ABC at Scotty Accents Company - Case Study Example

… … ABC at Scotty Accents Company… 20th May Report 0 INTRODUCTION The treatment of overheads has always been a sensitive area in business with different methods providing different results. The traditional approaches including overheads absorption costing, which is the method used in this case, do not identify the specific activities involved in the production of the different models of kitchen taps - Brass and Chrome. Instead, overheads are placed in a single pool and allocated based on volume related allocation bases such as machine hours in this case. This means that products are sometimes charged for resources they never use. This has resulted in distortions in the cost of both models and has led management to make decisions to discontinue products based on erroneous figures. This has been proven in the case of Scotty Accents where one costing system - absorption costing indicates that the production of Brass was not as profitable as Chrome while the other – activity based costing (ABC) indicates that it is the other way around. Therefore, different costing methods provide different results and can lead to different decisions being taken in terms of pricing and product mix. This problem is known as product-cost cross-subsidization where the over-costing of one product in Scotty Accents case leads to under-costing of the other product (Horngren et al 136). 2.0 IDENTIFICATION OF KEY BACKGROUND INFORMATION The income statement that has been generated at November 2011 indicates that the Chrome model kitchen taps which was just introduced generates a higher net income than the Brass model which the company has been manufacturing for over seven years. However, the decision to concentrate marketing resources on the Chrome model and begin the process of phasing out the Brass model should not be taken at this time. The reason is that a calculation produced by the controller Jimmy Nader who proposes another costing system (ABC) indicates that the Chrome model is less profitable. While I understand the concern expressed by the president, decisions on what to produce and the quantities to produce should be based on a system that generates reliable information. Not all activities are driven by volume and so it is easier to identify costs based on activities associated with a product. This method identifies activities such as soldering, shipments, quality control, purchase orders, machine power and machine set-ups. The cost objects – Brass and Chrome are then assigned costs based on the activities that relate to their production. Each activity has its own cost allocation base and in this case the cost allocation base for soldering is the number of solder points; for shipments – number of shipments; quality control – number of inspections; purchase orders – number of orders; machine power – machine hours; and machine set-ups – number of set-ups. Although, Nader admits that there are shortcomings with the allocation base for some of the activities that is the best that could be done at this time. ABC is a very objective measure but Mason wants some subjectivity to be introduced in order to suit her desires. However, this is the first time that Chrome has been introduced and the process can be refined to gain efficiency improvements in the production of this model. ABC is a widely recommended approach that has the advantage of identifying causally related cost drivers. In fact, some of the advantages include: ABC places emphasis on individual activities as main cost objects – each activity having a specific purpose (Horngren et al. 140) Higher levels of accuracy can be achieved using ABC since the method involves calculating the cost of each activity and assigning costs based on the activity which led to the production of the item (Horngren et al. 140) ABC systems facilitate more favorable pricing and product-mix decisions (Horngren et al 136) Process improvement and product design can be facilitated so that decisions relating to cost control can be made (Horngren et al. 136) Success can be achieved as a result of improvements in manufacturing and business outcomes when ABC is implemented (Fei and Isa 227) The results achieved from implementing ABC is very different from those generated from less costly methods but the information provided by using this approach often leads to major decisions that affect profitability and other factors which determine business performance (Estrin et al. 73). 