Indigo Limited - Report Example

Indigo Limited Report to the Sales Manager – Indigo Limited The objective of this report is to provide an outline on the relevant costs and non-relevant costs. Applying the principles of relevant and non-relevant costs, the report presents a statement showing the minimum price that the company could bid to secure the manufacture and supply of a one-off batch of 1000 trolleys which are similar to the ones being made by the company. The report also highlights the usage of activity based techniques to improve the performance of the company. The statement on the suggested bid takes into account the standard costing for the products and the changes in the cost figures found out of the investigation carried out at the instance of the sales manager. 1. Relevant and Non-relevant Costs As commonly understood cost is a monetary measure of the resources sacrificed or foregone to achieve a specific objective such as acquiring a good or service. In a business situation costs are important for arriving at the selling prices, planning the future production targets, making sales forecasts, making managerial decisions in different business scenario and also to exercise an effective managerial control on the operations of the firm. Depending on how the costs change or react to given business activity or volume, the costs can be classified as relevant costs and non-relevant costs. In the process of taking a decision on whether to accept a one-off batch production of an item similar to the one being produced by the company, the important aspect to be considered is the ‘relevant costs’. Relevant cost is “A managerial accounting term that is used to describe costs that are specific to managements decisions. The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process.” (Investopedia, 2009) Relevant costs are those appropriate to a specific management decision. Relevant costs are the future costs that will differ among alternatives. One might use the past costs to help predict those future costs but the past costs are otherwise irrelevant to the decision. Application of relevant costs in decisions relating to acceptance of one-off contracts must be done with a careful understanding of all the effects of such decisions on the future profitability of the company. ‘Relevant costs’ are the amounts by which costs increase and benefits decrease as a direct result of a specific management decision. Relevant costs are the future costs that differ from the alternatives being considered. Incremental or differential costs are relevant because they are the ones that differ from the alternatives. Since all costs are not relevant, managers should identify those costs which are relevant for decision making. ‘Non-relevant costs’ on the other hand are those which are not related to a situation requiring management’s decision. Historical costs may be a useful basis for making informed predictions of the expected future costs but they by themselves are past costs that are irrelevant for decision making. Past costs that are unavoidable because they cannot be changed no matter what action is taken are called ‘sunk costs’. “Absorbed fixed overheads that will not increase or decrease as a result of the decision being taken” (Scarlett, 2007; Walker, 2008) ) are non-relevant costs. When a short-term decision is taken it is important that costs and revenues relevant to the decision are considered and non-relevant costs and revenues are excluded from the calculations (Pizzey, 1989). The following illustration exhibits how relevant costs play a key role in deciding the course of action to be taken by Newell Rubbermaid Incorporation while reorganizing the production line. Newell Rubbermaid Incorporated is a large group of company engaged in the manufacturing and marketing of consumer and commercial products. It operates through the following five segments: Cleaning and organization, Office products, Tools and Hardware, Home Fashion and other (WrightReports, 2008) The production manager of the company is contemplating the reorganizing of production line at the home appliances division. The following statement presents the financial data underlying the choice among the two options “Do not Reorganise” and “Reorganise” for home appliances. The First two columns provide all data, whereas the next two columns provide only relevant costs or revenue. The expected future manufacturing labor costs ($640,000 and $480,000) and the expected future reorganization costs ($90,000) differ between the alternatives and hence they are relevant costs. Determining Relevant Revenues and Relevant Costs for Home Appliances All Data Relevant Data Do not Reorganise Reorganise Do not Reorganise Reorganise Revenues a $6,250,000 $6,250,000 - - Costs: Direct Material b 1,250,000 1,250,000 - - Direct Labor 640,000 c 480,000 d 640,000 c 480,000 d Manufacturing Overhead 750,000 750,000 - - Marketing 2,000,000 2,000,000 - - Reorganisation Costs - 90,000 - 90,000 ---------------- -------------- ------------- ----------------- Total Costs 4,640,000 4,570,000 640,000 570,000 ---------------- --------------- -------------- ------------------ Operating Income 1,610,000 1,680,000 (640,000) (570,000) --------------- ---------------- ------------- ------------------ -Difference $ 70,000 - -Difference $70,000- a 25000x$250 = $ 6,250,000; b 25,000x$50 = $ 1,250,000; c 20x2000x$16 = $ 640,000 d 15x2000x$16 = $ 480,000 Source: Horngren et al., (2002) Although the revenues, direct material costs, manufacturing overhead and marketing costs are future costs they do not differ between the alternatives and hence they are Irrelevant. The data in the above statement indicate reorganizing the production line will increase the predicted