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CASE ANALYSIS You have just been hired as an accountant by LifeStyle Furniture, a manufacturer of specialty, handmade furniture based in Tasmania. The furniture produced by Lifestyle is in two ranges, Modern and Classical. The two ranges are different in design, but both are high quality, hand-made furniture and are priced accordingly. The owner of the company, Brendan Pierce, has always believed in pricing a quality product based on how much their larger competitors are pricing theirs. His argument has been that \"our product is as good, if not better, than the mass producers of furniture, so we should be charging at least as much, if not more, than what they charge\". When you arrived at work for the first time, you learnt that the though the company has been in existence for the last twelve years, they have never had an accountant. The accounts were typically prepared by the Jodie Watts, secretary of Brendan Pierce and Tom Nicholson, a part-time accountant who came in once or twice a month. Tom has informed Brendan that he could no longer spare the time to come in and has suggested the need for an accountant on a full time basis, which is why you have been hired. Brendan, though, is still not convinced of the need for a full time accountant. \"Look, why do I need a full-time accountant? At the end of the day, all I need to do is total up my revenues, total up my expenses and the difference is my profit. Do I really need to understand my product costs? What is the purpose of that? It's not like I can lower my prices if my product costs are lower. I just follow the big guys like Harvey Norman and A-mart and price my product according to their prices. Why do I need to know what my product costs are?\" asked Brendan. Jodie, who has been the secretary cum bookkeeper (of sorts) since the day the company started has prepared some information for you. Trying to be helpful, she has alphabetised the accounts. \"I do not know much about accounting,\" said Jodie. \"But Tom has said that we need a Schedule of Cost of Goods Manufactured and a Schedule of Cost of Goods Sold, whatever that means. I have last year's accounts for you, so could you please prepare those schedules or whatever and get it to Brendan?\" The alphabetised list of accounts can be found in Appendix A. Four days into your work, there was a fire over the weekend in the main office that stored the accounts. The manufacturing facility was not affected and work could go on, however, most of the information that was for the current year's accounts was damaged and only partial fragments were readable. These are shown in Appendix B. Luckily your work on last year's accounts were not affected as you had brought them home to complete and was still in process of completing them. Management Accounting 201 Page 1 CASE ANALYSIS \"You need to get me back all the information that's now lost! My creditors want to see that information and I need you to work on it asap! If you can't do it, I'll get someone else who can!\" cried Brendan when he saw you. Sifting through ashes and interviewing selected employees, you have worked up some additional information: a) Jodie remembers clearly that the predetermined overhead rate was based on 60,000 directlabour hours to be worked for the year and $180,000 in overhead costs. (\"Tom mentioned this before he left,\" Jodie said. \"No idea why it is important, but if it can help you, good luck\".) b) The production supervisor's cost sheets showed only one job in process on 30th April. Materials of $2,600 had been added to the job, and 300 direct labour hours had been expended at $6 per hour. c) The accounts payable are for raw material purchases only, according to Jodie. She clearly remembers that the balance in the account on 1st April was $6,000. Checking with Brendan for his cheque stubs, payments of $40,000 were made to suppliers during April. (All materials used were direct materials.) d) A charred piece of the payroll ledger shows that 5,200 direct labour hours were recorded for the month. Jodie has confirmed that there were no variations in pay rate (i.e. all employees were paid $6 per hour.) e) Records in the warehouse indicate that the finished goods inventory totalled $11,000 on 1st April. f) From another charred piece of paper, you discerned that the cost of goods manufactured for April was $89,000. You are now ready to reconstruct the T-accounts and give Brendan the information he needs before you lose your job! When you went in to tell him that you can now start working on the information, Brendan tells you that he has spoken to Tom (their previous part-time accountant) and that the following information are required: \"Tom says we need the following information: Work in process at the end of April, raw materials purchased in April, Overhead applied, Cost of goods sold in April, and Raw materials used in April. He also suggested that we should be looking at whether the overhead was over- or under-applied, whatever that means. \" Management Accounting 201 Page 2 CASE ANALYSIS As you were about to leave, Brendan stopped you. \"Listen, I have heard talk of this new costing system that some of our competitors are using and I want to know more about it. I need you to tell me what it's all about and whether it would suit us. They are calling it ABC or something like that. It is said to be a better costing system but I am not sure. Tell me more about it. I need to know how it works, its benefits and its limitations. If it works for us, I would like to implement it as well. I do not want to be left behind!