Managerial Accounting Case Studies (Essay Sample)
Case assignment expectations:
Carefully review the material in the link below.
Review the Farm Financial Standards Council case study from here.
LENGTH: 3-5 pages typed and double-spaced
Managerial Accounting Case Studies
CASE STUDY NO. 1
Name of Farm: John & Mary Farmer
Commodities Produced: Corn & Soybeans
Unique characteristics of this case: John and Mary have an arrangement to
share equipment with their son who operates a similar farming operation
Operational & Production Information
John and Mary Farmer produce corn and soybeans on their 1060 acre crop farm
located in the corn belt of the mid-west. 480 acres of corn and 480 acres of
soybeans are raised annually in a rotation. Additionally an 80 acre farm owned
by John and Mary is crop share rented to their son who has been farming for 12
years. For the sake of this case study, only John & Mary's farm is being
considered during the process of designing a managerial accounting system.
John and Mary own 340 acres of the 1060. 800 acres is rented of which a 50/50
crop-share arrangement is used on 480 acres and the remaining 320 acres is
cash rented. The 800 acres is rented from a total of 5 different owners.
John and Mary's farm is operated independently of their son's farm. However,
the unique feature of these farms is that one common line of machinery is owned
between the two operations. John and Mary own one major tractor, the combine,
a major piece of spray application equipment, a smaller tractor, and a few pieces
of minor equipment. Their son owns one major tractor, the tillage equipment,
and a planter. Each party independently owns their own pieces of equipment.
The estimated value of the equipment owned by each of the two entities is
proportional to the amount of crop land that each entity operates. Custom fees
for machinery operation do not change hands between these operations because
of the proportional ownership of the equipment. John and Mary's son operates a
total of 700 acres which is also rotated between corn and soybeans.
John and Mary raise corn and soybeans for the cash market. It has not been
their intent to produce either seed crops or other specialty crops in the past, but it
could be an option in the future. They have on-farm grain drying and storage
facilities in which they routinely condition their crops for market.
Ownership, Management, & Employee Structure
John and Mary own and operate their farming business as a sole-proprietor.
Production agriculture has been a part of the Farmer family legacy for
generations. John is the primary decision-maker for all operating decisions. The
major capital decisions usually become joint decisions between both John and
Mary. Mary has a successful off-farm career, which places high demands on her
time. Therefore, Mary is not involved in the day to day operations of the farm
This farm has no outside full-time employees. Occasionally a part-time high
school student is hired to assist during busy seasons. John performs all of the
bookkeeping tasks for this farming operation. Mary would say that bookkeeping
is John's hobby and passion. The use of on-farm computer accounting software
has offered new and additional opportunities for gathering information about the
farm's performance. Simultaneously, challenges of implementing the accounting
system as they are moving toward managerial accounting have occurred.
John is nearing retirement age and will likely retire in the next 5-7 years. As
stated earlier, production agriculture has been a major part of the Farmer family
legacy for several generations and John and Mary would like to see it continue
for generations to come. Family values and community service has been an
important part of John and Mary's focus in the past and will continue to be a
focus in the future.
It is unlikely that a change away from a corn and soybean rotation will occur in
the near future based on cultural practices. It is John's desire to be able to better
assess the differences in cost of producing corn and soybeans on each farm.
Analyzing the value of the different lease arrangements between farms is also on
John's radar screen. Like commodities from all farms gets mixed with other like
commodities after harvest since they are conditioned for market with on-farm
facilities. Keeping the crops separated by farm or field once they are harvested
is not important at this point. John would also like to know the differences in
profitability on an annual basis between each of the two commodities even
though major changes in the type of crop planted is unlikely.
John doubts that he will be making major changes in his production system
between now and retirement but still wants to fine tune his operation. As he
looks at his son's farming operation from a distance, John can see a
resemblance of his own management mind set a few years back. That is to say
that he sees the younger Farmer focussed more heavily on production
management than on financial management and accounting. John's hope is to
get in place a sound managerial accounting system that will be fine tuned by the
time he retires. In so doing, when his son takes over the entire operation, a
system will be in place that can easily be modified to help the next generation
address the managerial decisions that will be key in the future.
