Island Wheels Management Accounting - Case Study Example

Overhead Cost Prediction Model for Island Wheels Name Class Lecturer Date Abstract Cost accounting is a very important means through which companies can reduce or eliminate production costs and determine the price in such a way that they maximize profit. Cost formulas are tools used for measuring costs of products for the purpose of cost accounting. A regression model for overhead cost predictions has been developed for Island Wheels. This is particularly because it is more scientific and accurate in determining overhead costs. ABC method has also been considered for use by Island Wheels due it its expansion plans. Contents Contents 3 Introduction 4 Regression Analysis Formula 4 Evaluation of Cost Formulas 5 Overhead Cost Predictions 6 Product Costs for Island Wheels 7 The Concept of Activity Based Cost (ABC) 8 Steps to implementing ABC 9 Benefits of ABC Method 10 Limitations of ABC Method 11 Application of ABC Method in Island Wheels 11 Bibliography 13 Overhead Costs Prediction Model for Island Wheels Introduction The three major purposes of a cost formula are: to help managers in valuing stock and measuring the cost of sales for financial accounting; to help managers assess the costs of products, activities, customers and services; and to help managers and operators acquire accurate and timely cost information and economic view about effectiveness of processes which helps in making strategic decisions and operational improvements. Cost formula also help in designing of products and services that are profitable and satisfy consumers’ expectations; facilitate signaling when upgrading in feature, effectiveness and speed are necessary; guide product mix and investment decisions; and assist the company in bargaining with their customers for prices, features and quality of their products, service delivery (CARDOŞ 2011). The cost formula has two major components namely; manufacturing costs, and non manufacturing costs. The manufacturing costs include: direct labor costs; manufacturing overhead costs, and direct material costs. The nonmanufacturing costs include; selling costs and administrative costs (CARDOŞ 2011). Regression Analysis Formula Island Wheels’ previous accountant prepared a cost model as shown below: SUMMARY OUTPUT FOR LABOUR Regression Statistics Intercept 46862.89075 X Coefficient 4.420494425 R Square 0.89947162 Standard Error 2647.20104 Observations 24 SUMMARY OUTPUT FOR MACHINE Regression Statistics Intercept 36557.37257 X Coefficient 26.96396219 R Square 0.902783345 Standard Error 2603.232264 Observations 24 The two summary output tables represent linear regression models whereby the overhead cost is the dependent variable, while the labor hours and the machine hours are the independent variables (X). The intercept is the fixed cost and the X coefficient is the slope of the line (Horngren 2009). The general formula of a linear regression model is: Y = α + β X where Y is the dependent variable, α is the intercept and β is the gradient of the line. Therefore the two models can be written as: i) Overhead Cost = 46862.89075 + (4.420494425 x Labor hours) ii) Overhead Cost = 36557.37257 + (26.96396219 x Machine hours) Evaluation of Cost Formulas High-low mothed. This method uses the lowest activity periods and the highest activity periods to conduct an educated guess of the components of the mixed cost (variable and fixed) (Horngren 2009). This technique is based on the fact that from time to time a change in total cost is believed to be as a result of a variation in quantity. The method involves the following steps: obtaining data points from a number of business periods; picking the two different activity levels; calculating the difference in volume and costs; calculating the variable cost; and computing the amount of fixed cost. The high-low method is a simple technique for computing the overhead costs. However, it can result to different answers because it is subject to the kind of low and high data points are selected. Furthermore, it is less accurate as compared to regression analysis and wastes data since it uses only two observations. Regression analysis. Regression analysis is a statistical technique for determining the associations that exist among certain veriables. It uses information from all observations, hence, more accurate relative to the High-Low method (Horngren 2009). It is also a more systematic way of determining values for overhead costs (Goosen 2014). Scatter graph method. This method requires that actual cost values from at least four or more operating periods be obtained and then plotted on a graph. A straight line of best fit is drawn such that the data points are evenly distributed either sides of the line and the line being in contact with the Y axis of the graph (Goosen 2014). The weakness of this technique lies in randomness of the line of fit. How the line is drawn can make a significant difference in the fixed cost amount and the variable cost rate (Goosen 2014). Overhead Cost Predictions i) When labor hours are increased to 8,500. The regression equation is: Overhead Cost = 46862.89075 + (4.420494425 x Labor hours) Overhead cost = 46862.89075 + (4.420494425 x 8,500) = 84437.0933625 The overhead cost when labor hours are increased to 8,500 is $84437.0933625 ii) When labor