Management Accounting Company Overview Classic Pen Company

¶ … Management Accounting

Company Overview

Classic Pen Company is an organization specializing in the production of pens, the Classic Pen has been enjoying the low costs for the production of BLACK pens and BLUE pen, and the company has enjoyed the profit margin of 20% of sales. Increase in sales makes sales manager to decide to expand business by introducing new product line, which could offer at a 3% premium. Thus, management introduced RED pens, which could be sold at 3% premium despite its complicated production requirements. PURPLE was also introduced last year because it is has been viewed to command 10% premium selling price.

Since the introduction of new products, the financial statement of Classic Pen has been disappointing and there is a need to address the problem to make the company to enjoy increase in profitability.

:Problem Identification

Production of new Red Pen and Purple Pen has made Classic Pen to incur higher costs of production. Interview with Jeffrey Donald, the manufacturing manager shows that Classic Pen is spending a lot more on purchasing and scheduling activities resulting the company to incur higher cost of production on its products. To produce RED pen, manufacturing department has to make total changeover by cleaning out all the remnants of the previous color produced in order to produce high quality product. The whole process is not only time-consuming, the production process of RED pen and Purple pen incurs higher costs. Currently, overall burden of direct labor was 300%. Based on current problem that the company is facing, manufacturing manager reflects that Classic Pen may not have the capacity to handle additional more production of new pen in order not to create complication in the company operations.

Addressing the problem is very critical to ensure that Classic Pen lower the cost of production and introduction of a new cost system will make the company to lower the costs. Activity-Based Cost (ABC) has been identified as an effective cost system that Classic could use to address the problem the company is currently facing.

Fundamental objective of this report is to evaluate whether Classic Pen could adopt Activity-Based Costing (ABC) to address the current financial problem that the company is facing.

1.2: Definition of Activity-Based Costing

Activity-Based Costing model is a type of special cost system that identifies activities within an organization and assign cost to each of the activity. Typically, ABC divides production into core activities, defines these costs, and allocates these costs to products depending on the consumption rate of these activities.

"ABC assigns costs to activities using multiple cost drivers, and then allocates costs to products based on each product's use of these activities. Using multiple activities as cost drivers, it reduces the risk of distortion and provides accurate cost information." (Akyol, Tuncel & Bayhan 2005 P. 44).

ABC provides a way to look at the organizational operating costs and find techniques to dissect the underlying activities that make the cost to exit. ABC is specially adapted for the manufacturing company because ABC assigns costs in a more logical manner and assigns costs to the activities causing the real overhead in the production system as well as assigning costs to the products actually demanding the activities. With ABC, an organization can soundly estimates the costs of products and services and identify the unprofitable products. Moreover, ABC could be used to lower the price of the products that are being over priced. More importantly, ABC could be used to identify production process that is ineffective within an organization.

1.3: Difference between Traditional Costing System and ABC system

ABC is different from traditional costing system because traditional costing divides costs into period costs and product costs. The products are similar to direct material, factory overhead, and direct labor. The period costs in the traditional costing include costs of selling materials, general and administrative costs. Meanwhile, these costs are allocated to production both under job and process technique.

Fundamental difference between ABC and traditional costing system are as follows:

Table 1: Difference between ABC and Traditional Costing System

Traditional Costing System

Activity-Based Costing

Allocate costs on single volumes measures which include direct labor costs; direct labor hours. Factory overhead is traced to output and prime costs are traced to output. Traditional cost system accumulates costs via organizational units. In other word, traditional costing are cost objects consume resources.

ABC focuses on accumulating costs via several activities. ABC is activity analysis by assigning costs to objects causing activities and "identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service." (Luehlfin & Mason 2010 P. 1).

Traditional cost accounting mostly utilizes volume related allocation.

ABC uses drivers at various levels.

Traditional costing system is structure-oriented focus on the organization as a whole. Thus, process is missing.

ABC is process-oriented.

Tradition costing usually allocates costs to resources they do not use.

ABC only allocates cost to resources used for production process.

Traditional costing may distort the decision-making purposes by providing relatively cheap method of complying with financial reporting.

ABC is not inherently constrained by the financial reporting requirements ABC system are inherently design to facilitate special reports as well as facilitating effective management decisions with regard to costs of activities used to "design, produce, regarding the costs of activities undertaken to design, produce, sell, and deliver a company's products or services. At the heart of this flexibility is the fact that ABC systems focus on accumulating costs via several activities." (Luehlfin & Mason 2010 P. 2).

Making right decision is very critical to enhance organizational competitive advantages. Appropriate information about costing could make an organization to enjoy cost advantages. The report discusses the purpose of these information systems to enhance greater understanding on the appropriate cost techniques that Classic Pen could employ for the production of its products in order to enjoy cost reductions.

2: Purpose of these Information Systems

Equipped with accurate information is critical to enhance organizational efficiency. Manager of organizations that produce multiple products should be equipped with the right costs information to enjoy cost reduction. Having wrong information about the costs could jeopardize organizational competitive advantages. The main purpose for providing these information systems is to evaluate Activity-Based Costing (ABC) and recommend an effective costing system that is applicable for Classic Pen business process.

