True Cost of King Plc - Research Paper Example

 King plc : “True Cost”, fact or fiction? Introduction King Plc is faced with a dilemma on whether to continue or discontinue Lillywhite product line. The profitability of the product is being questioned by Ben , the former Accountant, and had recommended discontinuance of the said product line. He based his recommendations on the absorption costing of financial accounting. The financial and management accountants view costing methods of King PLC differently. The first one uses the traditional costing system that values inventory for financial statement purposes while the latter sees cost accounting as a basis for decision and internal information. The management wants to have some more information before it comes to a decision for the product. Based on the information provided, study analyzes the traditional costing method used for financial accounting and the direct costing approach recommended in management accounting. Other methods of appraisal are also reviewed to determine appropriateness of measure for King Plc. A conclusion is drawn based on the analysis that will be recommended to management of King Plc. Part 1. Discussion of two methods of castings and other non-financial measures that would help management in decision making. 1.1. Conflict between the 2 costing methods The underlying problem of the management is how to apportion and allocate the overhead costs into the two production centers after the introduction of the new product line. To resolve the issue, the management decided to apportion the overhead costs into the four cost centers quarterly as follows: Low tech production center £ 25,000 Hi-tech £25,000 Stores Service Centre £25,000 Maintenance Centre £25,000 Total Factory overhead per Quarter £100,000 The management had also simplified the allocation and spread it into the two production centers, namely £50,000 each for the low tech and high tech centers. The two centers therefore are absorbing the costs of operation of the Maintenance and Stores services Centers. Shown below is the comparison of the two profit centers’ cost analysis that emphasizes use of the profit contribution revenue and net profit contribution. Ben Hogue’s costing used absorption process wherein fixed cost is allocated in the unit cost of the product. The calculation shows the second quarter net profit falls below the target production, fixed cost remain the same causing a net loss in the second quarter. Absorption Process costing Sales 120,000 315,000 Less cost of goods sold Opening stock 0 174,000 Production 290,000 205.9 Less closing stock 174,000 75,400 116,000 304,500 Gross profit 4,000 10,500 Under absorbed 0 14,500 Net profit 4,000 -4,000 What is direct costing? It is a method wherein the cost of the product or operations is determined by allocating to it an appropriate portion of the variable cost or direct cost. It treats fixed overheads such as selling and administrative costs as period costs. Period costs are those associated with time and not an output. It is a variable that is constant per unit of output, and in total varies proportionately with the volume (Gordon & Shillinglaw, p. 574) By doing so, the direct contribution of the product is shown. The inclusion or exclusion of the fixed expenses in the inventory and cost of good sold causes the profit to vary in the contribution margin of the two computations. What is fixed costs? In contrast with variable cost, fixed cost does not change from period to period in response to changes in the degree from which the factory capacity is used. (Gordon & Shillinglaw, p. 574) The second computation shown below is the direct costing approach used by Sarah wherein she excluded the fixed cost from the unit cost of the product. Sarah’s analysis showed a positive contribution for the first and quarter sales. Sarah’s direct costing analysis Sales 120,000 315,000 Less Cost of goods sold' Opening stock 0 0 Production 240,000 170,000 Less closing stock 144,000 62,400 96,000 252,400 Contribution 24,000 63,000 Fixed costs 50,000 50,000 Net Profit/loss -26,000 13,000 2. Suggested figures to be used by management Differences of contribution of 2 costing methods 1st quarter sales 2nd quarter sales Absorption 4,000 -4,000 Direct costing 24,000 63,000 Differences 20,000 59,000 In the second computation, the direct costing income is more than the absorption process that only proves that Lillywhite product line should not be discontinued as it has contributed to the profitability of the company. In this context, costing used by Sarah should be given attention by management in its future decisions. The contribution margin (sales revenue minus direct costs) gives the management a quick decision in short-run profit planning. The quarterly overhead costs are subtracted from the contribution margin to arrive at the net profit or loss. Fixed costs according to Matz p. 591) should be isolated from the product for purposes of decision making. 