Chapter 1 Introduction

Contents
Contents..................................................................................................................... 1 Acknowledgement.......................................................................................................3 - Abstract ................................................................................................................... 4 - Introduction ...........................................................................................................5 Motivation of the Study..........................................................................................5 -The Research problem:..............................................................................................6 -Objective and significance of the study......................................................................6 -Hypothesis .............................................................................................................. 7 -Research questions....................................................................................................7 Literature Review........................................................................................................ 9 Contents................................................................................................................... 13 Research Strategies:.................................................................................................15 Research Design:................................................................................................... 15 Sample and Sampling Techniques.............................................................................16 Research method .....................................................................................................16 Gathering and collection Data :..............................................................................17 Contents................................................................................................................... 17 COST ALLOCATION IN GENERAL................................................................................19 Purposes of cost Allocation........................................................................................20 Cost allocation Bases:...............................................................................................21 1

Cost Drivers.......................................................................................................... 21 Cost objects........................................................................................................... 22 Common cost objects.............................................................................................23 Tracing costs to cost objects..................................................................................24 Methods of cost allocation ........................................................................................26 Types of cost allocation.............................................................................................27 Cost allocation plans.................................................................................................28 A) TYPES OF ALLOCATION PLANS...........................................................................28 b) Suggestions should also be considered when developing a CAP:........................29 c) VALUE OF COST ALLOCATION PLANS .................................................................29 Traditional and Activity Based Cost accounting systems:..........................................31 Traditional Method:................................................................................................31 Activity-based Costing ...........................................................................................34 Data gathered through the questionnaire..................................................................55 Contents................................................................................................................... 61 Conclusion:...............................................................................................................63 Limitation:................................................................................................................. 66 Criticism of Activity-based Costing.........................................................................66 Problem With Cost-allocation..................................................................................67 References:...............................................................................................................69 Books:....................................................................................................................69 Internet:.................................................................................................................69 Glossary....................................................................................................................70 Appendix................................................................................................................... 75

Acknowledgement First and foremost, we would like to thank our supervisor of this project, DR. LILIAN GHEYATH for the valuable guidance and advice. We also would like to thank DR. INGUVA, DR. ABDULLAH SALIH, DR. AKBAR & DR. Samia. Besides, we would like to thank MR. ABRAHAM MATHEW for providing us with a good data to complete this project. Finally, an honorable mention goes to our families and friends for their understandings and supports on us in completing this project. Without helps of the particular that mentioned above, we would face many difficulties while doing this project.

- Abstract
The subject matter of this research paper is the detailed consequences of putting in place an Activity-Based Costing system and its structure within the manufacturing industry. Moreover, it defines steps within ABC application .The research topic is about (cost allocation in manufacturing company) and the implementation was on Emirates Containers. Through research paper we realized that most U.A.E. manufacturing companies especially the biggest one are used the ABC method and shift from traditional method for calculating cost .because The difficulty inherent in choosing a proper and accurate product costing method for manufacturing enterprises has been widely discussed by academics and practitioners. The important limitation of traditional (absorption) costing methods had been deeply discussed along with advantages of other costing method as Variable Costing or Activity-Based Costing (ABC). Despite the fact that issues relating to ABC have been widely discussed by researchers and practitioners in the past ten years, this modern concept still lacks general rules governing both methodology and cost. The implementation of ABC system could enhance control over overhead costs and lead to better and accurate management decisions, so ABC system is more realistic and it will help manufacturing companies in planning for future expansions and improvements of product level.

The concept of Activity-based costing (ABC) system is a method of allocating

costs to products and services. It is generally used as a tool for planning and control. It was developed as an approach to address problems associated with traditional cost management systems that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. With these defense managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services.

Different source of information were consulted together .These sources include books, internet research and questioner.

This study is about comparison between traditional methods and ABC method

- Introduction
Management cannot avoid the decision making process which always focused on specific goals and without data the decisions lack both efficiency and effectiveness. So in the growing era of competition, the methods of ascertaining the accurate cost of a product or service or devising methods to control the same is a matter which requires skill, ability, imagination and innovation. Thus the cost accounting techniques helps the management in planning, controlling and decision making.

Determining the cost of a product, service or process or an operation is the objective underlying here. This information is vital in important decisions such as make or buys decisions, profitable product mixes, introduction of new products, pricing strategies and discontinuance of un viable product lines.

Thus our project is about to assess the importance of cost allocation as the costs can be broadly classified as Direct and Indirect costs but the techniques that required to allocate the indirect costs to products or processes to arrive at the most reliable cost figures to help the management in the decision making process is our focus of the project.

Motivation of the Study

We learned from our classes that the cost allocation methods are vital in arriving at the accurate cost of a product where a company produces more than one product or wherein more than one process involved. Also we learned that the accuracy of cost is vital for management decision making which can even lead companies to disasters if the information is not accurate and reliable.

-The Research problem:

Actually we found there are many reasons for searching for new approach for costing and that du to knowing that traditional method is not appropriate and it lead to not accurate decisions because it give not accurate costing information. and that reasons are listing below Tremendous change in manufacturing and service industries.

Decrease in amount of direct labor usage.

Significant increase in total overhead costs.

May be inappropriate to use plant-wide predetermined overhead rates based on direct labor or machine hours when lack of correlation exists

Complex manufacturing processes may require multiple allocation bases : this approach is called Activity-based costing ( ABC).

-Objective and significance of the study

1. To know different between traditional costing and activity-based costing(ABC).

2. Need for new approach for costing because traditional costing not sufficient and appropriate in all cases .
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3. Ascertaining the accurate cost allocation methods to help the management in their decision making process. A wrong cost allocation can lead the company into disastrous decisions.

-Hypothesis
To arrive at the accurate cost allocation through the Activity based costing method and to compare it over the traditional method.

-Research questions
Can ABC system overcomes the defects on the Traditional method?

If ABC will give accurate information more than traditional method?

Chapter 2 Literature Review

Literature Review

Cost allocation is a process where indirect costs are assigned to different departments, processes or products. It is a management accounting tool that can help to control costs, maximize profits and motivate employees, regardless of industry. Consequently, it improves decision making and helps companies to meet their ultimate goals. The usefulness of accounting cost allocations have been debated for many years. Thomas argued that financial cost allocations are irrelevant (Turner et al, 2008). However, in his other works, cost allocations for managerial purposes might be useful in attaining certain behavioral response and hence the objectives of the firm (Turner et al, 2008). There are many methods of cost allocations; the traditional method of using a single cost driver, Activity Based Costing (ABC), Time Driven ABC and Ratio of Cost to Charges (RCC). ABC is a widely recognized as a superior method of allocating overhead costs (Witherie et al, 2006). Even though this method has been more emphasized for implementation in the manufacturing industry, the service industry does also benefit from this method due to their high indirect costs such as overheads and labour. Previously, limited costs analyses were performed by banks due to limited knowledge of cost allocation by cost accountants (Zabihollah, 2005). However, with rising challenges in keeping internal costs low with higher profit returns in business units, product lines and customer services, cost allocation is a necessary evil (Zabihollah, 2005). The competitive environment in the banking industry makes ABC imperative to achieving the levels of profitability required (http://www.decisionsciences.org/Proceedings/DSI2008/). ABC was implemented in the banking industry in the United States and United Kingdom since the 1980s (Witherie et al, 2006; Helmi et al, 1996).

