Introduction
Sierra Ltd. is an automotive parts’ manufacturer situated in Eastbourne, England. The company manufacturers several distinct products and follows the traditional cost management system. It uses machine hours as the basis of allocation of overheads to its product costs. This report provides an assessment of Sierra’s finance director’s proposal to adopt the Activity Based Costing system for allocating overhead costs more appropriately and to increase sales margins.
The most important issues faced by Sierra Ltd. are the declining revenue and profits since the last five years, low projected net profits for 2016 and high product costs. Sierra Ltd. also faces issues related to successful implementation of an ABC system in the company. The issue of Sierra’s declining profits and high product costs will be addressed in this report by analyzing its current cost accounting practices and its effect on total sales revenue. Further, the proposed activity based cost management system shall be critically examined to address issues related to its efficacy and successful implementation in the company.
This section will deal briefly with the current cost accounting and product pricing practices that are followed by Sierra Ltd’s management that have caused a decline in the company’s profits during the last five years. Sierra manufactures around 10 major product lines and almost 200 distinct product variants. It follows the traditional costing approach where “direct costs, such as direct labor or direct materials, are used to make a specific product or service, and are traced directly to that product or service” (Toit et al., 2007). The company incurs high cost of overheads and allocates them arbitrarily to its products using machine hours.
Since the company manufactures a variety of products, almost half of which are tailor- made, it incurs heavy overhead costs unlike its competitors that generally have only one product line with very few product variants. Experts believe that traditional costing approach “has become increasingly inaccurate as the relative proportion of overhead costs has risen” and that “this distortion of costs can result in inappropriate decision-making” (CIMA, 2008).
The finance director of Sierra Ltd., Baljit Kaur has observed that allocation of these overheads has created distortions in product costs and has caused Sierra’s product margins to decline. Similar flaws in traditional costing system were observed in XYZ Textile Company of Taiwan when “calculated product costs under the existing cost accounting system deviated from the actual amounts” and the management “failed to receive accurate unit cost and useful information for decision-making” (Duh et al., 2009).
It can thus, be safely concluded that one of the major reasons for high product costs and resultant low product margins in the company is that under traditional costing, “all manufacturing costs are assigned to products- even manufacturing costs that are not caused by the products” (Garrison, Noreen and Brewer, 2012). In such situations, companies generally adopt the Activity Based Costing technique to improve their cost management system and to reduce costs. “Companies that used ABC have been able to reduce cost, to increase profitability based on a cost-effective ABC system, and to provide a management tool for better decision-making” (Xu, 2012).
Activity Based Costing
Having dealt with the current costing strategies that have influenced Sierra’s revenue and profits adversely and have resulted in high product costs, I now turn briefly to the issue of successful implementation of Activity Based Costing System in the company. ABC is a conventional costing approach that “traces costs to products according to the activities performed on them” (Turney, 1989). It involves two stages in which the first step requires identification of key activities in the manufacturing process upon which overheads can be allocated. The second stage is the identification of overheads and their allocation to appropriate activities with the help of cost drivers (CIMA, 2008).
Major and Hopper (2005) correctly examine that Activity Based Costing approach allocates cost resources to activities, and then those activities are allocated to respective cost objects. This is done by assigning causal relations to the objects and activities which are done through either volume or non-volume cost drivers. Hicks (1999) states that ABC highlights several areas for effective cost control which generally remain invisible under the traditional costing approach. He outlines that ABC is particularly useful when cost of material movement is required to be isolated and measured. This allows companies to bring out several operational changes that further improve their product effectiveness
Roztocki and Schultz (2003) opine that “manufacturing firms with multiple products that place different demands on overhead” are most likely to benefit from implementing the ABC system. According to Suresh B.K. (2015), application of ABC in a manufacturing set-up helps in identifying direct costs more effectively and enables to highlight any potential loss or inadmissible product waste that allows managers to improve product profitability in the long run.
Furthermore, Kannaiah (2015) states that managerial and costing information produced by an ABC system not only enable an improvement in the operational, tactical and strategic decisions of a company but also provide them competitive advantage in the industry. Soekardan (2016) also outlines that ABC helps companies in identifying and understanding product cost and pricing patterns and behavioral trends in customers’ demands, which subsequently increase their potential to improve their efficiency. Kumar and Mahto (2013) argue that ABC is most suitable and beneficial for those companies that employ flexibility in their manufacturing processes as the system acts as a vehicle for more accurately and appropriately depicting cost causation effects in operations especially when the level of overheads are high.
