One of the critical challenges for businesses is remaining both consistent and relevant in the market. Consistency comes in the form of producing the same products in terms of quality and at an affordable rate despite price fluctuations. While consumers understand that prices might vary due to some changes in the larger economic environment, they expect that a company’s proposed changes to its pricing do not limit access to products. Through consistency, a business establishes relevance as it ensures availability of products for its target market. Consequently, consumers are likely to strengthen their loyalty to the organization leading to a reliable stream of income thereby boosting company growth and development. However, new entrants, who mostly come along with diversification of already existing products, bring about market disruption and such is the case that faces Sierra Ltd. Of the various issues noted are such as new start-ups focusing on manufacturing of one product, which could be a result of why they experience low overheads. In such a case, these companies end up experiencing high profit margins. Sierra Ltd invests in the manufacture of various auto parts for luxury cars, which means an increase in the number of operations, both direct and indirect. Based on the company’s financial performance in the past five years, there has been a considerable decline. Proposals have been given to move the company from being a product based costing system to an activity based system as this would bring about more accountability, while also acting as a foundation for decision making as pertains to product pricing.
Assessment of current costing and pricing practices
Baljit Kaur, the company’s financial director, describing Sierra’s current costing system stating that a 30% margin on all manufacturing costs of all products is normally added and forms the basis of coming up with the final price for the products. This means that the 30% added is expected to cater for the cost of manufacturing alongside other direct and indirect costs, such that when the product is sold, the revenue generated is sufficient to cater for the said costs, while also promoting company growth and development. Nonetheless, Baljit confessed that the method has not been as successful as the company would have wished, thereby proposing an upgrade of the accounting system. Baljit noted that Sierra uses a traditional costing system, which allows for easy identification of direct labor and materials associated with the company’s various product lines. However, according to his assessment, the company experiences issues when it comes to allocating overhead costs. Consequently, Sierra adopted a strategy whereby it uses machine hours as the basis for allocating production overheads to each product line. Baljit expressed fear that such a strategy ends up distorting the real cost of some products. In support, Drury (2015) noted that, “Distorted product costs are reported with the traditional costing system that uses the volume-based cost driver” (p. 277). Such distortions occur because of various factors, which a company should put into consideration. As an example, there is a possibility that Sierra bases pricing on the number of products manufactured at the expense of the company’s investment in various aspects such as labor costs or the amount of machine hours. In this case, the company analyzes the number of products manufactured in a specified amount of time, after which a decision is made regarding the suitable price for these products.
Delegate your assignment to our experts and they will do the rest.
Drury (2015) warned that challenges are bound to occur when a company uses volume-based cost drivers as a basis of assigning non-volume related overhead costs, which can result into issues in reporting product costs. Chiang (2013) compared direct and indirect costs stating that while the former can be traced, companies face challenges when tracing the latter. In an organization, indirect costs demand execution of an allocation process as they cannot be traced directly in an economical way (Chiang, 2013). With such a fact at hand, it becomes clear that Sierra has been basing its pricing practices on assumptions of how much cost the company incurred during the product development process. There is fear that Sierra has been investing too much in some products with the expense not being mirrored in the final value or rather price for a particular product. Silvia Sierra, the company’s managing director, expressed her concern stating that Sierra has not been managing production costs of engine components, which could be a potential source for the high overhead costs encountered. This explains why she proposed reduction of production costs for these particular products. Bendul and Apostu (2017) advised that, “… production companies should consider all aspects of the development and production of the product, including the need for cost reduction, already during the design phase of the respective product and before any decision towards the manufacturing is taken, an approach known concurrent engineering” (p. 1). This means that if Sierra was using such a method described above, as pertains to the production of engine components, it could be having stability as is the case in other product lines.
An assessment of the company’s top management official’s views regarding its current status reveals that the entrance of new small start-ups has caused a shift in demand and supply for Sierra. The sales director, Chris Singleton, stated that these new companies have invested in fast and agile product design and development processes, in addition to specializing in only one product line with few variants. Based on views from Baljit and Sierra, the company’s costing and pricing strategy has not been as stable as it would be expected. Baljit recommends a shift to activity-based accounting, but Sierra is opposed to such a proposition. Nevertheless, the reality is that the company’s costing and pricing strategies are not effective. Dependence on a traditionally oriented costing approach has led to distortions in reporting product costs. The result is that the company has not been able to price its products such that the overall value not only caters for both direct and indirect costs, but also generates substantial profit margin for the company. Sierra relies on a non-informative approach, which involves adding 30% margin on all manufacturing costs for the various products it sells. This margin does not reflect the real value of the products themselves as pertains to the revenue they are supposed to generate for the company. The fact that there is diversification makes it even harder to come up with a standard approach to manage product costs. Drury (2015) described product diversity as being a situation where products consume different overhead activities in proportions that are dissimilar. Sierra engages in production of clutch and engine components as well as transmission components. Of the two product lines, manufacture of transmission components involves many variants as each product is specific to a particular consumer. In such a case, the likelihood of distortion in product cost reporting increases and this affects pricing of products (Drury, 2015).