Cost allocation has been studies as a complex organizational problem over the last century (Homgren, 1996).it has been studied under the rubric of overhead allocation. Extant research on cost allocation is diverse and progressively heading from the theoretical prescription of 'no allocation'(Thomas,1969;Wells,1970;Vatter,1945)to
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'strategic allocation'(Gal-or,1993;Alles and Datar,1998;Cavallazzo et.al.,2001).Its use in competitive markets has been prevalent over the last century but little is understood about the cause and effect relationship of costs and the driving forces behind the costs(Horngren,1996)Despite these diverse theories and practices on cost allocations, costs are still allocated in organizations to serve various organizational purposes (Zimmerman,1979,2000;Horngren et al.2000).Empirical evidences also strongly endorse the use of cost allocation for various organization purposes(see for example , Fregman and Liao,1981;Atkinson,1987;dean et.al.1991).Most of the uses impact on decision making in a very simplistic situation and does not draw the complex issues facing real life organizations (Kaplan and Johnson,1987). In 1923,J.Maurice Clark coined the Phrase 'different cost for different purposes', but most companies only have one costing system, which is used for all purposes: stock valuation, planning ,control and decision making(Brignall,1997).Prior to the introduction of ABC costing system, a number of companies, particularly manufacturing sectors, used a traditional costing system called volume-based costing system which is volumebased cost driver such as direct-labor hours ,direct labor cost, or machine hours. At most the cost are classified into two main parts that are product cost which is a cost assigned to the goods that were either purchased or manufactured for resale and period cost where administration and selling are recognized as expenses during the period in which they are incurred .If inventories are manufactured , the product cost is relatively easy to trace to production job but manufacturing overhead is not easily traced to jobs as these costs often bear no direct relationship with individual jobs or units of product(Hilton ,2005). The conventional or traditional accounting system allocates the manufacturing overhead to the products either plant wide overhead rate or on twostage allocation system. The former allocates cost on a single activity base for the entire factory. but the latter assigns manufacturing overhead cost based on departmental activities. Under this system, at the first stage, the manufacturing cost is collected into cost pools and then attached to products by a method based on unit volume of production such as direct labour hours (Brignall, 1997). Thus, the allocation of manufacturing cost depends on the types of resources that the products consume. The greater the products consume the resource, the higher the overhead attached to the products based on one particular activity base such as direct labour hour, machine hour or direct labour cost. Furthermore, this system allows for cost distortions, which will be greater in business units with a higher proportion of overhead costs (Baird, Harrison, & Reeve, 2004). While this approach has the advantage of simplicity, it will result in systematic miscosting where overheads are not volume driven (Innes & Mitchell, 1997).

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Researchers noted that this system failed to reflect other resource or cost of activities that added value to the production (Adams, 1996; Innes & Mitchell 1997; Johnson & Kaplan, 1987). Other than that, Copper and Kaplan (1987, cited in Adams, 1996) assert that traditional cost and management accounting systems such as those based on standard costing and absorption costing have measured company performance imperfectly because they have not kept up with the developments in production technology and consumerism. Therefore, to avoid biased cost reporting, the allocation of overheads to cost objects should not be based on a common volume-related measure, such as direct labour hour but on the groups of activities which generate those overheads (Kaplan, 1987, cited in Adams, 1996).

An overhead allocation based on activity centers avoids a common consequence of traditional output-based costing system particularly under cost low volume products. study conducted by Innes and Mictchell (1997) found that overheads based on activity centers facilitate the targeting of unnecessary, wasteful, resource usage and the costly effects of over-complex ways of running a business process. This technique, which is popularly known as Activity-Based costing (ABC), is a system that focuses attention on the costs of various activities required to produce a product or service (Baird et al., 2004: 384). This system is in favor of many organizations in order to provide true cost information for their strategic decision-making. The ABC, first developed by Cooper and Kaplan (e.g. Cooper, 1988; Cooper and Kaplan, 1988), is a system that will reduce the level of arbitrary cost allocations associated with traditional costing systems and result in more accurate product cost (Baird et al., 2004). Many authors have advocated the benefits of ABC, and a number of studies have provided empirical evidence to support those benefits (Anderson, 1995;) Foster and Swenson, 1997; McGowan and Klammer, 1997; Norris, 1994; Swenson, 1995 all cited in Baird et al., 2004). Spicer (1993, cited in Adams, 1996) noted that besides providing more accurate product costing, ABC also improves the basis upon which strategic decisions, involving resource allocation, product mix, pricing and marketing, are made. Cagwin and Bouwman (2002) further listed authors who are in the opinion that, the application of ABC is more effective in specific environmental conditions (enabling conditions) such as manufacturing complexity (Jones, 1991), environments with specialty product costs (Srinidhi, 1992) and diverse (multiple different) business environments (Cooper & Kaplan, 1988). Furthermore, the refined treatment of overhead cost by using ABC system can facilitate the identification of how individual customer influences the cost of supply (Innes & Mitchell, 1997). Bellis-Jones (1989) found that when ABC is
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used in this way, customer profitability profiles and analysis are possible and market strategy is enhanced by this intelligence (cited in Innes & Mitchell, 1997). In the beginning, ABC cost management system was common in the manufacturing environment where the identification of activities associated with the products was still less complex and in some instances the activities were direct. However, now even the service sectors adopt ABC cost management, acknowledging the importance of cost information for survival in the increased competition. A number of researches revealed successful applications of ABC in private as well in public service sectors, such as financial institutions, hotel sectors, health centers, transport companies, and telecommunication (Adams, 1996; Cagwin & Bouwman, 2002; Innes and Mitchell, 1997; Kock, 1995; Kullven & Mattson, 1994; Lambert and Whitworth, 1996). Thus, the service sectors shift the cost management focus from conventional costing system to the ABC system.

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Chapter 3 Research methodology

Contents
Contents..................................................................................................................... 1 Acknowledgement.......................................................................................................3 - Abstract ................................................................................................................... 4 - Introduction ...........................................................................................................5 Motivation of the Study..........................................................................................5 -The Research problem:..............................................................................................6 -Objective and significance of the study......................................................................6 -Hypothesis .............................................................................................................. 7 -Research questions....................................................................................................7 Literature Review........................................................................................................ 9 Contents................................................................................................................... 13 Research Strategies:.................................................................................................15 Research Design:................................................................................................... 15 Sample and Sampling Techniques.............................................................................16 13

Research method .....................................................................................................16 Gathering and collection Data :..............................................................................17 Contents................................................................................................................... 17 COST ALLOCATION IN GENERAL................................................................................19 Purposes of cost Allocation........................................................................................20 Cost allocation Bases:...............................................................................................21 Cost Drivers.......................................................................................................... 21 Cost objects........................................................................................................... 22 Common cost objects.............................................................................................23 Tracing costs to cost objects..................................................................................24 Methods of cost allocation ........................................................................................26 Types of cost allocation.............................................................................................27 Cost allocation plans.................................................................................................28 A) TYPES OF ALLOCATION PLANS...........................................................................28 b) Suggestions should also be considered when developing a CAP:........................29 c) VALUE OF COST ALLOCATION PLANS .................................................................29 Traditional and Activity Based Cost accounting systems:..........................................31 Traditional Method:................................................................................................31 Activity-based Costing ...........................................................................................34 Data gathered through the questionnaire..................................................................55 Contents................................................................................................................... 61 Conclusion:...............................................................................................................63 Limitation:................................................................................................................. 66 Criticism of Activity-based Costing.........................................................................66 Problem With Cost-allocation..................................................................................67 References:...............................................................................................................69 Books:....................................................................................................................69 Internet:.................................................................................................................69 Glossary....................................................................................................................70 Appendix................................................................................................................... 75

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Research Strategies:
Our research follows Quantitative research strategies, so the principal orientation to the role of the theory in relation to research is deductive, as a result of that the epistemological orientation to adapt a natural science model in particular positivism ,Epistemological considerations loom large in considerations of research strategy .To a large extent, these revolve around the desirability of employing a natural science model versus interpretivism .and the ontological orientation will be objectivism. Objectivism is an ontological position that implies that social phenomena confront us as external facts that are beyond our reach our influence .Ontological consideration constitute important dimensions of the quantitative contrast.

Research Design:
The research design is a case study about (Emirates containers) with a view to revealing important features about its nature. Regarding to the level of analysis is about organization. The case study design it's developing analytic and problem solving skills and allow for exploration of solution for complex issues.

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Sample and Sampling Techniques

In order to investigate our research question we need to study a population with specific characteristic and those population are Managements and Accountants in manufacturing industry .In addition to that the sample strategy we employed probability sampling and we chose the Stratified sample because our sample chosen based on occupation .Regarding Response rate was: Number of usable questionnaires Total sample Unsuitable or uncontestable members of the sample x 100

50 80 - 20

x 100

=83.3%

50 number of usable questionnaires 80 total sample 20 unsuitable or uncontestable member of the sample

So the respond rate=87.5% which is avoid us to bias in our result or conclusion.

