From the extracts of the profit and loss statement of Sidcup Furnishings Ltd. from the years 2002 to 2005, the direct materials cost have notably fluctuated in the years observed, evidenced in the increase in 2002 to 2004 and experiencing a significant decrease in 2005, largely due to the changes experienced in the price of hardwood, the raw material used for making Sidcup's products. Additionally, the trend in production for the overall hardwood furniture industry must be viewed in light of the underlying trend movements of another competing industry: metal furniture. The decided shift of consumers from hardwood to metal has significantly impacted the industry, making hardwood prices fluctuate like it did. The direct labour, on the other hand, represented the largest component of the direct costs incurred by the company and is consistent so throughout the four years of observation. This is somewhat caused by the hiring of additional temporary employees when the need for it arises. The trend in the costs in the direct labour is markedly proportional to the trend in the costs of direct materials, as well as factory overhead and other overheads costs, which should normally be the case. However, a noted decrease in the direct labour cost of 2004 is incompatible with the overall movement of the profit and losses of the company, an incompatibility observed which would translate as opportunities for the company to save on direct labour costs.
Annual profits for Sidcup has followed the trend of the production costs, which should not be the case since the longer a company operates, the more it should be able to control its costs to reflect a change on profit for the company. This downturn of profits can be attributed to product proliferation, which is a problem within the hardwood furniture industry. This has hindered the introduction of special purpose and highly efficient machinery and equipment, and while the industry finds it relatively easy to drop product lines and styles, hardwood furniture companies must maintain the capacity to produce old as well as new product lines. This problem is particularly acute in the more expensive wood office furniture lines. Reorders of wood furniture must match style as well as wood grain pattern and colour (which may not be the same as when the pieces were new). Additionally, the industry was influenced by different economic factors over the period studied. It was very much affected by cyclical changes in the economy. Expansions or contractions in output and associated changes in profit in this component can be very closely tied to changes in the growth of new residential and commercial construction, because furniture is generally purchased when families move into new homes or when offices are newly opened. In periods when the economy is suffering from downturns and especially when new residential and commercial construction slows down in expansion, this component of the industry registers small gains in output and, in turn, insignificant gains in profit. Conversely, when the overall economy booms, and especially when new residential and commercial construction increases, output in this industry is alive or posts increases and profits also tends to rise.
Following is the profit margin for the company from what available information has been provided for in the excerpt from the income statement for four years in £000s.
PROFIT MARGIN 2002
NET INCOME 2,430
10.7 or 11%
PROFIT MARGIN 2003
NET INCOME 3,570
13.8 or 14%
PROFIT MARGIN 2004
NET INCOME 2,760
11.2 or 11%
PROFIT MARGIN 2005
NET INCOME 1,090
Operating profit margin ratios have averaged at 10% during the years at observation, the last year (2005) suffering an all-time low among the four years because of the observed out-datedness of their estimation system.
WEAKNESSES IN THE MATERIAL COSTING PRACTICES
The direct material prices established at the beginning of the year are used to determine the direct materials cost for the manufacturing company. It was not mentioned in the case but it should be that an estimate criteria document included in the cost estimate for the materials in order to fully assess the extent to which the estimates are justified. Additionally, the estimate criteria document must clearly describe the methodology by which the cost estimate was developed. Time and cost assumptions and cost elements associated with each activity may not be clearly identified, defined, and documented in the cost estimate, resulting to poor estimates, which ultimately reflect in the decrease in profits for the company. Elements for program activities should have included quantity, unit of measure, labour hours per unit, total labour hours, material usage rate per unit, total material cost, equipment usage rate per unit, total equipment cost, overhead rate and total overhead allocated cost. The cost estimate should have been updated in a timely manner in response to relevant changes in its basis, background data, or assumptions, which the company failed to due even with the nature of their production processes. An appropriate change control document and an estimate development history should have been attached to the cost estimate and the estimate development history include an itemized and chronological list of the changes made to the cost estimate since initiation of its preparation, and the rationale for each change should have been likewise included.
