It has always been a part of every financing decision to determine product prices and account for changes, if necessary. On the perspective of the customers, a price increase would generally be unfavorable, considering an added burden on their part. On the standpoint of the producers or sellers, any price change, particularly a price increase, would generally indicate an added income on the company, ceteris paribus. However, since it is an unfavorable move on the customers’ stance, it would as well denote possible losses for the company when they lose their market share because of the customers’ resistance on their business move.
Simply, the purpose of this paper is to (1) assess the presented schedule of Sparta Glass Products’ (SGP) unit costs at various production volumes; (2) evaluate whether changes are necessary for SGP’s cost allocation system and, if any, work out on how it may be implemented; and lastly (3) compare results using the two price levels presented, both at the current estimated cost schedule, and at the suggested cost allocation system obtained from the changes made in (2).
SPARTA GLASS PRODUCTS I. Problem Presentation Sparta Glass Products (SGP) is currently facing a dilemma on whether to charge, at its current price, their nonglare glass product at $2. 36 per square, or to return to their previous market price of $2. 15. Apparently, Christina Matthews, the product manager of SGP, and Robert Alexander, the controller of the Specialty Glass Division, one of SGP’s four divisions, increased the price of their nonglare glass by around 9. 767 percent.
This pricing decision, in response to increased corporate pressure to improve profit margins, was specifically driven by the need to obtain a considerable amount of capital to fund a recently approved long-term expansion and modernization program. Hoping that the competitors would follow their move, unfortunately and eventually, situations proved otherwise, Matthews reasoned out that a sufficient number of SGP’s customers would still patronize the company’s product and prevent sales from declining, even at the current price of $2. 36 per square foot.
However, a tight spot still exists between the two company officers on the subject of this price change. Matthews believed that the reason for SGP’s significant market share loss was due solely to the price change, considering that all else did not quite exhibit changes during the last nine months. And the product manager trusts that SGP will regain its original market share if it goes back to its $2. 15 price charge per square foot. Furthermore, she feared that, if the competitors’ prices were not met, SGP’s sales will continue to decline.
For the information of those concerned, SGP’s competitors maintained a selling price of $2. 15 per square foot since SGP’s price increase to $2. 36. II. Data Analysis Presented in Exhibit 1 is the sales-volume price-history data for nonglare glass in SGP’s market region for the previous eight quarters, in view of SGP’s market-based price adjustments made on a quarterly basis. Evidently, and as mentioned, the competitors of SGP, since 2001, did not follow SGP’s lead in the increase of prices. Hence, a considerable decline can be noticed especially since SGP’s price increase on the fourth quarter of the year 2001.
Now, visibly, it is a battle between product prices and essentially a bigger market share. For SPG, what is still a fundamentally imperative consideration is the recapturing of the lost market share and, of course, earning profit instead of possible losses, which will now be two of the eventual objectives of doing an in-depth analysis of Sparta Glass Product’s cost allocation system and pricing strategy. Presented in Exhibit 2 is SGP’s schedule of unit costs, both manufacturing and other incurred expenses, at various increasing production levels.
A careful analysis of such estimated cost allocation schedule reveals the following information: Direct material is appropriately considered as a variable manufacturing cost, constant at the per unit level ($0. 56) and varies in proportion to the production volume (i. e. $84,000 at 150, 000 square feet, $98, 000 at 175, 000 square feet, and so on) or goes up in parallel with total cost (Baker 2002). The classification of direct material as a variable cost appropriately recognizes the fact that materials cost for SGP varies with the number of square feet produced.
Direct labor is evidently the activity center, or the activity driver, for SGP’s manufacturing operations. This is supported by the fact that its cost allocation system provides for the other costs, excluding direct material, shipping and depreciation, as an allocation or as a percentage of direct labor. Considering that direct labor is the main activity driver, it is quite safe to assume, for that matter, that SGP’s manufacturing operations is more labor-intensive. Exhibit 2 shows that SGP’s direct labor cost per unit partly decreases in the 175 and 200, 000 production volume, though goes back to its increasing behavior.
