Analysis of Cost Allocation Methods and its Impact on Decision Making

This report examines the cost allocation methods employed by Beztec Limited, focusing on the implications of traditional costing versus activity-based costing (ABC). The analysis reveals the disadvantages of traditional costing, which often leads to inaccurate product costing and potentially flawed decision-making due to the arbitrary allocation of overhead costs. The study demonstrates how ABC provides a more accurate allocation of costs, leading to a revised understanding of product profitability for Beztec's Lexon and Protox printers. The report includes a detailed income statement analysis, calculation of activity rates, and a recalculation of operating income using ABC, highlighting the importance of selecting the correct cost allocation method. Furthermore, the report addresses the ethical considerations for accountants, particularly in situations where personal interests may conflict with the company's best financial interests and the importance of maintaining financial stability. The report also analyzes the gross profit margin under both costing systems and discusses the treatment of under/over recovery of overheads, culminating in recommendations for Beztec's accountant and a final conclusion emphasizing the importance of accurate cost allocation for informed business decisions.

MANAGEMENT ACCOUNTING

Executive summary
This assignment contains a detailed analysis of the different cost allocation method that a
company uses to allocate its overhead. It also discusses about the importance of cost
allocation method and also the impact on the decision making process. A recommendation
has been made at the end of the project in order to help the accountant of the company in
choosing the correct cost allocation method.

Contents
Introduction................................................................................................................................3
Traditional system of costing and its disadvantages..................................................................4
Activity Based Costing..............................................................................................................5
Importance of using correct costing method..............................................................................6
Analysis of cost data of Beztec limited......................................................................................7
Recommendation for the accountant........................................................................................10
Analysis of gross profit margin of the company......................................................................11
Treatment of under-over recovery of overheads......................................................................12
Conclusion and Recommendation............................................................................................13
Bibliography.............................................................................................................................14

Introduction
It is the duty of the management of the company to do product costing correctly and in the
most appropriate manner. Product costing is a difficult and a complex task that is assigned to
the management. There are various factors that a company has to look upon before taking a
final decision (Datar, 2015). If the company does not study the factors efficiently then it
might take wrong decisions which will have an adverse effect on the company financially
(Atkinson, 2012).
In the given case study, the company engages in the production of two types of printers
namely, Lexon and Protox. Since, the company is earning low operating income from Lexon
it is thinking of stopping its production. The accountant of the company, Sue smith is against
stopping the production as she thinks the low operating income has resulted because of wrong
selection of the cost allocation method. The results will be different if the company changes
the method by which it allocates the cost. There are two types of cost allocation method
which are explained in this report (Berry, 2009).

Traditional system of costing and its disadvantages
In the traditional costing method, there is a pre determined rate that is calculated based on a
particular factor such as machine hours or labour hours. This rate is charged among all the
products that are produced by the company (Boyd, 2013). However, if there is existence of
any kind of joint costs then such costs is allocated to all the products so that unit cost of each
product is determined.
As the name suggests, this method is considered to be old and obsolete because this method
ignores the actual consumption of the resources. This costing method is preferred by the
companies that produce a single product and also when there are not many activities involved
in the production process (Easton, 2010). In the recent times, a company usually has a
modern production process that involves production of multiple products that involve many
activities. It is a complex process and therefore, traditional costing method is not used for
such companies.
It has been observed that when this accounting method is followed the burden of overhead
costs shifts from one product to another (Datar, 2015) . The overhead costs are not distributed
in an equal proportion because the amount of resource that is utilised is not the same. If the
costs are distributed evenly then it will lead to wrong pricing of the product. Some products
may be over price whereas some products may be underpriced.
In order to overcome the drawback of traditional costing method, many companies has started
using Activity Based Costing which also taken into consideration the amount of resources
used (Holtzman, 2013).

Activity Based Costing
The modern way of allocating cost among various products is also known as Activity Based
Costing. This method has been introduced in order to overcome the disadvantages of the
traditional costing system (Datar, 2016). In order to allocation costs based on this method, the
company need to collect and analyse the cost data available. The number of units that are
consumed and the amount that has been spent on such units are recorded. Cost per unit is
calculated with the help of this information. On the basis of the rate per activity, the total
costs is distributed among various products (Datar, 2016).
This system of costing is considered to be more appropriate because it allocates costs only to
the product if it has utilised that specific function and only to the extent the consumption has
been done (Horngren, 2012). So, this costing method is considered to be more accurate and
reliable. The management is able to price the product correctly using the Activity Based
Costing.

Importance of using correct costing method
In order to take correct decisions, the management of the company must choose the cost
allocation method wisely. In order to understand this statement better let us taken into
consideration the scenario provided to us. In the given situation, the management is thinking
of phasing out the production of one model of printer which is called Lexon because it is
generating low operating income (McLaney & Adril, 2016). But if we use correct cost
allocation method and evaluate the data properly then the results obtained will be completely
opposite.
It is very important for the management of the company to choose a cost allocation method
which is appropriate. The product pricing decisions taken by the management is reliable on
the method that is adopted (Menifield, 2014). If the information on the basis of which the
decision is made is incorrect then the decision taken up by the management may also prove to
be wrong. Any wrong decisions taken up by the company may hurt its financial viability.

