Executive Summary
This report provides a critical analysis comparing the current costing system of Zauner Ornaments against activity-based costing (ABC) technique. To do this, the conditions of glass ball ornaments with and without ABC are presented with emphasis on financial data. It is found that major advantage of ABC is to enhance the profitability of Zauner due to more accurate allocation of costs. The explanation and supporting details are illustrated below.
Introduction
Even though the market Zauner product is gaining prominence in the market since its inception, the financial performance of the company for the recent years continued to decline. Due to this there is a need for an investigation that includes both financial and explanatory components for understanding the case. This will aid Yu in her proposal to adopt a new costing method under ABC approach. The scope of this report will include analysis of distinctive features of normal and activity-based costing systems. In addition, it will also discuss the reasons behind the financial performance issues that Zauner is facing. There are also recommendations to improve the situation and a conclusion. Most of the analysis is supported with financial data and computations and also facts of the company case. Although certain costing techniques are also useful to determine the relative advantages/ disadvantages of ABC like standard or value-based costing, the discussion is limited to ABC versus normal costing systems.
Problems in the current costing system
It only considered manufacturing costs where in fact the results of the latest financial data showed that transportation costs accounted for 35% of the expenses incurred under selling and distribution. Second, when estimating the overhead costs, the system used plant-wide overhead rate under the variable "machine hours". However, the design of processes is semi-automatic and manual work is necessary to complete such phases of manufacturing such as purchasing and scheduling including set-up. There is a lack of coverage when "machine hours" is used as lone and main variable. Third, the system cannot handle various changes in the business plan. The drastic rise in overhead rate is a symptom that machine variable alone is an insufficient representation of real costs of the company. Since the company is under increasing use of machines due to introduction of up-market products (i.e. specialty glass balls), the system undermined other costs (i.e. transportation).
More generally, normal costing system uses budgeted overhead rates which can distort actual results from operations. As a result, the increasing machine-based overhead rate pushed the costs requiring more cash to pay, more accounts payable to incur and other reduction in income-related accounts. In the past years when the firm started to produce other products, the financial alarm did not erupt instantly and required the current financial position and overhead rate to provide their obvious aggravations. Due to this, the system is responsible for the years of poor financial performance despite good turnover of the newest product line. The use of machine hours does not only understated indirect manufacturing costs but also the substantial contribution of labor in the completion of other products.
Contribution for improvement and Other Advantages of ABC system
The firm is basically under the problem of having good products, production on-demand, successful operations except prior to introduction of other products and currently anxious about its future profitability. Activity based costing (ABC) will aid in determination of true cost of the product particularly the high cost specialty products. ABC can propose cost improvement and even strategic plans to increase productivity. This can reserve the right for more innovative products to be continuously manufactured and polish the view of the manufacturing managers. Manufacturing costs have minimal insight on how to price products and ABC will broaden this lacking to obtain full benefits. ABC also focuses on indirect costs or the overhead that is very relevant to the problem of the firm. Since it intends to trace the cost rather than allocate, the confusion earlier rejected by Yu can be clarified (i.e. seeing transportation as cost) and strategies be streamlined (i.e. management of overhead) accordingly.
Findings in Comparing ABC and Existing Costing System
As observed, the unit cost for the specialty ornaments are overstated in the existing system while non-specialty ornaments are understated also in the existing systems compared to ABC results. This is possible for the existing system because it used machine hours as basis for overhead rate computation and allocation. As observed, Zauner product lines are high in volume but required no special activities such as stopping the production lines to remove glass remnants in machines eminent in producing products in the production lines. In effect, machines hours as basis for allocation undermines the presence of labor-intensive requirements of non-specialty products under ABC approach. Little overhead costs are allocated in specialty products because it did not have many machine hours rather set-up processes while the reverse is true (i.e. enormous overhead) for non-specialty products whose production is less critical and can be mass produced easily. However, specialty products require much personnel attention that labor hours have substantially jumped under ABC approach.
Recommendations on Costing System for the Firm
The firm should change its current system and replaced it with ABC technique. This can especially gain beneficial returns when the firm decided to expand to up-market brands which would reflect the same manufacturing complexity and labor-intensiveness of specialty products. If product line expansion is carried in the coming years, much more the significance of ABC is eminent because the manufacturing processes of up-market products are riskier compared to low-cost non-specialty products. As a result, proper costing is required for the company to maximize the benefits of the expansion. Since ABC also allocate indirect costs to the overhead (i.e. transportation), the prominence of up-market products in distant places could provide ease of allocation for the firm. The issue here is the transfer of value from normal places that may not be recognized by the firm and shipping costs are not included in the current system.
