ABC Costing System

This is a recommendation letter to the controller of Piedmont Manufacturing Company.  I have been asked to advise Piedmont on the ins and outs of an Activity Based Costing system.  I got an A+ on this one.

October 4, 2010

Jay Sutherlin, Controller

Piedmont Manufacturing Company

94 N. Pecos Road

Las Vegas, Nevada 89044

Dear Mr. Sutherlin,

I am pleased to advise you on the cost-effectiveness of an activity-based costing (ABC) system for Piedmont Manufacturing Company.  In order to evaluate whether an ABC system is worthwhile for your situation, you will need to analyze the benefits of improved information and decide whether the cost of implementation, $2.5 million, is justifiable.

ABC System

This type of system assigns costs to different production units, based on the activities performed.  In your case, this means the costs of metal and wooden furniture would be calculated by how many resources, such as engineering hours and materials, are consumed by each.

Piedmont is currently using an inferior approach, volume-based costing, which exposes the risk of misleading financial information, resulting in poor management decisions.  ABC provides better information but is expensive to implement.  It must be decided whether the benefits of switching to ABC outweighs the costs.

Benefits of ABC

Switching to an ABC system increases the quality of information available to the Company.  Managers use this information to support strategic decisions regarding product lines, market segments, customer relationships, and improved processes (CMA Canada 2008, 2-3).  Therefore, it is crucial that the data is accurate and leads to the right decision-making.  The following are the main advantages of implementing an activity-based costing system:

1.  Improved Decision Making

2. Improved Measures of Profitability

3. Cost Estimation

4. Process Improvement 

5. Cost of Unused Capacity

You must decide if the improved information quality is worth the cost for your company.  In order to do so, you also need to consider the limitations of an ABC system.

Limitations of ABC

Although ABC leads to many advantages, there are a few disadvantages as well.  It is sometimes difficult to directly associate a cost to one product due to its ambiguous nature.  Product costs do not always include every related expense, like marketing and engineering costs, due to requirements of generally accepted accounting principles (GAAP).  Also, it can be very expensive to install ABC and usually requires a year or more for adequate development and implementation.  In summary, the limitations of an ABC system are as follows:   

1. Allocations
2. Omissions of cost
3. Expense and time

Once you are aware of the advantages and disadvantages of ABC, you must look at firm-specific data that supports your decision.

Cost of Implementation

I have compiled a table in Appendix A, which shows the improved quality of information resulting from the use of ABC over volume-based costing.  As the table shows, the variance in cost-estimation between systems results in a $110 difference for metal chairs and $27.50 for wooden chairs per unit.  The company is overestimating the profitability of metal chairs by $1.375 million and underestimating the profitability of wooden chairs by $1.031 million annually.  The impact on information resulting from the ABC system can lead to substantial enhancement in decision-making, cost estimation, and process improvements (Blocher, Stout, Cokins, and Chen 2008, 126-130).

The total cost of implementing this system is $2.5 million.  This is approximately 10% of this year’s revenue.  It is up to you to decide whether you think the information quality resulting from a switch to ABC is worth that much to your company.

Conclusion

I hope that the information I have provided is adequate for you to begin decision-making.  I remind you to consider the benefits of improved information compared to its cost.  Use the appendix to analyze the impact of ABC on your financial decisions, and determine whether the Company can afford to implement the new system.

Once you have evaluated all related circumstances, I advise you to meet with me to discuss your decision.  If you decide to switch to the activity-based costing system, I have additional advice about implementation processes.  Please call me at (419) 221-0008 if there are additional matters you wish to discuss.

Sincerely,

Emily Diepenbrock

Attachment

Appendix A Information based on 25,000 and 75,000 units of production for metal and wooden chairs.
Volume-Based Costing
Total Overhead (OH)	$2,000,000
Total Direct Labor Hours (DLH)	100,000
Overhead rate per DLH	$20.00
	Metal Chair	Wooden Chair
Total OH Assigned	$500,000	$1,500,000
Number of Units	5,000	20,000
Overhead Costs per unit	$100.00	$75.00
Unit selling price	$400	$200
Unit product cost:
Direct materials and labor	(200)	(80)
Factory overhead	(100)	(75)
Cost per unit	(300)	(155)
Unit Margin	$100	$45
Activity-Based Costing
Activity Consumption Driver	Cost	Activity Consumption	Activity Rate
Engineering hours	125,000	12,500	10
Number of setups	300,000	300	1,000
Machine-hours	1,500,000	150,000	10
Number of packing orders	75,000	15,000	5
Overhead Cost	Metal Chair	Wooden Chair
Engineering hours	$10.00	$3.75
Number of setups	40.00	5.00
Machine-hours	100.00	50.00
Number of packing orders	5.00	2.50
Overhead Costs per unit	$155.00	$61.25
Unit selling price	$400.00	$200.00
Unit product cost
Direct materials and labor	(200.00)	(80.00)
Factory Overhad:
Engineering	(10.00)	(3.75)
Setups	(40.00)	(5.00)
Machine running	(100.00)	(50.00)
Packing	(5.00)	(2.50)
Cost per unit	(355.00)	(141.25)
Unit Margin	$45	$59
Comparison	Metal Chair	Wooden Chair
Unit overhead cost
Volume-based	$100.00	$75.00
Activity-based	155.00	61.25
Difference	55.00	13.75
Unit margin
Volume-based	$100.00	$45.00
Activity-based	45.00	58.75
Difference	55.00	13.75
Total Difference Between Systems	$110.00	$27.50