Potential for activity based costing (ABC)
Stefano and Filho (2013) described activity based costing as an approach that treats clients as the objects of cost analysis. This occurs in parallel with an analysis of ownership costs of suppliers. Such emphasis seeks to demonstrate a more informed understanding of the features of indirect costs. Notably, an activity based costing “… is designed and implemented on the premise that products consume activities, activities consume resources and resources consume costs” (Stefano & Filho, 2013, p. 80). This means that activities, drivers and resources all form an integrated grid for understanding ABC. CIMA (2008) compared ABC to transitional cost accounting noting that an ABC system accumulates overheads for every activity in an organization. After that, costs of these activities are placed in relation to products, services or consumers that cause particular activity. It is important to note that analysis of the initial activity is the most difficult of ABC. Descriptively, activity analysis refers to the process of locating appropriate output measures of activities as well as cost drivers (resources) and their impact on costs of manufacturing products or providing services (CIMA, 2008). Unlike traditional costing systems, ABC has the flexibility to provide special reports, which allow the management to make decisions regarding different costs such as those associated with designing, selling or delivering products or services. Different from traditional costing system, which focuses on accumulating costs within operating areas, ABC sheds light on accumulating costs through activities (CIMA, 2008).
Some of the issues highlighted as related to Sierra Ltd involve challenges with the company’s current accounting system. As the company’s financial director, Baljit has expressed concerns regarding limitations in this particular system, which are preventing the company from realizing profits as is expected. A review of the company’s financial performance from 2012 to 2016 demonstrates a decline in sales revenue from £60,000 in 2012 to £50,000 in 2015. This decline is, in part, due to new entrants in the market. As Chris noted, these new start-ups have not only applied efficient methods of production, but their focus on one product line helps them reduce overhead costs, which affect the pricing of products. Information gathered earlier reveals that dependence on the traditional costing system might lead to distortions in reporting product costs, which affects the revenue generated in the long-run. Additionally, such a company as Sierra has invested in different products, and as Drury (2015) noted, product diversity increases the likelihood of distortions in product cost reporting. According to CIMA (2008) “ The main advantage of ABC is that it minimizes or avoids distortions on product costs that might occur from arbitrary allocation of overhead costs” (p. 5).
Sierra Ltd stands to benefit greatly from transition to an ABC system. The fact that it invests in the manufacturing of different products provides the rationale for using the proposed system. This means that the company will be in a position to track unique processes along the different product lines in terms of what activities are involved and how much they cost. ABC allows access to accurate information regarding the cost of products, services, processes as well as activities. Therefore, for Sierra Ltd to employ ABC, this would mean access to information leading to better understanding of company processes as well as cost behavior during analysis. Consequently, the management uses this information to improve decision making at both operating and strategic levels, leading to activity based management (CIMA, 2008). Sierra Ltd has the ability to employ this particular system as it could help in managing and evaluating processes in its various product lines leading to greater insight and hence effective pricing strategies.
Factors to consider
In order to implement ABC in its cost management system, Sierra Ltd should consider a number of variables, which are vital in such a process. According to Shields (1995) an organization should consider support from top management, association of cost management system with competitive strategies, as well as performance evaluation and compensation, whether there are sufficient internal resources (employees, time, machinery), and consensus regarding the goal of the proposed cost management system. These are perceived as fundamental variables, which determine the effectiveness of a cost management system. For Sierra Ltd, the company should, for instance, invest in training employees on how to use an ABC system, align the new system with company objectives in order to achieve integration. All other elements mentioned should also be part of Sierra’s focus as it transitions towards an activity based costing system. This will help in matching activities in that there will be information to compare revenue generated and expenses. This particular approach is called a matching concept and it helps an organization know the exact amount of profit or loss in a particular trading period. Sierra Ltd will be in a position to manage its finances through application of an ABC system. Therefore, there is great potential for the company to rise above its competitors following application of such a system as it will have access to pertinent information relating to costs of activities and other operations as they occur. ABC will help Sierra realize some of the profit lost in previous years.
References
Bendul, J. and Apostu, V. (2017) “An Accuracy Investigation of Product Cost Estimation in Automotive Die Manufacturing”, International Journal of Business Administration , volume 8, number 7, pages 1-15.
CIMA (2008) “CIMA Topic Gateway Series Number 1: Activity Based Costing.” Available from http://www.cimaglobal.com/Documents/ImportedDocuments/cid_tg_activity_based_costing_nov08.pdf.pdf [accessed 24 October 2016]
Chiang, B. (2013) “Indirect labor costs and implications for overhead allocation”, Accounting & Taxation , volume 5, number 1, pages 85-96.
Drury, C. (2015) Management and Cost Accounting, 9th edition. Cengage Learning EMEA.
Shields, M.D. (1995) “An Empirical Analysis of Firms’ Implementation Experiences with Activity-Based Costing”, Journal of Management Accounting Research , Volume 7, pages 148-166.
Stefano, N. M., & Filho, N. C. (2013) “Activity-based costing in services: literature bibliometric review”, SpringerPlus , volume 2 , page 80.
