CHAPTER ONE

INTRODUCTION 1.1 The Background to the Study

The businesses have gone through drastic changes in their operations during the past decades. All these developments and the changes forced companies to review their product costs and the costing bases in order to be competitive in the local as well as in the international markets. Firms have been using several costing systems over the years, namely standard costing, marginal costing and absorption costing in pricing their final products.

Solideal Loadstar is one of Sri Lanka's best kept secrets and its biggest exporter, accounting for just over two percent of the nations near seven billion dollar export earnings.In the world market now control 20 percent in the solid tyre and about five percent in the industrial tyre markets are hold by Loadstar (Pvt) ltd, Loadstar makes industrial and construction tyres, rubberized tracks, wheels and rims at its Sri Lanka facility, catering to buyers in the United States, Europe, Australasia, Africa and the Middle East. the company turns out about 6,500 tyres daily for heavy equipment firms such as Caterpillar, JCB, Komatsu, Fiat, Yale and John Deere. Loadstar is also making rubber tracks to replace the steel traction chains used in heavy earth-moving equipment.

The company scoops up 40 percent of Sri Lanka's annual production of 100,000 tons of raw rubber. It also imports about 15 percent of its rubber needs. Tyre exports fill 700 containers each month. The business has grown steadily over the years and the company

has kept our world with buyers despite the ups and downs associated with investing in Sri Lanka.

The organization has grown in verticly by expanding their operation into some raw material and intermediatory products manufacturing.Manufacturing of steel componets to rubber tracks (Metal pieces),installation of raw rubber processing faciliting (Mixing facilities),installation of used tyre crushing facilities for reusage as a cost reduction strategy are the operations which added some sub products and intermediatory processing activities in the overall organization operations.

The problem of not having a proper system to identify the sub and intermediatories products level cost and use of available cost information for transfer pricing was led to Inaccurate pricing and incorrect overhead absorption in the final products level in the company. The present practices of Loadstar to absorb overall overheads to products based on the volume of rubber used for the production of different products without going to the sub products or input levels. The current practice does not consider the complexity involved or number of sub products in the production of a final product. The companys current products portfolio consists of thousands of different products which differ in complexity in production. Some products are more complex and used so many sub products with different complexities to produce than others, even though both may use the same amount of rubber. Based on the current method of overhead absorption, same amount of overhead cost will be allocated for both products if both products have the same amount of rubber usage. However, to be meaningful, the complex products should draw more overheads than the less complex products. As a result of the problem in costing, the company is undercharging some complex products and overcharging less complex products. The
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adverse effects would be incurring losses on undercharged products and losing sales may be on overcharged less complex products, as they are overpriced to the customers. An essential feature of decentralized firm is responsibility centers (Eg.cost-, profit-, revenue-, or investment-canters). The performance of these responsibility centers are evaluated on the basis of various accounting numbers, such as standard cost, divisional profit, or return on investment (as well as on the basis of other non-accounting measures, like market share). The second issue is the determination of accurate pricing system to the company. This pricing includes decision about the transfer pricing of components and pricing of intermediatories between the different production facilities and the decision on the price charged to finished products when transferring to the associated companies.

1.2

Identification of the Issue

The company is having a centralized raw rubber processing department which is having 94,000 tons annual processing capacity. The row rubber is used as basic raw material and with other chemical and crushed used tires dust is used in formulae for this process. Final product of this process is the main raw material in the tire manufacturing process. The product of this process is known as the first stage compounds and the compounds appearance in hard form like a flap. This output can be stored in pallets and can be handled easily with material handling equipments. This product can easily be transported and have a life time around two to three weeks. This compound needs a second stage processing and this second stage process is done in each and every production facility.

Even though all products get same features by appearance there are some differences in the compound production process. Some compounds require more than one cycle in mixing process while some may enough one processing cycle. The figure 01 shows first stage compounds in work in progress and the figure 02 shows the finished first sate compound. Figure 01: First stage compound in work in progress

Figure 02:

Finished First Stage compound

The present costing system does not separately calculate the overhead cost of each product at Central Mixing Plant (CMP).The raw material cost is calculated by using the Bill of Materials (BOM) using the moving average prices of the raw materials. The bill of

material identifies the material quantity requirement in units level in each product level. As there is facility to capture raw material cost to each product level an accurate figure about material cost can be calculated. The study is focusing to the decision on the transfer pricing by identifying the correct cost of CMP and the other intermediatories services received by CMP. Identification of fair share of central services cost and finance cost also considered. Figure 03 shows the study focus. Figure 03: Study focus area

As shown in figure 03 there are two divisions they provide services to CMP. Ancillary products division (APD) used old tyres to manufacture raw material to CMP as a cost reduction strategy.APD incur around 71 Mn LKR annual overhead expenses for its operation. There is a requirement of identification of fair share of corporate head office expenses to CMP after identifying the usage of common services by the CMP. Loadstar sells the final products to Solideal Trading at the rate of cost + 2% and directly to the some selected customers around the world. A frequent complaint from Solideal is that products overhead cost is so high for some products and some products are not

consistently priced. This resultant frequent price changes and it makes their life difficult in selling the products to end customers. Also it was noted that there were some periods the overall company was making losses even though the company row material prices are low compared to the other competitive rubber based products manufactures. It was also brought to the notice, that in future the company may lose orders due to inconsistent prices, global recession and ever increasing competition from the Chinese manufacturers. As a result of the organization expansions to global level manufacturing facilities like production facilities in China, Korea and Canada, there were some sub products transfers between these production facilities. The requirement of transfer pricing for these sub products were arisen. Sub products demand has been increased during last few years in high quantum that has led to create bottle neck at CMP and the substantial amount of capacity of the central mixing plant has been utilized for the catering of external customer demands. The above mentioned problems prompted the author to investigate the proper costing and pricing system.

1.3

Objectives of the Project

The author has identified three objectives for the study. 1. To identify the ability of using activity based overhead cost allocation to selected production facility. 2. To find out the most accurate cost and the ability of using this cost in transfer pricing decisions in management accounting 3. To use the overhead absorption results for divisional cost performances analysis.
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The project will identify cost structure of the organization and how activity based costing can be used for the improvement in management decision making in the organization. To meet the above identified objectives of the project the author selected the CMP of Loadstar (Pvt) limited as a pilot project.

1.4

Significance of the Project

The company absorbs overheads to products based on the volume of rubber used for the production of different products. This method of overhead absorption is clearly not ideal and incorrect as it does not consider the complexity involved and the sub products or input types in the production of many different products. Some products are having more complex process compared with others, even though both may use the same amount of rubber. Based on the present method of overhead absorption, same amount of overhead cost will be allocated for both products since both products consume the same amount of rubber. However, to be meaningful, the complex product should draw more overheads than the less complex product. The fault in costing system leads to faulty pricing. Because of this problem in costing, the company may be undercharging more complex products and overcharging less complex products. The adverse effects would be incurring losses on undercharged products and losing sales may be on overcharged less complex products, as they are overpriced to final customers. The project of implementing Activity Based Costing for sub products transfer pricing, will help to overcome those inefficiencies and will result in correct product costs and prices. And same way it will provide facility to measure the cost performances of the each
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division without considering whether particular division is producing a final product or a sub product.

1.5

Methodology

Case based study method was followed. Examination of the present costing system to understand the current practices ,collecting of data about the present system to determine an appropriate costing system were carried out. Production process study, getting of data from ERP system was carried out. Developing a model based on ABC technique with gathered Data and Information, checking the available facilities in ERP system for comprehensive system like ABC and identifying the development requirement for ERP system were carried out. Developing the basic model in excels environment and analyzing the date, arrangement and Presentation of analyzed information was carried out.

1.6

The Limitations of the Study

When continue with this project initially the following limitations were identified: The project is carried out for the environment which does not have previous working experience with a comprehensive costing system like Activity Based Costing (ABC) system. Only the major activities are expected to be analyzed and all the activities could not be analyzed in detail due to the non availability of historical data as the objectives identified earlier are different from the new project objectives.

Finding a most suitable cost driver is also a major challenge and in most circumstances tried to get more accurate driver which shows the course and affect relationship. In some instances without going to more accurate driver some closed driver selected as cost factor involved in going to more accurate data. Reliability of data. Most of data collected from the factory accountant and from the ERP system. The knowledge level of factory accountant and the accuracy of fed data to ERP system are subject to some human errors. The time factor made it extremely difficult to implement ABC Companywide before the deadline of the project paper and hence decided to carry out the project as a pilot project only in the Central Mixing Plant (CMP) where basic product component is produced.

