Abstract
This report addresses the key issues outlined by the owner and founder of Delta One, a manufacturing company from the West Midlands. The management is interested in knowing whether the current costing system is flawed and whether activity-based costing should be considered. Another issue is related to the degree of customer input analysis by applying the Customer Profitability Analysis to improve marketing and sales efficiency. It is theorized that the segmentation at Delta One will benefit from this data. Finally, the report analyzes incremental budgeting and its prospects in the current economic environment in which the company operates.
Introduction
Manufacturing companies often encounter performance issues that vary from minor ones to serious impediments to the work process. Such a situation is natural, and occasional flaws occur in most entities. Their presence on its own does not imply major problems for the entire organization, but the ability to identify, analyze, and solve such issues is vital for a company pursuing sustained growth. Based in the West Midlands, Delta One has several decades of experience in specialized part production. Its products are actively used in the assembly and restoration of classic cars, and there has been no shortage of clients. With 40 people currently employed in the company, Delta One is a medium-sized organization that has already reached a considerable scale but still has a non-complex structural framework. While this organization is reported to be among the best players in its niche, the management still identified several concerns that may impede its development in the long term. This report aims to analyze these concerns based on the relevant data.
Issue One
First of all, the founder and owner of the company, Bob Baily, is concerned about the costing system that is currently in place in Delta One. Since the organization was created, it has employed the absorption costing system. The production manager remains convinced of its effectiveness, as well as of the correction of costing. Nevertheless, Bob does not fully agree with this idea, expressing reasonable concerns regarding its relevance to the current situation. Furthermore, one of the company’s loyal customers recently moved to another manufacturer, prompting Bob to explore the matter more profoundly. More specifically, the recently lost customer continuously purchased a detail called Flex Switch 101. Delta One’s sales manager insists that pricing should not be an issue in this regard, as there has been no increase for this particular item. In addition, the recently introduced detail called Lux Switch 250 is expected to yield considerable returns even at a high price due to stable demand.
The data supplied by Delta One’s management allows for a more detailed examination of the profound issues associated with the central problem. Bob reports that, over the past five years, direct labor hours in the production line have been reduced by a total of 15%. With a higher degree of automation, workers now spend less production time per detail, which is supposed to optimize the costs. As for Flex Switch 101, the margin is, indeed, as low as reported by the sales manager. With the cost of production averaging 23.75 pounds and the selling price being 25 pounds, the profit margin is only 5%. Therefore, the company has little or no room to reduce the selling price under the current circumstances. In fact, if it becomes any lower than that, Delta One’s profits from selling the part will be non-existent.
However, their problem may actually lie deeper than the selling price set at the moment. Compared with the newer and more expensive part, Lux Switch 250, Flex Switch 101 reveals certain production issues. For some reason, an older – and supposedly less complex – detail consumes more labor hours than its newer counterpart. Flex Switch 101 requires 60 hours of direct labor, whereas the same figure for Lux Switch 250 is twice as low, averaging 30 hours. Accordingly, these labor-associated expenses are accumulated with the overheads absorption, contributing to an elevated cost of production. Overall, the manufacturing cost of a single Flex Switch 101 exceeds Lux Switch 250 in all respects except the cost of materials, which is understandable, considering the higher quality of the second detail.
From one perspective, the problem could stem from the flaws in the manufacturing process. The management of Delta One reports major automation improvements that have reduced the direct labor required for the production of a single detail by 15%. However, Flex Switch 101 continues to require significant labor hours to be manufactured, which is twice as much as the newer detail. This is logical since Flex Switch 101 mostly relies on older business processes that were developed before the automation upgrades were introduced to Delta One’s manufacturing process. As a matter of fact, it is often easier to design new production patterns in updated conditions than to adjust the well-established ones to the new reality. Of course, the optimization of production will lower the costs of Flex Switch 101, but this process cannot be completed quickly and without costs.
Instead, it is proposed to analyze the allocation of pricing that is currently employed by the organization. As per Delta One’s production manager, the company has its absorption costing system. The key feature of this paradigm is that it allocates specific overhead costs to each unit produced at the factory. These costs are fixed and do not depend on whether the product was sold within the period in question. As most business frameworks do, the absorption costing system has its benefits and disadvantages. On the one hand, it includes more costs in the end inventory. This implies that these expenditures become the assets that persist into the next balance sheet period. Thus, the subsequent income statement of the company sees fewer expenditures, positively affecting the reported financial performance of the entity. In terms of the ending inventory, absorption costing usually accounts for a higher degree of precision. It includes a variety of costs, in addition to the direct ones, while complying with most established principles of accounting, as well.
