Management Accounting of Sober Plc - Essay Example

?(a) Calculate the total profit on each of Sober plc’s three types of product using each of the following methods to attribute overheads: (i) The existing method based upon labor hours; and (ii) Activity Based Costing. i) Volume Based Costing using Direct Labor Hours Overheads Overheads Cost Deliveries to retailers 4,800,000 Set-up costs 12,000,000 Purchase orders 7,200,000 Total Overhead Cost 24,000,000 Product Total Labor Hours Labor Hours per unit Labor Rate per unit Sunshine 200,000 100 1,000 Roadster 220,000 138 1,375 Fireball 80,000 200 2,000 Total DLH 500,000 Total Overhead Cost 24,000,000 Total DLH 500,000 Overhead Rate per DLH 48 Sunshine   DLH Assigned 200,000 Overhead Rate 48 Total Overhead Cost 9,600,000 No. Units 2,000 Overhead Rate per unit 4,800 Roadster   DLH Assigned 220,000 Overhead Rate 48 Total Overhead Cost 10,560,000 No. Units 1,600 Overhead Rate per unit 6,600 Fireball   DLH Assigned 80,000 Overhead Rate 48 Total Overhead Cost 3,840,000 No. Units 400 Overhead Rate per unit 9,600   Sunshine Roadster Fireball Selling Price 8,000 12,000 16,000 Direct Material 800 1,200 1,800 Direct Labor 1,000 1,375 2,000 Overhead 4,800 6,600 9,600 Total Variable Cost 6,600 9,175 13,400 Contribution Margin 1,400 2,825 2,600 ii) Activity Based Costing Activities Cost Deliveries to retailers 4,800,000 Set-up costs 12,000,000 Purchase orders 7,200,000 Activity Consumption Sunshine Roadster Fireball Total Number of deliveries to retailers 100 80 70 250 Number of set-ups 35 40 25 100 Number of purchase orders 400 300 100 800 Activities Cost Activity Level Activity Rate Number of deliveries to retailers 4,800,000 250 19,200 Number of set-ups 12,000,000 100 120,000 Number of purchase orders 7,200,000 800 9,000 Sunshine (2000 units) Activities Activity Rate Activity Level Total Overhead Overhead per unit Number of deliveries to retailers 19,200 100 1,920,000 960 Number of set-ups 120,000 35 4,200,000 2,100 Number of purchase orders 9,000 400 3,600,000 1,800 Overhead Cost per unit     9,720,000 4,860 Roadster (1600 units) Activities Activity Rate Activity Level Total Overhead Overhead per unit Number of deliveries to retailers 19,200 80 1,536,000 768 Number of set-ups 120,000 40 4,800,000 2,400 Number of purchase orders 9,000 300 2,700,000 1,350 Overhead Cost per unit     9,036,000 4,518 Fireball (400 units) Activities Activity Rate Activity Level Total Overhead Overhead per unit     Number of deliveries to retailers 19,200 70 1,344,000 672 Number of set-ups 120,000 25 3,000,000 1,500 Number of purchase orders 9,000 100 900,000 450 Overhead Cost per unit     5,244,000 2,622   Sunshine Roadster Fireball Selling Price 8,000 12,000 16,000 Direct Material 800 1,200 1,800 Direct Labor 1,000 1,375 2,000 Overhead 4,860 4,518 2,622 Total Variable Cost 6,660 7,093 6,422 Contribution Margin 1,340 4,907 9,578 b) In not more than 1,500 words write a report to the directors of Sober plc, as its management accountant. The report should: (i) Evaluate the labor hours and the activity based costing methods in the circumstances of Sober plc. Volume Based Costing Under the existing circumstances of Sober plc, direct labor hours is used as a basis for volume based costing throughout all the three ranges of the bikes. Overheads are allocated to each product on the basis of direct labor hours such that overhead rate is computed to be ?48 per hour. That rate is then multiplied by the number of hours taken by each product to obtain the total overhead cost pertaining to each product. Each product’s overhead cost in then divided by the number of units of the corresponding product to obtain overhead rate per unit. In this way, Fireball has the maximum overhead rate of ?9,600 whereas the overhead rates for roadster and sunshine remained at ?6,600 and ?4,800 respectively. It is important to note that the biggest reason behind the relatively overhead rate per unit of Fireball is the less number of units produced. Its total overhead cost is however the lowest among all the three products. (Lal, 2009) If the Contribution Margin of the three products is analyzed, then it can be observed that Roadster is making the highest Contribution of ?2,825. Fireball, which incurred the highest overhead rate per unit, is slightly behind the Roadster by earning around ?2,600 per unit. Sunshine, which had the cheapest overhead, is also making the lowest contribution margin of merely ?1,400. From the bovver findings, it can be concluded that besides having incurred the highest overhead rate per unit, still Fireball is earning handsome contribution margin. On the other hand, there is an alarming situation for Sunshine such that even consuming the lowest overheat rate, it is still way behind the other two products in terms of making considerable contribution margin. (Gupta, 2001) Activity Based Costing In case if Sober plc adopts activity based costing instead of Volume based costing, there is a significant amount of discrepancy that can be noticed in terms of overhead rates per unit of all the three products. The overhead rates per unit are calculated in such a manner that actual activities that which drive those overheads to be incurred, are used as a basis for allocating overhead expenditure. Allocation of overheads is made in such a manner that each product is allocated an overhead cost with respect to the level of activity consumed by that product. The activity rates are multiplied by the activity level of each product to obtain the overhead cost pertaining to that product. That overhead cost is then divided by the number of units to obtain overhead rate per unit. (Russell, 2001) If the overhead rate per unit is observed for all three products, Fireball, which consumed the highest overhead rate per unit in volume based costing, consumed the lowest overhead rate per unit in activity based cost amounting to ?2,622. Sunshine and Roadster respectively consumed overhead rate per unit of ?4,860 and ?4,518. On the other hand, if contribution margin of all the three products is evaluated, it can be observed that due to consuming least overhead rate per unit, Fireball has shown incredibly good results and earned around ?9,578. Roadster managed to earn around ?4,907 showing satisfactory results. However, Sunshine reflected rather disappointing results such that it barely managed to earn ?1,340 which is very low as compared to Fireball and Roadster. Overall, the performance of Sunshine has remained very