Question

Sip Organic is a cold-pressed juice manufacturer that creates special wellness juices. As the budget accountant in the new processing department, you are given the task of identifying direct and indirect costs of each new cold-pressing machine.

The controller has asked that you classify the majority of the juicer and department costs as indirect. Classifying the majority of costs will allow you to use the direct labor-based overhead allocation method. Using this method will also charge a lower amount of overhead as long as the costs are smaller direct labor costs.

As the accountant, you have realized that classifying the majority of the costs as indirect will cause a penalty for other departments that typically have larger allocations. These same departments will have lower performance ratings as a result of the change in classification.

• Share how you would handle this situation to be sure that classifying the majority of the costs does not cause penalties for other departments that have larger allocations.

Answer 1

A.) Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

B.) With ABC, a company can soundly estimate the cost elements of entire products, activities and services, that may help inform a company's decision to either:

1. Identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim)

2. Or identify and eliminate production or service processes that are ineffective and allocate processing concepts that lead to the very same product at a better yield (process re-engineering aim)

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.

C.) Methodology of ABC focuses on cost allocation in operational management. ABC helps to segregate

Fixed cost

Variable cost

Overhead cost

The split of cost helps to identify cost drivers, if achieved. Direct labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The cost driver is a factor that creates or drives the cost of the activity. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions (cost driver) takes at the counter and then by measuring the number of each type of transaction. For the activity of running machinery, the driver is likely to be machine operating hours. That is, machine operating hours drive labor, maintenance, and power cost during the running machinery activity.

D.) In the given question classifying the majority of costs will allow us to use the direct labor-based overhead allocation method. Using this method will also charge a lower amount of overhead as long as the costs are smaller direct labor costs.

As the accountant, we have realized that classifying the majority of the costs as indirect will cause a penalty for other departments that typically have larger allocations. These same departments will have lower performance ratings as a result of the change in classification. So if we use Activity based costing for allocation of indirect expenses based on cost centres, indirect cost will not cause a penalty for other departments that typically have larger allocations.