Sales Forecasting - Case Study Example

Introduction

As a new accountant for the Australian Electronics division of High Tech Incorporated, the first task is to look at the current issues faced by the Head of Electronic division, Finance, Purchasing, Sales, and Production managers. The issues are grouped into five broad categories discussed below; a methodology for forecasting sales for a budget year, a proposition to purchase excess inventory from a winding up competitor before they are needed, Activity Based Costing, a decision on the cost matching principle and a decision whether to outsource production of a component.

Sales Forecasting

Sales forecasting is an important component of the production business, since it enables a business to better plan for the future and financial statements. Ideally, sales forecasting means the determination of the quantity of production to make to meet sales targets and avoid over production, which increases storage costs. A sales forecast tries to predict how much of a produced product is likely to be sold over a period of time, hence help define how much of the product to manufacture. Accurate sales forecasts will help the business plan for production, raw materials required, overhead costs and projected income versus expenses (Kahn, 2002). There are three main methods used to forecast sales; qualitative techniques, time-series analysis, and causal methods.

Qualitative techniques of sales forecasting are usually used in new business areas or in new market products that are yet to penetrate the market. In this case, human judgement and expected product rating skills are used to generate quantitative production estimates (Kahn, 2002). The best way to conduct qualitative sales forecast is by using market research, where hypothetical testing of real markets and potential customers is done by the business to estimate sales. This includes getting feedback from expected customers about the product being sold, and predictions are made. The other method of qualitative sales forecasting is by having a panel of experts in the product field to predict the expected penetration of the product in the market.

The next method of sales forecasting is the use of causal methods, which basically refer to statistical inference of expected markets (Kahn, 2002). This method requires the collection of data that is expected to influence sales trends, which are then converted into statistical techniques like regression analysis or econometric models. This method is very effective since it takes into consideration both internal and external factors likely to affect product sales and manufacture. All micro and macro-economic factors are modelled statistically to give expected sales numbers.

The best method of sales forecasting is by using time-series analysis, where historical sales and production figures are modelled to give future expectations (Kahn, 2002). This is the best method in this case since the business has been operating and has previous sales data. For example, it has already been indicated that Zenith sales are increasing with a corresponding fall in Prime sales. One of the best methods of creating a time series analysis is the creation of a trend line equation based on historical sales and projecting this into a future trend, which then shows expected sales for the current year. In this case, Dominic’s method would be best since it is calculated using previous years’ sales to predict future sales and production requirements. This requires the input of all the managers; finance, production, purchasing and sales to provide figures for their respective departments for previous years, and then an expected model for the future is created based on these numbers.

Inventory Management

An analysis of the proposal to purchase excess Theolite from Jaymie Electronics should be looked at from different angles, which then decide whether to purchase the stock or not. The most obvious advantage of this transaction is the discount offered for buying the inventory from a winding up business. Bulk purchase provides two distinct advantages; the discount received, and the reduced transportation cost from shipping one bulk purchase (Horngren, 2014). Additionally, excess stock provides a buffer for future use, in case production increases exponentially, we have the inventory to cover this need.

However, the disadvantages of bulk purchase of inventory before it is needed also needs to be considered. Inventory comes with a cost that needs to be managed, for example, bulk purchase ties up funds in the inventory that would otherwise be used for other business (Horngren, 2014). Since production inventory cannot be disposed as required until it is used for production, the business might have liquidity problems in the future. The other factor is warehousing and storage costs for extra inventory (Horngren, 2014). We need to consider the cost incurred in storage and security of the excess inventory and determine whether the discount applied at purchase will still make economic sense after applying the underlying costs. As indicated, excess stock will take up space, utility and maintenance costs that might outweigh the discount received. Inventory management should be done in anticipation of demand; the company needs the inventory now, but future usage might change and the inventory becomes obsolete. In this case, the quality of the inventory also needs to be looked at. Holding inventory for long periods of time reduces its quality in terms of degradation, a cost that will have to be factored in the estimation of income (Horngren, 2014). From this, the inventory might also become obsolete as production and sales needs change, which will make the company hold worthless stock. Finally, the legality of the transaction has to be observed; is the company winding up the inventory in a legal manner or is it the purchasing manager making a personal decision. After considering these factors, and looking at the accompanying numbers, then a decision can be made on whether to purchase the inventory or not.

