Accounting for Managers: Interpreting accounting information for decision-making

ACCOUNTING DECISIONS 161

Leading companies, according to Kaplan and Cooper (1998), use their enhanced
cost systems to:

ždesign products and services that meet customer expectations and can be
produced at a profit;
židentify where improvements in quality, efficiency and speed are needed;
žassist front-line employees in their learning and continuous improvement;
žguide product mix and investment decisions;
žchoose among alternative suppliers;
žnegotiate price, quality, delivery and service with customers;
žstructure efficient and effective distribution and service processes to targeted
market segments.

There are two methods of overhead allocation: absorption costing (the traditional
method) and activity-based costing. These are compared in the next section,
together with variable costing, a method that does not allocate overheads at all.
Table 11.1 shows a comparison between the three methods.

Alternative methods of overhead allocation

Variable costing

We have already seen (in Chapters 8, 9 and 10) the separation of fixed from variable
costs. A method of costing that does not allocate fixed production overheads to

Table 11.1 Alternative methods of overhead allocation

Variable costing Absorptioncosting Activity-based costing

Allocates only
variable costs as
product costs.

Allocates all fixed and variable

production costs as product

costs.

Allocates all costs to
products/services that can be
allocated by cost drivers.
All fixed costs are
treated as period
costs.

All non-production costs are

treated as period costs.

The distinction between

production and non-production

costs is not important.

Accumulate costs in cost centres

and measure activity in each cost

centre.

Accumulate costs in activity cost

pools and measure the drivers of

activities for each cost pool.

Budgeted overhead

rate=

cost centre costs

unit of activity

(e.g. labour hours)

Cost driver

rate=

activity cost pool

activity volume

(e.g. purchase orders)

Calculate product/service cost

for each cost centre as unit of

activity (e.g. labour hours)×

budgeted overhead rate and add

for all cost centres to give total

product/service cost

Calculate product/service cost

for each cost pool as activity

volume×cost driver rate and

add for all pools to give total

product/service cost