Activity Based Accounting System Of Sierra Limited

Adoption of an appropriate costing system is highly important for accurately assessing the resources that are being used for manufacturing of different products of the company. The inclusion of all direct and indirect cost associated with manufacturing of product can help to make decisions regarding pricing of the products in effective manner. The current report is based on the case of Sierra Limited, which has faced many issues regarding declining sales revenue over the years. It has been suggested by management of company that declining performance is caused by ineffectiveness of traditional costing system of Sierra. The present report has carried out detailed investigation of current costing system and it has suggested new activity based accounting system for Sierra Limited. The report has recommended implementation of new accounting system in detailed manner.

1.Assessment of current costing and pricing practices of Sierra

The Sierra is currently implying traditional costing method that is allowing the company to record cost of products based on machine hours. The machine hours are used for allocating overhead to products and machine hours are serving as the core basis for estimating factory overheads (Burns and Vaivio, 2001). This costing system is ignoring the aspect of non-manufacturing expenses, which are crucial for defining overall price of the product (Cagwin and Bouwman, 2002). In order to add the margin for non-production cost, Sierra is adding 30% of margins which is not precisely depicting the cost of manufacturing the products and company is not generating significant level of profit.

It has been highlighted by Baljit that reliance on traditional costing method leads to distortion of cost for some products of Sierra. The distortion of product’s cost may cause the company to set prices that may not cover cost for production and non-production and thus the sales revenue of company is continue declining (Cooper and Kaplan, 1991). One significant problem with machine hour costing system of Sierra is that estimation of costing requires additional clerical work and cost of accounting activities goes up. The researchers of accounting have reflected that machine hour costing is not suitable for small and medium enterprises due to high cost associated with it (Kaplan and Anderson, 2013). Followed by this, the traditional costing method might also lead to inaccurate pricing of the Sierra and the company is continually facing declining revenues without even knowing the true cause of their declining performance.

2.Suitability of Activity based costing

The activity based costing method enhances the ability of business to combine all activities of production, assigning to cost to those activities and then determining the overall cost of products (Anderson et al., 2002). The traditional method being implied by Sierra is not leading to indication of accurate cost of products and the activity based cost method can help to resolve this issue as it allows to take all of important factors into account before assigning cost to any product. The current costing system of Sierra is not considering indirect cost of manufacturing (non-manufacturing expenses) into account. The indirect cost refers to management and administrative cost of Sierra. The consideration of activity based costing method can help the Sierra to consider all of non-manufacturing expenses in calculation of overall cost of products (Kaplan and Anderson, 2013). Thus, inclusion of number of drivers for estimation of overall cost of the products will allow the Sierra to know about true cost of producing a specific product. The Sierra will be able to use number of drivers apart from using only machine hours and it will help the company to overcome shortcomings associated with traditional costing method of Sierra Limited.

In terms of internal use of decision making, the activity based costing method can help the management of Sierra to make rational decision making (Burns and Vaivio, 2001). The information obtained through activity based costing method will allow the decision makers of Sierra to check the details of spending and they will be able to document all of indirect and direct spending in highly precise manner. Thus, by fostering an easy understanding of activity based costing, it will more likely prevent the decision makers of Sierra to allocate unnecessary cost to the products and more precise cost can be recognized. The management of Sierra will be able to look at number of machine setups, the cost of material which is being purchased or used and number of machine hours etc (Innes, Mitchell and Sinclair, 2000). Thus, the current problem of cost inaccuracy of Sierra as highlighted by Baljt, will be minimized by maintaining reliance on activity based activity method over the traditional costing method. In accordance with this, the accurate costing will allow the firm to make pricing decisions with huge precision and the firm will be able to increase revenue from sales of its different products.

The activity based costing method will also allow the Sierra Limited to eliminate of reformulate those products that are not offering them huge profitability (Kaplan and Anderson, 2013). Likewise, the company can reduce price of those products which are overpriced. Along with this, activity based costing method will enable the Sierra Limited to identify and taking necessary steps for lowering the cost of some specific products (Tse and Gong, 2009). For instance, it has been highlighted by Silvia that they need to lower the cost of engine components being manufactured by Sierra with an aim of enhancing revenue from sales of engine components. However, currently it cannot be assessed effectively that cause of declining performance of Sierra Limited is increasing cost of engine components. The activity based costing method will allow the Sierra Limited to accurately identify whether they need to lower the cost of engine components or of any other product being produced by Sierra Limited.

In similar way, the Sierra will be able to eliminate the production processes that are not leading to better yield (Anderson, Hesford and Young, 2002). For instance, the Baljt has argued that there are many competitors within industry that are using 3D technology for preparing agile product designs. Thus, the activity based costing method can help the Sierra to identify that whether cause of poor performance are products or the processes of company. In this manner, the company can remodify its processes and it can replace their obsolete production processes with new most sophisticated processes such as based on 3D printing technology. The Sierra Limited can use information of activity based costing for reducing the wasteful spending of resources and they can utilize resources in efficient manner (Kaplan and Anderson, 2003). Finally, the Sierra Limited can recognize and analyse their profitability and they can make operational and capital/long term decisions in effective manner (Cooper and Kaplan, 1991).

