Question

Q·1 Identify and explain ONE (1) of the six common cost classifications used in a manufacturing business.

Q2 Explain why a business using a cost leadership business strategy would have different management accounting information requirements to a business using a product differentiation business strategy.

Q3 Identify and discuss ONE (1) advantage and ONE (1) limitation of Kilmarnock using income as a basis to allocate overheads to jobs.

Q4 Explain, using appropriate examples, the significance of equivalent units in a process costing environment.

Q5 Identify and discuss TWO (2) factors that need to be considered when managing a justin-time (JIT) inventory system.

Answer 1

ANSWER 1

Types of Costs (Cost Classifications)

Costs can be classified into different categories for different purposes.

Costs may be categorized according to their: (1) management function, (2) ease of traceability, (3) timing of charge against revenue, (4) behavior in accordance with activity, and (5) relevance to decision making.

According to Management Function

1. Manufacturing costs - incurred in the factory to convert raw materials into finished goods. It includes cost of raw materials used (direct materials), direct labor, and factory overhead.

2. Nonmanufacturing costs - not incurred in transforming materials to finished goods. These include selling expenses (such as advertising costs, delivery expense, salaries and commission of salesmen) and administrative expenses (such as salaries of executives and legal expenses).

According to Ease of Traceability

1. Direct costs - those that can be traced directly to a particular object of costing such as a particular product, department, or branch. Examples include materials and direct labor. Some operating expenses can also be classified as direct costs, such as advertising cost for a particular product.

2. Indirect costs - those that cannot be traced to a particular object of costing. They are also called common costs or joint costs. Indirect costs include factory overhead and operating costs that benefit more than one product, department, or branch.

According to Timing of Charge against Revenue

1. Product costs - are inventoriable costs. They form part of inventory and are charged against revenue, i.e. cost of sales, only when sold. All manufacturing costs (direct materials, direct labor, and factory overhead) are product costs.

2. Period costs - are not inventoriable and are charged against revenue immediately. Period costs include non-manufacturing costs, i.e. selling expenses and administrative expenses.

According to Behavior in Accordance with Activity

1. Variable costs - vary in total in proportion to changes in activity. Examples include direct materials, direct labor, and sales commission based on sales.

2. Fixed costs - costs that remain constant regardless of the level of activity. Examples include rent, insurance, and depreciation using the straight line method.

3. Mixed costs - costs that vary in total but not in proportion to changes in activity. It basically includes a fixed cost potion plus additional variable costs. An example would be electricity expense that consists of a fixed amount plus variable charges based on usage.

According to Relevance to Decision Making

1. Relevant cost - cost that will differ under alternative courses of action. In other words, these costs refer to those that will affect a decision.

2. Standard cost - predetermined cost based on some reasonable basis such as past experiences, budgeted amounts, industry standards, etc. The actual costs incurred are compared to standard costs.

3. Opportunity cost - benefit forgone or given up when an alternative is chosen over the other/s. Example: If a business chooses to use its building for production rather than rent it out to tenants, the opportunity cost would be the rent income that would be earned had the business chose to rent out.

4. Sunk costs - historical costs that will not make any difference in making a decision. Unlike relevant costs, they do not have an impact on the matter at hand.

5. Controllable costs - refer to costs that can be influenced or controlled by the manager. Segment managers should be evaluated based on costs that they can control.

ANSWER 2

Competitive strategy refers to a way of creating competitive advantage over competitors. It represents a greater value for the customer, created either by lower prices or by providing greater benefits and services that justify higher prices.

Generally speaking, there are four possible ways to differentiate a business – to become a cost leader (meaning that you become the lowest-cost producer in the industry) and to become a differentiation leader (meaning that you compete in areas other than price valued by customers), both in a narrow or broad scope of business’ activities.

Choosing the right competitive strategy is crucial strategy development step for the corporate, business unit and products and/or services success.

COST STRATEGY

Cost strategy is built on no-frills. Cost leadership strives towards cutting costs to a minimum possible levels in order to provide customers with lower prices and thus boost their savings. Cost strategy prerequisites normally relate to high technical capabilities and access to capital for the company to invest in technology and assure economies of scale.

In most of the cases cost strategy for first-movers lead to significant increase in market share and capacity utilization, that further drives down costs.

Building a strategy on minimizing costs requires a company to achieve:

• High productivity
• High capacity utilization
• Use of bargaining power to negotiate the lowest prices for production inputs
• Lean production methods (e.g. JIT)
• Effective production process
• Effective distribution channels

Leading cost leadership brands have obtained a major success by introducing revolutionary business models built on a single base – the lowest possible prices for a given perceived value.

DIFFERENTIATION STRATEGY

Differentiation strategy is built on a belief that one needs a clear and unique positioning. Differentiation leadership focuses in providing perks that add value for consumers, while higher prices are a sort of “make up” for their higher costs.