hours are increased to 2,300 hours. The regression equation is: Overhead cost = 36557.37257 + (26.96396219 x Machine hours) Overhead cost = 36557.37257 + (26.96396219 x 2,300) = 98574.485607 The overhead cost when machine hours are increased to 2,300 is $ 98574.485607 The R-squared (the coefficient of determination) measures the explanatory or predictive power of a regression model. It indicates how well the linear regression model fits the data (Lewis-Beck n.d.). R2 shows the amount of observed variance explained by the model (Reyna 2007). In this case R2 is 89.947162% for the labor hours’ model and 90.2783345% for machine hours’ model. Firstly this implies that, holding machine hours constant, 89.947162% of the variation in overhead cost is explained by labor hours. Secondly this implies that, holding the labor hours constant, 90.2783345% of the variation in overhead cost is explained by machine hours. The two results show that the two linear regressions fit the data well. The standard errors for the labor hours’ model and machine hours’ model are 2647.20104 and 2603.232264 respectively. This means that, averagely, using the regression model to predict overhead cost results in an error of about $ 2647.20104 for the labor hours’ model, and an error of about $ 2603.232264 for the machine hours’ model. Since the standard errors are small, the models are good predictors. Therefore, from the analysis of the R2 and the standard errors, the prediction is valid. Product Costs for Island Wheels Product Cost Per Unit = Overhead Labor Cost + Overhead Machine Cost + Direct Material Cost + Direct Labor Cost + Machine Time Cost Per Unit Overhead Labor Cost = Total Labor Overhead ÷ Total Number of Units (37,000 ÷ 3000) = $12.5 Per Unit Overhead Machine Cost = = Total Labor Overhead ÷ Total Number of Units (43,000 ÷ 3000) = $14.33 Road. Product Cost Per Unit = 12.5 + 14.33 + (0.75x160) + (2.5x20x80) + (36557.37257+26.96396219) = $40731.1665322 Total Product Cost = $40731.1665322 x 1500 = $61096749.7983 Trek. Product Cost Per Unit = 12.5 + 14.33 + (1.4x160) + (3x20x80) + (36557.37257+26.96396219x0.5) = $41621.6845511 Total Product Cost = $41621.6845511 x 1000 = $41621684.5511 MBX. Product Cost Per Unit = 12.5 + 14.33 + (0.85x160) + (1.5x20x80) + (36557.37257+26.96396219x0.25) = $39126.9435605 Total Product Cost = $39126.9435605 x 500 = 19563471.7803 The Concept of Activity Based Cost (ABC) ABC method can be defined as the procedure of costing method which centers on activities executed in 2008). production process. It is the technique of the costing and supervising of activities which involves tracing resource consumption and costing final outputs (Edwards 2008). The ABC model originally focused on manufacturing industry where technological developments and productivity improvements had reduced the percentage of direct labor and material costs, but increased the proportion of indirect or overhead costs (Edwards This method of costing come out to satisfy the requirement for accurate information about the cost of resource demands by individual products, services and customers (CARDOŞ 2011). Activity Based Costing can also be defined by the equation below: C/A = HD + M + E + S Where C/A is the projected cost per activity; H is the amount of labor hours necessary to carry out the activity; D is the pay per labor hour; M is the material costs necessary to carry out the activity; E is the equipment costs to carry out the activity; and S is the subcontracting costs to carry out the activity (Makepeace 1997). The ABC method was developed as an approach to tackle the defects of traditional cost management systems, which have overtime proved to lack the capacity incapable to accurately find out actual cost of production, or give constructive information for operating decisions (CARDOŞ 2011). The traditional method of costing depended upon the random addition of a percentage of overhead costs on to direct costs to arrive at a total product cost. This kind of costing method generally assigns costs on the basis of one quatity measure. Thus this approach rarely satisfies the scientific principle required in accurate cost allocation. Therefore, this technique of costing has improved in accuracy due to rise in the percentage of overhead costs (Edwards 2008). THE ACTIVITY-BASED COST MANAGEMENT FRAMEWORK Source: (CARDOŞ 2011) Steps to implementing ABC The ABC model involves two broad stages. The first stage involves assigning costs to group of costs in an activity center on the basis of a cost driver. The second stage involves allocating costs from the group of costs to a product on the basis of how much the activities are consumed in the production process of the products (Roztock 2000). These two stages can be presented in four steps. The ABC technique applies cost drivers to apportion the costs of assets to activities and unit cost. Cost drivers are the factors that influence the cost of a particular activity (Edwards 2008). Identify activities or cost pools. The implementation of ABC requires the organization to undertake a detailed breakdown of the process of operation of each task center (Edwards 2008). A flow chart of the procedure is usually used for recognizing these major activities. Identical processes must always be pooled together in order to set up the desirable activities for ABC. This