C. With such determinations there is not enough information and structure to know if a company can actually meet allowable costs.
Ferrara, William, L., Cost/Management Accounting The 1st Century, Management Accounting (us), December, pp.0-6.
Ingram, R.W., Albright, T.L., Hill, J.W., 001, Managerial Accounting information for decisions, nd Edition, South-Western College Pub, Australia.
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