Building a strategy on a differentiation requires a company to continuously invest in and develop:

• Superior product quality (features, benefits, durability, reliability)
• Branding (strong brand recognition, desire and loyalty)
• Industry-wide distribution across all major channels (i.e. the product or brand is an essential item to be stocked by retailers)
• Marketing capabilities (advertising, sponsorship etc.)

Differentiation strategy could be further divided into:

• Purification (decrease in price; decrease in perceived value) – examples: EasyJet, Tata, Logan etc.
• Hybrid (decrease in price; increase in perceived value) – examples: IKEA (SCM optimisation), Loreal (new brands as a response to crisis) etc.
• Sophistication (increase in price; increase in perceived value) – examples: Mercedes (status), VW (reliability); Toyota (TQM)

Despite the fact that these brands pointed out above achieve significant economies of scale, they do not rely on a cost leadership strategy to compete. Strong marketing capabilities enable them to sell products for a premium and at the same time persuade customers to become brand loyal.

FOCUS OF THE STRATEGY

Cost strategy as well as differentiation strategy could be narrow or broad. Small and medium sized companies are often forced to become focused, namely a niche player, since they are unable to compete against better-resourced broad market companies’ offerings. Only true understanding of the market dynamics and customers’ unique needs in combination with unique low cost or well-specified products and/or services eventually result in strong brand loyalty.

How to successfully differentiate your products and/or services in the market? Are your products and/or services uniquely positioned in the market? If not – follow the steps written below:

Step 1: Examine existing positioning of the company and its products and/or services in customers’ minds

Step 2: Choose the competitive strategy (cost strategy vs. differentiation strategy) you think you should be following

Step 3: Analyze the competition and determine the industry standard

Step 4: Study market dynamics and search for market gaps

Step 5: Choose your most appropriate competitive strategy and look for potential practical solutions

ANSWER 3

A small business involved in manufacturing must deal with overhead costs. These are the costs beyond wages and materials that you incur for maintaining a manufacturing operation. These costs include such things as rent, utilities, employee benefits, insurance, equipment depreciation and property taxes. There are advantages and disadvantages to these costs that with some planning you can maximize the benefits while minimizing the costs.

Absorption Costing Advantage

Treating manufacturing overhead as part of the cost of each product can help you effectively price your products for profit. Many companies mistakenly think that the cost of goods manufactured is labor plus materials only. Use manufacturing overhead to your advantage by counting it in the cost of each item manufactured. In this way, you price your products to pay the bills and a produce a profit.

Tax Advantages

All of your manufacturing overhead costs are tax deductible. You should track all of these costs as part of your manufacturing expense. This will allow you to reduce your taxable income and therefore lower your tax burden. Many overhead costs are deductible in the year they are incurred, which is to your advantage. Equipment, however, must be depreciated over a period of years.

Rising Prices Disadvantage

In an inflationary environment, rising overhead expenses can force you to raise prices on your products, even if materials and labor do not rise. You have to make enough from your products to keep up with facility costs, and the only place to get this money is from the prices for which you sell your products. Failing to control overhead costs could price you out of the market.

Cash Flow Disadvantages

Overhead costs continue even if you are not manufacturing. That means you have to keep spending cash on overhead during machine outages or other manufacturing downtime. You could find wind up spending cash while not earning cash. You should keep an emergency fund to cover manufacturing overhead during non-manufacturing periods.

ANSWER 4

Definition of Equivalent Unit of Production

An equivalent unit of production is an expression of the amount of work done by a manufacturer on units of output that are partially completed at the end of an accounting period. Basically the fully completed units and the partially completed units are expressed in terms of fully completed units.

Equivalent units are used in the production cost reports for the producing departments of manufacturers using a process costing system. Cost accounting textbooks are likely to present the cost calculations per equivalent unit of production under two cost flow assumptions: weighted-average and FIFO.

Example of Equivalent Units of Production

Assume that a manufacturer uses direct labor continuously in one of its production departments. During June, the department began with no units in inventory and then started and completed 10,000 units. In addition, it started 1,000 units but they were only 30% complete at the end of June. The production cost report for this department will indicate that it manufactured 10,300 (10,000 + 300) equivalent units of product during June.

If the department's direct labor cost was $103,000 during the month, it's June direct labor cost per equivalent unit will be $10 ($103,000 divided by 10,300 equivalent units). This means that $100,000 (10,000 X $10) of labor costs will be assigned to the finished units and $3,000 (300 equivalent units X $10 labor cost per equivalent unit) will be assigned to the 1,000 partially completed units.

ANSWER 5

JIT is a manufacturing management process. It was first developed and applied in the Toyota manufacturing plants in order to meet consumer demands with minimum delays. Taiichi Ohno of Japan is referred as the father of Just In Time. Toyota met the increasing challenges for survival through a management approach that was entirely focused on people, systems and plants. Toyota realised the Just In Time approach would only be successful if every person within the Toyota was committed and involved in it if plant and processes were properly arranged for maximum efficiency and output, and if the quality of the goods produced and production programs were scheduled to meet demands exactly.

