Abc: The new approach to decision making policies

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Confidentiality Statement:

Pomodoro clothing company Ltd. has requirements under the Company Code of Business Conduct. One of the Company's requirements states that internal information for company's employees only and may not be shared with anyone outside of the company. Disclosure of confidential information include business plan, costing strategies, information about operations and any other non-public information that might be used to competitors. Therefore Internal data, Internal costing reports and internal documents are classified as Company's internal hence not attached with this project report.

1.0 Introduction:

Costing is involved in our daily life although we may not always realize it. When we pay for goods in a shop, we are part of an intricate costing transaction that helps the manufacturer pay salaries, heating, lighting, rent, VAT, taxation and so on. Pricing is a complex business involving a large number of people but the bottom line is always that the sale price has to be greater than the price of production, anyone selling lower than the cost of production will swiftly go out of business. This is why manufacturers know the price of every single part of their production process. Thus costing system is important part of any type of business or organization either is small, medium or large.

1.1 Types of Costing Systems:

There are many types of costing systems available for business to use most of these costing systems are designed to assign costs to products, they are classified mainly in three types:

Direct Costing Systems: are only assigning direct costs to objects and they are not in place to measure and assign indirect costs to cost objects.

Traditional Absorption Costing Systems: are assigning all indirect costs allocated to the production department and then charged to products using volume-related bases such as machine hours or direct labour hours.

Activity based Costing (ABC) Systems: are used to assign costs more accurately to products and department in today's complex business world. (Drury 2004)

1.2 What is Activity Based Costing?

Activity based costing is an approach to dealing with overheads in full costing that treats all costs as being caused by activities. Advocates argue that it is more relevant to the modern complex business environment than is the traditional absorption costing. (Atrill, P. and Mclaney, E.2006)

ABC focuses on accurate information about the true cost of products, services, processes, activities and customers. Using ABC, organisations gain a thorough understanding of their business processes and cost behaviour during ABC analysis. Management then applies this insight to improve decision making at operating and strategic levels.

1.3 Why ABC theory has arisen?

ABC theory has arisen as a result of both Traditional Absorption Costing Systems and Direct Costing Systems have fundamental weakness and can therefore be inaccurate as a means of costing. Traditional costing systems assumes that all products consume all resources in proportion to their production volumes, tend to allocate to great a proportion of overheads to high volume products and too small a proportion of overheads to low volume products. ABC attempts to overcome this problem.

ABC involves the identification of cost drivers which cause the costs of an organisation's major activities. Support overheads are charged to products on the basis of their usage of an activity.

1.4 Aim of this Case Study Research:

Aim of this research is to show how ABC system gives the new approach to decision making policies and how performance of overall business can improve of Pomodoro Clothing Company compare to Traditional Absorption Costing system. ABC systems have the litheness to provide special reports so that management can obtain decisions about the costs of designing, selling and delivering a product. The key aspect is that ABC focuses on accumulating costs via activities, whereas traditional cost allocation focuses on accumulating costs within practical areas.

The main advantage of ABC is that it minimises distortions on product costs that might occur from arbitrary allocation of overhead costs. This case report will benefit account manager of Pomodoro Clothing Company and other managers of other similar industries task with improve overall business performance and decision making strategy for product pricing.

1.5 Outline of Research Project:

This project report has six sections after this Introduction. First, a literature review is described. Then an orientation is provided. Then research methodology is described. Then research findings are discussed. Next, key learnings are described. Finally, the report concludes.

2.0 Literature Review:

A literature review is employed as the research methodology in the study to determine how ABC system is useful for decision making and for improve profit of the organization. The literature on ABC was collected primary from books in the areas of cost management accounting, finance and management, which will be compared to project based documentation of case study research. The primary aim of the literature search is to help researcher to develop an effective guide on ABC system and their back ground, comparison with traditional costing, applications, benefits and limitations.

2.1 Background of ABC system:

Sixty years ago Goetz (1949) advocated ABC principles and he wrote:

Each primary [overhead] class should be homogenous with respect to every significant dimension of management problems of planning and control. Some of the major dimensions along which [overhead] may vary are number of units of output, number of orders, numbers of operations, capacity of plant, number of catalogue items offered.

The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. In the beginning ABC focused on manufacturing industry where technological developments and productivity improvements had reduced the proportion of direct costs but increased the proportion of indirect costs. In 1988 Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products. Over the years the increased opportunity cost of having poor cost information and the decreased cost of operating more sophisticated cost system, increased demand for more accurate product cost(Holzer and Norreklit,1991)

2.2 Definition of Activity based costing:

The concept of ABC was first defined in the late 1980s by R. Kaplan and W. Burns. There are some recent definitions of ABC by Chartered Institute of Management Accounting(CIMA) are quiet impressive for understanding the concept of ABC system.

