I will use Case 18-6, Midwest Office Products (MOP), to demonstrate my comprehension of the key principles relating to root cause cost drivers, direct versus indirect costs, responsibility centres, overhead rates and Activity Based Costing (ABC)
1. Root Cause Cost Drivers:
This is an activity that is the primary reason for a cost occurring and normally proportionate to the cost. Root cause cost drivers are used to allocate the cost of a task to an organisation, product or service. In MOP, a root cause cost driver for the desktop deliveries were the truck driver and delivery truck costs. Root cause cost drivers can be a single cost driver or several cost drivers.
2. Cost Driver Parameters:
Once a cost driver is determined, it is critical to measure the cost in the correct unit. Using the wrong unit of measure can drastically change the cost of a good or service. For example; when determining the truck and/or truck driver costs for desktop deliveries in MOP, you could allocate the cost by using hours required per delivery or by the number of deliveries per driver/truck.
3. Estimating Product Cost:
The accuracy of the cost of a cost object is dependent on the allocation of direct and indirect costs. The higher the proportion of indirect costs allocated to a cost object, the less accurate the cost estimation. This is because indirect costs are not directly traceable to a cost object and must be estimated. Conversely, direct costs are distinguishable and are easier to assign to the cost object. In MOP, a direct cost of the desktop deliveries is the cost of goods sold and an indirect cost is the order entry.
4. Responsibility (Cost) Centres:
These are cost objects used to trace and estimate costs incurred by business units, organisations, companies, etc. Managers have authority over responsibility centres in order to monitor and control costs. Responsibility centres may be used to monitor performance and costs. In MOP, when researching the operating cost, the director of operations might have used the cost centres for the warehouse, shipping and data entry to obtain the cost information.
5. Overhead Rates:
Overhead rates are used to allocate indirect costs expended by a product to the product. This is the budgeted best estimate because we are unable to specifically determine the resources consume by individual products. There are several methods used to calculate overhead rates. The two main rates discussed in the chapter are departmental and company-wide overhead rates. Departmental rates are based on a department's direct and indirect overhead costs and some measure of the department's activity (labour/machine hours, cost plus). Departmental rates are more accurate than company-wide (sometimes referred as plant-wide) rates when a company has multiple products as management can assess corporate inefficiencies more accurately. Company-wide overhead rates identifies a single cost driver and estimates the volume for the year to produce a per unit cost driver. In MOP, they used an overhead rate of 5% of COGS for desktop delivery.
6. Activity Based Costing:
ABC is an accounting method that determines the relationship between costs, activities and products. ABC allocates overhead more accurately to product than traditional methods; such as departmental or company-wide overhead rates; by identifying and costing each activity then allocating it to every product that required the activity. Other methods may overestimate costs of simple high volume products and underestimate complex low volume products. Although you receive better and more accurate information for cost management, ABC can be very complex and significantly more expensive to implement than other costs systems. In MOP, by using ABC, management was able to understand why they were losing money, as the overhead rate underestimated the costs of their delivery services.
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