ZENRE TECHNOLOGY: ANALYSIS OF COSTING SYSTEM

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The purpose of this report is to identify the actual cost for Robin and King models by using Activity-Based Costing System. The information that has been provided in preparing this report includes the income statement, direct materials and labour used, machine costs per hour and the manufacturing overhead other than machine costs. Zenre Technology manufactures two types of television, namely Robin which was being produced since 2004 and King which was only introduced in 2007. Based on the analysis performed, the company should concentrate on the Robin model since it is more profitable as compared to the King model which is incurring losses. Therefore, the King model should be phased out or find a way to improve efficiency to ensure that it is profitable. It is advised that Zenre Technology should adopt the Activity-Based Costing System in order to obtain more precise costing information on their products. This will aid in the elimination of wasteful use of resources which results in an increase in productivity.

2.0 Introduction

This report is prepared for the evaluation of Activity-Based Costing (ABC) system in determining the costs of various products manufactured by Zenre Technology and to deduce if the said system should be implemented. In this report, we analyse the information given and compare between the two costing systems. In addition, the differences between the two systems are clearly outlined and the effects of the ABC system are evaluated based on the cost of the models produced. The definition of ABC would be the refinement of the costing system by recognising the individual tasks used in the production process as cost objects.

2.1 Weaknesses of the current costing system

In the case examined, it is found that Zenre Technology uses a traditional costing system, also known as the plant wide costing system. The common characteristic of these systems is that they allocate direct costs to the cost object and allocate indirect costs based on a single plant wide cost allocation base. In the case of Zenre Technology, they calculate the overhead cost using machine hours, etc. The weakness of using a single cost pool, where the cost is allocated based on the machine hours used may result in inaccurate costs, which may lead to the inability of the company to provide accurate costing in a multi-product company (Rac & Petkovics 1990, p.748). This may result in the overcosting or undercosting of a product. In addition the weakness of the traditional costing system is that it also does not include non-manufacturing costs (Traditional Costing System 2006) such as administration costs (building security, rent etc.).

3.0 Activity-Based Costing (ABC) System

3.1 Principle

Activity-Based Costing (ABC) system is one of the many types of costing systems available for businesses to use. It refines a costing system by identifying individual activities that are required to produce both Robin and King models as their fundamental cost objects (Horngren, Datar, Foster, Rajan & Ittner 2009, p.170). Cost pools for each activity identified are set up for the purpose of assigning overhead costs based on its costs driver. The following are the activities carried out by the company with its cost allocation base as well as their respective cost hierarchy.

Activities Cost Allocation Base Cost Hierarchy

Soldering Number of Solder Point Output-unit Level Shipments Number of Shipments Batch Level

Quality Control Number of Inspections Batch Level

Purchase Orders Number of orders Batch Level

Machine Power Machine-hours Output-unit Level

Machine Setup Number of Setups Batch Level

3.2 Benefits

Activity-based costing (ABC) system allows Zenre technology to further improve on its accuracy in the process of costing for both Robin and King models. ABC system better assists in the process of refining the assignment of indirect costs to cost objects as it breaks up the indirect cost pool into finer pools of costs with different allocation bases (Horngren et al 2009). Thus, ABC system concentrates on the cost pertaining to each activity instead of focussing on a single cost pool used in traditional costing to prevent product overcosting and undercosting. Moreover, ABC system accurately represents the consumption costs as it does not assign costs of idle capacity to its products (Rac & Petkovics 1990, p.750). Inaccurate and misleading cost data may constitute to erroneous impression of a product's profitability. Also, ABC is particularly helpful in identifying business activities which are non value adding as it provides financial and non-financial information about activities and cost objects (Gunasekaran 1999, p.118). Last but not least, the system aids in the process of benchmarking which constitutes to quality control system (Chen, Firth & Park 2001).

4.0 Calculations

ACTIVITY

Total Activity Cost

Cost-Allocation Base

ROBIN

KING

Soldering

(number of solder points)

$942,000

= $942,000/1,570,000

= $0.60

= $0.6 x 1,185,000

= $711,000

= $0.6 x 385,000

= $231,000

Shipments

(number of shipments)

$860,000

= $860,000/20,000

= $43

= $43 x 16,200

= $696,600

= $43 x 3,800

= $163,400

Quality control (number of inspections)

$1,240,000

= $1,240,000/77,500

= $16

= $16 x 56,200

= $899,200

= $16 x 21,300

= $340,800

Purchase orders (number of orders)

$950,400

= $950,400/190,080

= $5

= $5 x 80,100

= $400,500

= $5 x 109,980

= $549,900

Machine power (machine-hours)

$57,600

= $57,600/192,000

= $0.30

= $0.3 x 176,000

= $52,800

= $0.3 x 16,000

= $4,800

Machine setups (number of setups)

$750,000

= $750,000/30,000

= $25

= $25 x 16,000

= $400,000

= $25 x 14,000

= $350,000

TOTAL

$ 3,160,100

$ 1,639,900

ACTIVITY-BASED COSTING SYSTEM

Unit Cost = +Direct Material+Direct Manufacturing Labor+Machine Cost

ROBIN = + $208 + $18 + $144

= $513.64

KING = + $584 + $42 + $72

= $1,107.98

Gross Margin per unit = Selling Price - Unit Cost

ROBIN = $900- $513.64

= $386.36 per unit

KING = $1,140-$1,107.98

= $32.02 per unit

Gross Margin Percentage per unit =

ROBIN =

= 42.93%

KING =

= 2.81%

5.0 Analysis

Based on calculations as shown above, Zenre Technology should continue with the production of Robin model and discontinue with the production of King model. There are 3 main reasons to justify our statement. Firstly, the unit cost for Robin model is cheaper than that of King model. According to the traditional costing system (simple costing system), the unit costs of Robin and King models are $570 and $798 respectively. The ABC system shows that the unit costs for both the models are $513.64 and $1,107.98 respectively (shown in 4.0 calculations). It is shown here that Robin models are overcosted where as King models are undercosted.

