The Process of Cylinder Manufacturing Company's Work - Case Study Example

Outline: Introduction What is the problem? Computation of budgeted costs per labour hour Part When overheads recovery is based on labour hours When overheads recovery is based on machine hours Part 2: Activity based costing (ABC) When overheads recovery is based on activity Part 3: Implementation of ABC system Conclusions The Cylinder Manufacturing Company Introduction: This case study is based on the need to restructure Cylinder Manufacturing Company’s costing infrastructure to bring it in sync with current realities. The age-old labour hour method of absorbing overheads needs to give way to a more scientific and suitable machine hour system that could possibly address current issues more effectively and appropriately. What is the problem? The main aspect that underpins this case study is the fact that the company is recovering overheads on labour hour basis, at a high rate of £150/labour hour. This aspect of overheads impinges upon the pricing and renders it very high and agonizingly uncompetitive in the market place. The new management is now thinking of changing the basis of absorption to machine hour basis, since machines do constitute a large extent of the manufacturing costs. Thus, it would be in the fitness of things to absorb overheads on a more suitable machine hour basis, which would be a true representation of overheads recovery, rather than the present system of an outdated labour hour method, which is unscientific in this case, as it is provides inflated and inaccurate results. The comparative impact on costs and resultant benefits by following the machine hour basis is being delved in this study. Also the aspect of over-absorption or under-absorption of costs also needs to be a subject matter of focus. Next, coming to the Activity based costing (ABC), how this would change the analysis of the costs between the standard and specialist products needs to be analysed. Finally, necessary guidance on the implementation of an ABC system needs to be addressed to. Computation of budgeted costs Direct Labour - £170,000 -------------- Prime Cost £170,000 Overheads: Machinery - £279,500 Setting off - £200,200 Machine exp £119,600 ------------- £599,300 ---------------- Total costs £769,300 ---------------- 1. Computation of labour hour rate = 170,000/4000 £ 42.500 Computation of overhead = 599,300/4000 = £149.825 Total budgeted rate £192.325 1. Budgeted labour rate : £42.500 2. Budgeted overheads rate : £149.825 3. Total cost per labour hour : £192.325 Table 1: When overheads recovery is based on labour hours: When computation of total overheads costs are based upon budgeted labour hours of 4000 hours, Serial Description total Basis Of Appmt. Standards products (High volume) Specialised products (Low volume) 1. Machines 279,500 Labour Hours (5:3) 174,688 104,812 2. Setup and Engineering support 200,200 Labour Hours (5:3) 125,125 75,075 3. Materials handling 119,600 Labour Hours (5:3) 74,750 44,850 Total When absorbed as basis of labour hours works out to 599,300 374,563 374563/2500 £149.82 224,737 224,737/1500 £149.82 Table 2: When overheads recovery is based on machine hours: Computation of total overheads costs are based upon budgeted machine hours of 6500 hours, Serial Description total Basis Of Appmt. Standards products (High volume) Specialised products (low volume) 1. Machines 279,500 Machine Hours (7:6) 150,500 129,000 2. Setup and Engineering support 200,200 Machine Hours (7:6) 107,800 92,400 3. Materials handling 119,600 Machine Hours (7:6) 64,400 55,200 Total £599,300 £322,700 £276,600 When absorbed as basis of machine hours this works out to 322,700/3500 £92.2 276,600/3000 £92.2 Thus it is seen that the rate under the labour hour method works out to £149.82/hour, whereas under the machine hour method it works out to just around £92.20. Thus, prima facie, it is seen that the better option would be in terms of machine hour rate for the following reasons: 1. There is a clear excess of £57.62/hour, being the difference between the rates of labour hour rate of £149.82/hour and machine hour rate of £92.20. Thus, by following machine hour rate, it is seen that the impact on product cost would be lesser. 2. Due to absorption of high overhead into the cost of products, both mass produced high volume products and specialty products cost higher, with increased overheads having to be borne by the ultimate customer. Moreover, it is also seen that the low volume high costs specialty products, as rightly pointed out by the Production Manager, needs to be borne by the regular high volume units. 3. The induction of machine hours would set things in the right perspective, especially against the milieu, increasing use of machines over manpower. The hourly machine rate of £92.20 would also be reflective of machine overheads used for production. 4. In the perspective of selling, the Marketing Manager has rightly commented that selling at high prices in a competitive market could spell danger in the long run, especially when competitive products are available at lower rates with better quality. 