WEAKNESSES IN THE LABOUR COSTING PRACTICES
Measuring the quantity of direct labour is less of a problem. The
quantity of direct and indirect labour is measured in hours. It is relatively
easy to record hours worked on time cards and to assign hours or fractions
of hours to specific jobs or departments in the factory. Labour hourly rates for Sidcup Furnishings are allocated at the beginning of the year to determine the direct labour costs. However, this system of allocation does not prove to be beneficial to the company in that even the production manager has pointed out that the direct labour costs have increased disproportionately over the past few years and have become ineffective due to the new manufacturing environment that the hardwood furniture manufacturing industry have been exposed to. In response to the increased need for human resource at some points in time due to increased production, the company hires additional temporary people to perform the tasks which cannot be performed any more by the regular employees. This forms a significant part of the direct labour costs, which may not be justified in the output that the temporary workers bring to the company in that their expertise may not be of the same as those of the regular employees, thus they tend to eat more time and resources. Just as well, changes in the rates of the wages and salaries have to be taken into account in estimation, in order to fully absorb the direct labour costs which is accrued by the company at the time concerned.
WEAKNESSES IN THE OVERHEAD COSTING PRACTICES
While it is not difficult to estimate direct materials and direct labour to be
used in a specific job, it is very difficult to estimate the factory overhead.
Overhead is not traceable to any specific job and, therefore, must be
allocated (1993). Allocation could be based on actual factory overhead incurred if there were an assurance that actual costs would be reasonably uniform each month. Instead, there are wide fluctuations in the timing of actual overhead costs. Some overhead is variable, rising and falling with production and other overhead is fixed, remaining fairly constant each month. There are
seasonal variations as well as other influences that cause actual overhead to
fluctuate. The customers cannot wait until the end of the year for an
accumulation of total actual overhead costs. It is necessary to estimate the
total annual factory overhead and apportion it into units which can be
charged directly to a specific job. As overhead costing estimates cannot be a hundred percent accurate due to the untraceability of certain costs, it is only understandable that the firm makes certain mistakes in their estimations. However, such allowances should not be so small as to not take into account those considerations which must be of paramount factor to estimation of the overhead costs.
As for the labour costing practices, if the company is able to save on labour costs in 2004 without sacrificing the amount of hardwood furniture productivity, then supervisors need to look at what made the labour costs in 2994 lower compared to the other years while also maintaining the normal level of hardwood furniture production. The ability to control production runs may be one of the factors profit growth in the company has been witnessing a decline. The furniture firm must remain even more flexible in terms of production capabilities than competitors, many of whom are also troubled by short, inefficient production runs and difficulty in incorporating highly specialized and efficient equipment. Some notable advances in the technology of manufacturing hardwood furniture have been introduced, and should therefore be applied to the firm so that the labour force will be more motivated and productive in their work.
With respect to the overhead costing practices, an average rate based on reliable estimates of overhead costs is better than using an actual rate. Even an annual period may have some shortcomings as a base for calculating overhead rates. Economic cycles have the effect of causing sales and production to be lower than normal for two or three years and then swing into a high cycle. Using
one annual period may result in a predetermined rate that is either higher or
lower than normal. A normalized predetermined overhead rate is based on
several years activity rather than one (Lewis 1993). It is an average of the period of at least five years. The factory has six different production and service departments that has production costs that include factory overhead. In a plant that performs only a few major operations, it may be expedient to develop an overhead rate based on one activity base, such as direct labour cost. This plant-wide overhead rate used to apply factory overhead to all units of output is a single overhead rate based on one activity base. Production departments may be labour dominant, machine dominant, or may use a large amount of space. It may be beneficial to the company to examine the extent to which each production department is affected by direct labour, machines, space usage or any other dominant factor that drives the costs of overhead upward.
In the estimating department may lay the profitability of the firm. It is of vital importance that the estimating activities be done right and fair in order to fully realise profits that the organisation expects from its resources. Since prices are determined by estimating the normal delivered price per unit of material, delivery terms and lot sizes must be specified to account for extra charges or discounts on quantity purchases. A serious consequence of improperly allocating costs which cannot be economically traced directly to the product lines is that unprofitable product lines could be carried while profitable product lines could be discontinued. It is imperative that the most precise methods of allocation within the practical limits of cost-effectiveness are used. The drastic effects of severe competition on Sidcup Furnishings Ltd. have caused a long overdue inquiry into the allocation methods used in the traditional cost accounting systems. The system should provide cost information for financial accounting requirements as well as for management decision-making purposes. The cost system should identify costs first by responsibility centres and ultimately with final cost objects. Fairness is difficult to administer because of its subjective nature. Using the ability to bear the cost as an allocation base criterion does not serve the purpose of measuring management performance. It should be used with discretion.
