Cost Allocation for Decision Making
The purpose of this paper is to answer a few important questions: Why do companies allocate costs? How do companies allocate costs? And how this cost allocation can affect the decision making of the company. It is important for the companies to find the proper method to allocate the costs. Cost allocation is an important issue in many companies because many of the costs associated with designing, producing and distributing products and services are not easily identified with the products and services that are created.
It would have been easier for companies to allocate cost if costs were directly traceable with the products and the cost allocation would have been minor issue for the company. The decision-making process, is heavily relied on the information the company has received from the cost allocation process. By having all the correct information available, decision-making becomes an easier task and having the incorrect information can be affect the company for months or even years. But first let’s talk about cost accounting, cost allocation and it’s purpose. Cost/ Managerial accounting
Managerial accounting is concerned with providing information to managers, this information is for those who are inside the organization and who direct and control its operations(Managerial Accounting and Managerial Accounting Practices). Managerial accounting can be contrasted with financial accounting, which is concerned with providing information to stockholders, creditors and others who are outside an organization. Managerial accounting includes things like budgeting, information on the cost of a companies goods or services and performance reports.
These reports provide information on how well the company is proforming by comparing actuals to budgets and/or benchmarks. Other analytical reports are perpared to investigate specific problems such as a decline in profitability of a product ( Ray H. Garrison, Eric W. Noreen and Peter C. Brewer p 1). Yet other reports analyze other business situation or opportunities. Purpose of cost allocation A cost is generally understood to be an expense incurred in an economic activity to achieve a specific product or service. All types of businesses, not-for-profits, governmental agencies have costs.
To achieve a goal or objective, an organization acquires resources, transforms them in some manner, and delivers units of product or service to its customers. Costs are incurred to perform these activities. For planning and control, decisions are made about areas such as pricing, product costing, outsourcing, and investments. Different costs are needed for different purposes. In each instance, costs are determined to help management make better decisions for the company or agency(Business and Finance, 2008). In the past and some even today believed that costs are allocated only for accounting purposes.
On the other hand many believe that cost allocation is an important segment in the accounting system of the company since it can help companies to value inventory for external reporting purposes, for planning and monitoring the cost of activities and processes, and for various short term and long term strategic decisions. When incurred, costs are initially reviewed by the accounting system and the accounting staff to classify the type of expense. Costs with one or more characteristics in common may be accumulated into cost pools(Business and Finance, 2008).
Costs are then reclassified to the correct expense account, from these cost pools to one or more cost objects. A cost object is an activity, a unit of product or service, a customer, another cost pool, or a segment of an organization for which management needs a separate measurement and accumulation of costs (Business and Finance, 2008). There are different classifications of costs as when a company decides on a product or services we split those costs into manufacturing costs and nonmanufacturing costs . Manufactuting cost are split in three different categories, direct labor, direct material and manufacturing overhead cost.
A direct cost can be traced to a product or service which includes: Direct labor- which is the cost of the labor that’s directly connected to a product or services. Direct labor is sometimes called touch labor, since direct labor workers typically touch the product while it is being made. ( Ray H. Garrison, Eric W. Noreen and Peter C. Brewer p 39-40) An example of direct labor is an assembly line worker. Labor cost that cannot be physically traced to the creation of products, or that can be traced only at great cost and inconvenience, are considered to be indirect labot. ( Ray H. Garrison, Eric W.
Noreen and Peter C. Brewer p 40) Direct material are those materials that become an integral part of the finished product and whose cost can be traced to the finished product. ( Ray H. Garrison, Eric W. Noreen and Peter C. Brewer p39-40) Manufacturing overhead is the third element so manufacturing cost, it includes all costs of manufacturing except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials; indirect labor; maintenance and repairs on production equipment; and heat and light, property taxes, depreciation, and insurance on manufacturing facilities.
Only cost associated with operating the factory are consider to be manufacturing overhead cost. A company also incurs other costs associated with its selling administive functions, but these costs are not included as part of manufacturing overhead. Only those costs associated with operating the factory are considered to be manufacturing overhead. You also have nonmanufacting costs and those cost are divided into two categories: selling and administrative. Selling cost includes all cost that are incurred to secure customer orders and get the finished product to the customer.