Cost and Profit Centers
It is assumed from the discussion with John and Mary that their primary interest
is in knowing the differences in cost of production between farms and their
differences in overall profitability between commodities produced in different
years. It can be further assumed that John is very interested in setting up a
managerial accounting system that will be the basis for gathering information for
management purposes for the next generation as well.
With those assumptions, John's managerial accounting system will have a
support cost center for his equipment, shop and maintenance, and general farm.
He will have production cost centers for each land owner and one each for the
stages of production. A profit center will be established for each commodity for
each year. Additionally a cost center will be established for general, sales and
administration as well as for financing.
Schematic of Relationship Between Centers
The following schematic details the relationship between each of the cost centers
and profit centers. Be sure to note that this schematic is the likely schematic for
John and Mary Farmer based on their situation and desires. Other variations of
this plan may certainly be possible and workable.
Figure 1. Center Schematic.
Allocations and Allocation Criteria
The method selected to allocate costs out of either a support cost center or a
production cost center is critical. Selection of that method should be based on
the unique characteristics of each specific business. The following methods of
allocation may be logical for the John and Mary Farmer operation.
Service Centers: Allocation Methods
Center Allocated to: 1st Choice 2nd Choice
Equipment Crop Production Hours Mngt Discretion
Crop Harvesting Hours Mngt Discretion
Shop & Maintenance Crop Production Hours Mngt Discretion
Crop Harvesting Hours Mngt Discretion
General Farm Hours Mngt Discretion
Corn Processing Hours Mngt Discretion
Soybean Processing Hours Mngt Discretion
Crop Storage Hours Mngt Discretion
Employees, Production Crop Production Hours Mngt Discretion
Crop Harvesting Hours Mngt Discretion
Corn Processing Hours Mngt Discretion
Soybean Processing Hours Mngt Discretion
Crop Storage Hours Mngt Discretion
Transportation Crop Harvesting Miles Bushels
Sales & Marketing Miles Bushels
Chevy Pickup Crop Production Miles Hours
Crop Harvesting Miles Hours
General Farm Miles Hours
G & A Miles Hours
Vehicles Sales & Marketing Miles Hours
General Farm Miles Hours
G & A Miles Hours
John G & A G & A Hours Mngt Discretion
Loans Financing Assets Mngt Discretion
Support Cost Centers: Allocation Methods
(Activities) Center Allocated to: 1st Choice 2nd Choice
Crop Production Corn-Bean Production Trip Acres Hours
Crop Harvesting Corn-Bean Production Planted Acres Harvest Bushels
General Farm Corn-Bean Production Center Acres Trip Acres
Corn Processing Corn Marketing Moisture Points Purch. Bushels
Soybean Processing Soybean Marketing Bushels Trip Acres
Crop Storage Corn-Bean Marketing Avg. Inventory Purch. Bushels
Support Cost Centers: (cont.) Allocation Methods
(Sites) Center Allocated to: 1st Choice 2nd Choice
Own Farm 2003 Own Corn March 31 Acres Mngt Discretion
2003 Own Soybeans March 31 Acres Mngt Discretion
Elmer Farm 2003 Elmer Corn March 31 Acres Mngt Discretion
2003 Elmer Soybeans March 31 Acres Mngt Discretion
Ward Farm 2003 Ward Corn March 31 Acres Mngt Discretion
2003 Ward Soybeans March 31 Acres Mngt Discretion
Schroeder Farm 2003 Schroeder Corn March 31 Acres Mngt Discretion
2003 Schroeder Beans March 31 Acres Mngt Discretion
Library Farm 2003 Library Corn March 31 Acres Mngt Discretion
2003 Library Soybeans March 31 Acres Mngt Discretion
Stuart Farm 2003 Stuart Corn March 31 Acres Mngt Discretion
2003 Stuart Soybeans March 31 Acres Mngt Discretion
Center Allocated to: 1st Choice 2nd Choice
Sales & Marketing Corn-Bean P.C.s Bushels Sales $
General & Administrative Corn-Bean P.C.s Bushels Sales $
Financing Corn-Bean P.C.s $ of Assets Sales $
Sample Financial Reports
The following sample financial reports are generated for the case study of the
John and Mary Farmer operation. Software from FBS has been used to
generate the reports that will incorporate the cost and profit center design
Figure 2. Service center allocations to Crop Production Center using Trip-Acre cost driver.
