Activity-Based Costing for Logistics and Marketing - Term Paper Example

FINANCIAL ACCOUNTING 4000 By Table of Contents 4 ANALYSIS AND HISTORY OF THE DEVELOPMENT OF THE COMPANY 5 Visual Merchandising 5 Development of Visual Merchandising Industry 6 Development of VMH 7 FINANCIAL ANALYSIS (Financial Years Ending 03/30/2012 and 03/31/2013) 8 PROFITABILITY RATIOS 8 Payables Period 8 Free Cash Flow 9 LIQUIDITY RATIOS 10 Current Ratio 10 Quick Ratio 10 EFFICIENCY RATIOS 11 Inventory Turnover 11 INVESTOR RATIOS 12 Earnings per share 12 Gross Margin 13 Absorption Costing 14 Activity-Based Costing (ABC) 15 Impact and Effects of ABC 16 CONCLUSION 17 References 19 APPENDIX 1: VMH CONSOLIDATED INCOME STATEMENT FY13 (see attached Excel file) 21 Abstract Making of decisions in an organization involves the assessment of production costs, quality management, and various other costs which involve material acquisition, security of products, and maintenance of production machines. In the selection of costing methods, this report observes that ABC costing is more preferred for product and service companies unlike AC which is applicable for only volume-based production. In both cases, it is determined that ABC costing is better than AC as it accounts for all expenses, direct or indirect that ensure production meets expectations. Hence fore, ABC and AC costing models differ in that the former provides more information on all charges involved in the manufacture and creation of products and services while the latter provides inadequate information that cannot be used in price determination as well as for other managerial purposes. This report concludes by identifying the constraints of AC costing and why ABC is more relevant for use by competitive production organizations and service companies. Keywords. Financial Year (FY), Absorption Costing, Activity Based Costing, Pricing Decision, and visual merchandising ANALYSIS AND HISTORY OF THE DEVELOPMENT OF THE COMPANY Visual Merchandising Visual merchandising is the display of products in a number of ways and methods that make the products more attractive and appealing to the general public or target market. Some of the methods of incorporating visual merchandising include display screens, colours, smells, lights, digital technologies, and sounds. Visual merchandising is not a popular term in the retail market as most companies and customers refer to it as promotional strategy. Festive seasons attract a lot of customers to various gift shops and retail stores based on available product displays. For instance, the Christmas season which is celebrated by Christians and Christian sympathizers all over the world incorporates Santa-inspired music, colourful lighting, and various other colour schemes that set potential customers in the festive mood. However, the use of visual merchandising in the retail industry follows the concept of reaching out. In many instances, customers do not make lists or budgets of what they have to buy until they identify products. In this case, visual merchandising is a form of customer attraction method which inspires customers to buy, schedule to buy, or hire a product. Hence, to a retail shop, visual merchandising is an added set of costs that is normally offset by profits acquired from the number of sales the retailer is able to make. However, besides the consumption of energy and other resources in the initial set up of the visual merchandising, the strategy is fairly management and sustainable (Diamond, & Diamond, 2007). Many retail companies have no capacity of integrating visual merchandising activities in their competencies and thus, they hire companies that only deal with visual merchandising. In this case, visual merchandising is an industry as it is a marketing strategy. Retailers in the UK involve restaurants, hotels, electronic shops, fashion houses, jewellery stores, and other related businesses. Hence, for retailers in the UK, visual merchandising is a common activity for marketing as well as an industry providing marketing solutions to various retailers. For companies dealing with visual merchandising such as Visual Merchandising Housing (VMH), their market classification is retail as well as they deal with final customers. There are three types of visual merchandising retailers; design and implementation, implementation, and consulting retailers. Design and implementation retailers are tasked with the tasks of designing and implementing visual merchandising with respect to the customer requirements or nature of the business. Implementation retailers provide the service of implementing existing designs to various types of retail stores and shops. Consulting retailers provide services to the end user on how to implement and/or design visual merchandising strategies. Development of Visual Merchandising Industry The development of visual merchandising industry covers various discoveries made in technological and marketing strategies. In this case, the most popular form of visual merchandising is the in-store displays of product sets. Retail companies present their products with respect to their use. For instance, retail companies