Methods of Cost Allocation

Answer:

The success of a production facility is very much dependent on the costing system it follows. There are two major methods of cost allocation- traditional costing and activity based costing. Depending on the complexity of the production process, the appropriate costing method is applied. We have been provided with a situation of a safe manufacturing company, CMI Safe Co, which follows the traditional method of costing. Recently the management has realised that it is not satisfied with the results even though the business has increased in volume and productivity.

In our discussion below, we have disused about the methods of costing and steps required by the management of company to be taken in order to ensure optimum results.

In order to calculate the cost of a product, the management collects data on all the expenses. The expenses which can be directly attributable to products are, directly added to the cost of the products.  There are other costs and services which are jointly incurred for various products. These costs are required to be allocated to all the products based on some attribute. Selection of this attribute is very important as it helps in determining the actual cost of product. Cost data is used by the management in order to make pricing decision. The demand and sale of the products are dependent on the price and cost. Therefore, we see that cost allocation can have direct impact on the sale of product.

For example, there are two products Product A and B, the direct cost for Product A is $5 per unit and that for product B is $ 8 per unit. The joint cost which are incurred for these products are $5000. Now these costs are required to be allocated amongst the product A and B so that total cost per product can be determined.

As mentioned earlier, these are the two widely implemented method of cost allocation. Both of these methods have their respective pros and cons. We have discussed about these methods in detail so that solution for CMI Safe Co can be arrived at.

Traditional costing is the old method of cost allocation, under which the joint cost incurred are allocated amongst the product using one single factor. This factor may be machine hours, labour hours, number of units etc. The point is, only one attribute for cost allocation is used irrespective of consumption of service (Berry, 2009).

Traditional Costing

For example, in above if the joint cost of $5000 includes expense of $500 which are incurred mostly for product A, then irrespective of usage, the cost will be allocated based on machine hours.

Traditional method of costing is best suitable for production processes which are simple and do not comprise of various functions.  This method has both its pros and cons which have been discussed below.

The traditional costing method of cost allocation is a very simplified. It does not involve huge data collection. Since this system uses only one attribute for cost allocation the management does not require details of various function and there consumption. This system is very easy to understand and implement. The management need not appoint special personnel’s in order to implement this system of cost allocation. Since this method can be easily implemented it saves a lot of time. Since this method allocates all other costs to the product irrespective of their nature, we can say that it recognizes the importance of fixed cost in the method of production. This method in generally used while the financial statements are prepares, therefore, not much reconciliation between the costs and accounting records is required when absorption costing method is implemented.

Therefore we see that the traditional costing method is quiet advantageous. But apart from benefits this method has its cons. Few of the cons of this method of cost allocation has been listed below:

The traditional costing method is not suitable where there are many production functions involved. Since the products use same functions it is important that charge of these expenses should be allocated based on actual usage of these functions. If this method is implemented in a production facility involving many functions, then it results in improper cost allocation, which leads to wrong product pricing. This may then harm the demand of the product. Since the overheads are allocated based on pre determined rate, it always results I over or under recovery of overheads. This requires adjustment in the books, which is a lot of work. This system fails to realise the importance of cost volume profit relationship as all the costs are allocated to the product irrespective of their nature. Allocation of cost based on one attribute results in wrong costing. This is the major con of this system.

Therefore, we see that the tradition system of cost allocation is easy to use, but it may affect the profitability of the business. Not using correct cost data will result in wrong product pricing which will end in absurd financial results. It is important that the costing system implemented is according to the production requirements.

Advantages of Traditional Costing

Activity based costing is the modern costing system that tries to cover the disadvantages of the activity based costing. Activity based costing as the name suggest, is the cost allocation system that allocates the cost amongst the product based on actual consumption of the activity. Under this system units consumed for each activity is individually calculated which is then used as an attribute to allocate cost amongst the products (Atkinson, 2012).

For example, the two products A and B are required to be inspected for quality check at the end of production. Product A requires more inspection than B. Number of total inspections done are 20, out of which inspection solely contributed to product A is 15. If total cost for inspection is $2000, then cost of $1500 will be charged to product A and $500 will be charged to product B.

Just like the traditional costing system, activity based costing also has few advantages and disadvantages.

Activity based costing takes into consideration the concept of actual usage or consumption of activity. This system ensures that only that part of cost is allocated to the product which is actually used by it. Activity based costing also helps the management to cut irrelevant cost. Since the cost are all collected based on activities, the management can understand the nature of cost, and this way they can eliminate the cost which are irrelevant or not required to be incurred. Collection of huge cost data, cost drivers and various activities provide the management with the insight in to total working of the organisation. This way any issues can be noticed and resolved. Activity based costing helps in better decision making. Since this allocation method allocates actual cost to the product, the management can use this data for pricing policy. They can rely on the result of this system for decision making.

Activity based costing is the modern costing technique which ensures that only costs which are actually incurred are allocated to the products. But this method also has a few disadvantages.

ABC method requires collection of huge amount of data, like amount expense for each activity, units consumed for each activity by each product, etc. this is a time consuming and expensive process. This method can’t be easily implemented like any other costing method. It requires professional knowledge and skill to be implemented. The management requires appointing special skilled persons in order to implement ABC. This methods if implemented then the cost data and accounting data required huge reconciliation.  The implementation of ABC is a complex process; it requires huge investment of human and financial resources which makes it tiresome.

