The Current Approach to Product Costing Used by Scott Accents and its Potential Weaknesses - Case Study Example

Running header: Product Costing Student’s name: Instructor’s name: Subject code: Date of submission: 1. The current approach to product costing used by Scott Accents and its potential weaknesses Scott Accent’s current approach to product costing uses machine hours at the rate of $.625 per hour in allocating manufacturing overheads. In other words, the company’s current approach to product costing allocates overheads costs based on single volume measures such as the machine hours in the current scenario, direct labor hours or direct labor costs (Andy, 2011). This is the traditional absorption costing. Although use of a single cost driver in allocating overhead hardly meets the cause and effect criteria desired for cost allocation, it is a relatively cheap and convenient means of complying with financial reporting requirements and is probably the reason why the company has been using it. Absorption costing has a number of weaknesses. The costing system results in distorted cost of products. In most cases, the method assigns overheads to products using the basis of their individual usage of direct labor. This gives rise to an inaccurate product cost. Absorption costing model assumes that costs are caused by products and hence every time a product has been produced, cost is incurred. Though the assumption is true for some direct costs it does not hold for most indirect costs. In addition, for most of the overhead activities, the proportions of the activity actually consumed by a product do not correspond to the single cost driver (Eric, 2003,). This is true for today’s manufacturing companies since products are produced using both manual labor and technology. Absorption costing uses volume based cost drivers like direct labor hours in assigning manufacturing overheads. In this case, one ends up with cost of goods sold that only includes product costs as defined in financial accounting. By assigning cost directly to products as opposed to activities then to product units, the cost report attained gives information on only what is spent but not why it is spent. When reporting on costs, separating costs that are traceable and those that are fixed is of paramount importance. This is because traceable fixed costs can then be booked to departments while common fixed costs are pooled together in the absorption costing approach. However, the base of determining the traceability of costs in the absorption costing model is unclear. The method has only one or few indirect cost pools for a single department or the plant as a whole. Application of costs in absorption costing model is usually based on an indirect cost driver. These indirect cost applications are usually financial based. Absorption costing method therefore, makes use of a system in which the total cost of producing a few products is divided among the various products. This implies that the method actually gives costs that may either be higher or lower than they actually are and hence they are distorted (Fisher, 2012). The method is therefore deemed to be misleading and hence not suitable for use in cost allocation and decision making. As such, the method is not helpful in decision making and can not assist in cost control and planning functions. 2. The proposed activity based approach to costing The newly proposed activity based costing method identifies the various activities performed by a firm and then assigns indirect costs to the product as has been done by Jimmy. The approach recognizes the relationship existing between activities, costs and products and hence allocates indirect costs to products less arbitrarily than the absorption costing approach described above (Pinson, 2004). The general advantages of an ABC system include; i) Product cost determination under ABC costing is more accurate and reliable since it focuses on the cause and effect linkage of cost and activities of a firm. ii) There is fair and correct fixing of selling prices under ABC since overheads are allocated on the basis of relevant cost drivers. iii) With ABC approach, control of overheads is possible through control and monitoring of activities. iv) ABC approach provides sufficient information necessary for decision making regarding profitability of different product lines. How ABC will overcome the weaknesses identified in the former approach Adoption of ABC approach will be helpful in overcoming the weaknesses associated with the former absorption costing method. This will be achieved through; i) Accuracy Cost of products will be determined more accurately through ABC since multiple cost drivers will be used in determining overheads. As such, it will be impossible for the high volume products to subsidize the lower volume ones when determining costs (John, 2005). In addition, if for instance chrome does not require a certain activity in its production, it will not have to share the costs associated with the activity with brass. This means that the products will be fairly priced and customers will not be exploited neither will the company make losses. ii) Planning and cost control Unlike absorption costing, ABC approach will enable pooling of costs by activities and hence help managers control the firm’s costs. ABC approach will help the company redesign its products to use more common components that will help reduce costs in the long run. Owing to the fact that the ABC approach uses multiple cost drivers in identifying the behavior of overhead costs, it will be possible for the management to come up with activity based flexible budgets which are more accurate and hence effectively control costs. iii) Profitability The use of ABC approach will enable the company come up with measures to facilitate reduction of cost on its products thus boosting its profitability. iv) Variance analysis The use of ABC approach will help in accurately determining variances. This is because it results in more accurate actual costs as opposed to absorption costing. As such, Material usage variance, labor usage variances as well as other variances will have more elaborate meaning if the firm has adopted activity based costing (Peterson, 2006). It is easier to investigate such variances when the firm is using ABC method, as opposed to the traditional method of cost estimation. 