Activity based costing (ABC) is an 'approach to the costing and monitoring of activities which involves tracing resources consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.'(CIMA Official Terminology)

ABC is an 'approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.' (CIMA Official Terminology, 2005)

2.3 Comparison of traditional costing and ABC

The traditional method of costing relied on the arbitrary addition of a proportion of overhead costs on to direct costs to attain a total product cost. In contrast to traditional cost accounting systems, ABC systems first accumulate overheads for each organisational activity. They then assign the costs of these activities to products, services or customers (referred to as cost objects) causing that activity. In comparison with traditional methods, costs will be allocated in different proportions, so highlighting unprofitable products that should either be improved form the range.

This type of costing system usually allocates costs based on a single volume measure, such as direct labour hours or machine hours. While using such a basic volume measure to allocate overheads as an overall cost driver, this approach seldom meets the cause-and-effect criteria desired in accurate cost allocation. Traditional absorption costing has become increasing inaccurate as the relative proportion of overhead costs has risen. This distortion of costs can result in inappropriate decision making. (Drury C, 2004)

2.4 ABC in practice:

ABC activities have been around for nearly 30 years and many companies in a variety of sectors have implemented activity based costing. ABC has brought about radical changes in cost management systems. The principles and philosophies of activity based costing apply equally to service companies, government agencies, process and manufacturing industries.

ABC focuses on accurate information about the true cost of products, services, processes, activities and customers. Using ABC, organisations gain a thorough understanding of their business processes and cost behaviour during ABC analysis. Management then applies this insight to improve decision making at operating and strategic levels. This is then known as Activity based management (ABM).

2.5 Benefits of ABC system:

ABC provides a more perfect method of costing of products and services.

It allows for a better and more comprehensive understanding of overheads and what causes them to occur.

The Availability of cost driver's rates can be used as an input into the design of new products and modification of existing ones.

It makes costly and non-value adding activities more visible, so allowing managers to focus on these areas to reduce or eliminate them.

The main advantage of ABC is that it minimises or avoids distortions on product costs that might occur from arbitrary allocation of overhead costs.

It supports other management techniques such as continuous improvement, scorecards and performance management.

2.6 Reported drawbacks of ABC

ABC is a relatively new technique and the potential problems may appear only over a longer period of time. The initial activity analysis is clearly the most difficult aspect of ABC. Activity analysis is the process of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service.

ABC can be difficult and time consuming to collect the data about activities and cost drivers.

It can be costly to implement, run and manage an ABC system.

Even in ABC some overhead costs are difficult to assign to products and customers. These costs still have to be arbitrarily applied to products and customers.

3.0 Orientation:

The Pomodoro Clothing Company Limited is UK's medium Scale organization supply brand women garments in many countries in Europe like England, Scotland, Welsh, Spain, Greece, Italy, France, Northern Ireland, and Denmark. Pomodoro clothing company has developed their own brand which is highly impressive in rural and urban market of Europe. The 'Pomodoro' brand has grown steadily over the last 17 years and is now well represented in almost all regions of UK and Europe.

3.1 Background of the Pomodoro Clothing Company Ltd.

Pomodoro Clothing Company first came and established in London, UK, in 1992. Pomodoro has been successful since its establishment in London; UK. The Pomodoro clothing company Ltd started initially with two directors and ten staff members in 1992. The company was small scale organisation which imported fashion goods from India. The company was suppliers of some reputed UK brands like NEXT, Erin Joe and Ann Harvey and some others. The Pomodoro Clothing Company has developed their own brands like 'Pomodoro' and 'Sorrento' in 1995 and started business as new comer in fashion world. In 1997 the Pomodoro Clothing Company Ltd. has developed with full departments comprising of: administration, human resources, design, quality control, accounts, production and marketing. The total numbers of employees in the company is now almost 60 people. Since 1999, Company achieved their target objectives and improve overall business.

The organisational context and reality of the company will be centre of this research.

Pomodoro is successful because it offers:

Super-competitive prices

Mainstream market product quality

Clear focus on the target market.

High product range

3.2 Achievements and objectives of Pomodoro Clothing Company Ltd.

Achievements:

The Company has a £950,000 annual turnover with a £195,000 net profit in the March 2009.(Appendix A)

Since 1992 company has achieved good profit every year.