Traditionally, only direct materials and direct labour were assumed
to be directly traceable to separate product lines. That assumption will no
longer be followed. Instead, it will be assumed that elements of
manufacturing overhead, administrative expenses and marketing expenses
may be economically traced to product lines, or revenue-producing divisions.
Activity-based costing systems attempt to improve the allocation of indirect
costs by identifying the activities that are responsible for the costs. Costs and expenses that cannot be economically traced directly to a cost objective are to be allocated on a rational basis. The specific types of indirect costs that are described in this chapter are listed here. Due to the importance of allocation methods in a changing economic environment both traditional costs and those that arise in response to the new technological changes in production methods are included. For accounting purposes, expenses are not normally allocated, but are charged to the accounting period in total. Nevertheless, there may be an attempt to trace expenses to cost objectives when it serves the purpose of management.
The estimating system of Sidcup should emphasise the flow of materials and parts. As materials flow through the production process the system tracks
costs at the operational level. Costs are accumulated in cells, processes or departments. Emphasis should be on material and conversion costs classified into (a) direct material costs, (b) conversion costs of labour, (c) conversion costs of machines and automation, and (d) conversion costs of factory support (Lewis 1993). Allocation methods must be revised or modified to match the changes of the new technology. For example, the production machinery used in a flexible manufacturing system should be depreciated using the production method based on estimated total machine hours and traced to each product passing through the system. The traditional method is to charge the straight-line depreciation to factory overhead and allocate the overhead to product lines on an activity base such as direct labour. The system must be refocused to identify the cost drivers (or causal factors) behind non-value added processes and functions as well as those which directly add value to the product. Storage time, setups, physical movement, and inspection time are costs that do not directly add
value to the product. Their cost system must attempt to identify the cost drivers behind these non-value added functions and must place greater emphasis on predetermined estimates of cost. The decision-making process will depend more on quick responses, which cannot wait for the collection of actual cost
Cost drivers are the causal factors in cost. According to (1993), using proper cost drivers is enormously revealing as far as the profitability of products is concerned. It is important to know what
the cost drivers are because controlling the drivers allows a company to control cost. Traditional cost accounting systems, which evolved in the early part
of the century, tended to assume that volume of production was the only
cost driver. Volume of production in a one-product firm could be measured
by units of production. If more than one product were produced, direct labour
hours or direct labour dollars were used as proxies for the number of units. Identifying cost drivers allows a company to allocate overhead costs more accurately, giving a better estimate of product line costs. Determining cost drivers also permits a company to more adequately control costs by controlling the drivers or activities that are the causal factors. In the case of Sidcup, these cost drivers include the presence of competition, economic factors and hardwood prices which must be taken into consideration to properly allocate estimates for client orders. Once the level of variability of an expense is determined, appropriate cost pools can be formed and cost drivers chosen. Expenses at the unit level may be applied by machine hours, material cost, or labour hours, for example. Batch level expenses can be applied by number of setups or setup time. Those at the product-sustaining level can be applied by number of engineering change notice, and so on.
The new decade brought many changes in manufacturing processes. Probably the most apparent difference is more automation -- computer-integrated
manufacturing (CIM), robotics, and more sophisticated equipment of every
type. Other changes include an increased emphasis on quality and continuous
improvement and use of just-in-time inventory systems and work-cell factory
arrangements. As the factory was altered, cost accounting procedures became outdated. Accounting is, after all, a financial model of business. When changes occur in the business, accounting should change to reflect them. Unfortunately,
the accounting system of Sidcup has yet to catch up with the manufacturing procedures of the contemporary times. Managers of companies that fail to make appropriate modifications in their accounting systems will find they have inaccurate product cost figures and lack data for making decisions. They may lose their competitive edge because they do not have the necessary information for operating in the new manufacturing environment. In line with that, managers should therefore make the necessary changes to their systems in order to account for the changes in their manufacturing processes. As Tatikonda succinctly pointed out,
'No system is perfect. All systems evolve with time and changing needs. If the current system is inadequate for the needs it should be changed. But, before a system is changed it is very important to find the real causes for the existing problems. Failure to do so will result in designing the new system with all the past problems intact. In other words, the system may be changed without any regard to the real needs, and as a result the same old problems will continue' (1987).