Management Accounting of Scotty Accent Company - Case Study Example

Management Accounting: Case Study Name Institution Course Lecturer Management Accounting: Case Study 1. The modern competitive market environment requires efficient managerial accounting for organizations in ensuring that production costs are correctly allocated to their respective products in optimizing product margins. Accounting for overheads represents an important and technical aspect of accounting for production cost in organizations from a cost control and cost reduction point of view. This is more so considering that overhead costs represent the larger part of production costs compared to direct production costs. Indirect material, labor and operating expenses pose a problem for managers in correct identification and allocation to particular costs centers and products. For correct costing and pricing for products, companies have to strive towards accurate measurement of cost items and allocating costs per unit for specific cost centers or products. Difficulty in correct allocation of unit costs to specific products is further aggravated by the presence of more than one product for an organization. While direct costs can be allocated to specific products, overhead costs are a result of the general operation of the company and as such cannot be easily attributed to specific products’ unit costs through equal allocation (Haider and Shaukat, 2011: 3). Scotty Accents Company sells two types of kitchen tap products, Brass and Chrome, and uses a full-costing traditional approach for its cost management. This approach is considered ineffective where more than one product is produced by a company since the products, though using similar production methods, have different production requirements and impact on the total overhead costs for the company, therefore cannot be allocated equal unit costs. Scotty Accent Company uses an overhead allocation system that assigns the costs in terms of the number of hours used in the production of the two products. Using this method, the two products are allocated overheads using the same cost per hour rate. Under this system, overhead costs are taken as service renderers for the products with product costs being assigned in terms of the number of hours spent on the provision of specific services in production of the products. The accrual concept attempts to improve on the accuracy of cost allocation for overheads by requiring that the costs incurred in production of particular products be accurately measured and assigned to that products in the accounts. The system in use at Scotty Accent falls short of meeting this criterion in terms of allocating machine costs for repairs and maintenance to the Brass and Chrome products while allocating machine hours to their unit costs. This fails to allocate accurately these costs to the products since the costs are not ongoing costs and thus cannot be equally attributed to the machine hours spent in production, but rather should be assigned to specific instances that the repairs were required during production of either product. The allocation of manufacturing overheads other than machine costs has been done based on the proportion machine hours use between the two products and therefore fails to allocate the costs to the specific cost centers for the two products. 1. A more accurate system for assigning overhead costs is Activity-Based Costing, which is more specific in assigning overheads to specific units of product in companies that produce more than one product. Modern management context requires that overheads be accurately assigned for each unit produced. This is necessary to ensure that the true cost of producing every unit of product is correctly identified to avoid masking the actual performance of particular products in enhancing the profitability of the company. This enables managers in making decisions over which products to keep in production and which ones to do away with. The true cost of producing a product should be ascertained so that the company does not hold unprofitable products in its manufacturing line at the expense of more profitable products. ABC method of allocating overheads to multiple products has the advantage of identifying costs of indirect support activities to particular product units through the use of specific overhead cost pools for each activity in the production process (John and Barbara, 2007). Overhead costs for particular support activities are allocated to the relevant cost pool and the total cost obtained for each cost pool assigned to the specific product units according to the relevant cost driver. The controller at the company has proposed an ABC system for the company that assigns overheads to the unit costs for each product based on the main activities involved in the production process of the Brass and Chrome products separately. The proposed system would allocate overhead costs according to the main activities for soldering, machine power, machine setups and quality control involved in the production of the two products. The overheads would also be assigned to the cost per unit for shipment and purchase orders. For these activity centers, cost drivers have been selected, which are number of soldering points, number of inspections, machine hours, number of setups, number of shipments and number of orders respectively. Adoption of the ABC system in the cost management for the products would enable management decisions on whether to face out the brass product in favour of the chrome product through a more accurate allocation of unit costs for each. The system would identify the product that needs improvement in terms of cost efficiency and would enable correct pricing for the products, which would improve the company’s profitability. ABC costing for overheads enables a company to understand the industry sector it operates in and in efficiently controlling the production system through consideration of more appropriate production methods and new processes that would lower cost of production and improve profitability. 