The company has received some awards in market segments and quality management.

The company has achieved annual growth rate of 12% compare to last year.

Objectives:

Main aim of the company to achieve annual growth rate of 15% in next year.

To determine new product prising system and improve overall business performance.

Assigning the cost of activities to products according to product's demand.

Assigning costs to cost pools for each activity.

3.3Research questions:

In recent years there has been significant focus on activity based costing (ABC) in medium scale manufacturing companies and other organisation in the UK. ABC is a type of modern costing system which gives an alternative to traditional absorption costing system. Account manager of Pomodoro Clothing Company use traditional absorption costing method which has caused some serious problems in decision making and overall performance of the company. The research objective questions to identify the new approach to decision making and improve overall business strategy using ABC system.

This is, based on concept covered above, this report focus on research questions in the main case:

How Activity based costing gives new approach to pricing and decision making strategy of the Pomodoro clothing company compare to traditional absorption costing?

How ABC system effect Company's profit compare to traditional absorption costing?

4.0 Research Methodology:

A case study method was used to collect data about research questions above relating to ABC system which gives new approach for decision making and improve overall business of Pomodoro Clothing Company. This case study report conducted using both secondary and primary data. These data were obtained from Pomodoro website, annual reports, media and other publications on the topic like textbooks, articles and journals. The majority of the data is secondary data which was easily accessible from the company. The primary data was obtained from the company's finance department. A thirty minutes informal interview was also granted to me by the finance director. Being a student and an employee of the company, I also had opportunity to speak to managers who are taking part in pricing decision making team to brief me with a broad knowledge on the topic during the research.

The research made use by the use of mixed method research, that is, qualitative and quantitative data collection techniques and analysis procedures to analyse the data. (Saunders M., Lewis P and Thornhill A., 2007). The qualitative and quantitative data were used to derive better costing system that is ABC for the company. Analytical conclusion was drawn from the outcome of these findings coupled with data obtained from other archival company data sources such as Management accountant's reports and information drawn from the face to face interview granted me.

The research methodology was single case research (Perry 1998; Saunders, Lewis and Thornhill 2003; Stocks and Perry 2007; Yin 1994) involving Pomodoro Clothing Company Ltd. a medium scale organisation. Having single case study justified because, firstly, it provided unusual access for academic research, and the case was investigated; an opportunity to investigate a significant decision making problem may be lost. A second justification for the single case study is that a medium scale organisation in UK provides rare chance to investigate their costing systems and their private records to academic researcher due to their company's private policies and strategies about the successful business. The researcher was an employee of the company and access to his own firm provided data and using his own work experience in the company that academic researcher can miss from a real story about pricing policies, costing and decision making strategies in business.

4.1 Type of research and research method

According to Saunders (2006) the methodology is one of the most significant parts of the research making process. I have used Exploratory research here which often relies on large sum of secondary data research such as reviewing available literature and/or data, or qualitative approaches such as informal discussions with managers (Saunders 2003) like it will be the case in this project.

Qualitative researcher typically relies on four methods for gathering information:

Participation in the setting,

Direct observation,

In depth interviews,

Analysis of documents and materials.

For this project, I have actually mainly used the analysis of financial reports of the company. There was direct involvement of researcher in project for direct observation and also analysis of project blue print and spreadsheets etc.

4.2 Researcher philosophy:

(Saunders, 2003)" Deductive approach owes more to positivist and the inductive approach to philosophies, the deductive approach owes more to positivism and inductive approach to interpretivism". After considering all concepts, it became evident that this research project would have to fall within interpretive philosophy as it required analysis of qualitative data inductive approach.

4.3 Instruments of data collection

The multi-method data collection strategy allowed for triangulation of findings, which increased the reliability and validity of the results. For this project, both primary and secondary data are used but all of them are qualitative research. For most of the parts secondary data are used. Those data are easily accessible, relatively inexpensive and quickly obtained. It can help to identify a problem, develop a new approach to the problem and in the case of this project; it can directly answer certain research questions. Saunders (2003) has identified two sources of secondary data:

Documents: process documents, design documents and pricing documents.

Archival records: Annual financial reports, project spreadsheets, and blueprints.

4.4 Why researchers rely on heavy use of Secondary data?

Secondary data include both quantitative and qualitative data, and they can be used in both descriptive and explanatory research. The data you use may be raw data, where there has been little if any processing or compiled data that have received some form of summarizing (Kevin, 1999). Researcher will need high quality of multipurpose data to compare with Literature and research findings because of nature of research. Secondary data is also fast, inexpensive and unobtrusive; researcher is already working with Pomodoro clothing company ltd., and that has avoided data collections problems and highly useful to assess the general validity of a case study.