CHAPTER

TWO

LITERATURE REVIEW 2.1 Introduction

Chapter two discussed bout the evolution of cost and management accounting theories with the business structure developments. Selection of suitable overhead absorption method, Importance in ABC as overhead absorption technique and evolution of ABC also discussed with the ideas put by theorists. Empirical studies about the ABC, ABC & Firm value and also issues involved with ABC implementation have been identified. New are in transfer pricing and the recent reported legal issues relevant to transfer pricing also discussed.

2.2

Selection of Suitable Overhead Cost Absorption Technique

Standard costing has traditionally been considered a very useful technique in planning and control, product costing and performance evaluation (Sulaiman et l., 2004). According to Mitchell (2005, p. 33), standard costing provides a number of benefits in performance evaluation: Standard cost variances provide feedback information designed to help managers control operations in accordance with the plans they have set. They highlight the difference between the planned costs of a period and the actual costs incurred over that time. Cost variances comprise several different elements that together make up the total reported variance: Costing system errors,

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Inappropriate standards, Uncontrollable random factors, and Controllable variances with operational causes

Conventional overhead cost absorption systems can report seriously distorted the product costs when the products that are manufactured are diverse. In particular, size batch-size and customized products diversity can affect the accuracy of the reported product costs. Activity based costing (ABC) is the answer. It is a development in product costing that has attracted much attention in the last few decades. Conventional cost accounting systems focus on units of particular products. Costs are allocated or traced to a product because each unit is assumed to consume resources. Therefore, conventional allocation bases measure only attributes of a unit, for example, the number of direct labour hours, machine hours or the costs of the direct material consumed in making the product. By contrast, ABC systems focus on the activities performed to produce products in the manufacturing process. Costs are traced from activities to products based on each products consumption of the activities performed (Cooper, 1990). Products uniqueness, simple production process with mass production did not lead to huge differences in overhead cost and further there were no such big differences in the resources utilization in such a situation simple overhead cost calculation method could cater the day to day cost management information requirements. Companies need costing systems to perform the following three major primary functions: Valuation of inventory and measurement of the cost of goods sold for financial reporting;
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Estimation of the costs of activities, products, services, and customers; and Providing economic feedback to managers and operators about process efficiency. The first need is driven by the needs of constitutes that are external to the organization: but as a requirement of investors, creditors, regulators, and tax authorities. The procedures for the external, financial reporting function are governed by a myriad of rules and regulations established by tax authorities, governmental agencies, private standard-setting bodies, and public accounting bodies. Especially in Srilanka Accounting Standard no 05 states the special treatments and the rules required for the inventory valuation. The second and third functions are arisen from the internal needs of the organization and the managers to understand and improve the economics of their operations. Managers need accurate and timely cost information to make both strategic decisions as well as operational improvements decisions. In the past, many companies attempted to meet these three different functions with a single costing system. In an environment of limited product and process variety where excellence in manufacturing processes was not critical for success a single costing system might have sufficed. There is no longer possible the traditional standard cost systems are still fine for financial reporting. Some companies, even today, have systems that use simplistic direct labour overhead costing systems, perhaps with only a single rate, despite operating plants with diverse processes, which might include both manual assembly and highly automated machining (Kaplan & Cooper 1998) Technical advancements, added features in the products and some customized products lead to variation in the production resources usage, in some instances not only the

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overhead cost the material cost also varies, in such situation requirement of an extra effort has been identified for more accurate overhead cost identification which reflect the repetition of resources utilization.

2.3

Emerge of Activity Based Costing

Initially the concept of ABC arisen in 1980s as a requirement of more accurate and meaningful management information requirements. Limitations in the traditional costing systems, changers in the production process and the variation in the same product with added features are the reasons behind the requirement of such costing system. Highlighting the limitations of the traditional costing systems in overheads cost allocation basis where product diversity is exists in terms of volume and complexity. The need for activity-based costing system for the firms with high level of competition and having diverse product mix are more likely to benefit from precise cost information and the introduction of activity-based cost systems with an added caution should be cost effective. (Cooper 1988) As competition increased, and as the basis of competition shifted away from the efficient use of direct labour and machineries, managers needed more comprehensive and accurate information about the costs of process, products, and customers than they could obtain from the system used for external financial reporting (Kaplan & Cooper 1998). Identification of cause and effect relationship in the resources utilization in production process is the concept lead for cost driver selection in a costing system. In a complex production system there may have more causes which lead to cost in such a situation one uniform or blanket overhead rate may distort the final result of the costing system.

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ABC acknowledges that products or services do not directly use up resources; they use up activities and to create activities it requires resources. ABC systems differ from traditional cost accounting systems in the nature of cost drivers used to trace costs. Traditional, unitbased cost accounting systems use only second-stage allocation bases, which are based on unit-level characteristics of the product. Typically, direct labour hours, machine hours and material costs are the allocation bases used. Allocation bases that measure characteristics of the product are called unit-level allocation bases. An ABC system, on the other hand, uses cost drivers that are related to unit-level, batchlevel and product-level characteristics. Examples of batch-level bases include set-up hours and number of set-ups. Examples of product-level bases include number of parts, number of times ordered and number of engineering charge orders. The three key areas of ABC are product cost differentiation, activities and their cost drivers, and identification of nonvalue-added activities and cost improvement opportunities (Raffish, 1991). Products cause costs by consuming activities required for their manufacture; therefore, specific cost drivers are used to measure this rupees cost consumption in terms of the rupee cost per unit of cost driver. This in a nutshell is the methodology employed in tracing general ledger resource costs (overheads) to products: identify activity levels, variable costs (both short-term and long-term), and volume- and non-volume-related costs. Short-term variable costs are driven by products at the unit level, consuming materials, direct labour, energy, overheads, and so on. At the unit level these short-term variable costs are traced to products (products consume costs) through the use of volume-related cost drivers. These costs change proportionately with the volume of production, hence the term volume-related. Thus, at the unit level of activity, short-term variable costs must be traced

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to products through volume related cost drivers. Other activity levels have also been defined: batch level, product level, process level and plant level. In each case the cost drivers must match the specific class level of activity. Long-term variable costs, considered fixed under traditional cost systems, are variable at the point or activity level of consumption at the batch, product, process, or plant levels of consumption. Classified as non-volume-related costs, resources are consumed by machine set-ups, engineering changes, the maintenance of equipment and plant security level. Thus, for different activity levels, long-term variable cost must be traced to products through non-volumerelated cost drivers. (Raffish, 1991). ABC is attracting considerable attention and activities more efficiently than getting rid of them; alternatively, we fail to see interrelationships among the activities creating these costs. ABC is a more relevant method for costing products than some older methods because it forces traceability of costs to products based on the resources consumed by the activities needed to produce individual products. The key factors are activities and their associated cost drivers. If a product does not use an activity, it should not absorb any of its related costs. The costing methods commonly used today, for example, may tie allocations of overheads to direct labour so that some products are being charged for resources they never used. Unless we change our allocation methods to recognize the shift in the character of overheads from variable towards fixed as the use of technology increases, severe product cost distortion will accelerate. (Joon Jong No and Brian H. Kleiner 1997) In summary, the ABC system employs a two-stage procedure (first- and second-stage cost drivers) in assigning costs to products. It traces costs first to activities (primary allocation) and second to products (absorption). Thus, under the ABC system the cost of a product is equal to the cost of materials plus the sum of the costs of all activities required producing the product.
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2.4

Evolution of Activity-Based Costing

Requirement of comprehensive information and complex production facilities lead to identify the need of new management information system Highlighting the limitations of traditional costing systems in overheads cost allocation in a situation of product diversity in terms of volume and complexity Cooper (1988a) illustrated the need for activity-based costing system. Consistent with this research, Cooper (1988b) found that the firms facing high level of competition and having diverse product mix are more likely to benefit from precise cost information and the introduction of activity-based cost systems with an added caution that the activity-based costing system introduction initiative itself should be cost effective. Robert S .Kaplan & Stevan R.Anderson(2004) argued that the traditional ABC model also often fail to capture the complexity ship order to customer rather than assume a constant cost per order shipped, a company may wish to recognize the cost differences when an order is shipped. Robert S .Kaplan & Stevan R.Anderson (2004) found despite of ABC attractiveness value proposition, however, ABC was not universally accepted. In an annual survey of the adaptation of management tools, ABC ranked below the medium, with only a 50 percent adaptation rate.

