Analysing advantages and disadvantages of switching to machine hours

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The Cylinder manufacturing company was founded by Mr Brinkwater in 1970 and it is a larger producer of oil tanks and is located in the north of Buckinghamshire in the United Kingdom. It was started as a company in 1970 and has enjoyed steady growth in both sales and profits.

Davina Brinkwater, the founder's daughter, joined the company in 1998. One of her first task was to revise the Accounting system for more accurate product cost information to support the firm's strategy of offering keen prices in a highly competitive market where a few firms dominated.

When Davina joined the company she realised that the company is using an 'Old Accounting System'. Davina is surprised by the depth of opposition that she faces in trying to change the organisation. Some members of the firm appear to be happy to accept the shortcomings of the old system on the basis that there are comfortable with it and they understand its working. However, with the support of her powerful and influential father, she wins the argument and now has the job of implementing her new system.

Company's current situation

Over the past five years, profits are below budget, overhead costs had risen to £599300 per month, a 46% increase, while direct labour hours have risen from £168200 to £170000, a small increase. The product processes are now largely mechanised with a high level of automation. Direct labour hours are 4000 compared with machine hours of 6500.

According to accountant, they are still absorbing overheads on labour hours and that they have an artificially high overhead absorption rate of £150 per labour hour. He claims that they are prising themselves out of the market on their established product line. He suggests that product costs would be more meaningful if absorbed on the basis of machine hours.

Davina is worried about falling profit and rise in overhead cost although company is meeting sales target but production costs are rising because of the switch to specialist products.

After the study of company's history, my recommendation is to change the current accounting system of the company. As firm is currently using traditional accounting system, they should change it to Activity Based Costing (ABC).

Activity based costing (ABC) assigns overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of labour hours. ABC is different approach and improves control of overhead by cost/cause relationships, which are activity and cost.

ABC system is a technique for more accurately relating the overheads to specific production or provision of a service. It is based on acceptance of the fact that overheads do not  just occur but are caused by activities, such as holding products in store products in store, which drive the cos.(Ref: Accounting An introduction by Eddie Mclaney and Peter Atrill. Forth Edition)

ABC is the only solution for the problem which the company is facing and implementing the new ABC is the big challenge. After implementing the new accounting system we will able to calculate cost of both the products Standard and Specialised product.

Problem and analysis of machine hours

After calculating machine hour with ABC system we have actual cost of both products. Standard products are using more machine hours than special products and they are giving less profit. Because there are 23 different versions of standard products in the market so we cannot increase the price of standard products. The main problem is specialised product is driving the cost more than the standard product because they needs more members of set-up, skilled labour and store orders. Standard product is absorbing the cost of specialised product.

The main issue is demand of specialised product not the price so that the company needs to meet the sales target and earn profit. The reason of that is we use less machine hours on the specialised products as compare to standard products.

Advice:

Advice is that as special products have more demand in the market as compare to standard products and they are giving more profit, we can increase the price the price of specialised product in order to gain more profit. We can run the manufacturing department in different shifts to earn more profit.

Question#2: Show how can an activity based system would change the analysis of the cost between the standard and specialist products?

As we know the company is using the old accounting system which is not able to calculate the actual costs of the product. We have to use the ABC system which analyse the actual cost of both standard and specialised products. ABC is an alternative to the traditional accounting system. This is the method of calculating the cost of business by focusing on actual cost of activities. "ABC system is a technique for more accurately relating the overheads to specific production or provision of a service. It is based on acceptance of the fact that overheads do not just occur but are caused by activities, such as holding products in store products in store, which drive the cost".(Ref: Accounting An introduction by Eddie Mclaney and Peter Atrill. Forth Edition)

We can calculate the cost between standard and special product using ABC system and we can see the difference.

After calculating this we can conclude that standard product is using more labour and machine hours and not giving any profit. Manufacturing manager is also worried about the standard product, as he is keeping cost low because there are 23 versions of the product in the market.

Specialised product is doing well in the market and meeting the targets and the sale is increased and there is still demand for the specialised product.

