The management of an organisation is entrusted with the one of the most important parts of decision making which is product costing. Determining the cost of a product is one of the most complicated tasks. It is important that decision be taken taking into considerations all the factors. Taking a wrong step might end up affecting the financial viability of the whole organisation. (Atkinson, 2012)
The company, Beztec limited produce two models of printers, Lexon and Protox. The management of the company is looking forward to phase out the older model, Lexon, based on the fact that it has lower operating returns. The accountant Sue Smith is of the view that, use of inappropriate costing methods has lead to these results. If the company will opt for change in cost allocation methods, then it would help the management take correct measures.
In the following report we have discussed about two methods of cost allocation, and why it is important to have proper allocation method. Also, we have laid down facts which will help the management to take correct decisions.
The traditional system of costing is the method of cost allocation amongst the products, in which a pre determined cost rate is allocated in between the various products based on a certain factor such as machine hours or labour hours (Berry, 2009). The joint costs which are incurred for various products are required to be allocated so that unit cost of different products can be identified.
This system is old and classified as traditional, as this system fails to incorporate importance of actual use of resources. The traditional system of cost allocation is more appropriate in firms which have one product and simplified production process with few activities (Boyd, 2013). The modern production processes involve complex process, more products and various activities. Due to the complexities of the nature of production it is important that the cost is allocated properly in order to ensure correct costing of the product.
This system of cost allocation shifts the burden of overhead costs from one product to another (Dash, 2016). The distribution of cost cannot be done evenly amongst the entire product as they use different amount of resources. This leads to improper cost allocation and costing of the product. This underpriceds some product and over prices the other (Datar M. S., 2015).
Due to these disadvantages the modern production facilities opt for modern, activity based costing. Since Beztec Ltd has two products which involve use of common activities, it is important that cost of these activities is allocated as per actual consumption in order to calculate the correct cost of the products.
Activity based costing is the modern form of cost allocation, which has been made keeping in mind the problems generated by the old traditional costing system (Datar S. , 2016). Under this system of cost allocation, thorough collection and analysis of cost data is done. Amounts incurred on various activities are recorded along with the units of these activities consumed by each different type of product. Using this data collected, cost per each unit of activity consumed is calculated. Based on this rate per activity, the cost is allocated amongst various products (Holtzman, 2013).
This system of cost allocation ensures that the cost is allocated to the product only is it has utilised that function and only to the extent till it has been consumed (Horngren, 2012). Therefore, this leads to correct costing of the product. The management can totally rely on the cost calculated based on activity based costing.
It is important that the companies choose correct cost allocation method in order to ensure correct decision making (Seal, 2012). Let us take the current case for example. In the given scenario the management wants to phase out one line of product, as it thinks that it generates mow operating income. But if we look at the data and use it appropriately we will have opposite results.
Implementation of correct cost allocation method is very important. The decision made by the management is based on the financial data. If this data is not properly arranged, then management might end up taking improper decisions which will affect the future of the company (Siciliano, 2015). Taking wrong decision might also lead to collapse of company in near future.
We have been provided with the existing income statement of the company which 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 |
From the above we can see that the operating incomes of the products are $ 71.50 per unit and $107.25 per unit for Lexon and Protox model respectively. The management has based their decision of phasing out the production of Lexon suing this data.
In order to evaluate the validity of decision of the management’s decision we need to calculate the operating income from the products if activity based costing was being used. We have used further information collected about the various activities consumed and calculated 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 |
Using this rate per activity unit, we have calculated the cost of activities which have actually been consumed by both the products:
|
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 |
Therefore we see the amounts of actual costs which consumed by both the products. The overhead cost which was allocated to Lexon under traditional costing is higher than what it has actually consumed, and that for Protox has been charged lower. Because of this allocation, the operating incomes form Lexon have declined and that form Protox have increased.
|
Beztec Limited |
|||
|
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 |
Therefore we see that the operating income per unit of Lexon is $129 per unit and that form Protox is $(121) per unit sold, whereas under the traditional system of cost allocation they were $71.50 and $107.25 respectively.
If the management would have phased out the production of Lexon based on the original income stamen, then it would have resulted in operating losses for the company, which would have lead to its downfall.