Depreciation expenses, as shown in the exhibit, pose a decreasing trend as the number of production volume increases. Variable manufacturing overhead consists of energy and miscellaneous supplies. This manufacturing cost appropriately includes such variable components, varying in proportion, supposedly, to the production volumes. However, the data presented that the variable manufacturing overhead is valued at 30% or dependent on direct labor. Fixed manufacturing overhead, as in SGP’s case consists of supervision, insurance and quality assurance.
Some costs are fixed as a result of management policy or are determined by management (Carter 2007: 3-2). However (since such is not explicitly indicated in SGP’s case), the fixed manufacturing overhead was charged as 55% of how much direct labor costs would be. Shipping, or freight costs, like direct material, varies as well with the total production volume, and remains constant at a per unit level. This means that when the number of production volume increases, the total cost of shipping increases as well, and vice versa.
As examined, there is not much problem or deliberation with how shipping cost is treated. Total manufacturing cost is the sum of all the costs incurred to produce the nonglare glass products. Naturally, this excludes the cost to sell or to market the product, for which are included, as for SGPs’ cost allocation system, in either the Corporate Overhead or the Selling an General Administration Expenses. It is the summation of direct materials, direct labor, depreciation, variable and fixed manufacturing overhead, and freight costs.
The trend for the Total Manufacturing Cost decreased for a couple of changes in volume, and goes back to its increasing tendency from the 225, 000 square feet volume and up. This is caused primarily by changes among the TMC’s components, like increases in the fixed manufacturing overhead. In SGP’s estimated cost allocation schedule, purchasing, security, and data processing are the considered components of the Corporate Overhead, which is not longer a part of the production costs, allocated as 35% of direct labor It accounted for a variable $0. 11 for volumes of 150, 000 to 225, 000 square feet, went up to $0.
13. However, this may not be considered a pure variable cost since there are still changes at the per unit cost of Corporate Overhead. Selling and general administration expenses are those incurred by offices not directly related to production, and those costs incurred to sell or to market SGP’s nonglare glass products. This is exactly why they are not considered as manufacturing costs, because they do not directly account for the glass product costs but are only incurred because other administrative operations to run the business, and in selling the product to the customers.
It consists of the sales-force compensation and corporate administrative support, allocated as 45% of the manufacturing costs. Total Cost is, of course, the summation of the manufacturing costs, the corporate overhead and the selling and general administration expenses. This consists of both the product cost and the period costs. Take note that four of four of SGP’s costs, whether fixed or variable, are allocated as a percentage of direct labor. This means that its probable increase or decrease may as well be influenced by an increase or decrease in the direct labor cost incurred. III. Proposed Revised Cost Allocation System
As an employed management accountant, after analyzing carefully SGP’s estimated cost allocation system, I hereby suggest a change some aspects of its cost allocation system. Some of its cost components do not necessarily reflect its actual use in the manufacturing or general operations. When I looked at the accounts more closely, some accounts, as stated, do not essentially constitute its stated behavior, if it is actually variable or fixed. Moreover, the presented cost allocation system, if not further corrected or enhance, may actually prove to be entailing more costs for SGP if these costs are not properly allocated.
It would be more useful, especially for crucial decision making purposes, if SGP properly analyzes each of its cost components, and how they must be allocated. Exhibit 3 SPARTA GLASS PRODUCTS Revised Cost per Square Foot at Various Production Volumes Production Volume (000 sq. ft. ) 150 175 200 225 250 275 300 Direct Material 0. 56 0. 56 0. 56 0. 56 0. 56 0. 56 0. 56 Direct Labor (per D. L. hr. ) 0. 3375 0. 3375 0. 3375 0. 3375 0. 3375 0. 3375 0. 3375 Depreciation 0. 27 0. 23 0. 21 0. 18 0. 16 0. 15 0. 15 Variable Mftg. Overhead 0. 10 0. 10 0. 10 0. 10 0. 10 0. 10 0. 10 Fixed Manufacturing Overhead 0. 30 0.
26 0. 23 0. 20 0. 18 0. 16 0. 15 Shipping 0. 11 0. 11 0. 11 0. 11 0. 11 0. 11 0. 11 Manufacturing Cost 1. 6775 1. 5975 1. 5475 1. 4875 1. 4475 1. 4175 1. 4075 Corporate Overhead 0. 14 0. 126 0. 1155 0. 105 0. 098 0. 091 0. 0875 Selling & General Administration (per unit sold) 0. 50 0. 50 0. 50 0. 50 0. 50 0. 50 0. 50 Total Cost 2. 3175 2. 2235 2. 163 2. 0925 2. 0455 2. 0085 1. 995 (Costs with correct classifications and behavior according to interpretation are no longer revised) Direct Materials, since it is a pure variable cost is maintained at a constant per unit price of $0. 56. No problem with that.
