Manac Plc is an electrical company who is facing 3 major problems, where the company is not having a target profit for the company, they find that more sales is more profit and they using Traditional Absorption Costing system to strategic Management Accounting and last not least they are not meeting the budgeted expectations.
This report explains about Models and concept of pricing decision which is divided into 3 major categories, such as Management Accounting, Economic theory and Marketing Pricing strategy. The report will explain benefits and limitations of 3 categories and state what pricing concept might suitable for the company, because Manac Plc must able to generate enough revenues and need to use Mark-up technique to help the company make the final price.
Furthermore it explains the purposes of the standard and variance analysis including the problems of using variances and how it relates to the ABC system for the company. Besides that it explains about comparison using traditional absorption costing system (arbitrary way) and Activity Based Cost system where many modern organizations uses ABC rather than traditional costing system. ABC system can also help management to make a reasonable pricing decisions if products on a cost plus basis.
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To: Board of Director
From: Financial Director
Date: January 8th 2010
Subject: Analysis of issues in Target profit
Manac Plc is a company that produces and sells a range of standard electrical goods. They produce and sell their products across many countries. Currently the company uses standard costing and absorption costing as a part of its approach, and Board of Director is having problem where the company is not meeting its budgeted target profits, because the company think that more sales is more profit. This assumption sometimes is not true. There are many issues that affect this company. Therefore in this report, Manac Plc is trying to identify the problems through 3 different categories which are from Models and concepts that affecting the pricing decision and what is their usefulness to the company also to identify which pricing method is suitable for Manac Plc.
Next category is the company needs to identify the role of standard costing and variance analysis in management accounting plus identify the value and limitations of variance analysis which have contributed to the overall profit figure. And last the company need to introduce the new costing system called ABC which is used by many organisations in modern way in order to replace the old costing system also known as traditional absorption costing system. This report aims to improve the board of director to understand the issues involved to Manac Plc.
2.0 The Model and Concept of Pricing
One of the problem that Manac Plc face is because Pricing problem which cause shortfall from target profits. Pricing decisions are set by the market emphasis will be on examining cost information that is required for product mix decisions. There are many model and concept to consider for pricing decision, for example, Management accounting, Economic theory and Marketing Pricing strategy.
2.1 Pricing in Management Accounting
Assume Manac Plc is facing long run pricing decisions; they should adjust the supply of virtually to cover all of the resources that are committed to it. If they can not generate enough revenues, they will not be able to survive (Drury 2004, pg 420). Based on (Drury 2004, pg 420) states that full cost or long run cost is used to represent the sum of the cost of all those resources that are committed to a product in long term. Let us assume Manac Plc has full computation of the resources in Appendix 1.0
Drury (2004, pg 421) mention that to determine a proposed selling price an appropriate mark up is added to estimated costs should be sufficient to cover a fair share of facility-sustaining costs and provide a profit contribution. This approach called as Cost Plus Pricing. According to Drury (2004, pg 431), Mark-up involves by the elasticity of demand being applicable to products which are subject to inelastic demand. Target mark up percentages tends to vary from product line to correspond with well established differences in custom and likely demand. For example, luxury goods with a high sales turnover may attract low profits margin.
2.1.1 Limitations of Full cost and Cost plus Pricing
Always on Time
Marked to Standard
Drury (2004 p 437) mentions that Cost plus Pricing has 3 major limitations. First the approach requires some assumptions to be made about future volume prior to determine the cost and calculating the cost plus selling prices. This can lead to an increase in the derived cost plus selling price when demand is falling and vice-versa. Secondly, there is no guarantee that total sales revenue will be in excess of total costs even when each product is priced above ââ‚¬Ëœcostââ‚¬â„¢. Drury (2004, p 431) states another main criticism is cost plus pricing has no relationship with demand,
2.1.2 Reasons for using Full cost and Cost plus pricing.
Another major reason for using this approach is that Cost plus pricing will only ensure that all the costs will be met and the target profits earned if the sales volume is same or greater than the activity level that used to estimate total unit costs Drury (2004 p 432).
Therefore it is argued that management attempts to adjust the mark up based on the state of sales demand and other factors which are vital in the pricing decisions. Target price is important, so the management should use this approach together with their knowledge of the market and their intended pricing strategies, before the final price is set. Drury (2004, p 432).
2.2 Pricing in Economic Theory
According to Drury (2004 p 412) basically using economic theory is not really practical to apply in pricing decisions. To determine the optimum selling price, it is also necessary for management to estimate total cost for each of the sales level given. For example:
Drury (2004) says the economic theory is difficult to apply in practice. Because it assumes a firm can estimate a demand for its products or aggregate level such as automobiles, coffee and crude oil. Therefore it is extremely hard to estimate demand curve at the individual level. Second is it assumes the only price influence the quantity demanded, for example a product quality and packaging, advertising and promotion. And last, the marginal cost curve can only be determined after considerable analysis and the final result of marginal cost. Based on Drury (2004 p 418) on the other hand, economic theory does provide useful insights and need for managers to think about price/ demand relationships, even if the relationship cannot be precisely measured.