3. Computation using ABC costing; Compose activity rates Cost driver Total cost Brass Chrome Soldering(no. of solder points $23,550 =(1,185,000/1,570,000)×23,550 =$ 17,775 =(385,000/1,570,000)×23550 =$5,775 Shipments(no. of shipments) $21,500 =(16,200/20,000)×21,500 =$17,415 =(3, 800/20,000)×21,500 =$4,085 Quality control (Number of inspections) $31,000 =(56,200/77,500)×31,000 =22,480 (21,300/77500)×31,000 =$8,520 Purchase orders (Number of orders) $23,760 =(80,100/190,080)×23,760 =$10,012.50 =(109,980/190080)×23,760 =$13,747.50 Machine power (no. of machine hours) 1,440 =(176,000/192,000)×1,440 =$1,320 =(16,000/192,000)×1,440 =120 Machine setups (Number of set ups) 18,750 (16,000/30,000)×18,750 =$10,000 (14,000/30,000)×18,750 =8,750 Total $120,000 $79,002.50 =$40,997.50 The number of units produced Brass =22, 000 units Chrome =4,000 units Therefore, unit overhead cost = Brass =$3.59/unit Chrome =$10.25/unit Therefore, new unit cost= Brass Chrome Direct materials $5.2 $14.6 Direct manufacturing labor $.45 $1.05 Direct machine costs $3.6 $1.8 Manufacturing overheads $3.59 10.25 Total $12.84/unit $27.7/unit Brass Chrome Total Revenues $495,000 $114,000 $609,000 Cost of goods sold (12.84×22,000) =282,480 =(27.7×4,000) =110,800 Gross margin $212,520 $3,200 Gross margin percentage calculation Gross margin percentage =Gross profit /Cost of goods sold Brass =212,520/282,480 ×100% =75.23% Chrome = 3,200/110,800×100% =2.89% 4. Whether brass production should be discontinued Gross profit margin using absorption costing; Brass = 181,500/313500×100%=57.89% Chrome = 34,200/114,000 = 30% Using the current traditional product costing approach, Brass has a gross profit of $181,500 which is a 57.89% gross margin. However, on using the ABC approach, the gross profit increases to $212,520 or 75.23% gross margin percentage. This implies that the product had been over costed making it appear less profitable. This is because it used to bear the biggest portion of the overhead costs at $5/unit or $110,000 of the total $120,000 while Chrome only used to bear $10,000 of the total $120,000 compared to the current $ 40,000. The implication of this is that using the absorption costing method, the selling prices of both the product s must have been wrong with chrome costing less than it should have costed (in fact, when the selling and administrative costs are factored in, the implication is that chrome was being sold at a loss) .on the other hand, Chrome was being sold at a bigger price than it should have been costing. The effect of using ABC costing is the revelation of these inaccuracies. Although the company might have wanted to discontinue production of brass, it should rethink its decision since Brass is actually more profitable than what is reflected on the statements. What the company should do is to adjust its price accordingly in order to boost demand and hence revenue. This will make its overall profitability to increase even more (Shaper, Volley, Weber and Lewis, 2011). Furthermore, discontinuing its production will actually mean that the company will be operating at a loss since Chrome the remaining product is actually being sold at a loss and this might even lead to its closure. What the company should actually do is to discontinue production of chrome or adjust its price upwards so that its production will no longer eat into the company’s profitability. 5. Nadia Mason’s concerns about the accuracy and limitations of an ABC system I think that Mason’s concerns are not based on facts but are based on limited knowledge of ABC costing approach as well as the fear of loosing her bonuses that are based on division revenues. This is because the ABC method is more accurate than the method currently in use. As has been observed, it has helped reveal that Brass is actually more profitable than was thought while chrome might be contributing to losses. As such, she should use the new information availed to adjust the selling prices of the products accordingly. In so doing, the revenues from the products is likely to increase which will lead to more bonuses for her. It is true that ABC is a complex approach to use (John, 2005). However, once the company has decided to change to it, decisions can be made about what cost drivers will be used for the entire production process hence eliminating the uncertainties and addressing Mason’s issues of concern. Once she has fully embraced the approach, she will realise that it is not only helpful in controlling costs but also in boosting the company’s revenues and hence her bonuses. 6. What Nader should do concerning Nadia’s concerns? Nader needs to explain his findings regarding the products costs to Nadia and show how the current costing methods might be contributing to the company’s losses due to inn accurate pricing of products. He should avail as much information regarding the ABC costing to Nadia and involve all those that will be affected in its implementation. In so doing, he will boost its chances of acceptance. In addition, he should involve Nadia in identification of activities and cost drivers to help her better understand the method and appreciate it while addressing her concerns 7. Reference articles: Andy, M2011, Activity based costing, Management Accounting Research Journal, vol. 22, no.2, pp.52- 57. The journal mainly talks about the alternative to the traditional approach to product costing. The article mainly focuses on the strengths of ABC costing and explains why it was found necessary to look for an alternative to absorption costing. The article also blames ABC for its complexity and suggests involvement of all stakeholders before its implementation in order to ensure its acceptance by all. In addition, the article gives a brief history of the ABC costing system. Fisher, G2012, Product costing systems: Finding the right approach, Journal of Corporate Accounting and Finance, vol. 22, no.4, pp. 63-77. The article recognizes the existence of multiple product costing methods and systems and hence the difficulty in identifying the right costing system for a given situation. The different costing approaches are identified as well as their strengths and limitations. The article identifies four questions to answer and points out at the advantages and disadvantages of various cost approaches in a bid to find the right balance of convenience, correctness and implementation costs in a product costing system. The article finally recognizes that use of good product management coupled with better cost systems will pay major dividends. References: Pinson, L, 2004, The ABC performance breakthrough, Dearborn Trade, Chicago. Eric, S, 2003, Tapping the potential of ABC, John Wiley and Sons, New York. John, M 2005, Cost accounting, Rutledge, London. Shaper, M, Volley, T, Weber, P & Lewis K 2011, cost driver optimization in activity based costing, 3rd ed., John Wiley & Sons, Milton. Andy, M2011, Activity based costing, Management Accounting Research Journal, vol. 22, no.2, pp.52- 57. Fisher, G2012, Product costing systems: Finding the right approach, Journal of Corporate Accounting and Finance, vol. 22, no.4, pp. 63-77. John, M 2005, Cost accounting, Rutledge, London. Peterson, D, 2006, managerial accounting, Macmillan, Melbourne. Read More