A study of the Cylinder Manufacturing Company

The company that manufactures cylinders is a major manufacturer of oil tanks. It is situated in the North part of Buckinghamshire located in United Kingdom. It was founded as a firm in 1970 and has seen steady growth in the profits and sales.

From 1970 until 1998, the company was producing its products employing a standard accounting method. The year 1998 saw the daughter of the founder Davina Brinkwater joined the company following her graduation from the university with a degree in accounting and finance. Following her joining, she analyzed the accounting system used by the company and suggested that they revise the accounting system because there was a need for more precise product cost data to help the company’s policy of providing a competitive price on a very competitive marketplace in which a handful of companies dominated.

Problem

When she joined the company, she analyzed the accounting system that is using “Traditional Accounting System”. With the help of his influential and powerful dad, Davain achieved the implementation of his New System, Which is “Abstract-Based Costing ABC”. However, she is confronted from the people in the company that she wants to transform the company. Some of the employees are content accept the challenge and are able to comprehend how the new system works. After the death of her father, she knows that she needs to demonstrate herself.

The real Problems

Davina is aware that the disruption because of the implementation to the brand new process may cause a lot of anxiety. That’s what happens when her accountant informs her that profits are not up to the budget. He’s very critical of the costing system currently in place, saying that it’s out of keeping with modern manufacturing processes and is far behind the current theories about the process of costing products. Based on the information provided by the accountant they’re still absorbing the cost of labour and overheads and possess an artificially large rate of overhead absorption of PS150 per hour of labour. He says their pricing is based based on their current product line. He suggests that costs for products could be more meaningful in the context of the number of hours spent by machines.

On the contrary, Davina decides that she herself examine the issue over the last five years. The result was these results.

The overhead cost has risen up to PS599300 per month , which is 46% more than the previous month.

direct labour hours have increased between PS168200 to PS170000

Direct work hours are 4000 when in comparison to machine time of 6500.

Davina is a manufacturing manager who asks Davina about the increase in overhead costs. He gives the following explanations.

23 different variations of a single item

The price of a product can be very high.

Material handling is becoming a major problem

Overtime is being pushed to the top

insufficient skilled individuals

Davin decides to discuss the matter with the marketing manager whom he informs

We’re facing intense competition for our high quantity lines, and we simply can’t beat the low prices in the market

However , we have been able to boost our sales

We are achieving our sales goals for the year.

OBSERVATION

After analyzing the history of the company and the launch of an activity-based method over the traditional one, I believe that all managers and employees are blames and blames. They were unaware of the problem until they’ve seen an increase in revenue and have achieved the goals for sales. There is also a greater demand for the particular product available on the market.

I figured out that the firm employs both methods simultaneously. Particularly, the company is focused on production of Standard products rather than Special production of products. Utilizing the standard process, they offer more labor-intensive service which results in the increase in overhead. They have not used or increase the amount of machine work. Which is the most demanding product available on the market.

“Realisation that overheads don’t simply happen, but are brought about by actions, such as keeping products in the store which drive costs is the basis of the concept of Activity-based Costing (ABC). The standard method is that direct labor hours constitute a cost driver which was probably accurate. However, it is now acknowledged that this is not the case.

In general, we consider overheads as the services for costing units. The price of which has to be billed to these units.

ABC considers that overheads are caused by cost units and these cost units have to be accounted for with the expenses that they create.” (Accounting as well as finance written from Peter Atrill and Eddie Mclaney)

ABC is the only solution and implementing the new activity cost-based system is the main problem. After the implementation of an accounting software system that is new,, we can calculate the cost of both the Standard and Specialized.

Cost of overheads budgeted per month

Machines 279500

Support for engineering and set-up 200200

Materials handling 119600

Total overheads 599300

Direct employment 170000

Total manufacturing cost excluding direct materials 769300

Solution:

In this case, we simply determine the machine hours that informs the base of overheads recovery using the ABC method.

Formula:

(Machine Hour / Total Hours) * Total Over heads

Standard Product (3500 6500) * 599300 = 322700

Specialised Product: (3500 / 6500) * 599300 = 276600

After calculating machine hours with the ABC system , we can calculate the actual costs of both products. It is easy to determine that the standard product uses longer hours than specialist product. Since there already are 23 different variations of standard products available on markets, the is a lower demand, we can’t increase the cost of standard products due to the competition in the market.

On the other hand, the potential for specialized product is present in the marketplace and popularity is also very extremely. The specialised product is priced higher than the standard product. Only the business requires skilled workers, which will increase the amount of store and set-up orders in comparison to the normal product.

Standard product will absorb the costs of Specialised product.

Standard Product is not giving greater profits, therefore we have to develop a new product, which is specialized and has the market and is able to generate more profits. Specific product to meet profits targets.

The only reason is that the business has lower hours on machines and dependent on labour that has led to an increase in the cost of overheads, and the profit graph decreases.

Recommendation

As I have mentioned earlier, the demand for this product on the market, and the product is generating higher profits. This is why it is necessary to raise the cost that the products are sold at.

