Advanced Cost Accounting Questions:
Q1) (ACTIVITY BASED MANAGEMENT)
Seneca Foods is a regional producer of low-priced private-label snack foods. Seneca contracts with local supermarkets to supply good-tasting packaged snack foods that the retailers sell at significantly lower prices to price-sensitive consumers. Because Seneca’s production costs are low, and it spends no money on advertising and promotion, it can sell its products to retailers at much lower prices than can national-brand snack food companies, such as Frito-Lay. The low purchase prices often allow the retailer to mark this product up and earn a gross margin well above what it earns from brand products, while still keeping and selling price to the consumer well below the price of the brand products.
Seneca has recently been approached by several large discount food chains who wish to offer their consumers a high-quality but much lower-priced alternative to the heavily advertised and high-priced national brands. But each discount retailer wants the recipe for the snack foods to be customized to its own tastes. Also, each retailer wants its own name and label on the snack foods it sells. Thus, the retailer, not the manufacturer, would be providing the branding for the private-label product. In addition, the retail chains want their own retailer-branded product to offer a full snack product line, just as the national brands do.
Seneca’s managers are intrigued with the potential for quantum growth by becoming the prime producer of retailer-brand snack foods to large, national discount chains. As they contemplated this new opportunity. Dale Williams, the senior marketing manager, proposed that if Seneca enters this business, it can think of even higher growth opportunities. Seneca does not have to sell just to the discount chains that have approached it. Local supermarket chains may also be attracted to the idea of having their own brand of high quality but lower-priced snack products that could compete with the national brands, not just be a low-priced alternative for highly price-sensitive consumers. Perhaps Seneca could launch a marketing effort to regional supermarket chains around the country for a retail-brand snack food product line. Williams noted, however, that the local supermarket chains were not as sophisticated as the national discounters in promoting products under their own brand name. Each supermarket chain likely would need extensive assistance and support to learn how to advertise, merchandise, and promote the store-brand products to be competitive with the national-brand products.
John Thompson, director of logistics for Seneca Foods, noted another issue. The national-brand producers used their own salespeople to deliver their products directly to the retailer’s store and even stocked their products on the retailer’s shelves. Seneca, in contrast, delivered to the retailer’s warehouse or distribution center, leaving the retailer to move the product to the shelves of its various retail outlets. The national producers were trying to dissuade the large discount chains from following their proposed private-label (retailer-brand) strategy by showing them studies that the apparently higher margins they would earn on the private label would be eaten away by much higher warehousing, distribution, and stocking costs for these products.
Heather Gerald, the controller of Seneca, was concerned with the new initiatives. She felt that Seneca’s current success was due to its focus. It currently offered a relatively narrow range of products aimed at the high-volume snack food segments to supermarket chains in its local region. Seneca got good terms from its relatively few supplier because of the high volume of business it did with each of them. Also, the existing production processes were efficient for the products and product range currently produced. She feared that customizing products for each discount or supermarket retailer, plus adding additional products so that they could offer a full product line, would cause problems with both suppliers and the production process. She also wondered about the cost of providing new services, such as consulting and promtoins, to the supermarket chains and of developing some of the new items required for the proposed full product line strategy. Heather was attracted to the growth prospects offered by becoming the preferred supplier to major discount and supermarket chains. But she was not as optimistic as Dale Williams that these retailers truly believed that selling their own private-label foods would be more profitable than selling the national brands. Perhaps they were only using Seneca as a negotiating ploy, threatening to turn to private labels to increase their power in setting terms with the national manufacturers. Once production geared up, how much volume would these retailers provide to Seneca? How could Seneca convince the large retailers about the profitability associated with the new private-label strategy?
Gerald knew that Seneca’s existing cost systems were adequate for their current strategy. Most expenses were related to materials and machine processing, and these costs were well assigned to products with the conventional standard costing system. But the new strategy would seem to involve a lot more spending in areas other than purchasing materials and running machines. She wished she knew how to provide input into the strategic deliberations now under way at Seneca, but she didn’t know how to quantify all the effects of the proposed strategy.
a) How can activity-based costing help Heather Gerald assess the attractiveness of the proposed policy?
b) Assuming that Seneca starts to supply new customers-large discounters and supermarkets outisde its local region-what ABC systems would be helpful to guide the profitability of the strategy and assist Seneca managers in making decisions?