(Drury 2004, p 418) says in pricing decisions, most organizations need to make decision about their product and services. The firm has little or no influences to set up the selling price of its products or services, these firms described as a price taker, such as wheat, coffee and rice. A firm who selling products or services which are highly customized or different with from each other by special feature, have some responsibility in setting prices and will be influenced by the cost of the product is described as price setters, such as computer, car and electrical.
2.3 Marketing pricing strategy
Based on (Drury 2004, p 432) there are 2 pricing policies need to be selected before setting up the final price, they are price skimming policy and penetration pricing policy.
A price skimming policy offers a safeguard against unexpected future increases in costs or demand. Once the market becomes saturated, the price can be reduced to attract market that has not yet been exploited. For example, high initial prices maybe charged to take advantage of new product when demand is initially inelastic.
Drury (2004, p 433) mentions penetration pricing policy is to gain fast acceptance of the product when close substitutes are available and easy to enter. It is easier if the product is new than later on the buying habits become established. Drury (2004) mention in Sizer (1998) suggest that in the introduction stage it may be suitable to shade upward or downward the price to create more favourable demand in future years. Such price may result in a higher sales volume and a slow competitive be preferred, which will enable the company to establish large market share and to earn high profits in the long term.
3.0 Definitions of Standard cost and Variances
In order for Manac Plc to overcome pricing problem and budgeted expectation is they have to review back of standard cost and variance analysis.
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Kaplan (2007, p 108) define standard cost is based on technical specifications for the materials, labour time and other resources required and the prices and rates for the materials and labour. According to Kaplan (2007, p 109) Standard cost has been defined as a planning technique that reports variances by comparing actual costs to pre-set standards so facilitating action through management by exception. Based on Kaplan (2007, p 120) Variance is the difference between actual results with standard results. Standard cost is obtained by establishing a standard quantity of materials or labour for each unit of product and a standard price or rate for each unit of the resource (Kaplan 2007, p 108). Refer to appendix 1
3.1 Purposes of standard costing
Standard costing is one of the most important costing system in organization whose activities consists of a series of common or repetitive operation and to produce each unit of output (Drury 2004, p 726). Since Manac Plc is manufacturing company that produces electrical goods, so they produce lots of number of products and it is possible there will be loss or wastage in production. That is why Manac plc need to apply standard cost where it has sufficient benefits for the company, such as :
According to Kaplan (2007 pp 108) Standard cost is used to set standards of performance, which can be used as target for achievement. These standards provide a stage for finding ways of improving efficiency and minimizing waste, they are used for planning, preparing the plans for example, the annual budget and schedules of resource requirements (Kaplan 2007, p 109). Based on (Chadwick 1998, p 129) mentions they are used for monitoring actual performance. For example, comparing actual performance with standard performance, it can investigate the reason for variances so that management can exercise control over operations. And last, they are used to measure inventory values. For example, raw materials, work in progress and finished goods at standard cost within the costing system
Usage of Variances
Kaplan (2007, p 120) says a variance analysis is the evaluation of performance by means of variances, whose timely reporting should maximize the opportunity for managerial action. Total cost variances can be analysed into price and usage variances (materials), rate and efficiency variances (direct labour) and expenditure and efficiency variances (variable production overheads). Variances are Favourable (F) if actual costs lower than standard and adverse (A) if actual costs are higher than standard. A hierarchy of cost variances can be viewed in appendix 2.0
3.2.1 Problems of Variances
According to Drury (2004, pg 802) says that there are several factors why actual performance might differ from standard performance. First cause is a variance may arise as a result of an error in measuring the actual outcome. For example, labour hours for a particular operation may be incorrectly added up or indirect cost might incorrectly fill as a direct labour cost. Unless there is an investigation leads to an improvement in the accuracy of the recording system. According to (Drury 2004, p 803) a second cause relates to standard becoming out of date standards, if an operation is subject to change to take into account learning curve effects. Investigation of variances falling into this category will provide feedback on the inaccuracy of the standards and highlight the need to update standard. Thirdly, variances can result from faulty machinery or human errors. In this situation, the company needs to identify the cause of the inefficiency and lead to corrective action to eliminate the inefficiency being repeated. Finally, variances can be due to random or uncontrollable factors, this problem happen when the operation is performed by the same workers under the same conditions. Any investigation of variances due to uncontrollable factors will not produce any benefits because no assignable causes (such as inaccurate data, out of control and out of date standard) (Drury 2004, p 803)
3.2.2 Investigation of Variances
According to Drury (2004 p 801) in the final stage of this process, management should decide which variances should be investigated. Using policy of investigating can be very expensive and time consuming and it would give bad improvements in operation even if the cause of the variance was determined. In other words, they have to investigate only those variances that produce benefits in excess of the cost investigation, for example:
Based on Drury (2004, pg 802) , Simple rule of thumb models based on arbitrary criteria such as investigating the absolute size of variance is greater than a certain amount that exceeds some predetermined percentage. By using statistical models that compute the probability that a given variance comes an in-control distribution and benefits of investigation furthermore by statistical decision models that take into account the cost and benefits of investigation.
