The Suitability of Alternative Costing Systems - Case Study Example

REPORT Directors, Skoog Manufacturing Company Consultants The suitability of alternative costing systems Date: 16/04/2014 Introduction Indirect costs or overheads usually offers a challenge to companies on how they should be allocated to a single product since they are incurred generally in the process of manufacturing a large number of product units. It might seem unreasonable to ignore overhead costs entirely when accumulating the costs of making a product, and yet there cannot be a completely satisfactory way of sharing out these costs between the many different items of production that benefit from them. Nevertheless, there are costing methods that have been formulated to solve these problem including absorption costing and activity based costing. The present costing system is flawed There is a great need to evaluate the current costing policy as it may be misleading decision making in most departments of Skoog Manufacturing Company and consider the need to change to a more appropriate costing strategy. The specialised flexivalve 10 valves are considered to be performing better than the simple valve 301 valves which might not be the case. If we consider that most of the increase in overheads is attributed to increase in production of the specialised flexivalve 10 valves and that most of the overhead costs are directly and proportionately related to these valves it is likely that the simple valve 301 valves may be yielding a higher margin than the specialised flexivalve 10 valves. For the allocation of overheads on the basis of labour hours to be appropriate, there would need to be a direct relationship between overheads and labour hours. From the information provided, this does not appear to be the case. A traditional method of cost allocation, such as the one based on labour hours, was developed when an enterprise produced a narrow range of products which underwent similar operations and consumed similar proportions of overheads. Moreover, when such methods were being widely used, overhead costs were only a small proportion of the total costs, with direct labour hours and material costs accounting for the largest proportion of the total costs. Skoog Manufacturing Company is producing two different products, a simple valve 301 and a specialised flexivalve 10, which goes through different production procedures as indicated by the production manager. The specialised flexivalve 10 valves require twice as many components as the simple valves, need more specialist engineers to monitor the changes, lots of small production runs and many more set-ups per shift as compared simple valves. Therefore, allocation of overheads on the basis of labour hours will tend to allocate too great a proportion of overheads to the higher volume valve 301 than lower volume flexivalve 10, ignoring the fact that the lower volume product requires relatively more support services. In addition, the company is now largely mechanised with a relatively high level of automation and as a result has significantly reduced the size of workforce. Direct labour costs account for a relatively smaller proportion of total costs with overheads making up the highest single cost item. The total overhead costs are 72.33% (1,218,100/1,684,000) of the total manufacturing cost which is a fairly large proportion as compared to 15.14% (255,000/1,684,000) attributed to direct labour cost. Based on these allegations, it seems likely that attributing overheads on the basis of labour hours may lead to inappropriate decisions. Switching to a machine hour overhead recovery base on the allocation of overheads An alternative allocation of overheads on the basis of labour hours will be to allocate the overhead cost based on the machine hours spent by each of the two products. This method may be more effective than the previous method used because Skoog Manufacturing Company is now largely mechanised with a relatively high level of automation. Based on Budgeted direct machine hours of 6,500 per month, the effect of implementing this new absorption method will be as follows: Budgeted overhead burden = Kr 1,218,100 6,500 hours = 187.4 per machine hour Budgeted overhead will be allocated to the products using the absorption rate of Kr 187.4 per machine hour while direct labour rate will remain as it was at Kr 63.75 per labour hour. Therefore, switching to a machine hour overhead recovery base on the allocation of overheads between standard and specialised products will only affect the indirect cost or overhead costs allocated to the products while the direct costs will remain unaffected. The change in absorption rate will in turn affect the total manufacturing cost and hence the profits. Therefore, the unit manufacturing cost and margins will be calculated as follows: Costing and prices for “Valve 301” and “Flexivalve 10” (based on one month normal production) Valve 301 (Kr) Flexivalve 10 (Kr) Materials 15700 6100 Direct labour 3825 956 Overheads (60 x 187.4) 11244 (15 x 187.4) 2811 Total manufacturing cost 30769 9867 Production quantity (units) 200 50 Unit manufacturing cost 154 197 Selling price 199 299 Profit 45 102 Margin 22% 34% The effect of using machine hours as the basis of absorption of overhead costs rather than labour hours are clear from these calculations. Total manufacturing costs of the two products will reduce significantly with Valve 301 valves showing a 18.6% decrease while Flexivalve 10 valves showed a 15.1% decrease. This in turn triggered an increase in the profit margin with Valve 301 valves showing a massive increase from 5% to 22% and Flexivalve 10 valves increasing from 22% to 34%. This is another clear indication that the use of labour hours in absorption of overheads was flawed because the company is meeting its sales targets but production costs are rising because of the switch to specialised products. However since the specialised products are sold at higher prices profits should not be falling. From the above calculations, it is apparent that switching to a machine hour overhead recovery base on the allocation of overheads between standard and specialised products will make both the simple Valve 301 valves and the specialised Flexivalve 10 valves appear attractive due to the good margin levels. This can be attributed to the fact that the company’s production processes are now largely mechanised with a relatively high level of automation. Therefore, most of the overhead costs incurred by the company can be attributed to maintaining these machine and work done using the machines. Over the last 3 years overhead costs have risen by 76% to Kr 1,218,100 per month, whilst direct labour costs have hardly changed at Kr 255,000. Therefore, labour hours are not the ones causing the increase but rather investments in machines and automation which have a direct and proportionate relationship with machine