How do companies choose their overhead cost allocation? How do companies choose optimal cost management based on critical production activities that create and capture value? What is the nature and function of spending allocation? What are the sources of cost indicators or cost drivers? What are some of the policy implications of activity-based costing for the formulation of effective cost allocation and management strategies?
These managerial accounting questions relate to effective cost allocation and optimal cost management strategies of a business enterprise: the right mix of cost management strategies that maximizes return on investment and shareholder wealth while which minimizes the cost of operations, simultaneously.
The correlation between optimal cost management and effective activity-based costing is critical to sound business strategy choices designed to maximize the wealth-producing capacity of the firm. In this series on effective cost allocation and optimal cost management, we’ll focus on the relevant strategic cost issues and offer some operational guidelines.
The primary purpose of this review is to highlight some basic cost theory, strategic cost relationships, and industry best practices in effective cost allocation designed to optimize cost management. For company-specific cost management strategies, consult a competent professional.
Activity-based costing (ABC) is an effective management technique for allocating and controlling overhead costs. Overhead expense analysis and allocation can be made more accurate by using ABC techniques for a wide range of products, for product expense and profitability analysis, and for proper distribution and control of overhead expenses.
Keep in mind that optimal cost management and effective activity-based costing for each company differ markedly depending on the general dynamics of the industry, the structure of the market: the degree of competition, the height of the barriers to entry/exit, market competition, the stage of the industry’s life cycle and its competitiveness in the market. position. In fact, as with most market performance indicators, a company’s specific cost management position is revealing only by reference to industry expected value (average) and company benchmarks and best practices. generally accepted industry.
Cost Allocation Phases:
In the first phase, the main activities of manufacturing or selling finished products are properly identified and classified according to the hierarchy of expenses. The expense hierarchy makes it easy to classify activities based on how easily they can be traced back to a product or product lines. Such activities may include material procurement, production runs, materials handling, order processing, inventory management, storage, and transportation.
In the second stage, activity expenses are assigned to each product or product line and cost drivers or cost drivers, and overhead expenses are listed according to the major activities required to create and capture value. A brief review of the existing academic literature suggests that the nature of the production activity or transaction decides the appropriate cost indicators or cost drivers.
The activity-based costing system uses an appropriate cost driver that differs with the nature of the production activities that generate costs. In addition, there are several levels of activities: unit level, batch level, product level, and facility level. Also, facility-level activities take place at the plant level and are somewhat difficult to trace, while unit-level activities are product-specific and easier to trace back to products.
In practice, proper identification and careful analysis of the costs incurred for each set of costs are necessary and critical to the proper determination of the cost driver rate. Finally, companies track and allocate the cost of activities or operations to final products, goods, and services. As you know, cost tracking is the process of directly matching an expense to a product being produced, where expense allocation uses estimates to apply costs to products or product lines. While many costs can be directly assigned to products, some costs are related to multiple products or change per unit and must be allocated proportionally.
Some operational guidelines:
Effective cost allocations require management accounting personnel to identify the objects to which the relevant costs will be allocated, accumulate the relevant costs in different cost pools, and identify the most appropriate basis/method for allocating the relevant costs. Note that not all spend is relevant and spend controls are subject to vertical differentiation level organizational authority.
Also, not all expenses need to be unified. For example, fixed costs do not change with an increase or decrease in the quantity of goods or services produced or sold. In fact, fixed costs are expenses that must be paid by companies, regardless of any business activity within a specific scale of production. Therefore, it can be misleading to standardize the fixed costs of production, ceteris paribus.
To formulate optimal cost allocation strategies, management must understand and anticipate some of the challenges associated with expense allocation and activity-based costing. Some of these challenges include: traceability, materiality, method, accuracy, and timeliness. As I have already explained, some expenses are not easy to track. The identification, analysis, tracking and allocation of appropriate expenses must be carried out using multiple methods and defensible assumptions.
In practice, the allocation of expenses is based on managerial data and analysis with the help of information technology. However, judicious analysis of cost drivers and allocations must be guided by a thorough understanding of well-established cost theory and generally accepted accounting principles. For example, when looking at cost tracking and allocation, companies must determine how accurately to allocate individual expenses. With modern computer systems and cost analysis, it is often possible to track each cost driver even when there are multiple products: goods and services.
Also, not all expenses are material. And because there are costs and benefits associated with finding, analyzing, and mapping spend data, companies must decide how much to account for spend drivers. This is the accounting concept of materiality. Companies must always weigh the costs and benefits of all managerial decisions. Business managers must decide if the benefits justify the costs and what amount of cost analysis is optimal in terms of the company’s profitability.
Finally, companies must create and maintain multiple cost systems. And use appropriate techniques such as traditional costing, job costing, process costing, or variable costing to facilitate internal managerial decision making and external financial reporting requirements. Note that variable costing is not allowed for external reporting, but can be useful in helping managers make resource allocation and other business decisions efficiently and effectively. Successful companies often maintain managerial accounting cost systems to facilitate internal planning and financial accounting cost systems designed to support the external financial reporting function.
In short, cost accounting systems and activity-based costing make it easy to accurately estimate the costs of products, goods, and services, which is critical to profitable business operations. Business managers must know, understand, and anticipate which products are profitable and which are not. Therefore, the cost analysis must be relevant, accurate, timely, and consistent with the calculation of economic advantage. To create and maintain a competitive advantage in the global marketplace, companies need effective identification of cost drivers, cost allocation, and optimal expense management strategies—the right combination of expense management strategies that maximizes return on investment and shareholder wealth while minimizing the cost of operations. , simultaneously.
