Should the Firm Use Activity Based Costing - Example

Rolls Royce Contents 3 Introduction 3 Discussion about the firm 4 Should the firm use Activity based Costing? 8 Should the firm use standard costing? 11 Should the firm analyze future projects through relevant costs? 13 Summary and Conclusion 14 References 16 Abstract The report analyzes between various methods of costing with respect to Rolls Royce as a company. Rolls Royce as a company has long faced difficulties in cost control. In fact it was due to its inability to curtail costs that led to its nationalization and subsequent creation of a separate company dealing only with cars. In recent years too it has faced constraints on operating profit due to its inability to cut costs. So two methods of costing namely Activity based costing and standard costing is analyzed on whether the company should use this method. For valuation of future projects the costing method of relevant costing is analyzed. Introduction This report analyses the Rolls Royce Company in terms of costing. Costing is required to be undertaken on any firm to analyze the cost of running business or operations. The estimation of total cost for a firm is important for further analysis against breakeven point or profit. The breakeven point is calculated as a point where total revenue equals total costs. And after that particular point the company starts earning profit. The estimation and calculation of profit is done using the formula TR-TC. There are various methods of costing. Each method has its particular advantages and disadvantages. If costs are not estimated correctly then the viability of a company in terms of its profitability and steps on how to increase profitability or areas of cost control cannot be identified. Even in case of evaluation of a future project costing is important because for the simple reason that a project is viable only if it generates more money than is put into it. Here in this report Rolls Royce as a company is analyzed and with particular reference to the method of costing. At first A brief review of Rolls Royce is given including a discussion on its market share, goods and services produced by it, its competitors etc. Then the discussion shifts to whether the company should use Activity based costing (ABC). The subject of using ABC as a method of estimating costs for the company is critically analyzed in terms of international business environment and how ABC could be applied for Rolls Royce. The costing is also analyzed on the basis of standard costing. The discussion for this type of costing revolves around why this method of costing should be used for Rolls Royce. The discussion on why is centered on topics such as costs, quality, variance and evaluating it in terms of international business scenario. Ultimately the discussion moves on to the question whether the idea and the method of relevant costing should be used in context of project evaluation. The use of relevant costing is analyzed in terms of firm’s future plans like consolidation, merger acquisitions etc. For the report most of the relevant materials has been referenced from secondary sources of data and company website. Discussion about the firm Rolls Royce is a British car manufacturing company. The company was formed by Mr. Rolls and Mr. Royce in 1906. Originally MR. Royce had an electrical and mechanical business which he had opened in 1884. His company had manufactured a 2 cylinder car named Royce 10. He met with Mr. Rolls at that point of time. Mr. Rolls had a car dealership business. He typically preferred cars which were 3 or 4 cylinders. But Mr. Rolls was impressed by the 2 cylinder Royce 10 and decided to be the exclusive seller selling all Royce cars. The cars would be sold under the name Rolls Royce. Then in 1906 the company Rolls Royce was incorporated. For manufacturing cars the company chose to locate its facility at Derby because the town offered electricity at low costs. Since opening the new company would require fresh capital so, new shares were issued to the public and then in 1907 the company acquired C.S. Rolls and company. The non car interests of Mr. Royce’s company continued to work separately. The company slowly improved on its engine power from the initial 10 Hp model to 30 Hp models in 1906. The 40-50 HP model was unveiled in 1906. The company management and directors primarily persuaded by Mr. Claude Johnson adopted to solely concentrate on the 40/50 HP model named as silver ghost. The Silver ghost model was extremely popular and resulted in the company getting lot of positive reaction and acclaim. The company continued manufacturing Silver ghost solely until slowing demand for the model resulted in the company had to manufacture a smaller and cheaper version called twenty. In 1931 Rolls Royce acquired Bentley. In the year 1907 Mr. Rolls wanted that the company should start manufacturing aircraft engines. However initially rest of the directors did not like the proposal and feared that the company will face financial troubles as the company will be perceived as more risky and the banks might withdraw their overdraft facility that they offered for the company. Then the start of World War 1 spelt some trouble for the company as the market of luxury cars fell. The company found good opportunity in making aircraft engines to keep the company viable. It was also persuaded by the war office to make aircraft engines for its aircrafts and fighter planes. The company found it difficult to keep up the amount of the engines that were demanded by the war office. To meet extra demand the company increased their production facility but did not allow other manufacturers to manufacture under their license. They