Management Accounting at Wallen Manufacturing - Case Study Example

Wallen Manufacturing Customer Insert His/Her Name Customer Insert Grades Course Customer Insert Tutors Name May 3, 2012. Outline 1. Question 1 2. Question 2 3. Question 3 4. Question 4 5. Question 5 6. Question 6 7. References Question 1 Wallen Manufacturing uses Volume-based-product costing system to allocate overheads. It thus utilizes only one cost driver that is direct labour dollars as shown by the Wallen’s current accounting information. This implies that the firm’s overhead costs are assigned to the products on basis of utilization of the direct labour. That is manufacturing overhead costs to be incurred by the firm were divided by budgeted direct labour dollars to obtain predetermined overhead rate of 875%. Firm may have used this method because it is easy to use than Activity Based Costing (ABC) as it allocates total overhead costs altogether. Wallen has assigned manufacturing overhead costs directly to Jaza, Nance and Meliss. For instance, Jaza, Nance and Meliss are assigned manufacturing overheads of $420.00, $315.00 and $210.00, respectively. This costing system has a problem in that some overhead activities costs consumed by Jaza, Nance and Meliss do not match up with direct labour dollar cost driver which is also true for many other modern firms that use technology and manpower to produce their products. This system uses cost drivers such as direct labour dollars, machine hours for overheads allocation. Therefore, the product costs are based on the absorption costing which include both variable and fixed costs (total cost) (Marx, 2009). Another problem is that this system is outdated because many firms and particularly Wallen uses computers and machines for manufacturing. Computes and machines make firm’s system redundant as they utilize direct labour hours in cost calculation. Manufacturing costs are not assigned appropriately since direct labour hours as cost driver is not one of the best drivers to use, in this case Wallen should have combined machine hours with direct labour dollars for better results. The volume-based costing contradicts other drivers of cost that might contribute to products cost. Finally, this system may initiate bad management judgments since it does not include specific non-manufacturing costs (Johnson, 2012). Question 2 ABC offers more correct analysis of the product cost; however, firms normally utilize it as additional costing system. Cost allocation bases employed in ABC vary from Volume-based costing bases (Johnson, 2012). ABC establishes every activity related with manufacturing a product as well as allocating cost to such activity. Cost allocated to activity is eventually allocated to the products which need activity for the production (Johnson, 2012). For instance, Wallen has activities like machinery, machine setup, inspection, material handling and engineering which can use activity drivers like machine hours, number of setups, number of inspections, raw materials costs and number of charge orders, respectively. ABC is an accurate system of product costing because firms allocate costs only to items that need activity for the production such as Machinery, inspection, machine setup, material handling and engineering. Which means that it is able to estimate individual product’s cost precisely. Through process of assigning overhead cost to the product, ABC assists in recognizing non-profitable products or inefficient activities that consume the firm’s profitability of the effective processes or greatly profitable products. Thus, ABC eliminates assigning costs that are irrelevant to the product. In addition ABC is easy to interpret and understanding of the internal management cost; it also enables benchmarking of the overhead costs (Nayab, 2011). ABC solves the issues found with volume-based costing system. It corrects volume-based costing system limitations by recognizing all costs and activities that are incurred or undertaken when manufacturing and distributing the product, carrying out a process or a service. ABC enhances the volume-based costing system by utilizing two-stage assignment procedure and numerous cost drivers. First stage identifies significant activities and manufacturing overhead expenses are allocated to such activities in accordance with resources utilized. The concentration on consumption of resources implies that ABC support firm’s strategic decisions. Each