ABC Costing and Absorption Costing - Berry Ltd - Case Study Example

Management Finance Task Introduction Berry Ltd currently uses the absorption costing method for accounting for the production and selling costs of three products. The company’s products are labeled as X, Y and Z. The absorption costing method implemented by the company absorbs overheads depending on the direct labor hours. The company seeks to increase the revenue levels, thus increase the profit. Activity Based Costing method has been proposed to facilitate the achievement of the objectives. However, some of the company’s board members are in the dark regarding the meaning of terms such as Activity Based Costing (ABC). Absorption costing method, Cost plus pricing and the standard mark-up. In light of the situation of the board members, this document presents the following: first, discussions of the features of the ABC and the influence of both ABC and marginal costing on the selling price and the sales volume of the company’s products. Second, discussions on the purpose of a budget and the conflict between the purposes with regards to Berry Ltd are presented. ABC costing and Absorption costing Cost allocation is a concept that refers to the determination of the expenses incurred to offer a service. Costs can be allocated as direct, indirect and incremental costs. In the production process, manufacturers should be able to determine what costs fall under direct, indirect and incremental, in order to facilitate the ascertainment of cost of production (Smith 2003). Activity based Costing is a concept that refers to the ascertainment of various activities involved in the production of goods and services. Thereafter, the overhead costs are allocated to each activity and then assigned to the products and services. Activity Based Costing recognizes the fact that, during a production process, not all costs are attributed to the volume of products and services produced. Therefore, Activity Based Costing determines the cost drivers associated with the customers, batches, products and administration-related costs directly connected to the units produced. A seclusion of the costs that are not related to unit production is recommended in order to ensure accuracy in cost measurements to facilitate informed decision-making during the production process (Gunasekaran 1999). In order to prepare an Activity Based Costing, one should be familiar with the following terms: activity, activity cost pool and cost drivers. An activity, in this context, is any action, event work or transaction that invites cost in the process of product production or service delivery. Activity cost pool can be defined as the overhead costs attributed to a specific type of activity such as materials ordering costs and machine installation costs. A cost driver is any activity or factor that has a direct cause-effect relationship with the resources used. In order to achieve a successful implementation of Activity Based Costing, the following steps are mandatory: activity identification, assigning the cost of resources to activities, output identification and the assignment of activity costs to output (Franz & Islam 2004). During the first step (activity identification), a manufacturing organization should engage in a deeper analysis of the operating process of each responsibility center. Each process might involve one or more activity required to produce an output (Mansor, Tayles & Pike 2012). During the second step, assigning the cost of resources to activities, an organization engages in tracing costs to cost objects in order to ascertain the origins of the costs. Costs can fall under three categories. They include direct, indirect and general costs. Direct costs are those that can directly be linked to an output. Indirect costs are those that cannot be allocated to an individual output for the reason that more than two outputs benefit from them. During the third step, output identification, an organization engages in the identification of activities that use its resources. Lastly, the fourth step, assignment of activity costs to outputs, the activity costs are assigned by activity drivers to the outputs based on the level of demand for such activities (Al-Omiri 2012). On the other hand, absorption costing system, used by Berry Ltd, assumes that all the production costs are generated by a production process, thus the products bear the total production cost such direct and indirect material, and direct and indirect overheads. In other words, under the absorption system, both the direct and indirect costs of production are assumed to be the cost of products. Therefore, the difference between the systems is that Activity Based Costing recognizes that not all costs are attributed to products and services, whereas, Absorption costing assumes the contrary (Benjamin, Muthaiyah, & Marathamuthu 2009). Product cost under Absorption method Considering that Berry Ltd absorbs overheads on the basis of direct labor hours, per unit labor hours for product X, Y and Z are (30/12) = 2.5, (36/12) = 3, and (24/12) = 2 respectively. Consequently, the total labor hours for products X, Y and Z are 50,000, 48,000 and 44,000 respectively. Therefore, per unit production cost is as below. Product X Y Z Units 20,000 16,000 22,000 Direct material cost/ unit 25 28 22 Direct labor cost/unit 30 36 24 Indirect costs/ unit 27.55 28.7 31.3 Production cost / unit 82.55 92.7 77.3 The production cost under Activity Based Costing method Product X Y Z Total Units 20,000 16,000 22,000 58,000 Direct material cost 500,000 448,000 484,000 1,432,000 Direct labor cost 600,000 576,000 528,000 1704000 Labor hours/unit 2.5 3 2 7.5 Total labor hours 50,000 48,000 44,000 142,000 Number of batches 40 20 55 115 No. of purchase orders 160 100 220 480 No. of machine hours 30,000 20,000 30,000 80,000 Machine set up cost 97,391 48,696 133,913 280000 Material ordering