Overhead costs are then allocated to production according to the use of that activity, such as the number of machine setups needed. This chapter will explain the transition to ABC and provide a foundation in its mechanics.Īctivity-based costing is an accounting method that recognizes the relationship between product costs and a production activity, such as the number of hours of engineering or design activity, the costs of the set up or preparation for the production of different products, or the costs of packaging different products after the production process is completed. To account for these changes in technology and production, many organizations today have adopted an overhead allocation method known as activity-based costing (ABC). Because of this decrease in reliance on labor and/or changes in the types of production complexity and methods, the traditional method of overhead allocation becomes less effective in certain production environments. In these situations, a direct cost (labor) has been replaced by an overhead cost (e.g., depreciation on equipment). For example, a mobile phone production facility in China replaced 90 percent of its workforce with robots. Many of these industries have significantly reduced their use of direct labor and replaced it with technology, such as robotics or other machinery. However, many industries have evolved, primarily due to changes in technology, and their production processes have become more complicated, with more steps or components. This allocation process, often called the traditional allocation method, works most effectively when direct labor is a dominant component in production. In the past, overhead costs were typically allocated based on factors such as total direct labor hours, total direct labor costs, or total machine hours. For example, for a manufacturer allocating maintenance costs, which are an overhead cost, is it better to allocate to each production department equally by the number of machines that need to be maintained or by the square footage of space that needs to be maintained? Whereas Kamil and Barry are discussing the allocation of hours, the issue of allocating costs raises similar questions. Similarly, businesses and other organizations must create an allocation system for assigning limited resources, such as overhead. Ultimately, each must decide which method to use to allocate time, and they can make that decision based on their own analyses. Both roommates make valid points about allocating limited resources.
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