JIT approach has the capacity, when adequately applied to the organisation, to improve the competitiveness of the organisation in the market significantly by minimizing wastes and improving production efficiency and the product quality.

Why JIT concept matters?

The main focus of JIT is to identify and correct the obstacles in the production process. It shows the hidden problems of inventory. Just In Time method prevents a company from using excessive inventory and smoothens production operations if a specific task takes longer than expected or a defective part is discovered in the system. This is also one of the main reason why the companies (which are opted for JIT) invest in preventive maintenance; when a part/equipment breaks down, the entire production process stops.
The prime objective of JIT is to increase the inventory turnover and reduce the holding and all connected cost. This concept was made applicable again by the Japanese firms, placing an order for the material, the same day for the production of the product.
Thus, the Just In Time approach eliminates the requirement to carry voluminous inventories and incur heavy carrying other related costs to the manufacturer. In order to avail the benefits of JIT system, there should be an optimum synchronization between the manufacturing cycle and delivery of material. Just In Times requires a good understanding of the supplier and the manufacturer in terms of the quantity and delivery of the material. In the event of any misunderstanding between the manufacturer and supplier of the material, the entire production process may come to a halt.
One example of JIT system is a car manufacturer, a manufacturer of the cars operates with bare minimum inventory levels, as there is a strong reliance on the supply chain to deliver the parts required to manufacture cars. The parts required in the manufacturing of cars do not arrive before or after they are needed; rather, they arrive only when they are needed.
Successful JIT implementation wholly depends on how the manufacturer manages its suppliers. A lot of pressure is exerted on them, as the supplier of the materials have to be ready with an ample quality material, as the need arises.

Elements involved in JIT

Continuous improvement:

• Attacking fundamental problems and anything that does not add value to the product.
• Devising systems to identify production and allied problems.
• Simplicity: Simple systems are simple & easy to understand, easily manageable and the chances of going wrong are very low.
• A product: oriented layout for less time spent on materials and parts movement.
• Quality control at source to ensure every worker is solely responsible for the quality of their own produced output.

Eliminating waste: There are seven types of waste:

1. Waste from product defects.
2. Waste of time.
3. Transportation waste.
4. Inventory waste.
5. Waste from overproduction.
6. Processing waste.

Waste minimization is one of the primary objectives of Just In Time system. This needs effective inventory management throughout the whole supply chain. Initially, a manufacturing entity will seek to reduce inventory and enhance operations within its own organization. In an attempt to reduce waste attributed to ineffective inventory management, SIX principles in relation to JIT have been stated by Schniededans and they are:

1.       Reduce buffer inventory.
2.       Try for zero inventory.
3.       Search for reliable suppliers.
4.       Reduce lot size and increase the frequency of orders.
5.       Reduce purchasing cost.
6.       Improve material handling.

Advantages & Disadvantages of Just-In-Time Systems

Advantages of Adopting Just-In-Time include:

• Just-in-time approach keeps stock holding costs to a minimum level. The released capacity results in better utilization of space and bears a favourable impact on the insurance premiums and rent that would otherwise be needed to be made.
• The just-in-time approach helps to eliminate waste. Chances of expired or out of date products; do not arise at all.
• As under this management method, only essential stocks which are required for to manufacturing are obtained, thus less working capital is required. Under this approach, a minimum re-ordering level is set, and only when that level is reached, order for fresh stocks are made and thus this becomes a boon to inventory management too.
• Due to the abovementioned low level of stocks held, the ROI (Return On Investment? of the organizations be high in general.
• As this approach works on a demand-pull basis, all goods produced would be sold, and thus it includes changes in demand with unanticipated ease. This makes JIT appealing today, where the market demand is fickle and somewhat volatile.
• JIT emphasizes the ‘right-first-time’ concept, so that rework costs and the cost of inspection is minimized.
• By following JIT greater efficiency and High-quality products can be derived.
• Better relationships are fostered along the production chain under a JIT system.
• Higher customer satisfaction due to continuous communication with the customer.
• Just In Time adoption result in the elimination of overproduction.

Disadvantages of Adopting JIT Systems

• JIT approach states ZERO tolerance for mistakes, making re-work difficult in practice, as inventory is kept to a minimum level.
• A successful application of JIT requires a high reliance on suppliers, whose performance is outside the purview of the manufacturer.
• Due to no buffers in JIT, production line idling and downtime can occur which would have an unfavourable effect on the production process and also on the finances.
• Chances are quite high of not meeting an unexpected increase in orders as there will be no excess inventory of finished goods.
• Transaction costs would be comparatively high depending upon the frequency of transactions.
• JIT may have certain negative effects on the environment due to the frequent deliveries as the same would result in higher use and cost of transportation, which in turn would consume more fossil fuels.

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