Writing for Technical and Non-Technical Readers

This assignment was to explain the difference between depreciation, amortization, and depletion.  The first version is geared towards someone without an accounting background.  The second version is for technical accounting readers.

Version #1:

The terms depreciation, amortization, and depletion all describe a method of allocating the cost of operational assets to match the expense period in which it is incurred.  However, they differ in the method of calculation as well as the operational asset being considered.  Depreciation refers to the cost allocation of tangible assets, while amortization is used for intangible assets, and depletion is for natural resources.

Depreciation is determined by subtracting the residual value from the historical cost then dividing by the estimated useful life.  Under the straight-line method, the same amount of depreciation is incurred each year.  While the straight-line method is most commonly used and is required under GAAP, other methods of depreciation include the sum-of-the-years’-digits method, double-declining-balance (DDB) method, and activity-based depreciation.

Intangible operational assets are subject to amortization.  Like depreciation, it is necessary to determine the useful life and residual value of the asset and whether it is a period or product cost.  Items subject to amortization include bonds and patents.  However, some intangible assets are not subject to amortization like trademarks and goodwill.  This occurs because the useful life of the intangible asset is indefinite.

The final cost allocation method is depletion.  Since the depletion of natural resources is directly tied to its extraction, it is usually calculated on an activity basis.  Depreciation and amortization of assets used to withdraw natural resources are often also calculated using the units-of-production method (Spiceland, Sepe and Tomassini, 504-516).

Version #2:

In accounting, it is sometimes necessary to decrease the value of certain items over time.  For instance, a machine used in a factory will be worth less in the future than it was when it was purchased.  Rather than incur a large loss all at once, accountants use a method of reducing the value over time.  In this example, it is called depreciation.  Depreciation is the method of deducting value from a tangible item, such as machinery or other equipment, over time. 

To determine the depreciation rate, one must estimate the amount of time they believe the object will be valuable to the company.  This is referred to as the estimated useful life.  One must also assess the value it will be worth at the end of its useful life, also known as the salvage value.  In order to determine a year’s worth of depreciation, an accountant subtracts the salvage value from the original price of the item then divides it by the estimated useful life.  As the years accumulate, the depreciation is summed together into an account called accumulated depreciation.  This amount is subtracted from the original value of the item to determine the current value.

While depreciation is used to reduce the value of a tangible item, accountants use separate terms for other instances.  Amortization follows the same idea as depreciation, except it applies to intangible items such as bonds and trademarks.  Amortization is calculated in a way very similar to depreciation.  Accountants also use a term called depletion to describe the extraction of natural resources like oil from a source.  Though the calculation of depletion differs from depreciation and amortization, the fundamental idea is the same.  The terms depreciation, amortization, and depletion all describe a gradual decline in value but they vary in the nature of the item.

Recommendations for Improving Profitability

This assignment was to advise We Love Our Pets on ways to increase profitability given the company's income statement.  Here it goes:

Wilson & Layton, Inc.

1234 Almeda Avenue

Detroit, MI 12345

(565) 404-9544

September 1, 2010

Mr. Steve Hoover

We Love Our Pets Owner

2447 Wilkins Avenue

Detroit, MI 12349

Dear Mr. Hoover,

The purpose of this letter is to discuss recommendations for improving the profitability of your company, We Love Our Pets.  It is our objective to increase sales volume while identifying ways to cut costs.

In order to further the success your company had in its first year, I recommend expanding the market share of your services and adding a merchandising line.  In addition, I recommend reducing expenses related to rent and supplies.

First, I would like to point out that your wash and trim service is 20% more profitable than your flea and tick removal service.  As you work to expand your market share of these services, I advise targeting the grooming portion of your business.  In order to increase business, I suggest offering a package that includes both grooming and flea and tick removal service.  At your current price, you charge $25 and $30 for these services, respectively.  A bundle option would include the wash and trim portion at $20.  I believe this would increase your sales by 10%, leading to an increase of $14,000 in revenue.  In addition, spending more money on advertising can enhance your client base and lead to greater profitability.