4.5 Sampling of the research

For this project, the non probability convenience sampling technique will be used. The convenience sampling attempts to obtain a sample of convenient elements (Malhorta, 1999). The researcher is the one who primarily selects the sampling units. By the way, "often, the respondents happen to be in the right place at the right time" (Malhotra, 1999).

In the case of this project, the criteria for choosing the sample of documents, the company chosen fits perfectly to the subject and, most of all, the researcher is an employee of this company. This convenience technique is the least expensive and the least time consuming of all sampling techniques. Convenience samples can be used in exploratory research to "generate ideas, insights or hypotheses" (Malhorta, 1999).

4.6 Method of Data Analysis

The data collected will be grouped into qualitative and quantitative data. This is to avoid data volatility and ensure efficiency in the analysis of the data. Excel will be used to generate the output. The output would be drawn from collected data and using calculations for product pricing of Pomodoro clothing company ltd. by activity based costing compared to traditional absorption costing. This would be a means to interpret the analysed data and draw a specific result to research questions.

In conclusion, it is important to emphasize that this research relies on multiple sources of data interpretation and therefore the risk of it being invalid at results will be reduced nominally. However, a reasonable attention will be given on all the above issues to ensure that errors and inconsistencies are minimized throughout the research.

5.0 Research Findings:

The purpose of this chapter is to explain findings and results come out from this research, to present results, I have used different literature to compare with the multipurpose secondary data and documentation of implementation project. Using this research, the chapter indicates details come out from analyzing qualitative database of traditional costing system of the company.

After having gathered the needed information we are now going to analyse it and come out with our discovery of the study. Due to the fact that raw data cannot be considered useful for decision making purposes, it is indeed necessary to present data in a more useful manner to ensure easy understanding to prospective users. In this respect, therefore, this chapter purport to present data collected from the field for the research work in order to avoid misleading. Thus, the chapter seeks to use appropriate analytical measure to package raw data as to foster easy understanding of the field data.

The members of the senior management team of Pomodoro clothing company Ltd. discussed the introduction of a new product (embroidered woollen coat) to the company's range of high quality women garments in October 2009. A major agenda item was pricing. The management accountant had given much thought to pricing policy and one of his concerns was that of dealing with the recovery of overhead within a full cost pricing policy. The discussion centred around the traditional method currently in use, compared and contrasted with ABC, which re-examines the problem that has faced accountants for decades; that of allocation and absorption of overhead.

5.1 Production cost using Traditional Costing method

Traditional pricing method has been based upon absorption costing and the treatment of overhead usually followed a set procedure.

ï‚· Cost centres are identified and established within the organisation.

ï‚· Cost centres may be producing or service centres.

ï‚· Wherever possible a direct charge is made to a cost centre i.e. allocated overhead.

ï‚· The overhead cost for the service centre is then transferred to producing centres.

ï‚· The total overhead cost for each producing centre is then divided by for example, machine or labour hours per the cost centre.

ï‚· This is then used to absorb the overhead to products.

ï‚· If planned activity levels are actually achieved then overhead may be fully recovered in the short run.

Such method may successfully be used where there is a limited product range and predetermined rates are well planned on achievable production budget volumes.

The firm has three major producing cost centres; Production, Processing and Packing.

The standard hourly rate paid to the employees in each cost centre is £5.50. 5.2 Production cost using Activity based costing

Activity Based Costing offers a workable and more effective insight into overhead allocation and recovery.

The application of ABC involves a set procedure:

ï‚· Accounting for and collection of overhead

ï‚· Allocation of overhead to form cost pools associated with 'value adding' activities

ï‚· Identification of cost drivers

ï‚· Determination of cost driver rates ie: pool / driver volume

ï‚· Recovery and charging of overhead to product / service based upon the demand for the activity.

ABC method applied to the new product of Pomodoro clothing company ltd.

We have recently analysed the value added processes and data then identified various activities, cost drivers within those activities and current volumes that apply across the producing unit as a whole and have applied ABC method and technique.

(Budget Plan Period January - March, 2009)

The company has a number of products, one of which is a new product (embroidered woollen coat). In the budget periods January - March 2009, we plan to produce 250 per month (i.e. 750 pieces in three month period) and to achieve this total level of volume; the output will require the following activity demand:

ï‚· 5 set ups

ï‚· 5 purchase orders

ï‚· 2 standard maintenance plans for volume of 750 units

ï‚· 100 material movements

ï‚· 75 inspections

ï‚· 10 sales customers

Thus overhead cost per unit = £10,775 / (3 x 250) = £14.37

Here we can see that the overhead when associated with cost pools and identified to the activities which drive cost, shows an overhead unit cost of £14.37.

