The Purpose and Value of FreeAir Skate Pty Ltd - Term Paper Example

Table of Contents Table of Contents 1 Introduction 2 How a management accountant can add value to FreeAir Skate Pty Ltd. 2 Preparation of an Income Statement and Schedule of Cost of Goods Manufactured. 3 Schedule of costs of goods manufactured 5 Determine which expenses are mixed and separate the variable and fixed components to derive a cost formula for each mixed expense 5 Discuss the purpose of ABC. Evaluate whether ABC should be introduced 6 Conclusion 7 References: 8 Appendix 9 Introduction John Eustace who is the owner of FreeAir Skate Pty Ltd thinks that the company does not require a full time accountant due to its small size and wonders what the accountant would be doing after the end year financial statements have been prepared. In addition, he does not understand the financial information that has been provided to him regarding the various costs that the company has incurred in the course of producing and marketing its products. On the other hand, the company’s production manager does not understand how to classify costs into either fixed, variable and mixed costs. In addition, he does not understand what value ABC system would add to the company. As such, this report has been prepared for John Eustace in a bid to convince him why the company needs to have a full time accountant. First, the paper explains the purpose and value that the company would derive from having a management accountant. Secondly, the report presents a schedule of costs of goods manufactured and an income statement as well as an explanation to the manager indicating their use. The paper then identifies the mixed costs and their formula before explaining the purpose of ABC and why the company should consider its implementation. How a management accountant can add value to FreeAir Skate Pty Ltd. In order for the company’s management to always make informed decisions regarding operations, production and investments, the company needs an accountant who will provide the company with decision useful information which would lead to better performance and hence profitability. This is the role of management accountant. The information provided by the management accountant will improve the company’s ability to improve operations as well as profitability. In addition, the company will be able to create a competitive advantage through development of cost allocation processes that leads to more competitive pricing of products (Drucker, 1999). The management accountant will also add value to the company in the following ways. a) Reduced expenses- the management accountant will help the company to lower its operation expenses by providing the management with accounting information that helps in reviewing the cost of economic resources as well as other business operations. The information will allow the management to better understand how much it costs to run the company. Management accountants are also able to conduct analysis on the quality of economic resources the company uses in the production of the skateboards it produces. Thus, if the information shows that quality will not suffer through use of cheaper raw materials, the management will make such changes in a bid to reduce production costs. b) The management accountant will help the firm improve its cashflows through use of budgets which act will act as the company’s roadmap for future business spending. Such budgets are important as they will help the company save money through carefully analyzing the necessary and unnecessary costs (Gary, 2011). The unnecessary costs as avoided while efforts are made to ensure that costs remain within budget. c) The management accountant will help the company with sound business decisions. This is because business decisions will not only be based on qualitative analysis but also on the management accounting information to make better decisions. The information provided by the management accountant will be useful in quantitative analysis for various decisions opportunities. Such information will help the management review all opportunities through the quantitative analysis prism thus ensuring that business decisions are made on the basis of clear decisions. d) Having a management accountant will lead to increased financial returns for the company. The management accountant will help prepare financial forecasts relating to consumer demand, potential sales and the effects that consumer price changes have in the economic market place. The management will use this information in a way that ensures that the company produces enough skateboards to meet consumer demand at competitive prices. As such, the company will realize increased profitability as well as efficiency through having a management accountant in addition to making more informed production, operations and investment decisions for the company which will eventually lead to greater organizational success. Preparation of an Income Statement and Schedule of Cost of Goods Manufactured. FreeAir Skate Pty Ltd Cost of Goods Manufactured Schedule For the Year Ended 30th December 2014 Direct materials used $ Beginning raw materials inventory 300,000 Add: Cost of raw materials purchased 800,000 Total raw materials available 1,100,000 Less: Ending raw materials inventory (50,000) Total raw materials used 1,050,000 Direct labor 400,000 Total direct costs 