Importance of Cost Allocation Methods in Decision Making for Beztec Limited

This study analyzes the importance of cost allocation methods for Beztec Limited, with a focus on traditional and activity based costing. It includes an analysis of cost data for the company and recommendations for the accountant, Sue Smith. The study also covers the treatment of under-over recovery of overheads and its impact on decision making.

Introduction to Management Accounting
1

Executive Summary
The following study contains a detailed analysis on the various types of cost allocation
method. It also contains information on importance of choosing the collection costing method
for an organisation. There are recommendations made in order to help an accountant with the
decisions making function.
2

Contents
Executive Summary...................................................................................................................2
Introduction................................................................................................................................4
Traditional system of costing and its disadvantages..................................................................5
Activity based costing................................................................................................................6
Importance of using correct costing method..............................................................................7
Analysis of cost data of Beztec Limited....................................................................................8
Recommendation for Sue Smith..............................................................................................11
Analysis of gross profit margin of the company......................................................................12
Treatment of under-over recovery of overheads......................................................................13
Recommendation and conclusion............................................................................................14
Bibliography.............................................................................................................................15
3

Introduction
The management of an organisation is entrusted with the one of the most important parts of
decision making which is product costing. Determining the cost of a product is one of the
most complicated tasks. It is important that decision be taken taking into considerations all
the factors. Taking a wrong step might end up affecting the financial viability of the whole
organisation. (Atkinson, 2012)
The company, Beztec limited produce two models of printers, Lexon and Protox. The
management of the company is looking forward to phase out the older model, Lexon, based
on the fact that it has lower operating returns. The accountant Sue Smith is of the view that,
use of inappropriate costing methods has lead to these results. If the company will opt for
change in cost allocation methods, then it would help the management take correct measures.
In the following report we have discussed about two methods of cost allocation, and why it is
important to have proper allocation method. Also, we have laid down facts which will help
the management to take correct decisions.
4

Traditional system of costing and its disadvantages
The traditional system of costing is the method of cost allocation amongst the products, in
which a pre determined cost rate is allocated in between the various products based on a
certain factor such as machine hours or labour hours (Berry, 2009). The joint costs which are
incurred for various products are required to be allocated so that unit cost of different
products can be identified.
This system is old and classified as traditional, as this system fails to incorporate importance
of actual use of resources. The traditional system of cost allocation is more appropriate in
firms which have one product and simplified production process with few activities (Boyd,
2013). The modern production processes involve complex process, more products and
various activities. Due to the complexities of the nature of production it is important that the
cost is allocated properly in order to ensure correct costing of the product.
This system of cost allocation shifts the burden of overhead costs from one product to another
(Dash, 2016). The distribution of cost cannot be done evenly amongst the entire product as
they use different amount of resources. This leads to improper cost allocation and costing of
the product. This underpriceds some product and over prices the other (Datar M. S., 2015).
Due to these disadvantages the modern production facilities opt for modern, activity based
costing. Since Beztec Ltd has two products which involve use of common activities, it is
important that cost of these activities is allocated as per actual consumption in order to
calculate the correct cost of the products.
5

Activity based costing
Activity based costing is the modern form of cost allocation, which has been made keeping in
mind the problems generated by the old traditional costing system (Datar S. , 2016). Under
this system of cost allocation, thorough collection and analysis of cost data is done. Amounts
incurred on various activities are recorded along with the units of these activities consumed
by each different type of product. Using this data collected, cost per each unit of activity
consumed is calculated. Based on this rate per activity, the cost is allocated amongst various
products (Holtzman, 2013).
This system of cost allocation ensures that the cost is allocated to the product only is it has
utilised that function and only to the extent till it has been consumed (Horngren, 2012).
Therefore, this leads to correct costing of the product. The management can totally rely on
the cost calculated based on activity based costing.
6

Importance of using correct costing method
It is important that the companies choose correct cost allocation method in order to ensure
correct decision making (Seal, 2012). Let us take the current case for example. In the given
scenario the management wants to phase out one line of product, as it thinks that it generates
mow operating income. But if we look at the data and use it appropriately we will have
opposite results.
Implementation of correct cost allocation method is very important. The decision made by the
management is based on the financial data. If this data is not properly arranged, then
management might end up taking improper decisions which will affect the future of the
company (Siciliano, 2015). Taking wrong decision might also lead to collapse of company in
near future.
7