Direct Labor, just like Direct Materials, which is also a prime cost, is variable in behavior. Especially that assuming that SGP is more labor intensive; the cost of labor per unit must be constant at the total level. Also, even Direct Labor hours were not mentioned, I will assume that the costs presented in Exhibit 2 are still in the relevant range of activities, direct labor cost average would be, $0. 3375/d. l. hour spent. Assuming that all activities are within the relevant range, the per unit cost of the Depreciation, which is fixed in nature, decreases as number of produced units increases.
Since overhead may be classified as a percentage of another cost, such as direct labor, the VARIABLE manufacturing overhead can now be appropriately classified as 30% of direct labor, since the latter has already been adjusted. Consequently, the cost amount will now coincide with its appropriate behavior, which is constant at a per unit price. Cost allocation for the fixed manufacturing overhead is changed. A fixed cost does not change in total as business activity increases or decreases (Carter 2007: 3-1). If analyzed carefully, fixed manufacturing overhead, just like any fixed cost, changes in an INDIRECT proportion to the change in units.
Therefore, it is improper to allocate it as 55% of direct labor, since in Exhibit 2, direct labor itself varies. Assuming that the costs in Exhibit 2 are still within the relevant range of activities, the average of the total fixed manufacturing overhead generated in Exhibit 2, will be $45, 250, constant at the total level. Considering that this cost is fixed in nature, its per unit cost will decrease as the number of units produced are increased. Shipping costs, also a variable cost, remains at $0. 11 per unit, and increases in direct proportion to the increase in production volumes.
Notice that, compared to Exhibit 2, the manufacturing costs for the smaller production volumes were increased and those for the higher production volumes were likewise reduced. Considering all product costs, a more proper cost allocation system was made, generating less manufacturing cost (because of the presence of fixed amounts) to be incurred when more volumes are produced by SGP. In the case of the Corporate Overhead, there is not much substantial report or identification that it qualifies as a percentage of direct labor. However, even if that is the case, it may still be possible to allocate such an amount from direct labor cost.
In SGP’s revised cost allocation schedule though, Corporate Overhead, since it is more related to the overall manufacturing operations that direct labor alone, will be classified as 35% of the sum of the variable and fixed manufacturing overhead. Why these two costs? Because, as indicated in the components of Corporate Overhead (purchasing, security and data processing), it is more appropriately categorized as or inclined to changes in overhead, which consists of all manufacturing costs not traced directly to the specific output (Carter 2007: 2-10).
Notice that it decreases as the number of units increases, mainly influenced by the behavior of the fixed manufacturing overhead. Since Corporate Overhead now consists of both fixed and variable elements, it now becomes a semi-variable cost. The specific variable and fixed portion of this cost may, however, be separated using the Least Squares Method, but is not longer necessary for this Exhibit. Marketing expenses are actually computed in proportion to sales.
In SGP’s old (I will be using the word ‘old’ and ‘unrevised’ words simultaneously to refer to SGP’s schedule in Exhibit 2) cost allocation system, marketing expenses along with general administration expenses, are allocated as 45% of the manufacturing cost, which should not be. Since, again, selling expenses are dependent on sales, not product costs. In Exhibit 1, Sales Volume was actually determined. However, these sales volumes are not exactly the same with the identified volumes in Exhibit 2 or 3 and the expenses are shown as incidental to the production volume.
Also, there is no way to determine quantitatively how much marketing efforts contribute to increase sales volume. Thus, the allocation of the selling and general administration would be assumed as $0. 50 0/unit sold. Though, amounts as selling and general administrative expenses and direct labor are quite hard to determine given that data were not sufficient to identify exact cost amounts. However, I have assumed that even the amounts in Exhibit 2 were still in the relevant range of activity. IV. $2. 15 versus $2. 36: After all considerations, which is more ‘appropriate’?