Second, I advise expanding your services to include pet accessories.  This would be an excellent complement to your grooming service and would further increase your sales opportunities.  Items I recommend selling at your shop include pet shampoo, brushes, collars, and dog clothing.  Adding an accessory line will increase the overall profitability of your business and provide clients with an opportunity to do more business with you rather than competitors.

Third, I recommend moving your business to a new location.  Upon researching the common rent expense in the commercial Detroit area, I discovered that you could easily rent an office space for $1,500 per month, rather than $3,000.  This would lead to an $18,000 cost savings in one year without compromising the quality of your business.

Lastly, I suggest you contact your flea and tick removal supplier to work on reducing your costs of supplies.  Oftentimes, suppliers will cut retailers a deal in order to garner more of your business.  If your supplier is unwilling to do so, I recommend searching for other wholesalers who can provide your business with quality supplies at a lower cost.  Building a strong relationship with your supplier can have a tremendous effect on your business. 

Please consider my recommendations for increasing revenue through bundling services and adding an accessory line, as well as decreasing expenses by moving office buildings and developing a strong relationship with suppliers.  I am confident that these steps will positively impact the profitability of your business.  If you would like to continue discussing ways to improve your business, feel free to contact me.  I wish you luck with your business endeavors.

Sincerely,

Emily Diepenbrock

10 Tricks to Mastering the Art of Persuasion

During one of my daily visits to www.msn.com, I found a great article about persuasion tools.  I think they are great tips,  and I wanted to share them:

10 Tricks for Mastering the Art of Persuasion

1. Start Things Off:  People are more likely to agree to do something that has already been started for them.  If you need to ask for help on something, or delegate a task to someone else, try to start the project before handing it off to another.
2. Help Them Imagine: Say something like, “I know it'll be a late night, but can you imagine how relieved we'll be if we get the job done before going home?” This tactic paints a vivid picture in the person's mind of the pleasure if she/he does — or the pain if she/he doesn't — do what you asked.
3. Stress Their Loss:  People are more persuaded by the perception of losing something than gaining it.  If you were trying to convince a client to make a certain business decision, make sure to stress what they would lose by not doing so.
4. Give First:  People are psychologically conditioned to return a favor.  If you need to ask someone for help, do something for him or her first.  Then, it will be more difficult for them to decline your favor.
5.  Over-Ask:  People feel a sense of guilt when declining a request.  If the second request is something they can afford to comply with, then they’ll grab the opportunity.  Much like a little kid asking for a pony, hearing no, then asking for a dog.
6. Make Them Laugh:  Getting someone to laugh makes people like you more and thus are more open to your ideas.
7. Use “We”:  Studies have shown that the reassurance of  “we” is more productive in persuading people than other techniques. The use of "we" immediately conveys a sense of belonging, commonality and support.
8.  Majority Rules: When persuading, point to evidence of what others are doing that is similar to what you are trying to persuade the other person to do. After all, when making decisions on our own, we likely survey the scene for reassurance anyway.
9. Be Positive: One of the most powerful principles of persuasion rests on a person's need to remain consistent with his past actions. People are more likely to be persuaded to behave in certain ways if they have acted that way before — and it has been noticed.
10. Have Good Timing: Sometimes it’s not what you ask for but when you ask for it. People are most persuadable immediately after thanking someone, so it's the perfect time to ask for a favor: My pleasure. In fact, I was hoping you might be able to help me out with something too.

Job Advice Proverbs

For an assignment in my Accounting Communications class, I had to give a presentation on an article of my choice from www.collegegrad.com.  I found an interesting piece on proverbial advice for the working world.  These were my favorites:

• Look for solutions, not problems. Anyone can identify problems.
• Talk 20 percent and listen 80 percent. And avoid those who talk 100 percent.
• Show respect for your boss in everything you do. Don’t join in when others are boss bashing. It can be contagious.
• Learn to become a team player. College rewards individual performance. Employers reward team performance.
• Limit yourself to one glass of beer or wine when dining out with coworkers or clients. And wait for someone else to order liquor first.  Don’t be the only one.
• Life isn’t fair. And sometimes work isn’t either. There will be some days when just getting through the day is the best you can do. Wait until tomorrow to see if things clear up. They usually do.
• Give back to those who are less fortunate than you. No matter how hard you have worked to get where you are now, there is always someone who has not had the same opportunities that you have had in life. Do your best to help meet the needs of others.
• Always remember that work should never be your sole purpose in life. No one ever said on their death bed, I wish I would have spent more time at the office.

What are your favorite proverbs or work tips?

Accounting Portfolio

The purpose of this blog is to share the things I am currently working on in my Master of Accountancy program at Bowling Green State University.  Questions and comments are welcome.