Uniform costing and interfirm comparison
Uniform costing and interfirm comparison: Inter-firm comparison is a natural outcome of a uniform costing system. Uniform costing is the foundation stone over which the structure of IFC is developed and adopted on a large scale. Inter-firm comparison can be defined as the technique of evaluating the relative performance, efficiency, costs and profits of firms in a given industry. The meaning of IFC can be easily explained by considering the main object of the system.
In other words, IFC consists of the following procedure:
(a) Data are collected from participating organizations or firms by their trade organization or centre of inter-firm comparison.
(b) The management of an organisation is provided with information which will allow them to determine the efficiency being achieved, measured by comparing the performances of other businesses.
(c) An attempt is made to show why results vary from one business to another, i.e., any weakness is highlighted.
(d) Extensive use is made of financial and cost ratios.
Objects of Inter-Firm Comparison:
The main purpose of IFC is the improvement of efficiency by showing the management of participating firms its present achievements and possible weaknesses. These firms have to contribute their data to the central body which acts as a neutral body. This central body ensures confidence and it gives reports regarding comparisons only to participants.
The following are important objectives of inter-firm comparison:
(a) IFC analyses the cost of different firms with a view to spotting out relative efficiency.
(b) IFC provides aid to management in enforcing and reviewing budgetary control and standard costing. These techniques enforced in one firm are compared with those in other firms making more efficient use of the same. Inadequacies of standard costing and budgetary control are located by making inter-firm comparisons and remedial measures are introduced.
(c) IFC helps to prepare a comprehensive and detailed plan for firms or units to obtain optimum use of human and material resources.
The main objection of IFC is the improvement of efficiency and identification of weak points. IFC is a scheme consisting of the exchange of information with regard to cost, profit, productivity and efficiency between the participating firms through a central organisation. IFC focuses on the remedial measure of a number of problems related to profit, sales and production.
In inter-firm comparison coordinated and monitored through an apex body or central organisation, attention is usually concentrated on the following major important are:
(i) Is profit adequate?
(ii) How efficient is selling?
(iii) How efficient is production?
The organisation of IFC:
The organisational set-up for inter-firm comparison may be in the form of either a trade association or a Government department or centre for inter-firm comparison. There may be a trade association of participating firms. Firms submit their required information to the association. The Trade association analyses the information collected from the firm and presents a report to each member firm.
The job of coordinating and analyzing of data provided by firms of an industry may be entrusted to a Government Department. The main objective of such an organisation structure of IFC is to exercise price control and regulation of firms.
In the UK, the British Institute of Management had set up a centre for Interfirm comparison in association with the British Productivity council. The centre was established just to meet the demands of trade and industry for an expert body for inter-firm comparison. Such a type of organisation has to prepare schemes for inter-firm comparison. In India also there is a need for such a centre. Thus there should be a central body to coordinate and monitor inter-firm comparison.
Method or Approach for Inter-Firm Comparison:
Firms wishing to obtain the benefits of inter-firm comparison have to approach the central body or apex body constituted for IFC. A fee may be charged for carrying out comparisons. The method of the approach adopted by the central body will be governed by the type of industry or trade and the problems and circumstances present.
The possible procedure may be as below:
- Firms which are to participate in an inter-firm comparison have to submit their data to the central body. These figures are compiled on the basis of uniform definitions of terms, procedures, methods and accounting periods.
- After all necessary steps have been taken to ensure that the participating firms can benefit from the comparison, a number of ratios are compiled. These ratios are shown in a summary form distinguishing.
(a) Ratios for the group of firms participating in the inter-firm comparison.
(b) Ratios for a single firm.
Each firm is given a report compiled along these lines.
- The ratios for the group and the ratios for the single firm are compared one by one.
- Once any significant deviation from the norm (average return on capital employed) is established, the possible reasons for this deviation may be located by examining other ratios.
Ratios of Inter-Firm Comparison:
Ratios used in the inter-firm comparison are of four types:
(i) Primary Ratios
(ii) Supporting Ratios
(iii) General Explanatory Ratios
(iv) Specific Explanatory Ratios
Uniform costing and interfirm comparison
All the ratios can be taken together to form a pyramid as given below:
In addition to the above ratios, some other ratios may be used for the purpose of systematic analysis of operational results. These cover all aspects of business activities and are meant for the measurement of the effectiveness of the resources.
