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Using a heuristic approach, the authors attempt to construct the measurement and error cost trade-off curves that demonstrate the decision problem in choosing an appropriate cost management system for a firm.
One of the fundamental issues in management accounting is the allocation of overhead costs (or common costs) to cost objects (such as products, services, customers, or departments). In the end, all indirect and support resource costs have to be traced or allocated to products, services, and customers for pricing as well as inventory valuation purposes. In the case of costs associated with customer-sustaining activities, costs should be allocated to the specific customer and not to the products. Traditionally, a firm's manufacturing operations for cost accounting and control purposes are structured as either production (operating) departments or support departments. In practice, both operating and support departments incur overhead or indirect costs. For example, take an assembly operation, which is a production activity; overhead costs here will include indirect material, indirect labor (such as supervision), depreciation, and utilities costs. Similarly, consider a support department, such as a machine set-up department; the overhead costs here may include depreciation, utilities, setup labor, and so forth.
Material and labor costs can be easily traced to cost objects through physical tracing because the product design specification will exactly provide information detailing how much material and labor are required to manufacture one unit of a product. These direct costs are not difficult to measure and assign to final cost objects. Indirect costs such as overhead cannot be easily assigned to individual products because these costs are common to all products manufactured during a specific period. Furthermore, some indirect costs maybe incurred per batch, some maybe per job, and electricity and heating costs may be incurred for the operating period.
There are two approaches used in management accounting to allocate overhead costs: the traditional method (TM) and the activity-based costing (ABC) method. In the TM, the firm makes the distinction between support departments and production departments. The costs are allocated in two stages. First, the support department costs (indirect costs because the cost object is a product) are allocated to the production departments using one of three methods: (a) direct method, (b) sequential method, or (c) reciprocal method. Then, in...