The company viz. King Plc is in the production of electronic circuit boards for the airline industry and has already produced nine circuit board in one production centre and has just introduced a tenth circuit board, Lilywhite, which is going to be used in satellite tracking systems. But introduction of the new circuit board would require re-organization of the factory into two production centres, called 'Low Tech' and 'High Tech' production centres. For making the apportionment easier, overheads were apportionment in four cost centres and then final overhead cost was analysed in two different production centres. It is seen that reorganization of the factory needs a huge amount of financial investment and going to consume 4/5th of time for the technical support from the maintenance service centre. Moreover it was noticed that the manufacturing of Lilywhite was more complex than other products and uses 7400 components to the construction because of which the company will be in need of more staff and warehousing facilities. Lilywhite's budgeted sales was targeted at 20% of the total sales of the company for the next two quarter which was in excess of the breakeven point. But when the company started selling the product, Lilywhite in the market, the result came out disappointing for the 1st quarter as the sales of that was very low in compare to the budgeted while the 2nd quarter was fair in which it achieved more. At the same time if we see, production of Lilywhite then we can say that in the 1st quarter, the production attained as high as 20000 and the next quarter was let down by almost 30%. In respect to this problem created, the chairman called a meeting in which Financial Accountant, Ben Hogie, presented a profit and loss account on the basis of absorption costing for both the quarters and he suggested to the board that this product should be discontinued to stop occurring losses to the company. The chairman believed from the profit and loss account presented by Ben Hogie that the production of Lilywhite should come to an end, or deep investigation must be done to analyse the figures. New management accountant, Sarah Willis, gone through the older profit and loss account created by Ben Hogie and then generated another profit and loss accountant using marginal costing method and the figures came out totally different than that of Ben's P & L account. Now chairman of King Plc would be thinking whether to follow absorption costing or marginal costing based P&L account and continues the production or ceases it.
TASK - 1
The cost accountingÂ system in which theÂ overheadsÂ of an organization are charged to the production by means of the process ofÂ absorption is called absorption costing. In the absorption costing, all the production costs are absorbed into products. Costs are first apportioned toÂ cost centres, where they are absorbed usingÂ absorption rates and then are allocated to the respective production centre. But only variable costs of production are allocated to the products while calculating by marginal costing. In this method inventory is measured at variable cost of the production, while fixed production overhead costs are treated as a cost of the same period in which they are incurred. Marginal costing is also called as direct costing as it involves ascertain direct costs.
As the assistant of the new management accountant, I have gone through the accounts prepared by both, Ben Hogie and Sarah Willis, in this case we have no inventory stock in the first quarter due to the launching of a new product and that's why the costs are recorded at the full cost of £14.50 per unit to be absorbed by each unit. And the closing inventory is also valued at the full cost of £14.50 per unit. At the other hand if we see, the production of the second quarter was lower than the budgeted. The under-absorbed overhead arises because of the actual level of production was 5800 units lower than expected. The lower variable cost is justified by the lower volume of production but the fixed cost element of £2.5 per unit must be charged on the expected production units because fixed costs do not decrease when production volume decreases. This part of the production cost charge must therefore be included by adding £14500 (5800*£2.5). This method is useful in preparing financial accounts as it recognizes the importance of the fixed costs in the production. It shows less fluctuation in net profit even if sales of the company fluctuate. But the only thing is it may not be useful in making decisions, planning because it considers variable cost and fixed cost and highlighting total cost which ignores the cost volume profit relationship.
On the other hand, new management accountant drew out P&L account using marginal costing method. The cost of the production is recorded at the variable cost of £12 to be absorbed by each unit manufactured. And the closing stock is valued at the variable cost of production £12 per unit. It is assumed that variable cost increases if the production is increased and vice-versa. Here, fixed costs are believed to be the period cost and reported as a separate line in the profit and loss statement.
One thing which came into my mind was, Ben Hogie didn't consider the over absorption of the production even while preparing 1st quarter's account using absorption costing method. In marginal costing the problem of under or over absorption never arise. Therefore the value of closing stock will be higher in absorption costing than calculating using marginal costing. And as a result of bringing forward a constituent of fixed overheads in inventory values, cost of sales in determining profit in absorption costing will include fixed production overhead of previous quarter but will exclude fixed overheads occurring in the current quarter by including them into opening stock values in current quarter whilst marginal costing charges the them in full into profit and loss account for that quarter. More clear ideas about the effect of production and sales policies can be understood which can help in making managerial decisions by differentiating marginal costing from the other one. Profit per unit can be influenced by the actual volume of production in absorption costing which won't happen in the case of marginal costing. If management takes decisions on the basis of marginal costing method which was prepared by Sarah Willis then it can be useful knowing the fact that identification of variable costs and of contribution enables management to use cost information more easily for decision-making rationale. I think it would be easier to decide upon how much contribution can be influenced by transforming in sales volume and profit remains unaffected by the change in production. However, in absorption costing, profit can be affected in a certain period by the change in production volume and sales volume as well. It is not easily seen in this case because behaviour is not analyzed and while calculating actual profit, incremental costs are not counted. I would strongly recommend the chairman to continue production of Lilywhite for all of these reasons.
TASK - 2
Activity-based costing (ABC) is a costing model that recognizes the activities within the organization and disperses the cost of each one activity to all products and services in accordance with the consumption of the elements by each direct and indirect cost. In other terms, ABC is relatively new approach to allocating overhead costs to products.
Using ABC method to allocate the resources can be beneficiary to the King plc being it enables more accurate costing of all activities to be acquired throughout the organization. Sarah must have thought that this method is easier in finding where high and low costs have been deserved and the cause. It enables costing of processes, supply chain and value stream so it can be assumed that it will help out in solving the individual cost of products.
There are mainly two types of cost centres, Service cost centre and Production cost centre in King plc. Production cost centre are involves in the production activity, with the output in the terms of electric circuits and the service cost centres are not directly involved in the production activity but provides essential back up to the production activity. The management accountant would have divided the overhead costs into two categories: those which may be allocated as a whole to each cost centre just like they allocated a whole unit to manufacture Lilywhite, and those which have to be apportioned over a number of cost centres according to how the cost centres benefit from the cost incurred. But this method is quite complicated in drawing it out and it is also time consuming. It will result in extra labour cost. Activity-based costing (ABC) highlights that activities use companies' resources and drive costs (rather than volume by itself driving costs). And as a result, the king plc would be benefiting from ABC with a significant amount of overhead concerning to a diversity of activities in providing goods and services to customers whose demand also diverge. With king plc, we have noticed that in the 1st quarter the demand of the Lilywhite was lower than 2nd quarter. The demand of that product is growing higher which can be seen from the data provided but if we follow activity-based costing, then the accounts to be prepared would be depend on historical data so we cannot depend upon those data provided. We can't get the perfect idea about the present situation of the company. It comprises of indirect material, indirect labour and other indirect costs of production. The types of indirect cost depends on the nature if the business and on whether it is a manufacturing business like repairing of machinery, safety procedures. In this case, management accountant should have absorbed into the products. The management accountant has to devise a scheme of allocation and apportionment. It should fair to all departments involved in the process of allocation and apportionment. It should be easy to understandable by all concerned. But in this case of King plc, if we implement this ABC method then it would end up in extra cost and it won't be so easy to understand because it consist of lots of calculations. Moreover, this method is difficult to explain and analyzing the data provided would be more complex. It takes longer timing to do the calculations and it is also a sophisticated process. I don't think implementation of this method in King plc would be that beneficiary.