According to the Market Manager, the company is meeting the overall sales goal and there is a higher demand. There is a need to increase the machine hours to ensure that the production of the product specialized increases and increase the cost of the product. This will increase the profits, and will help overcome the overhead cost. It is possible to increase machine hours that can boost production. In addition, to adapt labor, we can operate the manufacturing department on different shifts in order to maximize the amount of machine hours and labour for our product that is profitable.

Section II: – Explain how an activity-based approach will alter the analysis of the cost of special and standard products.

We will first look at the issue, and then we’ll work through these numbers. To firstly, to determine how traditional cost accounting methods could tackle them; and secondly to study the ABC method as a whole. Of the methods we’ll be examining just ABC will utilize all the data in great detail. This is in keeping with the general principles of the standard method.

(ref: http://business.fortunecity.com/discount/29/abcworkex.htm)

Analysis

The company is using the traditional accounting system, which means that they use one pool of overheads , and they can’t estimate the actual drive of the expense, whereas the “ABC system” is a method to more precisely link costs to specific production or the provision of a service. It is based upon the recognition of the fact that overheads don’t just happen as a result of activities like storing products in stores, or storing products and other activities that affect the price”. (Ref Accounting: An Introduction to accounting by Eddie Mclaney and Peter Atrill. Fourth Edition)

When we calculate the price of traditional and specialized products with ABC method, we can identify the difference.

The traditional Direct Labour Hours

Formula:

(Labour Hour / Total Hours) * Total Over heads

Formula:

(Machine Hour / Total Hours) * Total Over heads

Standard Product (3500 6500) * 599300 = 322700

Specialised Product: (3500 / 6500) * 599300 = 276600

When we calculate the price of the standard product and the specialized one, we will have machine hours as well as work hours. Here we are able to easily determine that the standard product absorbs more hours of labour as result of the machine hours is that they are producing fewer items. The manufacturing manager is concerned regarding the product’s standard version as he wants to keep the price low as there are 23 variations of the product available on the market. Because of the cost and standard product competition, it’s not making a profit to the company.

In contrast, specialised products are on been introduced to the market and is running well in the market. According to the marketing manager, the product it is meeting its objectives and the sales are growing, and there is a demand for the product that is specialized. However, the manager of manufacturing is concerned about the price of manufacturing it. He will require more skilled workers as well as machine setups, and the expense of handling material.

Cost Analysis:

Activity-based costing (ABC) assigns manufacturing overhead costs to the products in a more sensible way than the usual method of allocating costs purely according to the number of hours spent by machines. Activity-based costing first assigns costs to the specific activities that cause the majority of the cost. It then assigns the costs of these activities only to the items that are in fact requiring the actions.

Activity-based costing acknowledges that engineering specialization tests, machines, installations, and many more are costs that result in the company consuming resources. In the context of ABC the business will determine the expense of the materials used for each of these tasks. Then, the costs for each of these tasks will be assigned to the products that required the services. In this case, Standard Product will be given a portion of the costs for the standard Engineering, Testing and the setup of machines. Other products that rely on all of these processes will also be assigned a portion of the costs. Specialised Products will not be given any costs for special testing or engineering and will be assigned just a tiny amount of set-up.

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The case we study The Cylinder manufacturing company is making use of a single pool for overheads. However, the cost of the standard and specialized product is not calculated using the company’s activities. The budgeted overheads cost per month is the sum of overheads, so it’s impossible to know what product is taking the expense, and also what we can earn from it. The accounting system of the past shows the Set-ups, Machines and material handling as a sum for each product.

Machines 279500

Set-ups 200200

Marterial 119600

Total overheads 599300

It is one pool of overheads, from which we can’t estimate the price that the merchandise. The firm produces two kinds of products Standard and Specialised. Therefore, we need to determine the price of each product. Then we examine these numbers in a more detailed manner with the help of ABC system. We can see the modifications.

APPLYING ABC SYSTEM:

Hours of operation

Standard Product (3500/6500 * 279500) 150500

Specialised Product (3000/6500 * 279500) 129000

Set-Ups

Standard Product (80/280 * 200200) Standard Product (80/280 * 200200)

Specialised Product (200/280 * 200200) 143000

Material Handling

Standard Product (160/460 * 119600) 41600

Specialised Product (300/460 * 119600) 78000

Utilizing the ABC system we now have cost based on activity of our products. We are able to analyze the changes. In accordance with these new figures the standard product absorbs the cost , and the principal expense driver is our own specialized product. We have a few options to earn profit through our product. Our special product is our profit producing product. If it meets the sales targets in the marketplace, its means there is a need for this product

What can a company do?

There is a need for increase the price of Specialised products on the market

The Machine Setups can be increased.

The Machine Hours and labor Hours

Employ the Skilled Labour

Increase the production of specific products

The store must be able to manage the price of the order

We have mentioned above that the company requires more skilled workers and requires a boost in configurations. This means that products with specialized functions are more a percentage of the total costs. When we charge the product specialised in accordance with its function, we can determine the exact cost.

Conclusion and recommendation:

The activity-based costing method is more precise in revealing the actual work that are involved in the production. Since companies began measuring the cost of operations (instead of using the departmental classifications of accountants) They began to use ABC cost data to implement an activity-based approach to management.