1,450,000 Manufacturing overheads Indirect labor 200,000 Depreciation –Plant and equipment 90,000 Miscellaneous manufacturing overhead 100,000 Plant supplies used 60,000 Property taxes on plant 10,000 Plant utilities 50,000 Total manufacturing overhead 510,000 Total manufacturing costs 1,960,000 Add: Beginning work-in-process inventory 100,000 Less: Ending work-in-process inventory 80,000 Cost of goods manufactured 2,040,000 FreeAir Skate Pty Ltd Income Statement For the Year Ended 30th December 2014 Revenues $3,500,000 Opening finished goods inventory $400,000 Less cost of goods manufactured $2,040,000 Cost of goods available for sale $2,440,000 Less closing finished goods inventory ($120,000) Cost of goods sold ($2,320,000) Gross income $1,180,000 Less Expenses Retail store utilities $20,000 Depreciation-Retail store equipment $55,000 Miscellaneous retail store overhead $70,000 Marketing, distribution and customer services costs $190,000 Council rates for retail store $3,000 Sales salaries and commissions $350,000 Total expenses $688,000 Net Income $492,000 Explain the purpose of both the Income Statement and Schedule of Cost of Goods Manufactured. Income statement The purpose of income statement is to show how the company performed for the ended period in terms of income. In other words, it shows whether the company’s operations during the year generated a profit or loss. For instance for the period of 2014, the company generated a profit of $492,000 which is a good performance. Schedule of costs of goods manufactured On the other hand, the cost of goods manufactured schedule shows the calculation of the costs incurred in producing the goods during the period under review. It is the cost used in calculating the cost of goods sold after adding opening stock and subtracting closing stock (Johansen, 2011). As can be seen above, the company incurred manufacturing costs amounting to $2,040,000 as can be seen in the schedule above. This is a relatively good figure given that the company generated a profit of $492,000. Determine which expenses are mixed and separate the variable and fixed components to derive a cost formula for each mixed expense Mixed costs are semi variable costs since they have both variable and fixed components. In arriving at mixed costs, I used the high-low method. The formula used in all cases is y= a+bx in which a = fixed cost, b= variable cost per unit and x = number of units. The mixed costs for the company included the following costs; a) Advertising is a mixed cost with a variable portion and a fixed portion. The steps followed in arriving at this decision are shown in the appendix attached. it is given by the following formula; y =32,543.5+ 0.15x It means the company has to pay $32.43 on advertising whether or not it makes sales and $0.15 for every unit sold. b) Insurance is a mixed cost with a variable portion and a fixed portion. The steps followed in arriving at this decision are shown in the appendix attached. it is given by the following formula; y= 1500+0.2x It means that the company has to pay $1500 on insurance whether or not it makes sales and an extra $0.2 per any unit sold. c) Warranties is a mixed cost with a variable portion and a fixed portion. The steps followed in arriving at this decision are shown in the appendix attached. it is given by the following formula; y =210+6.4x It means that the company has to pay $210 on insurance whether or not it makes sales and an extra $6.4 per any unit sold. Discuss the purpose of ABC. Evaluate whether ABC should be introduced ABC or activity based costing is a method of more accurately allocating costs than the traditional absorption costing which uses labor hours, labor dollars or machine hours in allocating overheads. This is because all the activities or processes that are involved in a production process are not necessarily related to direct costs like labor or machine hours. For instance, allocating costs that are related to machine set ups or orders on the basis of labor hours or machine hours may be misleading. A better basis of allocation would be to use number of set ups or number of orders respectively (Jane, 2011). As such, ABC serves the purpose of allocating costs more accurately thus resulting in better priced products and hence more profitability for the company. In other words, ABC assigns manufacturing overhead costs to products more logically than the method the company is currently using (absorption costing) which simply allocates costs on the basis of either machine or labor hours. The system assigns costs to the activities that are the real causes of overheads first before assigning these costs of the activities only to the products that actually use the activities. As such, using ABC will for instance lead to better costing of the three types of skateboards since a product will only be assigned a certain cost if the activities involved in its production use that cost (George, 2001). As such, a type of skateboard that does not require machine setup or instance will not be allocated costs that relate to machine setups which will ensure accurate pricing of products. The new ABC system will add value to the company in a number of ways. As stated above, the system will allow the company have a more accurate costing of the skateboards it produces. This will in turn help the management in knowing the cost that is friendly to the customer