Factors influencing Activity Based Costing Samples for Students

Questions: 1. Describe the Changes in Cost Structure that are likely to have occurred at Cravings for Cakes over the last 20 years, and Explain their causes. 2. Explain whether the existing Costing System understates or overstates the cost of a) Lamington b) Danish Pastry 3. Explain how Activity-based Costing could overcome the deficiencies inherent in the existing Costing System. 4. What factors should Ursula B. Bright consider when deciding whether to use Activity based Costing. Answers: Executive Summary In the given case, Cravings for Cakes Pty Ltd was engaged in the business of manufacturing a wide range of delicious cakes and pastries. The company was started 20 years ago where at that time the company was engaged in the manufacturing of pies, finger buns and lamingtons. The margin of the goods was good and the company was using only simple machinery but lot of hard work. Currently, the company along with its ongoing products has started the manufacturing of Danish pastries, donuts and vanilla slices. These are low volume line products but they have a good margin. The workers use to complain for these products as they involve a lot of hard work and are of low volume a well but being they have a god margin thus the company is preferring these product as well. Over the last 20 years, the factory certain changes have been taken place. The company has introduced computer-controlled mixing machines and ovens which replaced a lot of direct labor operations, and now more emphasis has bee n placed on quality and delivery performance. But in spite of these changes the profit of the company are declining on a continuous basis which has been alarming for the management. The management has asked the workers to concentrate on increasing the productivity especially for the high margin goods. 1.Changes in the Cost Structure Cost structure refers to the combination of fixed and variable cost that has been incurred by the business. In the given company, the cost structure has witnessed multiple changes. Earlier being it was highlighted that the company was using simple machinery and there is lot of work been carried out manually, thus, the company has to incur more of the labor cost in producing the cakes. But with the passage of time, the things have changed and the company has now started using computer-controlled mixing machines and ovens which replaced a lot of direct labor operations, and now more emphasis has been placed on quality and delivery performance. Thus as result of these changes cost structure of the company moved from more of the labor cost towards overhead costs. The cost structure which was earlier being concentrated more towards and has a high percentage of labor cost has now moved towards overheads cost which includes depreciation, maintenance cost of the machinery etc. In the traditi onal cost structure the proportion of the fixed cost was relatively high. This was majorly on account of the high labor cost the company use to incur. Similar is the case with Cravings for Cakes Pty Ltd, looking at the business model of the company, the management must have hired more permanent staff with itself keeping the fixed cost as high. But with the passage of time and the automation that has taken place in the company, the same fixed cost has decreased. The main reason for the changes that has been taken place is mainly because of the automation that has been witnessed in the entire industry. This has resulted in reducing of the manual process and ultimately the labor hours and its associated cost has reduced in multiple folds. At the same time, being the cost has reduced but at the same time the cost related to asset maintenance, depreciation etc has increased. Although the increment in the cost is not as much as the decrease that we have witnessed in the labor cost. But with the all these process, the competition has increased in the market. Thus, in order to survive in the market one has to make their prices more competitive than its competitor. This has a direct impact on the sales prices and one has to reduce the same to survive in the industry. Thus, overall, the cost that one has saved in the first process has been occupied by the decrease that he has witnessed in the sales prices on account of growing competition. Another ma in reason behind the change in the cost structure is the changes that we have witnessed in the traditional and the modern cost theory. 2.Understatement and Overstatement of cost The company has been working since last 20 years. Earlier the company has been using the traditional costing method under which they were manufacturing a wide range of delicious cakes and pastries. The company was able to survive in that market at times when they were engaged only in the production of cakes and pastries but at soon as the company went into the automation phase where they started using computer-controlled mixing machines and ovens which replaced a lot of direct labor operations, and started emphasizing more on quality and delivery performance, there profit declined and they started facing troubles relating to their survival. Being the automation that has been carried out is done with an intention to reduce cost and dependence on the fixed cost but it has worked other way round for the company. This shows that the modern costing theory that has been placed by the management has made the cost structure correct which was not well effective in the past. This shows that th e cost structure that was there in the past for the company was not correct and the cost was understated. Thus through the modern costing technique, the management came to know about the understatement cost and when they correct that the profit got reduced. This has majorly impacted the fixed cost of the company as result; the management of the company has asked the employees to work on increasing the sales volume of the company. Thus considering the above logic, it has been proved that the existing cost system has understated the cost of the finished goods that has been produced by the company. 