Analysis of cost data of Beztec Limited
We have been provided with the existing income statement of the company which is as
follows:
Beztec Limited
Income statement for the financial year ended 31December 2017
Lexon Protox Total
Revenues $23 760 000 $7524 000 $31 284 000
Cost of goods sold 15 048 000 5 266 800 20 314 800
Gross margin 8 712 000 2 257 200 10 969 200
Selling and administrative
expense
6 996 000 1 613 700 8 609 700
Operating income $1 716 000 $643 500 $2 359 500
Units produced and sold 24 000 6 000
Operating income per unit sold $71.50 $107.25
From the above we can see that the operating incomes of the products are $ 71.50 per unit
and $107.25 per unit for Lexon and Protox model respectively. The management has based
their decision of phasing out the production of Lexon suing this data.
In order to evaluate the validity of decision of the management’s decision we need to
calculate the operating income from the products if activity based costing was being used.
We have used further information collected about the various activities consumed and
calculated the activity rate per unit consumed:
Activity-cost-driver quantities
Activity-cost driver (driver
quantity) Lexon Protox Total
Soldering (number of solder
points)
13,33,125 4,33,125 17,66,250
Shipments (number of
shipments)
18,225 4,275 22,500
Quality control (number of 63,225 23,963 87,188
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inspections)
Purchase orders (number of
orders)
90,113 1,23,727 2,13,840
Machine power (machine-hours) 1,98,000 18,000 2,16,000
Machine set-ups (number of set-
ups)
18,000 15,750 33,750
Calculation of activity rate
Activity-cost driver
Total activity
costs
Total Number of
Activities
Rate per
unit
Soldering 11,65,725 17,66,250 0.66
Shipments 10,64,250 22,500 47.30
Quality control 15,34,500 87,188 17.60
Purchase orders 11,76,120 2,13,840 5.50
Machine power 71,280 2,16,000 0.33
Machine set-ups 9,28,125 33,750 27.50
Using this rate per activity unit, we have calculated the cost of activities which have actually
been consumed by both the products:
Allocation of Activity Cost
Activity-cost
driver
Lexon-
Activity
Lexon -
Amount
Protox-
Activity
Protox-
Amount
Soldering 13,33,125 8,79,862.50 4,33,125 2,85,862.50
Shipments 18,225 8,62,042.50 4,275 2,02,207.50
Quality control 63,225 11,12,753.62 23,963 4,21,746.38
Purchase orders 90,113 4,95,621.50 1,23,727 6,80,498.50
Machine power 1,98,000 65,340.00 18,000 5,940.00
Machine set-ups 18,000 4,95,000.00 15,750 4,33,125.00
Total 39,10,620.12 20,29,379.88
Therefore we see the amounts of actual costs which consumed by both the products. The
overhead cost which was allocated to Lexon under traditional costing is higher than what it
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has actually consumed, and that for Protox has been charged lower. Because of this
allocation, the operating incomes form Lexon have declined and that form Protox have
increased.
Using this cost allocation rate we have recalculated the operating income per unit from both
the products:
Beztec Limited
Income statement for the financial year ended 31December 2017
Lexon Protox Total
Revenues 237,60,000 75,24,000 312,84,000
Cost of goods sold 136,78,620 66,36,180 203,14,800
Gross margin 100,81,380 8,87,820 109,69,200
Selling and administrative expense 69,96,000 16,13,700 86,09,700
Operating income 30,85,380 -7,25,880 23,59,500
Units produced and sold 24,000 6,000
Operating income per unit sold 129 -121
Therefore we see that the operating income per unit of Lexon is $129 per unit and that form
Protox is $(121) per unit sold, whereas under the traditional system of cost allocation they
were $71.50 and $107.25 respectively.
If the management would have phased out the production of Lexon based on the original
income stamen, then it would have resulted in operating losses for the company, which would
have lead to its downfall.
10

