Managerial Accounting

Word-1500/ Answers required only for 1,2,5,6,7

QUESTION:

Pristine Limited (PL) manufactures and sells fireproof safes and document containers of various shapes and sizes for home use, including safes made to Australian/New Zealand Industry standard AS/NZS 3809. The division now makes 50 different products but these fit into the two main product groups of 35 metal safes and 15 more recently developed plastic safes.

Table 1 shows last quarter’s income statement by product group.

Table 1—Quarter 1 income statement by product group

	Metal	safes	Plastic	safes	Total
	$	$	$	$	$	$
Sales revenues		296900		246800		543700
Direct materials	21500		20680		42180
Process and support costs	231770		170280		402050
Total costs		253270		190960		444230
Net income		43630		55840		99470
Profit margin		14.7%		22.6%		18.3 %

The managing director, Christine Smith, is concerned because the net margin on metal safes has fallen below the company’s target of 20 per cent and because company profits have been falling despite overall sales growth and increased capacity utilisation. Metal safes is the high volume product group but sales fell by 5 per cent last quarter. Plastic safes sell at much lower volumes, but the sales of plastic safes increased by 15 percent last quarter, despite recent price increases and their apparently high margins. The marketing director, Colin Drake, tries to explain the trends as follows:

The margins on metal safes are being squeezed because of ridiculously low prices set by the competition. However, the increased sales of high margin plastic safes should compensate for this. I therefore propose to concentrate marketing resources on plastic safes.

However, Christine highlights that despite selling more plastic safes overall profitability is falling. She questions the reliability of the present costing system, which has remained very traditional despite PL having become a much more complex business in recent years. PL’s process and support costs are currently absorbed on the basis of total process hours using a single overhead absorption rate of $23.65 per process hour. Christine

argues that although raw materials are cheaper, overall production of plastic safes is quite complex and she questions whether the simplistic costing system is missing something. She requests an investigation into improved costing procedures using an activity-based costing model.

It is established that there are five main activities undertaken by PL.

Table 2 shows details of these activities, their cost drivers and their estimated costs per quarter.

Table 2—Data on key activities

Activity Cost driver Estimated costs

Insulation process Insulation process hours $ 180700

Assembly process Assembly process hours 69600

Quality control Number of inspections 80080

Materials management Number of requisitions 47800

Selling and administration Number of sales orders 23870

Total process and support costs 402050

Table 3 shows last quarter’s actual activity rates.

Table 3—Activity rates for the last quarter

Activity Metal safes Plastic safes Total activity

Insulation process hours 7000 6000 13000

Assembly hours 2800 1200 4000

Total process hours 9800 7200 17000

Number of inspections 40 100 140

Number of requisitions 300 700 1000

Number of sales orders 30 47 77

The assembly process for plastic safes is quite complex and there has recently been a high level of rejects. This has resulted in the need for increased quality control activities. Plastic safes generally comprise more components than metal safes, causing more material movements. The plastic safe product group is still new and PL’s customer base is characterised by a large number of customers each ordering small volumes.

REQUIRED:

1) Explain TWO general problems associated with Pristine Limited’s traditional costing system.

2) Highlight FOUR indicators that the current costing system is outdated and flawed.

3) Calculate the activity cost rates to be used in the desired activity-based costing system.

Activity	Cost driver	Estimated Costs	Total Activity	Cost per units
		$		$
Insulation Process	Insulation Process hours	180,700	13000	13.90
Assembly Process	Assembly process hours	69,600	4000	17.40
Quality Control	Number of Inspections	80,080	140	572.00
Material Management	Number of requisitions	47,800	1000	47.80
Selling and administration	Number of sales orders	23,870	77	310.00

4) Prepare a revised income statement by product group tracing process and support costs to product groups using activity-based costing methodology.

Activity	Cost per units ($)	Metal Safes	Plastic Safes
			Cost ( $ )		Cost ( $ )
Insulation Process	13.90	7000	97,300.00	6000	83,400.00
Assembly Process	17.40	2800	48,720.00	1200	20,880.00
Quality Control	572.00	40	22,880.00	100	57,200.00
Material Management	47.80	300	14,340.00	700	33,460.00
Selling and administration	310.00	30	9,300.00	47	14,570.00
Total process and support cost			192,540.00		209,510.00

Quarter 1 Income Statement by product group
	Metal Safes	Plastic Safes	Total
	$	$	$	$	$	$
Sales revenues		296,900		246,800		543,700
Direct materials	21,500		20,680		42,180
Process and support cost	192,540		209,510		402,050
Total cost		214,040		230,190		444,230
Net income		82,860		16,610		99,470
Profit margin		27.9%		6.7%		18.3%

5) Briefly explain the differences in product costs and net profit margins between the two alternative costing systems.

6) Prepare a report to the managing director, stating the benefits, costs and issues of adopting the activity-based costing system to Pristine Limited.

7) You are asked for suggestions about increasing profitability for a customer of Pristine Limited that purchases low-margin products and requires costly services. Prepare a brief paragraph suggesting methods to improve profitability for this customer.