\" REQUIRED: Prepare a report (no more than 10-pages) for Brendan Pierce that addresses the following: a) The purpose of a product costing system. b) Preparation of a Schedule of Cost of Goods Manufactured and Cost of Goods Sold. (The schedules may be in the appendix). Explain why some items have been excluded from the schedules. c) Complete the T-accounts and determine the following: i. Work in Process at the end of April; ii. Raw materials purchased in April; iii. Overhead applied in April; iv. Cost of Goods sold in April; v. Raw materials used in April; and, vi. Over- or under-applied overhead in April. d) Discuss how overheads can be over- or under-applied and how the company should deal with the over- or under-application. e) Evaluate whether ABC should be introduced. (Hint: remember to consider both the costs and benefits of any action recommended.) Management Accounting 201 Page 3 CASE ANALYSIS Appendix A Administrative salaries ....................................... Advertising expense ............................................ Depreciation -- factory building ............................ Depreciation -- factory equipment ........................ Depreciation -- office equipment ........................ Direct labour cost ................................................ Raw materials inventory, beginning ..................... Raw materials inventory, ending ........................ Finished goods inventory, beginning ................... Finished goods inventory, ending ...................... General liability insurance expense ..................... Indirect labour cost .............................................. Insurance on factory ........................................... Purchases of raw materials ................................ Repairs and maintenance of factory .................... Sales salaries ...................................................... Taxes on factory ................................................. Travel and entertainment expense .................... Work in process inventory, beginning ................. Work in process inventory, ending .................... Management Accounting 201 $2,400 1,200 800 1,600 180 21,900 2,100 3,200 46,980 44,410 240 11,800 1,400 14,600 900 2,000 450 1,410 1,670 1,110 Page 4 CASE ANALYSIS Appendix B Bal. 1st April Raw Materials 12,000 Bal. 1st April Work in Process 4.500 Actual cost for April Manufacturing Overhead 14,800 Accounts Payable Bal. 30th April Finished Goods Bal. 30th April Cost of Goods sold 16,000 Management Accounting 201 Page 5 8.000 A REPORT FOR BRENDAN PIERCE ON THE ISSUES AT HAND IN LIFESTYLE FURNITURE A. Purpose of a Product Costing System. First and foremost, it would be vital to define costing as the process of determining the costs of products, services and activities. Cost accounting is used to determine the cost of products, jobs or services (whatever the organisation happens to be involved in). Such costs are usually built up using a process known as cost accumulation. The entire process of allocation costs to products is important for any organisation that seeks to match costs incurred in making the products and revenues generated from their sale (matching concept). Below are some of the aims that a product costing system aims to achieve: One of the aims of a product costing system would be valuation of inventory. Inventory in hand must be valued for two reasons. One, for the closing inventory figure in the statement of financial position and two, for the cost of sales figure in the income statement. The valuation of inventories will affect profitability during a period because of the way in which the cost of sales is calculated. Cost of goods sold = Cost of goods produced + the value of opening inventories - the value of closing inventories. Another aim would be that a product costing system would be valuable in pricing decisions. Many companies attempt to set selling prices by calculating the full cost of production or sales of each product, and then adding a margin for profit. 