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Purposes of Cost Allocation Traditional Costing System
Product cost and period cost Usage Criticisms Definition Comparison Steps Benefits and Limitations
Application in GM
Appear on the income statement when goods are sold, prior to that time they are stored on the balance sheet as inventory. Appear on the income statement in the period incurred.
Departmental focus, not process focus Focus on costs incurred, not cause of costs Over-costing or under-costing
Complex products are not allocated an adequate amount of overhead costs. Simple products get too much.
Often automated
Use proportionately smaller amount of direct labor making direct labor a poor allocation base for factory overhead
Multiple allocation bases should be used to allocate overhead expense In such situations, managers need to consider using activity based costing (ABC)
ABC Definitions
Activity based costing is an approach for allocating overhead costs. An activity is an event that incurs costs. A cost driver is any factor or activity that has a direct cause and effect relationship with the resources consumed.
Costs
Activities
Products
First stage
9
Second stage
Example
ABC Steps
Examples of Activities
1. Processing purchase orders. 2. Handling materials and parts. 3. Inspecting incoming material and parts. 4. Setting up equipment.
Level of costs
Application
When do we use ABC?
The manufacturing process or number of products has changed significantlyfor example, from labor intensive to capital intensive automation. Production or marketing managers are ignoring data provided by the existing system and are instead using bootleg costing data or other alternative data when pricing or making other product decisions.
Started developing ABC in 1986, GM has fully implemented ABC as a statistical analysis system for product costing since 1993.
Initiation feasibility analysis is done (1986) Adoption (1987) decision to invest some level of resources is made Adaptation (1990) analysis is made of firms activities and cost drivers, ABC information is available but not yet used by nonaccounting staff for decision-making ? Acceptance(1991) occasionally used by upper management AS AN INPUT for decision-making, but still considered a project or model Routinization commonly used by upper management for decisionmaking and considered a normal part of the information system, astablishing a net-work ABC user in GM. Infusion/integration used extensively and fully integrated within the primary financial system
Helps GM to find the most profitable assets in company, including customers, investments and products. Drives GM efficient decision making in manufacturing more profitable products and stopping unprofitable ones. It will enable GM to be more cost effective and run the business more efficiently. Reduce expenditures by eliminating un-value-added process ABC system creates a competitive advantage for GM
Easy to identify where high (and low) costs are being incurred and the cause.
Helps companies figure out ways to raise profits without raising prices More accurate costing of products/services, customers, distribution channels. A valuable tool for both business and process improvement. Helps with future product planning by allocating resources effectively
Integrates well with continuous improvement programs (Six Sigma, Kaizen, Just-in time, Total Quality Management...), A valuable tool for both business and process improvement
Complex, time consuming, and costly to collect data Cost of buying, implementing and maintaining activity
based system
Conclusion
ABC was developed in 1988 as a solution to the inadequacy of traditional system, however, there are many limitations in ABC system that lead to further research and result in the development of lean accounting methods such as Balanced Scorecards and Economic Value Added (EVA) which is less complex and costly than ABC system
Reference
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