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See Also: All of us have used cost allocation, the process of assigning common costs to ending inventory and cost of goods sold (COGS), as part of our Financial Services offerings since it is required by GAAP. Our goal has been to either reduce taxes or increase reported earnings, depending on our client’s needs and circumstances. But what about cost allocation’s other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)? In this wiki, we will explain how to go about implementing activity based costing. Other Uses for Cost AllocationManagers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for assigning overhead costs of various activities, usually support departments, to products or services being produced and/or sold allowing upper management to assess and analyze their profitability. By knowing what the true “cause-and-effect” relationship is, managers are able to more accurately assess the true cost of a product/service. They can determine if carrying certain products/services contributes to overall profitability given the demand and price sold for.
Cost allocation can also be used to reduce wasteful spending and/or promote more efficient use of resources (especially PP&E) by evaluating needs and uses for the year to come as part of the planning/budgeting process. Managers can then be evaluated on their planning effectiveness, leading to better communication, sharing of resources, and cost efficiency. They can also use it to manage product and process design. As allocations are broken down/determined, the use of resources becomes transparent from a process standpoint, allowing managers to improve operations as needed. [button link=”https://strategiccfo.com/scfo-lab-sl?utm_source=wiki&utm_medium=button%20cta” bg_color=”#eb6500″]Learn About The SCFO Lab[/button] Traditional Cost AllocationPrior to the advent of computers, one based the traditional method of allocating overhead costs on a single volume-based allocation base or cost-driver. Unfortunately, volume-based costing allocated overhead using one allocation base that may or may not have had a “cause and effect” relationship to the costs being allocated to the product or service. For example, suppose a manufacturing firm had two production departments – one that used a large labor force with few pieces of equipment and one that was predominantly machine driven. Allocating Personnel or janitorial costs on the basis of machine hours would be very inefficient. By the same token, allocating maintenance costs and building costs to products or services based on direct labor costs would be equally inaccurate. ABC CostingActivity Based Costing allocates costs based on multiple cost pools (activities or department budgets) each with its own appropriate (“cause and effect”) cost drivers. This leads to more accurate costing and improved control over overhead costs. Activity based costing is especially effective when a firm has a highly diverse or heterogeneous product or service mix, when overhead costs account for much of the total costs, and in situations where the manufacturing process is capital/PP&E-intensive. Implementing Activity Based CostingThe steps involved in activity based costing are:
We will discuss them shortly. Direct Method of AllocationBefore we continue, it would be good to discuss the three methods discussed in step 4. The direct method allocates costs directly from the support departments to the operating departments that use its services. For example, the personnel department might allocate its overhead (i.e., ALL of its departmental costs) based on the number of employees in each of the operating or production departments. It is a simple method that only considers the total cost drivers in the operating departments. Continuing with this example, personnel department costs would be allocated 100% based on 100% of the employees in the operating departments with no regard to those employed in personnel, maintenance, engineering, service or any other support department. Step Down Allocation MethodThe step-down method takes the allocation process one step further. It takes into account that support departments use other support department’s services. This may include the personnel department provides services to employees in the janitorial department. Under this method, allocate costs in a series of steps. First, allocate costs from the most used support department to all remaining departments. Then, choose another support department. Allocate 100% of its costs to the remaining support departments and all the operating departments. And this process is continued until all of the support departments’ overhead have been allocated to the operating departments. While this method is typically a little more complicated than the direct method, it is also more effective in allocating costs. Reciprocal Method of AllocationThe third method is the reciprocal method. It takes the concept that support departments make use of each other’s resources one step further. This two-step method uses allocation ratios. Thus, the total cost of each support department is calculated based on the formula that total cost for one support department is equal to its costs plus that of the allocated costs from other support departments it accepts services from. The costs include overhead since no support department’s costs are direct costs. Example of Activity Based CostingLets consider a simple example that involves a company with the two following support departments:
This company also has the following two production departments:
Let’s further assume that 10 employees work in Janitorial, that Personnel uses 1,000 square feet of building space, that Assembly employs 60 workers in a 4,500 square feet area, and that Finishing has 20 employees who also work in a 4,500 square foot space. ARTICLES YOU MIGHT LIKE June 9, 2022 Hiring the right accountant When I meet a business owner operating at a successful $10 million in revenue, they often mention, “My CPA”… I immediately know that CEO/Entrepreneur is referring to their Tax CPA. That is because one thing that all Entrepreneurs have in common is that they must file a tax return. So, from Financial RatiosSeptember 24, 2021 See also:Quick Ratio AnalysisPrice to Book Value AnalysisPrice Earnings Growth Ratio AnalysisTime Interest Earned Ratio Analysis Use of Financial Ratios Financial Ratios are used to measure financial performance against standards. Analysts compare financial ratios to industry averages (benchmarking), industry standards or rules of thumbs and against internal trends (trends analysis). The most useful comparison when Read More »CPA’s are SpecializedJune 8, 2021 The Difference in CPAs Looking back at my career I don’t know how many times I have introduced myself to someone and they ask, “Are you a CPA?” and I say yes. Then they tell me “you must be very busy with tax season” and I look at them with a bit of awe and How does activityActivity-based costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. It increases understanding of overheads and cost drivers; and makes costly and non-value adding activities more visible, allowing managers to reduce or eliminate them.
Does activityBy using activity-based costing, you can: Take into consideration both the direct and overhead costs of creating each product. Recognize that different products require different indirect expenses.
What is the principle that activityThe basic principle of ABC is that products consume activities. Activities or tasks undertaken during an operation attracts or cause costs, meaning that activities are the cost drivers. The system assigns costs to activities rather than products.
How product costs are determined in activityActivity-based costing (ABC) is a method to determine the total cost of manufacturing a product, including overhead. It is calculated by taking the cost pool total and dividing it by the cost driver.
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