Product_Costing

Module 5 Case Analysis: Product Costing INTRODUCTION How much does a product cost' How can a company determine the cost of a product' These are questions every manager needs to be able to answer. Most companies allocate overheads to products using a two-stage procedure. In the first stage overheads are assigned to cost centers, while the second stage allocates the costs accumulated in the cost center to products. Activity Based Costing (ABC) basically seeks to remove some of the variable costs incorrectly applied to the fixed costs. In this paper I will differentiate between traditional costing and ABC as it applies to the case study about Steinway Piano. First I will define the terms: traditional cost allocation and ABC. Then I will determine why Steinway Piano is a good candidate for ABC. Finally, I will identify several dysfunctional decisions that could be made using the traditional cost allocation method; after all, accurate decisions are vital to success. Traditional Cost Allocation The traditional costing systems focus on the product in the costing process (King, 2000). Costs are traced to the product because each product item is assumed to consume the resources; therefore, traditional allocation bases measure only attributes of the individual product item. For example, these would be the number of direct labor hours or machine hours or value of materials consumed. However, in many modern-manufacturing operations, overheads are not homogeneous in terms of being primarily influenced by volume. Indeed it could be argued that the majority of overheads in a modern manufacturing operation are largely unaffected by changes in production volume. The logical conclusion is that if products are to be costed in a manner that reflects their actual consumption of resources then they must absorb their share of overheads on the basis of the activities; nevertheless, traditional cost systems focus on the product. Costs are traced to the product because each product item is assumed to consume the resources. Alternatively, if products are to be costed in a manner, which reflects their actual consumption of resources, then they must absorb their share of overheads on the basis of activities. An alternate approach to the traditional cost allocation method is the ABC method. ABC What is Activity Based Costing' ABC is an accounting technique that allows an organization to determine the actual cost associated with each product and service produced by the organization without regard to the organizational structure. (FAA, n.d.). Costs are traced from activities to products based on the products demands for these activities during the production process. The allocation bases used in activity-based costing are thus measures of the activities performed. These might include such activities as set-up time or number of times a product handled. Not only is the nature of allocation base used by activity-based costing different, but also the number of allocation bases used to trace costs in the second stage is different. Where a traditional system may use up to three second stage allocation bases (direct labor hours, machine hours and value materials used are the most common) an activity-based system makes use of many bases including such bases as set-ups, items ordered, number of times moved, amongst others. Does Steinway Piano make a good candidate for ABC' In my opinion, Steinway Piano does make a good candidate for ABC. Although using ABC is lengthy and complex, the advantages outweigh the disadvantages. Using this type of costing method attempts to focus on the activities performed in producing the pianos during the manufacturing process rather than simply allocating resource costs to products using a volume base. The Steinway Piano manufacturing process is highly complex; therefore, Steinway uses skilled craftsmen. Because of this high degree of specialization and complexity, it is increasingly important to trace the cost of the product to overhead items; consequently, it is imperative for the company to keep a keen eye on the expenses; otherwise it could prove to be costly. By using the ABC method, costs and cost drivers will provide managers critical analysis of the operation. Most importantly, the primary value of using the ABC method is defining fixed costs within activities and treating them as variable costs, thereby redefining behavior of the cost. This will ultimately enable managers, the decision makers of the company, to learn about the company using a different paradigm. There are severe limitations in a traditional costing system. The background material (2005) indicates the several limitations; the first is the inclusion of fixed costs in a product. This is nearly certain to interfere with good internal decision-making.  The simple fact is that fixed costs are going to be incurred whether we manufacture an additional unit of product or do not manufacture that additional unit of product.  To include fixed costs in the product cost requires that we, in some way, allocate the fixed costs to the individual units of product.  That has the adverse effect of treating these fixed costs as if they were variable.  To treat a fixed cost as if it were variable is a gross abuse of this process; therefore, if Steinway uses the traditional costing system, it can have serious implications for pricing and marketing decisions, product line decisions, and strategic decisions affecting the long-term viability of this company. CONCLUSION In this paper I have defined traditional cost allocation as well as ABC. Then I determined why Steinway Piano is a good candidate for ABC. Finally, I identified several dysfunctional decisions that could be made using the traditional cost allocation method to show why ABC is vital in many companies, especially when the costs of a product vary from unit to unit. References King, D. (2000). The ABC of Overhead Allocation. Retrieved from: http://www.accaglobal.com/publications/diplomanewsletter/15674 FAA. (n.d.). Retrieved from: http://www.faa.gov/ait/bpi/handbook/chap5.htm Steinway Piano. Retrieved from: http://www.steinway.com/ Touro University International. Background Information Module Five. (2005).