Strategic Management and Accounting Case of C Ltd - Essay Example

Strategic Management And Accounting – The case of C Ltd. ID number: Number: Table of Contents Table of Contents 2 a) Methods of product costing and effect on competitive strategy and cost control 2 Standard Costing 3 Activity-dependent Costing 3 Absorption Costing 4 b) Adoption of alternative transfer pricing approaches and their effects 5 Cost-dependent pricing 5 Market-dependent Pricing 7 Bargained Pricing 7 c) Alternatives to traditional incremental budgeting 7 Activity-dependent Budgets 8 Performance-dependent Budgets 8 Zero-Based Budgets 9 References 10 a) Methods of product costing and effect on competitive strategy and cost control Product costing refers to the process of calculating the amount of money spent by a company to manufacture its products. The elements under the purview of product costing are cost of raw materials, logistics, inventory costs, salaries and wages of employees, utility bills and all expenses relating to the products in concern. Determining product costing helps a company to monitor the efficiency of its operations, fix prices of its products, initiate cost-control measures, determine marketing expenditures and increase return on investment. For instance, procuring cheaper resources can enable a company to keep product costs low, thereby helping either in generating higher profit margins, or lowering selling prices and increase the company’s competitive edge in the market (Lister, 2014; Caplan, 2014). Some of the types of product costing methods are: Standard Costing Standard costing is the conventional method of costing used by most of the companies today. In this method, a company computes the product cost by forecasting the prospective expenditures that the company is going to incur based on expenditures in the previous fiscal; and derives the final price of its products after forecasting future demand of its products. In short, it is a retrospective process that tries to create benchmarks for future costs of production based on its past costs of production. There are 3 components of standard costing: cost of raw materials, cost of labour and overhead expenditures. These three costs are combined and using the targeted value of production, the company determines the cost of each unit of the product. Standard cost can be defined as the budgeted cost of a unit of output The prime benefit of standard costing method is the simplicity of this method. It helps in setting a target cost of production by benchmarking the costs of each factor of production. Creating cost benchmarks using this process is beneficial to the overall cost budgeting of the company. Also, it enables a company to create target revenue levels that it should derive from the sale of each unit of its products. However, standard costing method does not provide the platform for a company to analyse the individual cost factors in details. Also, actual costs incurred by a company for producing its goods during a particular fiscal year may be significantly more than the standard costs of production estimated, due to various real-time factors such as inflation, availability of raw materials and price increments by suppliers. Due to this, the standard costing method is often unreliable and it fails to provide the company with competitive advantage and cost-effectiveness (Wilkinson, 2014; Marx, 2009). Activity-dependent Costing Activity-dependent costing is a recent development in the domain of product costing. In this method, a company fixes the prices of its products by computing the actual costs it is incurring for the manufacture of the products, rather than establishing cost standards based on historic expenditures. It also assesses the market in its present status, as opposed to the standard costing principle of forecasting future market dynamics. In short, it is a present-oriented process that focuses on present market conditions and present product costs. Activity-dependent costing method emphasises on the inspection of all the activities associated with the manufacture of a company’s products. This method is greatly effective in the modern competitive and ever-changing business environment. It portrays a more accurate image of the company’s efficiency and performance, and pin-points areas that require further development. It is an intensive method that includes all the costs related to production. It also enables a company to calculate costs incurred depending on time spent on each activity and raw materials used up by each unit of product, thereby providing much more valuable strategic data to the company. Activity-dependent costing method also presents a clearer segregation of overhead costs and eliminates the possibility of unidentified veiled expenses. Since it focuses on actual costs incurred by a company for producing its goods during a particular fiscal year, there profits derived are not much deviant from targeted profits. This method also considers various real-time factors such as inflation, availability of raw materials and price increments by suppliers. Due to this, activity-dependent costing is a much more precise method compared to standard costing and provides the company with strategic competitive advantage and cost-effectiveness. However, this method is equally as complex, laborious and exhaustive in nature and would require significant efforts by C Ltd. for a switch-over from standard costing (Wilkinson, 2014, Fritzcsh, N.D.). Absorption Costing Absorption costing is a method where a company focuses on the cost of raw materials, cost of labour and overhead expenditures. In other words, this method helps the company to decide on the proportion of capital allocation towards fixed costs, variable costs and labour costs