This report deals with the issues faced by a client company Sierra Ltd related to the managerial accounting practices and product pricing strategies that the company and as a consequence company is facing a decline in revenue and profits during the previous few years. The company manufactures and sell automotive parts to car manufacturers, company deals in 10 different product lines which are the combination of uniform and distinct variants. The parts are manufactured by using state of the high-quality art processes and technologically updated plants. Other than the concerns that are discussed above, the company faces difficulties in the pricing strategies related to few specific products such as engine components, where the company is facing competition in the industry also the overhead allocation using the traditional basis of costing(Bhimani, et al., 2008). In this report, I intend to find out the reason of their costing system failure the impact (positive or negative) after switching to activity based costing commenting on their concerns related to the system changeover i.e. effects of new software development and training requirements and the possible consequences. While implementing new costing system as proposed by their finance director and the achievement of the anticipated percentage of margins in which the company is facing difficulty.
Assessment of Current Costing And Pricing Practices of The Company:
The company is using the traditional basis of costing for the pricing purposes and allocation of overheads to different products based on machine hours. The tracing of material and labor cost using the traditional basis of product cost determination is easy(Bt Fadzil & Rahabah, 2012). However, proper allocation of overheads to drive at a proper product cost needs to be handled carefully, the method used to allocate overheads costs plays a vital role in determining the pricing decision and overall formulating the pricing strategy of any firm especially when the firm under consideration is any manufacturing firm.
Currently, the company is not able to reach the anticipated product margin i.e. they wanted to attain 30% margin on their products but current accounting system excessive setup costs related to some of the specialized products of the company. The variance in product ranges that requires additional customized product costs and dealing with the competitors who specializes in one product having agile product designs and fast development processes(Fei & Isa, 2010).
Analysis of the system:
The company is following traditional costing system for all the product ranges, from engine and clutch products up to the highly specialized transmission components allocation of overheads is done on machine hour basis. It is an arbitrary basis of allocation of overheads, the usage of pools in this costing system is very few, and the resulting allocation of cost is highly average. The decision taken on that basis related to pricing might turn erroneous and not for generating high margins for the company. (Bhimani, Foster, and Datar, 1999).
In traditional basis only basic indirect overheads are accounted for product pricing that is prominent, and the net effect of all the components are ignored. Jamaliah and Mariah (2008; 7) has pointed out that the true reflection of the relationship between the indirect cost and individual products can rarely be determined by using traditional costing(Johnson, 2015).
Since the company is currently facing decline and cost structure of the company needs revision to avoid the risk of calculating inappropriate product prices, because of the allocation of production overheads on very uniform basis i.e. labor hours, labor dollars or machine hours. The company is using the same methods for the products cost of simple and complex nature having a significant range of variance, i.e. the product ranges that requires overhead allocation on more complex basis rather than considering machine hours at the whole.
The company needs to revise its costing as well as pricing strategy because it would ultimately lead manufacturer to calculate wrong and inappropriate selling price and thus overall performance of the company gets affected in short and long run (Lui & Pan, 2007).
Suitability of Activity Based Costing:
As the company is considering for accounting system changeover and wants to move to activity-based costing it is first to understand that what activity based costing plan is.
It is a method of assigning overhead manufacturing cost to the products in more standardized and more logical manner. In activity-based costing the process is different than traditional costing, it is the process in which overhead costs are not directly assigned to the products by direct labor hours machine hours or any other basis(Major & Hopper, 2005). In this method the overhead cost first assigned to those activities which serve as the real cause of generating overheads after that the cost is then allocated to products for which those activities were performed or which has demanded such activities.
The activity based costing is suitable for the company when the company is involved in the manufacturing of those products which have specialized production processes by customer’s demand and diverse product variants. Sierra Ltd is using the same pricing policy for all ranges i.e. they have a standardized range of engine and clutch components that does not require different activities during each production run whereas the transmission components have many variants that require huge labor time for construction.
The same strategy for pricing is not suitable for a different range of products. As ABC strategy significantly reduces the product cost if it is utilized in a proper way and using proper product range. The ABC strategy is useful for the company if it is used in an appropriate cost reducing manner. It would significantly reduce the cost of products and helps in moving the graph of profits upward.
The transmission components have specialized nature for each customer and diversified variants of products; machine hours are also increasingly required for the proper manufacture of the products thus increasing the labor utilization as well. If the overheads cost is allocated on the traditional basis to this range of products, it would heavily increase the product cost because of high machine utilization and more labor hours (Shields & Memphis, 1995).