Figure 3. Corn Own Farm 03 Cost Center. Note that Internal Sales move crop at cost to Corn Marketing
Figure 4. Corn Marketing 2003 project displaying production and
processing expenses on a per-bushel basis.
Figure 5. Corn Marketing 2003 project displaying production and processing
expenses on a total $ basis.
Figure 6. Corn Profit Center Income Statement. Note that S,G&A and
Financing are overstated on a per-bushel basis because only 9,706 bushels out of
91,970 2003 production were sold and 2002 production crop sales were not
considered in this case study.
Figure 7. Inventory change by quarter.
03/31/03 03/31/03 03/31/03 06/30/03 06/30/03 06/30/03 09/30/03 9/30/2003 09/30/03 12/31/03 12/31/03 12/31/03
CA Marketing Total Total
Inventories Unit # Units $/Unit Valuation # Units $/Unit Valuation
CS1000 Corn Market BU 12952 $1.75 $22,628.00 81463 $1.29 $105,133.00
CS2000 Soybean Market BU 5354 $4.31 $23,059.00 14700 $4.38 $64,332.00
Finished Goods $45,688.00 $169,465.00
CA Investment In Total Total
Growing Crops Unit # Units $/Unit Valuation # Units $/Unit Valuation
100103 Corn Own Farm 03 BU $8,250.00 $20,032.00 $21,548.00 0 $0.00 $0.00
100104 Corn Own Farm 04 BU 0 $0.00 $2,026.00
100203 Corn Elmer Farm 03 BU $3,725.00 $14,773.00 $16,407.00 6028 $0.00 $0.00
100204 Corn Elmer Farm 04 BU 0 $0.00 $2,067.00
100303 Corn Ward Farm 03 BU $1,763.00 $7,902.00 $8,802.00 3336 $0.00 $0.00
100304 Corn Ward Farm 04 BU 0 $0.00 $1,224.00
100403 Corn Schroder Frm 03 BU $13,174.00 $20,623.00 $0.00 0 $0.00 $0.00
100404 Corn Schroder Frm 04 BU 0 $0.00 $2,183.00
100503 Corn Library Farm 03 BU $14,145.00 $25,318.00 $26,349.00 0 $0.00 $0.00
100504 Corn Library Farm 04 BU 0 $0.00 $4,896.00
100603 Corn Stuart Farm 03 BU $5,723.00 $12,151.00 $13,134.00 3891 $0.00 $0.00
200103 SoyB Own Farm 03 BU $3,881.00 $14,135.00 $12,263.00 0 $0.00 $0.00
200203 SoyB Elmer Farm 03 BU $1,086.00 $9,510.00 $6,956.00 1182 $0.00 $0.00
200303 SoyB Ward Farm 03 BU $440.00 $3,384.00 $4,933.00 791 $0.00 $0.00
200403 SoyB Schrdr Farm 03 BU $8,224.00 $13,295.00 $0.00 0 $0.00 $0.00
200503 SoyB Library Farm 03 BU $11,791.00 $18,536.00 $20,569.00 0 $0.00 $0.00
Work In Process $72,203.00 $159,660.00 $130,962.00 $12,397.00
4 Clarity 4L gal 23 $84.00 $1,955.00 0 $0.00 $0.00
5 Frontier gal 139 $62.00 $8,635.00 0 $0.00 $0.00
6 Flexstar gal 12 $90.00 $1,084.00 0 $0.00 $0.00
7 Fusion gal 0.00 0.00 0.00 0 $0.00 $0.00
8 Glystar gal 132 $20.00 $2,607.00 37 $20.00 $731.00
10 Trifluralin gal 91 $16.00 $1,450.00 0 $0.00 $0.00
11 Weedar 64 gal 23 $11.00 $249.00 0 $0.00 $0.00
12 Weedar LV6 gal 73 $17.00 $1,263.00 73 $17.00 $1,263.00
13 Harmony oz 3 $11.00 $35.00 0 $0.00 $0.00
14 AMS lbs 826 $0.00 $264.00 269 $0.00 $86.00