operating income by $70,000. It may be noted that we arrive at the same conclusion if we use ‘all data’ or ‘only relevant’ data in the analysis. “However by confining the analysis only to relevant data the managers can do away with the clutter of confusing irrelevant costs. Understanding which costs is relevant and which are not helps the decision maker concentrate on obtaining only pertinent data and saves time”. (Horngren et al., 2002) There are some potential problems in adopting relevant cost analysis. These should be carefully avoided while doing the analysis. They are: (i) The general assumption that al variable costs are relevant and all fixed costs are irrelevant should be analysed by taking into account the relevance of each fixed and overhead costs affecting the managerial decision, (ii) Unit cost data may mislead the decision maker when irrelevant costs are included in the analysis. Similarly the analysis may get vitiated when the same unit costs are used at different output levels. 2. Statement showing the Minimum Bid for the one-off Batch of 1000 Trolleys The following statement shows the minimum price that the company can bid to secure the one-off batch contract of supplying 1000 trolleys. Indigo Limited Statement of Cost Description Unit Rate £ Amount £ Unit Cost £ Steel Kgs 500 20 10000 10.00 Copper Kgs 125 16 2000 2.00 Maintenance Labour 3000 3.00 Variable Overheads Units 1000 0.80 800 0.80 Fixed Costs 2250 2.25 Marketing Dept Cost 1000 1.00 Total Cost 19050 19.05 Even though the standard costing assumes the price of steel at £ 13 per Kg the investigation of the sales manager reveals that the current price of steel is £ 20 per kg and since the company does not keep higher stock of steel, it is necessary that steel for this order is to be bought at that price. Therefore the cost of steel for the bid is to be taken at £ 20 and not at £ 13 as assumed in the standard cost. As regards the copper, the purchase cost of £ 22 per kg is irrelevant as the company rarely uses copper. If the company decides to sell copper to another manufacturer instead of using it in the manufacture of trolleys, the copper would have fetched only £ 16 per kg. Therefore the company is having an option of using it in the manufacture taking the cost at £ 16 per kg or to retain it to be sold to another manufacturer at £ 16 per kg. However financial prudence would suggest using the copper at £ 16 per kg in the additional one-off order for the manufacture of trolleys instead of finding another manufacturer to buy it £ 16 per kg. The fact that there is no buyer readily available for copper is to be considered here. Labour cost of £ 4,500 used in standard costing becomes a non-relevant cost as far as the production of these additional 1000 trolleys is considered. Irrespective of whether these additional trolleys are manufactured or not the company would incur the direct labour cost of £ 4,500 as the company is not working in full capacity presently and this batch of production can be fitted in with the other production. Therefore the direct labour cost of £ 4,500 included in the standard costing becomes non-relevant. However the additional maintenance labour cost of £ 3,000 needs to be included in the cost as such cost would be incurred especially for making the additional batch of production. Fixed overhead cost of £ 5,125 based on 500 hours at £ 10.25 per hour is also non-relevant for arriving at the minimum cost of the trolleys. This is because of the fact that these costs would any way be incurred by the company even if this additional order is not produced. Therefore the fixed cost of £ 5, 125 has not been considered in the calculation of the minimum bid; instead the additional fixed cost of £ 2,250 estimated has been considered. The additional cost of £ 1,000 that would be incurred by the marketing department to secure this order is relevant and is to be included in the minimum bid working. Considering all the above relevant and non-relevant costs, the minimum cost per unit of trolley is worked out at £ 19.05 as against the standard cost of £ 19.50 per unit. By quoting £ 19.05 the company would not be financially worse off. 3. Activity-based Techniques of Costing “Activity based costing is an alternative to the traditional way of accounting.” (Value based Management, 2009) With the growth of the complexity in business operations, there is an increased need to assign the large indirect costs on an appropriate basis. This basis is arrived at based on some of the activities connected with the manufacturing and selling of products and services. The Activity B Based Costing system (ABC system) enables the adoption of various activities as the cost drives for allocating the indirect costs. In the traditional costing system it is assumed that cost objects make use of resources whereas in the case of ABC system the assumption is that the cost objects consume activities. This makes vast difference in the profitability of products/services as computed under the two different costing systems. “Activity-based Costing is a methodology that produces a bill of activities for cost objects such as individual products, services, or customers by measuring the cost and performance of activities and resources.” (Moore, 2000) ABC system acknowledges that a firm cannot manage its cost but it can only manage the activity being carried out which will ultimately change the cost as a consequence (Emblemsvag, 2000). The underlying assumption under the existing costing system is that the costs can be managed based on the controls established by the budgets. The current system of standard costing where the allocation of direct and indirect costs is made based on the established standards may not provide correct