The Excel Limited - Activity Based Costing System - Essay Example

Managing Finance Executive Summary Excel Limited needs to stipulate clear costing objective in order to evaluate costing appropriately for pricing strategy. Considering and evaluating all system the most suitable costing system for Excel limited is Activate Based Costing, as ABC generates costing on basis of cost drivers, and that is most suitable to the nature of its business. The company is following fixed budgeting system that has more of demerits than advantages. The company requires flexible zero based budgeting and a master budget needed to planned with all sub budgets for sales, production cost, administration cost, selling an distribution cost, capital budgeting as well as cash budgeting. Financial analyses of the company reveal that though liquidity position of the company is good to meet short term obligations, but its earning powers, and efficiency to collect receivables and inventory turnover is much below the industry standards. It is suggestible that the company should make capital in investment in machine costing $3 million in order to make cash savings in cost of sales on the basis of in depth analysis of investment made as per payback and NPV methods of capital expenditure budgeting. Contents Executive Summary Contents Cost Concepts Budgetary Process Financial analysis Evaluation of potential investment expenditure Conclusion Appendixes References Cost Concepts The aim of any pricing strategy is to cover the costs involved in the project and earn desirable profit. Costs in any project can be traced as direct or indirect costs. Direct costs are those that are easily traceable by the management to specific items like direct material and direct labour for specific product. Whereas Indirect costs are common to many items and cannot be traces to any specific item or area. Indirect costs are charged to item on basis of certain allocation techniques. Again from the point of production the costs are either prime costs or conversion costs. Prime costs are direct material and direct labour costs and these are directly related to production. Conversion costs are related to transforming direct material into finished goods and these include direct labour and factory overheads. Costs further changes with volume of production. On basis of relationship to volume costs are either fixed costs, variable costs or mixed costs. Fixed costs remain constant over a relevant range of volume or output. Variable costs are assumed to change in direct proportion to changes in volume/ output. Mixed costs contain both fixed and variable attributes, and may be semi variable costs and step costs. Semi- variable costs usually represent a minimum fee for making a particular product or service available, and variable portion is cost for using the product/ service. As in case of telephone bills there fixed charged like rent and variable portion the costs of number of calls made. Steps costs change abruptly at various levels of activity as those costs are acquired in indivisible portion and the best example for this is the supervisors’ salary. Then functionally speaking costs may be manufacturing costs, marketing costs, administrative costs, and financing costs. Manufacturing costs are direct material, direct labour, and factory overhead costs. Marketing costs are incurred to promote product/ service. Administrative costs are incurred in directing, controlling, and operating a company. Financing costs relate to acquiring funds for the operations of the company. Then from the point of view of planning, controlling and decision making, costs may be standard or budgeted costs, controllable and non- controllable costs, and opportunity costs. Standard or budgeted costs are those that should be incurred in a particular process under normal conditions. Controllable costs are those where management can influence the emergence of such costs; and uncontrollable costs are not directly administered by the management. Opportunity costs are most important in costs planning as such costs are used when a decision to pursue one alternative is made. Opportunity costs are not actually incurred as they are relevant to decision making. Costing is the process and technique of ascertaining costs, and for that different methods are employed. Terminal costing (also called Job/Batch/Contract costing) is applicable where the works consist of separate jobs/batches/contracts. Costs are collected for each job/ batch/ contract. It is applicable where production is not repetitive like in printing or machine tool manufacturing. Another method called Operation/ Process/ Period costing is applicable where standardized products result from a sequence of repetitive and continuous operations/ processes. The costs cannot be traced to specific units and are averaged for the number of units manufactured. The above stated costing methods use different costing techniques that enable the entity to ascertain costs for cost control and decision making purposes. The first technique is called uniform costing that uses standardized principles and methods of costing like methods of defining costs, allocation/ apportionment of overheads to cost centers/units. Marginal costing is another technique that ascertains costs in terms of marginal cost defined as those costs that arise due to change in volume of production, that is, variable costs only. Under Direct costing technique all direct costs consisting of all variable and some fixed costs are charged to products. Absorption costing is the technique that charges all costs, variable as well as fixed, to products/ operations/ processes. Under standard costing technique costs are predetermined in conformity with most efficient operations and use of resources. Standard costs are compared with actual costs and variances, if any, are analyzed. Activity- based costing technique is one where costs are grouped according to what drives/ causes them to be incurred. These cost drivers are used as the absorption base. The most suitable costing system for Excel Ltd. is Activity based costing (ABC) as this technique focuses on different costs for different purposes and the identification of only those costs which are relevant to a particular decision. For making plastic storage bins processes or job costing that may adopt direct costing or absorption costing techniques are not suitable as there overhead recovery basis is inappropriate for typical product strategy decisions. Also the traditional fixed and variable cost split is often unrealistic since as the business grows, they often become more complex. Under ABC