cost 105,333 65,833 144,834 316,000 Machine running cost 157,500 105,000 157,500 420000 General facility costs 135,525 90,350 135,525 361400 Total production cost 1,595,749 1,333,879 1,583,772 4,513,400 Production cost per unit 80 83 72 From the above two tables, under ABC method, the production costs of all the products are lower as compared to the products under absorption costing method. Therefore, using the cost plus pricing strategy, the product prices will be higher under absorption method than ABC method. Since the demand for products X and Y is price elastic, a higher price, caused by absorption costing method, reduces the level of demand thus lowers the sales volume. The Budget Budgeting is a concept that refers to the procedure of monetizing an individual or organizational plan to facilitate achievement of objectives within a defined period. Budgetary planning can be considered as a short lived measurement and monitoring of long lived strategic plans of an entity. Strategic planning entails the formulation of strategic plans that state and describe the goals to be pursued and achieved with respect to the corporate policy framework. Therefore, through budgeting, a long-term corporate plan can be turned into action. The results of a budgeting process are used for performance evaluation, coordination, communication, motivation, clarification of responsibility and authority, planning, cost control and decision-making (de Waal 2005). The Master budget framework The overall measurement of the budget plan is known as the master budget. A master budget contains the functional budgets. A functional budget contains the details of income and expenditures for a definite functional department. The master budget, therefore contains a combination of the budgets of various departments within an organization. A master budget is made up of both production and non- production budget. Production budgets are a sales budget, finished good budget, material budget, labor budgets and overhead budgets. On the other hand, the non-productive budget includes selling and distribution, the administrative budget, cash budget, and research and development budget (Barrett 2005). Budgeting process To be able to prepare a budget for Berry Ltd, the management should be aware of the following four steps in the budgeting process: information gathering, Planning and organizing, budget preparation and control measures. During the first step - information gathering – historical performance, the results are collected. The historical information is processed in view of various issues such as the business goals and objectives, and the overall business environment such as rivals and the economic issues (Barrett 2005). The collected information relates to the past performance of the company and should not be used as is, in the budgetary process. Therefore, the management should assume specific factors such as sales level, the expected demand level and price levels, to aid the budgeting process. Assumptions are made based on the past information. During the second step – planning and organization – planning involves the formulation of the goals to be achieved by the Berry organization. In addition, it involves the provision of a series of activities to be implemented in order to facilitate the achievements of the formulated goals (Maccarrone 1996). Once the planning process is complete, the process of organizing is initiated. Organizing involves the ascertainment of the available resources, financial, physical and human. In this step, maintaining efficient communication process between the parties involved in the budgeting process is imperative for the success of the process. Efficient communication process would ensure the delivery of complete and accurate information on matters such as the level of human and financial resources available in an organization. Distorted information regarding these issues will adversely affect the budgetary process (Maccarrone 1996). During the third step – budget preparation – in this step, the historical information gathered about Berry Ltd’s past performance are incorporated with the assumptions, the organization’s objectives and courses of action and the information on resource availability. The result of the information blend is used to project on items such as the revenue levels, the product demand levels and the expenditure levels. Another important task in the step is hiring, training and assigning workforce to their areas of expertise to support the budget implementation (Maccarrone 1996). During the fourth step – control – after the implementation of the budget, the outcome of a company’s activities can be compared against the contents of the budget. That is, the budget can be used as a tool that pushes for the achievement of a firm’s objectives. Berry Ltd could use the budget to take corrective measures, where necessary, to ensure that the activities run as planned. The control-tool aspect of the budget ensures the achievement of the company’s goals and objectives (Maccarrone 1996). The purpose of budgeting A budget is prepared primarily for the following purposes: coordination, communication, control, motivation, clarification of responsibility and authority and planning. First, budgeting aids the process of planning. Planning is defined as the process of setting objectives and goals and the course of actions to be taken in order to ensure the achievement of the goals. Based on the definition, a budget shows Berry Ltd the direction toward achieving its objectives. For instance, Berry Ltd is considering increasing the sales volume and the profitability level. A budget has been prepared using the two costing methods above (ABC and absorption costing) to identify the strategy that would deliver the objective (Smith, 2005). Second, the budget can be used as a control tool. The Alpha Ltd’s management team can use a budget to measure the