as well as the company. This will in turn mean improved sales and hence revenue and thus increased profitability. Using ABC, the management will be able to know which of our three products is most profitable and which one may be operating at a loss (Freedman, 2015). As such, the management will either adjust the product prices accordingly or stop the production of the loss making product while focusing sales efforts on the profitable products thus increasing profits without necessarily increasing prices. In addition, use of ABC will help us determine whether our activity costs are in line with the set standards. If they are not, then the management may want to focus on cost reduction. Using ABC, we can also be able to identify and earmark those business activities that do not add value to the production process and hence are a burden to the business so that we can eliminate them which should lead to more profitability. Despite the above merits of the ABC system, there are some costs involved in its implementation and hence the need to consider them before the decision to implement the system is taken. First, the implementation of the system will entail a huge capital outlay for the company. Furthermore, more running costs will also be incurred in data collection, recording and analysis. This could also be time consuming (Caplan, 2005). It should also be noted that implementing the system will mean running two parallel costing systems since the output of the system can only be used for internal reporting purposes and not for external reporting. In addition, given that there is nobody who is familiar with the system in the company, we will need to undergo extra costs for training the relevant people on how it works for the company to achieve the desired results. Conclusion This report has discussed the value that would accrue from the company having a management accountant. In this regard, it has been reported that the management accountant will help the management with decision useful information thus implying increased efficiency and productivity for the business. It has thus been recommended that the company considers hiring a full time management accountant. In addition, the role of ABC as well as the value it would add to the company has also been discussed. Its ability to result in better costing of products and hence better pricing has been seen as the single most benefit that would accrue from its implementation. Other advantages include elimination of activities that do not add value to the production process and hence profitability. As such, the implementation of the system would lead to increased profitability that would outdo the costs associated with its implementation. Thus, the management has been advised to consider its implementation in the company which would lead to increased profitability for the company and hence future success. References: Jane, M2011, Advantages and disadvantages of activity based costing with reference to economic value addition, Oxford, Oxford University Press. Freedman, J2015, Advantages and disadvantages of activity based costing, Retrieved on 27th April 2015, from; http://yourbusiness.azcentral.com/advantages-disadvantages-activity-based-costing-11280.html Caplan, D2005, Management accounting: Concepts and techniques, London, Rutledge. George, S2001, Activity costing and input-output accounting, New York, Irwin. Drucker, P1999, Management challenges of the 21stcentury, New York, Harper Business. Gary, S2011, Introduction to management accounting, London, Rutledge. Johansen, M2011, Management control systems, New York, John Wiley & Sons. Eddie, M2013, Management accounting for decision makers, Sydney, Prentice Hall. Appendix We can use the High-low method to separate mixed costs as follows; Variable cost per unit is given by y2-y1/x2-x1 Where; y2 = total cost at the highest level of activity y1 = total cost at the lowest level of activity x2 = number of units at the highest level of activity x1 = number of units at the lowest level of activity But mixed cost formula is y= a+bx Where a = fixed element b= Variable element per unit x = number of units Therefore; a) Cost of goods sold = (277,500-76500)/(1850-510) =$150 hence b = 150 Remember mixed cost y=a+bx 277,500 = a+150*1850 which gives b as 277,500 implying that a is zero which shows that this is a variable cost. b) Distribution variable cost =(23,125-6,375)/ (1850-510) = 12.5 23,125=a+12.5*1850 which gives b as 6375 implying that a is zero which shows that this is a variable cost. c) Advertising variable cost = (32821-32620)/(1850-510) = 0.15 32620= a+ 0.15*510 which gives b as 0.15 implying that a is to be given by 32620 =a+ 76.5 hence a= 32,543.5 which implies that this is a mixed cost given by the formula y =32,543.5+ 0.15x d) Insurance variable cost = (1870-1602)-(1850-510) =0.2 1870 = a+0.2*1850 giving b to be 0.2 and hence a is given by 1602 = a+102 meaning a = 1500 which implies that this is a mixed cost given by the formula y= 1500+0.2x e) Warranties = (12050-3474)/(1850-510) = 6.4 3474=a +510*6.4 giving b to be 3260 and hence a is given by 3474 =a+3264 meaning a =210 meaning this is a mixed cost given by the formula y =210+6.4x f) Packaging = (2405-663)/(1850-510) = 1.3 2405= a+ 1850*1.3 or giving b to be 2405 which implies that a is 0 and therefore this is a variable cost. 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