5. Thus, it has become necessary for Cylinder Manufacturing Company to review its pricing strategies and prices in order to become more competitive and indulge in economies of large scale production which ultimately would be beneficial for all concerned - the producers, the buyers, the ultimate consumers and the Government. 6. A lower overhead recovery rate would, in effect, reduce costs and also rationalise the ultimate selling price to customers. This, in effect, could also provide marketing personnel with more leverage and options to market the products and command a larger market share for its products. Part 2: Activity based costing (ABC): It is now necessary to consider the aspects of activity based costing in order to show how activities could be an appropriate guide for determining real and not notional costs to be carried to product costs and finally selling prices. However, it is first necessary to define and determine the scope of ABC. This is a method of allocating costs to individual products, services, department or cost centre. It could also be in terms of knowing how much of the cost burden could be rightfully passed on to respective heads or product centres. Thus, since ABC equates costs with what has actually transpired, or on actual usage, it is by far, the most effective and accurate projection of costs. Thus, it is useful for managerial decision making and cost controls and also major cost considerations. There are, in effect, only two methods by which companies could enhance profits and profitability. The first is through larger volume sales, or higher turnover. However, under certain set of circumstances, this may not be possible, especially when there are recessionary trends, strong competitors with lower prices and also, unfavourable investment climates for expansion to increase markets with larger sales off take. Under such circumstances, an astute and judicious CEO chooses the second option. He cuts costs wisely, mainly in areas where the difference shows. Thus cost controls and conservative spending would entail higher productivity, increasing capacity utilisation and better use of resources and assets like materials, machinery, manpower and money. Through conservation and controls, the business is realigned on the path of high growth and profitability, with excellent results - just what the top management wanted. It is now necessary to include some cost details regarding allocation of overheads following the level of activity based costing (ABC). Table 3: When overheads recovery is activity based Serial Description total Basis Of Appmt. Standards products (High volume) Specialised products (low volume) 1. Machines 279,500 Machine Hours (7:6) 150,500 129,000 2. Setup and Engineering support 200,200 Number of set ups (2:5) 57,200 143,000 3. Materials handling 119,600 Number of stores orders (35:65) 41,860 77,740 Total £599,300 249,560 349,740 Thus, it is seen that by following the activity based costing (ABC), overheads recovery need to augur as follows: 1. For low volume yet standardised products, for which no special efforts are required, the quantum is £249,560, while the high priced items are absorbing a larger portion of overheads at £349,740. The proportion of bearing overheads is 41% for the standard products and 59% for the non-standard ones. 2. Thus by following the activity based costing method, the arguments put forth by the marketing manager that the high priced products are resulting in larger share of overheads to be borne rings false. It is seen that by following ABC, the high priced specialties units are undertaking a larger share of the burden than the standard product. 3. Thus, by following ABC, it is seen that the company could set up competitive price, based on actual costs, and not notional costs as are being presently carried out. 4. This could result not only in scientific and accurate determination of costs, but could also set handsome margins that could be achieved by marketing and achievable production targets that could be met by production. 5. The main aspect of ABC is that it could set forth managerial decision making in terms of production planning, pricing, market incentives and discounts and marketing accessing, especially in large competitive markets. “The activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity. Some of the advantages ABC offers are an improved means of identifying high overhead costs per unit and finding ways to reduce the costs.“ (Encyclopedia: Activity Based Costing. 