MCFR

MCFR



Business Management

Introduction

The overall aim of this paper is to provide an overview of how overhead costs are allocated to production, both by traditional methods and by more radical approaches developed in the later 20th century. A subsidiary aim is to recognize the increasing need to understand a company's cost base and the contribution that Activity-Based Costing can make to this understanding.

Discussion

Traditional Costing- Full costing

The idea of full costing is disarmingly simple: establishing the cost of a product - a unit of output - (which might be a manufactured article, but which might equally well be a service) in a way that takes account of all the costs involved in production. There are different ways of arriving at the answer, which largely depend on the nature of the output - are all the outputs different, are they all identical, or are they perhaps the typical products of a multi-product or multi-service organization, large quantities of a range of products or services (Drury C., 2005, pp. 75).

Managers need to know what outputs cost to produce or deliver (and what profit is earned by each main category of output). For financial accounting purposes, this is important because it is necessary to split production-related costs between cost of sales (which are expensed in the period to match the related sales) and closing stock (which is carried forward as an asset into future periods and expensed against future sales) (www.iei.liu.se).

For decision-making, this knowledge is also important because of the need to:

Allocate resources and marketing efforts between product lines;

Review product ranges and decide which new products to introduce, and which existing products to retain or to abandon;

Choose between manufacturing in-house and outsourcing products or components; and

Compare an organization's costs against those of its competitors for benchmarking and cost reduction purposes.

Note that this approach tends not to distinguish between variable and fixed costs in the way that CVP does. If a business intends to make a profit by setting prices which cover all its costs, the cost behavior distinction is less important. The key distinction for product costing is between direct costs and indirect costs or “overheads”.

Direct and Indirect Costs

Direct costs are costs that can be traced directly to a product. They may be product-specific (e.g. unique materials and components, or the wages of dedicated production staff who work on only one product). They may also be traced by a process of attribution (e.g. wood used to make chairs, tables and desks can be traced to the three products based on quantities used; wages of production staff who work on all three products can be traced to the products based on records of hours worked).

In both cases the traceability is highly accurate and there is unlikely to be any doubt or disagreement as to how much direct cost is fairly attributable to a product.

However, there are many costs involved in production, or in the delivery of goods and services, which are general "background" ...