3.Recommendations for activity based costing

There are number of factors that are needed to be considered by Sierra Limited for adoption of activity based costing system of accounting. In order to recognize that whether new costing system is aligned with the environment, structure and capabilities of the business, Sierra needs to works closely with expert team (Chan, 1993). It is important to recognize the unique business situations of Sierra Limited and to understand the linkage of those unique aspects of business with the accounting structure of the firm. One of an important aspect that is highly important to be considered by Sierra Limited is that it needs to consider perspective of change management into account (Innes, Mitchell and Sinclair, 2000). In order to smoothen the transition from existing accounting system to activity based accounting system, it is needed to be ensured by the company that all stakeholders are involved and their consensus is obtained (Cooper and Kaplan, 1991). Transition to new system requires to prepare and gain acceptance about new accounting system among the staff of company. Prior to taking forward the proposal of Blajt, Sierra Limited needs to communicate extensively with the staff about the need of implementing new activity based accounting system. The explanation of key benefits of activity based costing system to the employees regarding accuracy of cost estimation can help to overcome their resistance and management of Sierra can smoothly implement new accounting solution.

Along with this, after gaining consensus of wider organizational members, the management of Sierra needs to make decision regarding training of staff. As highlighted by Silvia, the company has incurred huge resources for training of staff to smoothly operate current machine hours based accounting system. Rushing to the new activity based accounting system can cause huge problem for Sierra Limited in terms of declining morale of employees and lack of employee engagement can cause failure of new accounting solution (Kaplan and Anderson, 2003).

 In addition to these factors, in order to implement activity based costing, Sierra Limited needs to allocate cost based on numerous cost tools that might have associated cause and effect cost drivers. This will enable the company to estimate the overheads, which are being assigned to departments of production and then to assess cost of each product separately (Tse and Gong, 2009). Mainly there are two categories of measures for activity based costing system including; transaction drivers and duration drivers (Anderson, Hesford and Young, 2002). The transaction drivers will require Sierra Limited to count that how many times an activity occurs, for instance in order to produce clutch and engine components it is importance to recognize that what is the frequency of each activity. The same is needed to be done for all underlying products of Sierra. Secondly, the company needs to ensure that how much time is taken by each activity to complete. Followed by these categories, Sierra Limited needs to consider the five level approach of activity based costing including; batch level activity, unit level activity, customer level activity, organization sustaining activity and product level activity (Pohlen and La Londe, 1994).

4.Conclusion

The current accounting system being followed by Sierra Limited is traditional machine hours based which is distorting the cost of different products of company. The existing costing system has led to estimation of prices in less accurate manner, which is considered as basis of declining performance of Sierra. The report has highlighted that activity based costing method is aligned with the requirements of Sierra and company can track its cost in more precise manner. The activity based costing method will also set grounds for decision making by Sierra Limited and it will help to eliminate production processes that are not generation desired results. The Sierra needs to consider change management perspective into accounting and acceptance of key stakeholders is needed to be obtained. Similarly, training of employees, pooling of cost tools and recognition of cost drivers are important for implementing activity based costing.

 

 

References

Anderson, S.W., Hesford, J.W. and Young, S.M., 2002. Factors influencing the performance of activity based costing teams: a field study of ABC model development time in the automobile industry. Accounting, Organizations and Society27(3), pp.195-211.

Burns, J. and Vaivio, J., 2001. Management accounting change. Management Accounting Research12(4), pp.389-402.

Cagwin, D. and Bouwman, M.J., 2002. The association between activity-based costing and improvement in financial performance. Management Accounting Research13(1), pp.1-39.

Chan, Y.C.L., 1993. Improving hospital cost accounting with activity-based costing. Health Care Management Review18(1), pp.71-77.

Cooper, R. and Kaplan, R.S., 1991. Profit priorities from activity-based costing. Harvard Business Review69(3), pp.130-135.

Innes, J., Mitchell, F. and Sinclair, D., 2000. Activity-based costing in the UK’s largest companies: a comparison of 1994 and 1999 survey results. Management Accounting Research11(3), pp.349-362.

Kaplan, R.S. and Anderson, S.R., 2003. Time-driven activity-based costing. Available at SSRN 485443.

Kaplan, R. and Anderson, S.R., 2013. Time-driven activity-based costing: a simpler and more powerful path to higher profits. Harvard business press.

Pohlen, T.L. and La Londe, B.J., 1994. Implementing activity-based costing (ABC) in logistics. Journal of Business Logistics15(2), p.1.

Tse, M. and Gong, M., 2009. Recognition of idle resources in time-driven activity-based costing and resource consumption accounting models. Journal of Applied Management Accounting Research7(2), pp.41-54.

 

 

 

 

 

 


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