2.5

Empirical Study Results of Activity Based Costing Implementation

An empirical study has been done in India by Manoj Anand professor finance and accounting area Indian Institute of Management a nationwide survey has been conducted

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to capture the issues and the design and application of contemporary cost and management tools. The performance of ten ABC user firms vis--vis their matched size- and industrycontrolled counterparts who have not adopted activity-based costing. Though ABC user firms had abnormal returns on the date of announcement but not statistically significantly different from their counterparts. Thus, they questioned the adoption of activity-based costing if it does not lead to creation of firm value. (Gordon and Silvester 1999) The firm superior performance subsequent to activity-based costing adoption revealed that the ABC adoption decision was rational value-enhancing choice and it was not a fad or fashion or forced selection (Malmi 1999). It reported that 75% of the ABC users found it financially beneficial decision. (Shield and McEwen 1996) The success in ABC implementation is based on top management support, compensation and training (McGowan and Klammer 1997).

2.6

Activity-Based Costing & Firm Value

ABC directly touch with the production process and it try to identify and segregate the activities in to value added and the non value added and open the eyes of management to reduce and eliminate the non value added activities and the end it focuses to increase the value of the firm Though activity-based costing corrects the product-cost distortions but no such study has been done to demonstrate that it increases the profitability of the firm. (Bromwich and Bhimani 1989)

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The success at cost management could have substantial impact on the firm value (Groth and Kinney 1994). It is argued in favour of integrating activity-based cost management systems with the measures of shareholder value such as economic value added. The resultant integrated cost management systems could provide better governance mechanism for improving processes, optimizing the use of capital and thus create shareholder value (Hubbell 1996). Kennedy and Affleck-Graves (2001) examined the link between activity-based costing implementation and creation of shareholder value using Report framework and event study methodology. Brown and Warner (1980 & 1985) got responses from ABC users and nonABC users. They found that choice of management accounting system such as activity based costing for a sample of UK firms had a significant impact on firm value (27% over the three years from the beginning of the year in which activity-based costing was first introduced). Shields et al. (2000) examined the impact of activity-based costing on firm performance may be indirect through the mediating influence of other variable. Cagwin and Bouwman (2002) in their survey of 210 internal auditors found that the firms with diverse product portfolio and with high proportion of overheads cost when they have adopted activity-based costing along with other strategic initiatives such as JIT and TQM, it resulted in substantial improvement in their return on investments. The other enabling conditions for the efficacy of the ABC in the organizations are sophisticated information technology systems, absence of excess capacity and competitive environment. 2.7 Activity-Based Costing Issues in Implementation

With simple and understandable costing system all involved parties can simple implement and understand further there is no need of special background preparation for such simple costing system.

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When implement a comprehensive costing system like ABC it may create so many issues in implementation as well as interpretation of the result in such situation it may create so issues in implementation. Ness and Cucuzza (1995) argued that the activity-based cost systems are superior to traditional costing systems and they could fail due to poor implementation process, Player and Keys (1995) and Pattison & Arendt (1994). Jayson (1994) found in response to Management Accountings first fax survey that implementing activity-based costing is worth the investment. The most common problem reported was the difficulty in identifying the cost drivers. Shield (1995) and Shields & Young (1989) found that the firms top-level manager champions the ABC project; cross-functional teams, process orientation and adequate training to the employees on the ABC; linkages between activity based team oriented performance metrics to the compensation plan; decision-making at shop-floor level, who have process knowledge; and review ABC implementation initiative in long-term perspective were the key success factors for ABC implementation The top management support, Activity Based Cost Management (ABCM)-linked performance evaluation and compensation plans, numbers of applications of ABCM in the organization and time-in-use of application have been found to be ABCM success (Foster and Swanson 1997). Brown et al. (2004) found that the association between organizational size and initial interest in activity-based costing significant. Based on the survey findings of the Cost Management Group of the Institute of Management Accountants, 1996 Krumwiede (1998) reported the activity-based costing adoption status and factors affecting its success.

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The top management support, information technology sophistication, large size firms, and integration with the financial system were the factors affecting the usage of the activitybased costing. The use of activity-based cost system is found to be positively correlated with the firm size. The organizational factors such as top management support, nonaccounting ownership and the training were found to be vital in the successful implementation of the activity-based costing. Shaw (1998) observed that one of the biggest challenges to adoption of activity-based costing/management is increased adoption of enterprise-wide resource planning systems the role of the management accountant will thus change from scorekeeping to strategic advisor. Endorsing the role of implementation process, Anderson and Young (1999) in a study of 21 filed research sites of two firms examined the relationship between activity-based costing systems, contextual factors, and factors related to ABC implementation process by using surveyed interview process. They found that implementation process has clear influence on the ABCM success and the contextual setting directly influences the process and outcome. The criteria for success of ABC systems is its ability to provide more accurate cost data vis--vis traditional cost The time driven approach of ABC could avoids the most of above identified problems in ABC.It uses time equations that directly and automatically assign resources cost to the activities performed and transaction proceeds. Only two parameters need to be estimated capacity cost rate for the department and capacity usage by each transaction processed in the department. (Robert S, Kaplan, Steven R Anderson 2007)

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2.8

Transfer Pricing

Transfer pricing is simply the act of pricing of goods and services or intangibles when the same is given for use or consumption to a related party (e.g. Subsidiary) there can be either Market-based, i.e. equivalent to what is being charged in the outside market for similar goods, or it can be non-market based. Transfer pricing is of increasing importance to corporations as in a globalised economy their operations extent to countries with diverse taxation regimes and regulatory capacities. The pursuit of profits, cash flows, marketing goals, economics of scale and competitive advantage through divisionalization, joint ventures, subsidiaries and affiliated necessitates of cost to measure performances and tax profits. Transfer pricing is portrayed as a technique for optimal allocation of costs and revenue among divisions, subsidiaries and joint ventures within a group of related entities (Prem Sikka & Hugh Willmott 2010) Importantly, two-thirds of the managers say their transfer pricing is non-market based. There can be internal and external reasons for transfer pricing. Internal include motivating managers and monitoring performance, e.g. by putting a cost to imported inputs. External would be taxes and tariffs (Mayank K.Agrawal 2004). The globalization has added new complexities to the politics of transfer pricing. Freed from the limitations of territorial jurisdictions, corporations can more easily establish subsidiaries, affiliates, joint ventures, special purpose entities and trust in favorable geographical locations to take advantage of low taxes and subsidies. (Prem Sikka & Hugh Willmott 2010)

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2.9

Transfer Pricing & Legal Background.

With spread of Multinational Corporations (MNC) business activities around the world the governments has emphasize on the transfer pricing and the tax effect on the transfer pricing. Most of MNC also trying to get the tax benefit by using the transfer pricing techniques. Even Loadstar trading partner Solideal International in US recently had faced with some US tax authorities legal action with regard to the transfer pricing and US division operating profit. The transfer pricing policies of GlaxoSmithKline, a global pharmaceutical company, have also been scrutinized by the US tax authorities who claimed that the rate the company charged for marketing services supplied by its U.S. affiliate from 1989 to 1996 was far too low, and thus understated Glaxo's US income and avoided around $5.2 billion of US taxes After some 17 years of protracted litigation and negotiations, Glaxo settled the dispute by making a payment of US$3.4 billion (US IRS press release25, 11 September 2006; The Times, 12 September 2006). However, the company is involved in another $1.9 billion dispute (Wall Street Journal, 23 May 2009). The transfer prices of another major pharmaceutical company, SmithKline, came under scrutiny by the Canadian tax authorities (Turner, 1996; McMechan, 2004). For 22 the years 1980 to 1989, the authorities challenged the companys pricing practices for cimetidine, an active ingredient used in the manufacture of the drug Tagamet. SmithKline formulated, packaged and distributed the drug and earned considerable profits in Canada.

2.10

Divisional Performance Measurement

Because of the complexity of companies operations, it is difficult for top management to directly control operations. Therefore a company is divided into divisions and is allowed
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divisional managers to operate with a great deal of independence. When autonomous divisions are created it arises the danger that divisional managers might not pursue tasks that are in the best interests of the company as a whole. Many companies have business activities in more than one country. In fact, the operations of some large corporations involve so many different countries that they are called multinational businesses. The problems of managing and accounting for a company that has international operations can be very complex, and detailed study of these issues should be required. The measures traditionally used by the organizations to measure the divisional performance has been return on investment (ROI), this type of criterions measures the divisional profit against the level of investment in assets attributable to a division. However, if ROI is used to evaluate managerial divisional performance it can lead to suboptimal decisions. For example, divisional managers may be incorrectly motivated not to undertake a project with a return in excess of the cost of capital simply because it has a lower projected ROI than the current ROI for the division as a whole. To help overcome this problem conventional wisdom advocated the use of controllable residual income (RI), which is controllable profit less a charge for the cost of capital employed. Previous empirical studies, however, suggest that RI does not appear to be widely used in practice.