2005). Part 3: Implementation of ABC system In the case of implementing activity based costing, it is necessary for the new management to call a joint meeting of the heads of production, marketing and finance divisions of the company and apprise them of the current problems and the apparent solutions she has in mind. The decision makers need to be impressed that it is in the best interests of the company that the present costing system be overhauled and the ABC system installed without further delay. The perceived benefits and advantages in enforcing this regime needs to be communicated to the team leaders, and if necessary, to the workforce, since ultimately the changes would percolate down to their levels. It is seen that workforce does not like to be forced into accepting changes in present costing regime. They need to be cajoled into accepting these changes. It is necessary that the new management impresses upon them the need for change for the better and seek their co-operation and active involvement in the benefits that would accrue in the not-too-distant future. The salient features of ABC for this company would be as follows: 1. The overhead cost differentiation between high volume standard products and low volume specialty products could be evened out, and each product line would eventually have to share the actual costing, in terms of their activity and not pre-fixed notional and inaccurate costs. 2. Product pricing and its variations, to suit different markets and clients could be more accurately determined and enforced. This would lead to profits being more scientifically and cost effectively rendered, and also better cost management and administration. 3. The war of attrition between production, marketing and finance divisions could be well resolved and differential or tiered pricing could be practised with relative ease and convenience, since now management is well aware of what actual costs are and how margins are to be allotted, product-wise or market-wise. 4. During the times of recession or boom, the management of Cylinder Manufacturing Company is aware of how much to lower, or to hike the prices of its products. Having the accurate costs that best determine pricing strategies and objectives, it is well in command of the situation. 5. Should the management be confronted with a situation regarding cost control and reducing prices in a competitive market, or for capturing new territories, it knows with a fair degree of accuracy the price below which it cannot sell. 6. The essence of activity based costing is to quantify the inputs for achieving a particular task or producing a particular product. This is derived by conducting task identification, assessment and breakup of the tasks and its subcomponents and the costs involved. “After calculating the effort (in work hours), one can derive costs for that specific task by factoring in the hourly cost of the person who performs that task. The compilation of costs for all tasks in the project is the total project cost.” (Papers on Activity Based Costing and Similar Term Paper Topics: From the Paper. (2009). 7. In the case of this company, ABC needs to be implemented at the earliest to gain its benefits and repair all the damages that have been caused due to use of a faulty overhead absorption system. Over the years the company has moved out from a labour intensive production system to a machine generated production. Since bulk of the production is machine generated, it is important that machine hour rates be enforced, which is a more accurate and appropriate determination of costs. Moreover, since machine hour needs to be enforced, it could be used at least for the beginning, instead of labour hours that may not be deterministic in the present scenario. 8. In the case of Cylinder Manufacturing Company the opposition to the new systems is real and not notional. Therefore, it is necessary that the services of an expert cost consultant is retained in order to attend any issues that may arise during the implementation of the ABC regime and to iron out any threats that may arise. The workforce needs to be impressed that the ABC regime is in the best interests of the company and its workforce and needs to be implemented without any further delay which could spell real disaster for the firm, including its closure. Conclusion: This case study is based on the need to restructure Cylinder Manufacturing Company’s costing infrastructure to bring it in sync with current realities. The age-old labour hour method of absorbing overheads needs to give way to a more scientific and suitable machine hour method that could possibly address current issues more effectively and appropriately. However, the major aspect of acceptance by the present workforce is a major issue that needs to be tackled. It is believed that implementing of a new ABC regime would, not only reduce costs but could significantly usher in larger profitability in future years through cost controls and effective managerial cost decision making. Bibliography Encyclopedia: Activity Based Costing. (2005). [online]. Nation Master.com. Last accessed 09 March 2009 at: http://www.nationmaster.com/encyclopedia/Activity-Based-Costing Papers on Activity Based Costing and Similar Term Paper Topics: From the Paper. (2009). [online]. Aca Demon: Term Papers and Essays. Last accessed 09 March 2009 at: http://www.academon.com/lib/paper/105829.html Read More