did this to keep the prestige and reputation of the company intact. However, in 1971 the company faced great problems due to high development costs that the incurred while making a jet engine. Subsequently the company was nationalized in the year 1971. In 1973, car division of the company was spun off as Rolls Royce Motors, a separate entity but the marine and aircraft engine business continued as public company until 1987 when it was privatized as Rolls Royce PLC. Over the years the company that has remained in constant competition with Rolls Royce is GE. Market Share from 2002-2004 (MICHAELS and LUNSFORD, 2005) As is clearly seen from the figure there has been long struggle to remain the dominant player of the market in between GE aerospace and Rolls Royce. However 2003 onwards Rolls Royce seemed to have beat its competitor. The latest market share shown below also confirms this view. Figure 1: Market share (Parker, 2013) As seen in this figure from 2013 Rolls Royce remains the dominant player in the industry with 54% market share. It is followed by GE aviation which holds about 34% market share. However the major concern that is causing headaches for the company is the fact that the company operates at a very low operating profit margin. The company that is Rolls Royce operates at an operating profit margin of just 11.3% whereas its closest competitor GE operates at an operating profit margin of 18.7%. As per the geographical reach of the companies are concerned and the particular market of operation the following figure serves as a good guide. The figure shows that Rolls Royce engines have been most popularly used in country of Asia and North America as compared to GE whose main market has been Europe, Africa and Latin America. The demand for the no. of aircrafts has been highest in Asia Pacific. So it can be understood why Rolls Royce has the highest market share in terms of aircraft engine market. Should the firm use Activity based Costing? Activity based costing mainly deals with allocating and assigning the overhead cost of a product in a very traditional and logical way by allocating the cost on the basis of its machine hours. Activity costing mainly identifies and involves in the activities related to the setting up of machinery, testing and also engineering. The activity based costing assist a company in handling and facing the difficulties through the assignment of the overhead on more than one activity of the running machine. The activity based costing mainly determines and establishes the relationship between the cost, products and activities. Activity costing in modern days has gained importance because the manufacturing overhead cost has increased significantly. Rolls Royce is also benefitted by the application of the activity based costing. Rolls Royce has modified its accounting policy. The share of the development cost is mainly avoided by the work share partners and the revenues that are received will reflect the proportionate cost of forecasting by comparing the manufacturing cost of the engine (Rolls Royce 2013). Factors influencing the decision of Activity based costing The factors affecting Activity Based costing can be broadly defined into two heads as follows. Technical Variable: The technical factor cannot only be applied for activity based costing. The technical variables includes various activities such as selecting the cost drivers, identifying the main activities, and problem in accumulation of the cost data. Contextual behavioral and organizational factor: It mainly includes the initiation, adaptation, acceptance and adoption. Roll Royce is influenced by the factors of the activity based costing as the nature of its highly and well regulated aerospace industry signifies that both time and determination to drive the cost out from the business. The ramification of implementing the activity based costing in the industrial business environment is that activity based costing is usually used or applied in decision making process it helps in designing the cost in a better way. But it is not necessary or compulsory that it will provide its contribution towards the overall efficiency and effectiveness in collecting information required for its decision making. It may sometimes be irrelevant and serve in such a way that it detaches itself from the key factors or the elements for taking effective and efficient decision. Rolls Royce has provided importance and has focused on the investment that will improve and develop the operational performance of the company and improves the technical capability and reducing the cost. Structure of distribution cost by using Activity based costing Activity based costing for distribution of cost are structured in a way that the overhead cost for each activity are accumulated by the organization and then the cost of the various are assigned in such a way that the cost of the activities related to the products, services and also the other related cost of that activity. It establishes a relationship between the cause and effect. In case of Rolls Royce the inventories and the work in progress are usually valued at a lower cost and the values are realizable on the basis and method of first in and first out. The distribution cost generally includes the direct materials and also direct labor cost where it is suited and applicable and the other related overheads that are related and attached with the depreciation in the plant and equipment and land and machinery are incurred in transferring the inventories in proper and safe condition in their present location. The net realizable value can be calculated as the selling price that is estimated and deducting the estimated cost and also the cost that is related or included in marketing and selling and distribution (Coins. 