Secondly, Robin model has a higher gross margin percentage than King model. Based on the traditional costing system, gross margin for Robin and King models are 36.67% and 30% respectively (Refer to Appendix A). On the other hand, ABC system shows that Robin model has a gross margin percentage of 42.93% while King model has a mere 2.81% (Refer to Appendix B). Gross margin percentage is defined as the percentage that a company retains as gross profit from the selling price.

Lastly, with reference to Appendix C, the operating income derived from Robin model is $121.36 but for King model, it is -$212.48. Therefore, Robin model results in a profit but King model makes a loss. Operating income is calculated by the deduction of selling and administrative expenses from the gross margin.

Therefore, Zenre technology should continue with Robin model and discontinue with King model.

6.0 Accuracy and Limitations of an ABC System

The accuracy of ABC system lies in the determination of the actual cost driver as the cost-allocation base of each activity. Mason was concern about the cost drivers used in Nader's determination of the costs to assign to each of the allocation bases. Nader had used number of setups and number of inspections as allocation bases but Mason suggested that if Nader were to use setup hours and inspection hours instead, the conclusion derived would be different. Hence, the use of proper cost driver is vital in the measurement of the system's accuracy.

Also, the number of activities included affects the accuracy of ABC system. Some activities are not considered to be economically feasible in the process of television production. For instance, the amount of screws needed to assemble the television parts. Therefore, as not all of the activities can be determined, the total costs calculated would not be fairly accurate as well.

The limitations of ABC system is that the data collection process for this system is very time consuming. Besides, the cost to implement and maintain ABC system is high, resulting in high capital expenditure in the long-run. Furthermore, the implementation of ABC system is not easy as some organisations may be highly resistant to change. Lastly, ABC system is a transparent system which some managers may not approve of as they would prefer to keep some things out of the view of the company owners.

7.0 Ethical Issues

With reference to the case at hand, there appears to be a conflict between two parties, James Nader, Zenre's Controller and Sandy Mason, the divisional president. The reason for this conflict is the disagreement with the type of allocation bases to be used to evaluate costs in production of the models and the method of application. This is due to Mason's desire to lower costs in order to reflect a higher profit as her bonus is affected by profit. In the current situation it is the question of ethical standards that would affect the company's profitability, and therefore Nader must make his decision based on competency, credibility and integrity.

With the application of the ABC system, there may be unfavourable consequences, but Nader should report the exact information to the relevant parties as the issue is jeopardising the future of the company. Therefore, Nader should uphold the values of integrity and credibility of his profession as an accountant to report the actual results. Even if Nader faces the risk of losing his job, he should enforce his accountability to the firm and disclose the true cost numbers to the company.

There are several suggestions that Nader should do in response to his supervisor - Masion's instructions. The first would be to report the situation to the immediate manager above his supervisor (Horngren et al 2009, p.42). If the manager seems to be in the loop of the same opinion, then the next option would be to report to the CFO or the CEO or equivalent and explain the dilemma and its effect on the future of the company. If assuming the CEO is involved too, then Nader would have to seek advice from the IMA Ethics Counsellor so that he would have a clear view of the possible courses of action that he could take (Horngren et al 2009, p.43). Lastly, Nader would also be advised to consult his legal attorney in relation to the ethical dilemma he is experiencing at his workplace.

8.0 Conclusion

Zenre Technology manufactures two television models, Robin an older product and King, a newer model introduced in 2007. However, James Nader, Zenre's financial controller decided to incorporate the ABC system which resulted in less that savoury results in the costing which lowered profits compared to the existing traditional costing system. Therefore, it is recommended that Zenre Technology discontinue the production of King model, or research on a more cost efficient way to produce the products, and implement the ABC system in the corporation.

9.0 Appendix

Appendix A

TRADITIONAL Costing Sytem

Gross Margin per unit =

1. ROBIN =

= $330

2. KING =

= $342

Gross Margin percentage per unit =

1. ROBIN =

= 36.67%

2. KING =

= 30.00%

Appendix B

Traditional Costing System

ABC System

Robin

36.67%

Robin

King

30.00%

King

Gross Margin Percentage for both costing systems

Appendix C

Traditional Costing System

ABC System

Robin

King

Robin

Operating Income ($)

1,430,000

390,000

19,800,000 - (513.64 x 22,000) - 5,830,000 = 2,669,920

Number of Units Sold

22,000

4000

22,000

Operating Income/unit ($)

65.00

97.50

2,669,920/ 22,000 = 121.36

Total Operating Income of both costing systems

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