such as IKEA use visual merchandising in their furniture stores through the arrangement of furniture products to represent family settings and office layouts. However, the development of the adult film industry is one among the leading inhibitors of visual merchandising needs for contemporary retailers. Dating back to pre-WWII industries, organizations, and retailers; visual merchandising was used in the identification of business establishments within developing cities as well as tourism centres. For instance, during the prohibition era, the production/sale/consumption of alcohol was banned in the United States thus increasing alcohol demand from the UK and other European countries such as Italy, Spain, and France. For alcohol smugglers, visual merchandising helped US-based customers to identify alcohol retailers and distributors. On the other hand, speakeasies in the prohibition era used specific lighting sequences to attract customers of the bootlegged alcoholic beverages (Diamond, & Diamond, 2007). Post-WWII advances inspired the development of visual merchandising as new technologies such as powerful light emitting diodes (LEDs) were introduced. This led to the promotion of identity products such as electronics from a certain vendor as well franchised establishments of fast food chain stores. The discovery of music players and digital displays improved the visual merchandising capabilities and audiovisual messages or rhythms were better conveyed to and comprehended by customers. The digital migration from analogue systems has improved the industry’s capabilities as well as creating new markets. Visual merchandising has been borrowed by the real estate industry to capture visual-sensitive customers into buying the establishments. Lighting systems and angles of reflection, colour of light, and audio rhythms are some of the features real estate buyers look for hence the relevance of visual merchandising in contemporary industry markets. Development of VMH VMH was developed in 1993 as a small retail shop for fashion garments. With specificity based on wedding gowns, the founders of VMH discovered that an adjacent fashion shop attracted more customers than they were. This spooked curiosity for one of the founders, Ellen Diamond; to conduct a survey on what attracted customers to some business establishments and not others. The survey covered about 20 business establishments so that there are two of each kind. Using interviews and observations to gather data, Hellene discovered that all establishments with well-lit-front display-panes or with brighter neon signs attracted more customers – both curious and instant customers. This study inspired the conversion of the fashion store to a private company specializing in visual merchandising designing and implementation. In 1994, VMH was founded and established as a local visual merchandising company. With the results of the market, study conducted prior to the founding of VMH was used to identify potential customers (Diamond, & Diamond, 2007). Towards the start of 2000, technological advances had reached digital stages and displays could transmit visual messages from computerized gadgets or memory devices. In this case, VMH incorporated the delivery of services such as the designing and implementation of complex product sets, lighting systems, colour blending, and display-screen installations. The development of VMH is however, dependent on the market growth as well as the emergence of new markets for visual merchandising - an example is real estate market for visual merchandising. Thus, the market growth and development of new markets influence the company’s revenue generation as well as spending in the implementation of industry changes. FINANCIAL ANALYSIS (Financial Years Ending 03/30/2012 and 03/31/2013) PROFITABILITY RATIOS Payables Period Payables period is the duration that a company takes to pay up its invoices. Companies anticipate for long payables periods as they accumulate more cash at hand good for capital and free cash flow. While it is a good thing for the company, too long payables periods are not mutually as good to customers as they are to the company. Thus, creditors require payments within a considerably acceptable period – for instance, 2 months is acceptable for highly dynamic retail companies. For VMH, the payables period increased from 56.35 for FY12 to 57.45 for FY13. This increase can be attributed to two major occurrences; the quick ratio and current ratio changes. The fact that the company’s quick ratio changes from 0.22 to 0.2061 shows that the company was operating at an under per scale and the decrease from FY12 into FY13 explains the increase in payables period. Thus, at the period of paying invoices, the company did not have enough cash or liquid assets that it could use to pay up the invoices in time. Thus, creditors are paid once enough liquid assets are obtained to meet their magnitude of debt. The increase in payables period translates to a longer period of accumulating cash for paying debtors rather than mitigating working capital or free cash flow. This shows that an investor risks receiving his/her