Importance of Accurate Product Costing

In a production facility, it is important that all cost are collected appropriately and allocated amongst the products in order to ensure correct pricing of the product (Holtzman, 2013). The costing data helps the management take important decisions, regarding the operations of the business. Beztec Limited had two major products, Lexon and Protox. Lexon is an old product and Protox in the newly introduced model. The management is in a fix about the decision of whether they should continue with the new model or not. It is important that the profitability of the product be checked in order to take the appropriate decision. Using a correct costing system is important so that correct profitability can be determined (Horngren, 2012)

The costs which are directly related to the particular product are wholly allocated to that particular product. There are other costs also, which are incurred jointly (Menifield, 2014). These joint costs are required to be allocated amongst the product so that total cost the product can be determined. This allocation of overhead cost needs to be done using an appropriate allocation rate. It is important that the allocation rate determined is based on actual consumption and use of resources. If improper allocation rate is applied to the products then it results in wrong decision making by the management (Atkinson, 2012). This leads to wrong pricing of the product, which results in wrong profitability. When the company is unable to rely on its costs data then it becomes difficult to take any decisions. Therefore, it is important that correct allocation methods is applied in order to allocate the cost 

Traditional costing is the costing system which uses one single overhead rate in order to allocate the joint products. In this system the costs are allocated amongst various products based on single attribute or cost driver (Berry, 2009). This method fails to incorporate the concept of actual consumption of resources while allocating the cost. This leads to improper cost allocation. Even if the services used by a product are very less, a large portion of costs can be allocated (Noreen, 2015). This increases the cost of the product, which increases the selling price. When the customer finds the same product from other manufacturer at cheaper rate, they would definitely go for it. This affects the demands. Therefore we see that traditional costing can be wrong to be implemented in some cases. Where there are various costs and various products using one cost attribute to allocate cost, it will lead to wrong results (Boyd, 2013). The main disadvantages of traditional costing include improper allocation, ignorance of actual consumption and use of improper data for cost allocation.

Problems with Traditional Costing System

In the given scenario we see that production overhead is allocated amongst the product using the rate of $27.50 per machine hour used. But when we see the table for consumption of the activity, we see that the activities are not evenly used by both the projects, some activities are used more than the other by all the products. Distribution of production overheads based on one overhead rate has resulted in shift of the major expense to the Lexon model. Therefore, we see that traditional costing can result in improper accounting of cost data (Raun, 1962).

Activity based costing is the improved cost allocation methods which allocates the cost incurred on various activities based on actual usage of these activities (White, 2009). Implementation of these methods will help in calculation of true cost and profitability of the products.

Using the data provided on various cost drivers we have calculated the rate per cost driver. The following table shows 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

 If we allocate this cost based on the actual consumption of activities we get the following cost data:

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

The total cost of the product will now be changed:

Total Cost under Activity Based Costing
Costs	Lexon	Protox
Total	Per unit	Total	Per unit
Direct materials	54,91,200	229	38,54,400	642
Direct production labour	4,75,200	20	2,77,200	46
Machine	38,01,600	158	4,75,200	79
Total direct	97,68,000	407	46,06,800	768
Production overhead	39,10,620	163	20,29,380	338
Total cost of goods sold	136,78,620	570	66,36,180	1,106

Therefore we see that under traditional costing system the production overhead which was charged to Lexon was $52, 80,000 and that to Protox was $6, 60,000, has now become $3910620 and $ 2029380. The overhead which was not even consumed by the Lexon models was also allocated to it. This resulted in lower profitability form Lexon, and higher profitability form Protox model, when it was incurring losses.

The actual allocation showed that the new introduces model Protox resulted in loss for the company for $725800.

Therefore, using activity based costing will result in accurate a proper data for cost allocation.

In the given scenario we see that the CEO of the company Beztec Ltd, Steven Kay, is not convinced that the activity based costing should be implemented. It is important that decisions like these be taken based on the advantage of company and not for individual advantage for the management.

Being an accountant it is important that Sue Smith carry professionalism and integrity in her work. The APES 110 Code of ethics for professional accountant lay down that the work conducted by the professional accountants should be carried with professional competence and due care. She should also use professional scepticism in her work (Cochran, 2017). Her understanding of applicability of Activity based costing is correct and she should continue with it (Datar M. S., 2015). 

Calculating Cost Driver Rates for Activity-Based Costing

Not reporting the overheads as per activity based costing will lead to projection that the product Protox is profitable to the company, when in actual they line of Protox models have been resulting in losses.

