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Introduction
The Shetland Wool Company is a small family-owned business that manufactures very high-quality hand-knitted wool sweaters. The company owns an office where all operations not related to the manufacturing process are conducted. On the other hand, the production process is not centralized as employees work from their homes. Finished sweaters are purchased by the exclusive outlets in small numbers. However, the managers are generally not satisfied with the businesss performance and suspect that the problem may be with the applied methods of costing and chosen pricing policies. For this reason, they first analyzed the companys variable and fixed costs that can be seen in Table 1, and now seek to determine the new expenditure evaluation strategies.
For the current year, the numbers of variable and fixed costs are equal to £198 per product and £340,000 respectively. However, for the next years forecast, the companys sales director wants to significantly increase the expenditures for advertisement from £115,000 to £285,000. He believes that such a strategy would eventually allow garment sales to surge rapidly and reach 5,000 products. Yet, this idea is opposed by the sales director, who predicts that 3,000 products sold are the upper-most limit that The Shetland Wool Company is able to achieve. Therefore, there is also a lot of disagreements in the top management regarding future production.
Table 1: The Companys Variable and Fixed Costs
As for the pricing policy before the company set the price that is two times higher than manufacturing costs at normal production volumes. Nevertheless, now the Managing Director considers using the marginal costing method to determine expenses and future price. As for the latter, the Managing Director plans to sell the goods at the prices a little bit higher than the marginal cost. In this regard, the current report seeks to address the issues that The Shetland Wool Company encounter concerning determining product costs and pricing.
Costing Methods Overview
Costing methods differ in the way they arrange and consider various material and non-material expenditures. Each of them has its own advantages and disadvantages and, thus, is usually chosen based on the specific needs. The factors that affect the choice may include managers personal preferences, the type of industry that the company operates in, and the necessity to deliver long- or short-term decisions (Gersil and Kayal, 2016). As such, there are three costing methods that The Shetland Wool Company can use, namely marginal costing, standard costing, and absorption costing.
Marginal Costing
Marginal or variable costing is an accounting method that allows the company leaders to make better short-term decisions. At the core of this technique is a consideration of solely the variable manufacturing costs (Datar and Rajan, 2018). They include raw materials cost, labor cost, and variable overhead production costs (Mundung et al., 2020). Although variable costing is not used for external reporting, it is often included in internal reports.
Such popularity of this method is explained by its ability to provide new perspectives on the problems that such types as absorption costing fail to do. In this respect, Corporate Finance Institute (n.d.) maintains that because managers sometimes blindly rely on the latter accounting technique, they can overlook certain opportunities. For instance, consider that the companys total costs, including fixed manufacturing costs, are equal to £600,000 when producing 1000 units of a certain good. Then, if the manager receives additional order to make 1000 more products for £460,000, he/she may refuse to accept it as the overall price is significantly less than the assembling expenses. However, since production does not lead to the increase in fixed costs, manufacturing of 1000 new goods may, in reality, bring additional profit to the company.
Still, on the other hand, marginal costing also has certain drawbacks that the decision-makers should consider. For example, Gersil and Kayal (2016) argue that this method is rarely used to determine the prices of the products. That is explained by the fact that fixed costs can only be assumed constant in the short term but not in the long run. Last but not least, it is sometimes hard to predetermine whether some costs should be considered as variable or fixed as they have the qualities of both, which increases the probability of miscounting.
Absorption Costing
Absorption or full costing is the second accounting method that can be used by The Shetland Wool Company to determine the prices for the garment. In contrast with marginal costing, this technique entails all the manufacturing expenses, including those that are fixed (Datar and Rajan, 2018). As Nan (2019) notes, costs that are considered to be directly borne by products are included in production costs, and those that arise from sales or management are included in period costs (p. 653). For this reason, Nhaca (2019) asserts that the absorption costing method allows fixed production cost unitization, which makes it easier and cheaper to implement compared to the first accounting technique. Indeed, a more detailed analysis of the incurred expenses provides a better understanding of the potential costing issues. As a result, managers can identify the area that should be improved much easier.