On the other hand, absorption costing systems include a certain degree of cost generalization. Under such circumstances, the management of Delta One can hardly see the details of the costs endured in the production of a single detail, especially in the case of Flex Switch 101. In addition, the company’s profitability can see a certain level of inflation since the fixed costs are not deducted from the revenues unless the details are sold. The combination of these factors can create an unrealistic perception of both revenues gained and costs endured, which may be partly responsible for the commendable turnover reported by the management of Delta One. Under these circumstances, the generalization of costs prevents a thorough and detailed analysis of the company’s performance. Therefore, it is possible to conclude that the system currently employed by the entity is flawed to a degree, and improvements can be proposed.
In light of the issues identified with the current costing system in place, it appears feasible to consider an alternative that will put the company’s performance in line with its goals. As a replacement option for absorption costing, it is proposed to implement the activity-based costing system that will ensure a more profound understanding of the operational costs and requirements for further improvements. Based on the available information, pilot tests have been calculated, applying the activity-based costing system to Delta One’s production expenditures, provided in Appendix 1. Evidently, the basis of the costs remained unchanged, including the cost of materials and labor.
The primary difference consists of the modifications made to overhead costs. Activity-based costing introduces more detailed data regarding the cost of manufacturing. As a result, the overheads have been reduced from 2,718 pounds to 1,686.5 pounds. The additional costs considered still lead to an actual decrease of manufacturing costs from 4,750 to 3,718 for Flex Switch 101. As a result, the actual cost per unit is 18.59 and not 23.75. With the current pricing in effect, this extends the profit margin from 5% to 26%. At the same time, it creates room for lowering the prices if it is necessary to prevent the outflux of customers to competitors.
Overall, the implementation of the activity-based costing system is a viable option for Delta One in the near future. From a logistics perspective, the primary requirement for this process is to have a special outcome upon which the costs will be measured. For Delta One, this will not be a problem since the machinery is enabled and the materials are handled in a specific, tangible manner that results in the production of a single detail unit. The computations are made on the basis of specific “activities”, which function as the central concept of this framework. They include both the number of times an activity is repeated and the duration of each iteration. All of this data is already available to the management of Delta One, enabling a profound investigation into the detailed costs endured. Instead of having all of them accumulated in a single overhead pool across all operations, the management will be able to see the exact processes that consume their funds.
In terms of disadvantages, such a level of details requires more time to prepare and compile a precise report. It requires a logistically efficient mechanism of internal data exchange across the whole company. This point is not projected to become too problematic, as the size of Delta One is adequate for the task with about 40 employees. However, once the company begins to expand further, it will become more difficult, which is why it is important to anticipate the complications and develop a fitting mechanism beforehand. In addition, the external use of activity-based costing is limited, which makes it necessary to maintain a simultaneous framework of external use. Finally, the impact of the system is not as considerable when overhead costs account for a small portion of total costs (Alsayegh, 2020). However, in the case of Delta One, overhead costs are a major expenditure, making activity-based costing an adequate solution.
In fact, the model has a history of successful implementation across different industries. For example, da Silva Etges et al. (2020) discuss the application of activity-based costing in such a complicated sphere as healthcare. According to them, its implementation has led to “care-cycle optimization throughout the care trajectory and the identification of care benchmarks that can facilitate health system improvement opportunities” (da Silva Etges et al., 2020, p. 813). This positive experience confirms the system’s effectiveness in industries where waste is prevalent. Through activity-based costing, managers can identify excessive expenditures and eliminate these unnecessary elements, thus optimizing the entire service and production cycle. At the same time, Alsayegh (2020) warns that this paradigm is demanding organizational and communicative structure parameters within the entity, which accounts for the majority of associated difficulties. Therefore, activity-based costing has a history of success across different spheres, but there are also potential issues to anticipate when working with it. For Delta One, the system is an optimal choice that will optimize its pricing policies and production cycle, contributing to the company’s sustained growth.
Issue Two
The range of the issues encountered by Delta One is not limited to the questions surrounding the current costing system implemented by the company. The recent departure of a loyal client has raised reasonable concerns regarding whether the organization’s understanding of its customers can be improved. In this regard, there are many beneficial tools that can provide such knowledge. One such instrument is the Customer Profitability Analysis, or CPA, which consists of determining the overall profitability of a single client across a given period. In other words, it helps to see each customer’s contribution to the organization’s profits across all interactions between the client and the entity (Balling et al., 2018). Evidently, the end goal of most commercial organizations is to generate profits or gain more revenues than expenditures. However, as implied by the currently provided financial data of Delta One, this company mostly focuses on total profits without segmentation per customer. For example, the recently lost customer was a regular one, but it remains unclear whether they actually made a considerable contribution to the company’s profits.
