Cost and pricing analysis

Activity Based Costing for Zauner Ornaments

Introduction

The pricing strategy of products of Zauner Ornaments defies all logic as fixed prices were not cost based but as per prices of similar products in the market . Zauner Ornaments when tried traditional costing reached at an alarming situation . An analysis based on activity based costing is required to avoid the confusion created by traditional costing . In fact Activity based costing (ABC ) surrounds costing and its absorption to products on activities that actually drive the cost . In this write up an approach is undertaken

to make scenario clear for Zauner Ornaments on costing front and for reframing its pricing strategy . An effort has been made to establish basis of allocation plant- administration overheads based on ABC , and also to calculate using ABC . While using ABC a comparison has been established between ABC and traditional costing , and finally arriving at a conclusion that Zauner Ornaments need a change in its pricing strategy

1

Establishing basis of allocation of plant- administration costs

Activate based costing uses cost drivers to assign cost of resources to activities and unit cost as a way of measuring an output (Activity based costing , OSD Comptroller I Center . In to allocate plant- administration costs to each of three products , we have to find out cost drives that drive plant- administration costs . For that it is necessary to under stand the logic behind `Activity Based Costing (ABC . ABC works on the following principles or rules

Overheads costs are attributed to Cost Units on the basis of benefits received from indirect activities (meaning activities that cause overheads

The performance of such indirect activities coupled with demands made of these activities helps in arriving at quantum of each such activity performed to produce a product . These activities consume resources (i .e overheads costs ) as per cost drivers (activities that generate cost

Cost centers pay for such resources depending upon number of activities used or required for the product

Therefore overhead costs are recognized and attributable to such activity that is acting as cost driver and the numbers of such cost drivers used depend upon the complexities of operations to produce a product

Thus , overhead costs of each cost centre are then attributed to each unit of product as per cost drivers (activity ) required for each unit of the product

As per information available Plant administration costs constitute costs incurred on `Supervisions , `Labor relations , and `Clerical costs

Supervision cost is directly related to supervision or inspection of the working of the plant . The term supervision relate to the activity to oversee productivity and progress of employees who report directly to supervisor . Accordingly the best cost driver that comes to mind is `Inspection per batch ' or `percentage of plant capacity used . Exhibit 5 provides that only 70 of the plant is used but further information about use of 70 of plant among three categories of products is not provided . Therefore as per information available , inspection per box is the next suitable cost driver

The next component of plant- administration cost is cost incurred on `labor relations . The term `Labor relation ' refers to field of relations between employer and employees . Here the most suitable cost driver is Direct Labor Cost as provided in Exhibit 5

The third component of production- administration costs is clerical cost . Naturally clerical work is related to work in proportionate of production of ornaments . For this we have two alternatives from Exhibit 3 , one is `number of ornaments ' in each category of production or `number of batches

Yu gathered the the information about exact expenditure on each of its above stated components is not available . Accordingly a common cost driver for three components can best be the basis of allocation of production- administration overheads

As discussed above , the components of `supervision ' and `clerical cost have a common cost driver `number of batches . Though in case of `labor relation ' cost the best cost driver is direct labor cost , but in absence of separate information about the cost of `labor relation ' component in the allocate this cost on direct labor basis . As labor relation activity is also somehow connected with supervision activity , the next best cost driver that can be selected is the one to be used for `supervisions costs ' component , i .e , `number of batches . Accordingly on the basis of information available , the most suitable cost driver for production- administration cost can be settled at `number of batches

Based on above discussion the plant - administration costs are allocated as under Supervision cost on the basis of cost driver `number of boxes ' used for each product comes t0 39 .2 for Small colored glasses , 36 .59 for large colored glasses , and 24 .39 for specially ornaments . It appears job of small colored glass is more labor oriented than the other two products

2

Calculations of ABC costs of each product per box- basis

ABC costs for each product constitute its direct material and labour cost and overheads costs allocated on the basis activity cost drivers of each of the respective overhead cost

Cost drivers used for overhead cost allocation are as under

Overheads Cost Driver

Production scheduling overheads Number of batches required for annual production volume

Machine set up costs Number of batches required for annual production volume

Equipment Depreciation Number of machine operations per ornament

Plant Depreciation Number of inspection performed per ornament

Quality Inspection Number of boxes used for each category of production

Packing overhead costs Number of boxes used for each category of production

Plant- administration costs Number of batches of production

(determined as above

Accordingly ABC cost of each product per box is calculated as under :ABC costs calculative above present an altogether different scenario than what was reflected in traditional volume based costing as shown in exhibit I . Though in both cases the products Small Colored glass and Large Colored is costing more than their selling prices , but ABC costing of these products is much lower than activity based costing has rational approach of selecting the activity or the cost driver for the purposes of overhead cost allocation over products

3

Activity Based Costing versus Costing Based on Standard Volume or Direct Material plus direct labor

In contrast to traditional cost accounting system , ABC system first accumulate cost for each organizational activity , and then assign the costs of the activity to the products , services , or customers (cost objects ) causing that activity . As one might expect , the most critical aspect of ABC is activity analysis . Activity analysis is the process of identifying appropriate out measures of activities and resources (cost drivers ) and their effects on the costs of making a product or providing a service (Michael S . Luehfling