(Bryman&Bell, 2007)

Research method
We following the research principles so as we said that our research is quantitative one so we must use questionnaire method in gathering the data .we use that method rather than interview because we want to test our hypothesis not to build the hypothesis .The type of Questions in our research is questions about knowledge and we follows the Binary response format this format is include (Agree Disagree - Don't know).

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Gathering and collection Data :

The present study is based on both secondary and primary sources of information collected from the officially published secondary recourse like website, books and the primary data include the result from our questionnaire that distributed to the population. Through gathering and collecting information we followed multiple steps which represent the instruments of the research. First of all we start reading more and more about the topic to be fully involved, and then we implement the study on the reality.

Chapter 4 Analysis and Interpretation of Data

Contents
Contents..................................................................................................................... 1 Acknowledgement.......................................................................................................3 17

- Abstract ................................................................................................................... 4 - Introduction ...........................................................................................................5 Motivation of the Study..........................................................................................5 -The Research problem:..............................................................................................6 -Objective and significance of the study......................................................................6 -Hypothesis .............................................................................................................. 7 -Research questions....................................................................................................7 Literature Review........................................................................................................ 9 Contents................................................................................................................... 13 Research Strategies:.................................................................................................15 Research Design:................................................................................................... 15 Sample and Sampling Techniques.............................................................................16 Research method .....................................................................................................16 Gathering and collection Data :..............................................................................17 Contents................................................................................................................... 17 COST ALLOCATION IN GENERAL................................................................................19 Purposes of cost Allocation........................................................................................20 Cost allocation Bases:...............................................................................................21 Cost Drivers.......................................................................................................... 21 Cost objects........................................................................................................... 22 Common cost objects.............................................................................................23 Tracing costs to cost objects..................................................................................24 Methods of cost allocation ........................................................................................26 Types of cost allocation.............................................................................................27 Cost allocation plans.................................................................................................28 A) TYPES OF ALLOCATION PLANS...........................................................................28 b) Suggestions should also be considered when developing a CAP:........................29 c) VALUE OF COST ALLOCATION PLANS .................................................................29 Traditional and Activity Based Cost accounting systems:..........................................31 Traditional Method:................................................................................................31 Activity-based Costing ...........................................................................................34 Data gathered through the questionnaire..................................................................55 Contents................................................................................................................... 61 18

Conclusion:...............................................................................................................63 Limitation:................................................................................................................. 66 Criticism of Activity-based Costing.........................................................................66 Problem With Cost-allocation..................................................................................67 References:...............................................................................................................69 Books:....................................................................................................................69 Internet:.................................................................................................................69 Glossary....................................................................................................................70 Appendix................................................................................................................... 75

COST ALLOCATION IN GENERAL

Cost allocation is fundamentally a problem of linking (1) Some cost or groups of costs with (2) one or more cost objectives, such as products, Departments, and divisions. Ideally, costs should be assigned to the cost objective that caused it. In short, cost allocation tries to identify (1) with (2) via some function representing causation. Linking costs with cost objectives is accomplished by selecting cost drivers. When used for allocating costs, a cost driver is often called a cost-allocation base. Major costs, such as newsprint for a newspaper and direct professional labor for a law firm, may each be allocated to departments, jobs, and projects on an item-by-item basis, using obvious cost drivers such as tones of newsprint consumed or direct-labor-hours used. Other costs, taken one at a time, are not important enough to justify being allocated individually. These costs are pooled and then allocated together. A cost pool is a group of individual costs that is allocated to cost objectives using a single cost driver. For example, building rent, utilities cost, and janitorial services may be in the same cost pool because all are allocated on the basis of square meters of space occupied. Or a university could pool all the operating costs of its registrars office and allocate them to its colleges on the basis of the number of students in each faculty. In summary, all costs in a given cost pool should be caused by the same factor. That factor is the cost driver. Many different terms are used by companies to describe cost allocation in practice. You may encounter terms such as allocate, attribute, reallocate, trace, assign, distribute, redistribute, load, burden, apportion, and reapportion, which can be used interchangeably to describe the allocation of costs to cost objectives.
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Purposes of cost Allocation

What logic should we use for allocation cost? The answer depends on the purpose (S) of the cost allocation. In short, there are no firm rules that we can rely on there is no best cost -allocation system. There are nearly as many schemes for allocation as there are companies. We focus in general concepts that provide guidance when managers design these systems. Recall that cost allocation support a companys CMS the system providing cost measurement for strategic decision making, operation control, and external reporting. We list four purposes of cost allocation here; 1 To provide information for economic decisions The economic decision that may need cost Allocation information: 2 To decide whether to add a new product To decide whether to manufacture a component part or to purchase it from another manufacturer To decide on the selling price for a product To motivate managers and other employees Managers and employees need to be encouraged to design products that are simpler to manufacture or less costly to service. Sales representatives need to be motivated products or services 3 To justify costs or compute reimbursement to push high-margin

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 It is important to cost products at a fair defense contracts.

price, especially in government

A consulting firm that is paid a percentage of the cost savings resulting from the implementation of its recommendations needs to justify costs in order to compute reimbursement 4 To measure income and assets for reporting to external parties Inventory costs must be determined for financial reporting and for reporting to tax authorities. Under generally accepted accounting principles, inventoriable costs include manufacturing costs but exclude research and development, marketing, distribution, and customer service costs.

Cost allocation Bases:

Cost Drivers
Cost drivers are the dynamic factors that have the ability to change total costs (i.e., there is a direct causal relationship between the change in the activity or amount of the cost driver and the total cost incurred). Cost drivers may be either volume based, activity based or based on any number of other operational characteristics that we will define in this section. Generally, however, volume-based cost drivers are used in traditional costing allocation systems and volume-based as well as other non-volume cost (and activity) drivers are used for activity-based costing allocations. Cost drivers are often used as overhead allocation bases Typically, cost drivers are activity bases that are closely correlated with the incurrence of manufacturing overhead costs in an activity center. Often, manufacturing overhead is allocated to products, etc. through the use of cost drivers (which are then referred to as allocation bases). Types of cost drivers 1. Activity based Activity -based cost drivers relate to an activity (e.g., packaging, inspection, etc.). 2. Volume-based

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Volume- based cost drivers are based on an aggregate volume of output (e.g. the number of direct labor hours used or the number of production units). 3. Executional (Short-term) Executional cost drivers are the dynamic factors that are helpful to the firm in managing the short-term costs of the firm (e.g. relationships with suppliers, enhancements to the production process, and involvement of staff in creating a more efficient process). 4. Structural (Long-term) Structural cost drivers are strategic decisions or plans made by the firm that have a long-term effect on the cost (e.g. experience, available technology, complexity, etc.).

Examples of Cost Drivers: Number of purchase orders processed. Number of material requisitions. Number of receipts. Number of setups. Number of machine hours. Number of assembly labor hours. Number of inspections. Number of boxes shipped.

Cost objects
Cost objects (or cost objectives) are defined as resources or activities that serve as the basis for management decisions. Cost objects require separate cost measurement. Cost objects may take most any form; however, they will represent the most relevant components of a particular businesss decision-making requirements. Cost objects may

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be products, product lines, departments, geographic territories, or any other classification that aids in decision-making. a. Focus of cost objectives Cost objectives focus either on costing (valuation) of product or inventory (i.e., product costing) or cost control (i.e., cost comparison to standards and budgets). Integration of product costing with cost control objectives maximizes the effectiveness of management accounting system. b. Cost measurement depends on use Cost objects may have more than one cost measurement depending on their use for either reporting or management decisions. Inventory (product) costs for financial statements are usually different than costs reported for tax purposes. Both inventory (product) costs and costs reported of tax purposes are different from costs used by management to make decisions. c. Accumulate and Allocate Cost accounting systems accumulate costs that are directly traceable to cost objectives and also allocate joint costs that are not directly traceable to cost objectives. d. Identifies joint costs Cost allocation identifies joint costs with an appropriate cost objective and is intended for the following purposes: 1. Assisting decision- making 2. Motivating employees 3. Measuring income and assets 4. Justifying costs

Common cost objects

1. Product Costs Product costs are all costs related to the manufacturing of the product. These costs are inventoriable (i.e., considered as assets before the product is sold) and are said to

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attach to the units of output. Product costs consist of direct materials, direct labor, and manufacturing overhead. 2. Period Costs Period costs are expensed in the period in which they are incurred and are not inventoriable. Period costs include selling and administrative expenses, interest expense, and all other costs of selling the product and administering and managing the operations of the firm. 3. Manufacturing Costs (Treated as Product Costs) Manufacturing costs include all costs associated with the manufacture of a product, including both direct and indirect costs. These costs are specifically capitalized to the cost of the manufactured product, according to various available and appropriate methods. The existence of manufacturing costs leads to the need for tracing of the costs to specific cost objects through direct means or via cost drivers (or, allocation bases) and the use of a costing method to determine the cost of the product for inventory purposes, cost of goods sold, etc. 4. Non-manufacturing Costs (Treated as Period Costs) Non- manufacturing costs are those costs that do not relate to the manufacturing of a product. These costs (e.g., selling, general, and administrative expenses) are expensed in the period incurred.