dividends later than expected – this trend invites closures or lower investor turnover. Free Cash Flow The free cash flow ratio shows how able a company is to operate positively after it has cleared all operating expenses. This also means that the number of sales the company makes contribute to the total revenue. However, after the clearance of operating costs, the free cash flow can indicate how viable the company is in ensuring growth. However, if a negative cash flow is incurred, probabilities are that the company is making heavy investments or the company is running short of profitable business. For VMH, free cash flow against sales shows that the company had 3.49% and 3.1% for FY12 as FY13 respectively. A positive free cash flow shows that the company is meeting most of its financial goals but investing little amounts. Additionally, it shows that the company’s sales generate up to 3% profit after balancing expenditures. However, this profit margin is low given that no major investments are made. Thus, VMH performance under this category is unfavourable for investment as the industry type restricts growth and development as new entrants and freelancers make up the competition. LIQUIDITY RATIOS Current Ratio The current ratio measures liquidity and varies considerably from company to company and across different industries. The current ratio measures the performance of a company in that, if the ratio is 1, it means that the company is in a position to pay up its bills without the need to sale inventory. The standard current ratio is 2.0 and any ratio that is under 1 shows that the company or firm at hand is operating under per as compared to its competitors. This may also indicate that competitors are operating more efficiently hence the inability to meet the minimum financing requirements. Ithis case, a ratio of less than one shows that the company requires external funding or other sources of funds to meet its current liabilities. For the case of VMH, the current ratio for FY12 is 0.57 against 0.5805 for the FY13. The difference between the FY12 and FY13 current ratios is 0.0105 that also indicates the improvement that the company made from FY12 to FY13. However, given the current ratio of less than one, VMH requires external or other sources of funding to settle its bills such as labour, operating costs, and inventory management without the need to sell inventory. However, VMH can sell its inventory in order to meet the bills for each operating period. Industry wise, VMH operates under per and thus, competitors are operating more efficiently. According to the current ratio, it is unadvisable for investors to invest with the company, as competitors appear to be doing better, a factor that can compromise the company’s sustainability in the long-term. Quick Ratio This measures the company’s ability to meet short-term obligations with liquidated assets. For instance, a quick ratio of 1.5 means that the company acquires £1.5 for every £1 and therefore the company is able to settle short-term liabilities. However, large quick ratio means that the company has too much cash at hand or in the bank that may require to be invested elsewhere. For the case of VMH, the quick ratio of 0.22 for the FY12 and 0.2061 for FY13 shows that the company is unable to meet its short-term liabilities with the most liquid assets. This means that the company has to sell its inventory in order to handle its short-term liabilities. In addition, too small current ratio may indicate the company’s need for a bailout or borrowing from external sources. However, a YOY quick ratio of less than one means that the company’s long-term business approach must be rethought and better marketing and operating strategies identified. The quick ratio of 0.2061 for FY13 shows that the company is underperforming with a decrease from the previous financial year showing escalating situation bad for long-term investment, as capital gains may not match investor expectations. EFFICIENCY RATIOS Inventory Turnover Inventory turnover is an indicator of how long it takes a company to sell an inventory item. A lower inventory turnover indicates a slower business period. However, various considerations are essential in the identification of inventory turnover. It is normally acceptable that companies with higher inventory turnover are better placed than those with lower turnover. Conceptually, lower turnover does not rule a company unprofitable as lead times, fluctuations, nature of the items, and ordering time are considerations that affect the inventory turnover. The inventory turnover for VMH is 9 for FY12 and 8 for FY13. For the FY13, VMH went down by 1 meaning that FY12 was a favourable year for inventory turnover. For FY13, inventory turnover can be affected by lead time changes, timing or orders, seasonal fluctuations, or nature of the products traded. This decreasing trend shows that VMH is taking longer to sell its inventory thus indicating under per or unfavourable business environment. An investor investing in this company is likely to incur company related liabilities based on YOY long-term poor performance. Inventory turnover is