3.0 ANALYSIS The following calculations using ABC costing provides a more accurate cost for a unit of each type of kitchen tap as well as the gross margin and the gross margin percentage. Calculation of unit cost Description Brass ($) Chrome ($) Direct materials 5.2 14.6 Direct labor 0.45 1.05 Machine costs 3.6 1.8 Activities:     Soldering 0.01 0.01 Shipments 0.52 0.52 Quality control 0.29 0.29 Purchase orders 0.11 0.11 Machine Power 0.01 0.01 Machine Set-ups 0.38 0.38 Unit cost 10.57 18.77 Table 1 – Unit Cost of Kitchen Tap Models The information in Table 1 indicates that the cost of the Brass model kitchen tap is $10.57 per unit compared to a cost of $18.77 for the Chrome model. Table 2 provides information on the gross margin and gross margin percentage. Calculation of Gross Margin and Gross Margin Percentage Details Brass Chrome Selling Price per unit 22.50 28.50 Cost per unit 10.57 18.77 Gross margin 11.93 9.73 Gross margin percentage 112.83% 51.82% Table 2- Gross Margin and Gross Margin Percentages The table indicates that on each unit of the Brass model kitchen taps sold the gross margin is $11.93 while on the Chrome model the gross margin is $9.73. The gross margin percentage is higher for the Brass model at 112.83 per cent compared to 51.82 per cent on the Chrome model. This suggests that the Brass model is more profitable than the Chrome model. 3.1 Key Findings ABC can definitely inform decision making in various ways. The Chrome model should not be discontinued since it is generating a profit. Additionally, the Chrome model was just introduced and so it would be best to look at ways to decrease the time taken for machine set-up and other activities associated with its production n order to reduce costs. Furthermore, it may also be possible to increase the price of the product overtime in order to generate a higher gross margin. It is not unusual for the cost of products to increase after the introductory period after feedback has been received from customers and for the introductory price to be lower than normal in order to facilitate the marketing of the product. 3.2 Reflections Nadia Mason expressed some concerns about the accuracy and limitations of the ABC system. However, every system has some challenges. Most of the concerns that have been raised about ABC are cost and time related. ABC has been described as a complex and comprehensive process that requires careful analysis (Estrin et al. 73). It has also been described as subjective. However, there are cases that require judgment as in the case where Nader decided to use number of machine set-ups and number of inspections instead of using the hours taken to perform each as pointed out by Mason. However, Mason agrees that there are some measurement challenges. This is where subjectivity and professional judgment is required. 4.0 ETHICAL ISSUE AND REFERENCE ARTICLES In response to the ethical dilemma Jimmy Nader should provide details of why it would be difficult to allocate certain costs using a different allocation base than the ones propose. However, Jimmy Nader should not adjust his calculations to suit Nadia Mason’s quest to achieve high bonus payments. Nader needs to be objective in what he does since he is working for the shareholders of the business and not for Mason. The accounting profession provides guidelines for its members and one of them is objectivity. Jimmy therefore needs to abide by it. There are a number of articles and books that provides information relating to the current approach being used by the company in comparison to absorption costing and other traditional costing systems. (See Fe and Isa; Horngren et al; Hughes; Suthummanon et al; and Turney). These authors provide important information that will convince the company that ABC is the best costing system for a manufacturing enterprise. In addition to the advantages of using this costing system these articles also point out some of the challenges and shortcomings identified. The article by Suthummanon et al entitled Applying Activity-Based Costing (ABC) To a Parawood Furniture Factory also provides useful information in this regard. 5.0 CONCLUSION ABC has a number of advantages to recommend it. It is great for making important decisions in terms of product-mix and product pricing. However, it is complex and time consuming and requires some amount of subjectivity in come cases where there may be difficulties in deciding on the merits of using one allocation based over another. Works Cited Estrin, T.L., Jeffrey Kantor and David Albers. Is ABC Suitable for Your Company? An impartial Analysis of overall operations can tell you yes or no, in S. Mark Young Readings in Management Accounting, New Jersey: Pearson Prentice, 2004. Print. Fei, Zhang Yi and Che Ruhana Isa. The Effect of Activity-Based Costing on Firms Performance, A Study Among Chinese Manufacturing Firms. Australian Journal of Basic and Applied Sciences, 5.9 (2011): 227 – 37. Print. Horngren, Charles T., George Foster and Srikant M. Datar. Cost Accounting: A Managerial Emphasis. New Jersey: Prentice Hall, 2000. Print. Hughes, Andrew. ABC/ABM - activity-based costing and activity-based management: A profitability model for SMEs manufacturing clothing and textiles in the UK. Journal of Fashion Marketing and Management, 9.1, (2005): 8 – 19. Print. Suthummanon, Sakesun, Wanida Ratanamanee, Nirachara Boonyanuwat, and Pieanpon Saritprit. Applying Activity-Based Costing (ABC) To a Parawood Furniture Factory. The Engineering Economist, 56 (2011): 80 – 93. Print. Turney, Peter B. B. Activity-Based Costing: A Tool for Manufacturing Excellence. Target, Summer, (1989): 13-19. 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