Managerial accounting case study: company background and business problems

Managerial Accounting

Elkay is a manufacturer of sinks. The company has three plants, serving different markets. The Ogden plant is high-volume, low-margin production. The company has new technology that makes it an innovator in efficiency. The Lumberton plant focuses on high margin items. Broadview is for commercial, institutional and specialty products. The company's information provides feedback about profits that indicates one customer type provides all of the profits, and the other customer types are significant money-losers.

Assessment of Problems and Issues

The company faces a few issues in the marketplace. Elkay now has new competition entering the market from China, and this new competition is going to drive down the price on poorly-differentiated products at the low end. This is a natural consequence of new competition in a market that was previously in an equilibrium state. The new competition is going to challenge some of Elkay's customers to drop the company.

Another issue in the marketplace is that Elkay is recording lower profits. There are numerous potential causes for this. The industry is driven by the housing market, which is slumping. This means that most firms in the industry are seeing reductions in profitability, so Elkay is nothing exceptional in that regard. If prices or volumes are declining due to Chinese competition, that could also be an issue for Elkay with respect to its positioning in the industry.

Managers at the company do not trust the costing information that they have now. For example, when it came time to deal with some of the sacred cows, the company's managers did not believe the data. Elkay needs to have a costing system that its managers know and trust, something that can be used to make strategic decisions. In addition, the costing system performed poorly with respect to understanding the cost of serving individual customers, in particular where discounts are concerned. The company actually does not know what makes a product or customer profitable or unprofitable. Intuitively, they understand it means selling the product for more than it costs to make it, but management simply does not have access to that information -- of did not until the ABC system was installed.

Analysis of Underlying Causes

One of the issues was the lack of trust in the costing system, and with good reason. The costing system prior to the introduction of ABC was entirely arbitrary in the way that it allocated factory and corporate overhead. The three factories produce different products for different markets -- this does not need to be complicated. Introducing activity-based costing was a good step towards providing better information to managers.

This issue leads to another problem -- inertia and resistance among managers at the company. The response to the introduction of ABC was pathetic, and indicative of the type of broad-based cultural problems that can bring down an organization. While managerial accounting cannot solve organizational culture, there might be opportunity at Elkay to convince some of these intransigent managers if the presentation can thoroughly disassociate the new ABC plan from the sloppily-introduced plan of many years ago. Even the speed with which the ABC system was approved was indicative of the cultural issues -- personal credibility sold the system rather than empirical evidence. The Six Sigma guy would have spontaneously combusted at the very thought.

Lastly, even post-implementation there is a problem. Somehow, only 1% of products are contributing all of the firm's profits (more actually, because some products lose money). This is a highly unlikely outcome, so there is probably something wrong with the calculations in the ABC system and the company needs to find out what that is.

Recommendations

The first issue to be resolved is the 1% issue. Either this is true, which would be stunning, or there is a problem with the costing system. The company should not proceed further -- with the costing system, or with the rationalization program -- until the error is uncovered. These decisions are too important to let such a strange result slide. The company also needs to add to the system a different system of allocating administrative overhead. There can be considerable differences in how much time is spent on different customers, so the necessary process flow and process times for administrative activities need to be identified - the current approach is not good enough.

In general, however, I like the new system. There are some flaws in its implementation that should be addressed, however. An ABC system is, after all, garbage in-garbage out. The overhead allocation is still a little bit sloppy, because it is based entirely on direct labor hours. It is recommended that the company take more care in determining its overhead allocations. The company has multiple plants, and multiple pieces of equipment, so square footage used should be taken into consideration, even taking into account the cost of that square footage. In general, quick and dirty allocations are of less value than ones based on careful analysis. There is nothing pragmatic about doing ABC quickly if the inputs like allocations are wrong. The company will simply waste a lot of time and make a lot of bad decisions on the basis of this faulty input. Another example would be estimating the time to set up for each process -- if this information does not already exist the company should record it. Downtime is expensive, after all.

I would want the system to be more temporally refined -- once a month can be improved upon. With the technology they are using, they should be able to fine-tune these results to the daily or even hourly level. Clearly, one month aggregates are important because they filter out variability, but more discrete data would allow for variability in process or set up times to be detected. At the very least, process efficiency can be improve with more discrete data.