Activity Based Costing

Many companies use the traditional costing methodology to assign costs of a production business to the period in which they were incurred, so overhead costs are cumulatively applied to all products. However, in a multi-product setup, this method is not efficient, necessitating the use of an Activity Based Costing (ABC) setup that assigns most overhead costs to specific products (Horngren, 2014). In this case, every single product’s production cost can be traced and determine its profitability. A simplified model of Activity based costing is the breakdown of production into core activities that give the final product. After this, costs are defined for these core activities in terms of the overheads that they consume, and finally, each cost is allocated to the products produced in terms of the units of the activities needed to finalize the production of each product. Looking at traditional costing, product and period costs are divided and allocated to the period income to get the net revenue, for example, all administrative expenses are charged as a lump to income, and product costs like direct and indirect costs are also charged. In activity based costing, the period costs are allocated to specific products according to the units that they consume, so overall profit from specific products is calculated. Activity based costing provides the added advantage over traditional costing by giving specific product costs, which will then be used to calculate future production and sales for the specific products. With these, the business is able to make better decisions regarding the production or discontinuation of certain product lines.

However, it should be noted that activity based costing must be based on absorption costing methodology, where inventory does not take a percentage of period costs but absorbs all production costs. In this case, generally accepted accounting principles are not strictly followed, so it is understood that activity based costing is used for internal managerial accounting decisions and not used for formal external reporting practices (Horngren, 2014). However, this costing methodology is very important for a production setup in determining the production trends of products; which products for which to increase production and which products for which to reduce production or discontinue. With this, the production and sales manager are able to make better decisions; which product to produce more of and market more since it gives higher margins as opposed to other products that give lower margins.

From this analysis, activity based costing should be implemented in the business. Since the business produces more than one type of product, it would be prudent to implement activity based costing to get the specific costs incurred per product and get the profitability of each product. As indicated, the main method of implementing activity based costing is done in three steps. The first step is the identification of the activities that go into production, after which overhead costs are all identified. The business then breaks the activities into products that utilize the activities, and the ratios in which the product use the activities. The overhead costs are then allocated to these products in their ratio of absorption.

Looking at the costs per PCB provided as below, the HT Zenith will take more of the activity costs, so it is needed to determine whether the increase in production cost for this component justifies the cost. With activity based costing, the company will be able to break down the cost into the three PCBs, and in turn get the cost per board by assigning specific overheads.

Cost matching Principle

Looking at the suggestion to move next year’s expected costs to the current period accounting, the best principle would be the application of the matching principle. The matching principle indicates that all expenses and revenues are to be matched into the period in which they are incurred and earned, irrespective of the period which cash is actually received or earned (Horngren, 2014). Since costs fall under expenses, they are to be matched into the period in which they are incurred, irrespective of the impact that they will have on the income statement at that period. In this case, the suggestion to move the expected maintenance costs that are to occur next year to this period’s income statement is not viable, since the costs will not be matched to the period in which they were incurred. The maintenance cost is expected to be done next year, so there is no way that the cost can be allocated to this year’s income statement. Despite the fact that the overall effect on the cumulative income statement for three years is not negative, the costs should be allocated to the specific period that they will be incurred.

Outsourcing Production

To get the unit cost of production for the MK1919, it is needed to look at the unit cost of production for 50,000 units, compare this to the fixed cost of production of 70,000 units and compare both of these to the unit cost of production for MHLV of $3.85 per unit. At 50,000 production level, the unit cost of production is taken by dividing the total cost of production for the $258,000 by the number of units, giving $5.16. This can also be given as below.

Units Produced

Unit Cost

50000

70000

Direct Materials

2.5

125,000.00

175,000.00

Direct Labour

0.6

30,000.00

42,000.00

Variable Manufacturing Overhead

0.75

37,500.00

52,500.00

Fixed Manufacturing Overhead

0.45

22,500.00

22,500.00

General and administrative overhead

0.86

43,000.00

58,400.00

Total Cost per unit

5.16

258,000.00

350,400.00

Given a total cost per unit of $5.16, compared to a total cost per unit of $3.85 from MHLV, it is prudent to take the offer since it reduces costs for the production considerably. However, more information needs to be provided in this calculation. In this costing methodology, the company still produces other products, so is the labour cost going to reduce when this production for MKA 1919 is outsourced? It would not make sense if the outsourcing does not reduce labour cost incurred in producing the other components. Additionally, the fixed manufacturing overhead does not change with outsourced production since it is already allocated to the whole production, so more information on the direct cost reduction is needed. This can be broken down as in the below table of irrelevant costs that will still remain with the business

Fixed Manufacturing Overhead

22,500.00

22,500.00

General and administrative overhead

43,000.00

58,400.00

Total Costs

258,000.00

350,400.00

This gives an additional cost regardless of the outsourced production, meaning that the costs will be higher. Based on this, it is recommended that the production of MKA 1919 is done in house to reduce costs.

Conclusion

From the above analysis, a few factors are realised, for example, that the best way to do sales forecasts for the company is by using historical trend analysis. On the issue of purchase of inventory from a winding up company, it is better for the Australian Electronics Division not to purchase the inventory at a discount. Activity based costing has also been explained, and it is prudent for the company to implement it, while it is recommended that the suggestion to bring forward next year’s tentative costs be shelved. Finally, the outsourcing of MKA 1919 is not a good idea because of the corresponding increase in cost.