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 expense allocation? What are the sources of expense indicators or cost drivers? What are some of the policy implications of activity-based costing in formulating effective cost allocation and management strategies?
These managerial accounting questions relate to effective cost allocation and optimal cost management strategies for a business enterprise: the right mix of cost management strategies that maximizes return on investment and shareholder wealth at the same time. which minimizes the cost of operations, simultaneously.
The correlation between optimal cost management and effective activity-based costing is critical to sound business strategic choices designed to maximize a company’s wealth-producing capacity. In this series on effective cost allocation and optimal cost management, we will focus on the relevant strategic cost issues and provide some operational guidance.
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 qualified professional.
Activity-based costing (ABC) is an effective management technique for allocating and controlling overhead costs. Overhead 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.
Keep in mind that the optimal cost management and effective activity-based costing for each company differs markedly depending on the general dynamics of the industry, the structure of the market: the degree of competition, the height of the barriers of entry/exit, market competition, industry life cycle stage 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 in reference to industry expected value (average) and company benchmarks and best practices. industry generally accepted.
Cost Allocation Phases:
In the first phase, the main activities of manufacturing or selling finished products are identified and properly classified according to the expense hierarchy. 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, material handling, order processing, inventory management, storage, and transportation.
In the second stage, activity expenses are assigned to each product or product line and cost indicators or cost drivers, and overheads are listed according to the main 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 expenses. In addition, there are several levels of activities: unit level, batch level, product level, and installation level. Also, facility-level activities are carried out at the plant level and are a bit difficult to trace, while unit-level activities are product-specific and easier to trace back to products.
In practice, the proper identification and careful analysis of the costs incurred for each set of costs is 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 that is being produced, where expense allocation uses estimates to apply costs to products or product lines. While many costs can be assigned directly to products, some costs relate to multiple products or change per unit and must be assigned proportionally.
Some operational guidelines:
Effective cost allocations require management accounting personnel to identify the objects to which the relevant costs will be allocated, aggregate the relevant costs into different cost pools, and identify the most appropriate basis/method for allocating the relevant costs. Note that not all expenses are relevant and expense controls are subject to vertical differentiation level organizational authority.
In addition, not all expenses must 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 unify the fixed costs of production, ceteris paribus.
To formulate optimal cost allocation strategies, management must understand and anticipate some challenges that come 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. Proper identification, analysis, tracking, and allocation of expenditures 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, sound 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 examining 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 expense 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 to what extent 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 whether the benefits justify the costs and how much cost analysis is optimal in terms of company 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 management 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 expenses for products, goods, and services, which is critical to profitable business operations. Business managers must know, understand, and anticipate which products are profitable and which products are not. Therefore, the cost analysis must be relevant, accurate, timely, and consistent with the calculation of economic advantage. To create and maintain competitive advantage in the global marketplace, companies need effective cost driver identification, cost allocation, and optimal expense management strategies—the right mix of expense management strategies that maximizes return on investment. investment and shareholder wealth while minimizing the cost of operations. , simultaneously.