activity cost driver is identified allowing the link between activities and resource demands made by these activities, giving managers clear outlook of how the products generate revenue and consume resources. In second stage, manufacturing overheads are assigned from cost pool to products according to the amount consumed by each cost driver (Marx, 2009). Wallen currently uses one cost driver, direct labour dollars; with the use of ABC Wallen will be able to have several costs drivers which will represent varied factors of the cost drivers correctly when firm’s products are assigned costs. The current costing system only traces the direct material and labour costs, which is not the case with ABC that has several cost drivers. In ABC, activities may be grouped as either non-value-adding or value-adding activities, allowing for elimination of those products that add no value. Wallen may also rank activities using ABC in accordance with value added to client (Differencebetween.net, 2011). ABC supports decision-making as the major planning tool for managers; it determines the variation between supply and demand for product allowing prediction of future resource consumption. ABC makes costing system of the firm interactive thus reducing uncertainty. In addition it gives correct costs of product line, which are particularly beneficial for Wallen’s Jaza product that has a price which is cost sensitive and needs regular promotion strategies as well as decisions on mix and range of product. The correct costs of the product line imply that costs will be forecasted on correct historical costs that reduce possible misleading information. Therefore, managers may evidently spot cost variability leading to profit increase due to reduced cost emerging from correct management of resources (Differencebetween.net, 2011). Question 3 Profitability Volume-based costing system   Jaza Nance Meliss Current Selling Price $639.00 $762.75 $600.00 Manufacturing Cost       Direct Materials $105.00 $157.50 $52.50 Direct Labour $48.00 $36.00 $24.00 Manufacturing overhead costs $420.00 $315.00 $210.00 Total Product cost $573.00 $508.50 $286.50 Gross Margin $66.00 $254.25 $313.50 Gross Margin Ratio 10.33% 33.33% 52.25% Jaza is least profitable with gross margin of 10.33% per unit based on current accounting system while Meliss is the most profitable with gross margin of 52.25% per unit. But this depends on accuracy of product costs reported. ABC system   Jaza Nance Meliss Current Selling Price $639.00 $762.75 $600.00 Manufacturing Cost       Direct Materials $105.00 $157.50 $52.50 Direct Labour $48.00 $36.00 $24.00 Machinery $110.25 $122.50 $238.88 Machine setup $0.43 $0.32 $1.89 Inspection $31.50 $46.20 $157.50 Material handling $82.03 $120.75 $39.38 Engineering $45.25 $6.90 $142.21 Total Product cost $422.46 $490.16 $656.35 Gross Margin $216.54 $272.59 -$56.35 Gross Margin ratio 33.89% 35.74% -9.39%         Based on ABC a different profitability picture emerges where Meliss is the least profitable among the three products with gross margin of -9.39% per unit while Nance is the most profitable with gross margin of 35.74% per unit. Notes:     Jaza Nance Meliss Manufacturing overhead budget         Machinery $3,675,000.00 $882,000.00 $1,837,500.00 $955,500.00 Machine setup $15,750.00 $3,465.00 $4,725.00 $7,560.00 Inspection $1,575,000.00 $252,000.00 $693,000.00 $630,000.00 Material handling $2,625,000.00 $656,250.00 $1,811,250.00 $157,500.00 Engineering $1,034,250.00 $361,987.50 $103,425.00 $568,837.50   $8,925,000.00 $2,155,702.50 $4,449,900.00 $2,319,397.50 Annual sales units 27,000 8,000 15,000 4,000           Cost per unit         Machinery   $110.25 $122.50 $238.88 Machine setup   $0.43 $0.32 $1.89 Inspection   $31.50 $46.20 $157.50 Material handling   $82.03 $120.75 $39.38 Engineering   $45.25 $6.90 $142.21 Contribution Under current costing Jaza, Nance and Meliss contributed $66, $254.25 and $313.50 per unit, while under ABC, they contribute $216.54, $272.59 and -$56.35, respectively to profit. Thus, Meliss which contributes more in current system will actually reduce profit under ABC.   