2002). Figure 2: Activity based costing Should the firm use standard costing? The benefits of standard costing for Rolls Royce is that a standard costing is used and applied as a rule or standard in establishing the authority which usually serves as a Yardstick for measuring and evaluating the performance of the company. Standard costing minimizes the wastage by identifying and evaluating the variances and then adopting the required corrective measures. In standard costing system the cost are generally established and the responsibility are assigned to the respective person and department that helps in increasing the delegation of authority effectively. The standard costing technique that is adopted by Rolls Royce generally attracts the attention of the management towards the items that are not developing and improving according to the desired plan. It provides an incentive to the workers and supervisors. Rolls Royce as it is a global company serving the customers by providing them integrated power solutions and defense aerospace, power markets , energy, marine. It is an efficient and effective tool used for planning marginal costing, evaluation of inventory and budgeting. It is very essential for the company as it assists the company in becoming conscious about its cost and focusing and providing importance on the standard cost and also the variance analysis. Rolls Royce applies standard costing as it establishes and develops the relationship between the variables like the usage and price (Berger, 2013). The factors that are influencing the standard costing in decision making are the standard costing technique is usually used by the managers who are responsible for manufacturing and measuring the cost of the goods sold. It provides an opportunity for setting the price of the future jobs. Standard assigns specified values to each of the finished product for each of the component material, labor, indirect overhead and direct overhead. When variances are evaluated regularly regulated the standard costing techniques that usually enable the manager to measure the cost efficiently. Standard costing provides a financial importance to inventory and also regulates the evaluation of the standard costing The management can compare identify and evaluate the significance of the rise in prices and finding some other way which helps in lowering the cost and improving the efficiency in production. The company which analyzes the standard costing provides the manager to compare the expectation of the company to the actual cost and also the profit margins. The ramification of using the standard costing in the international business environment is that the standard costing system is not suitable where just in time principles are followed, The standard costing system usually controls the various operating part of the organization as it generally ignores the various items related to the service , satisfaction of the customer, lead time service . The main disadvantage of application of standard costing is that is very time consuming and keeping it up to date. Managers may not be able to understand and apply standard costing and they may cause limitation for them in taking decision that is on their authority. The decision taken by the management may not be appropriate. Standard costing is a predetermined cost related to production of services or goods. There are certain limitations associated with consequences of standard costing. Setting of a standard is often considered as a difficult task by firms. This basically involves great degree of technical skill. The entire approach is expensive and at times cannot be implemented efficiently within a system. Business conditions are changing and this requires standards to be revised with time. Standard fixation is not possible for any organization since there are related components. On the other hand standards cannot be incorporated within those firms that are unable to manufacture standardized product or services. Standard costing has the major limitation in the form of psychological effects. If this approach fails to achieve desirable results then it leads to extensive frustration and resistance within team members. This approach at times appears to be a mode of discouragement rather than an incentive which stimulates organizational efficiency. Standard costing is not based on present circumstances and this leads to negative consequences of organizational activities. It is partially based on future forecast and partially dependent on past experiences. These uncertainties related to experiences create negative impact on operational procedure of a firm. On the contrary these factors cannot be eliminated since standard costing as an approach is based on these uncertainties. These uncertainties are closely knitted with standards and cannot be effectively separated. Hence it becomes difficult to obtain a correct standard. There is a need to update the system as and when required or else the entire procedure might get disrupted. Should the firm analyze future projects through relevant costs? Decision making is the case when an individual or a firm has to select one from two different alternatives. When there are no choices available then the firm or individual is certain and is if spoken in strict sense forced to make a decision. But when the firm or individual is faced with two different alternatives then the problem of decision making creeps in. If a mistake is made in case of making decision from a firms perspective than its future ramification can be grave. Since nobody has the ability to see the future, so the next best thing that can be possibly