Morelli Electric Motor Corporation manufactures electric motors for commercial use. The company produces three models assigned as standard, deluxe and heavy duty. The company uses a job costing system with manufacturing overhead applied on the basis of direct labour hours. The system has been in place with minimum change for 25 years.
For the past 10 years, the company’s pricing has been to set each product’s budgeted price at 110 per cent of its full product cost. Recently, however the standard-model motor has come under increasing price pressure from offshore competitors. As a result the price on the standard model has been lowered to $110. The company CEO recently had a discussion with the financial controller on why they are unable to compete with their other competitors. He even added that other competitors in the market are also producing the same standard models just like them and their selling price is only few dollars more than their production cost. He wonders that is that his company producing such an insufficient product.
However his financial controller explains that the actual concern should be more on the outmoded product costing system. He added that he raised a voice regarding the same issue on last year’s board. However, the management decided to keep the current costing system at that time. He highlighted that their product costing system is distorting their product cost.
Then to further show in detail on their actual position, he demonstrated the activity-based costing system to have a comparison with their current system. He compiled the basic data needed to implement an activity-based costing system. These data are displayed in the following table. The percentages are the proportion of each activity driver consumed by each product line.
It is a well-known fact that the traditional costing systems utilize a single, volume-based cost driver. This is the reason why the traditional product costing system distorts the cost of products. In most cases this type of costing system assigns the overhead costs to products on the basis of their relative usage of direct labour. For this reason traditional cost systems often report inaccurate product costs during computational method in practice. The problem is in the underlying methodology of the traditional costing systems. They adhere to the assumption that products cause cost. Each time a unit of product is manufactured, it is assumed that cost is incurred. This assumption makes sense for certain direct costs. The assumption does not work for activities that are not performed directly on the product unit that has been mentioned / involved.
The problem with this approach is that for most overhead activities, the proportions of the activity actually consumed by a specific product, does not universally correspond with a single cost driver. This holds true for most modern companies where products are produced by a combination of manpower and technology. The traditional cost accounting model employs a volume-based driver, such as direct labor hours or machine hours for the assignment of all manufacturing overhead costs. The conventional cost accounting model ends up with a cost of goods sold based on absorption costing and includes only product costs as defined in financial accounting. Fundamentally, traditional costing systems try to assign cost directly to products, rather than to activities first and then from the activities to product units. The typical cost report gives information on what is spent, but not why it is spent.
When overhead costs are cut in order to reduce total costs it is the symptoms that are treated and not the cause. In many cases the cutting of overheads is more likely to lead to a reduction in the quality of the products than to the long term reduction of the cost. Traceable fixed costs are booked to departments while common fixed costs are pooled in the traditional costing system approach.
The underlying assumption of activity based costing is entirely different from that of conventional costing systems. The conventional costing system assumes that products cause costs. Activity based costing systems have activities as the fundamental cost objects. Activity based costing systems also assumes that activities cause costs and that cost objects create the demand for activities. Activity based costing improves control of overheads by a cost/cause relationship, that are activity and cost. The system is flexible enough to relate costs to customers, processors, management responsibility and not just products. As the name suggests, activity based costing is a system that focuses on activities as the basic cost objects and uses the costs of these activities as building blocks for compiling the costs of other cost objects.
The use of an activity based costing system can also help a company to develop a way to analyse and justify manufacturing cycle-time improvements. The use of activity based costing according evolved over the last few years from a more accurate method of product costing, to a more scientific method of cost reduction, to an all-embracing advanced planning, monitoring and control system. It is therefore important to note that in activity based costing, costs are assigned to activities. The assignment is based on the consumption of resources utilized.
In utilizing activity based costing, costs are collected for each activity as an independent cost object. These costs are then applied to commodities as they undergo the different activities. The final product cost is built up from the costs of the specific activities that each product line has undergone. In other words activity based costing assigns activity costs to cost objects based on activity drivers that accurately measures consumption of the activity. When applied correctly activity based costing will diminish the issue of cost distortion by forming a cost pool for each activity that can be isolated as a cost driver. Performance improvement techniques should also include cost driver analysis, activity grouping, performance evaluation and activity based costing. A cost driver is defined as the root cause or reason for an activity to occur.
It is important to note that a cost driver should not be misinterpreted as an output measure. An output measure is a magnitude measure measuring how many outputs an activity produces. It is the output measure that should be followed to the cost object. After allocating costs to the activity cost pools, cost drivers are identified that are suitable for each cost pool. Then the overhead costs are assigned from each activity cost pool to each production job in proportion to the amount of activity used up by the job. In other words, activity based costing assigns activity costs to cost objects based on activity drivers that accurately measures consumption of the activity. The improved product costing accuracy in activity based costing comes from the identification of a large number of activity cost pools and the isolation of a suitable cost driver for each activity.
The importance of the correct activity classification is underlined in that activity classification should always include some kind of value-added / non value-added analysis and more importantly all staff involved in classifying activities should understand these definitions. The popular definition of a non-value added activity is anything that can be eliminated without detriment to the final product. Although activity classification is subjective, it is only a tool to help with performance improvement.
The company should implement and maintain this activity-based costing system as a strategic option to avoid any mislead. Based on the current situation, by implementing the activity-based costing system can help the company to measure the product cost more accurate and reliable. This system focuses on the cause and effect linkage of costs and activities in the context of producing goods or models which can help to measure the performance of activities and products. From the case, as we can see the price of the standard model should be lower than $106 in order to compete with other competitors that producing and selling the similar model. By lowering the standard model price, it enables the firm to recoup its competitive position in the market. In order to increase the demand based on the marketing studies price reduction also should be considered in this situation.
Moreover, regarding to the price of the Deluxe model, the price should be place near the target price of $481.53. This price should be considered in order to continue the product line. This important consideration should be taken since the sales in the standard and heavy-duty model markets depend on the firm’s offering a complete product line. To compare the old costing system with activity-based costing system, we found that the product price of Heavy-Duty model reduced from $255.20 to $248.73. However, regarding to the old costing system, its product cost distortion did not affect this model seriously compared to other two models which is Standard model and Deluxe model. By recommending this activity-based costing system, it has flexibility as it can increase and decrease the budget from the corporate down to the smallest unit of the firm when the focus or goals of the company change within the period.
To conclude this case study, Morelli Electric Motor Corporation should implement Activity-Based Costing (ABC) System as their product costing in order to measure the product cost more accurate and reliable. Activity based costing forces the manager to investigate fixed costs very closely. It therefore helps management to identify areas of inefficiency as well as recognize costs which we could have been conceived fixed but, which are in fact, variable or semi-variable to specific products.
Therefore the CEO of Morelli Electric Motor Corporation should more expose to the current market movement and starts to practice this method in order to sustain in their business as well as to compete with their respective competitors whose product has captured wider market circle at the moment. The company should also come up with an additional section in their current policy where it states that the management should shuffle up the current costing system as well as other related accountable systems that are in practice in a time frame of every five years. This would definitely help the firm to be financially stable at most situation as they could be linen based on the current market situation which changes from time to time.
