Management Accounting - Essay Example

?XYZ Financial Consultants Sprockets Ltd. Final Appraisal Report & proposal Financial Director, Sprockets Ltd. Financial Consultant Is the company’s current costing system doing its job? Date: 17th April 2011 1 An Overview The primary function of a company’s costing system is to keep an eagle eye on expenses while making sure they are absorbed in to the company’s pricing strategy. XYZ Financial Consultants were engaged by Sprockets Ltd to evaluate their prevailing job costing system for its efficiency. It was understood that Activity Based Costing method is being considered to replace the current traditional system and that recommendations in this regard were required. Therefore this is the final appraisal report of the evaluation and it is designed to methodically address the said requirements of the Sprocket Ltd management as follows. Table of Contents 1An Overview 2 1.1Existing costing system (20 marks) 3 1.2Issues in the traditional system 3 2An alternate method 5 2.1ABC system 5 2.2Recommended ABC implementation strategy 7 2.3Possible issues for Sprockets with ABC 10 3Conclusions and recommendations 11 4References 12 5Appendix: the most recent costing sheet 13 1.1 Existing costing system (20 marks) Sprockets Ltd was found to be a production company which engages approximately 300 jobs a year. The undertaken jobs are specified by the customers and production is carried on accordingly. At the moment there are three jobs (A, B and C) in production which are broadly similar to each other. As it was understood that A, B and C presents the typical size of a job that is accepted by Sprockets Ltd, they were used to appraise the existing costing system in the company. (The most recent job costing sheet is attached in the Appendix) The current costing system keeps an account of the direct production information i.e. direct materials, direct labour hours and machine operation hours for each job very efficiently. Thereby the respective expenses along with the direct expenses (i.e. 75% of the labour cost) are allocated to each job accurately. The production overhead on the other hand is absorbed at a flat rate of ?3 per machine hour. Based on the total cost calculated by this method for each job, the selling price is set to produce 25% gross profit. 1.2 Issues in the traditional system 1.2.1 The primary issues identified for Sprocket Ltd in their prevailing costing system stems from the production overhead allocation. Production overheads amount to approximately 20% of the total cost of production (ref appendix); which is a significant proportion of costs that must be accurately absorbed into each job separately. The total production overhead was recently analysed and split by Sprocket Ltd as in figure 1. Figure 1 Machinery is said to be a cost pool which consists of machine related expenditure and total salaries (?40,000) of two members of staff. Only the salary cost allocation was identified to be inaccurate in this cost pool as it does not depend on the operation of machine hours. Material handling costs (which are 20%) according to the analysis description is derived from material issues and thus remains unrelated to the machine hours. Inspection cost, which is the salary of the inspector hired by Sprocket Ltd to examine each job too is only barely associated to the machine hours. Sundries on the other hand are only 2% and are related to the factory. Thus its allocation by machine hours is acceptable. Thereby we’ve identified that, absorption of production overheads at ?3 per machine hour for each job is quite inaccurate for most part of the production expenditure. 1.2.2 It is a fact that the data collected and produced by a costing system is also incorporated into the general accounting system. For this reason the costing approach must allow for easy and sensible delivery of the data for reports to upper management. Sprockets’ traditional costing approach was identified to be lacking in this facility. For an example an in-depth analysis costs in ‘machinery’ cost pool for each job is unavailable where as such a data analysis report could aid in improvements to the production process. 1.2.3 Another concern is the ‘direct expenses’ (75% of the labour cost), which is almost 22% of the total cost. The reason as to why it is absorbed as per labour hours is unknown. Therefore ‘direct expenses’ must be analysed to confirm the validity of its absorption manner. Hence ‘is the company’s current costing system doing its job?’ Not quite. Above identified issues must be addressed in order to maintain an accurate and credible information system for vital decision making within the company. 2 An alternate method The issue of the present costing system identified in section 1.2 can be corrected via adopting an alternate method such as Activity-Based Costing (ABC). An outline of this system and how it can be implemented by Sprocket Ltd is discussed in this section. 2.1 ABC system This costing technique is based on the logic that “products consume activities and activities consume resources which incur costs” (simplestudies.com, 2011). Thus a costing system where a company allocates production factory overheads to activity centres (e.g. machine maintenance) and thereby uses cost drivers (e.g. machine maintained hours) to absorb the factory overheads to individual job/product is known as activity-based costing. An activity centre is where a cost is generated while a cost driver is the factor that actually generates the cost. Accordingly we can conclude the ABC system in three stages as follows (ref figure 2). (simplestudies.com, 2011) Figure 2: three stages of abc This system enables equally manufacturing and nonmanufacturing costs to be allocated to products, while excluding particular manufacturing expenses that are unrelated to production overheads. Also the use of several defined cost drivers will be more accurate than a solitary plant-wide rate which is used in traditional costing systems of Sprockets - at ?3 per machine hour. Apart from these desirabilities more noted Advantages of adopting ABC system (Source- simplestudies.com, 2011) are as listed below. Accurate product cost and product and customer profitability measurement: ABC has been proven to provide precise and thorough product information which is utilized by management in decision-making routes. It aids the management decisions to be better conversant regarding production capacities, product lines, product pricing, market segments, and target costing. Better-informed strategic decisions: Information collected relating cost drivers for each activity empowers management to make better-informed decisions with reference to product design, labour support, customer support, etc. Production improvement: ABC system delivers credible information that helps in production processes improvement (e.g. efficient production line design, reduce material wastage, etc.). 