Recommendation for Sue Smith
Smith is the accountant for Beztec Limited and it is her responsibility to make sure that the
financial data show true and correct view. It is her responsibility to ensure that the record
show the true nature of the transactions and the true position of the financials of the company.
Smith is of the view that activity based costing will ensure correct decision making by the
management, but because of the CEO’s personal interest she was forced to implement
traditional costing.
As the accountant of the company it is her responsibility to conduct her duties wills
professionalism (Taillard, 2013). She is responsible to conduct her duties in honest way in
order to ensure heath of the company. She is to conduct her work with total integrity and
objectivity wit professional competence and due care (White, 2009). The decision made by
the CEO, Steven Kay, to still carry the cost allocation based on traditional costing involves a
personal interest. Since his bonuses are dependent on the revenue of various divisions, Kay
wants to ensure that none of the divisions are phased out. Steven has a personal interest in
continuance of the division which has made his opinion biased.
Being the employ of the company it is smith’s responsibility to do correct by the company.
Taking a step in order to secure a financial benefit for the benefit of the CEO is ethically
wrong. The principles of ethic for the accountants also lay out that it is accountant’s duty out
there work with integrity and honesty.
Therefore we would suggest Sue to lay forward the results of both the cost allocation to the
management and the CEO and explain to them about both the results.
11

Analysis of gross profit margin of the company
We have calculated the gross profit margin of the company when it was using traditional
method and when it was using activity based costing, and we have the following data:
Gross Profit analysis
Gross profit margin under traditional costing 36.67 30.00
Gross profit margin under Activity Based costing 42.43 11.80
Therefore, form the above we can see that the gross profit margin for Lexon was 36.67%
under traditional costing method, but it raised to 42.43% under the activity based costing.
Similarly, under traditional method the gross margin for Protox was 30%, but under activity
based costing it reduced to 11.80%. This change in the gross margins for both the product
was result of change in allocation of overhead costs. Therefore, we see that how cost
allocation methods can affect the decision making function of the management.
12

Treatment of under-over recovery of overheads
Under the traditional costing method the cost allocated to the products are not based on actual
amount expensed but on some pre allocated overhead rate (McLaney & Adril, 2016). Since
the amounts recovered from the customers are based on some pre-determined rate, there
stands a difference in the books for the amount recovered and actually expended.
When the amount recovered is lower than what has been spent, there in under recovery of
overheads and when the amount recovered from the customers is more than the amount spent
it is the case of over recovery of overheads. This difference is to be treated in the books of
accounts to show the correct position. This treatment can be done in various days which have
been listed below:
- Carrying forward the amount of under-over recovery in the books to the next year-
the amount of under recovered or over recovered amount in the books is carried forward
as balance to the next financial year in which it is existed to the cost of units produced in
that year. This system of accounting for adjustment is not very appropriate as it affects
the cost of units of the next year. This leads to improper costing of the units. The expense
incurred in a current year should be accounted for in the same period in order to ensure
correct collection of data (Menifield, 2014).
- Adjustments of the over-under recovered amount in the remaining units – the
amount of under-over recovered costs are distributed amongst the units which are not yet
disposed and still in stock. This system is not appropriate as under this system the cost of
units differ in the same year. This results in different pricing of the product in the same
financial year. It is difficult to account for and also to implement. This is the least likely
used methods of cost adjustment in the books (Noreen, 2015).
- Writing off the over-under recovered amount in the profit and loss statement of the
same year- the amount which is to be adjusted in the books of accounts are directly
written off in the profit and loss stamen of the same year. This method helps in arriving at
the correct profit and loss for the current year. The adjustments for year are made in the
same year. This method is easy to implement and is most widely used by the companies
which follow the traditional system of cost allocation (Piper, 2015).
Therefore, we see that the companies may opt for any of the methods which are best suitable
to them.
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14

Recommendation and conclusion
From our discussion above, we see that it is important that the managements choose a proper
system of cost allocation in order to ensure corrected decision making. The decision of the
management should be based on correct data. The management should take into
consideration data from both the alternatives in order to make the correct decision. These
decisions should be taken keeping in the mind the best interest of the company and not self.
Therefore we would recommend the management to go with the application of activity based
costing and phase out the production of Protox models as it would result in operating losses
for the company.
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Bibliography
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