Thus the production cost of one unit of output using ABC as the basis of recovering the overhead shows:

£

Prime cost as above

35.98s

Production overhead

14.37

Production cost

£50.35

Production cost of a embroidered woollen coat using traditional costing was £53.85 compared to ABC system was £50.35.The difference £3.50 per piece between Traditional absorption costing and ABC. Thus ABC gives new approach to decision making and profit gain in overall business of Pomodoro clothing company Ltd.

Compared with traditional approach to overhead allocation, apportionment and absorption, ABC generates more accurate product costs however, recent research suggests that by improving the quality of cost and management accounting information, it also provides managers with a wider understanding of the economies of production and those resource consuming activities which when linked to the labour and capital provide the wealth to company's business.

6.0 Key learnings:

As a result of research findings from primary and secondary data obtained from Pomodoro clothing company ltd. and literature review, the following strategies are presented to achieve a new approach to decision making policies and improve overall business' profit in the company.

6.1 Recommendations:

In contrast to traditional cost accounting systems, ABC systems first accumulate overheads for each organisational activity. Then assign the costs of these activities to products, (referred to as cost objects) causing that activity. So I would like to suggest the account manger of the company to identify cost objects of all major activities in the company.

The proportion of costs that can be more accurately assigned to cost objects by ABC system that can be expected to have future cash flow impact. This would imply that appropriate cost information extracted from simplistic costing system may be sufficiently accurate for decision making purpose.

The initial activity analysis is clearly the most difficult aspect of ABC. Activity analysis is the process of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product. So I would like to suggest the account manager of the company to identify cost drivers using initial activity analysis in the company.

ABC systems have the flexibility to provide special reports so that management can take decisions about the costs of designing, selling and delivering a product.

ABC is particularly suited for long- term and strategic decision such as long- run pricing, product mix decision and capacity management, so it is very important for manager to have patient and observe all activities' cost drivers and cost pools for better result of the costing system.

Using new accounting software which include how to implementing ABC system in the company and also provide training to all departments regarding how to use the ABC system.

6.2Steps in development of an ABC System in the company:

ABC uses cost drivers to assign the costs of resources to activities and unit cost as a way of measuring an output. The benefits of ABC system reported by research included more accurate cost information for product prising, more accurate profitability analysis and improved cost control and a better understanding of cost causation. Various studies identified problems to implementing ABC system like data collection, difficulties to identifying activities and selecting cost drivers, lack of resources and inadequate computer software. There are four steps to implementing ABC.

1) Identify major activities

The organisation needs to undertake an in-depth analysis of the operating processes of each responsibility centre. Each process might consist of one or more activities required producing an output.

2) Assign resource costs to activities

This involves tracing costs to cost objects to determine why the cost occurred. Costs can be categorised in three ways:

i) Direct - costs that can be traced directly to one output. For example, the wood and paint that it takes to make a chair.

ii) Indirect - costs that cannot be allocated to an individual output, that is, they benefit two or more outputs, but not all outputs. For example, maintenance costs or storage costs.

iii) General/administration - costs that cannot be associated with any product or service. These costs are likely to remain unchanged, whatever output is produced. For example, salaries of administration staff, security costs or depreciation.

3) Identify outputs

Identify all of the output for which an activity segment performs activities and consumes resources. Outputs might be products, services or customers.

4) Assign activity costs to outputs

This is done using activity drivers. Activity drivers assign activity costs to outputs (cost objects) based on the consumption or demand for activities.

In this project report, this section gave idea about recommended actions which were clearly based on research findings and important for the account manager of the Pomodoro Clothing company ltd. and other managers of similar organisations in the UK and abroad.

7.0 Conclusion:

Activity based costing is an important costing method compared traditional absorption costing for new and existing business. The key aspect is that ABC focuses on accumulating costs via activities, whereas traditional cost allocation focuses on accumulating costs within functional areas. The ABC is to focus on cost drivers and try to minimise irrelevant costs of production. Thus ABC system develops new approach to operation and production and how to maximum use of resources to improve overall performance of the business.

In summary, study of literature and using research methodology I obtained research findings which are clearly showing that Pomodoro clothing company ltd., could gain new approach to decision making policies and profit making in overall business. It is better to implementing ABC system with recommended actions in this project.

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