These additional ratios are briefly explained below:
(A) Ratios of Performance Measurement:
- Value of Direct Material/Value of Production
- Cost of Materials/Quantity Produced
- Cost of Scrap / Cost of Raw Material
- Quantity of Scrap / Quantity of Raw Material
- Cost of Rejection / Cost of Production
- Total Output / No. of Workers
- Cost of Production/Machine Hours or Labour Hours
- P.V. Ratio i.e., Contribution x 100/Sales
- Contribution / Labour Hours
- Wages/No. of Workers
- Total Fringe Benefits/No. of Workers
- Idle Time / Total Time
- Overtime Hours / Total Labour Hours
- Standard Hours for Actual Production / Actual Hours
- Actual Hours / Budgeted Hours
- Power Cost / Machine Hours
- Repair and Maintenance Cost / Cost of Production
- Advertising Cost / Selling Cost
(B) Ratios to Judge Profitability:
These ratios show how profitable are company’s operations.
- Gross Profit Ratio i.e., (GP/Sales) ×100
- Net Profit Ratio i.e., (NP / Sales) × 100
GP ratio indicates manufacturing or trading efficiency while NP ratio shows overall profitability
- Return on capital employed i.e., Profit / Capital employed
ROLE indicates overall performance from the standpoint of profitability. It is the primary ratio in the pyramid of ratios
(C) Ratios related to Turnover:
The turnover Ratio shows how efficiently a company is managing current assets.
- Stock turnover ratio i.e., cost of sales/Average stock
This ratio shows the efficiency of inventory management. The average stock is the average of opening and closing stock
- Debtors Turnover Ratio i.e., Debtors * Days or Months in a year / Annual Credit Sales
Debtor’s turnover measures the efficiency in the collection of debts
- Creditors Turnover Ratio i.e., (Creditors x No. of days of months in a year)/Annual Credit Purchases.
This ratio measures the efficiency of the purchasing department in realizing credit facilities
(D) Liquidity Ratios:
These ratios show the liquidity position of the company to meet its day-to-day needs of working capital
- Current Ratio i.e., Current Assets/Current Liabilities
The current Ratio shows the ability of the company to meet its maturing current liabilities. An ideal ratio is 2:1 but it may differ due to the nature of the business.
- Quick Ratio or Acid Test Ratio i.e., Quick Assets i.e., Current Assets excluding inventory/ Current Liabilities
Quick Ratio indicates the ability of the company to meet its immediate current liabilities out of readily realizable current assets.
Reporting:
The central body collects and analysis the data supplied by participating firms calculates relevant ratios and prepares reports to be sent to the individual member firm. Normally code numbers are used in place of names of the firms so that information may remain confidential. The results and interpretations are presented in the report in such a way that individual firm data could not be identified.
On receipt of the comparative data and report of inter-firm comparison, it is the job of the management of the firm to compare operating and other results and the corresponding ratios with ratio furnished by the central body of IFC.
Advantages of Inter-Firm Comparison:
- Under IFC the weakness of participating firms are revealed and the management will be guided to remedial actions.
- The firm will come to know the trend of sales, profit and cost of an industry or trade as shown by different ratios. If all firms are suffering from falling sales, it will be indicated by the sales to capital or asset employed ratio. When an individual firm compares its own ratio with the ratio of the group, it will see that there are general reduction in sales.
- Management of participating firms is provided with the most significant facts on the basis of ratios carefully selected by the central body. The firm will have to do only the study of the ratios and the necessary action.
- Whether firm is doing better or worse than other firms is made known through the ratios. The firm can take positive steps to improve efficiency.
- The experience of the central body is at the disposal of participating firms. This knowledge can be very valuable in the analysis of the performance and profitability of the firm.
- The participating firm provides information willingly knowing that this remains confidential.
- IFC develops cost consciousness among participating firm.
- IFC leads to the avoidance of unfair competition. It guides in the direction of proper and positive efforts towards the improvement of performances.
- Inter-firm comparisons and related data help in representing the problem of the industry to regulating authorities and the Government in an effective and convincing matter. Information regarding the entire industry can be presented before the Government and not the isolated problem of the individual firms.
- Collective information provided under IFC can help the industry in its negotiations with trade unions.
Limitations of IFC:
It is obvious that inter-firm comparison is useful in improving productivity, efficiency and profitability. But benefits are obtained only when ratios are properly calculated and impartially used. The limitations of ratio analysis should be taken into consideration. It should be noted that a single ratio is of a limited value and their trend is most important. Moreover, the limitation of uniform costing should also be taken into consideration because uniform costing provides the very basis of inter-firm comparison
It should also not be ignored that certain extraneous factors such as prolonged strike, and power shortages may also adversely affect the performance of the industry in a particular period. Limitations and shortcomings of annual returns and data may also affect the reliability of conclusions.
It can also be pointed out that there are practical limitations in the formation and maintenance of an independent central agency for inter-firm comparisons. The cost of introducing uniform costing may make the management of firm reluctant to participate in a scheme of inter-firm comparison.