separately. In this method, when raw materials are procured, their costs are reported as company assets. As these materials are used for the manufacturing process, their costs are moved from Resources record to Work-In-Progress record, still classified as assets. Concurrently, labour expenditures are also moved from Labour Expenses record to Work-In-Progress record as assets. While overhead costs are initially reported as company expenses, they are subsequently moved into Work-In-Progress record as assets. When the products are manufactured, all these costs are moved from Work-In-Progress record to Inventory record as assets. Finally, when these products are sold in the market, these costs are moved from Inventory record to the Income Statement as expenditures. Due to this, every fiscal year, a portion of the costs of production would continue to remain as assets in inventory and not be reported under Cost of Goods Sold (COGS). This makes it difficult to formulate an appropriate cost budget for the company and fails to provide the company with competitive advantage and cost-effectiveness (Massachusetts Institute of Technology, 2014). b) Adoption of alternative transfer pricing approaches and their effects The manufacturing of finished products from raw materials and subsequent delivery to consumers consist of various sequential phases that are handled by different departments of a company. Within this sequence, transfer pricing refers to the price that the preceding department charges from the succeeding department for completing their part of the manufacturing process and handing over the semi-finished or finished goods. In a developed company, different business functions act autonomously and sometimes follow transfer pricing to make each unit profitable. The various transfer pricing approaches are discussed below (The Pennsylvania State University, 2010): Cost-dependent pricing In cost-dependent pricing, the transfer price is set after determining the cost of production. The different types of cost-dependent pricing are: Cost-only Pricing: For this type of pricing, the selling department charges the buying department only the cost incurred to complete their part of the manufacturing process. No additional charges are levied besides the cost of work. Due to this, the selling department only recovers its costs, but does not earn a profit. The fact that departments charge each other for handing over goods after working on them, gives these departments considerable degree of autonomy. However, since they do not earn a profit from the transactions, it still compels them to function as a single unit that produces goods and only the sales department earns profits directly from the consumers. At-cost transfer pricing suits the autonomous structure of C Ltd.’s different departments. However, it would not be a healthy adoption, keeping in mind the fact that departments engage in independent investments. Since the departments would not individually earn profits, it would create a constant shortage of cash and restrict investment objectives. Also, since each of the departments evaluate performance and appraise their employees independently, such activities would be impossible with earnings that only recover costs. As a consequence, lack of performance bonuses would cause demotivation among employees and they would back out from delivering higher productivity. Cost plus Mark-up Pricing: As observed above, cost-only transfer pricing is designed only to recover the costs of production, without earning any profit for the selling department. Due to this, cost plus mark-up transfer pricing is a more effective strategy, where the selling department charges a percentage of the production cost as profit margin (called mark-up) and the price charged consists of the cost of production plus mark-up value. Cost plus mark-up transfer pricing suits the autonomous structure of C Ltd.’s different departments. Moreover, since the selling department would earn an additional profit out of each transaction, it would enable each department of C Ltd. to pursue their separate investment goals and measure performance and appraise high-performing employees. As a consequence, it would motivate employees to deliver higher productivity and earn performance bonuses. Variable Cost plus Mark-up Pricing: As observed above, at-cost pricing and cost plus mark-up pricing both recover the entire cost of production incurred by the selling department. However, these strategies may not always seem justified to the buying department. For example, if the buying and selling departments of a company use same production facilities and related infrastructure, they should both bear the fixed costs alike; but cost plus mark-up pricing would simply transfer the liability of fixed costs solely to the buying department. Thus, to create a platform that would benefit both the buying and selling departments, variable cost plus mark-up transfer pricing is an effective tool. Under this pricing, the selling department estimates only the variable cost of production and attaches a mark-up that aims to cover both fixed costs and a decent profit margin. Since C Ltd. is in the business of tablet computers manufacturing with only two factories, it is highly likely that several of the related processes are housed under the same facilities and share common fixed costs. Also, since profit margin in the computers business is thin due to intense competition, variable cost plus mark-up transfer pricing would be an effective way to enable different departments of the company to pursue individual goals, yet keep overall production costs down. Besides these, it would also provide autonomy and profitability to different departments. Variable plus Opportunity Cost Pricing: Opportunity cost in this context refers to the additional profit margin that a department would have earned, if it had sold goods outside the company instead of the succeeding department. Thus, in this pricing, the selling department attaches an opportunity cost to the variable cost of production to determine the total chargeable cost. Variable plus opportunity cost can prove to be better than variable plus mark-up transfer pricing for C Ltd., since mark-up is fixed randomly and often cannot be justified to the buying department. On the other hand, opportunity cost can effectively demonstrate the money that the selling department would have made, had it sold the products outside the company. This would mean greater profitability, motivation of employees and cash surplus for investment. Two-way Pricing: The fixed costs, variable costs and mark-ups charged by a selling department would be clubbed as variable costs incurred, when the buying department hands over the goods to its succeeding department. This makes the general cost-dependent transfer pricing strategies ineffective and redundant. To address this problem effectively, two-way pricing can be an effective tool. The working mechanism of this strategy is to compensate the preceding selling department at a price that it finds feasible and sell to the succeeding buying department only for the variable costs of production. Two-way transfer pricing would not be feasible for C Ltd. since this strategy is designed to integrate processes and reduce monetary transactions in between departments. C Ltd., on the other hand, has autonomous departments with distinct income, investment and expenditure aspirations. Market-dependent Pricing In this strategy, the selling department charges the buying department at a rate that is prevalent in the market for goods at a similar state. This brings a sense of transparency in transaction and eliminates chances of exploitation of one department by another. However, in premature industries, it is quite common for price standards to be undervalued or even overvalued, depending on the market players’ strategies (i.e. either market penetration or market skimming). For C Ltd., this strategy is not recommended. Since tablet computers market and related components market are highly developed, there are virtually no chances of undervalued or overvalued prices. However, intense competition has forced market players to keep prices competitive and low. This strategy may be redundant for departments dealing with work-in-progress products which have no market price due to lack of takers. Thus, if departments of C Ltd. charge transfer prices at par with market rates, the end products cannot be priced competitively. Bargained Pricing In this strategy, the buying and selling departments discuss, bargain and finally, settle the price mutually. The benefit of this strategy is that price is set at a level that is justified to both the buying and selling departments. Since C Ltd. has each department working autonomously, bargained pricing is a highly recommended strategy. This would enable the different units to initiate price bargains keeping their own profitability in mind, while at the same time considering the overall profitability of the company. A bargained price would also eliminate chances of price exploitation and enable different departments to pursue their independent goals and objectives. Lastly, it would really give the feeling of autonomy to its employees and also, motivate them to perform higher, since price depends on quality as well as quantity and greater the productivity, greater are the performance bonuses. c) Alternatives to traditional incremental budgeting Incremental budgeting refers to the traditional form of budgeting that most companies use. In this process, budget for a year is formulated by tweaking budget of the previous year. The tweaking refers to increasing targeted levels of productivity or spending and assessing ways of responding to regulatory, economic and market challenges that were not present during the formulation of the previous budget. It is the simplest and most inexpensive form of budgeting and is helpful for companies in the same line of business and incremental growth in demand year after year. However, it is a past-oriented approach, works with outdated information, limits the ability to identify excess expenditures and forces overhead expenditures, even when the company’s current capabilities are sufficient to cater to its market. C Ltd. has very recently been experiencing the disadvantages of incremental budgeting, with increasing overhead expenses disproportionate to the company’s requirements. Although there are many alternatives to incremental budgeting, only a select few are described below that are relevant to the context of C Ltd (Hong Kong Institute of Accredited Accounting Technicians, 2013). Activity-dependent Budgets This type of budgeting has been developed based on the activity-dependent costing method. Conventional budgets believe that the number of goods produced determine a company’s overhead expenses. On the other hand, activity-dependent budgets take a more detailed approach in identifying the factors influencing overhead costs by focussing on the activities of the company. Due to this approach, the company has access to far more in-depth data than just production performance. The process of this budgeting is to recognise the companys different works, assess the factors that influence cost increments, compare costs incurred by the different departments to these factors and determine a target level of work activity (Kaplan Financial, 2013). If C Ltd. adopts activity-dependent budgets, it would benefit from accurate calculation of the cost of each action and scientific resource