linked to inventory days. Inventory days are the average period a company has to retain its inventory before selling it. Too long periods indicate low inventory turnover and high inventory management costs. A remedy for this challenge is to initiate a Just-in-Time approach effective in mitigating operating costs. For the case of VMH, inventory days increased from 40.38 for FY12 to 42.45 for FY13. This anticipates the change in inventory days to a slower market, competitors that are more efficient, longer lead periods, change in nature of products, close alternatives, or timing of orders. The increase in inventory days is inversely proportional to inventory turnover. Thus, the more the inventory days the lower the inventory turnover is. In this case, VMH’s inventory turnover decreased from 9 to 8 for FY12 and F13 respectively while inventory days increased from 40 to 42. This means that inventory takes longer to be sold for FY13 than it was for FY12 and therefore profitability and company performance was less viable for FY13 than it was for FY12. Investing in this company with reference to increasing inventory turnover means taking unnecessary risks based on the decreasing competitive power. Thus, long-term viability of this company is questionable and investors are advised against taking non-viable investment risks. INVESTOR RATIOS Earnings per share Earnings per share (EPS) indicate the returns per share from a company’s common stock. For the FY13, the EPS for VMH was £0.61 from £0.58 for the previous FY12 (VMH, 2013). Thus, it means that the company investors were in a better profitable position in 2013 than they were in 2012. However, with reference to other ratios, this may not be the actual case, as companies are known to pay increased dividends to shareholders with expectations of better financial futures. Additionally, the actual investment value may not be determined through the payments of favourable dividends. Companies and managers may restrain information leading to information asymmetry. In this case, the long term viability of the company cannot be tested by increasing earnings per share coupled the failure of other important ratios. Gross Margin The gross margin is the ratio of all sales revenues to the cost of producing such goods and services - expressed as percentage. The gross margin for VMH is 39% for the most recent financial year, FY13. With reference to FY12, VMH’s gross margin increased with 1.2% from 37.8% registered for FY12. This means that VMH operated much efficiently in FY13 than FY12. However, it is possible that sales did not increase but rather the producing costs decreased – a case that is likely to create tension to investors if production costs destabilized (Google Finance, 2013). Investors in this regard are advised to acquire more information regarding the company’s operational costs and relate to industry’s best performers. CRITIQUE OF ABC COSTING ABC costing and traditional absorption costing Traditional absorption does not provide enough information as it is based on cause-and-effect allocation (Wilks and Burke, 2005). For decision-making or pricing purposes, Absorption Costing (AC) does not provide enough or sufficient information hence the relevance of ABC (Drury, 2007). The above arguments represent the opinion of ABC-inclined individuals. However, based on these arguments, the comparison of AC and ABC shows that ABC provides more reliable information useful for decision making purposes unlike it is with AC. Absorption Costing Overhead costs are allocated using a two-stage process (Drury, 2007). Within the first stage, cost centers have overheads assigned (Hobdy, et al. 1994). Within the second stage, the accumulated costs at the cist centers are distributed or assigned to cost objects through selection allocating bases/drivers of cost. Ideally, the only base drivers are labor and machine hours only. According to Drury (2007), ABC has more information that AC because more cost centers are allocated in stage 1 and abundance of cost drivers in stage 2. AC is a volume-based system of costing that only accounts for volume-based costs while ignoring non-volume based cost drivers. Volume-based cost drivers indicate that overhead resources directly influence the number of units produced. On the other hand, non-volume based cost drivers involve the consideration of damages and fixing of those damages by investing more on overhead costs (Deming, 1996). Additionally, overhead resources may not translate to a proportionate number of produced units. This means that the number of units produced is a function of the overhead resources used such as direct labor and machine hours. By assessment of its nature, AC is suitable for production companies rather than service and retail companies (Cross, & Majikes, 1997). Activity-Based Costing (ABC) The ABC costing model is used in the identification of cost pools within an organization and assigns costs to services and products with respect to the number of transactions involved in the entire process of product or service production (Letza & Gadd, 1994). Stepleton et al. (2004) argue that the understanding of ABC