costing information for managerial decision-making. It may even result in over or under costing of the products and the ultimate determination of a wrong selling price for a particular product. For instance the setup costs and machine hours are some of the important elements in determining the allocation of indirect costs. The standard costing system does not take into account the impact of these costs on the overhead allocation. On the other hand, the homogenous cost pools and the choice of cost allocation bases tied to the cost hierarchy and carefully chosen cost drivers will give the managers greater confidence in the activity and product cost numbers when they choose to adopt the ABC system. Under ABC system “Costs are divided into homogenous cost pools and classified as output-unit-level, batch level, product or service sustaining and facility sustaining costs”. (Horngren et al., 2002) which makes the system superior to the traditional system of costing. The cause and effect relationship among the costs in the cost pool enables a realistic allocation of costs to products. Due to the historic background of traditional cost accounting methods the existing system tend to use direct labour hours, which is a volume related allocation base for cost assignment purposes. However with the mounting indirect overheads and the introduction of innovative technologies it may be absurd to allocate the cost on a total basis without regard to the individual impact of different elements. Under ABC system the costs are allocated based on the ‘cause and effect’ relationship between activities and cost objects which is gathered using appropriate cost drivers. The drivers though in a sense can be equated to cost allocation bases, in reality they are the estimates of actual cost behaviors of different activities which go into the production of the units. Therefore the cost drivers can be construed as the critical cost factors which enable a better management control on the activity costs. By defining activities and identifying the cost of performing each activity ABC techniques enable the organization to understand how it uses its resources and this understanding is at a greater level when the ABC techniques are used. This will help the organization to use its resources more effectively and efficiently to improve upon the productivity of the organization. There are three different features that make activity-based techniques as better options for managerial decisions. They are: (i) activity-based techniques create smaller cost pools associated with different activities, (ii) the techniques use the activity performed as a measure for each cost pool, and (iii) in some instances it is possible to trace the costs in a cost pool directly to products. These distinguishing features are not available in the case of standard costing or any other traditional costing system. This makes accurate costing of products using cost allocation bases of different activities, used by the products. Thus use of activity-based techniques refines the costing system to provide an efficient and reliable base for managerial decision-making. Different events, tasks or units of work with specified purposes form the activities on which the costing system is based. Since the activities can be related more precisely to products and services activity-based techniques are found to be better tools for managerial decision-making. Reflective Journal In producing the coursework, I could understand the meaning of relevant costs and non-relevant costs and their impact on the pricing decisions of managers. In working on this assignment, I could understand the importance of time management and this assignment motivated me to refer to different books and journals for improving my knowledge on costing in general and about relevant and non-relevant costs more specifically. Since there was abundance of resources I did not encounter any problems in completing the assignment. In fact in completing my next assignment I would refer to more professional journals and consult different articles written by professionals to add valuable content to my work. In completing the assignment I could easily understand the learning outcome of demonstrating relevant practical accounting knowledge and drawing up the cost statement. There was no learning outcome which was difficult. I believe that I have done the assignment to the best of my ability. Reference List Emblemsvag, J., 2000. Life-Cycle Costing. New York: John Wiley & Sons. Horngren, C.T., Foster, G. & Datar, S.M., 2002. Cost Accounting: A Managerial Emphasis. New Delhi: Prentice Hall of India Private Limited. Investopedia, 2009. Relevant Cost. [Online] Available at: http://www.investopedia.com/terms/r/relevantcost.asp [Accessed 11 November 2009]. Moore, K.R., 2000. Using Activity-Based Costing to Improve Performance - A Case Study Report. [Online] Available at: https://www.afresearch.org/skins/rims/q_mod_be0e99f3-fc56-4ccb-8dfe-670c0822a153/q_act_downloadpaper/q_obj_53ccc94f-1d9f-47e5-a647-6cd365c260db/display.aspx?rs=enginespage. [Accessed 10 November 2009]. Pizzey, A., 1989. Cost and Management Accounting: An Introduction for Students. London: Sage. Scarlett, B., 2007. Cima Management Accounting-Performance Evaluation. UK: Butterworth-Heinemann. ValuebasedManagement, 2009. Activity Based Costing. [Online] Available at: http://www.valuebasedmanagement.net/methods_abc.html [Accessed 11 November 2009]. Walker, J., 2008. Accounting in a Nutshell: Accounting for the Non-Specialist. UK: Butterworth - Heinemann. WrightReports, 2008. Newell Rubbermaid Incorporated. [Online] Available at: http://wrightreports.ecnext.com/coms2/reportdesc_COMPANY_651229106 [Accessed 11 November 2009]. Read More