In its current manufacturing situation, its semi-automated process does not make "machine hours" a concrete basis for settling an overhead rate. Emphasizing the error on a company-wide agenda only aggravates the problem. Also, current departments such as packing and shipping are done manually and so it is obvious that "machine hours" does not represent the cost driver for general expenses of each department. Further, the firm is a low-cost glass ball producer where it presently made success through market position. However, its profit continued to slump for consecutive years suggesting that demand-side approach to business is lacking. As a result, supply-side should achieve value the same manner as the demand-side. Since the current costing had made substantial understatements especially for specialty product lines, it showed that it cannot reflect measurement of cost-related efficiencies. ABC can provide such data for the firm to improve its value chain in producing risky and low-volume up-market product line.
Reasons behind Declining Return on Sales
As observed in the spreadsheet, return on sales of the current system is 12% which is reduced to only 4% under ABC approach. This is possible because the decrease in cost of goods sold for Zauner products in ABC is consumed by substantial increase in the same for specialty products. Cost of goods sold is computed by the multiplying the results of per unit cost in both systems to their corresponding sales volume. As a result, their difference is eminent where ABC even incurred a loss for the specialty products. In the issue of poor financial performance and declining return on sales for the past years, the firm is unable to identify the contribution of "labor hours" to cost and the small but complicated volume manufacturing of specialty products. As a result, it affects its pricing and ultimately its break-even frameworks. For example, the unit selling price of its small glass balls is only $30.00 well in fact, when labor costs and ABC approach is considered, it can go as high as $70. With this, it is apparent that the company is selling the good-performing product lines below manufacturing costs. In effect, positive response from the market for the innovation did not result to rise in bottom-line outcome due to misled and inappropriate costing.
Recommendations on Actions to Take to Improve Performance
The firm should use ABC approach especially in specialty and other up-market products. These products are considered labor-intensive, risky processes and substantial process investment compared to non-specialty counterparts. In effect, costing approach should be more conservative. In the operational issue, it should acquire new and dedicated machines for up-market products to increase productivity and also revenues. It should exploit the lucrative market by coupling investment strategy and costing techniques. Further, it should continue to produce and design up-market products for the next years to maximize the adoption of ABC technique. When machines are acquired, ABC can assure that the interference of labor in the process is accounted and this claim creates the synergy that exists between ABC adoption and strategy to expand product line.
Ultimately, the firm can focus its operations into the up-market demand. It should close its low-cost product line by transferring the brand name its non-specialty products are admired for to the up-market products. For example, the firm can create discounts in bulk purchases or sell the products in retail markets for ease of discounting promotion. It should obtain an integrated product portfolio where the up-market is prioritized and non-specialty brand name retained due to the change in market environment. This issue is concretized by the fact that the cost of shipping and machine investments will increase once the firm continuously create up-market products. The rise in such costs may require substantial investment which may affect liquidity of the firm. As a result, its low-cost business portfolio should be gradually reduced and retire once the brand name transfer is effectively executed.
Limitations of the ABC Proposal and ABC in General
Initially, there is an understatement for the cost of producing non-specialty products because they are machine-based units. At the strategic side, abrupt adoption of ABC which necessarily leads to increase in market price especially of the specialty products can reduce competitiveness of the firm. This is true especially when there are similar products in the market where up-market producers have lower prices. Thus, ABC has the weakness of infusing its findings instantly and directly in the market and even investment strategies of the firm in the case of purchasing new assets. Even if the firm has the information and measurement of performance, it has limited use of them because of the stakeholders involved. The recommendations above also are not recourses that can be executed immediately. Time, money and effort are elements necessary to make them reality but the firm is a low-cost producer and substantial investment in assets, processes and change in strategy can likely be impossible due to financial and experience bottlenecks.
In general, ABC is incompatible with mass production processes and machine-intensive products because activities are minimal. This is why small and large colored glass ornaments products are understated under ABC because human intervention is very small. Second, collecting data such as activities and “levels” can be tedious and costly. A small manufacturing company may not afford the requirements of implementing a company-wide ABC adoption. Computer systems, trained personnel and continuous evaluation in the manufacturing and non-manufacturing activities should be applied which can be impractical for small manufacturers. In the behavioral side, ABC can create managerial resistance because it can show the inefficiencies of the processes where their departments are link. Without support from managers, ABC adoption would be futile.
Conclusion
Zauner should adopt ABC technique is a gradual manner and also doing the same in reducing focus on low-cost product line. Its transfer of geographical market and success in up-market indicates the change in operating environment that requires adjustment in internal capabilities. By adopting ABC, its response to external changes and internal adjustments can be measure and evaluated on a periodic basis. With this, it can analyze whether the strategy should progress or bring back focus on low-cost product line by exporting to low-income countries. To succeed in ABC adoption, the company should consolidate commitment of managers. Installing incentives and creating committees to supervise the progress of ABC adoption with a concrete plan in mind should be a starting point to increase motivation to implement and degree of support to a newly established accounting idea.
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