3.Activity Based Costing Under the activity based costing the cost is allocated based on the different activities that have been carried out in the organization based on the actual consumption that has taken place in each activity. With the help of activity based costing, the activities in the organization is identified ad cost has bee allocated to each activity based on the actual consumption that has taken place in each activity. Through the help of activity based costing, a company can estimate the cost of the products, activities and services. This will help the company in decision making in relation to the products whether they wanted to continue with the existing products or any changes are required to be made in the product structure. Through the help of activity based costing, the company can determine the products which are relatively over priced and the management can work o reducing their cost so as to make the product more competitive in the market. This process cab further help in identifying ad eliminating the production processes that are ineffective in nature ad at the same time we cab determine the production process that are more effective considering the nature of business that has been carried out by the company. Through the help of activity based costing, one can better understand the product, customer cost and the profitability of the production processes. Traditionally the overhead cost has been allocated to the products based on the machine hours that have been spent on manufacturing the product. In the ABC costing technique the cost is first been allocated to the activities that have caused the overhead to happen for the product and then once the cost has been allocated to the activities, they are further been added to the product who actually depends on the activities. The difference between the two methods can be well understood with the help of an example. For example: A company manufactures two products. The first product a low volume item and the company required additional testing and some special engineering along with some machine hours set up to make the product. On the other hand, the second product is required in high volume. Being the product has been manufactured continuously, it requires less attention and no additional special activity is required. Now, in this case, if the company is using the traditional method of a llocating the overhead cost based on the machine hours, then very little cost will be allocated to the first product being the same was manufactured on lower quantity. On the other hand, high overhead cost will be allocated to the second product being the same has been manufactured in large quantity although in reality less overhead has been spent on the product. Thus through the help of the traditional costing technique the cost that has been determined for both the products are not correct and the results are misleading. This shortcoming of the traditional method can be overcome by the Activity base costing where the overhead cost are allocated based on more than one activity other than the machine hours. In case of the given company, the company has been engaged in manufacturing many different varieties of pies, finger buns and lamingtons. Currently, the company along with its ongoing products has started the manufacturing of Danish pastries, donuts and vanilla slices. Looking at the overall picture, being the company has been dealing in different product now, there seems like the overhead cost hasnt been allocated adequately among the different products that has been manufactured by the company, Through Activity base costing, the management of the company would be able to determine the product among the ones they are manufacturing whether the same is giving them an adequate amount of profit or not. Through this process they can work out whether to close the production of the products which are giving them limited or no profit. The correct allocation of the overhead amount will reduce unnecessary pressure from the products of the company and the management can realize the products fo r whom they are likely to concentrate in future in increasing the production. Being currently the management has no view as result before working out the correct product, they have just asked the employees to increase the production without realizing an determining the correct product which they should concentrate on. The management has asked the employees to work on increasing the sales of high margin products, but without adequate allocation of the overhead, the correct margin of the goods cannot be determined making the entire difference for the company and making things worse for the employees. The major difference that has been made in the last 20 years is the overhead allocation. It has been specified that the later products like Danish pastries, donuts and vanilla slices are being manufactured by the company in low volume but these are high margin goods. This shows that the overhead cost allocation is not consistent and this the major deficiency in the cost structure and theory adopted by Cravings