General explanation of the procedure followed
Contribution refers to the excess the unit selling price of a product over the direct costs of production related with the production of the said product. This accounting procedure is based on the assumption that fixed costs are incurred on timely basis (fixed costs are fixed for a certain duration of time) Hence, the fixed costs are considered irrelevant in decision making regarding the production of the said product.
Contribution per unit is thus defined as ‘the revenue generated to cover certain fixed costs, as well as cater for the profit margin of the trader. It is prudent for a manufacturer to continue producing products that have positive contribution.
Being informed by the above analysis, we conclude that:
1) Jaza product is the least profitable product produced Wallen limited. This is because one unit of Jaza yield the lowest contribution hence contributes less towards catering for fixed costs as well as generating net profits for Wallen.
2) Meliss is the best yielding (contributes the highest revenues) towards catering for fixed assets as well as generating profits for Wallen limited).This is evident from the above figure $313.50 compared to the revenues per unit generated by Nance and Jaza.
3) Reactions of Wallen’s competitors to Wallen’s strategy:
The competitors seem to invest much on the less profitable products ignoring the highest yielding products. This is because they tend to shy away from lowering slightly the price of Mellis to put off Wallen limited, which has continued to enjoy high profits from Mellis due to consumer insensitivity
Wallen limited is exposed to several dangers due to its pricing model.
It seems that Wallen does not have a predermined production model based on profitability. push to produce more Meliss product cutting down the quantity of Jaza would be desirable in the short term, due to increasing competition of the Jaza market. In total disregard of the above strategy, Wallen is pumping its resources in projects that yield less return. Cutting production of Jaza say to 3,000 in order to cater for long term
The strategy of increasing prices of Meliss arbitrarily (above the budgeted 150% of the cost) may cost Wallen limited its customers once a competitor realizes this.
Advantages of ABC costing
Activity based Costing is a method of costing that allocates costs to products or services, generally used as a tool of planning and control. It evolved as a development to address the problems that were associated with the traditional and conventional cost management systems because of the latter’s inability to accurately determine the actual service or production costs, which is a major setback for operational decision making. This means that based on the traditional system, managers were prone to making decisions based on inaccurate data, especially if multiple products are involved (Derya Eren, 2011).
Activity based costing therefore offers an improved method of identifying high overhead costs per unit with emphasis on their reduction, ABC system assists managers in better understanding of overheads. Traditional costing methods allocations standard level of fixed costs on all products regardless of the usage of the cost by a particular product.ABC therefore allows managers to allocate common business resources to specific users of the cost and on their relationship with a given cost driver thus arriving at a more accurate cost.
ABC system is easy to understand, and interpret. It has also been found to be accessible, usable and also implementable across all business regardless of the industry. This means that the advantages of this system can be enjoyed by establishments in all sectors.
The system uses a marginal cost as the base for computation base which contrasts with the traditional method that has been criticized for employing total costs in determining the total product costs (Craig A. Latshaw, Teresa M. Cortese Danile, 2011).
ABC system is the most effective system designed to earmark the activities that are a burden to The Company in terms of wastefulness and lack of value addition to the process. This provides a framework for the revision of such activities.
This system aids in the process of benchmarking which is a very integral part of total quality management and performance improvement
Limitations
Data collection for this system is quite time consuming. Essentially, ABC costing requires the use of a lot of data that is costly to collect such as the amount of each cost driver that the unit will use (Gary Cokins,.
The ABC system is rather expensive to implement for a company especially the initial cost outlay that may be deterrent to many companies.
The ABC system is rather transparent which means that some managers may approve since this system will most likely expose their inefficiencies. This happens because managers tend to hide under the umbrella of the fixed costs but when the blanket fixed costs is removed and their inefficiencies are exposed.
Q.5
The percentages for the raw material costs have been arrived at after the following analysis:
Raw material cost used in producing
Jaza8,000*105 =840,000
Nance15,000*157 =2,355,000
Mellis52.50*4,000 = 210,000
Total raw material cost .3, 405,000
Now taking the percentage of material cost used in each of the above products,
Jaza.840,000/3,405,000=24.66%
Nance2,355,000/3,405,000=69.16%
Meliss.210, 000/3,405,000 = 6.16%
5) Developing a product cost for the three products:
Start off by determining the budgeted direct labor for the three products.
Hence; Jaza . 8,000*48=384,000
Nance15,000*36=540,000
Meliss.4, 000*24=192,000
Now, allocating the costs to the three products using the above direct labor values per product we get the following unit costs:
Jaza Nance Meliss
Machinery9.57 6.81 19.14
Machine set up .04 .029 .008
Inspection 4.10 2.92 8.20
Material handling 6.83 4.86 13.67
Engineering..2.70 1.92 5.39
As a way of example, machinery overheads are arrived at after following the analysis below:
Jaza.3, 675,000/384,000 =9.57 (total machinery overheads divided by the base labor costs)
Nance. 3,675,000/340,000 =6.81
Meliss..3,675,000/192,000 =19.14
The above are overheads consumed per unit. Taking the whole budget into consideration, (i.e. producing 8,000 units of Jaza, 15,000 units of Nance and 4,000 units of Meliss) we get
PRODUCT Jaza Nance Meliss
Machinery. 76,750 102,150 76,560
Machine set up.. .. 320 435 32
Inspection.. 32,800 43,800 32,800
Material handling .54, 640 72,900 54,680
Engineering .21, 600 28,800 21,650
6) The budgeted price
PRODUCT Jaza Nance Meliss
$ $ $
Machinery. 76,562.5 102,083.3 76,562.5
Machine set up.. 328.13 437.5 328.13
Inspection.. 32,812.5 43,750 32,812.5
Material handling.54, 687.5 72,916.67 54,687.5
Engineering.21, 546.9 28,729.17 21,546.9
*In the above calculations, the formula given (pre determined overhead cost =budgeted overhead/budgeted direct labor cost has been use.).The budgeted labor costs remain $384,000 for Jaza,$540,000 for Nance and 192,000 for Meliss. Dividing the budgeted overheads by labor cost per each product gives the above costs e.g.
Breaking down the Machinery overheads, we get:
Jaza .. 3,675,000/384000*8,000 =76,562.5
Nance.. 3,675,000/540,000*15,000 =102,083.3
Meliss. 3,675,000/192,000 * 4,000 =76,562.5
References
Derya Eren Et Al. A comparative analysis of activity-based costing and traditional costing: World Academy of Science, Engineering and Technology 3, 2005
Ahmad Issa Alnajjar the Ability of Application Activity-Based Costing System on the Air Line Companies: The Case of the Jordan Aviation Company .European Journal of Economics, Finance and Administrative Sciences, 2011
Craig A. Latshaw, Teresa M. Cortese Danile. Activity-based costing: usage and pitfalls. Review of business, 2001
Dr Manoj Anand. Activity-Based Cost Management Practices in India:
An Empirical Study, 2010
Gary Cokins .Activity Based Cost Management: An executive’s guide. Wiley and Sons, 2011