2.11

Limitations of Financial Performance Measures

The historical limitations of financial performance measures can be summarized as follows: They focus on short-term periods and encourage short-termism;

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They are lagging indicators, evaluating the outcomes of management actions after a time period. Therefore it is difficult to establish a relationship between managers actions and reported financial results; They deal only with the current period, not the future; and They use financial accounting information based on the historical cost concept and thus tend to be poor estimates of economic performance. Given that the problems associated with the use of financial performance measures, two possible methods of dealing with them emerged in the early 1990s.The first (economic value added) seeks to improve financial performance measures and the second (the balanced scorecard) incorporates non-financial performance measures with financial performance measures.

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CHAPTER THREE

ORGANIZATION 3.1 Introduction

Loadstar private limited is a manufacturing division of Camoplast Solideal limited Canada. The organization has eight production locations and all facilities located in Ekala & Ja-Ela other than the two factories in Midigama and Kuruwita. The organization manufactures solid tyres, air tyres, rubber tracks and the wheels. 3.2 Organization and its Context

Solideal Loadstar is one of Sri Lanka's best kept secrets and its biggest exporter, accounting for just over two percent of the nations near seven billion dollar export earnings.

In the world market now control 20 percent in the solid tyre and about five percent in the industrial tyre markets are hold by Loadstar (Pvt) ltd, Loadstars closest rival in the global solid tyre market is Sweden's Trelleborg & the 250-million dollar firm was working with top management consultancy McKinsey and Company to fine tune operations and ensure a firmer grip on the global tyre market. Loadstar makes industrial and construction tyres, rubberized tracks, wheels and rims at its Sri Lanka facility, catering to buyers in the United States, Europe, Australasia, Africa and the Middle East.

Working across five plants situated close to rubber producing areas in Sri Lanka, the company turns out about 6,500 tyres daily for heavy equipment firms such as Caterpillar, JCB, Komatsu, Fiat, Yale and John Deere.

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Loadstar is also making rubber tracks to replace the steel traction chains used in heavy earth-moving equipment.

The company's 5,600 staff produces one of the biggest construction tyres in the world, with a diameter of seven feet (two meters) and weighing about 800 kilograms (1,760 pounds).These giant construction tyres are very costly to make due to high labour involvement because it is made using manual methods At its plant in Kotugoda, 18 kilometers (11 miles) from the capital Colombo, the male-dominated workforce handles complex machinery to make all sizes of solid and air-filled tyres. Another plant nearby uses around 48,000 tons of steel annually to churn out heavy duty steel rims to fit customer designs. Manufacturers such as Toyota, Nissan and Komatsu prefer to buy fully assembled wheels with flaps, tubes and tyres that can be directly used in their vehicles.

3.3

Joint Venture Partners

Loadstar (Pvt) Ltd. (LPL) was incorporated in 1984, as a joint venture between the Jinasena Group of Companies (JGC) in Sri Lanka, and Solideal Ltd. (SDL) of Belgium. The joint venture has brought together the proven engineering and management skills of the JGC with the technical know-how in tire design and production as well as the capability to market the product globally brought in by SDL. Solideal is dedicated to serving the tire, wheel and rubber track needs of the world's material handling and construction industries. Headquartered in Luxembourg, Solideal has R&D facilities based in Europe and Asia, manufacturing sites in Europe, North America and Asia, and over 100 distribution and service locations throughout the world.

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As per the joint venture agreement entered in to between the partners, the local collaborator largely handles the production and the engineering functions of the operations while the foreign collaborator handles the designing and the marketing functions of the products. Camoplast Inc. is a Canadian privately-owned company that is composed of two groups; Camoplast Tracks & Systems (headquartered in Magog, Quebec, Canada) and Camoplast Polymer Solutions (headquartered in Sherbrook, Quebec, Canada) employing 1,400 people worldwide. Camoplast Tracks and Systems is a world leader in rubber tracks and systems. It has R&D facilities based in Canada and Korea and manufacturing sites in United States, Canada, Korea and Europe. Camoplast Polymer Solutions is a North America leader in under-the-hood components mainly, engine covers, bottles and air ducts. It is headquartered in Sherbrook with R&D centers in Canada and manufacturing sites in Canada and United States.

The integrated company is operating under the name of Camoplast Solideal Inc. with a significant participation of the current shareholders of Solideal in the ownership of the company. Solideal and Camoplast brands are continuingly to be managed independently.

Camoplast Solideal Inc is operating R&D and manufacturing facilities in North America, The acquisition generated significant synergies and flexibility in purchasing, manufacturing, logistics and in R&D.The two companies are developing integration plans that build on the cultural similarities, respective strengths, and the best business and product development practices.

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3.4

Production Facilities.

The organization is having eight locations with different production facilities. All production facilities are located in Ekala Ja-Ela except two factories at Midigama and Kuruwita. 3.4.1 Ekala Tire Division LPLs first production unit was established in Ekala, and is referred to as Ekala Tire Division (ETD). It was an old factory that was used to assemble motor scooters. This was converted into a Solid Tire Manufacturing plant. This factory premise is 4.5 hectares in extent and presently, has the capability to produce 120 MT of Solid Rubber tires for a day. 3.4.2 Kotugoda Tire Division

The next factory to be commissioned was the Kotugoda Tire Division (KTD), in 1992. KTD was initially intended to be a production facility solely for Pneumatic Tires. With ETD reaching its maximum output, and the healthy growth in demand for solid tires, solid production lines too were brought into KTD. As at to date, production at KTD averages at, 45 MT of Solid Tires and 60 MT of Pneumatic tires per day. KTD is an ISO 14001:2004 and ISO 9001:2000 certified facility. 3.4.3 Central Mixing Plant

The Kotugoda complex also houses the new Central Mixing Plant (CMP). This is a fully computerized state-of-art mixing plant, and is the only one of its kind in the country. It has the capacity to mix over 310 MT of first stage compounds per day. This production unit has obtained ISO 14001:2004 and ISO 9001:2000 certifications as well. 3.4.4 Kyoto Metal Products Division (KMPD)

KMPD Commissioned in the year 2003. Kyoto Plant was acquired from Minebea Co., which was situated in the city of Kyoto, Japan. This is a completely automated unit
28

consisting of ten production lines. This production unit has obtained ISO 14001:2004 and ISO 9001:2000 certifications as well. Kyoto plant is situated in the Ekala Industrial Park. 3.4.5 Midigama Tire Division

This factory which is identified as MTD is situated in Deep South in Midigama in a land covering over 18 hectares. MTD, which was commissioned in 1998, is the most technologically advanced of the companys tire production units. The complex consists of the factory, staff accommodation, a six hectare rubber plantation and a Worker Facility Building. MTD presently has the capacity to produce 55 MT/day of Solid Rubber Tires and 80 MT/day of Pneumatic Tires. MTD also produces Rubberized Tracks for construction and presently runs at a capacity of 30 MT/day of tracks. LPL is one of the 4 companies in the world that has the technology to produce rubber tracks. MTD is also an ISO 14001: 2004 and ISO 9001:2000 certified facility. 3.4.6 Casting Factory

Commissioned in year 2007, this is the latest addition to Loadstar family. The factory is situated in Kotugoda and is one of the most technologically advanced casting factories in south Asia. The main product of this factory is metal piece, a primary component used in manufacturing rubberized tracks in Midigama Track division. At the moment these parts are imported, mainly from china and the level of quality of such imported metal pieces have not been satisfactory. With this new addition, Loadstar expects to manufacture its metal piece requirement.

29

3.4.7

Orex Tire Division

Orex is the latest addition to the loadstar family. The factory was commissioned in year 2008 at a total cost of Rs 195Mn and is located at the heart of the Ekala city. Currently the facility encompasses three projects. They are; Day-light project, Injection moldings project and T10 project. Currently is has a daily production capacity of 27 MT/Day. 3.4.8 Rubber Collecting Canters

LPL consumes about 70% of the total annual sheet rubber production in the country. In order to ensure that the company collects rubber in adequate quantities at prices that are attractive to the producers, LPL has set up fifteen rubber collecting centers covering six major rubber producing Districts There are 18 rubber collection centers. 3.4.9 Research and Development

The company has also established a fully equipped, dedicated Research and Development facility that has contributed to the continuous development of the product performances. This facility employs highly qualified and experienced Rubber technologists and engineers.

