Every business is involved in production where some costs are incurred. In order for a business to allocate its selling price to its products, costing analysis is required.Costing which is a method of accounting used by financial management is a very essential process. It gives a full description concerning all costs incurred in the business either variable or fixed. It gives the final production cost which in turn is used in determining the selling price of the commodities, the units to be produced which is equivalent to its market share.
Competition Bikes needs to put in place a costing system that is essential and economical to its production processes. Recently it’s using conventional based approach which involves assigning costs according to the volume of goods produced. This makes products to be the main determinant of costs. Competition Bikes are in a dilemma whether to continue with conventional approach or shift to activity method of costing.
Activity system of costing divides the costs into a number of activities used in the production process.
It takes an assumption that costs in an organization have multiple determinants different from its production. In order for the Competition Bikes to decide whether to shift or not, an evaluation is needed where some advantages of activity costing system are considered over conventional volume method of costing. One of the benefits of adopting activity based system of costing is that it gives an accurate computation. This is as a result of taking accounts for costs incurred in each level of production compared to when taken at the end of the production based on the volume produced.
Cost drivers are very essential tools when carrying out costing. The activity system of cost accounting gives a clear identification of the specific and precise drivers used in determining the costs. This is very important to any organization as incase of costing problems, it enables the cost accountants to trace them which making it easy to come up with the best mechanism of controlling cost. Through such analysis, it’s beneficial for the Competition Bikes to shift from conventional to activity method of costing which is a better system.
The other area that the report takes in to consideration is the breakeven point. This is important as the company is involved with two productions i.e. Titanium Bikes and carbon lite which is done using the concept of cost-volume-profits. This analysis brings the relationship between the profits, volume of goods produced, and the organizations costs. The benefit of an analysis based on breakeven point is to enable the firm to make proper decisions concerning prices of goods produced. The analysis shows that CVP is not an effective approach. This is because it takes an assumption that the organization deals with a single product which is not true to many organizations. Due to this assumption, an establishment of sales mix must be put into place. In every production there are two key types of costs incurred i.e. fixed and variable costs. The report examines the impact of changing them, of which it has shown that it will have a significant effect on the costs.
This refers to the method of reporting and financial recording. It involves the process of taking computations of the costs incurred in the process of producing goods (Chang, Pelliser, 1996 ). This costing is done by a finance manager who takes into consideration different types of cost information and uses them in the computations. This includes costs of company overheads, labor hours and the units of production. This is a tool used by analysts to identify cost drivers and in turn use them in computing costs. Competition Bikes needs to establish an efficient method of costing which is economical and provides accurate information. In order to come up with such a method, it has to examine whether to take volume based or activity based costing.
Volume based costing
It’s a traditional method of costing of which competition bikes is currently using in its computations. This type of approach allocates costs using the volume of goods produced. It’s different from activity based method as it uses a single cost driver which is the total volume of goods produced. This approach becomes very challenging to the organization when allocating costs using approach. The reason is that in costing, both variable costs and overhead costs are important, but this approach ignores overhead costs which are assigned to products on the basis of their usage of direct labor. It assumes any activity without direct impact on the volume of goods produced, as it considers the main drivers to be the product. It gives inaccurate reports as it’s a traditional approach used in the past where overhead costs were ignored. This was as a result of these costs taking an extremely small part on the overall costs of the organization, which is different nowadays as they are significantly high and the company cannot afford to ignore them.
It’s also a structure oriented approach, this implies that it’s more concerned with the chart of the organization rather than actual involvement in the production. It makes the process of production to be very shallow as it gives information concerning total amount of money used, without giving clear details of why it was spent. This brings a challenge incase the company wants to introduce measures of saving costs as no clear information given.
Activity based cost accounting
It’s a costing method which identifies all the activities involved in the organization concerning the production of goods. It assigns every activity the cost incurred in it before giving the full cost of production. It’s different from volume based which assumes products to be the main cost drivers unlike activities which are the main cost drivers. Activity based puts into consideration the overhead costs of the company enhancing their control through showing the relationship between activities in the organization and the costs incurred. It’s an efficient method as it enables analysts to have a clear cost links between the management responsibilities, products, organizational processes, customers and other cost drivers. Unlike volume based, this approach provides accurate computations as all cost drivers are examined basing them on the cost of running the company.
Another benefit of this approach is that it provides the organization with clear ways which can be used when implementing measures of cost saving (Chang, Pelliser, 1996). It’s a process oriented approach as it gathers information about the costs of the firm through organizational process evaluation. Costs problems are well addressed as it provides elaborate information which is used in establishing efficient mechanisms and elaborate information relating to resources used in each activity.
Organizational cost levels
Unit level; it’s a level where cost is incurred in producing one unit of a product such as cost of cost of direct labor and materials.
Batch level; it’s a level where cost is realized after producing a batch of goods such as cost incurred in planning.
Product level; it’s a level where cost of every product is computed without considering how many units have been produced such as cost of designing the product.