3. Other financial and non-financial factors should the company consider before it reaches a decision? A non-financial measurement that I would recommend to King Plc is the use of “balanced scorecard”. It is described as a “strategic planning and management system” being used by business and industry, government and non-profit government organizations worldwide. It is designed “to align business activities to the vision and strategy of the organization to improve internal and external communications, and monitor organization performance against strategic goals.” (Balanced Scorecard Inst.) This performance system will help King Plc, in their decision that adds strategic measurement to the traditional system being used by the company. This means there will be more non financial information that will further justify management decisions in addition to the financial data presented by the accountants. The Balanced Scorecard Inst. described this innovative system that was developed by Drs. Robert Kaplan of Harvard Business School and David Norton, as follows: "The balanced scorecard retains traditional financial measures. But financial measures tell the story of past events, an adequate story for industrial age companies for which investments in long-term capabilities and customer relationships were not critical for success. These financial measures are inadequate, however, for guiding and evaluating the journey that information age companies must make to create future value through investment in customers, suppliers, employees, processes, technology, and innovation."   The strategy map of a balanced scorecard is illustrated below. Source: Balanced Scorecard.Inst. The chart above shows the perspectives of a balanced scorecard that suggests viewing the organization according to learning and growth, internal business process, financial and customers’ standpoints. It is also a process of developing metrics, collecting data and analyzing it according to the effect of each perspective. In effect this becomes a strategy map, a chain reaction and communication tools that tell of how value is created within the company. It improves performance through learning and growth, that causes the development of the internal business process, that in turn provide desirable outcome to customer and financial perspective. Part 2. Identified problems with current system and the concept of Associated Benefit Costing. 2.1. Identified problems using the current system of overhead apportionment and allocation within King Plc. The problem that exists is the allocation of the fixed overhead expenses to the product that remains to be fixed within a relative output range. For example, depreciation, real estate taxes, taxes of plants and machineries, rents and salaries of manufacturing executives remain to be the same regardless of the volume of production. Other examples are maintenance and repair of the building, wages of janitors, watchmen and securities and insurance on property that are not directly related in the production. Criticisms against use of direct costing. The use of direct costing as an accounting method have been supported by company managers owing to its easy understandability, but was criticized by the American Institute of Certified Public Accountants. Matz ,(p. 391) cited the NAA Research Report No. 37 that said companies that participated in the study agreed that direct costing is a useful tool of analysis for internal purposes. The matching of costs and revenues is reported to be a useful figures to management in that it that “it can readily measure the increments in net income that accompany the increments in accompanying sales”. However, AICPA’s attitude on this, (Matz p.596) states “it should also be recognized that the exclusion of all overheads from inventory costs does not constitute an accepted accounting procedure”. The standard cost method has been criticized as Tarr, J. (DATE) as a method that is bese used for company that produces homogenous product, and a statement that does not provide any information that could be used for management decisions, and has large direct costs compared to indirect costs 2.2 Introduction of the Activity based costing to Kin Plc.. 2.1. What is an Activity Based Costing? The Activity based accounting or ABC is an alternative for the traditional financial accounting. The activity based costing is another way of assigning costs of products. It has been defined as a “costing model that identifies activity centers in the organization ABC identifies the cost pools, or activity centers, in an organization and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service. As a result, Activity Based Costing can support managers to see how to maximize shareholder value and improve corporate performance” (source). 2.2 What are the benefits of ABC to King Plc? Costing based on activities provides the following benefits to companies. For King Plc, ABC will be able to determine the true contributors to-and detractors- from financial performance. As in our case, ABC will help management identify if the new product is profitable or not. ABC can also assist management in identifying the most and least profitable customers, products and channels. It can predict costs accurately, forecasts profits and resource requirements that are associated with changes in the volume of production, resource costs and structure of organization. With ABC costing, it is easy to pinpoint root cause of poor financial performance, track work process and cost of activities. It provides the managers of costs information to improve performance, and to attain a better positioning of the product. A better bargaining position with customers is achieved when managers use ABC costing, as ABC costing gives them an idea of the break even point, and can get a better pricing for the product. In our previous computations, we found that fixed costs assigned to the product lower the profit contribution of the product. In this case, ABC costing implementation can help the employees understand the various costs involved in the production, analyze the cost, identify the value-added and non-value added to the