Smith is the accountant for Beztec Limited and it is her responsibility to make sure that the financial data show true and correct view. It is her responsibility to ensure that the record show the true nature of the transactions and the true position of the financials of the company.
Smith is of the view that activity based costing will ensure correct decision making by the management, but because of the CEO’s personal interest she was forced to implement traditional costing.
As the accountant of the company it is her responsibility to conduct her duties wills professionalism (Taillard, 2013). She is responsible to conduct her duties in honest way in order to ensure heath of the company. She is to conduct her work with total integrity and objectivity wit professional competence and due care (White, 2009). The decision made by the CEO, Steven Kay, to still carry the cost allocation based on traditional costing involves a personal interest. Since his bonuses are dependent on the revenue of various divisions, Kay wants to ensure that none of the divisions are phased out. Steven has a personal interest in continuance of the division which has made his opinion biased.
Being the employ of the company it is smith’s responsibility to do correct by the company. Taking a step in order to secure a financial benefit for the benefit of the CEO is ethically wrong. The principles of ethic for the accountants also lay out that it is accountant’s duty out there work with integrity and honesty.
Therefore we would suggest Sue to lay forward the results of both the cost allocation to the management and the CEO and explain to them about both the results.
We have calculated the gross profit margin of the company when it was using traditional method and when it was using activity based costing, and we have the following data:
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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 |
Therefore, form the above we can see that the gross profit margin for Lexon was 36.67% under traditional costing method, but it raised to 42.43% under the activity based costing. Similarly, under traditional method the gross margin for Protox was 30%, but under activity based costing it reduced to 11.80%. This change in the gross margins for both the product was result of change in allocation of overhead costs. Therefore, we see that how cost allocation methods can affect the decision making function of the management.
Under the traditional costing method the cost allocated to the products are not based on actual amount expensed but on some pre allocated overhead rate (McLaney & Adril, 2016). Since the amounts recovered from the customers are based on some pre-determined rate, there stands a difference in the books for the amount recovered and actually expended.
When the amount recovered is lower than what has been spent, there in under recovery of overheads and when the amount recovered from the customers is more than the amount spent it is the case of over recovery of overheads. This difference is to be treated in the books of accounts to show the correct position. This treatment can be done in various days which have been listed below:
Therefore, we see that the companies may opt for any of the methods which are best suitable to them.
From our discussion above, we see that it is important that the managements choose a proper system of cost allocation in order to ensure corrected decision making. The decision of the management should be based on correct data. The management should take into consideration data from both the alternatives in order to make the correct decision. These decisions should be taken keeping in the mind the best interest of the company and not self.
Therefore we would recommend the management to go with the application of activity based costing and phase out the production of Protox models as it would result in operating losses for the company.
References
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.
Dash, S. S. (2016). INSTITUTIONAL THEORY AND CSR. Retrieved from www.anzam.org: https://www.anzam.org/wp-content/uploads/pdf-manager/2844_ANZAM-2016-407-FILE001.PDF
Datar, M. S. (2015). Cost accounting. Boston: Pearson.
Datar, S. (2016). Horngren’s Cost Accounting: A Managerial Emphasis. Hoboken: Wiley.
Holtzman, M. (2013). Managerial Accounting For Dummies. Hoboken, NJ: Wiley.
Horngren, C. (2012). Cost accounting. Upper Saddle River, N.J.: Pearson/Prentice Hall.
McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United Kingdom: Pearson.
Menifield, C. E. (2014). The Basics of Public Budgeting and Financial Management: A Handbook for Academics and Practitioners. Lanham, Md.: University Press of America.
Noreen, E. (2015). The theory of constraints and its implications for management accounting. Great Barrington, MA: North River Press.
Piper, M. (2015). Accounting made simple. United States: CreateSpace Pub.
Seal, W. (2012). Management accounting. Maidenhead: McGraw-Hill Higher Education.
Siciliano, G. (2015). Finance for Nonfinancial Managers. New York: McGraw-Hill.
Taillard, M. (2013). Corporate finance for dummies. Hoboken, N.J.: Wiley.
White, T. S. (2009). The 60 minute ABC book. Bedford: Consortium for Advanced Manufacturing International.
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