Cylinder Manufacturing Company’s Activity-Based Costing System

The advantages of switching to machine hours as an overhead recovery base

Machine Hours

Basis Amount Units Rate/Unit Standard product Specialized product
Over heads
D. labour
machine Hours 599,300 6,500 92.2 322,700 276,600
D. labour Machine hours 170,000 6,500 26.15 91,525 78,450
Total machine cost 414,225 355,050
% 51.8% 48.2%

Labour Hours

Basis Amount Units Rate/Unit Standard product Specialized product
Manufacturing cost labour Hours 769,300 4,000 192.325 480,812.5 288,487.5

There was a reduction in overheads cost under standard product by 11.2% (63% – 51.8%). this means that by the company switching to machine hours, it made a saving under standard product of 11.2%. But there was no saving under specialized product and in this case manufacturing cost increased by 11.2% (48.2% – 37%). Switching from labour hours to machine hours will not be profitable to organisations under specialized production.

Many companies prefer to use this method of apportionment so that they can accurately determine the cost of the product. It can also be used to establish the selling price of a product so that they can make profits. Machine hour costing is considered to be accurate as overheads can be easily traced to each machine. Secondly, it is easier to obtain information about this system and therefore more reliable and easier to apply. Thirdly, this method is faster as compared to labour hours and therefore cutting down some production and operational costs since it can produce many products within a short period of time. Lastly, it is easier to apply this system of costing to any organisation because it has little complexity involved.

Machine hour method of costing has also its limitations but the management is required to carry out cost benefit analysis to establish whether it is profitable to use it. In introducing this method, the company may incur high capital outlay to buy and install the machines. In addition, the company requires employing new staff to operate the machines. These costs may be higher in the short run but beneficial and profitable in the long run

How an activity-based system would change the analysis of the costs between the standard and specialist products

ABC

Activity base Amount Rate/Unit Standard product Specialized product
Overhead No. Of setups 769,300 2,748 219,840 549500

ABC

Activity base Amount Rate/Unit Standard product Specialized product
Overhead No. Of store orders 769,300 1,673.39 267,583 501,717

From the above analysis, the Activity Based Costing system when used has a saving in the production of standard product but there is no saving in the production of specialized product. When the traditional method is used as costing method it’s the opposite.

According to the traditional activity based costing, overhead is applied to products using a single predetermined overhead rate based on a single activity measure in many production processes. With Activity-Based Costing, multiple activities are identified in the production processes that are associated with costs. The events occurring within the work causing activities are called cost drivers. They are used to relate overheads to products and services while using ABC analysis.

The ABC system assists the management to obtain better costs for their products. The management can use activity based costing to improve their profitability and clientele base. This is possible because information obtained from the calculations will help the management to know how best to reduce cost; make decisions on how to improve the process, product design, pricing and product mix. When a company is expanding its operations, calculating product cost is quite difficult because they produce more products and these products use different levels of resources. Activity based costing is adopted to solve this situation.

ABC is extremely useful in planning, as the establishment of this system necessitates a vigilant study of the total manufacturing or service process of the firm. This method highlights the sources of costs. An analysis of the sources can spot activities that which lacks any sort of valued addition to the product. Moving materials and accounting for transactions are a few examples of such non-value adding activities. Even though these activities cannot be totally eradicated, they may be abridged. Identification of how different activities influence costs can help in modifying the planning of factory layouts and improved efforts in the design process in order to decrease potential costs of production. Proper analysis of activities is believed to surely assist in better performance evaluation. At higher management levels, the activities can be aggregated to coincide with responsibility centres. Managers are the ones who would be accountable for the costs of the activities associated within the scope of their responsibility.

In ABC analysis, the so segregated spending pools are matched with the various work activities. This way the actual and true picture of the consumption rate of that particular pool can be figured out. In ABC analysis there is a possibility of frequently updating and refreshing of information. ABC analysis is often updated on a monthly, quarterly or weekly basis but standard costing is updated only on an annual basis. Standard costing would apply the overhead costs based on a single measure of activity.

Traditional costing simply allocates overhead costs and variable costs evenly through the number of units. It does not discriminate the number of activities performed for one unit or product. In the case of high tech industries like Dell which manufactures computers customized to a clients need, the amount of resources and costs associated to one laptop will never be the same with another laptop model. The cost incurred by one model is not dependent on the raw materials or spare parts alone.

The time it takes for producing one of the units is not equal. Since the variable labour costs are directly associated with time spent on producing one unit, it is only reasonable that the cost of the unit also be raise in accordance to the length of time it takes to finish it. This principle is to be followed through with other expense item like machine time, warehouse space overhead, rent, utilities, etc (Kaushik 172). The problem with traditional costing is its incapability to determine which product is costing the company more in terms of expenses. Its sole basis is the number of units made by the company.

The problem starts with the fact that not all products are equal in quality and complexity of design. There are several products that are produced in large quantities but cost the company a small amount only because of their simplicity. On the reverse, there are products that are produced in small quantities only because they are so complex to produce that it will take some time before they are finished. The costs associated with these complex products are naturally higher that is why there will be a smaller number of clients willing to buy them. If traditional costing is to be used, the company will mistakenly give a very low product cost for this expensive item simply because there are fewer on them on the inventory. The accounting method fails to account for the idea that it took more time and resources to make even if they are fewer in number.