Tracing costs to cost objects

Tracing costs to the cost objects or cost pools is complicated by the existence of direct or indirect relationship of the cost to the cost object. While direct costs are relatively easy to assign, the assignment of indirect costs is often much more complicated. Direct costs (easily traced) A direct cost can be easily (i.e., without excessive cost and without significant effort) traced to a cost pool or object, as the cost directly relates to that item. For example, raw materials (fabric or leather) used in the production process of a

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custom order (a couch) are easily traced to the cost object, the custom order. Examples of direct costs include:

1. Direct Raw Materials Direct raw materials are the costs of materials used in production or purchased (including freight-in net of any applicable purchase discounts) plus a reasonable amount for normal scrap created by the process. 2. Direct Labor Direct labor (For example, the upholsterer that makes the couch) is the cost of the labor that is directly related to the product or the performance of a service plus a reasonable amount of expected down time for the labor (e.g., breaks, setup, training, etc.).

Indirect costs (OVERHEAD ALLOCATED USING COST DRIVERS) An indirect cost is not easily traceable to a cost pool or cost object. The cost was incurred to benefit two or more cost pools or objects, and the specific benefit each direct cost gave to the cost pool or object cannot be determined without making some sort of reasonable estimate. Therefore, indirect costs are assigned to cost pools or objects using cost drivers that are considered to have a strong relationship to the incurrence of direct costs. The cost drivers that are used to allocate indirect costs are referred to as allocation bases. Often, all indirect costs are allocated to a single cost pool called overhead and allocated as a single pool. Overhead manufacturing business is termed manufacturing overhead. Examples of indirect costs include: 1. Indirect Materials Indirect materials are the cost of materials that were not used specifically or could not be traced to the completed product with ease. Examples of indirect materials include the cleaning supplies used in the manufacturing area, small replacement parts for the manufacturing machines, general research materials for a service firm, etc. 2. Indirect Labor

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Indirect labor is the cost of labor that is not easily traceable to a particular product, service, etc. most often; this type of labor supports the manufacturing process but does not work directly on the specific job, etc. Examples of indirect labor include forklift drivers, maintenance workers, shift supervisors, workers in the receiving department, janitorial staff, inspectors, engineers, training and other human resource staff in public accounting firms, etc. 3. Other Indirect Costs Other indirect costs are indirect costs other than those for materials or labor. Included in this category is depreciation for the facility and for the machinery, rent of the production warehouse, machine maintenance, property taxes on the building, insurance, rent, utilities, etc.

Methods of cost allocation

Now lets turn to the question of how companies allocate costs. Because final products or services are important cost objects to nearly all organizations, we focus on how companies trace direct costs and allocate indirect costs to these cost objects. Physically tracing the direct costs is usually straightforward. For example, the cost workers can record the time spent on each product. Workers can record the time spent on each product and the system can value each hour at the workers appropriate wage rate. Systems to accurately measure direct cost have been available for decades, even centuries. Allocating indirect costs is more complex, and accountants have more chance to influence the resulting cost by the allocation choices they make. Because of the growth in indirect costs for most companies, allocating indirect costs is especially important. Allocation is a 5-step process:

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1-Accumulate indirect costs for a period of time, for example one month, into one or more cost pools. Many simple cost accounting systems place all indirect production costs in a single cost pool. 2-select an allocation base for each cost pool, preferably accost driver, that is, measure that causes the costs in the cost pool. Companies that have a single cost pool for indirect production costs often use direct labor hours or direct labor cost as the cost allocation base. 3- Measure the units of the cost-allocation base used for each cost object (for example, a product) and compute the total units used for all cost objects (for example, all products). 4- Determine the percentage of total cost-allocation base units used for each cost object. 5- Multiply the percentage in step 4 by the total costs in the cost pool to determine the cost allocated to each cost object.

Types of cost allocation

Three Types of Allocations 1. Allocation of joint costs to the appropriate responsibility centers. Costs that are used jointly by more than one unit are allocated based on cost-driver activity in the units. Examples are allocating rent to departments based on floor space occupied, allocating amortization on jointly used machinery based on machine-hours, and allocating general administrative expense based on total direct cost. 2. Reallocation of costs from one responsibility centre to another. When one unit provides products or services to another, the costs are transferred along with the products or services. Some units, called service departments, exist only to support other departments, and their costs are totally reallocated. Examples include personnel departments, laundry departments in hospitals, and legal departments in industrial firms. 3. Allocation of costs of a particular organizational unit to its outputs of products or services. The pediatrics department of a medical clinic allocates its costs to patient visits, the assembly department of a manufacturing firm to units assembled, and the tax department of a CA firm to clients served. The costs allocated to products or services include those allocated to the organizational unit in allocation types 1 and 2.
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Cost allocation plans

A Cost Allocation Plan (CAP) is a document that identifies, accumulates and distributes Allowable direct and indirect costs under sub grants and contracts and identifies the allocation methods used for distributing the costs. A plan for allocating joint costs is required to support the distribution of those costs to the grant program. All costs included in the plan must be supported by formal accounting records to substantiate the propriety of the eventual charges.

A) TYPES OF ALLOCATION PLANS A distinction is made between two types of CAPs; i.e. the plans needed to allocate organization-wide and central services costs to individual departments within the organization (Indirect Cost Plan) and the plans needed to allocate costs within a department to grants and other final cost objectives. The indirect cost plan identifies and distributes the costs of services provided by support organizations (such as personnel, treasury, security, legal) to departments or units administering Federal grants or contracts. At the State level it is referred to as the State-Wide Cost Allocation Plan (SWCAP). Indirect cost/central service CAPs are usually approved by a Cognizant Federal agency. Similar types of indirect CAPs for central services are also common to local units of government and to larger nonprofit organizations. Indirect cost plans are discussed further in a later section. The second type of CAP distributes the administrative or other joint costs incurred within a performing (sub-recipient or contractor) department or unit, together with the service costs allocated to it under the indirect cost proposal, to
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all work performed by that department or unit. This type of plan is developed by the unit that directly operates the WIA program to allocate

Costs between its WIA and non-WIA programs and between cost categories within WIA. This type of plan is commonly referred to as a CAP.

b) Suggestions should also be considered when developing a CAP: Keep it Simple. The simplest and least costly method possible, based on a measure of relative benefit received, that will produce an equitable allocation of costs to programs and cost categories, should be used. Make it Replicable. The process that is developed must be able to be duplicated at any time, and with changes in the organization or funding levels. Simplify the Organizational Structure. The organizational structure of the CAP should be made no more complicated than necessary to allocate costs. Consider What is Required. The required structure and capabilities of the accounting system must be considered in designing an operable cost allocation process. Make Changes Prudently. Changes in an organizations CAP that result in retroactive redistribution of costs to the benefiting cost objective are allowable where the change results in a more equitable distribution of costs. Such changes in allocation methodology should be rare, should receive the necessary prior approvals, and should be justified and well documented.

c) VALUE OF COST ALLOCATION PLANS In addition to documenting the allocation of costs and prior approvals, the CAP has other benefits and advantages for the organization. As a management tool, the CAP provides a clear and concise method to develop budgets and prepare plans. It also promotes equitable sharing of indirect costs from all programs and activities, beginning with their appropriate recognition in the budget process. The CAP eliminates the arbitrary methods sometimes used to account for all costs as direct costs in order to achieve full reimbursement and establishes creditable fiscal accountability practices that recognize indirect and shared direct costs as a necessary cost of program delivery. It is vital to the establishment of financial management standards and practices that may be applied uniformly with all grantee agencies through the accounting and budgeting process, as well as, the creation of financial management structures that recognize that costs.
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Relative to programs or units of service consist of both direct and indirect costs. An additional benefit of the CAP is that it promotes the use of up-to-date, integrated grantee accounting systems and procedures within their organizational entities, so that shared direct and indirect costs can be identified and allocated across all programs and activities. Finally, the CAP meets Federal cost principles and standards when requiring approved plans as a prerequisite to claiming reimbursement of indirect costs and improves and standardizes fiscal management policies and practices.