30

CHAPTER FOUR

DESIGN AND METHODS (OR METHODOLOGY) 4.1 Introduction

In carrying out the study the following sequence of activities have been followed: Figure 04: The methodology
Examination of the present costing system

Determining an appropriate costing system

Developing ABC model and Data and Information gathering

Analysis of information

Data arrangement and Presentation

4.2

Examination of the Present Costing System

The present costing system was examined thoroughly to determine the weaknesses in relation to costing the existing product mix. Special attention was drawn on the total

31

overhead charged to final products level and total weight of the tires produced, as volume is currently used as the absorption basis. Different categories of cost elements were examined to verify their relevance in terms of applicability and amount to the Central Mixing Plant. Buyers expected prices for the tires were compared with companys prices to determine the magnitude of variations. The organization uses absorption costing system to allocate total labour and other factory overheads to different types of tires. Factory overhead and labour form a significant part of the total cost but cannot be directly identified as a number of products are being manufactured at present. The divisions product portfolio includes many different products which differ in production process times even though the appearance is same. Figure 05: Present Product Costing System Other Factory Overhead

Labour Costs

Allocation Rubber And other materials 4.2.1 Determination of Current Overhead Tires

Unlike Direct Materials, it is not possible to identify directly the overhead cost that goes into different types of compounds. The production process is such that the same employees and machines manufacture multiple types of compounds making it impossible to identify separately the overhead cost per type of compounds.

32

In addition to production and other overheads in Central Mixing Plant, a part of Head Office Overheads are apportioned to CMP, without using a scientific basis. The monthly allocation for CMP of head office expenses is Rs. 8 Mn. As part of this project and for the costs to be more meaningful, head office expenses were decided to apportion using suitable bases. In addition to the allotted head office expenses of Rs. 8 Mn, the divisions other overheads for an average production of 7800 tons per month is roughly Rs. 41 Mn. Therefore total overheads of the company per month roughly account for about Rs. 49 Mn, for an average production of 7800 tones. This calculates to be about Rs. 6/28- per 1 kg of compound production. 4.2.2 Overhead Absorption Rate

The divisions overhead absorption rate per 1 tons of compounds, assuming a total volume of 7800 tones is therefore Rs. 6,282. Overhead absorption rate = Total overhead per month Compound Volume = 49,000,000 7,800,000 = Rs. 6/28- per Kg (Rs. 6,282 per ton)

4.2.3

Product Pricing under Present Costing System

Based on the calculated overhead absorption rate, the product cost can be calculated by applying a 2% profit mark up. The other cost, which is direct material, is easily obtainable
33

through the system. Table 4 gives the prices of four (4) types of compounds under the present system of absorption costing. Table 01: Product Prices in Rupees under Present System

4.2.4

Strengths and Weaknesses of the Present Costing System

The followings have been identified as strengths of the current costing system. Easy to understand, compute and operate The following weaknesses have been identified in relation to the present costing system: Overhead absorption is based on the compound volume produced and not considering the complexity of the products. This is not acceptable as an accurate method to allocate overhead cost. The total overhead does not include a proper apportionment of overhead costs incurred by head office, which performs the majority of financial and administrative functions and all import and export activities. Other input divisions cost has not been taken into consideration

34

4.3

Determination of an Appropriate Costing System

Having analyzed the present costing system and after discovering its drawbacks, other costing systems such as Activity Based Costing, Marginal Costing were studied to find out the best costing system for the CMP. The Marginal Costing method was not considered as it does not allocate fixed overheads to products and thus makes it difficult to calculate a total cost on which to apply a 2% Margin to calculate the price. The Companys agreed pricing arrangement makes it difficult to apply the Marginal Costing Method. In an ABC system, overhead are traced to output through activities. This reduces the effect that variations in production volume has on the allocation of costs, allowing product costs to be determined more accurately. Therefore, an Activity Based Costing System was found to be the more suitable costing system under the circumstances since it provides more accurate cost information on individual products than any other costing system. 4.4 Developing the ABC Model and Data Gathering

When develop the ABC model for the selected area there were some activities involve these include from cost center defining to final rate calculation and the following sub headings discuss the each activities in detail 4.4.1 Defining Cost Elements / Activities

As the first step in the process of implementing ABC system, cost elements / activities were identified by reviewing financial statements, organizational charts, facility layouts, and discussing with employees. Table 2 gives details of such activities performed by the CMP.

35

Since the objective was to improve the existing system as it was relying on inaccurate absorption costing method to determine overhead cost and thereby product cost, the selected activities were thought to be adequately representing the complexity of the whole operation. When identifying activities the key objectives were to identify resource required to perform each activity for the expected volume of 87,550 tones of compounds annual demand. 4.4.2 Identify Organizations Cost Centers and Assign Activities / Cost Elements

As indicated in table 2, with regard to each cost element / activity the relevant departments or cost centers were identified. This was possible by looking at the information available in the system and by studying the nature of each expense. Based on the nature of each expense, the method of allocating it among cost centers were determined. Table 02 Cost Elements / Activities and Cost Drivers
Cost Center Cost Driver

Cost Element / Activity

Salaries and Wages

Maintenance,

Production

Control,

Product

Designing,

Quality

Ownership

Assurance and Safety, Stores,

Building, Machinery, Tools and equipment, Fittings, Furniture Office and

Maintenance,

Production

Control,

Product

Designing,

Quality

Based directly system

on

figures the

Assurance and Safety, Stores,

from

Equipment

Depreciation

Stationery

Maintenance, Production Control, Product Designing, Quality Assurance and Safety, Stores, Research and Development, Factory Overhead,

Actual consumption data

Electricity

Maintenance,

Production

Control,

Product

Designing,

Quality

KWH consumption in main production machineries.

Assurance and Safety, Stores, Research and Development, Factory Overhead,

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Cost Element / Activity

Cost Center

Cost Driver

Consumables

Gloves, other large items in small quantities.

Actual in production line level.

Central head office cost

General Administration

Head

Count

and

production ratio

Security, Welfare,

Legal, Medical

Cleaning, Insurance,

Maintenance,

Production

Control,

Product

Designing,

Quality

Head Count Ratio

Assurance and Safety, Stores, Research and Development, Factory Overhead,

Bus transport, Training

Subscriptions, License Fees

Factory Overhead

Ownership

Furnace Oil

Boiler

Ownership

Workmen Insurance

Compensation

Maintenance,

Production

Control,

Product

Designing,

Quality

Basic Salaries

Assurance and Safety, Stores, Research and Development.

Mobile Telephone cost

Factory Overhead, Production Control, QA and Safety, Product Designing, R & D, Maintenance, Stores

Ownership

Fixed Line Telephone

Factory Overhead, Production Control, QA and Safety, Product Designing, R & D, Maintenance, Stores

Ownership

Vehicle Hire

Factory Overhead

Ownership

Fuel

Factory Overhead, Maintenance, Stores

Ownership

Building Insurance

Maintenance,

Production

Control,

Product

Designing,

Quality

Square Footage

Assurance and Safety, Stores, Research and Development, Factory Overhead.

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4.4.3

Relationship between Overheads, Cost Centers and Cost of Final Product

It is important to understand the relationship between different overhead costs, the ownership of those expenses i.e. to which departments they belong and how they flow from one cost center to another to have a holistic view of the entire costing system. Before calculating overhead cost under ABC, it is very important to understand the relevant overhead costs, the cost centers and the flow of cost between the cost centers. Overhead costs at CMP are mainly categorized in to two: Directly attributable costs and Specific Assignment costs. The cost centers are of four types: Type 1: General Administrative cost centers Type 2: Production services cost centers Type 3: Production cost centers 4.4.4. Directly Attributable Costs Directly attributable costs can be directly allocated to respective departments without the help of an apportionment basis. After going through information in the financial statements and the Information system several directly attributable overhead costs in the CMPs cost structure were identified. The department incurring these overhead costs could be clearly identified with the information available. These costs are namely; Salaries and Wages, Subscriptions, License Fees, Telephone Cost, Fuel and Vehicle hire charges. 4.4.5 General Administrative Cost Centers

The costs of administrative support cost centers such as General Administration (head office allocated cost) are apportioned to production cost centers.

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These are centers which provide services to other cost centers. In the CMP the main service centers are maintenance, Factory Administration and stores. The costs of these centers can be traced to other cost centers using a suitable basis. E.g. the cost of maintenance can be traced to operating and administrative cost centers based on hours spent for each cost center. 4.4.6 Production Services Cost Centers

The overhead costs of operations support cost centers cannot be directly charged to the products or operating cost centers. Production control, Product Designing, quality assurance and safety, & R &D are included under this category. These are service activities and perform a function similar to service cost centers but more towards operating activities. However, it is not possible to measure directly the contribution of each cost center towards the main operating activities. For example even though it is known that production control personnel spends time on each of the operating activities, it is not practicable to measure the exact time spent on each of the operating activities. 4.4.7 Operating / Production Cost Centers

Operating activities directly work on the products of the organization. The operating activities are processing, handling. Costs of these activities directly flow to the cost objects; i.e. the compounds.