The inclusion of fixed costs in the product will lead to poor internal decisions because the resulting price of the product will be extremely skewed from the actual costs the company has taken to produce it. The result is that customers will be extremely irked by high prices on products that are deemed to be of low value. The company will also suffer from the low prices on products that were very expensive to make from the company’s standpoint.

The fixed cost does not necessarily mean that all products are equally using it for its production. Naturally, those products that are taking a long time to be produced should be assigned more “rent” expense as one of the fixed costs. The reason for this is because products that are staying inside the company premises are also occupying space which is what rent is paying for. Those items that are easily manufactured in large numbers and then sent out for delivery and sales should have lesser amounts of “rent” as one of the fixed costs when calculating for their individual unit costs. The activity it took to produce a product that consumes a lot of fixed costs should bear the majority of the fixed costs as well in order to produce an accurate pricing of goods.

If this basic principle is ignored and not implemented, naturally the pricing of goods would be distorted to a large degree. In extreme cases, the company might actually lose money even if they have a healthy sales figure and a reasonable profit margin. All of it can be attributed to not being able to collect the correct amount of money for the goods and services that costs the company a lot to start with.

Despite the plethora of benefits that ABC offers, many organizations over the world have found it difficult to implement the same in their manufacturing units. Few reasons for the inability to implement ABC are the high cost of implementation, use of costly-to-validate time allocations and finally the hardships of maintaining and updating the ABC model.

From the case given, Davina, the company founder’s daughter, has re-evaluated the costing system of this organisation. The information gathered by her shows that calculations from the production and marketing department are not in agreement with the costing system. Further, the prices of this company are not in line with the competitor’s prices and costs. This means that the management are not sure on how accurate the costing system is allocating overhead costs to standard and specialised products and therefore the solution is to apply ABC system.

The implementation of an ABC system

For the management to practice Activity Based Management, it must evaluate the cost benefit expected to arise from it is use. If the system is to enable the company to make better decisions regarding costing system, then it can choose it.ABC costing system is best used when; first, most of indirect costs are allocated using one or two cost pools. Secondly, most of the output unit level costs are described as indirect costs. Thirdly, the products produced have different resource requirements because of differences in process, batch size, complexity and in volume. Fourthly, there are higher profits from products which the company is not well suited to make and sell and lower profits products well suited. Lastly, there is a high misunderstanding between the accounting staff and operations management as to manufacturing and marketing costs of the products (Kaushik and Krackov, 178)..

As for the case of Davina, she should make important decisions about the level of information to use in implementing the ABC system of costing. The company should choose the correct number of activities to use and even cost pools. The company has already chosen the number of set-ups and orders which can further be identified differently. This will enable the management to further note the disadvantages and costs of adopting this system. In implementing ABC system of costing, the process involved is costly. Proper estimation of the costs for activity pools and allocation bases is required. In addition, there must be calculations to determine product costs and regular update of activity- cost rates. This makes the system complex to use but more accurate and reliable.

The ABC system can be more cumbersome if more and more cost pools are created. This may bring a lot of confusion in identifying the costs of different cost pools. Further the management should be careful not to use allocation for which data is readily available rather than the allocation bases they would have liked to use. Despite these problems, the ABC system of costing are considered to be practical because of change in technology and are applied by many companies around the world.

Davina should extensively prepare the staff for change. Most or all of the existing employees fear change because of many reasons. Some of them include; fear of loss of jobs, fear of technical knowhow, fear because of past experience from the same system, fear because the system has failed somewhere else, fear of complexity that is involved and others. Therefore she should overcome resistance by;

  1. The existing staff should be involved in decision making and participate fully for the change. The consultants should work together with the existing staff as a team to bring change.
  2. There must be a well designed personnel management action programme as part of preparing for the new change. This programme will specifically deal with employee training and retraining, development skills, recruitment and selection and natural wastage of the staff.
  3. There must be careful job design, good organisation of work, establishment of cohesive groups and creation of proper relations between the nature and the content of jobs and their task functions. This will influence faster task delivery and avoid repetitive work.
  4. Proper communication about the new system will also reduce resistance to change.

One common feature of the Activity Based Costing models that differentiate these models from the conventional volume-based costing models including the traditional ABC model is the identification of idle resources in resource pools. It follows that people who are exercising prudence in buying technical gadgets would only buy those that they need and not something that has an excess capacity of what they actually need on a daily basis. The high-end laptops will take some time in the production area as well as in the storage warehouses because they are naturally hard to sell. Even if the company is using a custom built order form to eliminate the inventory build-up, the length of time it takes to build one from scratch and deliver it to the customer’s doorsteps are still longer than that of lower models. In summation, ABC enables the company to correctly identify the areas where they are spending money a lot and pricing them accordingly for the market (Bruner, 78)..

References

Bruner, Robert. Case Studies in Finance: Managing for Corporate Value Creation, New York: Irwin McGraw-Hill, 1998.

Kaushik, Surendra & Krackov, Lawrence. Multinational Financial Management. New York: New York Institute of Finance, 1989