The importance of proper cost allocation methods in product costing

The management of the company which is engaged in production of goods is entrusted with one of the most important functions that are the decision of pricing the product. In order to evaluate the cost of the product, it is important that all the costs which are incurred are properly charged to the product in order to determine the correct price (Atkinson, 2012). The costs which are to be allocated are to be charged based on appropriate allocation methods. The method of allocation of costs should be selected based on the production process.

The given scenario consists of a company Beztec limited. The management of the company has been planning on phasing out one of its product line due to low operating profit margins. The accountant of the company has a different point of view and wants to lay the same before the management. But the CEO is not in her favour.

In the discussion below we have discussed various aspects of the problems of the given case, along with measures that should be opted for. The following will help both the management and accountant of the company to take a decision which is best suitable for the company. 

It is important the appropriate cost allocation methods are used by the companies, in order to ensure correct product costing (Berry, 2009). Use of improper cost allocation methods may lead to improper product costing which will result in improper decision making by the management.

The companies which are engage in production of only one type of product may opt for simple traditional costing methods. When only one type of product is manufacture, then it is known that all the costs which are incurred are in connection with production of that single product. Therefore, traditional costing can be used for allocation of costs in such cases (Boyd, 2013).

The companies engaged in more than one type of product, and also more than one activity which are jointly used by these products, should opt for activity based costing. Since the costs are jointly incurred under such cases, then allocation of cost should be based on actual consumption of activities.

Hence it is important that the companies opt for proper cost allocation method.

The traditional method of cost allocation is the method under which all the joint costs incurred are summed up and distributed among units products using a single cost driver. An estimated cost is determined; these are then divided based on expected consumption of machine hours or labour hours or any other cost driver. This rate of overhead allocation is hence pre determined (Dash, 2016).  This predetermined rate is then allocated to the units actually produced. 

Traditional costing method

This method of traditional costing is very easy to apply. Though this method is easy to execute, there are certain drawbacks of this method.

The method of allocation of costs under his system is not very accurate. The allocations of all the joint cost are done based on a single cost driver which results in improper allocation of costs. This method does not take into consideration the concept of consumption of resources in order to determine the basis of cost distribution.  The burden of cost consumption of one product is shifted to other product due to use of single cost driver. This results in improper product costing which results in improper pricing of the product (Holtzman, 2013).

Beztec limited has been facing the same problem of improper costing due to use of improper cost allocation methods. Implementation of correct costing methods will help the management have the correct view of the working of the company, which will help them in proper decision making.

Activity based costing is the improved cost allocation method, which was formed keeping in mind the disadvantages of the traditional costing method. Under the activity based costing, the joint costs which are incurred are individually allocated to the various products based on the various cost drivers (Horngren, 2012). This cost allocation method allocates cost based on actual consumption of the activities by various products.

The joint costs incurred by Beztec limited are currently being allocated using a single overhead rate. The various activities of the organisation are consumed by the products unevenly. That is, some activities are used more or less by the other product. Allocation of the cost amongst the units based on actual consumption will help the company determine the profitability from each of the divisions accurately (McLaney & Adril, 2016).

Once the data is collected activity based costing is very easy to execute. This method helps in proper allocation of costs which results in better decision making by the management.

The following income statement of Beztec Limited was made following the traditional costing method:

Beztec Limited Income statement for the financial year ended 31December 2017
	Lexon	Protox	Total
Revenues	$23 760 000	$7524 000	$31 284 000
Cost of goods sold	15 048 000	5 266 800	20 314 800
Gross margin	8 712 000	2 257 200	10 969 200
Selling and administrative expense	6 996 000	1 613 700	8 609 700
Operating income	$1 716 000	$643 500	$2 359 500
Units produced and sold	24 000	6 000
Operating income per unit sold	$71.50	$107.25

The above income statement shows that the operating margin for Lexon for 7.22% and that from Protox is 8.55%. The operating profit margin from Lexon is lower than Protox. Due to lower operating margin, the management wants to phase out the production of Lexon.

To help the management with the better decision making, we have collected the following data related to production functions:

Activity-cost-driver quantities
Activity-cost driver (driver quantity)	Lexon	Protox	Total
Soldering (number of solder points)	13,33,125	4,33,125	17,66,250
Shipments (number of shipments)	18,225	4,275	22,500
Quality control (number of inspections)	63,225	23,963	87,188
Purchase orders (number of orders)	90,113	1,23,727	2,13,840
Machine power (machine-hours)	1,98,000	18,000	2,16,000
Machine set-ups (number of set-ups)	18,000	15,750	33,750

Activity-based costing

The data listed above will help with the calculation of the profitability of the company from both the dictions under activity based costing.

Using the cost pools and cost drivers we have calculated the rate per activity:

Calculation of activity rate
Activity-cost driver	Total activity costs	Total Number of Activities	Rate per unit
Soldering	11,65,725	17,66,250	0.66
Shipments	10,64,250	22,500	47.30
Quality control	15,34,500	87,188	17.60
Purchase orders	11,76,120	2,13,840	5.50
Machine power	71,280	2,16,000	0.33
Machine set-ups	9,28,125	33,750	27.50

Using the rate per activity and actual consumption of resources by the each division we have allocated the overhead as follows:

Allocation of Activity Cost
Activity-cost driver	Lexon- Activity	Lexon – Amount	Protox-Activity	Protox-Amount
Soldering	13,33,125	8,79,862.50	4,33,125	2,85,862.50
Shipments	18,225	8,62,042.50	4,275	2,02,207.50
Quality control	63,225	11,12,753.62	23,963	4,21,746.38
Purchase orders	90,113	4,95,621.50	1,23,727	6,80,498.50
Machine power	1,98,000	65,340.00	18,000	5,940.00
Machine set-ups	18,000	4,95,000.00	15,750	4,33,125.00
Total		39,10,620.12		20,29,379.88

Therefore we see that the total overhead cost for Lexon under activity based costing is $ 3910620 and that for Protox is $2029380. Whereas the cost allocated to Lexon user traditional costing method was $5280000 and that for Protox was $660000. Therefore we see that due to use of traditional costing method the burden of cost of the units of Protox was shifted to Lexon. This resulted in higher operating cost for Lexon and hence lower operating margin.

