Question

You are working as a graduate within the engineering department of manufacturing and consulting focused public listed company. You and your team are working on the post-COVID recovery and how best to allocate capital. Your team has $1,000,000 in the capital at their disposal. The entire department is going to have a conference call next week and you have been asked to prepare a memo for the team regarding the financial options being considered. As the accounting department will be joining your memo is to prepare the staff for the call. The accountants are expected to use terms which may not be fully understood by the greater department. So your memo will be distributed before the call or you may be asked to speak on the call to assist everyone's understanding. The memo should discuss each of the following:

1. As there is still uncertainty about employees returning to work the capital may need to be moved from its current interest-bearing account elsewhere. Explain the opportunity cost associated with leaving the money in a bank account as opposed to other investment options that may mitigate that opportunity cost.

2. The stock price of your company has suffered due to the economic downturn. A focus at the company may be to encourage both current and prospective shareholders. Explain one way that the company could deploy company-wide excess capital to directly incentivise these investors.

3. Your company has been using traditional costing and is considering moving to Activity Based Costings for a number of product lines. Explain what is meant by Activity-Based Costings, how it differs from traditional costing, and how it may be advantageous.

Answer 1

1. Opportunity cost is an economic term used to define the Potential Income which is to be forgone. It can be understood as the Income which would have been earned, had the second best alternative been selected.

If we keept the money in interest bearing bank accounts, the opportunity cost associated with that may be huge as in a Post Covid World we have various opportunities in form of businesses trading at a discount and very favourable takeover and acquisitions can be made. Also the money may be requiered to get the business back on track and to overcome any disruption like supply chain disruptions or lack of workforce or labour. All the afore-mentioned alternatives will require using the money which is kept in the interest bearning bank account and if we do not act on these opportunities and grab them, the opportunity cost may be huge, even it may lead to closure of business and bankruptcy if supply chain and worforce needs are not normalised. Hence, the opportunity cost (benefits of these alternate uses of money) are far greater than the opportunity cost of just keeping the money in bank. Hence, the company should use the funds in alternatives which will provide better returns than to just keep the money in the bank.

2. One way that the company could deploy company-wide excess capital to directly incentivise the exisitng and potential investors is to give them money in their hands. In simpler terms, the company should follow a very generous policy of paying a higher dividend and should make buy-back offers to the investors. Carefully planned buy-back offers can also help to regulate the share price. Say a stock is trading at $80 per share and buyback offer comes at $100 per share, it is more than likely that the stock price will rise. Hence, buyback offers will have dual benefits of givin direct cash benefit to some shareholders and to give an increase in value of share to other shareholers. Hence, a generous buy-back policy is one way that the company could deploy company-wide excess capital to directly incentivise the exisitng and potential investors.

3. Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.

Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

While the traditional costing systems apportion or allocate the general overheads on vague and illogical basis like machine hours, direct labour hours, area etc. The ABC costing system finds the drivers which are then formed as the basis for allocating costs. For eg. Cooling is based on the driver of no. of units requiring cooling, instead of allocating the whole cooling expense on basis of total no. of units , even those which do not require cooling.

The ABC analysis helps to fully and truely account and allocate all overheads on basis of the identified activity drivers and thus results in a proper analysis of costing of the product. This analysis may help the firm to make better decisions based on the revised cost under the ABC costing and may even make some projects viable and profitable, which were earlier rejected due to traditional costing.

Cost Reduction

ABC helps the organisation to identify costs against activities and to find opportunities to streamline or reduce the costs or eliminate the entire activity, especially if there is no value added. It is particularly useful in identifying and quantifying process waste and providing vehicle for continuous process improvement through continuous cost reduction.

Activity Based Budgeting (ABB)

ABB analyse the resource input or cost for each activity. It provides a framework for estimating the amount of resources required in accordance with the budgeted level of activity. Actual results can be compared with budgeted results to highlight both in financial and non-financial terms those activities with major discrepancies from budget for potential reduction in supply of resources. It is a planning and control system which seeks to support the objectives of continuous improvement. It means planning and controlling the expected activities of the organization to derive a cost-effective budget that meet forecast workload and agreed strategic goals. The three key elements of activity based budgeting are as follows:

- Type of work to be done

- Quantity of work to be done

- Cost of work to be done

Business Process Re-engineering

Business Process Re-engineering involves examining business processes and making substantial changes to how organisation currently operates. ABC is a powerful tool for measuring business performance, determining the cost of business output, and is used as a means of identifying opportunities to improve process efficiency and ffectiveness. A business process consists of linked set of activities.

Benchmarking

Benchmarking is a process of comparing of ABC derived activity costs of one segment of company with those of other segments. It requires uniformity in the definition of activities a nd measurement of their costs.

Performance Measurement

Many organisations are now focusing on activity performance as a means of facing competitors and managing costs by monitoring the efficiency and effectiveness of activities. Activity performance measures consist of measures relating to costs, time, quality, and innovation.