All three types of allocations are fundamentally similar. Let us look first at how service department costs are allocated to production departments.

EXHIBIT4-1 Three Types of Cost allocation

Cost accounting system accumulates costs

Allocation Type 1 Costs allocated to responsibility centers.

Cost Objective 1 Responsibility centers.

Allocation Type 2 Allocation Type from Costs allocated 3 centers Costs allocated to centre one responsibility products, jobs, or projects. to another.

Cost Objective 2 Cost objective Responsibility 3 Products, products receiving Jobs, or Projects. or services.

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Traditional and Activity Based Cost accounting systems:

Traditional Method:
The traditional method of cost accounting refers to the allocation of manufacturing overhead costs to the products manufactured. The traditional method (also known as the conventional method) assigns or allocates the factorys indirect costs to the items manufactured on the basis of volume such as the number of units produced, the direct labor hours, or the production machine hours. We will use machine hours in our discussion. By using only machine hours to allocate the manufacturing overhead to products, it is implying that the machine hours are the underlying cause of the factory overhead. Traditionally, that may have been reasonable or at least sufficient for the company's
31

external financial statements. However, in recent decades the manufacturing overhead has been driven or caused by many other factors. For example, some customers are likely to demand additional manufacturing operations for their diverse products. Other customers simply want great quantities of uniform products. If a manufacturer wants to know the true cost to produce specific products for specific customers, the traditional method of cost accounting is inadequate. Activity based costing (ABC) was developed to overcome the shortcomings of the traditional method.

EXHIBIT4-2 Traditional & ABC system Traditional cost system

= cost driver

Direct Direct Labor Cost Material = Activity center Cost

Overhead Costs

Direct Trace

Direct Trace

DLH

Products 32

ActivityBased cost system

Overhead costs

Direct Materials Costs

Direct Labor Costs

Machining Activity costs (Cost driver A) Processing hours (cost driver D)

Assembly activity costs (Cost driver B)

Quality inspection activity costs (Cost driver C)

Direct Trace

Direct Trace

Number of parts (cost driver E)

Number of inspection s (cost driver F)

(cost driver D)

Products

EXHIBIT4-3
Comparison of Traditional & ABC Overhead Allocation Method Particular Traditional Overhead Allocation One or Few One or Few Correlative ABC Overhead Allocation Several Several Casual

Number of Cost Pool Number of Allocation Base Relationship of Allocation Base with cost

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Product cost accuracy

Could be Accurate enough for the company as a whole ,but the cost of individual product is not accurate Does not aid in cost reduction Simpler, less costly allocation system

More accurate because cost are allocated to products based on the Factory Resources They use

Cost Control

Aids in cost reduction

Cost system Complexity and cost

More complex more expensive cost allocation system

Activity-based Costing
These days the term Activity-based Costing is growingly used. It is necessary to view this term in the context of job costing and process costing. Job costing and process costing are two basic methods of cost accounting. Activity-based costing is not a distinct method of costing like job costing and process costing. It is only a new practice or intermediate change in the process of attribution of costs to jobs or processes. Earlier costs were first collected for production departments and service departments and finally the costs of production departments were absorbed by jobs or processes. Now in the context of activity-based costing, the costs are collected according to activities such as material ordering, material handling, quality testing, machine set-ups, customer support service, etc. and jobs and processes for

34

which cost collection is being attempted are loaded with costs of these activities rationally. Traditionally costing systems always use volume-related measures. Such as direct labour hours or machine hours to allocate overheads to products. Many organizational resources exist for activities that are unrelated to physical volume. Now volume-related activities consist of support activities such as material handling, material procurement, performing set-ups, production scheduling and first item inspection activities. Traditional product cost systems. Which assume that products consume all resources in proportion to their production volumes, thus report distorted product costs. Traditional costing systems were designed decades ago when most companies manufactured a narrow range of products and direct labour and direct material were dominant factory costs. Overhead costs were small and thus in appropriate overheads allocations were insignificant. Since information processing costs were higher, it was difficult to justify more sophisticated overhead allocation method.

In the present era, companies produce wide range of products and direct labor represents only a small percentage of total costs. The intense global competition has made decision errors due to poor cost information more probable and more costly. These changes contributed to advent of Activity- Based Costing. Given below are the two charts outlining how activity- based costing is different from conventional cost allocation:

Conventional Allocation of Common Costs

Production departments Service department 35

Product lines Stage 1 Stage 2

Assigning Allocating costs using a Measure measure of volume of

costs service

using usage

Activity based Costing

Service department Product Lines And factory overheads Stage 1

Activity cost pools

Stage 2

36

Assigning Application of cost Individual driver rates

costs

of activities

Factors prompting the development of activity based costing system include: 1. Growing overhead costs because of increasingly automated production. 2. Decreasing costs of information processing because of continual improvements and increasing application of information technology. 3. Increasing market competition, which necessitated more accurate product costs. 4. Increasing product diversity to secure economies of scope and increased market share.

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5. Traditional costing fails to capture cause and affect relationship. 6. Traditional costing often fails to highlight inter relationship among activities in different departments. 7. Growing dissatisfaction among the working executives regarding traditional costing, this is based on averages and estimates. 8. Traditional costing systems are driven by the need to value stocks rather than to provide meaningful product cost. 9. Direct labor has shrunk as percentage of total cost for majority of manufacturing companies. 10. Overhead costs are no long a mere burden to be minimized. Overhead functions such as product design, quality control, customer service, production planning and sales order processing are as important to customer as physical processes on the shop floor. 11. Availability of computer has enhanced requirement for improvement in information gathering technology.

Activity based costing emphasizes the need to obtain a better understanding of the behavior of overhead costs and thus it seeks to ascertain (i) what causes costs, and ( ii ) how they relate to product or services. ABC recognizes that in the long run most costs are not fixed and seeks to understand the forces that cause overhead costs to change over time. Activity-based costing is a system that focuses on activities. As the activities cause costs.ABC systems assume that cash outflows are incurred to acquire a supply of resources (i.e., labour, material and resources ) , which are consumed by activities. In other words, activities cause cost and products create demand for activities. A link is
38

made between activities and products by assigning costs to products based on individual products consumption or demand for each activity. Therefore, ABC system is based on understanding of the following.

(i)
(ii)

(iii) (iv)

Identifying major activities that take place in an organization. Creating a cost pool/cost centre for each activity or costing activities. Determining cost driver for each major activity. Assigning cost of activities to products based on products consumption or demand for activities.