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The above graphs show that, under the conventional approach the margins are largely similar between the two products. However the ABC method suggests that the more specialized product is more profitable. So, the company needs to rethink its manufacturing division and work to boost the quantity of product. Also, in the marketing department, they attempt to convince customers to purchase special products, which will result in an rise in cost.

The most important goal is a specialised product that could alter the financial situation of the company by increasing profit margins. It is a high-cost product that accounts for a large portion of overhead costs and by increasing the amount of hours worked by machines and labor hours, it’s possible to reduce the cost of overhead and boost the manufacturing of specialised products and marketing department could try to market it at an attractive price on the marketplace and make high ratio of profit. Marketing and manufacturing departments have to collaborate to increase profits by increasing the production of special products by utilizing more workers during overtime shifts, and meet demands of the marketplace.

Section III: – Provide advice on the introduction the implementation of An ABC system. What can be done to help Davina’s fear reduced?

Implementing Activity Based Costing is a effective tool for monitoring the effectiveness. Activity-based costing can be used to determine, explain, cost-assigning and monitor agency activities. Traditional accounting isn’t as precise as an effective cost management system. Activity-based costing helps identify ways to improve the efficiency of the business process by discovering the true cost of a service or product.

It is possible to use activity-based costing to direct management’s upon the entire cost of making an item and to establish the foundation for total cost recovery. It is evident Support services designed for activity-based resourcing as they provide quantifiable output units.

Activity-Based Costing means:

AEURC is an management tool that helps in more efficient allocation of resources

AEURC/ Is appropriate to both the appropriations as well as the revolving fund

AEURC/ Relates the total cost (resources used) to the work completed (outputs created)

AEURC/ Aligns costs with outputs, thus increasing the visibility of costs

AEURC/ can be useful when the forecasting of financial baselines

Implementation of ABC

Activity-based costing assigns cost to products and resources to produce units of price. The term “unit cost” refers to the “average amount” for producing one output unit. Calculate the unit cost through the division of the production cost by the amount of units of output that are produced.

If you can make an obvious connection between outputs and the costs you get an accurate picture of your financial situation. You can see that the cost shifts are transparent and clear that will allow you to make the right decisions when making decisions about how to allocate resources.

Total cost visibility considers all costs that are associated in the production or delivery of the product. For example, if are a parent who works for your company, you can look at total cost visibility.

You make them pay by giving them the vehicle. The work of your family member isn’t free, and you have to calculate the price of the vehicle in your total expenses.

You can follow four steps for costing for activities based on the activity

1. Perform analyses of operational processes of each component that is used to make the product. It is possible to be meticulous depending on the nature of your business.

2. You must assign costs to the activities. You must identify all the expenses in each of the activities. Include administrative costs up to the cost of the materials and labor.

1. Direct-costs can be linked directly to an output. For instance, the material costs (varnish wood, varnish, as well as paint) to construct chairs.

2. Indirect costs that are not allocated to a single output; that is they are a benefit to several outputs and not necessarily all of them. Examples include maintenance costs for the saws used to cut wood storage, costs for storage, other construction materials, as well as Quality assurance.)

3. General and Administrative costs that cannot be properly linked to any specific product or service created (overhead). The costs will be the same regardless of what outputs the process produced. Examples include the salaries of employees in the purchasing department, depreciation of equipment, as well as security for the plant.

3. Find outputs- identify all the outputs of each stage in the operational process. Outputs may be items such as services, customers, or products.

4. Assign output costs to activity costs. Assign the costs of activities to outputs with activity drivers. Activity drivers assign outputs costs according to the output’s usage of resources. A driver could be the number of times that an activity is completed (transaction driver) or the amount of time that an task is completed (duration driver). Activity-based costing helps managers to determine the activities that most valuable. These are the activities that best achieve a goal, provide an item, or satisfy demands of the customer. Activity-based costing increases efficiency and enhances the decision-making method by placing emphasis on actual cost.

Davina’s panic:-

After winning the battle about the old accounting system Davain’s now faced with the actual issues. She knows that it is difficult to set up the new system. And she’s going to be frightened when all those who aren’t satisfied with the new method is blamed on her. After reviewing the results, she was irritated and wondered what’s the issue? The system is working well, but she has to introduce new system, but it failed due to she has no skilled labour and she also doesn’t have the managerial skills. Anyone who can comprehend and manage effectively the ABC system.

My advice to Davina is:

There is a requirement for increase the price of Specialised products on the market

Increase the Machine Setups

The Machine Hours and the hours of labour

Employ the Skilled Labour

Increase the production of specific products

Controlling the store price of the order

We have mentioned above that the company requires more skilled workers and requires a boost in the number of setups. This means that products with specialized functions will have a higher proportion in total costs. When you charge the specialized product in accordance with its function, we can determine the exact cost.

As mentioned above, if Davina decides to take a risk according to my view, she’ll be able to beat the overhead ratio and she will also prove herself to those who are pointing at her. Then, the business is able to make a profit through its special selling of products.

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