15 NIS gal 16 $16.00 $256.00 2 $16.00 $40.00
16 Outlook gal 0 $0.00 $0.00 0 $0.00 $0.00
Chemical Inventory $17,798.00 $2,120.00
211 Kruger 211 Units 100 $20.00 $2,006.00 0 $0.00 $0.00
233 Kruger 233 Units 100 $20.00 $2,006.00 0 $0.00 $0.00
537 Dekalb 537 Units 18 $84.00 $1,511.00 0 $0.00 $0.00
19V2 Northrup King 19V2 Units 100 $23.00 $2,275.00 0 $0.00 $0.00
2105 Asgrow 2105 Units 150 $23.00 $3,378.00 0 $0.00 $0.00
2201 Asgrow 2201 Units 50 $23.00 $1,127.00 0 $0.00 $0.00
45A6 Northrup King 45A6 Units 32 $88.00 $2,812.00 0 $0.00 $0.00
4884 Dekalb 4884 Units 32 $91.00 $2,913.00 0 $0.00 $0.00
5018 Dekalb 5018 Units 18 $113.00 $2,026.00 0 $0.00 $0.00
35Y55 Pioneer 35Y55 Units 16 $99.00 $1,581.00 0 $0.00 $0.00
35Y65 Pioneer 35Y65 Units 45 $94.00 $4,219.00 0 $0.00 $0.00
36B08 Pioneer 36B08 Units 66 $118.00 $7,759.00 0 $0.00 $0.00
36R11 Pioneer 36R11 Units 100 $15.00 $1,546.00 0 $0.00 $0.00
92B12 Pioneer 92B12 Units 0 $0.00 $0.00 0 $0.00 $0.00
Seed Inventory $35,158.00 $0.00
Grand Total $125,159.00 $161,780.00 $176,650.00 $181,862.00
John & Mary Farmer 2003 Inventory Trends
1 2 3 4
Work In Process
Figure 8. Inventory change graph.
While the suggested solution detailed above might be the one utilized based on
John and Mary Farmers needs, the following schematic outlines the relationship
between the centers for an alternative managerial accounting design that is more
basic than the one selected by the Farmers:
General, Sales, & Administration
The following items will be assessed in particular:
Farm Financial Standards Council Model Case
Do you think that this case study with it proposed solutions will be useful to agricultural enterprises seeking to employ management accounting techniques? Why? Be specific in identifying benefits and possible drawbacks to the proposed solutions.
If the Farm Council Case did not use Activity Based Costing, identify several dysfunctional decisions that could be made using traditional cost allocation. Which solution do you prefer, the initial or alternative solution proposed in the case? Explain the difference between the suggested solution and alternative solution.
Read this article:Throw Out Fixed and Variable Cost Thinking—Bring In Activity-Based Costing for Distribution Decisions retrieved August 17, 2009
Throw Out Fixed and Variable Cost Thinking—
Bring In Activity-Based Costing for Distribution Decisions
Roger K. Harvey, D.B.A.
Consider the following scenario raised by John Shank, Professor of Accounting, Dartmouth College: “Suppose an airline has an empty seat on a flight leaving in one hour. Isn't the contribution approach (i.e., covering variable costs and ‘contributing' something to fixed costs) appropriate for pricing that seat?”