allocation based on the cost of actions. However, determining cost of different actions may be troublesome and difficult. Also, for implementing this budget, the company would have to significantly change its management functions and processes. Performance-dependent Budgets This type of budgeting has the objective of correlating data on the company’s performance with decisions regarding the assignment of resources. In this process, performance data is considered a real-time asset and it constantly interacts and influences the budget formulation, authorisation, implementation, review and assessment. Factors that are evaluated, while preparing performance-dependent budgets, are the worth of raw materials procured, number of finished goods produced, cost of completing each task in the company and the degree to which the company’s objectives have been fulfilled. The budget includes monetary and performance-related data and lays out means to attain the objectives of the company by means of boosting performance of each unit through judicious allocation and utilisation of resources (Young, 2003; Robinson, N.D.). Performance-dependent budgets would be a good option for C Ltd. The autonomous departments of the company already have their objectives clearly in place and evaluate their staff based on individual performances. Thus, relating the company’s spending pattern, based on the performance of different departments, would impart an added essence of competition to outperform and avoid the risk of shutdown. Linking expenditure on overhead costs to performance would also be cost-effective for the company. However, to implement this type of budgeting, C Ltd. would need to spend on mechanisms for accumulating performance data from each of these departments. Moreover, judging performance may not be easy for departments that deliver intangible products such as, software systems for tablet computers. A standard format of reporting performance data would also have to be developed, which would be intensive and costly. Lastly, the company may face opposition to this budget from the heads of its departments, since the company’s policy of allocating resources and capital, only to performing departments, would run opposite to their individual investment and growth priorities. Zero-Based Budgets In this process, a company starts preparing annual budget from the scratch, based on the company agendas and performances and does not merely extend the previous year’s budget into a new one. The process works if the company has just started its business and has to allocate resources for its intended operations. The primary aim of this budget is to ensure cost-effectiveness in expenditures, by axing off bad investments and raising expenditure into profitable initiatives. The budgeting process requires participation of the heads of all departments and other executives. Resource requirements are discussed, business prospects of different initiatives are assessed, past expenses are rationalised, alternative and more cost-effective ways of attaining goals are analysed and finally, the resource allocation plan is formulated. This not only eliminates wastage of resources, but also allocates them in a scientific manner and garners the support of all the department heads regarding the company’s expenditure pattern (Riley, 2012). However, it may become an extremely complicated and laborious process since C Ltd. is a large company with operations in Europe and manufacturing facilities in America and Asia; and it would be difficult to assemble and involve all the company executives at a time. Also, axing off non-performing ventures creates an intense work pressure and causes demotivation for employees in slow performing functions. References Caplan, D. (2014). PART 3: PRODUCT COSTING AND COST ALLOCATIONS. Retrieved from http://classes.bus.oregonstate.edu/spring-07/ba422/Management%20Accounting%20Chapter%2010.htm. Fritzcsh, R.B. (No Date). Activity-Based Costing And The Theory Of Constraints. Retrieved from http://journals.cluteonline.com/index.php/JABR/article/viewFile/5730/5807. Hong Kong Institute of Accredited Accounting Technicians. (2013). From traditional budget planning to zero-based budgeting. Retrieved from http://www.hkiaat.org/images/uploads/articles/PBE%20PII%20Steve%20Fong_apr12.pdf. Kaplan Financial. (2013). Activity Based Budgeting. Retrieved from http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Activity%20Based%20Budgeting.aspx. Lister, J. (2014). Product Costing vs. Cost Accounting. Retrieved from http://smallbusiness.chron.com/product-costing-vs-cost-accounting-37642.html. Marx, C. (2009). Activity Based Costing (ABC) And Traditional Costing Systems. Retrieved from http://financialsupport.weebly.com/activity-based-costing-abc-and-traditional-costing-systems.html. Massachusetts Institute of Technology (2014). Absorption Costing - Overview. Retrieved from http://ocw.mit.edu/courses/sloan-school-of-management/15-521-management-accounting-and-control-spring-2003/lecture-notes/web_class10.pdf. Riley, J. (2012). Zero-based budgeting. Retrieved from http://www.tutor2u.net/business/accounts/zero-based-budgeting.htm. Robinson, M. (No Date). Performance-based Budgeting. Retrieved from http://www.clear-la.cide.edu/sites/default/files/CLEAR_PB_Manual.pdf. The Pennsylvania State University. (2010). Transfer Pricing. Retrieved from http://www.personal.psu.edu/sjh11/BA521/NEW/Class08/TransferPricing.pdf. Wilkinson, J. (2014). Activity-based Costing (ABC) vs Traditional Costing. Retrieved from http://strategiccfo.com/wikicfo/activity-based-costing-abc-vs-traditional-costing/. Young, R.D. (2003). Performance-Based Budget Systems. Retrieved from http://ipspr.sc.edu/ejournal/assets/performance%20based%20budgets.pdf. Read More