Activity Based Costing For Pristine Limited: A More Effective Approach

Outdated and Flawed Traditional Costing System

1.Pristine Limited (PL) is a manufacturer and seller of fireproof safes and document containers of various shapes and sizes for home use, including safes made to Australian/New Zealand Industry standard AS/NZS 3809 (Atkinson, 2012). When it comes to preparation of product costing, the company uses traditional costing system, which is a weak system to get a true cost of the product. The general problems associated with PL’s traditional costing system :

• Use Of One Cost Driver: Traditional costing has a concept of using only one cost driver so as to allocate factory overheads such as direct labour hours or manufacturing hours. However, in actuality, there are many other cost drivers such as number of sales order, inspections, machine set ups, etc which are used to allocate the realted costs to each product (Berry, 2009). The more the activities are, the more are the problems of allocating all the costs associated with different activities using one cost driver.
• Missing Allocations: Due to using of one cost driver, the costs associated with different activities will be allocated using one cost pool and therefore, will be divided by total production hours. Such a costing system doesn’t consider the nature complexity of the products.For example; the overhead cost is $500/hour. If an extra hour is used to produce a product, the cost will be up by $500. Thus, the resulting allocations are vague or misleading.

2.Four indicators that highlight that the current costing system is outdated and flawed :

• The traditional costing system is not meant for businesses which are complex in nature or includes a number of activities or operations (Boyd, 2013). PL, being business with complexities past few years, is still using traditional approach of costing. As stated in the case, such a system has been questioned on the grounds of reliability by Christine (managing director).
• There are five different activities in PL’s operations with different cost drivers. However, PL has used asingle rate, resulting in allocation of different costs on the basis of single average rate.
• Where the plastic safe is a complex product and also, has low sales volumes yet it is showing an increase in profits due to issues in costing valuation. It has been shown at a cost lower than what its actual cost should have been. In a similar way, metal safes have been shown at a cost higher than what its actual cost should have been. This resulted in calculation of wrong profits. Such calculations would result in vague results such as PL wasn’t able to meet up with its sales targets.
• There is more material movement in case of plastic safes than metal safes. Also plastic safe, being a complex product, is recently facing a number of rejects. Thus, it is the observation of PL that there is a need of increased quality control activities.

3.

Pristine Limited (PL)
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Activity	Cost driver	Estimated Cost ($)	Total Activities	Cost Rate of Each Activity ($)
Hours
Insulation process	Insulation process hours	180700	13000	13.9
Assembly process	Assembly process hours	69600	4000	17.4
			Numbers
Quality control	Number of inspections	80080	140	572
Materials management	Number of requisitions	47800	1000	47.8
Selling and administration	Number of sales orders	23870	77	310

4.

INCOME STATEMENT
Particulars		Metal Safes	Plastic Safes	Total
Sales Revenues		296900	246800	543700
Less :
Direct Materials		21500	20680	42180
Process and Support Costs	Insulation process	97300	83400	180700
	Assembly process	48720	20880	69600
	Quality control	22880	57200	80080
	Materials management	14340	33460	47800
	Selling and administration	9300	14570	23870
Total Cost		214040	230190	444230
Net Income		82860	16610	99470
Profit Margin		27.91%	6.73%	18.30%

 5.

Particulars	Traditional Costing System	Activity Based Costing System
Product Cost · Metal Safes · Plastic Safes	$253,270 $190,960	$214,040 $230,190
Net Profit Margins · Metal safes · Plastic Safes	14.7% 22.6%	27.91% 6.73%

As represented by the table, with proper allocation of costs associated with differentactivities, we see major differences in values and high flaws of the traditional system (Donanldson, 2012). This can be explained as below:

• With allocation of process and support costs on the basis of cost drivers which is different for each activity, we obtained the true cost of the product. For example, where the cost of plastic safes was earlier $190,960, it is now $230,190 showing a difference of $39,230. Thus, the profits in case of plastic safes were up by $39,230. This resulted in unnecessary vague percentage of profits, that is, 15.87% up from what is should have been in actuality (Girard, 2014).The same is the case with metal safes where profit has been shown 13.21% down.
• With an incorrect costing system, queries such as low profits in case of metal safes inspite of having low prices, being less complex in nature and having higher sales than previous quarter couldn’t be answered (Holtzman, 2013). The vice versa is the case with plastic safes. With valuation through ABC Costing approach, all such queries gets resolved and the targeted results are being shown.