For distributors, the question takes many forms:
“Shouldn't we bid on that direct sale at a 3% margin … most of it goes to the bottom-line?”
“Shouldn't we under-bid on the systems contract … the big gross profit dollars on the contract contribute to ‘fixed' overhead?”
“Shouldn't we price it at ‘X' dollars … that will cover our variable costs?”
“Shouldn't we forgo the delivery charge…we're driving by their location anyway?”
“Shouldn't we pick up their new line … we're already carrying their other lines?”
How do you answer these questions in your daily decision making? Professor Shank answered his airline question this way:
I understand as well as you the sense in which that extra seat is free. What I have said is that for my 25 years of experience, the mindset that will sell that seat for $50 because it is free destroys companies. We have created the mindset that profit at that level is real profit.
I suggest it could also destroy industries—possibly the distribution industry. To continue the story … “the airline sells the seat for $50 and the “smart” passenger sits next to you. Her “discount price” of $50 comes up in the course of the conversation; you, the business traveler, paid $300 for your seat. The next time you fly you hold out for the “discount price” of $50 and sit next to another business traveler. You mention the $50 fare to your seat mate—a full-fare business traveler. You notice your old seat mate is sitting across the aisle talking to another business traveler. You overhear the word ‘$50.'”
It doesn't take long for the word to get around that seats are $50 and only dummies pay full price. With more seats selling at $50 than $300, what is the contribution of the flight to fixed costs? Look what fixed cost/variable cost thinking has done to the airline industry, paper manufacturing industry, trucking industry, to mention only a few. It could happen to our industry.
It's time to throw out fixed cost/variable cost thinking in distribution decision making. The history behind the fixed cost/variable cost distinction is traditional cost accounting systems for manufacturing companies—systems developed in the first half of the twentieth century. Costs were classified as either variable because they were thought to vary with volume or fixed because they didn't vary with volume. When an argument ensued between accountants and managers about a cost being fixed or variable, a compromise was to call it a semi-variable or semi-fixed cost. Why quibble over whether a cost is fixed or variable when the cost system that raises such questions only leads to poor strategic decisions?
In several articles and books on the subject, Robert Kaplan and Robin Cooper recommend using the Rule of One:
If only one person (or one machine) exists in a department, it can be considered a fixed expense. But when more than one unit of a resource exists in a department, it must be a variable resource. Something is creating a demand for the output from that department, and more than one unit of resource is required to satisfy that demand.
Today isn't in the first half of the twentieth century and our industry isn't manufacturing. It's time to stop “out-dumbing” our competitors and ourselves by answering YES to the questions raised in the opening paragraphs of this article. Fixed cost/variable cost thinking has no place in distribution decision-making. The reason why is customer driven costs.
Customer Driven Costs
As a distributor, your costs are far more driven by customer demands than they are by volume. Your pre-sale costs to earn the order are driven by preparation, visits, demonstrations, bids, quotes, follow-up, geography, etc.—customer demands. Your purchase costs to acquire products are driven by lines carried, lead-times, inventory levels, I/S costs, fill rates, etc.—customer and vendor requirements. Your storage and handling costs are driven by order size, standard/special order type, automation, product characteristics, packaging, inventory requirements, etc.—customer and vendor behavior. Delivery costs are driven by geography, distance, traffic congestion, equipment, etc.—customer requirements. After-sale costs are driven by returns, training, warranties, repairs, etc.—customer requirements.
Rather than think about costs as being either fixed or variable, think about costs as associated with the activities you do for customers. Take the delivery activity for example. If you think in terms of fixed costs/variable costs, truck leasing expense is fixed, the driver's salary is fixed, the truck maintenance contract is fixed, taxes and licenses are fixed, and in the situation that we'll describe next, even fuel is a fixed cost. With this mindset, you should deliver, without charge, a $10 carton of paper to a new customer located across the street from an existing customer. The $2.00 gross profit you earn on the delivered carton contributes to your fixed costs. Wow, what logic!
