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(Wiley Best Practices)Steven M. Bragg-Inventory Accounting a Comprehensive Guide-Wiley(2005)

(Wiley Best Practices)Steven M. Bragg-Inventory Accounting a Comprehensive Guide-Wiley(2005)

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Activity-based costing was developed in response to the shortcoming of traditional
cost allocation systems. The chief problem with these systems is that they do not
allocate overhead in a manner that truly reflects the usage of overhead. This is
caused by the lumping of all overhead costs into one large overhead cost pool, as
well as the use of inappropriate allocation measures to spread the cost of this pool
to products. The end result is incorrect inventory costing, which can lead to incor-
rect decisions based on those costs.
The problem becomes particularly obvious when the overhead cost pool greatly
exceeds the size of the allocation measure, which is frequently direct labor. In some
industries, where there is a great deal of machinery or engineering staff involved
(such as the automotive, drug, and aerospace industries), the ratio of overhead to
allocation measure is frequently in the range of 300% to 400%. This means that a
slight change in direct labor will result in the application of an inordinate additional
amount of overhead to a product, which, in all likelihood, was never justified by
changes in the usage pattern of the product to which the overhead costs are being

Another problem is that the overhead cost pool is only being allocated based on
one allocation measure. Many of the costs in the overhead cost pool have not the
slightest relationship to the allocation measure, and so should not be allocated based
on it. Here are some of the costs stored in the overhead cost pool that have no rela-
tionship whatsoever to the most common allocation measure, direct labor:

Building rent.A better allocation is based on the square footage of the facility
that the machinery and inventory storage areas related to a product line are using.

Building insurance.The better allocation is again square footage.

Industrial engineering salaries.A better allocation is the total number of units
expected to be produced over the lifetime of the product line.

Machinery depreciation.A better allocation is the hours of machine time used.

Machinery insurance.A better allocation is the hours of machine time used.

Maintenance costs.A better allocation is the hours of machine time used.

Production scheduling salaries.A better allocation is the number of jobs sched-
uled during the accounting period.

Purchasing salaries.A better allocation is the number of parts in a product or
the number of suppliers for a product from whom parts must be purchased.

Utilities.A better allocation is based on the hours of machine time used.

Warehouse salaries.There are several better allocations, such as the number
of receipts or shipments related to a product, or the number of parts in it.

Applying Overhead to Inventory/ 131


Adapted with permission from Chapter 16 of Bragg, Cost Accounting: A Comprehensive
Guide, John Wiley & Sons, 2001.

c09_4353.qxd 11/29/04 9:26 AM Page 131

It is evident from this list that most overhead costs have not the slightest relation-
ship to direct labor and that a good cost allocation cannot depend on just one basis
of allocation—several are needed in order to realistically portray the actual usage
of each element of overhead.
Another issue is that traditional cost allocation systems tend to portray products
made with high levels of automation as being deceptively low in overhead cost.
The issue is best illustrated with an example. If a high-technology company decides
to introduce more automation into one of its production lines, it will replace direct
labor with machine hours by adding robots. This will shrink the allocation base,
which is direct labor, while increasing the size of the overhead cost pool, which now
includes the depreciation, utilities, and maintenance costs associated with the ro-
bots. When the overhead cost allocation is performed, a smalleramount of over-
head will be charged to the now-automated production line, because the overhead
costs are being charged based on direct labor usage, which has declined. This makes
the products running through the automated line look less expensive than they re-
ally are. Furthermore, the increased overhead cost pool will be charged to those
production lines with lots of direct labor, even though these other product lines have
not the slightest association with the new overhead costs. The end result is a sig-
nificant skewing of reported costs that makes products manufactured with automa-
tion look less expensive than they really are and those produced with manual labor
look more expensive than they really are.
Another issue is that traditional cost allocation systems tend to portray low-
volume products as those with the highest profits. This problem arises because the
overhead costs associated with batch setups and teardowns, which can be a signifi-
cant proportion of total overhead costs, are allocated indiscriminately to products
that have both large and small production volumes; there is no allocation to a spe-
cific short production run of the special batch costs associated with it. This results
in undercosting of products with short production runs and overcosting of products
with long production runs. This is one of the most common cost accounting prob-
lems and results in incorrect management decisions to increase sales of short-run
jobs and to reduce sales of long-run jobs, which results in reduced profits as com-
pany resources are concentrated on the lowest-profit products.
Based on these examples, it is clear that there are serious problems with the tra-
ditional cost allocation system. It does not apportion overhead costs correctly, re-
sulting in management information about products that is only correct by accident,
and which results in decisions that are not based on factual data. Activity-based cost-
ing was developed in order to correct these shortcomings.

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