SOLA SYSTEMS, Costing SystemProduct cost under current accounting systemUnder the current accounting system the cost breakdown of each panel is given in the (Exhibit 1). The cost allocation system being followed at Sola system is such that it allocates the factory or production cost on the direct labor hour and other period costs such as warehousing, distribution, marketing and administration cost are based on the dollar sales revenues. Total cost as the percentage of sales is less for Panel A and greater for Panel B. Profit & Loss Statement for Products under Current Accounting SystemThe profit and loss statement under the current accounting system is given in (Exhibit 2).
The Revenues and net profit figures are greater for panel B but when rate of return is examined then it becomes clear that performance of product A is much better than the Panel B. Rate of return calculated as the profit divided by the cost is 51% for panel A and 38% for panel B under the current accounting system. Profit & Loss Statement for Region under Current Accounting SystemThe profit and loss statement for Regions under the current accounting system is given in the (Exhibit 4) similarly the cost breakdown of each region is also provided in (Exhibit 3).
We can see that Southern region is more profitable than the northern region primarily because the sales revenue is much larger in southern region almost 300% more than the northern region. Rate of return for southern region is 76% whereas the rate of return for northern region is in negative and is -12%. This differential in the rate of return for the two regions is arising because of the cost allocation system that is implemented in the Sola system, which distributes cost unequally. Higher Profit Rates for Panel A over Panel BAnalyzing the exhibits 1 and 2 would reveal us that Panel A has higher profit returns than the panel B but this analysis without taking into account the cost allocation system being followed at Sola Systems would lead us to wrong decision making regarding the products.
So it is critically important to analyze the current accounting system and evaluate whether this system is erroneous or giving correct results.
Current system allocates the period costs based on the sales revenues each product is generating therefore the product which has higher sales revenues either because of higher price or higher volume will tend to receive more cost allocation. Making such a system without analyzing the cost drivers properly could prove fatal for the products in terns of wrong decisions. Panel A has been giving more profit returns mainly because of the poor cost allocation basis and inadequate cost driver identification. The period cost which makes more than 50 % of the total product cost is allocated on the sales revenue basis thus inviting trouble.
For instance, if Product A requires more price tagging, packing and marketing effort, thus incurring more cost will eventually share less of this cost as some of the cost burden would be borne by the Panel B because it has higher sales revenues.