The management of the organisation has to take various important decisions which includes product costing also. The price determination of a product is a difficult job. The management has to consider many factors into consideration before taking any final decision. A wrong decision might hurt the financial stability of the company.
Beztec limited is engaged in the production of printer whose names are Lexon and Protox. The management of the company is thinking of replacing the older version of Lexon with a new version. The management has taken up this decision because of the low returns. It is the view of an accountant Sue Smith that these results are because of the adoption of inappropriate costing methods. It is also of the view that the management must change th method of costing which will help them to take correct actions.
In this assignment, we will learn about the two different costing methods and the importance of using an appropriate costing method (Atkinson, 2012).
Traditional system of costing and its disadvantages
In the traditional method of costing a pre determined cost rate is found out on the basis on any particular factor such as machine hour or labour hour and that rate is allocated among the various products. The costs that are incurred jointly also has to be allocated unit wise in order ascertain the unit cost (Berry, 2009).
Traditional system of costing is considered to be obsolete because it does not give important to the actual resources that are consumed in order to produce a particular product. This costing method is proffered by the firm who produces a single type of product and the firms whose production process is not complicated. However, we know that the production process nowadays is complex and comprises of many activities. In order to determine the correct price per unit of a product it is important to allocate the costs properly.
The burden of overhead costs shifts from one product to another under the traditional costing method. The costs cannot be allocated in any equal proportion because the resources consumed by different products may vary. So, if all the products are charged evenly it would lead to improper pricing resulting in under pricing some products and over pricing some of them (Boyd, 2013).
The firms engaged in production process with various activities usually opt for Activity based costing because of these disadvantages. Since, Beztec limited is engaged in the production of two types of products it would opt for modern costing method so that an appropriate price could be determined.
Activity Based Costing
The modern form of cost allocation is also known as Activity Based costing. This method was introduced in order to overcome the drawback of the traditional costing method. In the modern costing method, the management has to collect and analyse the data properly for the purpose of cost allocation (Girard, 2014). The units that are consumed in various activities along with the amounts incurred by them are recorded separately for each product. This data is collected in order to get the cost per unit of activity consumed.
The main reason why this costing method is preferred is because the costs are allocated only when the function has been utilised and only to the extent the function has been used. Therefore, it avoids over pricing or under pricing the product. The results found from activity based costing are totally reliable (Holtzman, 2013).
Importance of correct costing method
An appropriate costing method is required in order to take correct decisions. In order to understand this better let us take an example of the scenario provided to us. From the data provided to us, we will see that the company should phase out one line of production but when proper methods has been applies then the results obtained is totally different (McLaney & Adril, 2016).
It is very important for the management of the company to choose a correct costing method of allocation. The final decisions taken up by the management of the company are based on the financial data that they have. If the data on the basis of which the decisions are taken is found to be inappropriate or misarranged then the management might take wrong decisions which might affect the company adversely in the long run. A wrong decision may also result in collapse of the company (Paul, 2014).
Analysis of cost data of Beztec Limited
The existing income statement of the company is as follows:
|
Beztec Limited |
|||
|
Income statement for the financial year ended 31December 2017 |
|||
|
|
Lexon |
Protox |
Total |
|
Revenues |
$23 760 000 |
$7524 000 |
$31 284 000 |
|
Cost of goods sold |
15 048 000 |
5 266 800 |
20 314 800 |
|
Gross margin |
8 712 000 |
2 257 200 |
10 969 200 |
|
Selling and administrative expense |
6 996 000 |
1 613 700 |
8 609 700 |
|
Operating income |
$1 716 000 |
$643 500 |
$2 359 500 |
|
Units produced and sold |
24 000 |
6 000 |
|
|
Operating income per unit sold |
$71.50 |
$107.25 |
The operating income from Lexon is $71.50 per unit whereas the operating income from Protox is $107.25 per unit. The management is thinking of stopping the production of Lexon because of its low operating income.
The management must calculate the operating income of the products based on the activity based costing so that it can evaluate the validity of the management’s decision. In this assignment few more information is collected of the various activities consumed in order to calculate the activity rate per unit consumed:
|
Activity-cost-driver quantities |
|||
|
Activity-cost driver (driver quantity) |
Lexon |
Protox |
Total |
|
Soldering (number of solder points) |
13,33,125 |
4,33,125 |
17,66,250 |
|
Shipments (number of shipments) |
18,225 |
4,275 |
22,500 |
|
Quality control (number of inspections) |
63,225 |
23,963 |
87,188 |
|
Purchase orders (number of orders) |
90,113 |
1,23,727 |
2,13,840 |
|
Machine power (machine-hours) |
1,98,000 |
18,000 |
2,16,000 |
|
Machine set-ups (number of set-ups) |
18,000 |
15,750 |
33,750 |
|
Calculation of activity rate |
|||
|
Activity-cost driver |
Total activity costs |
Total Number of Activities |
Rate per unit |
|
Soldering |
11,65,725 |
17,66,250 |
0.66 |
|
Shipments |
10,64,250 |
22,500 |
47.30 |
|
Quality control |
15,34,500 |
87,188 |
17.60 |
|
Purchase orders |
11,76,120 |
2,13,840 |
5.50 |
|
Machine power |
71,280 |
2,16,000 |
0.33 |
|
Machine set-ups |
9,28,125 |
33,750 |
27.50 |
The cost of activities which have actually being consumed on the basis of rate per activity unit is shown below:
|
Allocation of Activity Cost |
||||
|
Activity-cost driver |
Lexon- Activity |
Lexon – Amount |
Protox-Activity |
Protox-Amount |
|
Soldering |
13,33,125 |
8,79,862.50 |
4,33,125 |
2,85,862.50 |
|
Shipments |
18,225 |
8,62,042.50 |
4,275 |
2,02,207.50 |
|
Quality control |
63,225 |
11,12,753.62 |
23,963 |
4,21,746.38 |
|
Purchase orders |
90,113 |
4,95,621.50 |
1,23,727 |
6,80,498.50 |
|
Machine power |
1,98,000 |
65,340.00 |
18,000 |
5,940.00 |
|
Machine set-ups |
18,000 |
4,95,000.00 |
15,750 |
4,33,125.00 |
|
Total |
|
39,10,620.12 |
|
20,29,379.88 |
From the above table, we can observe that the overhead cost allocated on the basis of traditional costing method is higher than the actual amount (Pratt, 2009).