Analysis of cost data of Beztec limited
The following table shows the income statement of the company:
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
The operating income for Lexon and Protox is $71.50 per unit and $107.25 per unit
respectively. On the basis of this information, the company decided to shut down production
of Lexon printers.
In order to check whether the decision taken up by the management was correct or not,
operating income using Activity based costing should be calculated. The activity rate per unit
consumed and information about various activity consumed should be used to evaluate the
decision (Noreen, 2015).
The total cost activities on the basis of these rate per activity which are consumed are as
follows:
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
inspections)
63,225 23,963 87,188
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 cost allocation rate we have recalculated the operating income per unit from 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

The actual amount of costs that are consumed by each product can be observed. The overhead
cost that was allocated based on the traditional system made the product overpriced because
the overhead allocated was more than what was actually consumed. The reason for the low
operating income of Lexon and high operating income of Protox was wrong costing method
of cost allocation (Piper, 2015).
The new cost allocation rate has been used to recalculate the operating income of each of the
product:
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
After the calculation under Activity based costing, we can observe that the operating income
form per unit of Lexon was $ 129 per unit and the operating loss from Protox was $ 121 per
unit. The operating income under traditional system for Lexon and Protox was $71.50 and
$107.25 respectively.
The management would have taken a wrong step by stopping the production of Lexon
printers as it would result in operating losses.

Recommendation for the accountant
Beztec limited has an accountant whose name is Sue Smith. As we know, it is the
responsibility of an accountant to make sure that the financial statements that are prepared by
the company for the interest of the stakeholders must reflect a true and fair view about the
company. It should be prepared in such a manner that the users of the financial statement gets
clear picture of the company’s financial performance and position (Seal, 2012).
Smith is a knowledgeable person as he has specialised skills in the field of accounts and
finance. According to him, the company must adopt activity based costing and made
decisions based on that results as it will help the management to take correct decisions
(Siciliano, 2015). The CEO of the company wanted smith to adopt traditional costing because
there was some personal interest.
It is the duty of the accountant to fulfil her responsibilities with professionalism and integrity.
The accountant must look for the benefits of the company and act accordingly. It is her duty
to look after the financial health of the company and maintain financial stability. She was
forced to not carry out his work independently because there was a personal interest of the
CEO of the company. The bonus that the CEO receives is dependent on the revenues of the
different departments so he does not want that production of any product stops.
Smith is one of the employees of the company and should act for the best interest of the
company. It will be unethical on his part to attain financial benefits or provide financial
benefit to any other employee at the cost of the company. Based on the principles that are laid
down by the authorities the accountant must work with honesty.
Therefore, sue must calculate the cost based on both the cost allocation method and then
explain his view to the management of the company based on the results obtained (Taillard,
2013).

Analysis of gross profit margin of the company
The gross profit margin for both the models of printers is calculated using Traditional costing
system and Activity Based Costing. The calculation is as follows:
Gross Profit analysis
Gross profit margin under traditional costing 36.67 30.00
Gross profit margin under Activity Based costing 42.43 11.80
From the above table, we can observe that the GP margin for Lexon under activity based
costing resulted to 42.43% whereas it was 36.67% under traditional costing. However, it was
seen that GP margin for Protox under activity based costing was 11.8% but under traditional
costing method it was 30%. Therefore, we can conclude that the choice of costing method
can have a great impact on the decision making process of the management (White, 2009).

Treatment of under-over recovery of overheads
As we know, traditional cost allocation method ignores the utilisation of resources and only
focuses on the distribution of the pre determined rate. It is not necessary that the pre
determined rate that is charged is correct and therefore, there might arise a difference in the
actual overhead per unit and the overhead recovered per unit from the customers.
When the overhead recovered from the customers is more than the actual overhead, and then
it is a situation of over recovery. Similarly, when the actual overhead is more than the amount
of overhead recovered it is known as under recovery. Such under or over recovery has to be
treated in the books of accounts.
The treatment of under/over recovery is explained below:
- Adjustment in the profit and loss account- The over / under recovered amount of
overhead can be adjusted in the profit and loss account of the same year. The company
can arrive at a correct profit and loss only after making such adjustments. These
adjustments are to be made in the same year. This method is most commonly adopted by
any companies as it is very easy to implement.
- Adjustments made in the remaining number of units- The adjustment for amount of
under/ over recovery has to be made in the number of units that are not yet sold and lying
in the stock of the company. This system is not considered to be good because the cost
per unit might vary from year to year. This might lead to pricing the same product
differently in the same year. This method is the least likely adopted by companies.
- Carried forward to the next year- In this treatment the amount of over or under recovery
is carried forward to the next year which affects the cost per unit of the next year. This
leads to improper costing of the product. The expense should be accounted in the same
year in which it is incurred to make a proper adjustment.

Conclusion and Recommendation
It is clear from the above discussion that the company must adopt correct costing methods in
order to avoid mispricing of a product. If the decisions made by the management are based on
any incorrect data or information then the company might suffer. It is the duty of the
management to take into consideration all the alternatives, evaluate them deeply and then
take a final decision. The decisions should be taken for the benefit of the company.
We conclude that the company must adopt activity based costing and should also stop the
production of Protox printers so that there are no operating losses that the company has to
suffer.

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