Disadvantages of Traditional Costing

From the above we can see that though the process of ABC results in accurate and reliable information, implementation of the process is very tiring and exhaustive. Continuous study of the data and any changes are required to be incorporated in order to ensure appropriate results. But this system helps the production enterprises with various functions to calculate proper product cost.

Analysis of Cost system of CMI Safe Co

The company was when established it has simple production processes, with time the company increased its products type and so the production process became more complex. The management of the company has been using the tradition based costing system since the beginning.

The management has noticed a sharp decline in the sale of units of metal safes, despite the demand in market. Also, there has been increase in the sale of plastic safes in spite of not much demand in the market. The management is also unhappy about the decline in profit margin of metal safes below 20 percent.

We have conducted a thorough study of the cost records of the enterprise and have found that the implementation of improper costing methods has lead to incorrect pricing decisions, which has affected the demand of both the products of the company.

Using some data of the production of the safes we have conducted the activity based analysis of the production data and which has resulted in the following:

Calculation of Rate per activity
Activity	Cost driver	Estimated costs ($)	Total Activity	Rate per activity
Insulation process	Insulation process hours	1,80,700	13,000	13.90
Assembly process	Assembly process hours	69,600	4,000	17.40
Quality control	Number of inspections	80,080	140	572.00
Materials management	Number of requisitions	47,800	1,000	47.80
Selling and administration	Number of sales orders	23,870	77	310.00
Total process and support costs		4,02,050

Calculation of cost of activity
Activity	Rate per activity	Metal safes- Activity	Cost for Activity	Plastic Safes – Activity	Cost for Activity
Insulation process hours	13.90	7,000	97,300	6,000	83,400
Assembly hours	17.40	2,800	48,720	1,200	20,880
Number of inspections	572.00	40	22,880	100	57,200
Number of requisitions	47.80	300	14,340	700	33,460
Number of sales orders	310.00	30	9,300	47	14,570

Income statement under activity based costing
Particulars	Metal safes	Plastic safes	Total
	$	$	$	$	$	$
Sales revenues		2,96,900		2,46,800		5,43,700
Direct materials	21,500		20,680		42,180
Other activity Costs –
Insulation process	97,300		83,400		1,80,700
Assembly process	48,720		20,880		69,600
Quality control	22,880		57,200		80,080
Materials management	14,340		33,460		47,800
Selling and administration	9,300		14,570		23,870
Total costs		2,14,040		2,30,190		4,44,230
Net income		82,860		16,610		99,470
Profit margin		27.91		6.73		18.30

Therefore, if we allocate the overhead cost as per actual usage of activity we see that the cost allocated to metal safe is $192540 and that to plastic safe is $209510. But if we go with the traditional costing system, the overhead allocated to metal safe is 231770 and that to plastic safe is $170280.

More cost was allocated to metal safes which resulted in low profitability from this section.

The company calculates the cost of the product and then adds a required rate of margin in order to set a selling price for a product. Since more cost was allocated to the metal safes, its overall cost increased and when margin was added it increased the selling price of the product. But in the safe manufacturing industry the other competitors were charging margin on lower total cost, which lead to lower selling price. Since the competitors were selling the same product at lower prices, the sale of metal safes got affected which resulted in lower units sold.

If we take the data from activity based analysis for the metal safe we see that, if actual overheads are allocated then the profit margin from such products is more than 20%, near 28%. Wrong allocation of cost data may lead to absurd results.

Moving to the plastic safe similar was the case. Since the management charges lower overhead to the product, lower selling price was charged from the customers. Since the company was selling same product at lower prices, the demand of plastic safes increased even if there was no market for them.

When the company was charging more cost, it lead to higher overall costs and lower margins from metal safes. They were then also charging lower cost to plastic safes which lead to higher margins from them. Appropriation of cost based on actual usage of activities provides actual and correct cost data. We have the following:

Particulars	Metal safes	Plastic safes
Profit Margin under traditional Costing	14.70	22.60
Profit Margin under Activity Based Costing	27.91	6.73

Therefore, we see that net margin from metal safe is actually 27.91% and not 14.70%. And the margin from plastic safes is 6.73% and not 22.60%.

Also the wrong allocation of cost lead to the following differences on the total cost of product:

Particulars	Metal safes	Plastic safes
Total Cost under traditional Costing	2,53,270.00	1,90,960.00
Total Cost under Activity Based Costing	2,14,040.00	2,30,190.00
Difference	39,230.00	-39,230.00

Therefore we see that $39230 which was actually expense of plastic safe was wrongly allocated to the metal safes.

Wrong allocation of cost data may lead to wrong a result which has leaded the management to take wrong decisions.

Conclusion

It is important that the management keeps itself and its processes updated with the growth of the company. From the report above we can see how implementation of outdated methods in costing can lead to wrong results which affect the financial position of the company. The activity based costing is to be implemented by the company with such production practices which involve many processes. Therefore, we recommend the management of CMI Safe co, to change its cost allocation method from traditional absorption costing method to activity based costing.

References

Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.

Berry, L. E. (2009). Management accounting demystified. New York: McGraw-Hill.