Identifying Activities. The first stage is to identify the major activities in the organization. Examples of activities include machine-related activities (i.e., machining cost centre) , direct laborrelated activities ( i. e .,assembly departments ) and various support activities such as ordering, receiving material handling, parts administration, production scheduling, packing and dispatching. This step requires the management accountant to acquire a familiarity with what is happening in the indirect areas of the organization. This has to be done systematically and involves examining physical plans of the work place (to identify how all space is being used) and payroll listings (to ensue all relevant personnel have been taken into account). This examination normally has to be supplemented by the observation of work and particularly by a series of interviews with staff involved. A number of criteria underlie the choice of activities. The activities should be at reasonable level of aggregation. To break down activities into actions and tasks (i.e., filing an order, photocopying a document) is usually too detailed for product costing. Such actions and tasks are normally combined into large purpose-oriented activities. For example activities may be listed as follows: Production schedule changes. Customer liaison. Purchasing. Production process set-up Quality control Material handling Maintenance Final choice of activities (i.e., aggregation of action and tasks) will be judgmental in any organization. In the beginning at the time of introduction of ABC, activity cost pool ran into hundreds. Now -a-days it is felt that 20 to 30 cost pools have become common.
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The choice is between information details and cost of setting up and operating the system. For example, an activity such as quality control can sub-divided into appraisal activity and prevention activity. The benefit of this would be more detailed profits of cost reported to management and a possible increase in the homogeneity of the costs in each activity cost pool. Creating accost pool/cost centre for each activity or costing the specific activities. The second stage requires that a cost centre (also called a cost pool) be created for each activity. For example, the total cost of all setups might constitute one cost centre for all set-up related costs. In other words after establishing the activity structure for the system, it is necessary to identify the resources consumed by each individual activity during the relevant period. This provides a basis for identifying level of costs in each pool. Both allocation (where particular individuals, suppliers or pieces of equipment are identified as having a full time commitment to a specific activity) and apportionment (where labor and equipment resources are shared by two or more activities) will be involved at this stage. In the absence of time records, labor and equipment usage will have to be identified in broad terms by observation and interviews. For other costs, such as occupancy, the most appropriate available measures of resource consumption (i.e., space occupied) should be used. Thus some amount of approximation and estimation is inherent in even ABC systems. The activity cost information generated on this pattern is very useful. It represents what is often called, a novel profiling of overhead cost for management rather than analyzing cost in terms of inputs (labors, supplies, equipment, and depreciation). It indicates how resources have been applied in the business. For example, cost of specific activities under customer order processing can be attempted as follows:

Customer Order Processing

Specific activities Pricing Draw up agreements Indirect labor 0.25 0.42 Occupancy costs 0.18 0.23 Depreciati on 0.02 0.03 Consumab les 0.08 0.10 Total 0.53 0.78 40

Customer vetting Customer Liaison Problem resolution Expedite delivery Adm./Secretariat Total

0.22 0.95 0.34 0.12 0.10 2.40

0.11 0.69 0.04 0.22 0.33 1.80

0.03 0.14 0.02 0.01 0.05 0.30

0.09 0.11 0.03 0.02 0.07 0.50

0.45 1.89 0.43 0.37 0.55 5.00

This type of analysis gives a particular visibility to overheads incurrence. It details why and how overheads have been incurred. It allows an assessment of relative magnitude and will permit time-periods and inter-plant comparison at a detailed level .In addition, Supplementary analysis of activities into value-added/non-value-added categories or core support activities can assist management in designing policies aimed at cost containment or cost reduction. Determining the Cost drivers for each activity. Next step is to identify the factors that influence the cost of a particular activity. The term 'cost driver' has been used to describe the events or forces that are significant determinants of the cost of activities. If production scheduling cost is generated by the number Of the production runs, that each production generates, then number of set-ups would represent the cost driver for production scheduling. A cost driver is a variable, which determines the work volume or work load of a particular activity. It will provide the justification for amount of resources consumed by an activity and hence its cost. Due to this casual relationship it will be a signification measure of activity cost variation. To permit its practical application in an ABC system, it must be conveniently driver will reflect the transactions, which underlie the activity under consideration. Hence the number of purchase orders processed, number of customer order processed, number of inspections undertaken and number of set-ups achieved all represent a volume of transactions related to an activity. Sometimes characteristics chosen represent factors, which primarily determine the number of activities undertaken and for this reason they are used as cost drivers. For example, number of customers, number of suppliers and number of component parts has all been used as cost drivers. These are all situational factors, which one would expect to influence the volume of transaction and hence the cost respectively, of the customer order processing, procurement and scheduling activities. Then special attention should be directed towards cost causality in determining cost drivers. The ascertainment of cost drivers will normally involve repeat interviews with personnel involved in the specific activities. The focus remains on identifying what causes a particular activity to consume resources and so incur cost. Some typical questions aimed at bringing out the cost drivers are given below: What is the number of staff working on particular activity?
41

Why are X numbers of staff needed? Is there sufficient staff? If not, why? What might cause the need for or more or less staff? What is it, that determines the amount of time spent on a particular activity ? Why is overtime worked? Why does the idle time occur? The end result of this type of questioning will be typical set cost drivers for each subactivity. Given below is a list of cost drivers indentified for different activities under customer-order processing: (This is to show a pattern of how cost driver are identified.)

Customer Order Processing

42

43

Activities Pricing

Cost drivers Number of orders Number of customers Complexity of orders Location of customers Number of orders Number of customers Number of customers Size of orders Location of Customers Order book Position Number of customers Number of orders Location of Customers Delivery Performance Product quality Number of orders Number of customers Location of customers Location of customers Production hold-ups Number of orders Number of orders Number of problems Number of Staff

Setting Agreements

Customer Vetting

Customer Liaison

Problem Resolution

Expediting Delivery

Adm. / Secretarial

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Therefore in order to link activity costs to product or service output, a cost driver has to be identified with each cost pool. As historical data are sometimes not available to undertake statistical testing of the relationship between the cost driver and the behavior of cost in the cost pool, the choice of cost driver may require the exercise of judgment. In practice, four alternative types of cost driver are to be found:

(i) Pure volume cost drivers. Pure volume cost drivers are most common and represent a reasonable homogeneous measure of the output of the activity concerned. Numbers of customers or number of inspections or numbers of call-outs are pure volume cost drivers. (ii) Weighted volumes cost drivers. These cost drivers are used, where the output of activity is clearly non-homogenous. If purchasing were an activity pool and purchase orders were made both domestically and overseas, the overseas orders may involve considerable more administrative work. In this situation it may be advantageous to weigh the overseas orders vis--vis the home orders. Based on the assessment of
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work undertaken to make respective orders, it may be decided that each overseas order be weighted by 1.5 before determining the total weighted volume of cost driver to be used in calculating the appropriate rate. (iii) Situational cost drivers. Sometimes a situational characteristic of the activity can be important in determining its work load and thus hold credence as its cost driver. For example, the number of suppliers pertaining to a particular purchasing activity could be used as the cost driver. In other words the number of suppliers is not an output measure of the activity but may be a convenient surrogate for a pure volume cost driver such as the number of purchase orders. Further, some of the purchasing cost may relate to vetting and liaisoning with individual suppliers. (iv) Motivational cost drivers. These cost drivers are used when the intention is to motivate cost-conscious behavior rather than produce product cost information in the most accurate manner. This type of cost driver may lack some of the qualities mentioned above but its selection may give prominence to one particular aspect of operations and influence managerial behavior in a desired manner. For example, in Japan, element of direct labor hour has remained a popular cost driver, deposit its inherent flaws, because it makes labor a costly resource and prompts designer to attempt optimum utilization of labor hours.

Time was taken to produce or render a service. These drivers create unit-level costs meaning that they are caused by the production or acquisition of single unit of product or the delivery of single unit of service. (ii) Batch-level cost. Costs that are caused by a group of things being made, handled or processed at a single time are referred to as batch-level costs. Using the batch is more indicating of the relationship between the activity (set-up) and the driver (different production runs). (iii) product-level (process-level) cost. A cost caused by the development, production, or acquisition of different items is called a product-level (or process-level) cost. These costs may include engineering change orders (E.C.Os), equipment maintenance, product development and scrap, if related to product design.
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(iv) Facility-level cost some costs cannot be related to a particular product line. These are, instead, related to providing a facility. For example, cost of maintaining building or plant security or advertisement promoting the organization. These costs and cost base are extensively used in traditional cost analysis. (v) Organizational-level cost. Certain costs are incurred at organization level for the single purpose of supporting continuing facility operations. Theses organizational level cost common too many different activates and products and services can be prorated among services and products on an arbitry basis only. Organizational level costs are not product-related. Thus, they should be subtracted in total form net product revenues instead of an arbitry and illogical apportionment.

Assigning cost of activities to products based on product's consumption or demand for activates. The last step involves tracing the cost of the activates to products according during the production process. A product demand for the activities is measured by the number of transactions it generates for the cost driver. The best way to complete the final step is to apply cost driven rate to individual products. Here it is important to state that if a cost driven rate is to be practical the variable chosen must be measurable in a way which permits its identification with individual products. For example the number of parts associated with each product must be known, if products are to be individually costed. The requirement may represent one of the signification costs of ABC, especially where a new system has been established to collect the cost driver to collect the cost driver information, both in total and for each product. The ability of a cost driver to meet this requirement should, therefore, be considered, when the cost driver is being chosen. Given below is a representative list to show how activities drivers should be listed for specific type of costs:

Cost Type

Related Activity Driver

47

 Manufacturing costs

Number of Number of Number of Number of Number of Number of orders Number of Number of Number of Number of Number of Number of

direct labor hours field support visits jobs scheduled machine hours machine set-ups maintenance work parts in product parts in stock price negotiations purchase orders scheduling changes Shipments

48

49

50

51

52

53

54

Data gathered through the questionnaire

Occupation We found that our sample was 20 managers and 30 accountants.

