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The report aims to demonstrate what factors could be preventing your company from performing to its full potential. The issues I will be discussing are pricing decisions, standard costing and variances analyses, as well as suggesting new costing methods that could help improve the way you handle your finances.
Deciding on what prices are best for the sales of your company is a complex process. This is due to the amount of factors that affect pricing decisions. You cannot simply rely on quantitative methods for a solution but instead gather as much information as possible so a suitable price can be established. The following factors are examples of what also needs to be considered. The internal factors affecting price include: the company's objectives and strategies (including short and long term decisions), costs (fixed and variable) economies of scale; knowledge from past experiences; price rises and the cost of applying various pricing schemes. The external factors include: competitive environment has to be researched including details like the structure of the market, the strength of the market and if competitive advantage exists. The legal environment, the international setting and consumer pricing regulations and are also important factors for making pricing decisions.
The positioning and the demand aspect are another two qualitative factors what need to be explored when making pricing decisions.
How do you want your electrical products positioned in the market? For example do you want the prices of your products to be a key part of how they are positioned? If you produce lower spec electrical goods then you want the price of these goods to be cheaper than your competitors. However, if the products you produce are of high calibre and are aimed at the wealthy section of the market then charging lower prices to gain higher sales will damage your image. You therefore have to be really careful how you position your products with their pricing because price by itself is not a key factor in determining whether a customer buys the products or not. Research will have to be done to decide what price points are acceptable as price either side of these points will discourage customers from buying your products.
How will your pricing affect demand? You need to understand the concept elasticity of demand, which relates to how many products you will sell if you change the prices. You must realise that if you drop the price this doesn't mean sales will increase or vice versa. You need to beware of the consequences if you increase/decrease your prices. For example will it spark a price war, will customers see the value of your products etc
Pricing models you could use to determine pricing decisions with their value and limitations.
Cost-plus pricing - Using your current absorption costing approach, all that is required is calculate the cost, determine the profit you want, and then set your price. The problem with this approach is that it ignores demand but assumes you can still set a price that will give you a profit. However the absorption cost model relies on a forecast for products sold; therefore you cannot calculate your product cost or mark up price without this forecast. You are assuming the customer will buy your products no matter what price you charge. Within your market, if you charge too high a price then your customers have a choice not to buy from yourselves and go elsewhere resulting in the forecast of your sales to be too high. If you take this approach you will see the company operating at a loss because the forecasts are based on selling a higher amount of units. Managers think this model is safe, however from the above information you will be able to see it is only safe if customers buy the amount of products your company forecasted.
Target return pricing - Many companies have less control over price than they would like to think. The market determines prices and a company that attempts to ignore this does so at its peril. Using this technique will help you to have control over the cost of your products from the design stage. This will be done by setting a price for the cost to produce the products once you have found the market price for that product. This will give your employees more satisfaction as they will feel more involved as they are set with the task of designing the products to meet the target cost. The barriers from different departments of your company will also be broken as they will all have to work together to reach the target cost. This model will also make you more orientated towards customer wants and needs as you have to sell at market value. However if you rely on producing excellent products this approach could affect your image as you may be forced to use parts that are of poor quality therefore producing poor quality products. The cost of implementing this new model will be high and will involve a lot more complex data.
Primary Product Pricing - This could be a channel that could be looked into. For example you could produce accessories for major companies like Apple. This will help widen your brand image, resulting in higher sales. The problem with this model is that customers will compare your accessory prices with the primary devices of apple. They are very large company and can afford to drop prices dramatically therefore you will need to be careful of the following situation. If you managed to strike a deal with apple and decided you would charge 10% of the purchase price of an iPod. If Apple decided to dramatically drop the price by 50%, the accessory at its present price would now be 20% of the of iPod price. Customers would view your price at being doubled compared with the primary device so you need to decide whether you are able to reduce your prices by the same amount and still achieve target profits.
ii) Standard costing and the related variances is a valuable management tool. If a variance arises, management becomes aware that manufacturing costs have differed from the standard costs.
If actual costs are greater than standard costs the variance is unfavourable. An adverse variance tells management that if everything else stays constant the company's actual profit will be less than planned. Only if the unfavourable margin is great would the variance by flagged as it would be unfeasible to check minor variances.
If actual costs are less than standard costs the variance is favourable. A favourable variance tells management that if everything else stays constant the actual profit will likely exceed the planned profit.
The sooner that the accounting system reports a variance, the sooner that management can direct its attention to the difference from the planned amounts.
The purpose of standard costing is to set a benchmark for measuring performance of a company. Engineers and accountants assist the managers in setting standard costs for major inputs, which include direct labour hours etc. The costing includes setting how much input will be used to produce each product and how much each input will cost. These standards are measured against actual performance. This process may display some problems that a manger must act upon so that it won't recur.
This basic method of comparing the standard and actual costs, finding problems then dealing with them accordingly is used in variance analysis. The process starts by producing performance reports that will highlight variances from the difference of the actual results compared to what was expected according to the standards which were set. The different variances will prompt the manager to ask questions about why the variance occurred, why has this variance increased again etc. The purpose of this analysis is to identify problems that need urgent attention, then finding out what factors are causing the problem and finally taking the appropriate action to rectify the problems. The concept of this method is to improve the operations of the company and not just point the finger at employees.
Above I have described the purpose for using standard costing and variance analysis. I will now evaluate the usefulness of some of the variances in identifying key areas that help improve the profits of companies.
