Introduction to Management Accounting

This report discusses cost allocation, traditional costing, activity based costing, ethical dilemmas, and their effects on profitability. It also includes a case study on Beztec Limited and their decision to continue with a new product. The report emphasizes the importance of using correct costing methods for accurate decision making. Course code, course name, and college/university are not mentioned.

Introduction to Management Accounting
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Executive Summary
The report below discusses the basis of cost allocation by concerns engaged in production.
The cost allocation process depends on the complexity of the production process and also the
number of divisions. In order to ensure correct data is used by the management for decision
making, proper cost allocation techniques should be applied.
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Contents
Introduction...........................................................................................................................................4
Importance of use of correct manner of costing.....................................................................................5
Tradition costing and its disadvantages.................................................................................................6
Activity based costing...........................................................................................................................7
Ethical dilemma in change of costing methods......................................................................................9
Effect of costing method on profitability.............................................................................................10
Under and over recovery of overheads and there treatment.................................................................12
Conclusion and Recommendation.......................................................................................................14
Bibliography........................................................................................................................................15
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Introduction
In a production facility, it is important that all cost are collected appropriately and allocated
amongst the products in order to ensure correct pricing of the product (Holtzman, 2013). The
costing data helps the management take important decisions, regarding the operations of the
business. Beztec Limited had two major products, Lexon and Protox. Lexon is an old product
and Protox in the newly introduced model. The management is in a fix about the decision of
whether they should continue with the new model or not. It is important that the profitability
of the product be checked in order to take the appropriate decision. Using a correct costing
system is important so that correct profitability can be determined (Horngren, 2012).
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Importance of use of correct manner of costing
The costs which are directly related to the particular product are wholly allocated to that
particular product. There are other costs also, which are incurred jointly (Menifield, 2014).
These joint costs are required to be allocated amongst the product so that total cost the
product can be determined. This allocation of overhead cost needs to be done using an
appropriate allocation rate. It is important that the allocation rate determined is based on
actual consumption and use of resources. If improper allocation rate is applied to the products
then it results in wrong decision making by the management (Atkinson, 2012). This leads to
wrong pricing of the product, which results in wrong profitability. When the company is
unable to rely on its costs data then it becomes difficult to take any decisions. Therefore, it is
important that correct allocation methods is applied in order to allocate the costs.
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Tradition costing and its disadvantages
Traditional costing is the costing system which uses one single overhead rate in order to
allocate the joint products. In this system the costs are allocated amongst various products
based on single attribute or cost driver (Berry, 2009). This method fails to incorporate the
concept of actual consumption of resources while allocating the cost. This leads to improper
cost allocation. Even if the services used by a product are very less, a large portion of costs
can be allocated (Noreen, 2015). This increases the cost of the product, which increases the
selling price. When the customer finds the same product from other manufacturer at cheaper
rate, they would definitely go for it. This affects the demands. Therefore we see that
traditional costing can be wrong to be implemented in some cases. Where there are various
costs and various products using one cost attribute to allocate cost, it will lead to wrong
results (Boyd, 2013). The main disadvantages of traditional costing include improper
allocation, ignorance of actual consumption and use of improper data for cost allocation.
In the given scenario we see that production overhead is allocated amongst the product using
the rate of $27.50 per machine hour used. But when we see the table for consumption of the
activity, we see that the activities are not evenly used by both the projects, some activities are
used more than the other by all the products. Distribution of production overheads based on
one overhead rate has resulted in shift of the major expense to the Lexon model. Therefore,
we see that traditional costing can result in improper accounting of cost data (Raun, 1962).
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Activity based costing
Activity based costing is the improved cost allocation methods which allocates the cost
incurred on various activities based on actual usage of these activities (White, 2009).
Implementation of these methods will help in calculation of true cost and profitability of the
products.
Using the data provided on various cost drivers we have calculated the rate per cost driver.
The following table shows the rate per activity:
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
If we allocate this cost based on the actual consumption of activities we get the following cost
data:
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
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The total cost of the product will now be changed:
Total Cost under Activity Based Costing
Costs Lexon Protox
Total Per unit Total Per unit
Direct materials 54,91,200 229 38,54,400 642
Direct production labour 4,75,200 20 2,77,200 46
Machine 38,01,600 158 4,75,200 79
Total direct 97,68,000 407 46,06,800 768
Production overhead 39,10,620 163 20,29,380 338
Total cost of goods sold 136,78,620 570 66,36,180 1,106
Therefore we see that under traditional costing system the production overhead which was
charged to Lexon was $52, 80,000 and that to Protox was $6, 60,000, has now become
$3910620 and $ 2029380. The overhead which was not even consumed by the Lexon models
was also allocated to it. This resulted in lower profitability form Lexon, and higher
profitability form Protox model, when it was incurring losses.
The actual allocation showed that the new introduces model Protox resulted in loss for the
company for $725800.
Therefore, using activity based costing will result in accurate a proper data for cost allocation.
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Ethical dilemma in change of costing methods
In the given scenario we see that the CEO of the company Beztec Ltd, Steven Kay, is not
convinced that the activity based costing should be implemented. It is important that
decisions like these be taken based on the advantage of company and not for individual
advantage for the management.