'Full cost plus pricing' can be particularly useful for companies which do jobbing or contract work, where each job or contract is different, so that a standard unit sales price cannot be fixed. In this case Mr. Pierce, a product costing system will be particularly useful for Lifestyle Furniture since we are not in the business of mass production and costs can be allocated to each product manufactured. This will enable us to make more sound pricing decisions instead of matching our prices with those of our competitors, which doesn't necessarily factor in our internal weaknesses and strengths. Another reason would be that it would help in the establishing of profitability of different products. Basically, if a company sells more than one product, it would be difficult to judge how profitable each individual product is, unless overhead costs are shared on a fair basis and charged to the cost of sales of each product. This argument is primarily in support of an absorption costing system. A product costing system is also more likely to give information to management that will greatly assist in general decision making, some of which include the following: Fine-tuning operations to generate higher profitability. Deciding where to cut costs in the event of a business turn-down. Matching actual costs incurred against budgeted cost levels for purposes of control. Creating strategic and tactical plans for future operations. Etc. In summary, product costing data act as feedback to designers, are used in manufacturing management to identify ideal workflow, influence the purchase of tooling, and are used in precise pricing of goods. Product costing is used in most routine production activities, including service occupations, although the level of detail sought is variable and usually determined by the size of the operation. B. Preparation of a Schedule of Cost of Goods manufactured and Cost of Goods sold. LIFESTYLE FURNITURE SCHEDULE OF COST OF GOODS MANUFACTURED FOR THE MONTH ENDING 30TH APRIL DIRECT COSTS $ $ Raw Materials Opening Inventory Add: Purchases of raw materials Raw Material Available Less: Closing Inventory COST OF RAW MATERIAL USED Direct Labour Cost PRIME COST INDIRECT COSTS (Production Overheads) Indirect Labour Cost Depreciation - factory building Depreciation - factory equipment Insurance on factory Repairs and maintenance of factory Taxes on factory TOTAL MANUFACTURING OVERHEADS MANUFACTURING COST FOR THE PERIOD Add: Opening Work in Process TOTAL WORK IN PROGRESS Less: Closing Work in Process 2,100 14,600 16,700 (3,200) 13,500 21,900 35,400 11,800 800 1,600 1,400 900 450 16,950 52,350 1,670 54,020 (1,110) COST OF MANUFACTURED GOODS 52,910 LIFESTYLE FURNITURE SCHEDULE OF COST OF GOODS SOLD FOR THE MONTH ENDED 30TH APRIL. $ Opening inventory (finished goods) Add: Cost of goods manufactured Goods available for sale Less: Closing inventory (finished goods) $ 46,980 52,910 99,890 (44,410) COST OF GOODS SOLD 55,480 Some of the items have been excluded from the schedules, they include: Administrative Salaries- this is an administrative expense recognized in the Income Statement as a deduction from gross profit so as to get the net profit. It is part of the expenses recognized in an organization's books. It cannot be part of the schedules which focus on the cost of manufacturing a product and the cost of goods sold. Advertising expense- this is a selling expense which is placed under operating expenses in the Income Statement. This is also part of the expenses that are deducted from gross profit to arrive at the figure for net profit. Depreciation (Office Equipment) - it is under the administrative expenses section and is part of the expenses that are subtracted to arrive at the figure for net profit. It cannot, therefore be included in any of the above schedules. General liability insurance expense- this is part of the administrative expenses in an income statement and is subtracted to arrive at the net profit figure. It cannot be part of any of the schedules. Sales salaries- it is part of the selling expenses under operating expenses in an income statement and is thus disqualified from appearing in any of the schedules. Travel and entertainment expenses- It is part of the administrative expenses under operating expenses in the income statement. Its presence is therefore missed in any of the schedules which deal with the cost of goods manufactured and the cost of goods sold. C. i. T- Accounts (Lifestyle Furniture; Month of April) Work in Process at the end of April. Work in Process Bal. 1 st April 4,500 Cost of goods manufactured Direct Materials 2,600 Manufacturing Overheads 89,000 15,600 Direct Labour 31,200 Prod. Supervisor cost 1,800 Ending Balance 33,300 89,000 Overhead applied to Work in Process inventory $180,000 = $3/labour-hr 60,000hrs This is used in the calculation of overhead costs for the process. Overhead cost applied - 5,200* $3/labour-hr= $15,600 89,000 Direct Labour costs - 5,200* 6= $31,200 Production Supervisor cost 300*$6= $1,800 ii. Raw materials purchased in April. Accounts Payable Payments to suppliers 40,000 Bal 1 st April Raw materials 6,000 26,000 purchased Bal 30 th April 40,000 8,000 40,000 Raw materials purchased would be 40,000-(6,000+8,000) =26,000 iii. Overhead applied in April. Manufacturing Overheads Actual Cost for April 14,800 Overhead applied to 15,600 WIP Over-absorption 800 15,600 iv. 15,600 Cost of goods sold in April Cost of Goods Sold Cost of goods manufactured Opening inventory (Finished goods) Cost of goods sold 89,000 Ending Inventory (Finished goods) 11,000 84,000 16,000 v. Raw materials used in April. Bal 1st April Raw materials Purchased Raw Materials 12,000 WIP 2,600 14,800 17,400 