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4.5

Analysis of Information.

Under this sub topic the data collection,grouping of these collected expenses to Directly Attributable Costs and specific assignment cost is done.The specific features of these costs also identified. 4.5.1 Data Collection

Various methods have been used in data collection. General ledger analysis and other records available are used in gathering data. When such records are not available informal chats with the experts on the subject have been done. Based on their views reasonable estimates have been made. The gathered data are allocated to various cost centers using several drivers. 4.5.2 Collection of Directly Attributable Costs

Payroll information was obtained from the human resources department and the finance department. The data include head count by employee category, basic salary, working hours, overtime hours and rate, employee benefits such as employers provident fund contribution, trust fund contribution, leave pay, entertainment allowance and annual bonuses. All the employees are assigned to various cost centers based on the work they perform. The information on other directly attributable costs was obtained by going through the information in the financial statements and Information system. 4.5.3 Collection of Specific Assignment Costs

Data relevant to specific assignment costs are obtained by scrutinizing the general ledger information and other schedules available. Both the fixed costs and variable costs are included under specific assignment costs. Building depreciation, Security, Legal, Cleaning, Medical Insurance, Bus transport, Training and Building Insurance are such fixed expenses that do not vary with the level of operation in the CMP. On the other hand
40

consumables, electricity, stationary, staff welfare, workmen compensation insurance are variable expenses which vary with the level of operation. Square footage of the building and various cost centers is obtained by referring to the building plan and plant lay out plan. When such information is not available for a particular area physical measurement is done. Building cost and equipment cost is obtained by referring to the asset schedule and general ledger. The costs of consumables, electricity, stationery, transport, staff welfare, insurance, and other expenses are obtained by referring to the general ledger, various schedules, and discussing with knowledgeable employees in each area

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CHAPTER FIVE

DATA AND INFORMATION ANALYSIS 5.1 Introduction

Chapter five discuss about the cost categorization based on the nature of cost. Schedules of direct cost and the schedules of service cost are explained in detail. Defining of primary cost allocation basis and Identification of cost drivers are explained. Calculation of overhead absorption rate data arrangement and presentation is explained. 5.2 Cost Categorization

All cost has been categorized into groups according to the nature of the cost and under each cost center level all above cost groups can be identified. The cost center breaking has been done based on the types of the activities performed by each division. Followings are the list of cost groups identified. a. Salaries and wages b. Other staff related expenses c. Electricity d. Rent e. Consumables f. Maintenance g. Production expenses h. Office expenses i. Fees and charges

42

j. Transport Expenses Above expenses categories are reported in 9 cost centers and these cost centers comprise one general service cost center, 5 production service cost centers and 3 direct production cost centers. List of cost centers are as follows a. General admin cost center CMP General Services b. Maintenance and Modification CMP Production services c. Internal logistics CMP Production services d. Components planning and stores CMP-Production services e. CMP compounds common Production Services f. Chemical weighing CMP Production Services g. First stage mixing plant (3 Mixers) Production h. First stage mixing AMX04 (1 mixer) Production i. First Stage Mixing 5th Mixer (1 Mixer) Production

5.3

Directly attributable costs

The identified directly attributable costs such as Salaries and Wages, Subscriptions, License Fees, Telephone Cost, Fuel and Vehicle hire charges are apportioned in detail as explained by schedules marked from DA 1 DA 5. 5.3.1 Schedule DA-1: Salaries and Wages

There are 230 employees working in the CMP, which manufactures compounds for internal usage and exporting. In addition to their basic salaries the other costs relating to
43

salaries are also accumulated in this schedule. These costs include Employees Provident Fund and Trust Fund contribution by the company, Entertainment allowance, Travelling Allowance, Overtime, Leave Pay and bonus cost. The basic salaries and the head count information in each cost center was obtained by perusing financial statements and from information collected from Human Resource Department. From the same sources the entertainment and travelling allowance paid to eligible people working in each of the cost centers were identified. Leave pay was calculated assuming every employee on average saves about 7 days of annual leave to be entitled for payment. Bonus was taken as equal to one months basic salary. 5.3.2 Schedule DA - 2: License Fees

This is the payment made monthly for use of SAP licenses for administrative work. The cost per license is Rs. 150,000 and there are 4 licenses in use for administrative work. So, this cost is directly attributed to Factory Administration cost center. 5.3.3 Schedule DA 3: Telephone

The mobile telephone cost is directly attributed to respective cost centers based on the limit allowed for different individuals in each of the respective cost centers. The average fixed line telephone cost of relevant cost centers were identified by going through telephone bills received for individual lines. Based on the past bills, an average cost per month for relevant cost centers were identified. 5.3.4 Schedule DA 4: Personal Fuel & Vehicle hires charges

The personal fuel is allowed only for employees above Manager Level. For the employees at each cost center, the respective fuel allowance is obtained from Human Resource department and the cost is calculated assuming the cost per liter of Petrol will remain the same during the next 12 months.
44

The rent of the vehicle given for use of Managers, senior managers and General Manager is charged to Factory Administration cost center. 5.3.5 Schedule DA -5: Stores rent cost & Insurance

Stores are in a rented premise situated closely to central office. The monthly rent cost of the said building is directly allocated to Stores cost center, Building insurance is apportioned among respective cost centers based on their use of building space. In other words, the apportionment is based on the square foot used by each cost center and is similar to the basis used to apportion building depreciation. 5.3.6 Schedule DA6: Depreciation

Depreciation includes depreciation of building and other fixed assets such as plant and machinery, tools and equipment, furniture and fittings and office equipment. Building in which CMP operations are carried out is nearly 12,000 Square foot in size and depreciated at an annual depreciation rate of 2%. The building depreciation cost is assigned to all cost centers based on their square foot usage of the building. Since store is in a separate rented building, building depreciation is not apportioned to stores. Factory floor plan is used to obtain square foot information and where necessary physical measurement was done to determine the areas occupied by each cost center. 5.3.7 Schedule DA 7: Factory Supplies

Estimated Factory supplies cost based on general ledger information is apportioned among relevant cost centers using the % of consumption of factory supplies by the cost centers as revealed by past data.

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5.3.8

Schedule DA -8: Head Office Allocated Cost

The head office costs such as Finished goods transport, general training, administration, finance, directors cost, and the costs incurred by central departments such as Information technology, Strategic planning, Central HR, Central R & D, Central Welfare and Security are apportioned to CMP using more than one basis. At the moment, a fixed amount of Rs. 12 Mn is apportioned to CMP, out of total head office costs. To allocate the above mentioned head office costs the following bases were used: Finished Goods transport is incurred by the head office. The amount incurred in transferring the finished goods of CMP is directly charged to CMP Training, General Administration, Information technology, Strategic planning, Central human resource, welfare and security cost are apportioned based on the head count. Directors cost and Central R & D cost is apportioned based on Production. Finance cost is apportioned based on raw material inventory value and fixed assets investment at CMP at the weighted average interest rate 5.3.9 Schedule DA 9: Security Cost & Legal Cost

The average monthly security cost of CMP is apportioned among respective cost centers based on the percentage of head count in each department. The average monthly legal cost of CMP is apportioned among respective cost centers based on the percentage of head count in each department. 5.3.10 Schedule DA 10: Cleaning Cost The average monthly cleaning cost of CMP is apportioned among respective cost centers based on the percentage of head count in each cost center.

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5.3.11 Schedule DA 11: Welfare Cost, Medical Insurance & Training The average monthly welfare cost of CMP is apportioned among respective cost centers based on the percentage of head count in each cost center. The average medical insurance cost per month is apportioned among respective cost centers based on the percentage of head count in each cost center. The average training cost per month at CMP is apportioned among respective cost centers based on the percentage of head count in each cost center. 5.3.12 Schedule DA 12: Workmen compensation insurance Workmen compensation insurance is related to employees basic salaries. From the information obtained through financial accounts, Human Resource department and consultation with the insurance company it was identified that the maximum compensation paid for an unfortunate accident per month is Rs. 140,000/-. Also from the financial accounts the insurance premium paid for workmen compensation was identified as Rs. 1,300,000 for the entire company during the last financial year. 5.3.13 Schedule DA 13: Bus Transport Cost This is the cost incurred to transport employees from CMP to defined destinations and back. The employees who are not provided fuel allowance in respective cost centers is assumed to be taking the benefit of this facility. Therefore average monthly transport cost is apportioned among respective cost centers based on number of employees in each cost center who is benefitted by this facility.