ordinary. However, Fireball is a promising product for Sober plc, provided its overhead allocation is made on the basis of some appropriate mechanism like activity based costing. (Horngren, 1967) ii) Examine the implications of activity based costing for Sober plc, and in so doing evaluate the issues raised by the two directors Implications of Activity Based Costing The implication of Activity Based Costing can best understood by evaluating the individual overhead rate per unit of each of the product as well as contribution margin earned by each product. By applying this technique, it can be observed that Sunshine has consumed the highest overhead rate thus generating the lowest contribution margin. Conversely, Fireball consumed the least overhead rate and hence earning the highest contribution margin. Therefore, the argument raised by the finance manager regarding the viability of Fireball is truly baseless and there is no rationale behind his argument to discontinue the production of Fireball. Fireball is the most highly generating contribution product among all the three products. It would be a very ridiculous decision if the production of Fireball is ceased. Even on the basis of volume based costing, Fireball stood at the second position after Roadster in terms of generating handsome contribution. So it is advised to the finance manager to carry on with the production of Fireball as it is consuming the least amount of overhead rate among the all three products as well as generating the highest contribution among all as well. If the argument of the chairmen is considered regarding the effectiveness of the Activity Based Costing, it seems as if there is a lack of knowledge that rests with the chairman. It is clearly evident from the profitability statements under both, volume based and activity based costing, that the profitability of each product has shown significantly different amounts. As far as the overall profitability of Sober plc is considered, it would definitely remain the same irrespective of which costing technique is used. However, the decision as to actually which product is making profits and which one is making losses is mainly analyzed by activity based costing. Thus, it can be observed that in case of the three products of Sober plc, the highest earning contribution product is Fireball. At the same time, Sunshine showed the lowest contribution among the three. The overall overhead costs for all three products are still the same but their proportion to each product is now different under activity based costing as compared to volume based costing. In a nutshell, Fireball is the one the production of which must be continued with and the argument of finance manager regarding the viability of the production should be ignored. As far as the argument of the chairman is concerned, it is partially true that the overall overhead cost for the company will remain the same no matter which costing technique is applied. But the real rationale of applying activity based costing is the determination of the profitability level of each product so that the decision to continue or discontinue a product can be taken on some rational basis. iii) Discuss the reasons why activity-based costing may be preferred to traditional absorption costing in the modern manufacturing environment. Preference of Activity Based Costing over Volume Based Costing In the current manufacturing world, the management accountants prefer activity based costing over volume based costing because of the strategic benefits that activity based costing provides. There are many areas on which are highlighted by activity based costing but they remain ignored under traditional volume based costing. Following are some of the areas due to which, the application of activity based costing is preferred over volume based costing: Reason for Overhead Costs Activity based costing provides a reason which is also termed as “cost driver” for a particular product such that it is that particular activity which drives a particular cost to happen. So in case if an activity is consuming too much cost, then its cost behavior can be controlled and as well monitored. (Drury, 2006) Difference in Scope Activity based costing has much broader scope than absorption costing. Activity based costing enhances the quality of the systems of management accounting particularly in multi-product and large multi-national firms where conventional system of overhead costing may produce misleading results. In contrast to that, absorption costing system is suitable only for small sized firms and firms having homogenous services or products. Absorption costing system helps in the overall efficiency and profitability of the production system but fails to estimate cost of separate or individual units of products. ABC mirrors the actual cost of individual product and thereby determines identify non-profitable and inefficient products which eat into the profitability of the products which generate higher revenues. Difference in Methodology ABC estimates cost of each individual unit whereas absorption costing divides the cost according to the overhead and number of units. ABC provides more actual figures for the cost of each individual product unlike absorption costing system. Difference in Approach The basic difference between both the techniques is the approach of each methodology. ABC traces the cost of individual unit whereas absorption costing allocates cost according to the overhead. ABC works on the basis of converting indirect cost into direct cost. ABC presumes the activities consume cost and cost is consumed by activities. Therefore, cost is calculated on the basis of activities not on the basis of overhead. (Williamson, 1996) Legal Validity Absorption costing is in accordance with the generally accepted accounting principles (GAAP) but the Internal Revenue Service (IRS) and Financial Accounting Standards Board (FASB) do not take ABC into account for financial statements which are externally published. Firms that comply with ABC system have to maintain accounting book, and two cost systems, one for using internal and the other for maintaining external reports, statutory compliance and filings. Conclusion Activity based costing system has much broader scope than traditional absorption system. Nowadays, numerous firms are following activity based costing system because it provides actual and exact cost as compared to absorption system. 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