The Cost of Producing a Unit of Advanced Circuitry - Research Proposal Example

Management Accounting Case Analysis College: Name: Students ID: Date: Course Name: Unit Code: Time: Instructor: Table of Contents Current Unit Production Costs using Volume-Based Costing 2 New Unit Production Costs using Activity-Based Costing (ABC) 3 Reasons for Observed Circuitry Performance and Applicable Production Decision 4 Advanced Circuitry Bad Performance 4 Boosted Circuitry and Customised Circuitry Booming Performance 6 Production Decision 7 Advantages of ABC Costing over the Current Volume-Based Costing 8 Limitations of ABC 10 Recommendations 12 Bibliography 13 Appendices 15 A.Volume-Based Costing 15 B.Activity-Based Costing 16 Current Unit Production Costs using Volume-Based Costing Using the collected data for February under volume-based costing, the current unit product cost for Advanced Circuitry, Boosted Circuitry and Customised Circuitry is as indicated in the table below (also refer to appendix A for more details); Figure 1: Current Unit Product Cost for Advanced Circuitry, Boosted Circuitry and Customised Circuitry Source: Author (2014) According to the figure 1 above, Advanced Circuitry was less costly to produce at $339.52 per unit followed by Boosted Circuitry at $449.29 per unit. However, Customised Circuitry was costly to produce than both Advanced Circuitry and Boosted Circuitry by a big margin. $904.29 was incurred to produce a unit of Customised Circuitry compared to $339.52 for Advanced Circuitry and $449.29 for Boosted Circuitry respectively. New Unit Production Costs using Activity-Based Costing (ABC) Using the collected data for February under activity-based costing, the new unit product cost for Advanced Circuitry, Boosted Circuitry and Customised Circuitry is as indicated in the table below (also refer to appendix B for more details); Figure 2: New Unit Product Cost for Advanced Circuitry, Boosted Circuitry and Customised Circuitry Source: Author (2014) According to the figure 2 above, Advanced Circuitry was less costly to produce at $357.92 per unit followed by Boosted Circuitry at $510.53 per unit. However, Customised Circuitry was costly to produce that both Advanced Circuitry and Boosted Circuitry by a big margin. $860.68 was incurred to produce a unit of Customised Circuitry compared to $357.92 for Advanced Circuitry and $510.53 for Boosted Circuitry respectively. Under ABC, the cost of producing a unit of Advanced Circuitry and Boosted Circuitry is more than the cost of producing the same unit under volume-based costing by $18.4 and $61.24 in that order. On the other hand, the cost of producing a unit of Customised Circuitry is less than the cost of producing the same unit under volume-based costing by $43.61 (see table 1 below); Table 1: Difference in Unit Production Cost between Volume-Based Costing and Activity-Based Costing Item Volume-Based Costing Activity-Based Costing Difference Advanced Circuitry $339.52 $357.92 $18.4 Boosted Circuitry $449.29 $510.53 $61.24 Customised Circuitry $904.29 $860.68 ($43.61) Source: Author (2014) Reasons for Observed Circuitry Performance and Applicable Production Decision Advanced Circuitry Bad Performance From the analysis above Frank Chan’s statement, “I have heard from the sales people that the Advanced is not selling as well as it could. They told me that we are pricing it too high. How is that possible? I was told that we were barely breaking even on this…” could be true. This is how this is possible; first, looking at the cost, it is much cheaper to produce Advanced Circuitry: it costs $339.52 (volume-based costing)/ $357.92 (activity-based costing) to produce one unit of Advanced Circuitry. In addition, Chan had earlier said that, “Head office normally demands a 20 per cent mark-up on the cost of each product”. Therefore, considering the 20 per cent mark-up, one unit of Advanced Circuitry ought to be selling at $407.43 (volume-based costing)/ $429.51 (activity-based costing). However, one unit of Advanced Circuitry was priced at $432. Since the company was using volume-based costing a price of $432 was $24.57 higher than the price that they should have charged of about $407.43. Still using ABC the price was still higher than a mark-up by $2.49 (refer to appendices) Even though the company was meeting its mark-up target, with such a high price, sales would be affected since, applying the law of demand, “the higher the price the lower the demand and the lower the price the higher the demand, Ceteris Paribas”, demand would be low implying less sales. Moreover, since sales are low it is tricky to break-even given that the company will not be raking in enough returns (Chadwick 2001; 35). Boosted Circuitry and Customised Circuitry Booming Performance While frank states that Advanced Circuitry, he also comments that, “…Boosted and Customised sales are shooting through the roof. We had to raise prices of the Customised to cool the market. Not sure if this is working as yet. Maybe we should also raise the price of Boosted.” The logic behind this is still based on the law of demand. From the analysis above, it is