Modern manufacturing cost structures
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This question and answer is for P1, but will also be of interest to P2 candidates.
You first need to read the article Management accounting ' performance evaluation (PDF 128KB) from the study notes section of the March 2008 Financial Management magazine. This article was written by Ian Herbert, lecturer in accounting and financial management at Loughborough University Business School.
Question
Sherwin Ltd is about to make a substantial investment in capital equipment to automate its factory. The factory makes a range of pet accessory products.
The new computer controlled machinery will allow the direct labour force to be reduced substantially.
The UK market has recently become more competitive due to an influx of cheaper imported goods. However, the organisation has good relationships with several very large supermarkets and numerous wholesalers supplying independent retailers.
Required:
Explain to management the likely implications of the proposed investment in automation for:
(a) the company's cost structure and product pricing
(b) management control and performance measurement.
Answer plan
Implications of automation
(a)(i) Cost structure
Capital investment will probably increase total fixed cost through higher depreciation, maintenance, finance charges and miscellaneous associated running costs.
Variable costs in the form of direct labour will probably decrease per unit. The basis for labour remuneration may also change from production volume to salary, further increasing fixed costs and reducing the proportion of variable costs.
The cost structure will change as a result. In this case, operational gearing (leverage) will increase, giving a higher break even point and a lower margin of safety ratio - assuming all other things such as selling prices and raw material costs per unit, remain the same.
A further issue is that the new cost structure may distort the cost of individual products if the company currently uses direct labour cost as its basis of absorption.
This is because the higher level of production overhead will now be absorbed on a much smaller level of direct labour. Small variations in labour input between products may result in unfairly large variations in total cost per unit.
(a)(ii) Pricing
The company needs to negotiate prices in its market which maximise total contribution.
Lower variable costs and thus higher contribution per unit should not lead to lower prices without good cause.
However, in the light of market competition, cost-volume-profit analysis might create insights into how Sherwin might increase total revenue given its new cost structure. Perhaps there is an opportunity to increase business volumes with the large supermarkets through lower selling prices if:
- variable costs are also lower and the contribution per unit can be maintained, and/or
- contribution gained through higher sales volume exceeds the contribution lost through lower contribution per unit.
It should be noted that if fixed costs have risen, these need to be recovered whether through higher contribution per unit or higher sales.
There will probably be little immediate impact of the automation initiative on the prices charged to the wholesale/retail market.
This sector may not be as price sensitive, but if, as might be expected in a buyer's market, customers start to demand a greater range of products, or indeed, product customisation, then smaller batch runs will increase the cost per batch*. Selling prices will need to reflect that expensive machine time is being lost in longer set-up/changeover times. It may be that the foreign imports, while cheaper, cannot provide flexibility and rapid response.
Sherwin may have some limited scope to increase or at least maintain selling prices. A marginal costing approach will allow management to see which individual products within the range are providing positive contribution and which ones might need to be discontinued, or at least have their selling prices reviewed.
Further analysis of costs, perhaps along the lines of activity based costing (ABC) would be helpful.
*With the continuing development of Just In Time manufacturing (with potential batch sizes of 1 unit), production machinery is becoming very flexible and the company may have the ability to change set-ups quickly and cheaply. However, given the scenario it would appear that Sherwin is feeling its way in modern manufacturing and we will assume that JIT is premature.
(b)(i) Implications for control
The most appropriate style of management control will probably be different from the one that Sherwin's management has been accustomed to. Once set up, the machines should be capable of producing many units without significant human intervention. However, more care will be needed to make sure everything is in order before each production run starts.
The management task will be more straightforward, as there will be less need to supervise and monitor human direct labour. But the flexibility to manage processes by intervening during production runs will be reduced.
As a result, there will be a greater premium on planning ahead rather than responding to changes as they occur. Some managers may find it difficult to adapt to this.
(b)(ii) Performance measurement
Rather than seeking to monitor direct labour and its use through standard costing, the emphasis will move towards performance measures designed to ensure that machine use is high and things are done right first time, every time.
Performance measures might include, for example, machine setup time, the incidence of machine faults, machine utilisation (maybe now 16 or 24 hours rather than eight hours).
Performance measures per machine type might be reported daily, or weekly, so as to highlight and correct any problems immediately. By contrast, standard costing measures - which are effectively directed at supervisor, rather than worker, level - tend to be applied monthly. In the case of the latter, supervisors seek to optimise efficiency across a number of interrelated issues - for example - using more labour to correct for substandard materials (adverse labour efficiency versus favourable materials price), reacting to rush jobs or customer specification changes by paying overtime (adverse labour rate versus improved overhead capacity variance).
In a highly automated environment, such scope for management intervention might be diminished and the performance measurement system will need to reflect the change in emphasis. Note that some standard costing measures might still be helpful - for example, materials price and usage variances together with fixed overhead capacity variances.
Whatever new performance measures are adopted, the aim is to ensure that the firm's objectives are met through a comprehensive system of control.
Exam tips
The second part of the question is quite difficult. You have to strike a balance between saying that OVERALL the need for operational control will not diminish, BUT it will likely change in emphasis.
Teasing out those nuances in emphasis is hard and questions like these will distinguish a pass script from a fail. Again, it helps to separate the two elements of the requirement, while tying back to the overriding issue of control at the end.
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