implies that product driven activities and customer driven activities should be separated in so as to set up two distinct identical activities (Roztock 2000). Distribute costs using resource drivers. After the identification of the activities, a resource cost of each activity can be calculated. This step entails outlining costs based on the cost objects to find out the reason for the occurrence of the cost. Costs can be classified in three ways: direct costs which can be associated directly to a specific output; indirect costs which can be allocated to two or more outputs; and administration costs which are not associated with any product. (Edwards 2008). Distribute costs using activity drivers. In the second stage, activities are associated with products through second stage cost drivers. Data is gathered in order to achieve accurate final product costs (Roztock 2000). The output for which an activity segment performs activities and use up resources is identified. These outputs may be customers, services or products (Edwards 2008). Assign activity costs to outputs. Assigning of activity costs to output is done by the use of activity drivers which assign activity costs to outputs (cost objects) based on the consumption or demand for activities (Edwards 2008). Activities are identified and categorized into different categories that have relationship with the different stages of the production process. Benefits of ABC Method ABC method of costing has a number of benefits which make it a better costing technique in determination of the cost of products. Firstly ABC offers a more accurate and reliable way of costing of products as compared to the traditional methods of costing. This ensures more accurate pricing and determination of minimum order size. Secondly, it allows for a better and broader comprehensionm of overheads and thei sources. It facilitates overhead costs allocate directly to the specific product. Thirdly, It makes expensive and worthless addition activities more detectable, so enabling managers to focus on these areas to lessen or remove them. Fourthly, it supports other management methods such as scorecards, performance management and continuous improvement. Fifthly, it helps in understanding which products are most profitable and where to focus sales efforts. Thus it helps in fixing the cost and selling price of a product. Sixthly, it facilitates cause and effect relationship which helps management in understanding the true costs and productivity of capital equipment hence helps to exercise effective cost control. Lastly, it provides necessary cost information to the management to take decisions on any matter relating to the business. This ensures that less time, money, and effort are spent on the wrong products, hence, it helps to remove all types of wastages and inefficiencies (Edwards 2008). Limitations of ABC Method Despite the advantages of ABC method over the traditional methods of costing, it has some limitations. Firstly, ABC systems are quite complex and costly to implement. ABC is at times complex and lengthy when gathering the information about activities and cost drivers. Sometimes it is expensive apply, carry out and administer an ABC system. Secondly, even in ABC some overhead costs are hard to allocate to products and customers (Edwards 2008). Application of ABC Method in Island Wheels Island Wheels bicycles are mostly hand-made. However, the manufacture of some part required the use of machinery. Cost records show the bicycles costing so much. The previous accountant reported that the costs were increasing drastically, but the management doesn’t understand why. The company has expansion plans and would like to develop a model for predicting overhead costs. With the expansion plans, direct labor is likely to be highly replaced with automated equipment. Therefore, margin accuracy for individual products is likely to become difficult to achieve. Consequently, the company’s indirect costs are will become the major portion of the total cost. If the company comes up with inaccurate cost measurements, they will lose bids due to overstated the costs of products, incur losses due to understated costs of products, and fail to detect activities that are not cost-effective. This makes it necessary for Island Wheels to adopt the ABC system due its accuracy in measuring costs. Bibliography Cardoş, Ildikó Réka: Pete, Ştefan. "Activity-based Costing (ABC) and Activity based Management (ABM) Implementation ." 2011. Edwards, Stephanie. "Activity Based Costing." Topic Gateway Series, 2008. Goosen, Thomas R. "Management Accounting Theory of Cost Behavior ." Micro Business Publications Inc., 2014. Horngren, Charles T.: Foster, George: Datar, Srikant M.: Ittner, Chris. Cost Accounting: A Managerial Emphasis, 13th edition. Prentice Hall , 2009. Lewis-Beck, Michael S. "R-squared." Department of Government, 224 Littauer. Makepeace, John. "Activity Based Costing." Doe G, 1997. Reyna, Oscar Torres. "Linear Regression using Stata ." Data and Statistical Services Princeton University, 2007. Roztock, Narcyz i: Valenzuela, Jorge F. : Porter, José D.: Monk, Robin:Needy, Kim LaScola M. "A Procedure for Smooth Implementation of Activity Based Costing in Small Companies." State University of New York at New Paltz / Department of Business Administration, 2000. Read More