Activate based costing (ABC ) lay preference to activity involved in production or services rendered while collecting as well as allocating the overhead cost . Whereas Standard Volume or Direct material plus direct labor (traditional costing ) the emphasis is on volume or cost of direct input while absorbing the overhead costs

Under ABC the underlying assumption is that activities drive the costs , which are driven by the product or customer . This radically differs from conventional costing systems , which is built on the assumption that product drive the cot directly ( TCM Bulletin , August 2002

ABC involves setting up of an information system which could help trace costs to cost objects . Under traditional costing standards and basis of overhead costs absorptions are predetermined and those basis are not flexible with reference to fresh available information

ABC identifies costs to each major activity instead of departments as is done under traditional costing system

Traditional cost accounting looks at what is spent , while Activity Based Methods look at what is done in terms of activities . From the point of view of latter , it is much easier to identify opportunities to reduce cost and improve performance , while maintaining the quality of care provided (Exact cost , 2008

Activate Based Costing provided the much needed flexibilities . The entities can go beyond gross margins and play with those vulnerable costs that may bring down the economics , or by other costing techniques

Activity analysis provides actionable information about process costing whereupon the entities can plan and develop schemes to reduce costing and enhance profitability

Under traditional costing system only the direct costs of material and labour can be related or traced to the products , whereas under activity based costing all activities can be classified as value added or non- value added activities . In to enhance profitability the entities get an opportunity under ABC to do away with non- value added activities

By applying activities to absorb the overheads in case of Zauner Ornaments , it is observed that allocation of expenses changed the entire scenario of each product costs . Small colored glasses and large colored glasses in fact were being sold at loss . The picture to Yu through Exhibit 1 was thoroughly contradicted by adopting absorption of costs based on specific activities or cost drives involved

4

Changes required in Price Strategy

Zauner Ornaments earlier fixed prices arbitrarily based on market prices of similar products . In fact analysis of costing was not involved whiles fixing prices of the product

Later when a traditional volume based costing was used to allocate overheads product wise , it was observed that product a different but alarming picture . Small colored glasses and large colored glasses were being sold at losses and the only product that was contributing to profits was specialty ornaments

A further exercise to absorb the overheads based on direct material and direct labor cost reversed the situation altogether and every product seemed contributing towards profits . This was also an exercise based on another traditional costing system not involving activities that drive the costs

The real picture emerged when Activity based costing was used and it was found that production of Small Colored glasses and large colored glasses were actually bringing losses , and the costing suggested a through overall of pricing of the product

In this regard the management of Zauner Ornaments should take the following steps

A through analysis of the ABC would bring forth activities that may be avoided in to reduce overheads as far as possible

A break even sale may be calculated taking into account the contribution from all the three products

Based on this required break even contribution prices of three products may be fixed keeping in view the market prices and competition available

It is true that market forces actually direct the price fixation , but activate based costing point out loopholes or flexibility in activities where the entity can bring in the required adjustments in to come up to the market expectations . It is true that gap between market prices of Small glass and large glass ball ornaments and their ABC costing is large , but Zauners can play with the scales of production to bring down the direct costs . In other words Zauners can take advantages of large purchases of direct material by persuading them to reduce the cost . The labor efficiency is another factor , which if improved , can bring down the direct labor costs to an extent to enable Zauners to come at a level of incurring competitive costs . If things do not workout in such fashions , Zauners may decide to dispense with the production of that category of production , the contribution wherefrom is not even breaking even . Activate Based Costing in fact open up a number of vistas whereupon the entity can play and redetermine its price strategy

Conclusion

Activate Based Costing is most modern and appropriate technique to arrive at true basis for absorption of overheads . Activities that drive cost are the real basis for absorption of overheads . Using ABC the Zauner Ornaments arrive at conclusion that two of its three products were being actually sold at loss . This is so as its price strategy was not at all cost based . Zauner was not even using traditional volume based costing in pricing strategy of its products . The real cost per box came to light when Zauner effected activate based costing . Use of ABC brought forth the costing effects on the earnings of the Zauner . Under such situation it is imperative that Zauner Ornaments should go for a change in its price strategy and base it on ABC analysis and within the limitations imposed market competitive forces

References

Activate Based Costing , Accounting for operational Readiness , OSD Comptroller I Center , viewed on March 10 , 2008

HYPERLINK "http /www .defenselink .mil /comptroller /icenter /learn /abconcept .pdf http /www .defenselink .mil /comptroller /icenter /learn /abconcept .pdf

Exact Costs , Traditional costing vs . Activate Based Costing , viewed on March 8 , 2008 , HYPERLINK "http /www .exactcost .com /Traditional_Costing_vs_Activity_Based_Methods http /www .exactcost .com /Traditional_Costing_vs_Activity_Based_Methods

Michael S . Luehfling , Activate Based Costing , Encyclopedia of Management , page 1 , viewed on March 8 , 2008 , HYPERLINK "http /gale .cengage .com /pdf /samples /sp665568 .pdf http /gale .cengage .com /pdf /samples /sp665568 .pdf

TCM Bulletin on Activate Costing System (ABC , ABC- the road to Cost Management , Vol .2 , August 2002 , HYPERLINK "http /greenbusinesscentre .com /Documents /TCM 20bulletin-ABC .pdf http /greenbusinesscentre .com /Documents /TCM 20bulletin-ABC .pdf

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