Total Direct wages variance
Wage rate variance and labour efficiency variance are the two parts that decide the total direct wage variance. Labour efficiency variance should be closely monitored as increasing the productivity of the labour force will help keep cost downs. However if you have a good workforce, good supervision it will have no effect if the demand for products is scarce. The variance will be unfavourable, which is not a true reflection of the efficiency of the workforce. Wage rate variance is also difficult to use as if higher skilled workers are completing a task that requires less skills the variance will be unfavourable and vice versa. If workers are completing tasks that are above their skill level, although it will result in a favourable variance the quality of the job will not be good enough which could affect future sales. The previous statement demonstrates how the two variances link. For example the lower skill workers will help favourable variance for wage rates; however it ultimately results in unfavourable labour efficiency. The only way this variance can be a key area in helping profits is if demand is sufficient and there are tasks available for all levels of workers.
Total direct materials variance
This is divided into materials price and usage variance. The factors affecting the price variance of materials is the amount purchased, how they are delivered and their quality. It is important to buy good quality materials as this will keep the usage variance favourable if the workers are properly trained and the supervision is first-class. Again you can see the link between the two variances so it is vital that the purchasing team are buying good quality products at the right price and that the workers are using these materials efficiently. Again the flaw with this variance is the demand aspect. If a company sets a standard for the amount of materials and buy all the materials in bulk for a cheaper price but the demand dramatically falls, the usage efficiency is badly affected although the materials are suitable and the workforce is using them efficiently.
Variances are not conclusions in themselves but instead are launch pads for further analysis, investigation and then action. Variances also allow the supervisors to defend themselves and their department against failures that were not in their powers to prevent. The variance analysis sets the benchmark to measure the fairness of the standard, allowing management to make reasonable adjustments. The manager's role is to eradicate unfavourable variances and to promote good performance and reward their workforce; however their supervisors and employees rely on accounting information system for facts which will provide them with important information of how to control costs. Variance analysis is a good tool to achieve this as long as the standard costs are fair.
iii) To identify the advantages of activity based costing I will firstly show the problems traditional absorption costs because and then demonstrate how ABC helps to overcome these problems.
The first problem with absorption costing is that overheads costs to products are calculated based on production volume, although in the real world overheads are not used in proportion to the volume of the products produced. When producing your goods you will be aware that many types of overheads are caused by non-production volume characteristics of the products such as its size or how complex it is to make, thus resulting in this method causing distorted production costs. . This occurs in two ways using the current approach. Firstly because of product volume where high volume products receive too much overhead and low volume products receive too little. When producing products you need to take into account that the products need to be designed, engineered, inspected etc. These aspects should not vary in cost dependant on the amount of units produced but instead vary with factors unrelated to the amount of volume produced. The second problem involves product diversity. For example large less complex products need more direct labour time compared to small complex products. However more complex products require more design work, longer machine set up and more inspections compared to less complex products. This results in products that need less direct production time are understated with overheads while large products that require less machine set ups, inspection but more direct labour etc are overstated.
From the above problems that absorption costing has I will now show what advantage the Activity based costing approach will bring. Activity based costing solves this problem by separating overhead costs into different cost pools. Costs that are caused by the same activity are pooled together and then allocated to products using an appropriate measure of the activity volume. Its aim is to trace where the costs are coming from for each product unit. For example instead of just applying the costs to the products directly, it understands that there are activities involved in producing each unit and that these activities actually use overheads. This model therefore converts the indirect cost to direct costs giving a more realistic cost to produce the products.
Activity based costing reflects the running of the project and contributes to strategic decision-making processes. Activity based costing shows the real cost of individual products and therefore helps identify wasteful or non-profitable products that eat into the profits of the products that are performing well. ABC also helps price products fairly; therefore companies are able to divide their products into different price category bands based on customer needs.
There are some difficult challenges in applying the activity based costing model in practice. For example how can you apportion the managing director's salary based on a single unit. The answer is obviously it is almost impossible to do so. Companies also run the risk of spending too much, time and effort to work out the overheads to be apportioned to each product based on usage. Absorption costing however doesn't have this problems as it simply divides all fixed overhead costs with the number of units produced and therefore is free from such complexities. However (hicks 1998) believes that it doesn't have to be time or effort consuming.
"any small or midsize organization can develop an ABC system. It doesn't require a great commitment of time or financial resources. Nor does it require the implementation of special software integrated into the general ledger-although for larger organizations that may be a benefit. It requires only that management view its operations through 'the lens of ABC' and create a model that will enable it to measure costs in accordance with that view."
Another hurdle to Activity based costs are the accounting principles for producing financial statement. On one hand absorption costing complies with the generally accepted accounting principles however when companies are publishing their financial statements, Activity based costing is not accepted by the Financial Accounting Standards Board or Internal Revenue Service. Companies that use activity based costing, therefore have to manage the two costing systems and accounting books, one for the company's use and another for external reports. Activity based costing is not accepted as external users of the financial statement do not need know which products are profitable so therefore it is believed that the ABC would overcomplicate the financial reports.
Overall when comparing absorption costing and activity based costing, it can be argued that activity based costing develops the quality of management accounting information. In large companies that produce a variety of products conventional overhead allocation methods such as absorption costing may produce misleading results. Although it has been challenged, it is still generally agreed that absorption costing remains more suitable for small companies with consistent products or services.
Above are issues that could be considered when trying to improve the profitability of your company. You cannot simply assume that more sales will improve profits without knowing the costs of increasing those sales. Sound implemented procedures along with good strategic management will improve your understanding of your finances and thus result in the company reaching their targets.