Activities involved while manufacturing such products are different for each and every product, and if ABC plan is successfully implemented in this regard, it will help to reduce the product cost reasonably and thus the overall pricing strategy is improved which affects the organization positively regarding desired margin attainment and sales improvement.
Thus by using the ABC plan for just specialized nature products the concerns of Silvia are accounted for related to software replacement and other technological measures that would be necessary after implementing ABC system on all range of products. Other cost-cutting measures should be taken into account about engine components as the activities involved in the manufacturing process are not diverse but standardized and uniform. Mathew also had concerns about the morale of the work staff that might go down after the accounting system change and that would affect the quality of the products.
The more activities identified, the more complex the cost structure would be. The estimates of cost could be more reasonable and accurate while applying the ABC system. Jamaliah and Maliah (2008), have contributed their views by saying that ABC costing serves to improve pricing decision making, by adopting ABC plan it would lead to better selling price and margin decision making and eventually enhanced bottom line figures for manufacturing or service organizations.
Factors for Successful Implementation of Activity Based Costing:
System changeover is never easy for any organization because it involves various factors to consider that makes the change of system successful in long run. When an organization is working on a certain system for years, it would be difficult for the organization to change the systems and operations entirely and move to the new system with the same workforce but different methods and techniques.
Sierra Ltd has employees trained and software installed based on the traditional basis of accounting measures and involving ABC plan in the system would require expertise and tactful way to incorporate the change of the costing system in the organization effectively (Thomas, et al., 2009). As ABC system would require different expertise and more advanced computer systems that handle the different levels of activities in a better and more product directed manner.
The following factors should be considered while doing the system changeover:
- The cost controlling measures should be taken into account while implementing the new costing system to the company. Therefore, identification of the activities involved and the cost drivers that would affect the pricing decisions.
- Consider appropriate vendors for software and applications for ABC system into the company’s environment. Readily available vendor support for any complication or change while operating the new system.
- Arrangement for training and another technological advancement in the company that supports the effective implementation of the new system.
- The culture of the organization, the resistance, and adaptability of the employees to change.
- Attractive motivational arrangements for the existing employees so that they would adopt the new system within less time and work quality should not be compromised. Extrinsic award system so that the motivational level rises.
- The decision making of the managers and upper management related to ABC system and its compatibility with firms policy.
- Tasks and goal clarity should be taken into account; employees must know their new role when the system changes and should not be uncertain about the role and its performance.
Baljit’s proposal would bring impressive change in the company’s cost structure but whole accounting system change for all products accounting is not suitable. The company should consider partial system changeover to reduce the costs reasonably. After that, with the success of initial system change, further measures should be taken.
As discussed in the report above, Sierra Ltd has suffered potential losses in the previous few years and had declining trend related to revenues. The costing system used by the company was not appropriate, and the pricing strategies of the companies have increased the costs and decreased the margins related to different and diversified product ranges. The company is facing tough time while dealing with those competitors having asingle line of products with fewer variants to tackle. The pricing strategy giving company tough time and become the cause of downfall. The company is considering to change the product costing system from traditional costing to activity-based costing system. By this, the arbitrary basis of overhead allocation would turn to more uniform and tested basis of allocation. As a result company would save the cost and makes the performance better. The proposal requires tactful handling to change the cost system of those products which has different activities based production structures. As the whole system changeover would not be feasible for the company.Different executives have contributed their views regarding the selection of best approach and changing the performance of the company in a better way. Choosing the best alternative and its effective application considering the best possible ways and taking in into account all factors that would help to cut the cost and increases the profits of the company are considered in the abovee-report.
After considering all the facts related to the company, its performance graph, and the cost determination practices I would recommend that:
- The company should change its overhead allocation and costing system from traditional costing to ABC strategy for transmission components to achieve cost-cutting measures and more comprehensive understanding of activities involved in the production of different kinds of customized products.
- The engine components production cost should be reduced by considering other measures such as reduction in labor-intensive techniques by substituting the more updated capital intensive techniques.
- After considering the effects of the above two measures, taking further decisions to convert the whole accounting system to ABC strategy i.e. using ABC costing system for engines and clutches components as well.
- Using highly sophisticated systems i.e. software for ABC strategy and profound training to handle the new system effectively.
- Providing extrinsic rewards to employees for making their motivation levels high so that the product quality would not be compromised.