Sparklin Automotive Costing Sparklin Automotive Company (Sac)

Sparklin Automotive Costing

Sparklin Automotive Company (SAC) is a leader in the spark plug business and has now developed a revolutionary new product that will enhance that leadership position. The new product allows the company to offer special-order spark plugs for the auto racing industry. The company needs to determine the best method of accounting for this product. The current accounting system is a basic costing system that delivers only basic information to the company's managers. Other systems have also been recommended for adoption to enhance the company's costing knowledge and improve managerial decisions. This memo will discuss some of the options for the new custom spark plug product in particular, taking the approach of comparing the new product with the normal spark plugs the company offers, and explaining why a different accounting system for the new custom plugs would be beneficial.

Current Practices

SAC currently utilizes the process costing method for its spark plugs. Process costing is a system commonly used when a company produces a large quantity of identical or similar products, as is the current situation at Sparklin Automotive (White, 2010). Process costing accumulates direct costs, and allocates indirect costs. Costs are assigned on a large batch basis, often over time period (Ibid). So for the current product, SAC examines its costs on a macro basis, using daily, weekly or monthly production as the basis, then working backwards to calculate an average cost per unit. There is little consideration of the cost of different products under this system.

Job Order Costing

For companies that break their work down into jobs, a system called job order costing is often utilized. These companies typically perform work that varies with each order. Examples of firms that would use job order costing are auto mechanics, print shops, accounting firms and plumbers. The new custom spark plugs at SAC are an example of the type of product that would normally be subject to a job order costing system. Each set of custom spark plugs will have different specs, and as a result the cost structure for each will be different.

The mechanics of job order costing are more complicated than for process costing. Record-keeping and cost assignment issues are more complex and harder to manage under a job order costing system, for example (Accounting for Management, 2011). Job order costing does not aggregate costs for any time period, but for each job. This means that overhead and other indirect costs utilized for that particular job must be measured and included in the cost. This process can be difficult and arbitrary, but ultimately the objective is to understand exactly what costs are going into the job. One complicating factor is that the overhead costs may be incurred anyway -- if there are no incremental new overhead costs then no overhead may be charged to the project. However, if the project is taking time away from management, or uses some factory space that is part of the overhead, then this needs to be accounted for. These decisions can be made at a later date, but they complicate the process of conducting job order costing.

There are a few ramifications of selecting job order costing for the custom spark plugs over process costing. The first is that because job order costing allows the company to better understand its cost structure, the company is in a better position to set prices for the project. This is important, because the price is typically going to vary by job. In this situation, the prices may even be contracted, or contracted within a range, to each racing team. Thus, it is critical that SAC understand what the costs for each order are, so that they can set prices effectively. In addition, job order costing provides specific cost information that the company can use to manage its cost structure.

Another benefit of job order costing is that it is congruent with this type of work. The company has not used job order costing because its work has not been conducive. However, job order costing is used for most custom work. The company can analyze its cost data in multiple ways if this system is used -- it can analyze on a project-by-project basis or the different jobs can be aggregated. The different jobs can be analyzed for trend as well. A final benefit is that the company is in a better position to accept or reject projects, because it has a better understanding from the outset of what its cost structure might be, based on knowledge of past projects. Not only does this help with setting prices, but it helps the company to avoid agreeing to bad projects.

Job order costing also allows for better sensitivity analysis of projects as well. Because each project can be analyzed independent of other projects, it can be subject to advanced analysis, which allows the company to control its costs and profit margins. With sensitivity analysis, the company can have a better understanding of the specific cost and profit drivers of its custom projects, which might be significantly different from the cost and profit drivers of its general mass-manufacturing work.

The main drawback of job order costing is that it is complicated, especially for companies that do not normally use it. The companies that normally use job order costing are accustomed to the measurements that need to be made, the techniques that are used, and the decisions that need to be made in order to make job order costing work. A firm like SAC is not accustomed to things like making decisions about indirect cost allocations.

In addition, it can be difficult to reconcile job order costing with process costing. This is because of the use of allocations for overhead and other indirect costs. For SAC, these allocations will reduce the total indirect costs charged to the regular spark plug production under the process costing system. This effectively complicates the process costing system and makes it a hybrid by introducing the concept of allocations to its indirect costs. SAC will need to weigh whether or not they wish to do this before implementing job order costing for the custom spark plug business.

Recommendation

It is recommended that Sparklin Automotive implement job order costing for the custom spark plug business. This type of costing system is congruent with this type of work. Job order costing allows the company to better understand the cost structure of its custom work, and to have a more accurate means of understanding costing so that it can set prices at an appropriate level. There are going to be some challenges that need to be overcome, specifically with regards to the allocations. It is therefore also recommended that the custom spark plug business be incorporated separately. This will make it easier for the subsidiary to track its costs and separate the indirect costs such as overhead and management from the regular spark plug business. The allocation function is therefore addressed, but this is done in a manner than allows the company to maintain the process costing system for its normal operations with minimal confusion.