Standard Costing
Finally, the last method that The Shetland Wool Company can implement in practice is standard costing. According to Indeed Editorial Team (2021), the latter allows the company leaders to make comparisons between the expected expenses and the actual ones. This, in turn, helps to identify and address the issues related to high costs, inadequate pricing, and sub-optimal performance (Eisenberg, 2016). Therefore, it leads to management by exception, meaning that company leaders need to concentrate on certain expenditures if the deviation of forecasted indicators from the actual numbers is quite significant (Eisenberg, 2016). Moreover, the clear and measurable difference between the ideal and real costs can make managers more motivated to improve their work and put more effort. Therefore, this method can be used with other cost accounting systems mentioned above as it can help The Shetland Wool Company what the reasons for unsatisfactory performance are.
The Usage of Marginal Costing: Critical Analysis
Based on the description of the costing techniques, it becomes clear that marginal costing is actually not the best method to account for the expenses and determine the product price. However, it can be noticed that since The Shetland Wool Companys employees that are directly involved in the production of the sweaters work from their homes, there are no fixed manufacturing costs incurred. Therefore, the difference that exists between marginal costing and absorption costing systems disappears, making both of these methods equally appropriate for determining the expenses and price. Moreover, under these conditions set the price that would be just a little bit above the marginal cost would indeed lead to profit. For instance, during the current year both the marginal and absorption costs are equal to 340,000/2000 + 198 = 170 + 198 = 368. Thus, the price that would be more than the latter value would result in profit.
Determining the Most Suitable Price
In order to suggest the most suitable prices both for the current and next year periods, the breakeven and margin of safety analyses would be provided. The former is calculated based on the following formula suggested by ():
In a similar vein, other values were determined and can be seen in Table 2.
Table 2: Determining Breakeven Units for the Current and Next Years
Note: All the fractional numbers were rounded towards a greater whole number as the company sells the whole units. For example, if breakeven unit was equal to 4,347.368 it was written as 4,348 units.
Based on the calculations, it is found that the most suitable price for the product during the current year will be £375. As for the next year, the two scenarios when the expenses for the advertising are left the same as during the current period and when this cost increased were considered. As such, when advertising expenses are equal to £115,000, the price should be £325 based on the predictions that the sales would be 3000 units. Conversely, when the cost is £285,000, the most appropriate price can approximately range from £315 to £325.
However, considering that not all the forecasts are precise, it is also necessary to suggest the best price based on the margin of safety analysis. For this reason, the formula to determine it would have the following form ():
Thus, all the results are indicated in the table below (Table 3).
Table 3: Determining Margin of Safety
Conclusion
In summary, the current report the issues that The Shetland Wool Company encountered in regards to costing and pricing. In this regard, the three costing systems were discussed as appropriate for the companys usage and included marginal, absorption, and standard costing methods. Moreover, it was shown that in the case of The Shetland Wool Company, absorption and marginal costing methods are equal as the company does not have fixed manufacturing expenses. Finally, breakeven and margin of safety analyses were conducted to determine the best selling price. It was found that the best price range is between £325 and £375 for different scenarios.
References
Gersil, A., & Kayal, C. (2016). A Comparative Analysis of Normal Costing Method with Full Costing and Variable Costing in Internal Reporting. International journal of management, 7(3).
Datar, S. M., & Rajan, M. V. (2018). Horngrens cost accounting: a managerial emphasis. Pearson.
Mundung, A. V., Tandi, A. A., Wakidin, F. I., Limpeleh, E. A., & Sungkowo, B. (2020, August). Comparative Analysis of the Wooden House Production Principal Cost Calculation Using the Full Costing and Variable Costing Method. In First International Conference on Applied Science and Technology (iCAST 2018) (pp. 165-169). Atlantis Press. Web.
Nan, N. (2019). Comparative Analysis of Marginal Costing Method and Absorption Costing Method.
Nhaca, Á. (2019). The Advantages as an Instrument of Management of the Variable Cost Method in Comparison With the Observation Method. Web.
Eisenberg, P. (2016). Implications of standard costing system in manufacturing: A case study. Journal of applied Management and Investments, 5(3), 162-165.
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