*NOTE: Make sure to think about the totality of Seneca’s operations, including its relationships with both supplier and customers. (i) Discuss how ABC can be used to manage and controls costs for Seneca’s manufacturing operations. The “whale curve” and some of those concepts can apply to this company. (ii) ABC can be used to measure profitability: internal to the companyand external by modeling the customer. (iii) Finally, use ABC to manage the company’s relationship with suppliers.
Q2) (COST-BASED DECISION MAKING)
Using published sources, identify the process of cost commitment during various phases of some product’s life cycle. Try to find several examples so that you can contrast the rate of cost commitment for different products.
*Note: Provide a minimum of two examples and document the process of cost commitment
during various phases of these products’ life cycles. In particular, indicate what
percentage of the costs will be committed at the design stage.
Q3) (FORMAL MODELS IN BUDGETING AND INCENTIVE CONTRACTS)
THE REVELATION PRINCIPLE IN BUDGET SETTING
Kentville Orchards grows and sells a wide variety of fruits. Norm Wilson, the vice-president-controller of Kentville Orchards, is responsible for all aspects of budgeting and forecasting in the firm. Norm has becoming both disillusioned and dissatisfied with the traditional approach that Kentville Orchards has taken to budgeting. Norm summarized his concerns as follows:
“The traditional approach, where we set budget objectives and then evaluate performance relative to those objectives, is not working well. First, the budget is focusing attention on the wrong things. The managers are interested in making short-run profit as large as possible and are not doing things to improve long-run profitability. Second, I do not think that the model of evaluating performance based on profits has the scope to evaluate the jobs that the managers are doing. Their jobs are much more complicated than a simple profit measure implies, and we need a more accurate picture of how well they are doing. Finally, the existing system is motivating the managers to build slack into both their standards and performance targets so that they can make budget and earn bonuses. As a result, our forecasting system is unable to predict either sales levels or input usage accurately.”
Norm went on to indicate that he was considering recommending to the senior management committee at Kentville Orchards that the current budgeting system be replaced with a new system using participative budggeting techniques. Specifically, the new system would require that the objectives for each management job in the organization be defined relative to the organization’s strategic goals by negotiations between the job’s incumbent and incumbent’s supervisor. From these general objectives, specific performance objectives would be set for each job each year through negotiations between the incumbent and the incumbent’s supervisor. The objectives would be multidimensional and would include performance objectives for all attributes of the job that are considered important.
The annual evaluation would reflect two dimensions of performance appraisal. First, the incumbent would be evaluated for innovation in developing ways of carrying out assigned responsibilities. Second, the incumbent’s performance would be evaluated relative to the targets that were negotiated with the supervisor. Norm summarized his feelings as follows:
“The only thing that is holding me back is that I do not think that the proposed changes go far enough. The proposed system deals with the problem of inadequate performance measurement but still provides managers with the incentives to understate their potential, since their performance will be evaluated relative to the targets that each manager negotiates with his supervisor. Moreover, the planned system, like the old system, still has the aspect of checking up on people rather than relying on them to do their jobs. Perhaps we should go even further and implement the proposed system but evaluate managers only on their ability to be innovative in undertaking the tasks that they have been assigned. If they are not evaluated relative to the targets that they set jointly with their supervisors, they will be motivated not to understate their potential. The bottom line is that I think that we should get rid of the concept of standards altogether, irrespective of who sets the standards. As a result of eliminating the concept of standards, the budget will serve to communicate and coordinate rather than be a threat and a means of checking up on the managers.”
Evaluate the initial proposal for the revision of the budgeting system as well as the proposal that would eliminate the use of standards.
*Note: Start by identifying the problems with the current budgeting and performance
system. Then, comment on the advantages and disadvantages of the proposed new
systems: one in which evaluation is based on participative budgeting and innovation
and the other in which evaluation is based solely on innovation.
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