costing cost driver is an activity that generates cost. This provides a means to trace the cost to individual product. Budgetary Process Budgetary control involves the establishment of budgets; continuous comparison of actuals with budgets for achievement of targets and placing the responsibility for failure to achieve the budget figures; and revision of budgets in the light of changed circumstances. Excel Limited fixed its budgetary targets for the year 2008 is to attain the Sales of $15,750,000, net income after 30% taxation to the tune of $840,000, dividend to shareholders of $1,320,000,currentratio of 2:1, and equity funds at $9,600,000. These targets fixed but without the impact of $3 million capital investment. Though a sort of Master budget has been presented for Excel Ltd. but its targets are fixed. Master budget is in fact summary of different activity budgets that are summarized in one report. As the budget states that total sales target is $15,750,000, but there is no sales budget that provide separate targets for sales of normal bins and sales for customized bins. Thus budget presented for Excel Ltd. is only a summary budget that incorporates all budgets. It sets out plans of operation for all departments for the budget period, but separate departmental budgets are not there. Fixed budgetary targets of Excel have certain inherent limitations. First it does not change with change in the level of activity. Therefore, it becomes an unrealistic measuring yard in case volume of sales actually attain does not conform to the one assumed for budgeting process. The management of Excel Ltd. will not be in a position to assess the performance of different departments on the basis of fixed budget prepared because such budgetary targets can serve as measuring sticks only when the actual level of activity corresponds to the budgeted level of activity. In view of above limitations of fixed budget of Excel Ltd. it is desirable that a flexible budget is prepared Such a budget is prepared after considering the fixed, variable and semi- variable elements of costs. Thus when budgeted level of activity is not attainable, flexible budget accommodate itself to actual level of activity, and thereby it helps in ascertainment of costs, fixation of prices and in ascertaining performances. Flexible budget is highly desirable for Excel as the sales in case of Excel are highly unpredictable, e.g., of normal bins or larger customized plastic bins with unique specifications. In case of Excel Ltd. Zero based budgeting is also suggestible. It is highly useful for manufacturing of customized bins as under zero budgeting review is made on the assumption that nothing should be based on anything done in the past. However zero budgeting can be introduced in Excel on trial basis first for customized bins and on its success it can be followed for normal production of bins. Zero based budgeting is actually an extension of cost benefit analysis method. Each decision unit is independent so that if cost analysis shows unfavorable results, then that unit can be dropped. Under zero based budgeting it is decided whether an activity is necessary to perform, and if so will the actual benefit be more than actual cost of the activity. It is suggested that before presenting the master budget that is summary of all budgets, Excel limited should prepare the following budgets in order to offer an opportunity for detailed reviews: Cost of production budget: this contains material budget and direct labour budget. The material budget deals with direct material as indirect materials are generally included in the works overhead budget. The direct labour budget tells about the estimates of direct labour requirements essential for carrying out budgeted output. Factory overhead budget: This can classified into three categories of factory overheads, direct, variable and mixed overheads. This budget will provide an estimate of all these overheads to be incurred in budget period. Administrative overhead budget: This budget covers expenses of all administration and management costs including salaries. Selling and distribution overhead budget: This budget includes all expenses relating to selling, advertising, and delivery of goods to customers. The preparation of such budget will depend a lot on the analysis of the market situations by the management of Excel Ltd., its advertising policies, research programmes and the fixed and variable elements of costs involved. Capital expenditure budget: as the Excel Ltd. is planning to make capital expenditure on a machine worth $3million and its sources, the capital budget include a complete guidance as to the amount of capital needed for procurement of capital assets need during budget period. Cash budget: Cash budget is a forecast of cash position by time periods for a specific duration of time. This helps in arranging short term short term borrowings in advance or making investment in case of excess cash than required. Financial analysis Financial analysis of the performance of Excel Ltd. is based on its assessment from liquidity, profitability and efficiency parameters and comparisons with industry standards. In fact liquidity is the prerequisite for the very survival of a firm. The short term creditors are interested in the short term solvency or liquidity of a firm. The importance of adequate liquidity to meet its current/ short term obligations cannot be overstressed. Current ratio of a firm measures the liquidity of a firm that assesses the ability of a firm to meet its short term liabilities as they become due. The current ratios of Excel Ltd. for 2007 based on actual figures and budgeted for 2008 are calculated in Appendix A. In any industry current ratio of 2:1 is considered optimum. However this norm may differ from industry to industry as well. The higher the current ratio, the larger is the amount of dollar available per dollar of current liability and the more is the firm’s ability to meet current obligations and greater is the safety of funds of short term creditors. The Excel Ltd. has this current ratio of 2.15:1 in 2007 that is based on actual figures, and it has budgeted that the performance of 2008 would bring in a ratio of 2: 1. Keeping these figures in view it can be safely said the Excel Ltd. is a solvent company that can meet its current obligations as those become due. But why the budgeted figures are lower than actual performance in 2007 is a matter of concern. This may be due to some liquidity crunch envisaged by Excel Ltd. while budgeting figures for 2008. However the industry norm is 2.3: 1. Excel Ltd. almost close to industry