The management is likely to phase out the line with losses. But the CEO does not want Sue to implement the activity based costing as it will phase out this line. The CEO has a personal interest in the running of the segment of the Protox model. His bonus is dependent on the revenues of the different divisions. Due to indulgence of his personal interest the decision made by Kay becomes biased. The decision to report the numbers based on activity based costing should be taken after taking into consideration the advantages it will generate to the company (Siciliano, 2015).

The methods of costing opted by the management will not affect the overall profitability of the company, but it will affect the profitability at division or product level (Datar S. , 2016). Since the total cost remains same and only the allocation rate changes under the different methods, the profit under various divisions are changed (Seal, 2012). The profitability of Beztec Ltd was as follows when traditional method of cost allocation was being implemented:

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	150,48,000	52,66,800	203,14,800
Gross margin	87,12,000	22,57,200	109,69,200
Selling and administrative expense	69,96,000	16,13,700	86,09,700
Operating income	17,16,000	6,43,500	23,59,500
Units produced and sold	24,000	6,000
Operating income per unit sold	72	107

After the application of the activity based costing the profit stamen was changed and looked like under:

Beztec Limited
Income statement for the financial year ended 31December 2017 (Under ABC)
	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

 We have calculated the gross profit percentages of the products under both the methods and we have the following:

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

Therefore from the above data we can see that the gross profit form Lexon models was 36.67% under traditional costing methods but under activity based costing it increased to 42.43%. The gross profit margin for Protox under traditional method was 30% but under Activity based methods the gross profit margin declined to 11.80%. This shift of margins amongst the product line was witnessed due to wrong allocation of overheads.

Under the traditional costing system the overhead allocated to the product are based on some pre determine overhead rate, even before knowing how much expense are to be incurred. The management budgets some expense in order to forecast the expense that could incur. Based on the budgeted units that are expected to be produced and sold, the management divides these expenses amongst these units. This is how a pre determined rate is calculated (Strathern, 2010). There is a difference between pre determined and actual overhead rate. The difference between these amounts is required to be adjusted in the books.

Calculating Cost and Profitability per Unit for Lexon and Protox under ABC System

For example, the management expects that total $50000 would be incurred for overhead for production of 10000 units, using this data we get the predetermined overhead rate as $5 per unit. Now during the financial year they actually incur an expense of $50500 and produce 11000 units, this makes the overhead rate $4.60 per unit. The difference between the allocated and actual overhead $0.40 per unit (5-4.6) is to be adjusted in the books.

In order to adjust the said difference there are certain methods which can be followed. The adjustment in the books can be done in three ways: 

Adjusting the over/ under recovery in the existing units during the financial year:under this system of adjustment of under and over recovery, the amount which needs to be adjusted is allocated amongst the existing units produced during the year.

For example, if the amount of over/ under recovery to be adjusted is $10000, and total 2000 units are in stock then the amount of $5 per unit will be adjusted in the price of these units.

This system of adjustment of recovery amounts is not very popularly used and implemented, since it shifts the loan of overhead of some units on the other reaming units. This creates a price difference. Also, implementation of this kind of adjustment is very complex (Taillard, 2013).

Adjusting the over/ under recovery by carrying forward the amount to the next financial year: in the cost records when the overhead accounts are prepared, the  allocated recovery rate is first charged to them, and then the actual amount is transferred, the reaming balance standing outstanding at the end of the year in these accounts are carried forward to next year. The overhead rate allocated to the new units is revised in order to adjust this opening amount. This system of adjustment always has some difference standing in the books. Since this does account for expense in appropriate manner this method is not very popular. 

Adjusting the over/ under recover by transferring to the profit and loss statement: this is the most popularly used and the most implemented way to adjust the under and over recovery amounts. Under this method the difference between the allocation and actual amount is directly carried forward to the profit and loss statement. The profits is adjusted for the expenses in the year in which they are incurred, this helps in presentation of correct data in the books of account, also this is a very simple way to adjust the differences. Hence, this system is most widely used.

Therefore the management can deal with under/ over recovery of overheads by the method which is most suitable to them

Conclusion and Recommendation

From the above discussion we can see that the product Lexon was generating profits for the company but Protox has been incurring losses. Implementation of activity based costing helps us analyse the cost data more appropriately. Implementation of traditional costing by the company will lead to wrong decision making by the management. This will harm the future viability of the company’s performance. If the company continues to produce Protox, it will keep incurring losses. Continuing the loss will harm the financial position of the company.

We would recommend Sue to implement the activity based costing as it helps to present the correct data to the management. Management should also consider data based on activity based costing as it is more authenticated form of cost allocation. Eradicating the production of Protox model will be in the interest of the company and hence same should be moved forward with. 

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