Some examples of selling cost are advertising expenses, freight, sales travel, sales commissions, sales salaries and cost of finished goods. Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization. Examples of this cost includes executive compensation, general accounting, secretarial and similar costs involved in the overall running of the organization(Ray H. Garrison, Eric W. Noreen and Peter C. Brewer p 41). Attcahed is a Schedule for Cost of Goods Manufactured, this schedule shows elements of cost: direct material, direct labor and manufacturing overhead:
Schedule of Cost of Goods Manufactured Direct Materials: Beginning raw materials inventory$25,000. 00 Add: Purchase of raw materials350,000. 00 Raw materials available for use375,000. 00 Deduct: Ending raw materials inventory35,000. 00 Raw materials used in production340,000. 00 Direct labor:75,000. 00 Manufacturing overhead: Insurance, factory5,000. 00 Indirect labor125,000. 00 Machine rental45,000. 00 Total manufacturing overhead cost175,000. 00 Total manufacturing cost590,000. 00 Add: Beginning WIP inventory65,000. 00 Cost of goods manufactured 655,000. 00
The diect materials cost is not the cost of raw material purchased in the period, it is the cost of materials used in the period. These cost are link to the product that is being produced and the indirect cost is identifed under the manufacturing overhead cost because it is not tied the product or service that is being produced but it is part of operating the company. Allocating Cost Cost allocations can be made both within and across time periods. If two or more cost objects share a common facility or program, the cost pool of the shared unit is a common cost to the users and must be allocated to them to the correct cost pool.
Bases of allocation typically are based on one of the following criteria: cause-and-effect, benefits derived, fairness, or ability to bear. The selection of a criterion can affect the selection of a basis. For example, the allocation of the costs of a common service activity across product lines or programs based on relative amounts of revenue is an ability to bear basis, whereas the same allocation based on the relative number of service units consumed by each product line or program would reflect either the benefits derived or the cause-and-effect criteria (Business and Finance, 2008).
Cost allocation then is the assignment of an indirect cost to one or more cost objects. Because this process is not a direct assignment and results in different amounts allocated depending on either the basis of allocation or a method selected by the company and there polices(Business and Finance, 2008). Costs of long-lived assets are allocated and reclassified as an expense across two or more time periods. For anything other than land, which is not allocated, the eclassification of tangible assets is called depreciation (Business and Finance, 2008). The bases for these allocations are normally either time or volume of activity. There are different methods of depreciation available. The costs of long-lived intangible assets, such as patents, are allocated across time periods and reclassified as amortization expense. Cost allocations within a time period are typically across either organizational segments or across units of product or service or programs for which a full cost is needed.
Allocations may differ depending on whether a product or program is being costed for financial reporting, target pricing or costing, or life-cycle profitability analysis(Business and Finance, 2008). Allocations to responsibility centers are made to motivate the centers’ managers to be more goal-congruent in their decisions and to assign to each center an amount of cost reflective of all the sacrifices made by the overall organization on behalf of the center. These allocations can be part of a price or transfers of cost pools from one department to another (Business and Finance, 2008).
This is also important for manufacturing companies who need to cost the resources required to complete their products. In costing a unit of product for, costs of production are assigned. With the unit of product as the cost object, production costs are either direct costs or indirect costs. The indirect production costs are allocated. Traditionally, manufacturers using labor-intensive technologies used a single basis of allocation based on labor, either in hours or in cost, associated with a single indirect cost pool.
A manufacturer using a more capital intensive technology might use a nonlabor basis such as machine hours. Today many firms produce a varied set of products, using varied technologies with many levels of complexity. Such firms need a more refined cost assignment system that uses multiple bases of allocation with multiple indirect cost pools, such as activity based costing (Business and Finance, 2008). While for product costing a unit of output remains final.
The cost system a company uses can require a cost requirement to an product prior to an assignment to a unit that is set for production. For instance, a batch has a cost assignment first to an individual job order; the total cost assigned to the job is then unitzied over the units the batch to determine the cost of one unit that is being produced. Once this is done, data is collected on each production process and then cost is broken down by each process that was done to get the final cost of each unit that was produced.