4.0 Activity Based Costing system
Traditional systems often tend to rely on arbitrary allocation of indirect costs, which is why it can provide misleading information for decision making (Drury 2004). But there is an alternative approach to product costing which is called Activity Based Costing.
Based on (Kaplan &Atkinson, p 97) the system that developed to provide more accurate ways of assigning cost of indirect and support resources to activities, such as : business process, products, services and customers is called Activity Based Costing (ABC). The objective of ABC is to measure and the price out of all the resources used for activities that support the production and delivery of products and services to customers (Chadwick 1998, p 99).
4.1 Stages and implementation
Since Manac Plc uses traditional costing (uses arbitrary way) as part of its approach to sell a range of standard electrical goods, it allocates overhead to production and service departments and it reallocates service department costs to the production departments, whereas the production process are identical to the cost centres used by traditional costing system and its using small number of cost centre. Second stage is to trace overhead to product using a small number of 2nd stage allocation bases (overhead allocation rates) (Drury 2004, p 372)
But for ABC costing system, it assign overhead to each major activity (rather than department), it also has many activity based cost centre called activity cost pool. There are 4 steps involved to implement ABC costing system in the company, First step, it is very useful to start examine a physical plan of the workplace and the payroll Drury (2004, pp 377). (Innes and Mitchel 1995b) states this activity called carrying out an activity analysis. For example, receiving a purchase budget, identifying suppliers, preparing purchase orders and performing follow ups. After that, determine how much the organization is spending on each of its activities, such as labour and lighting and heating costs. These costs should be based on cause-and-effect cost drivers, not based on arbitrary allocations (Drury 2004, p 380). Next is to select appropriate cost drivers for assigning the cost of activities to cost 3 objects to measure for activity cost drivers such as : Transaction drivers, duration driver and intensity Driver, (Drury 2004, p 380). And last step is to assign the cost of the activities to products; the cost driver must be measureable so that it can be identified with individual products (Drury 2004, p 381). Refer to appendix 3.0
4.2 Benefits and pitfalls of using ABC information
4.2.1 Benefits of using ABC information
Based on (CIMA 2007, p 83) finds that activity based costing (ABC) has number of benefits. First, ABC gives management a much better insight into what drives overhead costs than both traditional absorption costing and marginal costing. Second, ABC recognizes that overhead costs are not all related to production and sales volume, but they are nevertheless variable and controllable in the longer term.
(CIMA, p 84) mentions ABC can be used by management for various purposes such as to identify ways of reducing overhead costs in the longer term. This is because ABC shows the nature of resource-consuming activities, the costs incurred by each activity and the cost drivers for those activities, ABC can measure which products are most profitable and which are unprofitable and not covering their long run costs. Based on (Lucey 2002, p 53) ABC analysis can also be used to identify activities and costs that do not add value, which means an activity does not contribute to the final product or service, the driver of the non value adding cost can be identified and eliminated. ABC can help management to make sensible Pricing decisions if products or jobs are priced on a cost plus basis (CIMA, p 84).
4.2.2 Pitfalls of using ABC information
According to Drury (2004, pg 392) ABC systems has suffer from the same weakness as traditional cost systems by suggesting an inappropriate degree of variability. For example, to calculate unit product cost, batch level of activity costs are divided by the number of products produced. There is a danger for decision making because non volume related activity cost will be translated into a cost which varies with production volume. Based on (Drury 2004,p 393) says another problem is the concept of managing unused capacity is fine with human resources but the impact is not the same for physical resources, such as the acquisition of plant and equipment, but human resources are more flexible and can be adjusted in small increments. Therefore the supply of resources can more easily be adjusted to the usage of resources in a big amount and large increments.
(CIMA 2007, p 84) shows another criticism of ABC is it is impossible to allocate all overhead costs to specific activities, because some costs are incurred at a facility level, such as factory rental costs. These have to be charged to products on an arbitrary basis, just as in traditional absorption costing. So the selection of just a few activities and one cost driver for each activity means that ABC cost are based on assumptions and simplifications. Therefore the choice of both activities and cost drivers might be inappropriate.
All in all, some pricing systems are match with certain products in the company. Based on the information about pricing above, the company can spot that the full cost and cost plus pricing are important for target price, so the company can make decision before the final price is set.
Those organizations that have implemented ABC system still has an important role to play in controlling the costs of units level activities. And ABC system has been used for so many organizations in modern way, it is also related to the Standard costing. Variance analysis is most suited to control the costs of unit level activities, it also provide meaningful information for managing those overhead costs that are fixed in short term but variable in the longer term. But it cannot be used to manage all overhead costs. It is inappropriate for the control of facility sustaining costs because the costs of these resources do not fluctuate in the longer term according to the demand for them. There are also some factors that cause not meeting the target profits, such as recession, rivalry product, Competitors among companies and the design of the product.