leads to great knowledge of an organization’s operations and hidden expenses. ABC is a budgetary and analytical tool that appraises overhead as well as operating expenses by connecting costs to services, products, orders, and customers. Management is able to identify and isolate profitable from non-profitable services and products. Kaplan (1998) explains that all expenses have to be assigned to the performed activities in ABC’s case. The difference between ABC and AC is that the former allocates expenses to all the activities that go in top the process of manufacturing a product, providing a service, or in process performance (Kirshner, 1999). Once all individual costs are summed up, the total cost of a process are determined. ABC costing enables companies, especially mixed manufacturing and service, to distinguish the cost of tending to different customer segments (Ronen, &Spector, 1992). The financial systems show expenses upon which distribution to various activities is facilitated. According to Ferrara (1995), costs varying with units of production and costs varying with the complexity of products, and costs varying with the complexity of a product are elements of variable manufacturing as per ABC. ABC is grounded on the assumption that costs are not generated by the products but rather by the performed undertakings of organization, procurement, and the creation of the product (Goldratt, 1994). Impact and Effects of ABC Users of the ABC costing model argue that ABC computes much accurate data based on rationality. The practicality of producing the data is based on the number of activities required to produce the results. The impact of ABC can be attributed to its benefits that comprise; The recognition of the least and most economic and profitable customers, channels of acquisition and distribution, and products The accurate determination of contributors and detractors from results and inputs The precise forecasting of resource requirements, costs, and profits related to varying volumes of production, structure of the organization, cost of resources The transparent identification of the causes of poor fiscal performance Tracking activity and work process costs The provision of intellect to managers to dictate improvement Identification of better product mix Augmentation of the bargaining power with the client Attaining better positioning of products and services Equipping the workforce with proportional scenarios The use of amounts and identifiable percentages in the making of changes (Innes, 1999; Kaplan, 1998) With reference to decision making processes and needs, it is observed that AC costing is ineffective as it does not provide sufficient information required for pricing purposes or other organization management purposes. According to Wilks and Burke (2005), traditional costing models provide inadequate information as opposed to the capabilities of ABC. The stages of calculating ABC based costing according to Wlks and Burke (2005) include; 1. Identification of different organizational activities 2. Ration of activities with overheads 3. Supporting activities are spread across principal activities 4. Determination of activity cost drivers 5. Calculation of activity-charge drivers tariffs In ABC costing, Innes (1999) explains that pooling of overhead costs is the initial process which involves activities with consumed resources. Cost driver is a link that connects activities consumed with products and is found amid every activity cost pool and line of production. Cost driver is obtained by finding the ratio of activity cost to driver volume which in turn allows the attachment of overhead costs to products (Eden, et al. 1993). Based on the above description of ABC costing procedures, it is observed that overheads and activities are related. Hence, overheads are related to all activities that in turn cultivate cost pools. However, it should be noted that cost pools can be determined accurately with specificity attached to the type of organization, the product line, and specific corporate characteristics (Cooper, 1990). In order to appraise ABC costing as a reliable costing model, it should be observed that this system uses activities in place of functional centers and therefore delivered a much realistic pattern in which costs are comported (Norkiewicz, 1994). With regards to the performance of various publicly and privately traded companies, the use of traditional costing is minimal as companies do not agree with ABC as the best costing method, but they find it more reliable than the AC as it can be used for pricing purposes and managerial purposes. For instance, batch level activities are assumed to have fixed expenses under AC while ABC terms them as work executed per unit product or service created (Copeland, 1996). CONCLUSION The ABC costing model is used in the identification of cost pools within an organization and assigns costs to services and products with respect to the number of transactions involved in the entire process of product or service production (Letza & Gadd, 1994). However, ABC differs from absorption costing as the latter does not provide enough information