hours used by each product making machine hours the better method in allocate overhead costs. It is clear that the current costing system is hopelessly out of line with the companys updated manufacturing methods and current theory on product costing. The accountant is right to advocate for absorbing overheads using machine hours, “Product costs would be more meaningful if we absorbed overheads on machine hours.” ABC system An ABC system involves the identification of the factors which cause an organisation’s major activities. Support overheads are charged to products on the basis of their usage of the factor causing the overheads. An ABC system gives management a good understanding of the cost structures of making and selling a wide range of products. Switching to ABC can change the cost per unit calculations substantially. If an organisation determines prices based on cost like Skoog Manufacturing Company, greater costing information will be very useful and prices will change. Many ABC supporters claim that it can assist with decision making in a number of ways. It provides accurate and reliable cost information, establishes a long run product cost and provides data which can be used to evaluate different ways of delivering business. Activity based costing attempts to overcome the problems of allocating overheads to products by identifying the factors that cause the costs of an organisation’s major activities. The idea behind activity based costing is that costs are assigned to a product on the basis of the product’s consumption of these activities. It can be argued that it is activities that generate costs and not labour cost. The accuracy of ABC system will depend on the appropriateness of activities as costs drivers. Each cost driver selected should be appropriate to the overheads to which it relates. There should be a direct and proportionate relationship between the relevant overhead costs and the cost driver selected. In the case of Skoog Manufacturing Company, using the data provided in budgeted activity rates for a typical month and activity details for one month’s production of the simple Valve 301 valves and the specialised Flexivalve 10 valves cost drivers will be allocated as follows: Costs Cost driver Machines Machine hours Set-up and Engineering support Number of set-ups Material handling Number of stores orders The next step is to collect the costs associated with each cost driver into cost pools and charge costs to products on the basis of their usage of the activity. A product’s usage of an activity is measured by the number of the activity’s cost driver it generates. Machine overhead costs = Kr 578,500 Allocated to standard products = 3500 hours ÷ 6500 hours x Kr 578500 = Kr 311,500 Allocated to specialised products = 3000 hours ÷ 6500 hours x Kr 578500 = Kr 267,000 Set-up and Engineering support overhead costs = Kr 400,400 Allocated to standard products = 80 set-ups ÷ 280 set-ups x Kr 400400 = Kr 114,400 Allocated to specialised products = 200 set-ups ÷ 280 set-ups x Kr 400400 = Kr 286,000 Materials handling overhead costs = Kr 239,200 Allocated to standard products = 160 store orders ÷ 460 store orders x Kr 239200 = Kr 83,200 Allocated to specialised products = 300 store orders ÷ 460 store orders x Kr 239200 = Kr 156,000 In addition to these indirect costs or overheads, some labour is still being classed as direct when changes in technology have altered its nature to indirect. Therefore, it will be prudent to allocate a cost driver to labour costs so as to clearly allocate these costs to the two products, standard products and specialised products. The best cost driver for these costs is the number of labour hours used in production of each product. The allocation will be done as follows: Labour costs = Kr 255,000 Allocated to standard products = 2800 labour hours ÷ 4000 labour hours x Kr 255,000 = Kr 178,500 Allocated to specialised products = 1200 labour hours ÷ 4000 labour hours x Kr 255,000 = Kr 76,500 In order to recalculate the costs and margins of "Valve 301" valves and "Flexivalve 10" valves, the burden rates for each cost driver must be calculated. They are as follows: Budgeted Machine overhead burden = Kr 578,500 6,500 hours = Kr 89 per machine hour Budgeted Set-up and Engineering support overhead burden = Kr 400,400 280 set-ups = Kr 1430 per set-up Budgeted Materials handling overhead burden = Kr 239,200 460 store orders = Kr 520 per store order The budgeted labour rate will remain = Kr 255,000 4,000 hours = 63.75 per labour hour Costing and prices for “Valve 301” and “Flexivalve 10” (based on one month normal production) Valve 301 (Kr) Flexivalve 10 (Kr) Materials 15700 6100 Direct labour 3825 956 Machine overhead costs (60 x 89) 5340 (15 x 89) 1335 Set-up overhead costs (2 x 1430) 2860 (4 x 1430) 5720 Materials handling costs (6 x 520) 3120 (24 x 520) 12480 Total manufacturing cost 30845 26591 Production quantity (units) 200 50 Unit manufacturing cost 154.225 531.82 Selling price 199 299 Profit/Loss 44.775 (232.82) Margin 22.5% (77.9)% Using ABC system results in markedly different figures, especially with respect to the Flexivalve 10 valves which appears profitable under absorption costing but loss making under ABC. Under activity based costing, Flexivalve 10 valves shows a huge loss of 77.9% because ABC recognises the relatively high set-up costs, machine overhead costs and materials handling costs. Conclusion From the above analysis, ABC system can be said to be the better costing method for Skoog Manufacturing Company as it has been able to unearth the root cause as to why profits have been below the budget. More focus has been on the production of the Flexivalve 10 valves which is making a loss rather than focussing on Valve 301 valves which are profitable. The complexity of manufacturing has increased, with wider product range, shorter product life cyclesand more complex production process. ABC recognises this complexity with its multiple cost drivers. It is also concerned with all overhead costs and so therefore you should consider changing to the ABC costing system. However, a decision to adopt ABC should not be taken lightly because it requires a serious commitment of resources and top management. Its implementation is not easy but will be made easier with the availability of IT support within the company. To be effective, cost management must be based on a sound knowledge of the company’s cost structure, the proportionate of its overheads, the degree of competition, its information needs and an appreciation of how costs are determined and how they may be influenced. Only after consideration of these factors can a judgement be made to adopt the ABC system. Nevertheless, the advantages that arise from using ABC system are several and I will recommend the change to an ABC system. Work Cited Proctor, Ray. Managerial accounting for business decisions. Pearson Education, 2006. Read More