for Cakes Pty Ltd. 4.Factors required to decide for Activity based Costing In order to adopt Activity based Costing, management is required to consider certain factors. In order to adopt activity based costing, it is important for one to understand the different business activity. Though the help of these business activities the cost can be assigned and from these activities, ultimately the cost is transferred towards the products where the activities are related to. In the modern world, the management of the company has placed more emphasis on these costing theories being the same has helped the management in better decision making. There are certain factors that need to be focused in by the management of Cravings for Cakes Pty Ltd for adoption of Activity based costing. One of them is the determination of the critical activities of the company. In activity based costing the cost is allocated based on the different activities that have been carried out in the organization based on the actual consumption that has taken place in each activity. With the help of activity based costing, the activities in the organization are identified and cost has been allocated to each activity based on the actual consumption that has taken place in each activity. Thus, the first factor that needs to be considered by the management is the adequate determination of the activities for the business. The next factor is understanding the importance of ABC costing techniques for decision making purposes. Ursula B. Bright should determine whether the traditional costing method that they are using is able to provide them sufficient informa tion which is required for making adequate decisions in the business especially those related to the products. This factor will force the management of the company to go for ABC costing techniques. By looking at the current financial position of the company, it does not looks that the company is in a goo state. The management has already highlighted to the employees to work on increasing the production as it has become difficult for the company to continue in the current state, this shows the decision making of the company is not in a good state and the company is suffering and required some adequate base on which the management can rely for adequate decision making. The next major factor for the company is determination of sufficient of cost distortion. For an organization to adopt ABC costing there should be high potential for cost distortion. The cost distortions tend to impact the decision making of the company specially those related to the profitability analysis. In order to a dopt ABC costing technique, the management of the company is required to put proper attention to it. In order to ensure this, the management of the company is required to adopt adequate information system in the organization. Thu, the ABC costing technique requires considerable time and effort from the management and that can be done only when the management has sufficient time for ABC. Further, the size of the company is also an important factor that needs to be kept in mind at times of adopting ABC technique. For the ABC technique to be effective, the sales of the company are required to be between the ranges of $100 million to $500 million. Further ABC costing generally takes longer time to implement being the outcome of the same is being used for decision making. Thus, time is the major factor in determining whether the company should go for the ABC costing or not. Conclusion The Cravings for Cakes Pty Ltd was engaged in the business of manufacturing a wide range of delicious cakes and pastries. Because of the traditional costing technique the management of the company was unable to allocate the correct cost among its products. In this case, the management should get for ABC costing technique. With the help of activity based costing, the activities in the organization is identified ad cost has been allocated to each activity based on the actual consumption that has taken place in each activity. Through the help of activity based costing, a company can estimate the cost of the products, activities and services. This will help the company in decision making in relation to the products whether they wanted to continue with the existing products or any changes are required to be made in the product structure. The company will be able to determine the accurate cost for the products and this will help them in adequate decision making. References Accounting coach.com, Activity Based Costing, viewed on 7th May 2017, Retrieved from https://www.accountingcoach.com/activity-based-costing/explanation Ibrahim D, 2017, Factors influencing Activity Based Costing adoption in the manufacturing industry, viewed on 7th May 2017, Retrieved from https://businessperspectives.org/media/zoo/applications/publishing/templates/article/assets/js/pdfjs/web/viewer.php?file=/pdfproxy.php?item_id:1485 Reference for Business.com, Activity Based costing, viewed on 7th May 2017, retrieved from https://www.referenceforbusiness.com/small/A-Bo/Activity-Based-Costing.html Isa C, 2010, Factors Influencing Activity-Based Costing Success: A Research Framework, viewed on 7th May 2017, Retrieved from https://www.ijtef.org/papers/26-C130.pdf Krumwiede, K. R. 1998. ABC: Why it's tried and how it succeeds. Management Accounting (April): 32-34, 36, 38. https://maaw.info/ArticleSummaries/ArtSumKrumwiede98.htm Wright T, 2017, What Types of Businesses Do Activity-Based Costing?, viewed on 7th May 2017, Retrieved from https://yourbusiness.azcentral.com/types-businesses-activitybased-costing-28437.html