1. Regarding your experience did you think that traditional method is sufficient in costing? [ ] Agree [ ] Disagree [ ] dont know

We Found that 30% was agree that traditional method is sufficient in costing, 68% was disagree, and 2% dont know.

55

2. Do you think due to complex manufacture process we need a new approach than traditional approach? [ ] Agree [ ] Disagree [ ] dont know

We found that 50% was agree about the need of new approach, 40% was disagree, and 10% dont know.

56

3. Do you think that the organizations nowadays implement ABC system? [ ] Agree [ ] Disagree [ ] dont know

We found that 60% was agreeing that the organizations nowadays implement ABC system, and 40% was disagreeing.

4. Are ABC system fit all sizes of organization? [ ] Agree [ ] Disagree [ ] dont know

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We found that 20% was agreeing that ABC system fit all sizes of organization, 50% disagree, and 30% dont know.

5. Do you think that ABC system helping in accurate decision? [ ] Agree [ ] Disagree [ ] dont know

We found that 80% was agree that ABC system helping in accurate decision, 2% was disagree, and 18% dont know.

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6. Do you think that using ABC system will help control over Overhead costs? [ ] Agree [ ] Disagree [ ] dont know

We found that 38% was agree that using ABC system will help control over Overhead costs, 45% disagree, and 17% dont know.

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7. Can we consider that ABC system failed because its complex due to lack of training? [ ] Agree [ ] Disagree [ ] dont know

We found that 60% agree that ABC failed because its complex, 16% disagree, and 24% dont know.

Chapter 5
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Conclusions and Recommendations

Contents
Contents..................................................................................................................... 1 Acknowledgement.......................................................................................................3 - Abstract ................................................................................................................... 4 - Introduction ...........................................................................................................5 Motivation of the Study..........................................................................................5 -The Research problem:..............................................................................................6 -Objective and significance of the study......................................................................6 -Hypothesis .............................................................................................................. 7 -Research questions....................................................................................................7 Literature Review........................................................................................................ 9 Contents................................................................................................................... 13 Research Strategies:.................................................................................................15 Research Design:................................................................................................... 15 Sample and Sampling Techniques.............................................................................16 Research method .....................................................................................................16 Gathering and collection Data :..............................................................................17 Contents................................................................................................................... 17 COST ALLOCATION IN GENERAL................................................................................19 Purposes of cost Allocation........................................................................................20 Cost allocation Bases:...............................................................................................21 Cost Drivers.......................................................................................................... 21 Cost objects........................................................................................................... 22 Common cost objects.............................................................................................23 Tracing costs to cost objects..................................................................................24 61

Methods of cost allocation ........................................................................................26 Types of cost allocation.............................................................................................27 Cost allocation plans.................................................................................................28 A) TYPES OF ALLOCATION PLANS...........................................................................28 b) Suggestions should also be considered when developing a CAP:........................29 c) VALUE OF COST ALLOCATION PLANS .................................................................29 Traditional and Activity Based Cost accounting systems:..........................................31 Traditional Method:................................................................................................31 Activity-based Costing ...........................................................................................34 Data gathered through the questionnaire..................................................................55 Contents................................................................................................................... 61 Conclusion:...............................................................................................................63 Limitation:................................................................................................................. 66 Criticism of Activity-based Costing.........................................................................66 Problem With Cost-allocation..................................................................................67 References:...............................................................................................................69 Books:....................................................................................................................69 Internet:.................................................................................................................69 Glossary....................................................................................................................70 Appendix................................................................................................................... 75

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Conclusion:
The total overheads which are spread over the two products have been apportioned on different bases causing the production cost to differ substantially. A change from the traditional direct labor hour rate to activity based costing enable the company to: 1) Adjust the selling price of cans as the cost is more than 10% down from the cost as per traditional method because the companies pricing formula was based on cost plus approach. This enabled the company to compete in the market with a reduced price and to increase the market share. 2) The above findings affected the reported profit for the period to the extent that stock levels fluctuate between reporting periods. 3) Devise new cost control techniques to reduce the cost of production of bottles which goes up due to the changes as above. 4) Full product costing based on conventional costing system must be computed for accounting purposes but is not suitable for decision making. 5) Conventional costing always over cost high volume product and under cost low volume product, whenever the costs of some product related activities are unrelated to volume. 6) Activity Based Costing provides not only more accurate basis for product costs but also a mechanism for managing overhead costs.

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Uses of Activity-Based Costing

(i) Points a way to increase shareholder value. When an ABC system is combined with a review of investment costs for various tactical or strategic options, one can determine the return on investment to be expected for each investment option. (ii) Effectively appraises a distribution channel cost. An ABC system can accumulate all the costs associated with a particular distribution method, which allows manger to compare this cost to the profit margin earned on sales of products sold through it. One can then determine, if the distribution channel should be reconfigured or eliminated in order to improve overall levels of profitability. (iii) Effectively compares inter-plant perfoemance. An ABC analysis itemizes the costs of each plant and correctly allocates these costs to the activities conducted within them, which allow a company to determine which plants are more efficient than others. (iv) Provides reliable data for such decision-making as make or buy. An ABC analysis includes all activity's costs of a similar item that is purchased. More easily compared to the costs associated with manufactured item providing a comprehensive view of all costs associated with it and can then be more easily compared to the costs of similar item that is purchased. (v) Help to collect benchmark costs. By using internal ABC analysis to determine the costs of various activities, a company can create benchmark for these costs in potential acquison targets. (vi) Determine the cost of each activity. An ABC analysis can be revealing all costs of each activity within an organization. The system is really designed to trace the costs of only the most significant activities; but its design can be altered to itemize the costs of many more activities. (vii) Help to charge optimum price. An ABC analysis server all costs associated with a product and thus it is useful in determining the minimum it may be driven by the ability of the market to absorb a higher price rather than the underlying cost of the product. (viii) Help to make right products o be sold. An ABC analysis can be combined with product prices to yield a list of margins for each product sold. When the information collected is stored by market, product line, or

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customer, it is easy to determining which products have low or negative returns or yield such low margin volumes that are not worth keeping. (ix) Identification of non-value added costs. An ABC analysis can reveal which activities contribute to the completion of products and which do not. By focusing on those non-value-added activities that do not create value, a company can significant improvement in its profitability. (x) Helps to identify area to reduce costs. An ABC analysis reveals the cost of anything a management team needs to know about activities, products or customers, which can afterwards be sorted out to see where highest cost-item are located combining this with value analysis, one can determine what costs return the lowest value and structure a cost reduction programming a accordingly. (xi) Helps to identify most profitable customers. An ABC analysis can itemise the costs specific to each customer such as special customer service or packaging as well as increases in warranty claims or product returns .when combined with margins on products sold to customers, this analysis reveals, which customers are the most profitable , after all costs are considered. (xii) In brief it helps managers to: (a) Identify and mention significant technological cost. (b) Trace many technology costs directly to products. (c) Promote achievement of market share through use of target costing. (d) Understand the impact of new technologies on all elements of performance. (e) Translate company goals into activity goals. (f) Analyses the performance of activities across business functions. (g)Promote standards of excellence. (h) Helps to introduce business process re-engineering (BPR), which is a method of improving, replacing complex processes that already exist.BPR finds and implements radical changes in the way things are made or the way tasks are performed to achieve
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costs, service or time reductions.

Actually, the number of uses to which ABC system can be put is limited by the imagination of the user .It is necessary to address this is one, before system is installed

Limitation:
One of the major limitation in our research as we said before it's case study design so the frequent criticism of case study is that it's dependence on a single case renders it incapable of providing a generalizing conclusion

Criticism of Activity-based Costing.