Jaza Nance Meliss Volume-based costing       Current selling price $639.00 $762.75 $600.00 Total product costs $573.00 $508.50 $286.50 Contribution $66.00 $254.25 $313.50 ABC       Current selling price $639.00 $762.75 $600.00 Total product costs $422.46 $490.16 $656.35 Contribution $216.54 $272.59 -$56.35         Question 4 The current system is over-costing Jaza and Nance product lines that have high-volume units and under-costing Meliss that has low-volume units as shown by cost distortion in table below. Therefore, ABC is the best costing system compared with volume-based costing. Product cost distortion       Volume-based costing $573.00 $508.50 $286.50 ABC $422.46 $490.16 $656.35 Cost distortion per unit $150.54 $18.34 -$369.85 units produced 8,000 15,000 4,000 Total cost distortion $1,204,297.50 $275,100.00 -$1,479,397.50 Jaza and Nance currently are subsidizing Meliss but ABC has revealed this issue by allocating overheads accurately to the products. Thus, when cost is distorted so is selling price. Wallen budgeted selling price is 150% of full product cost thus we can conclude that current selling price is inappropriate because Jaza and Nance are over-priced and Meliss is under-priced which may be the reason why Jaza has low demand. With ABC management will not have to change prices of the product as budgeted price reflects the true cost of the product as shown below. ABC Budgeted selling prices Jaza Nance Meliss Product cost $422.46 $490.16 $656.35 Budgeted price (150% of cost) $633.69 $735.24 $984.52         Current budgeted price $859.50 $762.75 $429.75 current selling price $639.00 $762.75 $600.00 Strategic Actions Emphasizing Meliss product line as proposed by current costing system is expected to harm Wallen’s competitiveness. ABC indicates that Meliss’ product cost is $656.35 per product and using current selling price, Wallen incurs a loss of $56.35 per unit produced and sold. If real selling prices of Jaza, Nance and Meliss are the fair prices in market and the industry uses a mark-up of 150%, then the Wallen needs to evaluate the selling price of these three products line. Actually, budgeted selling price is determined by 150% of the full product cost, and for Jaza it is more by 35.64%, over the fair price in the market equal to ABC cost. This proposes likely overpricing of Jaza. Also Meliss production cost should be reviewed as it proposes likely inefficiencies and wastes in Meliss production. Question 5 ABC implementation requires more resources as it is complex, costly and time consuming. It also does not conform to Generally Accepted Accounting Principles (GAAP); thus, if implemented Wallen will have to use two accounting books and costing systems, for external and internal use, statutory compliance and filings. This leads to efforts duplication resulting to more cost and misinterpretation by various users (Nayab, 2011). ABC is not able to divide several overheads like CEO’s salary on per-product consumption basis. Likewise, employees infrequently dedicate 100% of working time to useful activities and not every productive activity attaches value to product. For instance, it fails to report time taken by workforce in awareness campaign like first aid resulting to considerable ‘cost leaks’ (Nayab, 2011). Question 6 To understand Question 1 and 2 it is good to take a look at an article by Sharman (1990) on “A Practical look at Activity-Based Costing”. This article will help in understanding the contribution of finance to business. It will show how an activity analysis can be undertaken and be implemented thus assist in refocusing on activities of the business. Thus, the manager will be in a position to understand ABC advantages and problems emerging from traditional costing that can be solved by ABC. Another article by Cokins (1997) on “If Activity Based Costing is the Answer” will assist the manager in understanding how ABC computes cost more accurately and how it has been used by other firms and give examples of firms like Coca Cola and Allied Signal Corp. It also takes a look at traditional costing approach and its limitations as well as comparison with ABC. References Cokins, G. 1997. If activity based costing is the answer. IIE Solutions, vol. 29(8):38- 42. Viewed May 3 2012, Differencebetween.net. 2011. Difference between ABC and traditional costing, viewed May 3 2012, Johnson, R. 2012. Traditional Costing Vs. Activity-Based Costing, viewed May 3 2012, Marx, C. 2009. Activity Based Costing (ABC) and Traditional Costing Systems: A pragmatic approach to Activity Based Costing (ABC) systems, viewed May 3 2012, Nayab, N. 2011. Pros and Cons of Activity-Based Costing, viewed May 3 2012, Sharman, P. 1990. A practical look at activity-based costing. CMA Magazine, vol.64 ( 1):8-11. Viewed May 3 2012, Read More