Facility level; these are indirect costs which cannot be linked to any single product such as office expenses and indirect labor.
Activity system of costing shows all the activities that leads to overheads costs of the organization. Due to this system enhancing allocation of activity cost pools, it enables computation of the fixed costs in the organization which differentiates period costs from products costs.
Through the analysis of the two methods of costing, Competition Bikes needs to change from its costing method and adopt activity-based system of costing. The reason behind is that Competition Bikes have a very large portion of its total cost being the fixed cost of over $500000 dollars. Activity based system will help in identifying the different drivers of this cost hence enabling the company to establish measures of saving costs. This approach comprises of six activities namely;factory setups, engineering services, quality controls, products movements, depreciation and utilities. It also identifies cost drivers based on each activity such as setups, engineering, inspections on quality controls and by products used by the factory, which is different from volume based approach which makes it hard for the organization to implement strategies of cost saving.
This system is very important as it will enable the company to have accurate costs estimations. This will provide different figures relating to fixed costs as opposed to volume based method. The system will enhance accurate computations by Competition Bikes and them to compute all costs occurring at each level that is variable costs at the unit level, cost of control at the batch level, cost of product movement at the product level and depreciation cost at the facility level.
2. A breakeven point.
It’s a situation attained when the total cost of production of a particular product becomes equivalent to the cost of producing it. Its analysis is a very vital tool used in decision making by the business. It helps the business in determining the amount of product to be produced in order to make this product profitable through production plans. This enables the organization to make better decisions concerning prices of the goods from the unit level.
It refers to the total number of units an organization is expected to produce in order to make the total cost equivalent to revenues obtained from this product. Titanium breakeven units is 1514, implying that Competition Bikes must sell such units of titanium for the organization to start realizing profits. The one for carbon lite is 915 while for the mix is 2429. This shows that the company needs to produce 2429 units of both products for the business to start making profits.
They are calculated by dividing the organization’s fixed cost with the contribution margin. The contribution margin refers to the variation between prices of one unit of a product and the unit cost of the same product. It gives a reflection of amount of money that a specific sale contributes in relation to covering the fixed costs of a firm. The contribution margin fortitanium is $230 since the unit price for titanium is $1500 and its variable cost is $1270.
Its sales mix is 550 units for titanium and 350 units for carbon lite. This shows that for every sale of 900 units made by the company, 550 are made up of titanium and the rest 350 are sales of carbonlite. This sales mix for both products is multiplied by their total contribution margin giving 234,500. It’s then divided by 900 so as to attain weighted average that gives a contribution margin of a single unit of the mix giving us 260.56. The contribution margin was obtained by dividing $500,000 by the common weight of the contribution margin giving us;
Titanium = 550/900 * 2478 =1514
Carbonlite = 350/900*2478 = 964
Breakeven points in terms of dollars
It gives an indication of the amounts of sales that have to be achieved so to enable the firm to cover its entire production cost. In terms of dollars, it’s obtained by multiplying units’ price of the product and its breakeven units.
Titanium = 1514 units *$ 850= 1,286,900
Carbonlite= 964 units *1500= 1,446,000
The analysis above indicates that Competition Bikes has to make a sale 1,286,900 of titanium and 1,446,000 of carbonlite for the business to start realizing profits.
b. Change in Breakeven analysis
Any change made in the fixed costs of the organization brings an impact that is significant to the breakeven analysis. Breakeven point brings the relationship in the organization between its price, fixed costs, variable costs and the volume of sales. If the company decides to increase its fixed cost by $20,000 it gives a new value of $ 520,000. This indicates that the company needs to sell additional units so as to cover that increase. Any change in the business direct materials will also cause significant impact on the breakeven point. If the company increases the cost of direct materials with 20% of the cost, variable cost of both products will increase by the same margin.
If contribution margin changes, it results to changes in the contribution margin of the weighted average. Since sales mix of carbonlite is 350, its contribution margin and sales mix becomes 15400. While that of titanium is 550, its contribution margin and sales mix becomes 104885 giving a total of 120,285.
Average weight of the contribution margin
Breakeven point for the mix
520,000/ 133.65 = 3900
Breakeven points using sales mix of each product
Titanium = 550/ 900 * 3900= 2200
Carbonlite = 350/ 900 * 3900= 1517
Breakeven value change in terms of dollars
Titanium = 2200 units *$850 = $1,870,000
Carbonlite = 1517 units *$1500 = $2,275,500
Every business should adopt a costing system which helps in computing costs incurred in the business. This information is very important in making decisions concerning the prices of the products. Within the two systems of allocating costs, that is volume based and activity based systems of costing. Volume based is not an efficient method as it assumes that product is the main cost driver. Through the above analysis, it’s clear that Competition Bikes should adopt activity based system as it provides accurate information, elaborate information that can be used in providing cost saving mechanism. It has also considered the breakeven analysis which is an important tool in deciding the prices of commodities. Lastly, the report has shown that if there is a change in either the fixed or variable costs, it brings a significant effect on the costs.
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