vi. 5,400 Overheads (Actual) 17,400 Over or under applied overhead in April. Finished goods Opening Inventory 11,000 Over-absorbed Overhead Balance 30 th April 800 16,000 D. How overheads can be over or under- applied and how a company can deal with over and under-application. Under-/over- absorbed overhead occurs when overheads incurred do not equal overheads absorbed. The rate of overhead absorption is based on estimates (of both numerator and denominator) and it is quite likely that either one or both of the estimates will not agree with what actually occurs. Actual overheads incurred will probably be either greater than or less than overheads absorbed into the cost of production, and so it is almost inevitable that at the end of the accounting year there will have been an over absorption or under absorption of the overhead actually incurred. Over-absorption means that the overheads charged to the cost of sales are greater than the overheads actually incurred. Under- absorption means that insufficient overheads have been included in the cost of sales. Under or over recovery of overhead will occur in the following circumstances: Actual overhead costs are different from budgeted overheads The actual activity level is different from the budgeted activity level. Actual overhead costs and actual activity level differ from those budgeted. The question of dealing with the over-recovery or under-recovery of expenses can be dealt with only with reference to the cause leading to over- or under-absorption. (i) Writing Off to Costing Profit and Loss Account: At the outset one should say that a small difference between the actual and absorbed amounts should simply be transferred to the Costing Profit and Loss Account. If, however, the difference is large, the cause should be investigated. Should the cause be abnormal (if the output has fallen, for instance) the amount of over- or under- recovery should be treated as an abnormal loss and transferred to the Costing Profit and Loss Account. (ii) Use of Supplementary Rate: Under this method, the balance of over and under absorbed overheads may be charged to cost of work-in-progress, and finished stock and cost of sales proportionately. This is done with the help of supplementary rate of overhead. If there has been a mistake in either working out the proper rate or selecting the proper method, it should be permissible to amend the cost and arrive at new (but correct) figures of cost. To the extent goods have already been sold, the difference in the two figures of cost (as already arrived at and the new correct one) should be debited or credited to the Cost of Sales Account or even to the Costing Profit and Loss Account. The goods remaining unsold should be costed at the correct rate. The corrective rate should be applied also to work-in-progress. (iii) Carry Forward to Subsequent Year: Some people, however, recommend that the difference should be carried forward in the expectation that next year the position will be automatically corrected. This would really mean that costing data of two years would be wrong. E. Should ABC be introduced? ABC, or Activity Based Costing is the alternative to absorption costing. ABC involves the identification of the factors (cost drivers) which cause the costs of an organization's major activities. Support overheads are charged to products on the basis of their usage of an activity. For costs that vary with production level in the short-term, the cost driver will be volume related (labour or machine hours). Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction- based cost drivers such as production runs or number of orders received. Benefits of ABC would include: The complexity of manufacturing has increased, with wider product ranges, shorter product life cycles and more complex production processes. ABC recognizes this complexity with its multiple cost drivers. In a more competitive environment, companies must be able to assess product profitability realistically. ABC facilitates a good understanding of what drives overhead costs. In modern manufacturing systems, overhead functions include a lot of non-factory-floor activities such as product design, quality control, production planning and customer services. ABC is concerned with all overhead costs and so it takes management accounting beyond its 'traditional' factory floor boundaries. Provides accurate and reliable cost information. Establishes a long-run product cost Provides data which can be used to evaluate different ways of delivering business. Criticisms of ABC would include: Some measure of (arbitrary) cost apportionment may still be required at the cost pooling stage for items like rent, rates and building depreciation. ABC is sometimes introduced because it is fashionable, not because it will be used by management to provide meaningful product costs or extra information. If management is not going to use ABC information, an absorption costing system may be simpler to operate. The cost of implementing and maintaining an ABC system can exceed the benefits of improved accuracy. Implementing ABC is often problematic