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As requested, evaluation of the bid for a bearings order has been calculated. The focus of the preparation was on cost calculation using alternative costing approaches. Based on calculation made and using data gathered the following recommendations have been made.
- Review the existing system if it is the appropriate approach of cost calculation.
- The traditional approach of overhead allocation needs to be replaced with activity based costing system as it will provide better product cost information for decision making.
- Competitors and customers requirements must be considered when bid price decision is made.
The discussion is directed on the two approaches that should be considered on price decision making. First the cost based approached is consider two alternative accounting methods that under which we calculate what will be the bid price charged to recoup the cost and achieve the desired return based. Followed by the market based approach under which will consider what customers want by using target costing.
The first focus is on the current system which is using the usual approach to the allocation of overhead by applying the overhead costs at a rate of 250% of direct labour. The unit-level driver is direct labour cost under consideration that is a good surrogate for measuring the complexity of the work involved. Exhibit 1 shows the manufacturing cost of the order using functional based cost accounting system under assumption that the order is for 10,000 units the bid price per unit will be $8.25.
The current system of assigning overhead to products using direct labour hours does not represent a fair measure of resources used. The limitation is that the unit level driver is the direct labour hour's rates being allocated by estimates of total usage for the period. These overhead activities are consumed in different proportion than unit-based overhead activities. Because of this, assigning overhead using only direct labour as a unit based driver can distort product costs. Furthermore, the risk associated with estimates of cost will influence the business and the result of the business decision that will be made. Have been demonstrated that the result of estimation process could have the following outcome: If an estimated manufacturing cost is excessively high, then business is likely to be lost as the products will be uncompetitively priced and if the estimated costs are low then profit will be lost because products are sold at an unattractive margin (Technology Engineering, 2000). Because cost information is so vital, its accuracy is essential. Hansen and Mowen (2007) point out that "the need for more accurate costing product has forced many companies to take a serious look to their costing product". (p.124). Additionally have been demonstrated the two factors impair the ability of unit-base rates to assign overhead costs accurate are the proportion of non-unit related overhead costs to total overhead cost and the degree of product diversity.
From this perspective the activity based costing views resource usage as being related to activities not units. The non-unit level drivers such as set up cost and design and parts administration are needed for accurate cost assignment. An accurate assignment of activities is important for the estimate to be reliable and all the steps in the manufacturing operation should be considered.
The accurate assignment of activities will give a competitive edge because accurate estimates allow informed business decisions to be made. For example estimates can highlight high cost areas, which then become the focus for improvement activity. Making decision based on relevant information is a challenging task. From this perspective the impact of forces that can influence the decision making process are the critical reasons of cost calculation for a bid. The three forces that will influence the decision on setting up a bid price are summarized as follow:
- Customers influence the bid price through their effect on demand. A high bid price may cause to reject the bid and look for the lower price offered by the competitors, or accept the bid but the price should be more attractive because of added incentives, such as longer terms of payment.
- Competitors are very important when preparing to submit a bid. A company with knowledge of its rivals technology, operating policies and plant capacity is able to estimates is competitor cost (Datar and All, 2000) being a valuable information in setting the bid price.
- Cost is important in setting up the bid price; the more attracting the bid price is to the customer the order will be accepted. Target pricing is the accounting method that is calculating the price based on what customer is willing to pay.
Understanding the cost and the market forces and what the market is willing to pay is the most important information based on which the bid price can be calculated. The method of working backwards the price to find cost is called target costing (Hansen, 2008 p.536).To achieve the target costing and winning the bid the cost needs to be reviewed and analysed if possible reduction could be made. This could be done by reviewing the cost of direct material those one being over 50% from total manufacturing cost a reduction will have a significant impact on the overall price. Moreover if the direct labour cost can be reduce by reviewing manufacturing operation and finding a solution to improve productivity will have a major impact on the overhead allocation this cost being 250% from direct labour.
When engaging in setting out the cost calculation of a bid, cost estimation is a critical piece. Estimating cost underpins all manufacturing activities and becomes an integral part of the sales process. Furthermore, the risk associated with estimates of cost will influence the business and the result of the business decision that will be made. Because cost information is so vital, its accuracy is essential. Abandoning the current price system and replacing with activity based system or target costing will allow to better measure the resources consumed and lead to a better pricing decision.
- Hansen, D.R. and Mowen, M.M (2007). Managerial Accounting, (8th Edition). Thomson South-Western.
- Horngren, C.T., Foster, G. and Datar, M.S.(2000). Cost accounting:a managerial emphasis, (10th Edition).Pearson,2001.
- Langfield-Smith, K., Thorne, H. and Hilton, R.W. Management Accounting: An Australian Perspective, (5th Edition). McGraw-Hill, 2008.
- Technology Engineering.(2000).Manufacturing -cost estimating Retrieved from http://www.twi.co.uk