Challenge of Allocating Costs to the Three SMUs in Fine Foods Inc - Research Paper Example

Professional Finance and Accounting Executive Summary Fine Foods INC just like many companies is faced with the challenge of allocating costs to the three SMUs. Apportioning the manufacturing overheads and other variable costs to the costs centres poses a great challenge as the manager of SMU2 feels that the methods have portrayed their performance as below the expected level hence poor evaluation. The paper therefore focuses on the best means that the company should use to charge costs to the costs centres in order to develop accurate reports that can be used to evaluate performance and make management decisions. The memo therefore proposes that management should consider identifying the cost drivers and monitor its activities to control their costs. In assessing whether to accept special orders, management needs to accurately compute contribution margin by only considering the variable costs. Fixed costs should only help in determining the break-even point for special orders. Performance evaluation should as well focus on factors that are within employees control rather than incorporating non-controllable costs elements to evaluate the employees working in the SMU2 sector. Part 1 The major concern of the SMU2 department is the use of inappropriate cost allocation model for the MP product where material costs, labour costs and variable costs are allocated to the product based on estimates. The allocation of material and labour costs to the MP product is acceptable since these are direct costs incurred in the product manufacturing. Allocation of factor overheads especially remaining factory costs should however be reviewed. These overheads should not be allocated to MP on a fixed percentage basis since MP special order sales only accounts for 2% of the revenue. Allocating the overheads on a fixed proportion therefore inflates the costs and reduces the contribution margin. In addition, allocation of media and promotion costs for SMU1 and SMU2 further fails to consider the cost drivers of the activities. Marketing costs should not be allocated depending on the weight of the products but the revenue derived from the effectiveness of such advertisement. This was, management will have to identify the increase in sales resulting from the incremental costs on advertisement. Allocation of management costs to the various products and departments has also failed to take into account the volume allocation and the level of activities performed by such shared staff on the various products. Activity based costing should be used to monitor the activities of the management to the various product lines and products. Fine Foods should for example use approved time sheets as completed by the management staff to allocate the costs. This will help monitor costs allocated to MP and ensures these costs are monitored and controlled. Special Order costs allocation Most of the special orders made by the company relate to the MP product and special orders constitute only 2% of the company revenue (Business, 4). Special orders play an important role in Fine Foods by meeting the demands of customers’ with specific demands and also in supplementing the sales of the MP product. Special orders evaluation should therefore be made by determining the contribution margin. Fine Foods increases their revenue through making special orders, sells their slow moving MP stocks and also enhances their customers’ loyalty. Special orders also enable Fine Food to develop a new revenue stream and helps in increasing the market share of the business in the highly competitive industry. Fine Foods management does not however correctly compute the contribution margin. In computing the CM, fixed costs should not be deducted but this should be used to determine the break-even level of sales. Including the fixed costs in accepting special orders have resulted in the meagre performance and will continue to frustrate the units operations. Fine foods should therefore analyse its special orders by correctly computing contribution margin and accepting those special orders which can break even. Performance evaluation in Fine Foods Performance evaluation is critical to an organisation as it provides feedback to the employees and guides the level of rewards management offers. In undertaking this process management must develop viable parameters of measuring performance in a manner that motivates the employees. A mix of individual and team based performance evaluation is usually preferred as it considers both individual achievements and team achievements. Fine Foods should therefore evaluate the employees of the SMU2 department when they meet the contribution margin and meet the company’s return on investments. Fine Foods use of operating profits fails to consider the nature of operations and the different types of businesses of the company. Using operating profits disadvantages SMU2 performance as it demoralises the units workforce. Because the unit sale of this department is small when compared with other departments, performance evaluation should consider other factors i.e. increase in sales, satisfaction of the customers’ and cost reduction measures. Because most of the costs incurred by the unit are uncontrollable, the performance evaluation should take into consideration the impact of such costs on the contribution margin. Uncontrollable costs should be left out when doing employee evaluation. Conclusions and Recommendations From the analysis of facts and circumstances above, management therefore needs to adopt the follow changes that will result in the following benefits: i. Management should allocate the fixed manufacturing costs based on the cost drivers. This will ensure accurate cost allocation and better decision making. ii. Costs incurred on top management should be allocated based on the level of activities management has done on the particular products and departments. Activity based costing should be adopted to help monitor and control these costs. iii. Accurate computation of contribution margin should be applied in evaluating on whether to accept or reject special orders. Fixed costs should help determine the break-even level of such sales. iv. Performance evaluation should take into consideration the nature of each department. In addition, striking a balance between team achievements and individual achievements is critical in ensuring employee morale is boosted. The evaluation should be realistic and only consider the factors employees have control over e.g. management of variable costs. The concerns of the SMU2 department are realistic and adopting these changes will ensure better results for the department and the business as a whole. Glossary Cost object – this is any item to which costs are separately measured. It could therefore be a product or raw material to which costs are determined. Cost driver- this is any factor that causes a change in the cost of an activity. For example, the number of units manufactured will determine the total costs incurred. Product vs period costs- product costs are the direct material, direct labour and factory overheads incurred when producing a product whereas period costs are the non-product cost that are expenses in the income statement as per the accounting standard e.g. interest expenses. Fixed vs. Variable costs – Fixed costs are the costs that do not vary with the level of activity while variable costs are those costs that change depending on the level of activity. Direct Vs. Indirect costs- Direct costs are the costs which can be easily and accurately traced to the cost object e.g. material costs whereas indirect costs are the costs that cannot be accurately traced to the cost object e.g. insurance and depreciation costs. Relevant Vs. Irrelevant costs – relevant costs are those that can influence management decisions since they can be controlled by management while irrelevant costs are those that management have no control over and are thus not considered while making management decisions. Controllable Vs. Uncontrollable costs – controllable costs are manufacturing costs that can be managed by making relevant management decisions. Uncontrollable costs on the other hand cannot be reduced by management. Volume allocation- this is a term used to refer to the cost allocation based on the level of output i.e. the quantity produced. Activity based costing- This is a costing system that monitors the activities of an organisation by taking into account the costs drivers and allocating such costs to the costs centres. It aims at improving the processes and eliminating those activities that add no value to the business. Contribution margin- this is the per unit measure of a product gross operating margin computed as the product price lea the total veritable costs. It helps in determining the break-even level of operation. Revenue centres- this is a division of that earns/gains revenue from product sale or service offered. Costs Centres- these are the parts of the organisation that does not produce direct profits but adds to the costs of running the business. Operating profits- are the profits a business earns from its normal operation i.e. the core business. Work Cited Business, T. A. (2013). Product Costing at Fine at Foods: Is It a Symptom or the Problem? IMA Educational Case Journal, 1-7. Read More