We have re-made the income statement of Beztec limited, in order to determine the actual profits earned from both the divisions of Beztec limited:

Beztec Limited
Income statement for the financial year ended 31December 2017
	Lexon	Protox	Total
Revenues	237,60,000	75,24,000	312,84,000
Cost of goods sold	136,78,620	66,36,180	203,14,800
Gross margin	100,81,380	8,87,820	109,69,200
Selling and administrative expense	69,96,000	16,13,700	86,09,700
Operating income	30,85,380	-7,25,880	23,59,500
Units produced and sold	24,000	6,000
Operating income per unit sold	129	-121

From the above income stamen we can see that the actual profits earned by the company from sale of Lexon are $3085380 and the company has incurred loss in the production and sale of Proton for $725880.

The operating profit per unit of Lexon is $129 and that of Protox is negative $121. Therefore, the contention of the management that the Line of production belonging to Lexon has lower operating profits is wrong. Clearly, production of the newer model Protox has been incurring losses which have resulted in lower profits for the company.

Hence, the management should discontinue with the production of Protox.

It is the duty of the company’s accountant to make sure that all the financial record of the company, reflect the true nature of the workings of the organisation. They should take decision based on what would be the cost suitable course of action for the company. 

In the given scenario, the company’s accountant Sue Smith is of the opinion that the company should incorporate the use of activity based costing in order to determine the profitability from both the divisions. Use of this system will help in proper allocation of cost data and determine the financial return from both the divisions.

But the CEO is of another opinion. The CEO of the company Mr. Kay does not want Sue to pursue with this option, as it will result in phasing out of the new production unit. The bonuses for the CEO are based on the revenue of the divisions. Due to involvement of his personal interest in the action, Kay is against the option presented by Sue.

Beztec Limited: a case of improper costing

In order to find a solution for the ethical dilemma of Sue, she should follow the APES 110. The guidelines for the accountants lay down that the work carried out by them should be done in professional capacity. The accountants are liable to follow due diligence and professional scepticism in their work in order to ensure honest results. If there are personal interest of the management involved in the decision affecting the working the company, then under such circumstance the persons with such personal involvement should excuse themselves from such plans (Siciliano, 2015).

Therefore, Sues contention to inform the management about the results under activity based costing is correct. She should take measures in order to make sure that the decision made by the management is based on correct information.

We have calculated the gross profit margin of the company under both, traditional and activity based cost allocation, and we have the following:

Gross Profit analysis
Gross profit margin under traditional costing	36.67	30.00
Gross profit margin under Activity Based costing	42.43	11.80

We see that the gross profit of the company from Lexon was 36.67% and that from Protox was 30% under the traditional method. Under the activity based costing the gross profit rate changed to 42.43% and 11.80% respectively for Lexon and Protox. Due to higher charges of overhead expenses on Lexon line, the margin from these products was declined. But when cost was allocated based on actual usage of activities the real gross profit margin from both the products were identified.

The gross profit margin for Protox is very low was compared to that of Lexon

As discussed above under the traditional method of cost allocation, the cost is allocated based on some predetermined rate and a single cost driver. When the actual expenses are incurred then there stands a difference in the books between the overheads recovered and overheads actually charged.

When the overheads charged from the customers are higher than the overheads actually incurred, and then there is the case of over recovery. When the overheads recovered from the customers is lower than what was actually incurred then it is a case of under recovery of overheads. 

In order to treat these differences in the books, any of the following can be opted for:

• Carry forward to next year: under this method of adjustment of over-under recovery of overheads, the extra or shortened amount of the overhead is carried forward to the next financial year. The carried forward amount is adjusted with the overhead of the next year and any balances reaming is again carried forward to next year(Piper, 2015).
• Adjust with the remaining unit: under this system the amount of over/under recovery is charged over the reaming outstanding units of the financial year. This increases or decreases there price. This system of adjustment is not very widely preferred as it creates a difference between the prices of the units produced in the same production cycle.
• Adjust the amount in the profit and loss statement: the amount of under and over recovery is straight away carried to the profit and loss statement. This is the most suitable and widely opted method of adjustment of under and over recovery of overheads (Seal, 2012).

Therefore, a company opting for traditional method of cost allocation may opt for any of the above methods for treatment of over/ under recovered overhead amount

Recommendation and Conclusion

From the discussion we can say that the selection of cost allocation method is very important for decision making functions. The method of allocation should be selected based on the production function and products. We would recommend the management to follow the same. They should opt for activity based costing method in order to determine the cost of products. This will help them in better presentation and analysis of cost data.

Based on the qualitative and quantitative discussion provided above, we would recommend the management to phase out the production of the newer model Protox and start using activity based costing. 

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