as it is based on cause-and-effect allocation (Wilks and Burke 2005). For decision-making or pricing purposes, Absorption Costing (AC) does not provide enough or sufficient information hence the relevance of ABC (Drury, 2007). AC is a volume-based system of costing that only accounts for volume-based costs while ignoring non-volume based cost drivers. Volume-based cost drivers indicate that overhead resources directly influence the number of units produced. ABC is a budgetary and analytical tool that appraises overhead as well as operating expenses by connecting costs to services, products, orders, and customers. Management is able to identify and isolate profitable from non-profitable services and products (Schonberger, 1986). To the companies, ABC costing boosts accounting accuracy and therefore investors can make informed decisions. This transparency into accounting shows that, with reference to negative growth in current, quick, inventory turnover, increased inventory days, increased payables period, and decreasing free cash flow against a 1.2% increase in gross margin places VMH as a negatively/slowly growing company. Within the industry, VMH is faced with competitors, online resources, and heavy presence of visual merchandising freelancers. Bottom line is that visual merchandising is a slowly dying industry that cannot meet investor expectations – VMH is an example of companies to avoid investing in. References Cooper, R. (1990). Explicating the logic of ABC, Management Accounting, CIMA, UK; 58–60. Copeland, T., Koller, T., & Murrin, J. (1996).Valuation – Measuring and Managing the Value of Companies. New York: McKinsey & Company, Inc., Wiley. Cross, R. and Majikes, M. (1997). Activity-based costing in commercial lending: the case of Signet Bank, Commercial Lending Review (Euromoney) 12(4); 24–30. Deming, W.E. (1996). Out of the Crisis, MIT CIA, Cambridge, MA. Diamond, J. Diamond, E. (2007). Contemporary Visual Merchandising and Environmental Design, Fourth Edition. Prentice Hall. Drury, C. (2007). Management and Cost Accounting, 6th edn. Thomson Learning. Eden, Y., Ronen, B. & Spector, Y. (1993). Developing decision-support tools for costing and pricing, Faculty of Management, Tel Aviv University, The Joseph Kasierer Institute for Research in Accounting 53 (3). Ferrara, WL. (1995). The old individually focused control concepts inherent in standard costing and responsibility accounting may be counterproductive in today’s world. Cost Management Accounting. London Press. FTSE. (2013). VMH. New York Stock Exchange. http://ftse.ftx.com/ Goldratt, E.M. (1994). It’s Not Luck, Great Barrington, MA: North River Press. Google Finance. (2013). Company Analysis: VMH. http://finance.google.com Hobdy, T., Thomson, J., and Sharman, P. (1994). Activity-based management at AT&T, Management Accounting 75(10); 35–39. Innes, J. (1999). The Use Of Activity Based Information: A Managerial Perspective. UK: CIMA publishing. Kirshner, S. (1999). The Customer Experience, #1. Net Company. Letza, S.R. & Gadd, K. (1994). Should Activity-Based Costing be considered as the Costing Method of Choice for Total Quality Organization. TQM magazine. MCB University Press. Norkiewicz, A. (1994). Nine steps to implementing ABC, Management Accounting, 75(10); 28–33. Piper, J., & Walley, P. (1991). ABC relevance not found, Management Accounting, UK: CIMA; 42–44. Ronen, B. and Spector, Y. (1992). Managing system constraints: a cost/utilization approach, International Journal of Production Research 30(9); 2045–2061. Schonberger, R.J. (1986). World Class Manufacturing: The Lessons of Simplicity Applied, Free Press, New York, Stapleton, D. et al. (2004). Activity-Based costing for logistics and marketing. Emerald Group Publishing Limited. VMH. (2013). Company Performance and financial statements. http://www.vmh.net/financials Wilks, C., & Burke, L. (2005). CIMA’s official study System. Management Accounting – Decision Making Management. CIMA Publishing APPENDIX 1: VMH CONSOLIDATED INCOME STATEMENT FY13 (see attached Excel file) VMH CONSOLIDATED INCOME STATEMENT FY13 2013-03-31 2012-03-30 Revenue (GBP Mil) 10,027 9,934 Gross Margin (%) 39 37.8 Operating income (GDP Mil) 750 756 Operating margin (%) 7.3 7.5 Net income (GDP Mil) 496 467 Earnings per share (GDP) 0.61 0.58 Dividends (GDP) 0.32 0.11 Payout ratio (%) 51.8 19.7 Shares (Mil) 812 805 Book value per share (USD) 5.01 4.66 operating cash flow (GDP Mil) 1030 1140 Capital spending (GDP Mil) -740 -830 Free cash flow (GDP) 290 311 Free cash flow per share (USD) - 0.58 Working capital (GDP Mil) - -970 Cash Flow Ratios Operating cash flow growth % YOY 685 129 Free cash flow growth % YOY - Capital Expenditure as % of Sales 8.27 7.25 Free Cash Flow/Sales % 3.1 3.49 Free Cash Flow/Net Income 0.67 0.68 Efficiency Ratios Payables Period 57.45 56.35 Days Inventory 42.45 40.38 Receivables Turnover 89.97 93.32 Inventory Turnover 8.6 9.04 Fixed Assets Turnover 2.04 2.1 Asset Turnover 1.35 1.34 Current Ratio 0.5805 0.57 Quick Ratio 0.2061 0.22 Table 1: VMH CONSOLIDATED INCOME STATEMENT FY13 (VMH, 2013; Google Finance, 2013; FTSE, 2013). 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