2.2 Recommended ABC implementation strategy ABC system implementation is often thought to be complex and time consuming, but given a collection of accurate and relevant information it is a definite asset to any organisation. Figure 3 presents a simple step by step approach the implementation process that was stretched from the three stage process of ABC in figure 2. Figure 3: simplified ABC implementation strategy It is our recommendation that Sprocket Ltd implements this strategy (figure 3) making the maximum use of currently available information. Consequently the following ABC system is proposed for the ‘production overheads’ absorption per job at Sprockets Ltd. (An illustration of proposed ABC cost absorption sheet is in figure 1 for job A) Steps 1, 2 &3: Machinery cost pool is to remain the same (cost driver to be machine hours) with the exception of salary expense of two staff where the cost driver was identified to be ‘allocated hours’ as per the time-sheets already being kept between the jobs. Material handling costs (which is believed to include store-man’s wages) is to be absorbed according to ‘direct materials-kg’ because the cost is not derived from machine hours but materials. Inspection expense was identified to be the salary of the inspector; hence the cost driver was identified to be ‘number of inspections’. Sundries (generally small amounts) will continue to be absorbed by machine hours as the costs are directly related to the factory. (Refer figure 4 for a summary of suggested cost drivers) Step 4: To calculate each cost driver rate, the total cost of the cost pool or the activity centre will be divided by the respective cost driver total. E.g. (Inspection expenditure/total number of inspections) =cost per inspection; (sundries/total machine hours) =sundries per machine hour; (material handling costs/total direct materials) =material handling per Kg; etc. Step 5: To assign costs to cost object (a job as in this case), each cost driver rate will be multiplied by the respective consumption of the cost driver for each job. For an example assuming that the material handling per Kg is ‘p’, then absorption of the said cost is ?300p for job A (refer figure 4). Figure 4: Production overhead aborption as per Abc system 2.3 Possible issues for Sprockets with ABC Foreseeable issues for Sprockets Ltd will be with regarding gathering and recording the few additional information e.g. number of inspections per job, allocated hours by two staff for each job-only need to be gathered as it is already being recorded on time-sheets. Also to address the issue of unclear direct expenses allocation that is 75% of the labour costs (refer section 1.2.3), detail analysis is required. Once this is done and inaccuracies are found in the traditional allocation, it would be appropriate to absorb it in the activity-based manner. Other possible concerns for Sprockets with adopting ABC largely associated with the disadvantages of the system. As in; ABC fails to assign the cost activities with uncertain cost drivers. Several general costs, for an example marketing, research & development, and engineering, are categorised as non-product costs (i.e. period costs) and are not encompassed into an ABC system according to GAAP (generally accepted accounting principles). In some cost cases, it is either impossible or unreasonable to try to identify a cost driver, in which case it is often practical to revert back to a traditional volume based allocation method e.g. as in Sprockets Ltd sundries allocation and machinery cost pool excluding salaries. 3 Conclusions and recommendations As requested by the senior management of Sprockets Ltd their prevailing costing system was evaluated and three major issues were brought to notice (section 1.2) concerning; inaccuracies in production overhead allocation, thereby system’s inability to deliver accurate sensible data reports for decision making and vague allocation of direct expenses. As a potential solution ABC system was introduced along with a proposal for an implementation strategy in section 2.2. The presented solution was designed taking into consideration the concerns of the senior management of Sprockets Ltd. Cost of implementing ABC would indeed be minimum as existing information and resources are thoroughly used. Extra work and expenses too are minimal as the implementation strategy is made simple (figure 3) and only the absolute essential would be required for application; e.g. to analyse the direct costs (one-time cost), record number of inspections (by the inspector), etc. Therefore XYZ Financial Consultants recommend that ABC system, as presented is indeed a viable option for Sprockets Ltd. Thank you. 4 References Dess, G. G., Lumpkin, G. T., & Eisner, A. B. (2006). Strategic Management (2nd ed.). New York: MaGraw-Hill. Kotler, P. (2003). Marketing management (11th ed.). New Jersey: Prentcie Hall. Wit, B. D., & Meyer, R. (2004). Strategy Process,Content, Context An international Perspective (3rd ed.). London: Thomson. CliffsNotes.com. Activity-Based vs. Traditional Costing. Retrieved: 16 April 2011 http://www.cliffsnotes.com/study_guide/topicArticleId-21248,articleId-21226.html. Simplestudies.com. (2011). Activity Based Costing. Retrieved: 14 April 2011 http://simplestudies.com/activity-based-costing_%28abc%29.html/ 5 Appendix: the most recent costing sheet Read More