2. The calculations below are used to obtain the unit cost, gross margin and gross margin percentage for the individual products under the ABC costing system. Cost per unit = cost allocation base units in each activity × total activity center costs Total units for each activity center Activity Base Cost per activity Brass Chrome Soldering 1,185,000 x 23,550 385,000 x 23,550 1,570,000 1,570,000 = 17,775 = 5,775 Shipments 16,200 x 21,500 3,800 x 21,500 20,000 20,000 = 17,415 = 4,085 Quantity Control 56,000 x 31,000 21,300 x 31,000 77,500 77,500 = 22,480 = 8,520 Purchase orders 80,100 x 23,760 109, 980 x 23,760 190,080 190,080 = 10,012.50 = 13,747.50 Machine Power 176,000 x 1,440 16,000 x 1,440 192,000 192,000 = 1,320 = 120 Machine Setups 16,000 x 18,750 14,000 x 18,750 30,000 30,000 =10,000 = 8,750 Total costs per product: = 79,002.5 = 40,997.5 The income statement would thus be: Brass Chrome Total Revenues 495,000 114,000 609,000 Cost of products sold 79,000 40,998 120,000 Gross margin 416,000 73,002 489,002 Selling and admin expenses 145,750 24,450 170,200 Operating income 270,250 48,552 318,802 Net income per unit = 270,250 = 12.28 = 48,552 = 12.14 22,000 4,000 Unit cost per product: = 79,002.5 = 3.59 = 40,997.5 = 10.24 22,000 4,000 Gross Margin = Selling Price – Unit Cost Selling price: Brass; $22.50 per unit, Chrome; $28.50 per unit Gross Margin = Selling Price – Unit Cost Brass; = $22.50 – 12.28 = 10.22 Chrome; = $28.50 – 12.14 = 16.36 Gross Margin % = Gross Margin x 100 Unit Cost Brass; = 10.22× 100 = 284.68% 3.59 Chrome; = 16.36 × 100 = 159.77% 10.24 3. The calculations above indicate that the full-costing system used by the company does not bring out the true costs, and consequently profit margins, for the two products. The system had assigned excessive costs to the production of the two products, therefore masking the profitability of the two products and resulting to an income statement that understated the profits accruing to the company. The company should continue production of the two products since they both indicate towards high profitability for the company. The brass model is more profitable than the chrome product. Therefore, none of the products should be faced out. 4. The concerns raised by the division president over the adoption of the ABC costing system are flawed and not based on management accounting principles. Her concern does not reflect the interests of the company and her rejection of the ABC system show that she is more concerned with her personal interests than profitability for the company. The use of machine hours for allocating machine setup and quality control overheads would be inaccurate compared to the ABC system. The suggestion to change the figures for chrome to favor the product over brass should a lack of professionalism required for managers and would be fraudulent misrepresentation of financial information for the company. 5. The controller should approach the division president with the completed ABC system for the manufacturing division showing the difference in results obtained from using the ABC system. The controller should consider referring the matter to a higher authority than the division president in the company should the division president fails in understanding the need to adopt a better accounting system for manufacturing overheads. 6. Haider, S., Ali, M. and Shaukat, M. (2011), “Strategic Management Accounting – A messiah for Management Accounting”, Australian Journal of Business and Management Research, Vol.1, No.4, 1-7, Sydney, Australia: The article in this journal discusses contemporary trends in the managerial accounting systems adopted for the modern competitive market environment. The journal details several traditional and modern accounting systems for overheads and outlines the advantages and disadvantages of using each of these methods for accounting for indirect costs. This reference would be useful to the two professionals in defining the shortcomings of the current full-costing method in use by the company. John, J. W., Barbara, C. (2007) “Cost Allocation and Activity-Based Costing Systems”, in Management Accounting, Information and Decisions. Boston: Irwin/McGraw-Hill. This article outlines the methodology and benefits of using the ABC system over other accounting systems for overheads. The article outlines the steps involved in using the sustem for multiple products costing with examples. The article would be important for outlining the need for the adoption of this system in the company and for demonstrating how the ABC system could be applied in accounting for overheads for the two products in the company. References Haider, S., Ali, M. and Shaukat, M. (2011), “Strategic Management Accounting – A messiah for Management Accounting”, Australian Journal of Business and Management Research, Vol.1, No.4, 1-7, Sydney, Australia: Australian Institute of Chartered Accountants John, J. W. and Barbara, C. (2007) “Cost Allocation and Activity-Based Costing Systems”, in Management Accounting, Information and Decisions. Boston, Massachusetts: Irwin/McGraw-Hill. Read More