47

5.3.14 Schedule DA-14: Electricity The average electricity cost per month in each department is calculated taking into account electricity consumption of lights, computers, air conditioners and machines used in each center. 5.4 Allocation Schedules

The allocation schedules are used to allocate the accumulated costs of service, administrative and operational support cost centers among the operational cost centers. 5.4.1 Schedule SC-1: Factory General Administration Overhead

The total overhead cost of factory administration cost center is apportioned among other cost centers considering the number of employees in each cost center. There is no cost remaining in the general factory overhead. 5.4.2 Schedule SC-2: Component Panning and Stores overhead Cost

The total overhead cost of stores is apportioned among other cost centers excluding factory administration, based on the average number of stores requisitions per month by each cost center. 5.4.3 Schedule SC 3: Maintenance & Modification Cost

The overhead cost of maintenance cost center is apportioned among other cost centers based on the time spent by the maintenance personnel. By discussing with the maintenance and other departmental managers the percentage of time spent by maintenance staff in other departments is estimated. The percentage so arrived is used to distribute the costs accumulated at maintenance. The total available time of all the maintenance employees is calculated and then reduced by 12% to accommodate for nonproductive time.

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5.4.4

Schedules SC 4: Internal Logistics & first stage chemical weighing Overhead Cost

The overhead costs of operational support cost centers; Maintenance and Modification, Internal logistics CMP,Compounds planning and stores,CMP compounds common, Chemical weighing CMP are apportioned to production cost centers based on the production tonnage in production cost centers. 5.4.5 Schedule SC -5: CMP Common Cost

General administration overhead cost too is apportioned among production cost centers based on the percentage of overhead cost in each cost center after apportioning service department and operational support department costs. 5.5 Selection of the Absorption Method / Cost Drivers

Before calculating overhead cost per compound kg, it is necessary to first determine the most suitable cost driver / absorption basis to absorb overhead cost of each production cost center. For this purpose it consider the number of production cycles required for the annual production 5.6 Arrangement of Overhead Data into One Cost Pool.

After allocating all services cost into production cost centers there are still three production cost centers as below. CPX010 CPX040 CPX060 1st Stage Mixing Plant-CMP (3 Mixers) 1st Stage Mixing of AMX004 mixer (1 Mixer) 5th Mixer production

Without calculating separate rates to above three cost centers one common overhead rate is calculated.
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5.7

Per Production Pass Rate Calculation

Production pass is the number of production kg cycles in CMP production. Some compounds require two or more times processing while other may require only one cycle. Below schedule shows the production passes requirement taken for the forecast demand. Table 03: Calculation of annual production passes

Budgeted Annual Demand Loadstar Other Group Demand: China Camoplast (Canada) Plattsburgh - Snow Tracks Emporia - Agri Tracks Other (non- Group) Demand: Japan Total

Tonnage 76,954 3,675 2,170 4,331 420 87,550

"Tons x No Of cycles" (No of Cycles passes) 1.0 76,954 1.0 2.0 2.7 2.0 3,675 4,340 11,564 840 97,373

Using this production passes overhead cost per each type of compound is determined considering the number of passes taken for each of the compounds. The total cost accumulated in operating cost centers is divided by the total production passes available in each of the production cost center to arrive at the indirect cost rate. 5.8 Project Output and Outcomes

Final outcome of this project is the new overhead absorption rate to the products level. This part describes how the proposed rate used for the products pricing and finally a comparison is done with the cost calculated in preset system 5.8.1 New Overhead Rates under Proposed Costing System

Other important factor considered in this calculation is the available capacity constraints. As a result of the capacity constraints organization has to outsource some quantities from

50

the market available capacity. When outsource the processing the organization has to pay higher rate than the internal processing cost. The table 04 shows method followed to allocate the outsource capacity to the final compounds. Further it is proposed to use the outsourced capacities to cater the third parties requirements and some mixed method to associated companies. Table 04: Allocation of capacities to the different requirements

Allocation of Available Capacity / Outsourced Requirement to Demand Demand ("tons x Available Outsourced cycles") Capacity Requirement Loadstar 76,954 76,954 Other Group Demand: China 3,675 3,254 421 Camoplast Plattsburgh - Snow Tracks 4,340 3,843 497 Emporia - Agri Tracks 11,564 10,239 1,325 19,579 Other (non- Group) Demand: Japan 840 97,373 17,336 0 94,290 2,243 840 3,083

As identified in table 04 the capacity is allocated to each customer level. When allocate the available capacity first priority has been given to the internal demand and the balance capacity is allocated to the other demands.

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Table 05:

Calculation of Different rates for internal processing and outsourcing.

Interna l Cos t Out Sourced cos t (LKR) (LKR) 37,705,576.85 173,132.10 197,907,856.31 7,194,115.71 79,371,207.18 43,818,161.53 2,344,000.86 46,549,827.00 5,549,686.06 374,063,736.60 46,549,827.00 94,273,028.53 2,641,377.39 58,502,750.32 38,776,725.18 4,436,560.30 198,630,441.72 572,694,178.32 97,616,363.02 70,472,784.28 165,257,484.24 906,040,809.86 94,290.00 9,609.09 9.61

Variable Cost 01 - SALARIES AND WAGES 02 - OTHER STAFF RELATED EXPENSES 03 - ELECTRICITY 04 - RENT 05 - CONSUMABLES 06 - MAINTENANCE 08 - PRODUCTION EXPENSES 09 - OFFICE EXPENSES 11- FEES AND CHARGES 12- TRANSPORT EXPENSES Tota l Va ri a bl e Cos t Fixed Cost 01 - SALARIES AND WAGES 02 - OTHER STAFF RELATED EXPENSES 03 - ELECTRICITY 04 - RENT 05 - CONSUMABLES 06 - MAINTENANCE 07 - DEPRECIATION 08 - PRODUCTION EXPENSES 09 - OFFICE EXPENSES 11- FEES AND CHARGES 12- TRANSPORT EXPENSES Total Fixed Cost Total Centra l Servi ces Cos t Anci l i a ry Products Di vi s i on Cos t Fi na nce Cos t Total Cost Number of Pa s s es i n Tons Cos t per pa s s es (Per Ton) Cos t per pa s s es (Per Kg)

46,549,827.00 1,299,919.82 2,264,507.02 50,114,253.84 3,082.77 16,256.24 16.26

Table 05 shows the calculation of overhead rates for internal processing and the outsourcing after allocating all relevant cost to internal processing and outsourcing. According to the calculations internal processing cost per pass is 9.61 LKR and outsource cost per pass is 16.26 LKR. The above two rates are used for the average rate calculation in three situations vis full demand is cater by internal processing, both internal and outsourced capacity are used in

52

some composition and where total demand is catered by using the outsource capacity. This calculation is shown in table 06. Table 06: Inclusion of outsource cost to final rate, based on the capacity allocation.

Allocation of Available Capacity / Outsourced Requirement to Demand Demand Out Sourcing Available Outsourced Internal Cost Average ("tons x CostCost Capacity Requirement (LKR ) Rate (LKR) cycles") (LKR) Loadstar 76,954 76,954 739,457,678 9.61 Other Group Demand: China 3,675 3,254 421 31,268,206 6,843,477 10.37 Camoplast Plattsburgh - Snow Tracks 4,340 3,843 497 36,926,262 8,081,821 10.37 Emporia - Agri Tracks 11,564 10,239 1,325 98,388,664 21,533,713 10.37 19,579 17,336 2,243 Other (non- Group) Demand: Japan 840 0 840 13,655,243 16.26 97,373 94,290 3,083 906,040,810 50,114,254

The new overhead rates under ABC system was applied to different type of compounds considering the number of cycles required by each type of compounds. Based on the new overhead rates and time consumed by each compound the new overhead cost per compound is calculated as given in table 07. Table 07: Calculation of new overhead cost per kg for different types of compounds.
No Of Cycles OH Per Cycl e Cos t (LKR) per Kg 1.0 9.61 1.0 2.0 2.7 2.0
10.37 10.37 10.37 16.26 OH Cos t Per Kg (LKR) 9.61 10.37 20.74 27.69 32.51

User Loadstar Other Group Demand: China Camoplast Plattsburgh - Snow Tracks Emporia - Agri Tracks Other (non- Group) Demand: Japan

5.8.2

Final Costing / Pricing under Proposed Costing System

The LKR price per each type of compound, after implementing ABC and under the previous method is compared in table 08.

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Table 08:

Price Calculations for different types of compounds in LKR.