In the same situation, if you outsourced delivery, you wouldn't think fixed cost/variable costs—you would think direct or out-of-pocket costs. If your carrier charged you $10 for the drop, you wouldn't accept a $2.00 gross profit order without a delivery charge.
Note: if the common carrier to whom you outsourced the delivery used fixed cost/variable cost, they would charge you almost nothing to make your delivery because you are a new customer and they drive by your customer's location anyway. Try this logic on UPS the next time you negotiate an outsourcing contract.
Let's look at a better way of thinking—an approach to gathering cost data in a distribution business that leads to better strategic decision making.
Activity-Based Costing (ABC) approaches the problem of accounting for costs from a perspective that is totally different from a fixed cost/variable cost classification scheme. ABC tries to give you a clearer picture of your costs of doing business, first, by identifying activities in your business and the resource costs associated with them and, second, assigning those activities to objects such as customers, products, or processes. Examples of “activities” in a distribution business are: ordering products from vendors, receiving products, selling products, taking orders, and delivering products. Resources are people, technology, equipment, supplies and money, and the costs associated with them. Customers, products, and processes consume resources and, therefore, incur their costs. ABC assigns (not allocates) costs to these objects based on their rate of consuming activities.
Let's return to the delivery example. ABC has you identify all resources and their associated costs that go into your delivery activity. It doesn't matter if a cost is fixed (e.g., truck lease) or variable (e.g., fuel), it is assigned to a delivery cost pool. If the warehouse supervisor spent 20% of her time scheduling deliveries, 20% of her compensation is assigned to the delivery cost pool. Notice that activity costs cut-across traditional distribution functions so resource costs assigned to delivery might come from the warehouse, office, administrative, or from wherever the resource originates. Also, notice it doesn't matter where in the General Ledger the expense is recorded. We map it to the activity cost pool that consumes the resource.
After all the costs identified with an activity are totaled, they are assigned to customers, products, or processes based on an “activity unit.” An activity unit, sometimes called a “cost driver,” is the usually the output unit that the activity produces. The output unit for the delivery activity is a stop or drop. Each customer is assigned a delivery cost based on how many activity units they consume (i.e., deliveries or stops they receive).
Exhibit I graphically illustrates the elements of an ABC system:
ABC identifies and assigns costs not based on their perceived behavior (fixed or variable), but rather based on what activities cause them and who consumes those activities. ABC recognizes that we as distributors do what we do—perform activities—to meet customer demands. We provide value-added services that require value-added activities and those activities consume costly resources. From there, it is a matter of assigning costs to customers if we are engaged in customer profitability analysis, to vendors if we are doing product-line profitability analysis, or to processes if we are trying to reengineer costs out of our business or out of the entire distribution channel.
We as distributors need cost information not to track the cost of manufacturing operations, but to make strategic management decisions—decisions on pricing, unbundling value-added services, customer profitability, vendor profitability, and automating processes. If we approach these decisions with a fixed cost/variable cost mindset, we will be flying by the same dumb decision-making rules that the airlines use every day. ABC offers us a new mindset—one which starts with customer requirements and ends with the “cost to serve” those needs. Let's adopt the ABC approach to strategic cost management as our tool for decision-making and throw out fixed cost/variable cost thinking.
Additional Sources of Information
This article is meant to suggest a new way of thinking about costs in distribution management. To learn more about ABC methodology, you may wish to consult the following articles and books:
Roger K. Harvey, The ABC's of Activity-Based Cost Accounting for a Distribution Business—White Paper #2. Available at no charge from Value Associates, Ltd., PO Box 1556, 564 Graceland, Carbondale, CO 81623.
Roger K. Harvey & Peter L. Mullins, Implementing Activity-Based Cost Accounting, Customer Profitability, and Product-Line Analysis in a Distribution Business—White Paper #3. Available at no charge from Value Associates, Ltd.
Roger K. Harvey, Activity Accounting and Customer Profitability Analysis for Distributors, 1994, Value Associates, Ltd., Voice: 970-963-1444, Fax: 970-704-9740. (Updated version of the book to be published in 1997.)
