Manufacturing Costs Composition and the Value Relevance of Accounting Numbers

Manufacturing Costs Composition and the Value Relevance of Accounting Numbers

  Traditional cost accounting model has been under heavy criticism because of arbitrary indirect cost allocation This problem has been cited as a major reason why product cost information has lost its relevance in decision making. This study predicts that arbitrary indirect cost allocation distorts cost information as well as financial statements numbers like inventory and cost of goods sold and hypothesizes that the value relevance of earnings decreases as the ratio of overhead cost to total manufacturing cost increases because cost of goods sold are distorted by arbitrary indirect cost allocation. At the same time, however, the value relevance of book value is expected to show the opposite because the value relevance of earnings and book value have been documented to implement each other.   The objective of this study is to examine the value relevance of earnings and book value as the ratio of overhead cost to total manufacturing costs changes in cross-sectional mode. Manufacturing cost information is obtained through manufacturing costs schedule disclosed by mandate in Korea.   The results of this study support the prediction, indicating that indirect cost allocation distorts accounting earnings through the distortion of cost of goods sold. As far as book value is concerned, however, the value relevance of book value increases as the ratio of overhead cost to total manufacturing cost increases, suggesting that high indirect cost companies have suffered relatively small distortion in book value because the impact of inventory distortion on the total book value is relatively small compared with low indirect cost companies.