6.As discussed and represented above, we witnessed a lot of flaws in the traditional approach of costing. The following report has been made to the managing director regarding changing the costing approach for better results (Horngren, 2012). It is advisable that the company should adopt activity based costing approach to prepare its books.

Activity based costing (ABC) is an approach of allocating overhead costs in a more practical way to the products than the previous approach of allocating costs on an average rate obtained on the basis of direct labour hours or production hours. It is a two way allocation, that is, firstly assigning costs to the activities that together sums up the total overheads and secondly, assigning the activities to only those products that has actually undertaken such activities (Mattessich, 2016). The reason entities are approaching towards ABC analysis in recent years are because (1) there is a significant increase in manufacturing overhead costs; (2) there is no correlation between the overhead costs with the production hours; (3) entities producing more than one products cannot use a single average rate for all its products as that would give a false cost; (4) there is a growing diversification in products as well diversified demands by customers. The benefits that can accrue due to activity based costing can be explained as :

• True Product Cost: It gives an accurate cost for each of the products the organization is specializing in. This also helps in understanding the true nature of overheads.
• Information about Cost Behaviour: With the correct understanding of overheads, an entity can take into view the expenditure they are making and whether it is justifiable or not. it helps in identification of activities that is no longer adding any value to the product.
• Control over Fixed Costs: with the correct cost information, management can exercise control over activities that are real cause for occurrence of fixed costs. This is possible as with proper allocation, one gets a clear picture of variable as well as fixed costs.
• Better Decision Making: The management can make decisions regarding cost reduction or cost cutting as a more reliable product cost is available with them. This also helps them in setting the selling prices of their products.

Adoption and implementation of ABC costing system is a costly process as it is a way broader concept and includes a number of resources (Mattessich, 2016). The issues associated with ABC costing can be stated below:

• Complex in nature: Due to using of different cost drivers and cost pools, it is complex in nature and this is why, it is a costly system .
• Measurement Difficulties: ABC analysis requires determination of various cost drivers and activities that can serve as the basis for cost allocation. Such measurements require extreme expertise and therefore, are costly. In fact, a simple ABC system also requires a lot of calculations for determining costs. Also, Activity costing rates have to be updated regularly.
• Other Difficulties : Such other difficulties that can be faced are selection of cost driver for an activity, allocation of common costs, varying rates of cost drivers, less knowledge of implementing ABC system properly (McLaney & Adril, 2016) 

7.For a customer of PL who prefers to purchase low margin products and costly services, better profits can be made if the company can consider the following suggestions:

• Sets a competitive price of products: This means having an understanding of the market price and setting the selling price accordingly. This would help in attracting customers. A customer has an understanding of all the selling prices set by different sellers in the market and accordingly, makes its decision of choosing the product. Therefore, setting prices higher than the market price would penalize the company and setting prices lower than the market price would raise questions on the quality of the product.
• Large volume sales of products: low margin products attract customers preferring qualitative products with low margin. Also, low margin products have more number of customers. With increase in number and size of transactions, the company can minimize the effect of costs by having sufficient sales and therefore, profits. The company should conduct practices such as advertising, sales promotion etc to increase its sales (Seal, 2012).
• Discounts from Suppliers: The Company should seek for discounts from suppliers. Discount received would result in deduction of costs and therefore, lead to more sales value and therefore, more profits.
• Making an Analysis of cost of substitute services available in the market : The company should analyze the costs of services of different market suppliers and make a decision based on that regarding which supplier should be selected (Taillard, 2013).

Thus, using above methods and such other similar methods, profitability can be increased or improved. 

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