Peter L. Mullins, Measuring Customer and Product Line Profitability: Beyond Turn & Earn, 1984. Available from Value Associates, Ltd., Voice: 970-963-1444, Fax: 970-704-9740. (Updated version of the book to be published in 1997.)
Tom Pryor & Julie Sahm, Using Activity Based Management for Continuous Improvement, 1996, ICMS, Inc., Voice: 817-633-2873.
 This article was inspired by Tony Hope and Jeremy Hope's book Tony Hope and Jeremy Hope, Transforming the Bottom Line – Managing Performance with the Real Numbers, (Boston, MA: Harvard Business School, 1996).
 John Shank, Contribution Margin Analysis: No Longer Relevant/Strategic Cost Management: The New Paradigm,” Journal of Management Accounting Research 2, Fall 1990, p. 28.
 Robin Cooper and Robert S. Kaplan, The Design of Cost Management Systems, (Englewood Cliffs, N. J.: Prentice-Hall International, 1991), p. 294.
 Tony Hope and Jeremy Hope, Transforming the Bottom Line – Managing Performance with the Real Numbers, p. 119.
 ABC accounting links together activities with a common purpose into “processes,” such as the processes of selling products and services, order taking and fulfillment, obtaining products, and managing inventories and deliveries. A typical process cuts across several traditional distributor functions. For example, the process “order taking and fulfillment” involves activities within the inside sales, warehouse, and delivery functions. “Business Process Analysis” then analyzes and re-engineers the process in order to reduce costs by eliminating unnecessary tasks, streamlining operations, and outsourcing inefficient activities.
Now discuss the assertions this author is making in terms of variable and fixed costing and why ABC may make more sense in these type of settings. Justify your answer with good reasoning. You should attempt to integrate the thoughts of this article and your critique of it with the comments you make above.
Running Head: MANAGERIAL ACCOUNTING
The choice of which costing approach a business uses will undoubtedly influence the way costs are viewed. In some cases it may even influence the way certain cost components are treated. Where as traditionally cost has been viewed and allocated as being fixed or variable, increasingly it is nowadays accepted that this should not the case.
Instead, the Activity Based Costing (ABC) approach has been found to allocate and capture cost more aptly and precisely (Goebel, Marshall $ Locander, 1998). The use of conventional methods of costing has been found to be inadequate in representing costs precisely especially in the face of organizations that have to consider product mix decision and manage its overheads.
Within any business operation, variable costs will include those that fluctuate with a production period and thus depend on the capacity at any given time. Fixed costs on the other hand will be those that remain the same despite the total production of the organization. Where as allocation determination of variable costs – direct materials, direct labor and variable overhead, is relatively easy with regards to different products, the challenge is allocating the component viewed as fixed to the various products (Mathews, 2002).
Under traditional costing methods, production indirect costs are allocated on the basis of volume (Frost, 2005). However, this does not represent the true picture given that the number of units produced and the direct labor are not the underlying causes of production of sales overheads. In reality, one customer may demand for a variety of goods while another will demand an equal quantity in homogeneous goods (Damme & Zon, 1999). When allocating overhead costs, the production of the homogeneous product will be lower as opposed to the variety yet the total production is the same (Zimmerman, 2010).
Using the case of John and Mary as a reference point, the will arise a cost distortion with regards to the volume difference between corn and soybeans. This is because in normal circumstances, low volume products will receive too little overhead and vice versa. However the truth is that for the production of corn and soybeans, will require, planting, weeding, spraying and harvesting despite the number of units produced. This will not vary depending on the units produced this creating a cost distortion (hope & Hope, 1996).
In order to determine the true cost of production for a specific production line, the traditional costing method is greatly inadequate. To address this short coming, the Activity Based Costing (ABC) method was developed. In its determination, the ABC takes into consideration more than one cost driver in allocating indirect costs . This makes it possible to determine more accurate cost drivers (C...
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