organization’s actual performance against the planned performance (target/ budget). In addition, a budget is majorly used to detect variances and formulate the most suitable corrective measures depending on the situation. An example of a corrective measure is reducing the prices of product X and Y, since they are price elastic; to induce an increase in the sales volume, thus increase the profitability level of Berry Ltd. Therefore, a budget can be used as a control tool or it can induce the act of control, thus it is important. As a result, the purpose works in tandem with the above-mentioned purpose (Smith, 2005). Third, the budgeting process enhances effective communication between various levels of management and between different functional departments within Berry Ltd. The enhancement of communication is achieved because the process involves liaison and discussion and consultation among all management levels. This ensures a proper coordination of activities. Therefore, budgeting can be used to facilitate communication within Berry Ltd thus it is of great significance. Consequently, the purpose complements the above discussed purposes (Rickards 2008). Fourth, budgets act as a motivator. The budget spells out the courses of action to facilitate the achievement of goals within a time frame. Managers are thereafter stimulated to utilize the allocated resources to meet the organization’s objectives. Managers are more motivated in instances where feasible goals are set. However, during instances where the budget presents a seemingly infeasible goal, the company’s management becomes demotivated. Concerning the Beery Ltd, the goal is to increase sales in order to improve the company’s profitability. The achievement of the company’s objective is partly dependent on changing the costing method from absorption, which is the current system, to Activity Based Costing method. Since it is possible to change from one costing system to another, it is therefore, possible to achieve the company’s objective. In turn, the management would be encouraged to work tirelessly to achieve the company’s objectives. For that reason, this purpose is not conflicting with any of the four discussed above (Rickards 2008). Fifth, coordination among the functional departments within an organization is necessary. The budgetary process is not complete without the inclusion of the monetary value of activities in each functional department within an organization. The process may require the cross checking of data between functional department within the organization. The activity creates some level of interaction, thus increase member-coordination between various functional departments within the company. For instance, concerning the Berry Ltd, the budget submitted by the finance department could be cross checked with the budget submitted by marketing department. As a result, coordination, as a purpose, interacts smoothly with other purposes of budgeting (Rickards 2008). Last, the clarification of responsibility and authority is important in an organization. It helps focus efforts of various managers toward a specific task thus reduce the chances of duplicating efforts. In addition, wastage of resources is minimized or avoided. A clearly established chain of command reduces power struggles thus minimizes conflicts between different levels of managers within Berry Ltd. Therefore, the purpose is in harmony with the other purposes discussed above (Rickards 2008). Budgetary conflict Budget is formulated to control the internal activities of companies’ such as Berry Ltd. However, considering the fact that it is based on assumed values, there it is possible for variance to occur (the difference between the planned and actual result). This is what is referred to as budgetary conflict. Unfavorable variance can be caused by a higher material price than planned, whereas, favorable variance is caused by a lower material price than planned. Favorable variance is always good for organizations, but unfavorable variance. Budget conflict can be minimized by incorporating all factors that would affect the items included in the budget. That is, it is always advisable to add a margin to offset an unfavorable variance (de Waal 2005). Limitations of budgeting First, over-reliance on budgetary figures may cause rigidity thus impede change. Second, it is not easy to set feasible targets, thus causing the demotivation of the management. Third, opposition arises when excessive pressure is caused by a budget. Fourth, the actual results cannot be accurately determined; only the approximations are being used for budgetary purpose (Ma, Bunch & Tang 2006). 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Mansor, N.N.A., Tayles, M. & Pike, R. 2012, "Information Usefulness and Usage in Business Decision-Making: An Activity-Based Costing (ABC) Perspective", International Journal of Management, vol. 29, no. 1, pp. 19-32. de Waal, A.,A. 2005, "Is your organisation ready for beyond budgeting?", Measuring Business Excellence, vol. 9, no. 2, pp. 56-67. Barrett, R. 2005, "Predictive planning: the next step in the planning and budgeting revolution", Measuring Business Excellence, vol. 9, no. 1, pp. 56-63. Maccarrone, P. 1996, "Organizing the capital budgeting process in large firms", Management Decision, vol. 34, no. 6, pp. 43-56. Smith, J. 2005, "Cost budgeting in conservation management plans for heritage buildings", Structural Survey, vol. 23, no. 2, pp. 101-110. Rickards, R.C. 2008, "An endless debate: the sense and nonsense of budgeting", International Journal of Productivity and Performance Management, vol. 57, no. 7, pp. 569-592. Ma, J., Bunch, B. & Tang, C. 2006, "Zero-Based Budgeting In China: Experiences Of Hubei Province/A Response To "Zero-Based Budgeting In China: Experiences Of Hubei Province", Journal of Public Budgeting, Accounting & Financial Management, vol. 18, no. 4, pp. 480-515. Read More