Accordingly, Sierra Ltd. can benefit immensely if it implements the ABC system. It shall not only be able to bring down its product costs but will also be able to effectively control costs in the long run. Duh et al. (2009) explain that ABC is highly useful when there is an apparent connection between the company’s product strategies of providing tailor-made products to its customers. It is even more useful when these products are manufactured and sold in larger varieties and smaller volumes since ABC helps in accurately calculating, measuring and controlling costs of diversified products. Since, Sierra Ltd. already manufactures and sells custom-made products, an ABC model would prove highly beneficial to the company.
Critical Factors for Successful Implementation
The above discussion finally brings us to the factors that are critical for successful implementation of ABC system if Sierra Ltd. decides to adopt ABC costing model. These factors should be keenly considered by the management before and during implementation of the system.
One of the major considerations in successfully implementing ABC is that the management should fully understand and support the system. “Their full support is essential for building commitment, ensuring that enough resources are allocated, removing any barriers and ratifying the results” (Naidoo, 2002). Another factor is the cost and time involved in implementing the system. If the management is unwilling to give Activity Based Costing system ample time to be implemented, understood and used by the employees, the system is bound to fail.
Much like the management, human resource personnel of Sierra Ltd. also needs to be fully supportive of the new costing system. It is the management’s task to effectively direct, supervise and motivate their subordinates to adopt the new costing system and use it for the company’s ultimate benefit. Xu (2012) points out that a major difficulty that has been seen in implementing ABC in developed nations is that conflicts generally arise among those charged with governance when they fail to communicate effectively to their subordinates and to departmental managers. Lack of cooperation and coordination among departments due to their concentration on achieving respective departmental targets causes implementation of new cost management systems to fail.
Major and Hopper (2005) have evaluated two approaches to mitigate such behavioral problems while implementing ABC. The first approach is to identify those factors that contribute to the success of implementation and to work on improving them. These factors could be quality management, project resources, training and education of staff, incentive schemes, system ownership and control, management support, employee participation and effective communication.
The second approach deals with identification of those factors that impact the stages involved in the implementation process and practices reducing their impact. For instance, potential distortions in product costs could be a major factor impacting the adoption stage. Similarly, support from top management or clarity and unanimity in system objectives could be few of the factors affecting the final stage of implementation.
Management of Sierra Ltd. also needs to carefully identify the cost drivers, cost pools and activities in the manufacturing process for proper overhead allocation. This is another critical concern which affects almost all companies. Barclays Service Provision also faced a similar issue while it was implementing ABC, when unclear cost and resource drivers such as courier costs, accounted for almost 50 per cent of its total product cost base (Porteous, 2001).
Firms face several problems in implementation of ABC system mainly because “introduction of ABC in many firms has focused on the architectural and software design of ABC, with insufficient attention being given to behavioral and organizational factors involved” (Shields, 1995). The top management of Sierra Ltd. is already hesitant to adopt the ABC system since they believe that their time and efforts in training management accounting staff to use their existing costing system would go to waste. Issues related to financial and psychological constraints have already arisen which depict that these would be the major concerns in implementing the proposed system.
Summary
As discussed in this report, the main points are the identification of current costing practices that have caused Sierra’s sales and profits to decline considerably since the past five years and the factors that are causing projected profits for 2016 to decrease further. The report outlines the benefits Sierra Ltd. would accrue and improvement in its current costing practices that it would witness if it effectively implements the Activity Based Costing system. Presently, these issues are critical to Sierra Ltd and need to be addressed at the earliest, because the company’s profits have been projected to decline considerably during 2016 which will eventually adversely affect the company’s brand image and market value.
The report has been prepared on the basis of limited information available on the company’s current costing and managerial practices. The report also does not provide any practical evidence or financial results to support the conclusions and appropriateness of ABC in Sierra Ltd. There is a high possibility that non-managerial causes could also be impacting the company’s sales and profits. The report has not included the impact of such factors.
Recommendations
Based on this summary, it is recommended that Sierra Ltd. should implement Activity Based Costing System. The company will be able to address its ongoing high product cost issues and will also be able to set achievable product margins with the help of ABC. Sierra’s current cost accounting system is flawed because of which its sales revenues have begun to decline considerably. Upon implementation of ABC system, Sierra’s profit margins would considerably improve due to appropriate allocation of overheads and reduction of total product costs. The company would also be able to price its products suitably and set feasible product margins upon adoption of ABC. Furthermore, the company would eventually be able to increase its total sales and total net profits in the future.
It is however recommended that financial and economic viability of the proposed costing system should be conducted by the management before implementing the ABC system. It is also recommended that technical and strategic feasibility studies be conducted along with introduction of alternative marketing strategies, to increase total sales of Sierra’s products.
References
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