Activity-based costing typically provides better information than traditional overhead allocation process. Still it is not the presence for all managerial problems. Following criticism has been leveled against ABC system: 1- ABC system implementation requires significant amount of time and cost to implement. 2- An environment of change must be created for implementation of ABC system. It requires overcoming a variety of individuals, organizational and environmental barriers as follows : (a) Fear of unknown and shift in status quo. (b) Potential loss of status. (c) A necessity to learn new skill. To overcome these barriers, a firm must recognize that these barriers exist. The causes of the barriers should be investigated. Then organization should communicate information about. What, Why and how of ABC to all concerned parties. It presents limitations of ABC system.

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3- Top management must be involved and support the implementation process. Lack of commitment or involvement of top management will make any meaningful progress slow and difficult. 4- Employees and managers must be educated in some non-traditional techniques that include new terminology, concepts and performance measurements. 5- Additional time will be required to analyze the activities taking place in the activity centers, trace cost to those activities and determing the cost drivers.

Problem With Cost-allocation

Allocation of uncontrollable costs. Responsibility accounting holds someone in some unit accountable for generating revenue and controlling costs.

The trick is to find out whom to hold accountable and at what level. Managers should be held accountable only for controllable costs.

Arbitrary allocations. Cost allocations are inherently arbitrary. Managers frequently make educated guesses.

Allocations of fixed costs that make the fixed costs appear to be variable.

Unitized fixed costs pose a significant problem.

Costs that are fixed (in the short run), are often divided by some base and allocated as variable (per-unit). Importantly, this is a question of perspective.

The higher up in the hierarchy the manager is, the greater the number of all costs that appear variable. The remedy is to allocate these costs, like clerical and administrative, as lump-sum allocations.

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 Lump-sum allocations should remain the same, year-by-year, regardless of total production. Lump-sum allocations ignore changes in activity-levels.

Allocations of manufacturing overhead to products using too few overhead and cost pools.

Too few cost pools cause serious product costing distortions. Generally, the more cost pools, the more accuracy is enhanced.

Does the benefit of more accurate allocation methods (i.e.more cost pools) outweigh the cost of obtaining this information?

Use of only volume-related allocation bases. Some manufacturers allocate manufacturing overhead to products using only volume measures (such as): o labor hours o machine hours

Not all overhead costs vary in relation to volume!

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References:
Books:
Horngren, Sundem, Strattion and Schatzberg , Management Accounting,14th

Edition, Person Prentice ,NJ 07458.

Charles T. Horngren, Srikant M.Datar, George Foster and Madhav Rajan Cost

Accounting, 13th Edition, Person Prentice ,NJ 07458.

CPA Exam Notes Business Environment & concepts

Internet:
http://www.emblemsvag.com/abc.htm http://www.cmr-journal.org/article/viewfile/221/511

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Glossary

Activity based costing (ABC)

Cost accounting approach concerned with matching costs with activities (called cost drivers) that cause those costs. It is a more sophisticated kind of absorption-costing and replaces labor based costing system. ABC states that (1) products consume activities, (2) it is the activities (and not the products) that consume resources, (3) activities are the cost drivers, and (4) that activities are not necessarily based on the volume of production. Instead of allocating costs to cost centers (such as manufacturing, marketing, finance), ABC allocates direct and indirect costs to activities such as processing an order, attending to a customer complaint, or setting up a machine. A subset of activity based management (ABM), it enables management to better understand (a) how and where the firm makes a profit, (b) indicates where money is being spent and (c) which areas have the greatest potential for cost reduction. Developed by professors Robert Kaplan and Robin Cooper of Harvard University in late 1980's.

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Arbitrary 1. Based on individual discretion, not on an objective criteria. 2. Based on bias or prejudice, not on fact or reason. See also capricious.

Controllable costs Expenditures that are subject to the discretion of a manager and, hence, can be kept within predefined limits. variable costs such as direct materials,direct labor, and variable overhead that are usually considered controllable by the department manager. Further, a certain portion of fixed costs can also be controllable. For example, certain advertising spent specifically for a given department would be an expense controllable by the manager of that department. Advertising expenses that benefit many departments or products are, however,noncontrollable cost.

Cost Valuation in terms of money of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service. All expenses are costs, but not all costs (such as those incurred in acquisition of an income-generating asset) are expenses. See also costs.

Cost allocation Assignment of indirect costs to a cost object (a job or task) without arbitrary apportionment. Costs can be allocated where the amount to be assigned can be determined accurately.

Cost allocation base

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The basis that is used to allocate costs to cost objects. In a traditional costing system there may be a single allocation base for each cost object, whereas in an activity-based costing system there may be many such bases. In practice the term allocation base is often used synonymously with activity measure or cost driver.

Cost allocation plan: A Cost Allocation Plan (CAP) is a document that identifies, accumulates and distributes allowable direct and indirect costs under sub grants and contracts and identifies the allocation methods used for distributing the costs.

Cost center 1. Defined geographical area, machine, or person to whom direct and indirect costs are allocated. 2. Distinctly identifiable department, division, or unit of firm whose managers are responsible for its all associated costs and for ensuring adherence to its cost-budgets. Also called cost pool. See also profit center and revenue center.

Cost driver In activity based costing (which states that products consume activities and activities consume resources) any factor which causes a change in the cost of an activity. An activity can have more than one cost driver attached to it. For example, a production activity may have the following associated cost-drivers: a machine, machine operator(s), floor space occupied, power consumed, and the quantity of waste and/or rejected output. Cost object Accounting data item (contract, customer, function, product, project, subdivision, etc.) for which a separate cost measurement is recorded
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Cost pool

Alternative term for cost center.

Direct cost Expense that can be traced directly to (or identified with) a specific cost center or cost object such as a department, process, or product. Direct costs (such as for labor, material, fuel or power) vary with the rate of output but are uniform for each unit of production, and are usually under the control and responsibility of the department manager. As a general rule, most costs are fixed in the short run and variable in the long run. Also called direct expense, on cost, operating cost, prime cost, variable cost, or variable expense, they are grouped under variable costs.

Indirect cost

Expenses (such as for advertising, computing, maintenance, security, supervision) incurred in joint usage and, therefore, difficult to assign to or identify with a specific cost object or cost center (department, function, program). Indirect costs are usually constant for a wide range of output, and are grouped under fixed costs.

Lump-sum 1. Single large amount; not consisting of several smaller amounts or installments. 2. Price of an entire lot, or group of goods or services, where no breakdown is give for individual items.

Reimbursement
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Amount refunded for costs incurred or expenses paid.

Tracing 1. Accounting: Following a specific piece of financial information back to its originating document by following its audit trail. 2. Cost accounting: Assignment of a cost to an activity or cost object based on a cause-and-effect (causal) relationship. Tracing is preferred over allocation where the required data is obtainable at a reasonable expense.

Traditional cost system: The traditional method of cost accounting refers to the allocation of manufacturing overhead costs to the products manufactured. The traditional method (also known as the conventional method) assigns or allocates the factory's indirect costs to the items manufactured on the basis of volume such as the number of units produced, the direct labor hours, or the production machine hours.

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Appendix

Questionnaire
We are Ajman University Students doing our graduation project which is about Cost Allocation in Manufacturing Company and we try to implement ABC system. And Activity Based Costing System (ABC) is an accounting method that allows businesses to gather data about their operation costs are assigned to specific activities. Can you please help us with filling this questionnaire which we believe will add valuable incites in our research?

Occupation [ ] Management [ ] Accounting

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1. Regarding your experience did you think that traditional method is sufficient in costing? [ ] Agree [ ] Disagree [ ] dont know

2. Do you think due to complex manufacture process we need a new approach than traditional approach? [ ] Agree [ ] Disagree [ ] dont know

3. Do you think that the organization nowadays implement ABC system? [ ] Agree [ ] Disagree [ ] dont know

4. Are ABC system fit all sizes of organization? [ ] Agree [ ] Disagree [ ] dont know

5. Do you think that ABC system helping in accurate decision? [ ] Agree [ ] Disagree [ ] dont know

6. Do you think that using ABC system will help control over Overhead costs? [ ] Agree [ ] Disagree [ ] dont know

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7. Can we consider that ABC system failed because its complex due to lack of training? [ ] Agree [ ] Disagree [ ] dont know

The END
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