norm in its budgeted figures of 2008. It can be analyzed that liquidity wise Excel Ltd.is meeting the expectations of its short term creditors. Profitability performance can be assessed through its earning power. Operating efficiency of a firm in terms of the efficient utilization of the resources is reflected in net profit margin. It has been observed that although high profit margin is a test of better performance, a low margin does not necessarily means a lower rate of return on investments. Therefore, overall operating efficiency can be assessed on the basis of combination of two and is known as earning power of the firm. The earning power or the ROI ratio is a central measure of the overall profitability and operational efficiency of a firm. It shows the interaction of profitability and activity ratios. It implies that performance of a firm can be improved either by generating more sales volume per dollar of investment or by increasing the profit margin per dollar of sales. For Excel Ltd. the earning power or return on investments is calculated in Appendix A: The above ratio shows that net profit margin as well as investment turnover is budgeted higher than actual 2007, and that is Excel Ltd. is expected to increase its earning power from 3.39% of total assets in 2007 to 4.91% of total assets in 2008. Earning power is also called Return on assets (ROI) and the industry standard is 8.5%. Comparing the industry standard Excel Ltd.’s earning power is much lower and the company has to utilize its assets more efficiently to meet the required standards. Efficiency in the performance can be judged through its inventory turnover ratio and average collection period. Inventory turnover indicates the number of times inventory is replaced during the year. It measures the relationship between the cost of goods sold and the inventory level. It is a test of inventory management. In general a high inventory turnover ratio is better than a low ratio. The average collection period reflects how quickly receivable or debtors are converted into cash. In other words this ratio is a test of the liquidity of debtors of a firm. Both these ratios are calculated for Excel Ltd. in Appendix A. It is noticed that Excel Ltd. is expecting a lower inventory turnover in 2008 as compared to actual in2007. In 2007 Excel had a n inventory holding period of 70 days, and that is expected to rise in 2008. The performance is very poor as the industry inventory holding period is only 30 days. Excel ltd. has to improve its inventory turnover ration in order to come near to industry standards. Similarly average collection period is expected to rise in 2008 to 68 days from actual figure of 53 days in 2007. Industry norms show debtors’ collection period only as 30 days. The performance on this count is inefficient and this will definitely affect the liquidity position of Excel Ltd. Evaluation of potential investment expenditure There are various methods of evaluating a proposed capital expenditure. The most popular methods are Average rate of return (ARR), Pay Back Method, Discounted cash flows (DCF), Net present value (NPV), and Internal Rate of Return (IRR) method. We have the information about cash savings in the cost of sales and required rate of return. Accordingly the evaluation can be done only on the basis of Payback method and NPV method. Based on these methods the evaluation is done as under: Payback Method: As per Lawrence J. Gitman (2006, page 419)1 ‘the Payback period is the amount of time require for the firm to recover its initial investment’. For the purpose of calculating payback period for Excel Limited’s investment on machinery worth $3 million the cash saving in the cost of sales have been assumed to be cash generated by the use of machinery costing $3 million. Accordingly pay back period is calculated in Appendix B Cumulative cash savings shows that investment in machinery of $3 million will be recovered in the third year of working of such machine. Pay back method is easy to calculate and simple to understand. But its major shortcoming is that it completely ignores all cash inflows after the payback period. This may be misleading in capital budgeting. Net present value(NPV) method NPV is based on discounting cash flow technique. NPV recognizes the time value of money while evaluating the cost and benefits of the project. Also it takes into account all benefits and costs during the entire life of the project. Net Present value may be described as the summation of the present values of cash proceeds in each year minus the summation of present values of the net cash outflows in each year. The decision rule for a project under NPV is to accept the project if the NPV is positive and reject if it is negative. Accordingly net present value of cash savings in cost of sales at 10% rate of interest is calculated in Appendix C. As the total present value of cash savings in cost of sales is $3424200 and the investment is $3000000, then the net present value is $424200. The investment is viable as the NPV is positive. Auditing appraisal based on NPV method has the following features: NPV considers the time value of money. NPV take into account all benefits arising out of proposal over its lime time. It would be noted that salvage value of machinery of $0.5 million is also taken into account while considering the total cash flow. Third and most important factor is that under such projects a changing discount rate can also be built into NPV calculations. This is important as normally the discount rate changes because the longer the time span, the lower is the value of money and higher is the discount rate. Therefore, when payback period of investment is 3 years and NPV is positive, the project is appropriate and the Excel Limited should execute the project. Conclusion The Excel Limited should adopt Activity Based Costing System. Further in order to formulate a practical pricing strategy, the company must introduce flexible budgeting instead of fixed budgets, and also master budget should be prepared with all its ingredients. The company has to improve its inventory holding period, debtors’ credit period and earning powers in order to come up to the industry standards. The capital investment on machinery is advisable in view of research made as per payback and NPV capital budgeting methods. Appendixes Appendix A Appendix B Payback period calculations Year Cash savings in the Cumulative cash Cost of sales savings in cost of sales 1 1200000 1200000 2 1000000 2200000 3 800000 3000000 4 600000 3600000 5 300000 3900000 Appendix C NPV calculations Word Count: 3215 References: Read More