A dilemma would now rest on which price level would be ‘appropriate’ or favorable for SGP after considering its ability to absorb both product and period costs, its ability to give larger profit margins, and, though not quantitatively reflected through the values that were and will be generated, its ability to possibly recapture its lost market share. Matthews, in fact, in SGP’s unrevised cost allocation method showed that unit costs grew with increasing volumes due to the cost allocation system itself. However, with the revised schedule, unit costs decreased as the number of production outputs increased.
In my analysis as management accountant, I will be presenting a comparison between the estimated and revised cost allocation system, using the two different price levels. This will give a first glance view of what will be the price level that will favor SGP. A. Using the Estimated Cost Allocation Schedule (Exhibit 2) Utilizing the estimated cost allocation system at various production volumes presented in Exhibit 2, I will be showing the effects of applying both the $2. 15 and $2. 36 charge per square foot of nonglare glass in a projected income statement (Figure 1). FIGURE 1
As seen, at the $2. 15 price level, losses were incurred in whatever volume produced by Sparta, using the old cost allocation system. Therefore, no matter, this cost allocation method would definitely not gain profit for Sparta and this would definitely not be something that senior management would like to see. So, this option would already be eliminated for obvious reasons. On the other hand, at the $2. 36 price level, income for all volumes was already attained. Notice, though, that there is considerably low income if the least production volume will be implemented.
In addition, there was lower income at the extremes of the production volume, because of the fact that nonmanufacturing expenses varied at these levels. This would provide information that the nonmanufacturing costs at the extremes of the production volume are higher than that of the ‘middle-sized’ volumes. B. Using the Revised Cost Allocation Schedule (Exhibit 3) I will now be showing the effects of applying the two price levels utilizing the revised cost allocation system presented in Exhibit 3. FIGURE 2 As seen in Figure 2, at the $2. 15 price level, net losses were incurred for the first three sets of production volumes.
This is because of the reason that Sales was not able to absorb the manufacturing costs of that particular volume. And the last four volumes incurred net income because of lesser manufacturing costs in proportion to sales. Remember that, in our revised cost allocation system, we generated lower costs for higher production volumes (because of the fixed amounts). On the other hand, the $2. 36 price level also generated income at all levels of production volumes. Note, however, that in contrast to Figure 1, the income proportionately increases as the number of volumes also increases.
Comparing the two cost allocation systems under the two price levels, it would be easier for management to decide whether which of the two prices will be charged for SGP’s nonglare products. Again, what we are considering here are its ability to absorb both manufacturing and nonmanufacturing costs, its ability to give larger profit margins, and, though not quantitatively reflected through the values that were and will be generated, its ability to possibly regain SGP’s lost market share.
V. Conclusion and Recommendation Based on the two figures, we can instantly conclude that SGP cannot definitely charge $2. 15 nor less while incurring manufacturing and nonmanufacturing costs indicated in SGP’s old cost allocation system. Moreover, charging $2. 15 at the new cost allocation system would be able to generate only income when large volumes are produced. It must be considered that when small volumes are made, losses may be incurred, because of the presence of fixed costs. But, consider that there may be times that SGP might need to produce at small volumes only. Therefore, it will be unfavorable for SGP to set such a price ($2. 15) when it necessitates small production.
On the other hand, using the $2. 36 price level for the old and revised cost system of SGP would both generate income for the company. However, let us look closely. Using the old costs (Exhibit 2) will generate lesser income for all production volumes compared to the income generated by the new cost allocation system. Moreover, the latter maintains a consistent increase in income as the number of sales and production volume increases (assuming that sales and production volume are the same).
Therefore, I, as management accountant of SGP, hereby conclude that using the new cost allocation system at a $2. 36 would be best for SGP and is recommended to be used. This new cost allocation system is concluded to be better in showing the actual behavior and components of SGP’s costs and, if further studied and enhanced, will help in better decision making for SGP. List of References Baker, S. (2002) Cost [online lecture] delivered for course HSPM J712 on 4 September 2002 at University of South Carolina available from <http://hadm. sph. sc. edu/Courses/Econ/Classes/Cost/intro/cost. html> [04 February 2008] Carter, W. (2007). Cost Accounting 14th Edition. Singapore: Custom Publishing.Sample Essay of PapersOwl.com