Being an accountant it is important that Sue Smith carry professionalism and integrity in her
work. The APES 110 Code of ethics for professional accountant lay down that the work
conducted by the professional accountants should be carried with professional competence
and due care. She should also use professional scepticism in her work (Cochran, 2017). Her
understanding of applicability of Activity based costing is correct and she should continue
with it (Datar M. S., 2015).
Not reporting the overheads as per activity based costing will lead to projection that the
product Protox is profitable to the company, when in actual they line of Protox models have
been resulting in losses.
The management is likely to phase out the line with losses. But the CEO does not want Sue to
implement the activity based costing as it will phase out this line. The CEO has a personal
interest in the running of the segment of the Protox model. His bonus is dependent on the
revenues of the different divisions. Due to indulgence of his personal interest the decision
made by Kay becomes biased. The decision to report the numbers based on activity based
costing should be taken after taking into consideration the advantages it will generate to the
company (Siciliano, 2015).
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Effect of costing method on profitability
The methods of costing opted by the management will not affect the overall profitability of
the company, but it will affect the profitability at division or product level (Datar S. , 2016).
Since the total cost remains same and only the allocation rate changes under the different
methods, the profit under various divisions are changed (Seal, 2012). The profitability of
Beztec Ltd was as follows when traditional method of cost allocation was being
implemented:
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 150,48,000 52,66,800 203,14,800
Gross margin 87,12,000 22,57,200 109,69,200
Selling and administrative
expense
69,96,000 16,13,700 86,09,700
Operating income 17,16,000 6,43,500 23,59,500
Units produced and sold 24,000 6,000
Operating income per unit sold 72 107
After the application of the activity based costing the profit stamen was changed and looked
like under:
Beztec Limited
Income statement for the financial year ended 31December 2017 (Under ABC)
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
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We have calculated the gross profit percentages of the products under both the methods and
we have the following:
Gross Profit analysis
Gross profit margin under tradition costing 36.6
7 30.00
Gross profit margin under Activity Based costing 42.4
3 11.80
Therefore from the above data we can see that the gross profit form Lexon models was
36.67% under traditional costing methods but under activity based costing it increased to
42.43%. The gross profit margin for Protox under traditional method was 30% but under
Activity based methods the gross profit margin declined to 11.80%. This shift of margins
amongst the product line was witnessed due to wrong allocation of overheads.
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Under and over recovery of overheads and there treatment
Under the traditional costing system the overhead allocated to the product are based on some
pre determine overhead rate, even before knowing how much expense are to be incurred. The
management budgets some expense in order to forecast the expense that could incur. Based
on the budgeted units that are expected to be produced and sold, the management divides
these expenses amongst these units. This is how a pre determined rate is calculated
(Strathern, 2010). There is a difference between pre determined and actual overhead rate. The
difference between these amounts is required to be adjusted in the books.
For example, the management expects that total $50000 would be incurred for overhead for
production of 10000 units, using this data we get the predetermined overhead rate as $5 per
unit. Now during the financial year they actually incur an expense of $50500 and produce
11000 units, this makes the overhead rate $4.60 per unit. The difference between the
allocated and actual overhead $0.40 per unit (5-4.6) is to be adjusted in the books.
In order to adjust the said difference there are certain methods which can be followed. The
adjustment in the books can be done in three ways:
- Adjusting the over/ under recovery in the existing units during the financial year:
under this system of adjustment of under and over recovery, the amount which needs to
be adjusted is allocated amongst the existing units produced during the year.
For example, if the amount of over/ under recovery to be adjusted is $10000, and total
2000 units are in stock then the amount of $5 per unit will be adjusted in the price of
these units.
This system of adjustment of recovery amounts is not very popularly used and
implemented, since it shifts the loan of overhead of some units on the other reaming
units. This creates a price difference. Also, implementation of this kind of adjustment is
very complex (Taillard, 2013).
- Adjusting the over/ under recovery by carrying forward the amount to the next
financial year: in the cost records when the overhead accounts are prepared, the
allocated recovery rate is first charged to them, and then the actual amount is transferred,
the reaming balance standing outstanding at the end of the year in these accounts are
carried forward to next year. The overhead rate allocated to the new units is revised in
order to adjust this opening amount. This system of adjustment always has some
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difference standing in the books. Since this does account for expense in appropriate
manner this method is not very popular.
- Adjusting the over/ under recover by transferring to the profit and loss statement:
this is the most popularly used and the most implemented way to adjust the under and
over recovery amounts. Under this method the difference between the allocation and
actual amount is directly carried forward to the profit and loss statement. The profits is
adjusted for the expenses in the year in which they are incurred, this helps in presentation
of correct data in the books of account, also this is a very simple way to adjust the
differences. Hence, this system is most widely used.
Therefore the management can deal with under/ over recovery of overheads by the method
which is most suitable to them.
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Conclusion and Recommendation
From the above discussion we can see that the product Lexon was generating profits for the
company but Protox has been incurring losses. Implementation of activity based costing helps
us analyse the cost data more appropriately. Implementation of traditional costing by the
company will lead to wrong decision making by the management. This will harm the future
viability of the company’s performance. If the company continues to produce Protox, it will
keep incurring losses. Continuing the loss will harm the financial position of the company.
We would recommend Sue to implement the activity based costing as it helps to present the
correct data to the management. Management should also consider data based on activity
based costing as it is more authenticated form of cost allocation. Eradicating the production
of Protox model will be in the interest of the company and hence same should be moved
forward with.
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Bibliography
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