Analysis of the cost

As firm is using old accounting system which cannot calculate the cost according to their activities. By using ABC system we are able to charge the different product according to their act this firm is using a single pool for the overheads, the cost of standard and specialised product is not calculated by their activities. Budgeted overheads cost per month shows the total of overheads so it is not possible to check which product is absorbing the cost, and how we can generate profit from it. The old accounting system is showing the Machine, Set-ups and materials handling as a total for both products.

With this method we cannot calculate actual cost of two products, so we use the ABC system to calculate the cost of each product.

With the help of this ABC analysis we can easily find out the profits of the two products. Specialised product makes the profit and it will meet the sales target either the demand of that product will increase.

There are few points which help to fulfill the demands of their product in the market:-

(A). Increasing the Price of product in the market.

(b). Increase the Labour Hours.

(c). Increasing the manufacturing of the product.

(d). Controlling the product in to the stores according to their order and cost.

(e). Make the balance between Machine hour and Labour hours.

(f). More skilled labour and more Set-ups in the manufacturing department

From the above calculations we can compare both products in different categories as:

Standard products:-

Facing competition in the markets.

Containing low prices in the markets.

Containing low profit margin.

Having low cost drivers.

Specialized products:-

Having no competition in the markets.

Containing high prices in the markets.

Containing high profit margin.

Having high cost driver.

Advice:

The figures show that under the traditional approach, the margins are broadly equal between the two products. However, the ABC approach shows that the specialised product is far more profitable. Hence the firm should reconsider its manufacturing department and try to increase the production of the product and in marketing department they try to switch customers to specialised product, with an increase in price. The specialised product will increase the profit margin and will help the company to improve its financial condition. As the demand of specialised product is more in the market, the company needs to increase the manufacturing by increase labour hour in extra shifts and high price in market which is possible because of demand.

Question #3: Advise on the implementation of an ABC system. How can Davina's fears be lessened?

Davina's father who was the founder of the company retired and hence she cannot expect support from him. So, Davina have to be confident of her and also take in confidence with other members of the department too. As discussed in the above two questions, it can be seen clearly that machine hours does not bring too many changes in absorption of overheads as because it does not consider all the activities in production.

Before giving the advice to Dvina on implementation the important thing is to make her understand the ABC system and its advantages and how an ABC system can change the costs between products.

What is Accounting and finance?

Financial accounting is the field of accountancy concerned with the preparation of financial statements for decision makers, such as stockholders, suppliers, banks, employees, government agencies, owners, and other stakeholders. In short, It is the process of summarizing financial data of business transactions and events taken from an organization's accounting records and publishing in the form of annual reports for the benefit of people outside the organization(Ref: http://encyclopedia.thefreedictionary.com/Financial+accounting)

Activity Based Costing (ABC)

Activity-Based Costing (ABC) is a method of allocating costs to products and services. It is generally used as a tool for planning and control. It was developed as an approach to address problems associated with traditional cost management systems that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions.ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods (Ref. http://rocfordconsulting.com/activity-based-costing%20(ABC).htm

Advantages of ABC

More accurate costing of products/services, customers, SKUs, distribution channels

Better understanding overhead 

Easier to understand for everyone

Utilizes unit cost rather than just total cost

Integrates well with Six Sigma and other continuous improvement programs

Makes visible waste and non-value added

Supports performance management and scorecards

Enables costing of processes, supply chains, and value streams

Activity Based Costing mirrors way work is done

Facilitates benchmarking

It helps to identify inefficient product, department and activity

It helps to allocate more resources on profitable product, department and activity

It helps to control the cost at individual level and on departmental level

It helps to find unnecessary costs

(http://en.wikipedia.org/wiki/Activity-based_costing )

Once they are aware of ABC system and problems associated with absorption of overheads, the advantages and implementation of ABC system will boost the company.ABC system gives the exact calculation of overhead and states exact cost of production.

Advice

My advice to Dvina is implementing the ABC system to meet their targets for more accurate product cost. We have to implement some steps in company by using ABC system which is discussed as:

Company will provide Training to their labours to improve their skills

Sell their specialized product at high price

Increase the machine hours

Use maximum resources and divide labour hour and machine hour in different shifts.

Use new tools and techniques in business processes.

To understand the needs and demands of the market.

By taking these steps she can overcome her fear of opposition, with the help of training program to the staff and labours will help them to understand the ABC system more easily and increase in manufacturing and price will be give a boost to profit margin.

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