The operating income per unit for the products based on this cost allocation rate is as follows:
|
Beztec Limited |
|||
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Income statement for the financial year ended 31December 2017 |
|||
|
|
Lexon |
Protox |
Total |
|
Revenues |
237,60,000 |
75,24,000 |
312,84,000 |
|
Cost of goods sold |
136,78,620 |
66,36,180 |
203,14,800 |
|
Gross margin |
100,81,380 |
8,87,820 |
109,69,200 |
|
Selling and administrative expense |
69,96,000 |
16,13,700 |
86,09,700 |
|
Operating income |
30,85,380 |
-7,25,880 |
23,59,500 |
|
Units produced and sold |
24,000 |
6,000 |
|
|
Operating income per unit sold |
129 |
-121 |
So from the above calculation we can see that there would have been operating losses for the company if it stopped the production of Lexon.
Recommendation for Sue smith
In every organisation, it is the duty of the accountant to ensure that the financial statement show a true and fair view of the company. So, in the given scenario it is the duty of Sue Smith, the accountant of the Beztec limited that the financial data provided by the company i useful and relevant (Rogers, 2015).
In the view of smith the company must opt for activity based costing as it would help the management to take correct decisions. But the CEO of the company forced her to implement the traditional costing method because of his own interest.
Smith must conduct her duties with professionalism as she is the accountant of the company. It is her duty to carry out her responsibilities diligently and carefully so that there is no harm on the financial stability of the company (Rosenfield, 2009). She is expected to work efficiently using her competent skills. The CEO of the company, Steven Kay, wants the accountant to follow traditional costing method because it would result in the higher revenues which would be beneficial for him as he would be able to get more bonuses.
It is the responsibility of the employees to perform for the best interests of the company. The CEO of the company is being unethical as he is deriving financial benefit from doing wrong to the company. Although, the CEO wants the accountant to carry out wrong activities, it is the responsibility of the accountant to work with integrity. So, Smith should find out the results for both the alternatives and explain the management and the CEO about the correct way (Schroeder, 2014).
Analysis of the gross profit margin of the company
The gross profit of the company when it adopts traditional costing system and Activity Based costing are as follows:
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Gross Profit analysis |
||
|
Gross profit margin under traditional costing |
36.67 |
30.00 |
|
Gross profit margin under Activity Based costing |
42.43 |
11.80 |
From the above data, we can observe that the gross profit for Lexon under traditional costing system is 36.67% whereas as per the activity based costing it was 42.43%. the gross profit for Protox was seen to be 30% under the traditional system but it reduced to 11.8% under Activity Based costing (Schroeder, 2014). This difference in the gross profits arose because of the allocation method of the overhead costs. So, it is clear from this that choosing an appropriate costing method can have a significant impact on the decision making process.
Treatment of over recovery and under recovery
Under the traditional costing system, the overhead is allocated on the basis of pre determined rate and not on the basis of actual amount that was expensed. The amount that is recovered from the customer is on the basis of the pre determined that has been charged so there might be a difference in the amount actual spent and recovered (Scott, 2014).
The situation when the actual amount spent exceeds the amount recovered then it is known as under recovery. However, when the amount recovered exceeds the actual amount spent then it is known as over recovery. The treatment of the under and over recovery are discussed below:
Conclusion
From the above discussion we can conclude that it is very important for the management to adopt a correct method of cost allocation as it may have a direct impact on the decision making process. All the decisions that are made by the management should be supported by correct data. The management must evaluate and analyse both the alternatives available and then draw a conclusion. The decisions taken up by the management should be for the betterment of the company and not for one self.
Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.
Berry, L. E. (2009). Management accounting demystified. New York: McGraw-Hill.
Boyd, W. K. (2013). Cost Accounting For Dummies. Hoboken: Wiley.
Girard, S. L. (2014). Business finance basics. Pompton Plains, NJ: Career Press.
Holtzman, M. (2013). Managerial Accounting For Dummies. Hoboken, NJ: Wiley.
McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United Kingdom: Pearson.
Paul, K. (2014). Managing extreme financial risk. Oxford: Academic Press, Elsevier.
Pratt, J. (2009). Financial Reporting for Managers: A Value-Creation Perspective. Hoboken: John Wiley & Sons, Inc.
Rogers, C. G. (2015). Financial Reporting of Environmental Liabilities and Risks after Sarbanes-Oxley . Hoboken, N.J.: John Wiley & Sons.
Rosenfield, P. (2009). Contemporary Issues in Financial Reporting: A User-Oriented Approach (Routledge New Works in Accounting History). [S.I.]: Wiley.
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Scott, W. R. (2014). Financial Accounting Theory. Toronto: Pearson.
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Siciliano, G. (2015). Finance for Nonfinancial Managers. New York: McGraw-Hill.
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