clear that Boosted Circuitry and Customised Circuitry are put up for sale at low down prices. It costs the company $449.29 (volume-based costing)/ $510.53 (activity-based costing) to produce one unit of Boosted Circuitry. Also, producing one unit of Customised Circuitry costs $904.29 (volume-based costing)/ $860.68 (activity-based costing). Now taking into consideration, the 20 per cent mark-up, one unit of Boosted Circuitry ought to be selling at $539.14 (volume-based costing)/ $612.63 (activity-based costing) and one unit of Customised Circuitry ought to be selling at $1085.14 (volume-based costing)/ $1032.82 (activity-based costing). However, at present one unit of Boosted Circuitry is selling at $450 whereas one unit of Customised Circuitry is selling at $620. Table 2 below clearly shows the difference in prices between the mark-up and the current prices using activity-based costing; Table 2: Comparison of Boosted Circuitry and Customised Circuitry Prices against the Mark-Up using activity-based costing Circuitry Current Price per Unit Under ABC Mark-Up Difference Boosted Circuitry $450 $612.63 ($162.63) Customised Circuitry $620 $1032.82 ($412.82) Source: Author (2014) From the figures above, it is evident that the earlier increase in the price of a unit of Customised Circuitry was not sufficient. The price of a unit of Customised Circuitry needs to be raised further and the price of a unit Boosted Circuitry needs to be raised too. Moreover, there are other factors that contribute to the ballooning sales for both Boosted Circuitry and Customised Circuitry. Boosted Circuitry is new in the market, and has slightly more advanced features seeing as it has been used in alarm systems that could be partly modified by customers to suit their requirements. Customised Circuitry is a top-of-the-range circuit board that allows for full configuration of the alarm system by customers and it incorporates the latest technology. Combining all the above factors, it is expected that sales will still remain high. Production Decision I do not think it is wise to throw out producing Advanced Circuitry and focus on Boosted Circuitry and Customised Circuitry only at this time. This is because of two reasons; (1) Advanced Circuitry are overpriced at the moment; and (2) Boosted Circuitry and Customised Circuitry are very much underpriced at the moment. Given these two reasons, it is hard to tell the effect of a correspondent price adjustment on the marketplace. Given that Advanced Circuitry is currently overpriced, the company should first cut down its price and maybe the sales volume for Advanced Circuitry would go up. As regards, Boosted Circuitry and Customised Circuitry, the company should first match the prices to the mark-up price and observe the response in the market. It is true that Boosted Circuitry and Customised Circuitry are more advanced technologically but that is not reason enough to abandon Advanced Circuitry at present. Therefore, the company should focus on producing all the three products then make necessary price adjustments. The response from the market subsequent to the price adjustments would offer more information as whether to abandon producing Advanced Circuitry in favour of Boosted Circuitry and Customised Circuitry. Advantages of ABC Costing over the Current Volume-Based Costing Indeed Antony was right in stating that, “…ABC looks at product costs on the basis of activities involved in their production rather than just volume. ABC integrates the cost of all activities into individual product costs rather than including them as overheads …” According to Dickinson & Lere (2003; 305), volume-based costing has its role; however, it does not fit all situations. Further, Dickinson & Lere (2003; 306) state that in choosing a costing system the interaction between resources, activities, and products or services ought to be well understood. This is because manufacturers spend their resources on activities so as to produce products. Lots of the resources used the manufacturing process can be mapped out to individual products and classified as direct materials or direct labour costs (Berling 2008; 835). On the other hand, numerous overheads merely relate circuitously to the end products. All the same, overheads are resources used up on a firm’s activities to produce products or assist in manufacturing. A good costing system should link costs with activities that consume resources and allocate resource costs to cost objects such as products or intermediary cost pools based on activities performed for the cost objects. Activity-based costing is able to do this whereas volume-based costing cannot. Therefore, ABC is a much better costing system when it comes to assigning resource costs to cost objects (Ben-Arieh & Qian 2003; 170). Apart from the explanation given above to support Antony’s statement, ABC has other advantages over volume-based costing. ABC presents more precise and revealing product costs, this helps to set the correct market prices hence leads to more exact product and client profitability measurements. It also offers more correct information that guides