product, and then implement the improvements to realize benefits. The process allows continuous improvement of the utilization of costs to attain overall efficiency. King Plc tends to benefit from ABC costing when it comes to customer service. ABC costing ascertains individual cost by deducting the product cost and the cost to serve each customer, giving us the picture of profitability. ABC costing guides managers to a correct marketing mix to serve customers as it rightly identifies customers’ profitability, product positioning and services accordingly. ABC costing provides King Plc, a measure of knowing the impact of cost reduction and savings for overall profitability, and gauging the overall performances of each cost centers. With this, King Plc can correctly identify what costs belong to high tech and low tech performance products. The continuous ABC costing implementation will add value to the company and to its stakeholders in terms of cost savings and eventually, profitability.. 2.3 Traditional costing vs. ABC costing Traditional costing designed 75 years, has been found to be lacking in information. The study of James Tarr stated that it has been designed for homogenous products which are no longer practical today. Today, several lines of products are being introduced simultaneously by a company to become globally competitive. Today’s companies have high overhead costs as compared to direct costs and substantial non-product cost that can dramatically affect the true product cost. Because of variety mix, Tarr contends that the homogenous average is no longer appropriate. This line of Tarr’s theory agrees with the proposed ABC costing that identifies fixed overhead according to activity. Tarr’s arbitrary reasons in favor of ABC stated that the leveraging effect of the fixed cost is a continuing effort on direct labor reduction on the assumption that a penny saved on direct labor is an effort to reduce price. The subjective imposition of fixed cost means that management has no knowledge of the true product cost. Management uses cost to calculate product pricings and incorrect information would lead to wrong decisions. Conclusion Sarah Willis is correct in being concerned with the way fixed overhead is currently apportioned and allocated between King’s production and service centers. She has reasons to be concerned about the way that overhead is currently being absorbed into products because it does not present the true situation of the product centers that may lead to wrong decisions. The direct costing showed that Lillywhite line is not a losing proposition, but what caused the net profit loss of the center is the improper allocation of the fixed cost. Based on the interpretations on absorption and direct costings, it is fair to conclude that figures derived from marginal or direct costing can be depended upon the management because it represents actual costs of production. Other costs apportioned to the product belong to the administration such as selling and maintenance. These are costs that could not be controlled by Lillywhite line in the process of production. Other measures of costing can be implemented by King Plc because of the significant benefits it will contribute to the profitability of the company. The non-financial measure such as Balanced Scorecard has been used by many organizations in communication information to enhance overall productivity and can also be followed by King Plc. Sarah can implement the activity based costing because it identifies costs related to each activity and can easily pinpoint problems and provide solutions in the process The future plan of King Plc of producing additional Lilliwhite variants introduces to the market a product variety, and it is important that ABC costing is initiated. The traditional cost accounting if further used will not provide an in depth and accurate analysis as to become a basis for decision. Finally, ABC costing is being recommended as a management accounting process to be able to identify the costs and activities that will be incurred in the production of the new Lillywhite variants and services. This process will give King Plc a competitive advantage to lower its prices without sacrificing quality. With ABC costing, sales will be increased, satisfies the consumers, and benefits the company and its stakeholders. In conclusion, it is recommended that a separate management accounting system be used to provide management information that is useful, a system that will reflect the business process and unconstrained by GAAP and AICPA rules intended for financial statements. w.c. 2571 References Balanced Scorecard Institute. Balanced Scorecard Basics. [On line] Available at http://www.balancedscorecard.org/BSCResources/AbouttheBalancedScorecard/tabid/55/Default.aspx [Accessed 11 January 2010] Gordon, Myron J and Shillinglaw, Gordon. (p. 573-574) Economics of Overhead Accounting: A Management Approach. Richard D. Irwin Inc. Illinois, 4th ed. 1969. Matz, Adolf & Curry, Othel J. (p. 591)Direct Costing. Cost Accounting – Planning and Control. Southwestern Publishing Co. Cincinnati, Ohio, 5th ed. 1972. Tarr, James D.(n.d.) "Activity Based Costing in the Information Age” [On Line} Available at htp://www.theacagroup.com/activitybasedcosting.htm. [Accessed 10 January 2010] Tyler, Will (n.d.) Analyzing product and customer profitability:(Time-Driven) Activity Based Costing. Activity Based Costing. [On line] Available at http://ezinearticles.com/?The-Benefits-and-Basic-Information-About-Activity-Based-1.[Accessed 11 January 2010] Read More