A major problem in many corporate accounting systems has been that overhead

A major problem in many corporate accounting systems

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A major problem in many corporate accounting systems has been that overhead costs are precisely applied to the products that they support. Effective performance measurement requires each product to bear its fair share of all costs incurred to create, make, sell, and service it. Direct costs pose no major problem; managers simply record all of the labor, materials, and other resources used by a product. However, assigning overhead costs becomes more difficult. Unlike direct costs, these costs seldom vary with changes in output. In the past, overhead costs did not pose major problems because they were smaller, i.e., labor costs accounted for much of a typical firm's costs. However, this situation has now changed. For one, labor has come to account for a smaller percentage of total costs, in some industries, less than 5 percent of total cost. In faster paced industries, larger investments in product development, process automation, and information have raised fixed costs. An IBM ad noted that 75% of all IT dollars go into infrastructure.
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40 To overcome the problem of assigning overhead costs, accountants developed activity-based cost accounting. ABC tries to trace costs to specific goods and services rather than arbitrarily allocating them on the basis of some universal measurement unit such as labor hours or machine hours. It seeks to identify cost drivers that reveal the sources of costs for products and services.* Exhibit 7 illustrates some cost drivers. Exhibit 7 Cost Drivers for Activity-Based Costing Activity Cost Driver Rate Material handling Number of components $0.25 per component Engineering and design Hours of engineering services $100.00 per hour Production setup Number of setups $55.00 per setup Assembly (automated) Number of components $0.75 per component Inspection Hours of testing $60.00/ hour of testing Packaging and shipping Number of orders $4.50 per order shipped Proponents claim that ABC helps firms to respond to changes in their product mixes, technologies, and processes. ABC forces managers to focus on activities that create costs rather than on end products. Activities for which no product or business process accepts as a necessary cost may be waste. POSTPONEMENT, DELAY, AND VALUE When an activity is done and where a good is placed can have a significant impact on a firm’s value delivery system. In the above sections we described four different market orientations. The three do-to-order orientations involve a conscious decision to postpone doing a product transformation activity, thereby causing the customer to wait for the product. This type of postponement is designed into the system in order to enhance product flexibility and resource efficiency. The system is more flexible because by waiting for the customer to decide what it wants, the firm can offer a wider range of product. The efficiency of the system is enhanced because the firm expends resources to make goods when it knows that it will be sold. This cost to the customer of this product flexibility is increased lead times.
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