Question

Stark and Company is a manufacturer that sells robots predominantly in the Asian market. Times have been tough for the auto industry and Stark and Company is no different. The company is under tremendous pressure to turn a profit. Several years ago, as analysts were predicting a large downturn in the robot industry, Stark decided to purchase a smaller niche robot maker in the hopes of capturing a different segment of the consumer market and to better learn the manufacturing processes of other robot makers. Starks still operates as two separate divisions, Classic and New Age, with each division manager employing a different manufacturing philosophy. The Classic manager is concerned with low input costs and quantity in production in addition to brand recognition and robot power. The New Age manager is concerned with quality and innovation in manufacturing in addition to fuel efficient and environmentally friendly robots. SAC continued to suffer losses even with the addition of the New Age division. While Classic appears to have good margins its sales levels are dwindling despite a large marketing campaign. New Age has had good sales levels but there is concern that its quality and innovation focus is not cost-effective. Upper management wants to adopt one manufacturing philosophy for the entire company and has hired you as an outside consultant to provide guidance on their performance evaluation of the two managers. Discussions with the controller revealed the following: SAC feels it has a good handle on direct costs. Since the two divisions use different input materials, these costs are tracked by division rather than allocated to the two divisions. Direct labour is allocated on the basis of manufacturing labour hours (MLH); New Age generally uses 60% of total MLH but its focus on quality makes it relatively more labour/less capital intensive than Classic. Thus, New Age generally uses only 40% of total machine hours. Indirect manufacturing costs are broken down into a number of categories based on the allocation method used to assign these costs to the two divisions’ cost of goods sold. Categories include carrying costs, variable overhead, fixed overhead-general, and fixed overhead-support. Carrying costs, like direct costs, are tracked by division and include storage space rental, insurance, spoilage and obsolescence. The first two items are recorded through third-party billing whereas the latter two items are determined by each division manager. Variable overhead includes indirect labour such as rework labour, supervisor and plant manager wages as well as indirect materials such as scrap and warranty expense estimates. This cost category is allocated to the two divisions on the basis of MLH. Fixed overhead-general includes plant amortization, equipment amortization, plant power/utilities, property taxes, and payments for guard and janitor services. SAC’s allocation method was suggested by the Classic manager; allocate costs on an equal (50-50) basis since the two divisions take up relatively the same amount of plant space. Fixed overhead-support mainly includes the costs from two production support departments, quality control and repairs & maintenance (equipment and products). These two departments provide services to both the Classic and New Age division. SAC uses a cost allocation method suggested by the New Age manager; allocate costs on the basis of defective products per 1,000 units produced, per division. SAC treats non-production related costs as period costs; as such, they are not allocated to the two divisions. Costs include research and development costs and marketing costs (which include marketing personnel salaries and advertising expenses). Bonuses to divisional managers are on the basis of Return on Investment (ROI). Returns are derived from gross margins, which are calculated using the allocation rules above. Upper management believes gross margins are also an appropriate measure to evaluate the two divisions.

Answer 1

1. Following are the weaknesses in the current allocation process:

a. All costs are not being included

b. Costs are distributed according to a fixed percentage

c. Direct costs are not considered independently

d. The distribution of costs is not done properly.

2. Following are the ways to improve the performance of the division:

a. A homogenous approach.

b. Adopting techniques like ABC

c. Budgeting according to the research and analysis

d. Calculation of variances and analysis of results

3. Following are the benefits to the managers:

a. Better bonus

b. Better control and understanding of errors in the process.

c. Better output by the division

d. Better management

.

.

Step-by-step explanation

1.

The above case study reflects many problems in the allocation of cost by the management and the following are few of those:

a. All costs are not being included

All types of costs, whether direct or indirect, variable or fixed, etc. should be comprised in the product cost. Here, marketing costs are being excluded which should be comprised independently as they are incurred for increasing the sales and profit of the products.

b. Costs are distributed according to a fixed percentage

The allocation of cost should be according to the percentage they are being used in every department, separately, to provide an idea of why and where the money is being spent in the organization. In the above-given case, the costs are being allocated on a fixed percentage without a thorough study of the reason for its occurrence.

c. Direct costs are not considered independently

Costs like direct labor are being charged according to the MLH. This is a direct cost and thus, should be charged independently as 'Direct Labor'. Only the indirect costs should be charged in this manner as it is hard to directly link them to a particular process or activity.

d. Distribution of costs is not done properly

Costs are being categorized as carrying costs, variable overhead, fixed overhead-general, and fixed overhead-support. However, they should be categorized as fixed or variable, direct or indirect, manufacturing or administrative, etc. When the costs are not categorized properly, it can be incredibly hard to locate their accrual.

.

2.

Both of the divisions are good at one thing and have few problems as well. Following are the ways to improve the performance of the division:

a. A homogenous approach:

The Classic Division is more concerned with the quality and cost while the New Age division wants to give a better quality product. Both of them are incomplete independently, so they need a more homogenous approach where they are concerned with quality and quantity and cost-effectiveness and innovation to perform in a better manner.

b. Adopting techniques like ABC

SAC should adopt ABC (Activity-Based Costing) technique. This will give them a clear idea of how and where to allocate the cost and in the end, they can either keep the cost separate to have a better understanding of which division needs improvement or club it to give one single cost analysis.

c. Budgeting according to the research and analysis

The case study mentioned that SAC was told about the downfall in the demand but, it is nowhere mentioned that they took measures for this. In any business, there are ups and downs. It is almost impossible to be certain about the changes but, the analysis may show possibilities and business must take measures accordingly.

d. Calculation of variances and analysis of results

Budgeting is significant in the process of cost control. It is more significant to analyze the results afterward. Calculation of variances and variance analysis can help SAC in understanding what the major issue for the losses is.

3.

Improving the quality of the work will not only help the company to grow, but it will also give a few extra perks to the managers as well. Following are the benefits to the managers:

a. Better bonus

Budgeting and ABC will help in understanding the issues with the allocation and costs which can be avoided. This will give a better result with a quality product which will increase the revenue and ultimately, give a better bonus to the managers.

b. Better control and understanding of errors in the process

The manager is responsible for how a process work and thus, has to control the costs and process itself, with the new method, managers will be able to understand the costs and will be able to control in a better manner.

c. Better output by the division

Separating the costs will give the division a better outlook at its process and will help them improve. This will increase revenue and output quality will also improve as few costs will be eliminated.

d. Better management

The management will improve and more bonus and output will motivate the managers to give better results which lead to a whole better management of the divisions and the organization.