Management Accounting

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Memo to James

To: James, CEO Rapid Mobiles

From: ———————————

Date: May 7, 2016

Subject: Comparison of current costing system with the suggested ABC costing system

Mr. James

I want to discuss the issues affecting our current costing system that has led to the increase in the losses made by the company. I will also discuss why the suggested ABC costing system would give different but better results. My memo is divided in a number of sections as follows;

  1. The strategy that a manager would have adopted in relation to retail customers and business customers under the existing costing system

To avoid the problems we are experiencing under the current costing system, the strategy the manager would have adopted would have been to run the two different types of customers (Business and retails) as two distinct entities which would have operated as two different cost centers. This is because the losses the company has been experiencing arise from the facts that the two types of customers are treated equally when indirect costs are being allocated assuming that the two types of customers consume the same amount of cost for different cost drivers. Separating the two departments would have brought out the differences in cost consumption leading to the right allocation of indirect costs. For instance using the strategy, the cost of processing account payments/enquiries for the two types of customers would have been different since it is obvious that business customers would have incurred more cost than the retail customers given that the number of account payments related to retail customers are only 126,000 compared to 474,000 for business customers. The same can be observed for other cost drivers. The effect of managing the two types of customers as two separate entities therefore would be to ensure that the costs associated with the departments do not mix at any time and hence each type of customers are allocated their rightful share of costs. This would ensure that their devices are rightly priced and hence ensure that the company makes some profit on every type of customer. The current strategy however leads to wrong pricing for each type of customer leading to the losses.

  1. The indicators in the business that suggest the existing costing system required investigation

There are a number of indicators that revealed that the existing costing system needed investigation. The first indication was when the business started operating at losses despite the fact that it had all along been making profits. The losses were being caused by the wrong pricing of the company’s products owing to wrong costing. The fact that the business had introduced retail customers called for a review of the costing system since the two types of customers did not incur costs in the same way. Even after introducing a new strategy to increase sales, the company continued to operate at losses despite sales having increased indicating need for review of the costing system. The fact that the current system does not trace costs directly to individual customers, either to the business or retail customers but treats all the operating costs as indirect allocating them to either retail or the business customers on the basis of total dollar value of the plans that the customers sign up to is also an indicator that the costing systems needed investigation since it assumes that the rate of absorption of the indirect costs is the same for both the customer types which is not true and hence the company ends up adopting the wrong prices for the two types of customers.

  1. Why there are differences in the profitability per retail customer and business customer between the two costing methods

Unlike the current method, there is no blanket allocation of costs in the proposed ABC system. ABC more precisely allocates the indirect costs to the items that actually used it. In this regard, ABC does not directly allocate the $7,500,000 indirect costs to the respective number of business and retail customers. ABC first of all identifies the activities that caused the costs including number of account payments/enquiries processed, number of times in-store help is provided etc. and the cost associated to these services is identified. After the identification, of the costs, these are allocated back to the individual types of customers depending on the level of activity each type of customer consumes. This ensures that each type of customer is only allocated a certain type of cost if and only if it has consumed the cost and the extent to which the cost is consumed. This ensures that no unnecessary costs are allocated to a certain type of customers. At the same time, ABC method ensures that we do not allocate a cost related to one type of customer to the other. This ensures we don’t over or underprice the services offered to any kind of customers. Thus, the differences in the two cost allocation methods is what caused the differences in pricing per retail customer and business customer and hence the difference in profitability as shown in the excel calculation.

Arising from the analysis above, it is clear that the simple method results in either over or underpricing services offered to a certain kind of customer which has resulted in the losses the company has been making. This is not the case with ABC method which ensures that the services are rightly priced and this would ensure that the company makes profit on each of the customers. Thus, I would recommend that the company considers adopting the proposed ABC method.

References:

Jared, B2011, Management accounting, London, Rutledge.