Cost allocation systems assign production costs to manufactured goods. Common methods include absorption costs, variable costs, and activity-based cost allocation. Companies choose the best method based on their manufacturing environment. Each method has advantages and disadvantages. Cost allocation systems are under scrutiny by management accountants and must comply with standard accounting principles.
Cost allocation systems are part of managerial accounting that focus on applying production costs to manufactured goods. There are many types of systems for this process, although many of the alterations come from a few basic configurations. Some common cost allocation systems include absorption costs, variable costs, and activity-based cost allocation. Companies often select the best allocation system based on their manufacturing environments, such as work order or process production. Each costing method has its advantages and disadvantages from an accounting standpoint.
Absorption cost allocation systems are often the preferred method of marrying financial accounting and management. Cost allocation is often an internal managerial accounting process, with the information obtained not for public disclosure. This method excludes all variable and fixed general, selling, and administrative (GSA) costs that do not affect the direct production of goods. In accounting, these costs fall under a period-forward expense. Expenses for the period go directly to the company’s income statement, reducing net income for a given month.
Variable cost allocation systems are similar to the absorption method in that they exclude GSA costs that do not affect the direct production of goods. However, the main difference here is the exclusion of fixed manufacturing costs along with GSA expenses. The elimination of fixed manufacturing costs reduces the production costs assigned to each product. The result is a lower cost of goods sold and higher gross profit. Many national accounting boards disagree with this method, as it creates a distorted income statement and inappropriate costs for manufactured goods.
Activity-based costing is quite different from these other two methods. These allocation systems look for activities that affect the manufacturing process. Each activity must have a cost driver, such as labor or machine hours. Under this method, accountants add up all the costs associated with a manufacturing activity. The cost driver helps companies determine costs per unit and allocate results accordingly.
Cost allocation systems are often under intense scrutiny by management accountants. Companies must ensure that the cost system properly handles all manufacturing costs and complies with the standard accounting principles that govern financial accounting. Failure to properly manage these costs can lead to serious problems, from lack of profit to poor audit results and failed accounting systems. Accountants can often alter or adjust as necessary to create the most cost effective and accurate system possible to stay in business and stay competitive.
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