Yes. I think the case study with its proposed solutions would be useful to the agricultural enterprises seeking to employ management accounting techniques. It is because the study adopts the activity-based method of costing product and cost allocations. Activities are the main focus on activity-based costing. The main theory in ABC is that overhead costs are originated by an array of movements, and those different products make use of these activities in a heterogeneous way.
Costing the activity is normally an in-between step in the distribution of overhead costs to products, to acquire more precise product cost information. However, occasionally the activity itself is the cost object of interest. Like for example, manager of a company might desire to know how much the company spends to acquire their raw materials, as input in a sourcing judgment. The activity of acquiring the raw materials incurs costs associated with negotiating prices with suppliers, issuing purchase orders, receiving fabric, inspecting fabric, and processing payments and returns.
The steps to product costing are: 1) Identify the cost; 2) Identify the direct costs associated with the cost object; 3) Identify overhead costs; 4) Select the cost allocation base for assigning overhead costs to the cost object; and 5) Develop the overhead rate per unit for allocating overhead to the cost object.
ABC improves steps #3 and #4 dividing large heterogeneous cost groups into multiple smaller, homogeneous cost groups. ABC then tries to choose, as the cost allocation base for each overhead cost pool, a cost driver that best takes hold the cause and effect relationship between the cost object and the incurrence of overhead costs.
Usually the best cost driver is a non-financial variable. ABC can moderately turn out to be elaborate. For example, it is frequently helpful to use a two-stage allocation method whereby overhead costs are allocated to intermediate cost groups in the first phase, and then allocated from these intermediate cost groups to products in the second phase. Intermediate step is useful because it permits the introduction of multiple cost drivers for a single overhead cost item.
Cost pools are usually established for each level in a hierarchy of costs in an activity-based costing. The following cost hierarchy is commonly identified for manufacturing firms:
Unit-level costs. These costs change in a more-or-less linear manner with the number of units produced for any given product. For example, fabric and thread are unit-level costs for a clothing manufacturer; if the company would like to increase production by 100%, it will need twice as much fabric and thread.
Batch-level costs. These costs change in a more-or-less linear mode with the number of batches run. Machine setup costs are regularly batch-level costs. The time needed to prepare a machine to run one batch of product is usually independent of the number of units in the batch; the same time required in preparing the machine to run a batch of 100 units as a batch of 50 units. Consequently, batch level costs do not necessarily differ in a linear way with the number of units processed.
Product-level costs: These costs are regularly fixed and direct with respect to a given product. An example is the salary of a product manager with responsibility for only one product. The product manager’s salary is a fixed cost to the company for a wide range of production volume levels. However, if the company removes the product totally, the product manager is not anymore needed.
Facility-level costs. These costs are usually fixed and direct with respect to the facility. An example is property taxes on the facility, or the salaries of front office personnel such as the receptionist and office manager.
ABC provides more exact product cost information because traditional costing systems commonly distribute all overhead, including batch-level overhead, using an allocation base that is suitable only for unit-level costs.
The traditional costing system distributes all overhead based on number of units produced. ABC method clearly identifies the cost hierarchy would correct this problem.
ABC could be effectively applied in merchandising and service companies as well as manufacturing firms. Although, originally ABC is attributed to manufacturing companies in the 1980s, by then hospitals were already allocating overhead costs to departments and then to patient services using methods comparable to ABC. Implementations of relatively sophisticated allocation processes were required in hospitals to comply with Medicare reimbursement rules. Other non-manufacturing industries that have benefited from ABC include financial services firms and retailers.
2. If the Farm Council Case did not use Activity Based Costing, identify several dysfunctional decisions that could be made using traditional cost allocation. Which solution do you prefer, the initial or alternative solution proposed in the case?
Unlike ABC, the traditional costing system distributes all overhead based on number of units produced which resulted to inappropriate identification of the cost hierarchy. Thus product costing and pricing is not at all very precise and effective.
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