done is try and predict a scenario. In fact all the decisions that are taken from a company’s perspective especially long term decisions focuses on analyzing the proposed future earnings based on predicting a scenario. So every decision making involves taking certain degree of risks because no matter what models are used in predicting the future, it involves certain degree of assumption. So making the best decision would involve choosing a particular option with the highest probability to succeed. Relevant costs analyze costs that are relevant for the project. Relevant costs are relevant for the company like Rolls Royce while choosing between different alternatives such as expansion, consolidation or downsizing. The Rolls Royce as a company is faced with low operating profit margin at around 11% as compared to its rival company GE at around 19%. To stay competitive the company must reduce its costs of operations. The company in recent years has diversified its operations base from being just a premium aircraft engines manufacturer to its current portfolio involving stake in nuclear reactor business, making piston engines for the marine industry. But it seems that the company has diversified its operations two fast and is now unable to handle extra pressure. This is evident from 2 profit warnings that have been issued by the company and job cuts for 2600 people. The result has been tremendous on the share prices. The shares which were selling at £12.75 at the start of the year are now trading 840p now a day (Tovey, 2014). This provides a window of thought the company management should put into deciding whether to go for downsizing or to stay with the diversified portfolio. One of the suggestions is that the company should split itself into two with one focusing on making aircraft engines and other on land and sea business. The other strategy would be to maintain the current position. Whichever strategy the company takes while going towards the future, it should be analyzed on the basis of Relevant costing. In order to be relevant a cost must qualify two criteria such as the costs affect the future and the costs differ from each other. For analyzing a project normally the following are referred to as relevant costs such as opportunity costs, differential cost, sunk cost and incremental costs. Opportunity costs refer to the opportunity that must be forgone while performing a particular activity. If Rolls Royce goes in for downsizing then the opportunity costs would involve the revenue from its non aerospace business that it has to forgo. Sunk costs are the costs that have already been incurred. Since sunk costs cannot be changed, so they do not affect decision. Incremental cost is the cost incurred in producing an additional unit. Differential cost gives the difference in cost within two different alternatives. Summary and Conclusion Rolls Royce is a manufacturing company it adopts both activity based costing and standard costing as it involves that in a manufacturing company the direct cost related to the labor and raw materials are to be allocated proportionately. The activity based costing helps in the allocation of the overhead cost that are caused due to variety of activities and utilization of the activities in a different activity. The company uses and applies the activity based costing as it provides importance and focuses on the cost drivers and the various activities that leads to the increase in the cost. The traditional costing that is used leads to providing importance on the drivers that are related to volume for example is the lab our hour. The activity based costing also provides facilities for the application of the drivers based on the transaction for example the order that is received. Therefore activity based costing helps in the assumption of fixed and variable cost. It is regarded as the most appropriate and correct method for costing the products and services. The standard costing is also an important tool of costing that can be applied by the manufacturing company like Rolls Royce it generally involves the estimation of the required cost incurred in the production process. The standards for costing are determined and identified and are formulated on the basis of the direct material cost that are essential for the process of production and the rate of pay fixed for the direct labor. These standards are required for planning a budget related to the manufacturing company. Therefore it can be regarded that the application of both activity based costing and standard costing are necessary. The company can adopt any method either activity based costing method or standard costing as per its requirement. References Berger, A. (2013). Standard costing, variance analysis and decision-making. London: GRIN Verlag . Print. Cokins. G. (2002). Activity based cost management: An Executives Guide. New York: John Wiley & Sons. Print. Kinney, M. and Raiborn, C. (2012). Cost accounting: Foundations and evolutions. Mason: Cengage Learning. MICHAELS, D. and LUNSFORD, J. L. (2005) Rolls-Royce takes fight to GE. Retrieved from: http://online.wsj.com/article/0,,SB111049293266776414,00.html. Parker, A. (2013) Rolls-Royce vows to fight headwinds. Retrieved from: http://www.ft.com/cms/s/0/cb0176a6-dff2-11e2-bf9d-00144feab7de.html#axzz3KdgUS7zA. Rolls Royce(2013). Rolls-Royce Holdings plc annual report. Retrieved from http://www.rolls-royce.com/Images/RR_Full%20Annual%20Report__tcm92-55530.pdf. Tovey, A. (2014). Rolls-Royce break up would boost shareholder value, says Investec. Retrieved from: http://www.telegraph.co.uk/finance/newsbysector/industry/engineering/11261091/Rolls-Royce-break-up-would-boost-shareholder-value-says-Investec.html. Read More