Rally Cycles Ltd is a company which manufactures bicycle pumps. They produce two models: a Regular model and a Deluxe model. Each model accounts for 50% of the revenue but the deluxe model has brought in a slightly higher profit than the regular model with £181,000 compared to £179,000.
The company has hired me as a management consultant to advice them on their cost accounting system and to provide them with recommendations.
The company currently considering changing the cost accounting system it uses to an Activity-Based Costing (ABC) system. The old costing system allocates service department costs based on machine hours to the machining and assembly departments. A separate cost driver of direct labour hours was then used to assign the support costs of the machining and assembly department to the two products. An ABC system identifies individual activities as the fundamental cost objects. For this company, activities include setting up machines and assembling products. The ABC system firstly calculates the cost these individual activities and then allocates the costs to the two products based on the mix of activities that is needed to produce each product.The two accounting systems give different profits for the Regular and Deluxe models which can be seen in Appendix 3. Under the existing cost accounting system
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(Appendix 3, Table 2), the Regular model gives a Net Profit of £229,000 and the Deluxe model gives a Net Profit of £131,000. This shows that the Deluxe model is less profitable than the Regular Model by £98,000. Under the new Activity-Based Costing system (Appendix 3, Table 3), the Regular model gives a Net Profit of £322,000 but the Deluxe only gives a Net Profit of £38,000. Under this system there is a Net Profit difference of £284,000. This is much more from the £98,000 difference under the existing cost accounting system. This shows that it is very important which costing system you use as the results can be very different. Using certain costing systems could lead to the company under costing or over costing their products. Therefore companies must be very careful when deciding on a costing system because the results will be taken into consideration when management decisions are made. Decisions based on distorted information can lead to unexpected or bad results.
Section 2 - The Old Cost Accounting System
The old cost accounting system may be distorting the company's product costs and profitability because it traces only a small number of costs as direct costs, and the costs are not allocated based on how the products use the department where the costs are generated. This leads to a lack of costs being traced back to the products and can give a higher profit per unit of output than is actually more realistic. If management believe one product is generating a high level of profit compared to another product, under one cost accounting system then they may decide to put more resources into producing more of this product. If on the other hand they had used another cost accounting system, which would perhaps have given a lower profitability for than product compared to another product, then they may not have made this decision.
Rally Cycles Ltd's two products also gave two different unit cost results when calculating it under the two different cost accounting systems. Under the old cost accounting system, the Regular model gave a profit per unit of £1.43 while the Deluxe model gave a profit per unit of £2.55. Under the new activity-based costing system, the Regular model gave a profit per unit of £1.74, while the Deluxe model gave a profit per unit of £1.69. This is quite a significant difference between the profit per unit of the two models under the different cost accounting systems. If management were faced with the old cost accounting system it would be very likely that they would decide to produce more of the Deluxe model as it is more profitable. Under the new Activity-Based Costing system, the management would probably make the opposite decision and produce more of the Regular model as it is slightly more profitable. This shows that the old cost accounting system could be providing the company with a distorted view of the product costs and profitability.
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One of the main reasons that old cost accounting system could be distorting the company's product costs is that only two cost driver rates are used throughout the analyses which are the number of units produced and the Direct Labour Hours. Rally Cycles Ltd uses the number of units produced to assign the cost of Machining Department and Assembly Department to products. Using the number of units as a way of assigning costs to product could lead to a distorted view of the product cost. This is because the number of units produced is not what drives the cost of these departments; rather the Direct Labour Hours in each department is what drives the cost. This leads to the Regular model being over charged and the Deluxe model being under charged. This can be seen in Appendix 1, Table 12 compared to the Activity-Based Costing system in Appendix 2, Table 8. The Activity-Based Costing system uses a larger range of cost drivers in order to cost products more accurately.
Another reason the old system is misinterpreting the products cost is because the assumption made by this system is that the costs are incurred when the product is manufactured. This makes sense for direct costs but not for indirect costs, and this is where the system fails. For activity overheads, the proportion of the activity costs that is actually consumed by the product does not have a direct link to a single indirect cost driver. Therefore for a company that produces a product using a range of activities but only uses a single cost driver will be distorting its product costs. These types of traditional costing systems assign costs directly to products rather than first to activities and then to products. It shows what costs are spent but not why it is spent. This is why when the company tries to cut total costs that the symptoms are treated but not the causes (Carl Marx, 2009). This often leads to reduction in the quality of the product rather than a reduction of cost in the long term. Therefore this system is not successful in the long term.
The old cost accounting system is a system in which the total cost is spread among its various products based on the idea that products cause costs rather than the idea than activities cause costs.
Section 3 - The New Activity-Based Costing System
A new cost accounting system that the company could introduce is an Activity-Based Costing system. This system