better-informed strategic decision making as regards product lines, budgeting, scheduling as well as market segmentation. Moreover, managers are able to get better product and process value through improved product design decisions, healthier customer support decisions, and nurturing value enhancing project. Furthermore, information availed through the ABC system makes easy the identification of areas where process upgrading is required (Lere 2000; 26). ABC offers enhanced information to make out the cost of unexploited capacity and develop a separate accounting system for this cost. This is because a lot of manufacturing firms experience seasonal as well as cyclic variations in production and sales. In the course of these fluctuations, at times plant capacity is not used meaning that the firm incurs costs at the batch-, product-, and facility-level activities that are not employed. In general, ABC helps in controlling capacity levels appropriately to trim down the cost of capacity underutilization and to price products by the book (Daly 2001; 17). In addition, ABC provides insight into underlying activities and makes it possible for the firm to mull over the option of outsourcing particular activities, or even moving to a different area in the industry value chain. Considering that a lot of costs, such as delivery costs, packaging, and branding, are consumer-driven, it is not possible to account for them through volume-based accounting, but they can be accounted for through ABC. Also, firms may well be doing business with some clients at a loss but they may perhaps not recognise this for the reason that costs are not evaluated in a manner that would let slip the true state of affairs (Drury 2005; 145). ABC together with customer profitability analysis (CPA) can be used to verify more precisely the revenue earned by dealing with some specific clients. This will as well boost profitability by keeping an eye on the entire lifecycle of cost and performance. It also supports constant improvement and total quality control and management since planning along with control are focussed at process level. ABC links a firm’s strategy to effective decision making and enables elimination of waste by enabling visibility of other non-value activities (Kuchta & Troska 2007; 19). Limitations of ABC Even though activity-based costing present healthier product costs as measured up against volume-based costing, the system has several drawbacks (Tuhtasinov 2005; 35). It is important that managers be acquainted with the following limitations of ABC: All costs do not have proper or clear-cut activity or resource usage cost drivers. Quite a few costs need to be allocated to departments and products based on subjective volume measures since ruling the activity that led to the cost is unworkable. Most costs that fall under this category are facility-sustaining such as factory rent, the costs of the information system, factory insurance, factory manager’s salary, property taxes for the factory, rates and factory building depreciation. In addition, if an ABC structure has loads of cost pools, the amount of cost allotment required may possibly be ever increasing (Douglas 1999; 57). Another problem is that product costs acknowledged through ABC may probably not take account of every bit of costs linked with the product. In general, product costs do not take in costs for certain activities such as advertising, marketing, research and development, as well as product design, among others even as a few of these costs can be mapped out to individual products. These costs are not incorporated in product costs for the reason that Generally Accepted Accounting Principles (GAAP) for financial reporting necessitates them to be accounted for as period costs (Charles & Hansen 2008; 490). The greatest limitation that managers may fear is that developing and implementing an ABC system requires a huge budget and is time-consuming. This could particularly be challenging for firms that have been using the traditional volume-based costing system, seeing as the cost of setting up a fresh ABC system may well be exorbitant. Besides, as a rule, successful development and execution of an ABC needs a year or longer just like many other modern management or accounting systems (Drury 2005; 146). Moreover, scores of overheads relate neither to volume nor to involvedness. Therefore, the capacity of one cost driver to wholly elucidate the cost conduct of every single one item in its coupled pool is uncertain. Also, there probably will be a trade-off involving accurateness, the number of cost drivers along with involvedness; and ABC tends to weigh down low-volume or new products with a castigatory level of overhead costs and for this reason it pressurises prospects for victorious improvement if it is employed with no due care (Giammalvo 2007; 10). Recommendations Given the above analysis, it is recommendable that the company adopts an activity-based costing system. The company specialises in the production of three different products and the allocation of costs across each product need to be accurate. This information will