Cooper & Kaplan (1988) argue that companies producing multiple products should be sensitive about the choice of costing system. Many companies have problems because management is not equipped with essential costing information that could enhance organizational efficiency. "Bad information on product costs leads to bad competitive strategy." (P 96). Cooper et al. (1988) further argue that tradition-costing system makes sense decade ago when many companies manufactured narrow range of products and it was very easy to trace production cost to individual product. "Back then, the costs of direct labor and materials, the most important production factors, could be traced easily to individual products." (P 96).

However, in the modern contemporary business environment, situation is different, businesses have proliferated product lines and marketing channels and "direct labor now represents a small fraction of corporate costs, while expenses covering factory support operations, marketing, distribution, engineering, and other overhead functions have exploded." (Cooper et al. 1988 P. 96). The simplicity traditional costing system could no longer hold the complex business operations of modern business. Typically, many businesses still allocate rising overhead and support costs to only products produced within the company and allocating no cost to marketing and distribution.

The basis of this report is to make the management of Classic Pen to understand that corporate support cost are divisible and costs should be split and be allocated to each activity within the company. Costs could be allocated to company activity as follows:

Production

Logistics

Distribution

Marketing and Sales

Technology

Service

Information Resources

Financial Administration

General Administration

Making a right choice about costing system will make company to enjoy several benefits. The report discusses benefits companies could derive from employing activity-based costing system, and the key characteristics of companies that could use ABC systems.

3: Benefits Companies could enjoy from adopting ABC Systems

One of the benefits companies could derive by implementing ABC system is that it will be easy to allocate costs to each activity within an organizational unit. Companies will also be able to paint an accurate picture on the costs that each activity generates. For example, a company producing multiple products will be able to allocate product costs to each of the product produced within a company and identify the products that enjoy lower costs and products the incur higher costs in the production system. Having equipped with this type of information, ABC allows company to concentrates on the product line that enjoys lower costs and eliminate or reduce the production of products that incur higher costs.

More importantly, a company could use ABC to lower overall costs of production thereby making company to increase profitability and enjoy competitive comparative advantages. Since ABC is process oriented, companies using ABC could allocate resources more productively. Typically, ABC will make management to allocate resources more closely and improving productivity.

Identification of characteristics of the companies using ABC is essential to provide greater understanding whether ABC will be suitable for Classic Pen.

3.1: Key characteristics of companies that make ABC more suitable

One of the characteristics of the companies that could use ABC is that the company should be producing different range of products. For example, a company producing BLUE pen, BLACK pen, RED pen, PURPLE pen, and other products could derive profitability using ABC system. By using ABC, the company will be able to allocate costs to each of the activity and the company will determine the activity that is enjoying lower costs and the activities incurring higher costs.

Moreover, a company providing different services such as IT service, Management Consultant, Auditing, Tax service and other professional service could use ABC system. Additionally, companies controlling different departments such as marketing departments, production departments, purchasing and supply departments, Human Resources department and Accounting department and other corporate overhead could use ABC and derive profitability. Cooper & Kaplan (1988) argue it is a good accounting practice to trace marketing expenses on the resources using the marketing service. The strategy will make a company to enjoy organizational profitability.

Based on the benefits identified the reasons ABC is useful and its associated benefits.

4: Usefulness of ABC systems and Drawbacks associated with the Systems

There is several usefulness of ABC system. With ABC system, a company will be able to understand the true costs of each product produced in the company as well as understanding productivity of capital equipment. More importantly, using ABC system will make a company to understand which products are more profitable, the company will be able to rank the products based on their profitability levels, and the practice will make a company to understand where to focus the sales efforts.

Additionally, ABC will make management to fix more accurate pricing for their products as well as determining minimum order size. ABC system will make the company to identify a wrong product. Thus, management will be able to spend little time, money and effort on a wrong product.

Despite its usefulness, "ABC systems are rather complex and costly to implement." (Luehlfin & Mason 2010 P. 2). Once implemented, ABC is costly to maintain because data concerning different activities must be collected, analyze and input into the computer system.

Managers who accustom to using traditional costing system might face challenges in implementing ABC systems because of the radical changes. More importantly, a manager could misinterpret ABC system when making decision. Costs assigned to each product could be misinterpreted making management to make wrong decision that could be costly to an organization.

Despite the shortcoming identified with ABC system, the report argues that ABC system is suitable for Classic Pen

5: Suitability of ABC system for suitable for Classic Pen

The report argues that ABC system is suitable for Classic Pen. There are many reasons making the report to suggest ABC for Classic Pen.

First, Classic Pen has started producing varieties of products and by implementing traditional costing system for the production process, Classic Pen will not know which type of Pens whether Blue Pen, Black Pen, Red Pen or Purple incur higher costs of production. By alleviating, the same costs of production for all Pens will be disastrous. Using the tradition costing systems, Classic Pen will not be able to allot correct sale price to each category of Pen.

Using ABC system, Classic Pen will be able to understand which category of Pen is cheaper to produce and the sale price that would allotted to the Pen. Moreover, using ABC system will make the company to understand the category of Pen that incurs higher costs and the company will be able to understand sale price to be allotted to each Pen category. It is a mistake to assume that all categories Pen will incur the same cost of production. As being revealed by the manufacturing manager, production of RED pens and PURPLE pens is more demanding than BLUE or BLACK pen. (Harvard Business School (1998).