Customer Profitability Analysis is a valuable tool that can help Delta One with this purpose. The basic calculations that enable it are rather simple and consist of deducting all costs endured to serve a customer from the total revenues provided by them. However, it is important to understand what is implied by total costs per customer, especially in the case of Delta One and its recently lost client. In the most basic sense, it can be mistakenly perceived as the following formula: (total sales per customer) – (total manufacturing costs per customer). Such an approach will not yield accurate results; the costs per customer extend beyond manufacturing. As such, marketing is a vital component of this equation, because the costs of acquisition and the cost of all interactions and shipments also need to be included. If this loyal customer had the details delivered to them, these costs should be included in their total when measuring the profitability. Similarly, if they ever made any additional payments outside the details purchased, this should account for the total revenues.
In other words, the CPA summarizes all costs and all revenues ever included in the interaction with a particular customer or customer group. Therefore, its primary benefit consists of the extended segmentation opportunity. As marketing is an integral component of successful business operations today, this benefit is of paramount importance for a medium-sized company aiming to secure its position and grow further. The CPA provides a clear understanding of how much it costs to acquire and serve a client while showing the level of profitability they ensure. Based on this data, it is possible to categorize the entirety of the customer base and arrange these groups on the basis of their total profitability. This way, the management will see which segments are the most beneficial ones. For example, young male adults may purchase more items than anyone, with average spending of $400 per annum. At the same time, they require more marketing and service expenditures, raising the average costs per client to $150. In this case, the average annual profitability of such a customer will be equal to $250. Simultaneously, middle-aged male clients may only purchase $350-worth of items per annum, but their acquisition and service will only cost $40, making their profitability $310. Accordingly, despite the higher revenues from younger clients, the middle-aged ones are more profitable.
In a similar manner, it is entirely possible that the recent loss of a long-term client may not be as serious as Bob fears. Evidently, lasting relations with a customer are valuable for the company, but it is important to know how profitable they have been in economic terms outside of the personal connection. This particular client stayed with Delta One for a long time, but it is also possible that their purchases were small and scattered across this period with large intervals. At the same time, there may be other customers who have come recently but already made higher profits for the company. Overall, it is important to commence this detailed segmentation process, as it will help to outline the core of the customer base that needs to be retained. Within the identified margin, Delta One will be able to offer flexible conditions that will retain the profits while preventing the exile of the clients.
Issue Three
The final issue that Delta One’s management seeks to resolve consists of the incremental budgeting concerns. In general, this concept implies the introduction of minor changes to the current budget that, when accumulated, results in significant improvements. The main idea is that a new budget can be drafted by making small-margin changes to the current figures. Accordingly, the implementation of major changes is limited in this case, which mitigates the risks but limits the immediate results. The examination of Delta One’s financial performance reveals that there is room for improvement in terms of incremental budgeting. For example, the primary point of concern remains centered around the direct labor hours allocated to the production of a single detail. It is possible to continue its optimization, especially for Flex Switch 101, by reducing the work hours spent on a single item. It can be done with a smaller margin, such as one or two hours of direct labors. The company will be able to produce more details at a longer distance. As long as the demand persists, Delta One’s gross profits will increase incrementally.
As for the more robust actions, it may not be the right time for serious budget risks. As the world recovers from the COVID-19 pandemic and amid various international tensions, the markets remain unstable. Global supply chains are still on the path to full recovery, whereas the performance of most economies is unstable. As the indeterminacy persists, Delta One should focus on incremental changes that gradually contribute to its performance. In the meantime, the management can work on a contingency plan and a long-term strategy to promote the company’s growth at a longer distance.
Conclusion
Overall, Delta One demonstrates adequate performance, gaining revenues and meeting the client’s needs. However, in order to continue on the path to further development, the company needs to implement several important improvements to its strategy, planning, and operations. First of all, it is necessary to consider an alternative to the current absorption costing system in the form of an activity-based system that will enhance the analysis opportunities. Second, in the sphere of customer relations, the company will benefit from a more profound framework of customer profitability analysis. This way, Delta One’s marketing and segmentation will see major benefits. Finally, it is recommended to remain loyal to the current incremental budgeting procedures by gradually optimizing the direct labor requirements per item. The current economic environment does not allow for major shifts amid global uncertainty.
Reference List
Alsayegh, M. F. (2020) ‘Activity-based costing around the world: adoption, implementation, outcomes and criticism’, Journal of Accounting and Finance in Emerging Economies, 6(1), pp. 251–262.
Ballings, M. et al. (2018) ‘Cause marketing and customer profitability, Journal of the Academy of Marketing Science, 46, pp. 234–251.
Da Silva Etges, A. P. B. et al. (2020) ‘Advances in value-based healthcare by the application of time-driven activity-based costing for inpatient management: a systematic review’, Value in Health, 23(6), pp. 812–823.