particularly inform the pricing strategy for the company that seems to be poor and shaky at the moment (Ostonaqulov 2005; 43). It is evidenced that Advanced circuitry is overpriced whereas both Boosted Circuitry and Customised Circuitry are underpriced. ABC assigns costs to each cost driver as opposed to volume-based costing that assigns costs based on overheads, therefore, ABC provides more accurate information as regards the cost of each product and will therefore help in pricing each product as it should be (AICPA 2004). Even though implementing the ABC system will require a huge chunk of resources and will consume a long period of time to implement, it is worthy for the company in the long-run. Managerial decision making is very important in driving the company’s business and accurate information ought to be used in making these decisions rather than relying on not as much of accurate information and ABC will in the end provide this information (Ashish et al. 2003; 32). Bibliography AICPA. 2004. “Implementing activity-based costing.” Accessed 27 April: . Ashish Garg, Debashis Ghosh, James Hudick and Chuen Nowacki, 2003. “Roles and Practices in Management Accounting Today,” Strategic Finance, 30-35. Ben-Arieh, D. and Qian, L. 2003. Activity-based cost management for design and development stage, International Journal of Production Economics, 83: 169–183. Berling, P. 2008. “Holding cost determination: An activity-based cost approach”. International Journal of Production Economics, 112(2): 829–840. Chadwick, L. 2001. Essential management accounting for managers. 3rd edn. London: Prentice-Hall. Charles, S.L. and Hansen, D.R. 2008. “An evaluation of activity-based costing and functional-based costing: a game-theoretic approach.” International Journal of Production Economics, 113: 480–494. Daly, J. L. 2001. Pricing for Profitability: Activity-Based Pricing for Competitive Advantage. New York:Wiley. Douglas Hicks, T. 1999. Activity-Based Costing, USA, John Wiley & Sons Inc. Dickinson ,V. and Lere J.C. 2003. “Problems evaluating sales representative performance? Try activity-based costing.” Industrial Marketing Management, 32: 301– 307. Drury, C. 2005. Management Accounting for Business, Thomson publishers, pp: 144-148. Giammalvo, P. 2007. Activity Based Costing (ABC): The Other Side of the Earned Value Coin? eJournal PM World Today. Kuchta, D. and Troska, M. 2007. “Activity-based costing and customer profitability.” Cost Management, 21(3): 18–26. Lere, J.C. 2000. “Activity-based costing: a powerful tool for pricing.” Journal of Business & Industrial Marketing, 15(1): 23–33. Ostonaqulov, M. 2005. Accounting Theory (Buxgalteriya Hisobi Nazariyasi), State Economics University Press. Tuhtasinov, B. 2005. Analysis of possible obstacles to implement Effective Costing systems, Activity-based Costing, in Uzbekistan, Research undertaken as part of BA Honors degree, WIUT. Appendices A. Volume-Based Costing Step 1 Overhead Budgeted Cost Cost Driver Rate Labour $435,000.00 3.5 hrs $124,285.71/hr Machine $560,000.00 7 hrs $80,000/hr Variable $180,000.00 4,500 units $40/unit Step 2 Labour Overheads $ 248,571.42 $ 124,285.71 $ 62,142.86 Machine Overheads $ 80,000.00 $ 160,000.00 $ 320,000.00 Variable Overheads $ 120,000.00 $ 40,000.00 $ 20,000.00 No. of Units 3000 1000 500 Step 3 Item Advanced Circuitry Boosted Circuitry Customised Circuitry Direct Materials $ 30.00 $ 45.00 $ 60.00 Direct Labour $ 160.00 $ 80.00 $ 40.00 Labour Overheads $ 82.86 $ 124.29 $ 124.29 Machine Overheads $ 26.67 $ 160.00 $ 640.00 Variable Overheads $ 40.00 $ 40.00 $ 40.00 Total $ 339.52 $ 449.29 $ 904.29 Mark-up $ 407.43 $ 539.14 $ 1,085.14 Price $ 432.00 $ 450.00 $ 620.00 Difference $ (24.57) $ 89.14 $ 465.14 B. Activity-Based Costing Step 1 Activity Budgeted Cost Cost Driver Activity Rate Production Scheduling $ 94,500.00 370 orders $ 255.41 Inspection $ 174,000.00 8,000 inspections $ 21.75 Packaging and Shipping $ 166,500.00 4,500 boards $ 37.00 Machine Set-up $ 176,400.00 17,000 set-ups $ 10.38 Machine Insertion $ 300,350.00 1,320,000 insertions $ 0.23 Machine Soldering $ 83,250.00 207,500 parts $ 0.40 General Supplies $ 40,000.00 7,000 machine hours $ 5.71 Procurement $ 75,000.00 207,500 parts $ 0.36 Hazardous Waste Disposal $ 65,000.00 60,000 grams $ 1.08 Step 2 Item Advanced Circuitry Boosted Circuitry Customised Circuitry Direct Material $ 30.00 $ 45.00 $ 60.00 Direct Labour $ 160.00 $ 80.00 $ 40.00 Overheads Production Scheduling $ 25.54 $ 5.11 $ 25.54 Inspection $ 21.75 $ 43.50 $ 130.50 Packaging and Shipping $ 37.00 $ 74.00 $ 111.00 Machine Set-up $ 20.75 $ 72.64 $ 124.52 Machine Insertion $ 27.30 $ 109.22 $ 218.44 Machine Soldering $ 10.03 $ 28.08 $ 50.15 General Supplies $ 5.71 $ 11.43 $ 22.86 Procurement $ 9.04 $ 25.30 $ 45.18 Hazardous Waste Disposal $ 10.80 $ 16.25 $ 32.50 Total $ 357.92 $ 510.53 $ 860.68 Mark-up $ 429.51 $ 612.63 $ 1,032.82 Price $ 432.00 $ 450.00 $ 620.00 Difference $ (2.49) $ 162.63 $ 412.82 Note: Given that the numbers of boards for each circuit were not given, we assumed a ratio of 1:2:3 for Advanced Circuitry, Boosted Circuitry and Customised Circuitry respectively Read More