Chinese Compounds Japanese Compounds Plattsburgh - Snow Tracks Emporia - Agri Tracks Present Proposed Present Proposed Present Proposed Present Proposed 372.23 372.23 324.29 324.29 541.23 541.23 409.82 409.82 7.44 7.44 6.49 6.49 10.82 10.82 8.20 8.20 4.50 4.50 5.50 5.50 4.50 4.50 4.50 4.50 6.28 10.37 6.28 32.51 6.28 20.74 6.28 27.69 7.81 7.89 6.85 7.38 11.26 11.55 8.58 9.00 398.26 402.44 349.41 376.16 574.09 588.84 437.37 459.21

Cost Details Raw Material Cost Wastage Packaging OH Margin Total Cost Per Kg

Below is a comparison of the prices under previous and ABC methods compared to prevailing market prices. Table 09: Comparison of proposed and price and the market price.
Proposed Price LKR 402.44 376.16 588.84 459.21 Market Prices LKR 729.00 709.00 849.00 829.00

Chinese Compounds Japanese Compounds Plattsburgh - Snow Tracks Emporia - Agri Tracks

According to the table 09 the company still provide a competitive prices than the market prices 5.8.3 Comparison of total overhead absorption Present and Proposed Costing System Under the previous method of absorbing overhead at Rs. 6/58- kg of compound, the overheads are under absorbed by a total of Rs. 575.6 Mn while under ABC; the total overhead cost absorption is Rs.956.15 Mn. The main reason for the correct absorption of overheads is the consideration given on the complexity when calculating the overhead rates to each type of compounds.

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CHAPTER SIX

DISCUSSION AND CONCLUTION 6.1 Introduction

Chapter six explains the details of analysis of information, grouping of the data for better analysis, allocation schedules and arrangement of overhead into cost pools. The final overhead allocation rate calculation, arrangement and presentation are explained in detail. The master summary and the project outcome are explained in detail in this chapter. 6.2 Selection and Application of Applicable Theoretical Framework

When selecting the appropriate theoretical frame for application it is more important to select the methodology which suits with the practical environment. Cooper has highlighted the requirement for activity-based costing system for the firms with high level of competition and having diverse product mix. The requirement of new system has been emphasized by identifying the limitations of the traditional costing systems in overheads cost allocation basis. As Foster and Swanson ABC and its application also as important as a costing system to an organization as it is having the number of applications. This multiple applications further increase the validity of ABC as a cost and management system for the modern environment. When analyze the ABC it has evolved during last three decades with various amendments to match with the business environmental changers. With the recent development i.e. Time Driven Activity Based costing (TDABC) it has given more concern about the time. All complexities have been built to time to some extent. Most of the aspects in TDABC have been adapted to this selected scenario at Loadstar (Pvt) limited.
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6.3

Defined the Scope

When define the scope of the projects the project writer concern about the scale of the overall business organization, complexities in business operations,inter relationships among various divisions in the organization,accessability to the data and the time constraint were taken into consideration. The above factors were led to scale down to the projects into CMP that is a one division of the selected organization. High fluctuations in the market conditions, complexity in the business process, frequent process changers in the business make the project writer to select the budgeted data without going to actual data. 6.4 Facilities in the ERP system and their application

The ERP system in the organization is SAP and more of sophisticated solutions are available as embedded facilities in this system. SAP specialists were involved for this project. The testing environment in the system was used for the testing of the activities. In some instances the basic designed methodology had to be changed to align with the available facilities in the SAP. Detail break down of the final overhead rates stage level OH monitories were specially affected by these restrictions. 6.5 Achievement of the identified objectives

In this exercise the cost related with different activities were identified and separate monitoring of the APD, central costing and other related cost were done. With the expansion of the organization business activities there could observe the substantial number of transaction between these groups of companies. The accurate and rational transfer pricing requirement is essential. With this exercise the company can calculate accurate transfer pricing between the related parties.

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All above rates were calculated by using the budgeted cost data and the standard processing parameters. At the end of specific time period the operational parameters and the budgeted target achievements could be monitored. The divisional cost performances were measured by calculating the overhead under or over recovery for a time period. The achievement of the target production level and the cost parameters can be monitored by using the overhead recovery report. This report can be seen as a inter link between the operation and cost data. 6.6 Overall Benefits to the Organization

ABC method can bring many benefits to the organization as it will give correct indication about the companys products. The correct cost data provides facility to identify the company products situation compared with the market prices. Followings can be listed as benefits among the large amounts. 1. Calculation of the true total product cost 2. Improvement of the decision making process in relation to product costs 3. Identification of activities cost 4. Identification of the factors that are responsible for cost creation 5. Cost reduction and Overhead decrease 6. Analysis and control of product profitability 7. Cost accounting system update in order to be more accurate 8. More accurate indirect cost allocation to products 9. More realistic budget preparation 10. Improvement of departments performance measurement 11. Abolition of loss making products 12. Improvement of activities performance

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13. Improvement of activities management efficiency 14. Improvement of the decision making process in relation to preservation or discontinuance of activities 15. Improvement of products quality 16. Identification of loss making customers and suppliers 17. Adjust pricing policy as to apply to increased product mix complexity 18. Attainment of synergies with Total Quality systems 19. Changes of product mix in order to better suit to customer needs from a value for money perspective 20. Improvement of outsourcing decision procedures 21. Improvement of customers management efficiency 22. Attainment of synergies with Just in Time systems 23. Motivation of the personnel that deals with cost accounting 6.7 Conclusion

According to project, the implementation of ABC systems in a manufacturing enviornment is excessively detailed as it requires a medium number of cost drivers and calculate the cost of a rather small number of activities. However, ABC adoptation to an organization have actually gained the benefits expected from ABC systems, the most important of which is the calculation of the true total product cost.The improvement of the decision making process in relation to product costs, the identification of activities cost, the determination of the factors responsible for cost creation, cost reduction, as well as the improvement of the analysis and control of product profitability. Furthermore, the problems encounted in ABC adoptation process encountered during ABC implementation process seem to be of medium severity.

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As far as the some parties involved in the process of implementation do not consider ABC as a future possibility and some parties include ABC implementation have different views regarding the extent to which they are satisfied with their current cost accounting system and the vacuum filled by the ABC.

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References 1. Anderson, S. W. and M. Young (1999), The impact of contextual and process factors on the evaluation of activity-based costing systems, Accounting, Organizations and Society, Volume 24, 2. Brown, D., P. Booth and F. Giacobbe (2001), Organizational influences, ownership, and the adoption of activity-based costing in Australian firms, University of Technology, Sydney, School of Accounting, Working Paper No. 46, June 3. Cooper, R. (1988a), Cost management concepts and principles: the rise of activity based costing part one what is an activity-based cost system, Journal of Cost Management, March, 4. Cooper, R. (1988b), The rise of activity-based costingpart two: when do I need an activity-based costing system?, Journal of Cost Management, Summer. 5. Cooper, R. and R. S. Kaplan (1991), Profit priorities from activity-based costing, Harvard Business Review, May-June. 6. Cooper, R. and R. S. Kaplan (1992), Activity-based systems: measuring the costs of resource usage, Accounting Horizons. 7. Cooper, R. and R. S. Kaplan (1998), Cost and Effect, Boston, Harvard Business School Press 8. Foster, G. and D. G. Swenson (1997), Measuring the success of activity-based cost management and its determinants, Management Accounting Research. 9. Kaplan, R. S. (1992), In defense of activity-based cost management, Management Accounting (US), Nov. 10. Malmi, T. (1997), Towards explaining activity-based costing failure: accounting and control, in a decentralized organization, Management Accounting Research,

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11. Malmi, T. (1999), Activity-based costing diffusion across organizations: an exploratory empirical analysis of Finnish firms, Accounting, Organizations and Society, Volume 24, Issue 8. 12. McGowan, A. S. and T. P. Klammer (1997), Satisfaction with activity-based costing cost management implementation, Management Accounting Research, 9. 13. Shields, M. (1995), An empirical analysis of firms implementation experiences with activity-based costing, Journal of Management Accounting Research, 9. 14. Joon Jong No and Brian H. Kleiner,(1997)How to implement activity-based costing 15. Jamaliah Abdul Majid, Maliah Sulaiman,(2008)Implementation of activity based costing in Malaysia 16. Robert S. Kaplan, Steven R. Anderson (2007),Time Driven Activity Based Costing 17. Prem Sikka, Hugh Willmott,(2010)The dark side of transfer pricing: Its role in tax avoidance and wealth retentiveness 18. Herbert Snyder, Elisabeth Davenport, (1997) what does it really cost? Allocating indirect costs 19. Supitcha Morakul, Frederick H. Wu,(2001), Cultural influences on the ABC implementation in Thailands environment

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