The management of costs remains pertinent to the successful operation of any company. To achieve a competitive edge a company must consistently improve their service or product quality, lower their service or product costs, and eliminate services or products that incur profit losses. Using a traditional costing system the portion of overhead costs allocated to the production of a service or product is determined by the total of direct labor hours used in production of the service or product. Companies implement refined cost allocation systems such as the activity based costing method with the intention of helping management strategically plan because these systems provide quality information to help management make informed decisions. In this essay, I will examine the use of cost allocations, the activity based costing method, and how companies can implement and benefit from activity based costing.
The allocation of costs serves four primary purposes throughout a company. The first is to present the information management needs to make an informed decision. The second is the reduction of non-essential uses of common company resources. The third is to encourage management to assess the efficiency of services provided internally. Finally, the fourth reason is the calculation of the “full cost” of a service or product to be used in price determination and financial reporting (Jiambalvo, 2009).
Cost allocation consists of three steps. The first step is the identification of the cost objective. Here it is established which service, product, or individual department needs costs allocated to it. The second step is the formation of individual cost pools. A cost pool is a collection of similar costs that is assigned to an individual allocation base. Finally, the third step is to select an allocation base that relates each cost pool to a cost objective. Ideally, each allocation base should share a common characteristic with all of the cost objectives, and should correlate each cost with the individual cost objective that produced the costs (Jiambalvo, 2009).
According to Jiambalvo, when indirect costs are fixed or a cause and effect correlation is not feasible the following approaches are used: the relative benefits approach, the ability to bear costs approach, and the equity cost to allocation approach (2009). The relative benefits approach states that the allocation base should result in more costs being allocated to the cost objectives that benefit the most from incurring the cost (Jiambalvo, 2009). The ability to bear costs approach states that the allocation base should result in more costs being allocated to products which are more profitable (Jiambalvo, 2009). Finally, the equity cost approach states that the allocation base should result in allocations which are fair and equitable (Jiambalvo, 2009).
Three main approaches are used for cost allocation: the direct method, the reciprocal method, and the sequential method. The direct method is the most commonly used method. Additionally, the direct method is the simplest method because it ignores service department costs that are provided to another service department. For instance, the janitorial department would not allocate costs to other departments for their services. Interdepartmental expenses would be bypassed as all costs would be allocated directly to each operating department. The sequential method distributes interdepartmental costs to other service departments in a chronological manner always moving forward never backwards. Typically, the “sequence” begins with the service department that is responsible for the largest quantity of services to the other departments and continues to the department that has provided the smallest amount of services to the other departments. However, the sequential method only partially accounts for interdepartmental services. Finally, the reciprocal method...
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