Cost allocation methods and inventory management in organizations

¶ … financial managers, it is important that you identify and allocate costs appropriately. Discuss the major cost categories. What are some of the methods used to determine the cost category?

Two primary categories of costs exist: direct costs and indirect costs. Direct costs, as their name suggests, are those that can be identified specifically as having a relatively stable contribution to the final cost of a project. Indirect costs tend to be more variable. A good example of direct and indirect costs may be found when constructing a budget for going to college. Examples of direct costs might include tuition, mandatory activity fees, and housing fees (such as the cost of a dormitory room). Without satisfying these costs, which are all directly paid to the institution, attending school is impossible. However, there are also indirect, contingent costs not paid to the school which are just critical and must be satisfied to successfully complete a degree such as books, transportation and off-campus rent (if not living on-campus), a computer, and personal expenses (Direct and indirect costs, 2010, Sallie Mae).

How can service organizations benefit from activity-based management to become competitive?

Activity-based management focuses on maximizing organizational value from streamlining processes, which makes it ideal for service-based organizations. For service organizations, 'people' and 'processes' rather than 'products' are the focus. Moving individuals more effectively from task to maximize their knowledge base or simply reduce transportation costs; eliminating wasteful extra salaries by consolidating tasks for workers; using technology to speed worker processes; and encouraging 'horizontal' management strategies rather than forcing workers to wait for top-down controlled decisions are possible reforms that can be facilitated with ABM. "Processes and activities are the central nervous system of the process-based organization and represent the core of what the organization does to create value for its customers and shareholders" (ABM, 2001, CIMA)

Cost flows in an accounting system

Cost flow assumptions involve how costs are allocated within an enterprise: the two most typical methods are LIFO and FIFO. Last in, first out (LIFO) means "the units remaining in ending inventory are costed at the oldest unit costs available; the units in cost of sales are costed at the most recent unit costs available" (Gibson, 2001, p1.). For industries with relatively stable demand and costs, and large inventories and predictable growth, LIFO is often used. It also tends to be more advantageous for tax purposes. FIFO "assumes that the cost of items sold in a period reflects the oldest cost in inventory just before sale. As a consequence, remaining inventory valued at FIFO more closely represents current or replacement cost," and is a more accurate reflection of the physical flow of goods, but can be disadvantage for a producer in an inflationary market (Gibson, 2002, p.1)

Product vs. period classification

Product costs are the relatively stable material costs that are involved in making the product, such as input materials, labor, and overhead (Product cost vs. period cost. (2010). Accounting for Management). Period costs include the more variable and less predicable costs of manufacturing such as administrative costs and marketing and sales costs.

Value chain

Value chain analysis, first popularized by Michael Porter, strives to maximize the value given to the customer so that it is greater than the cost of the activities used to obtain the good or service, while minimizing the costs incurred by the manufacturer. The primary value chain activities are inbound logistics: "the receiving and warehousing of raw materials, and their distribution to manufacturing as they are required," operations, "the processes of transforming inputs into finished products and services," outbound logistics, "the warehousing and distribution of finished goods," marketing and sales, "the identification of customer needs and the generation of sales," and service-related activities, or "the support of customers after the products and services are sold to them" (Value chain analysis, 2010, Net MBA). Reducing inbound and outbound logistics and operations costs, while maximizing quality in all these areas as well as communicating a strong message through marketing, sales, and service efforts creates value for the manufacturer and the perception of value for the customer.

Proactively controlling costs using target costing

Target costing involves a firm setting a target cost during the production or reformulation of a product so that the item will bring a certain desired profit margin for the firm. It places pressure upon designers to engage in lean manufacturing processes and development, as the desired cost (and desired profit) is set before, rather than after the item is finished and introduced into the market.

Conversion costs

Conversion costs are the direct costs of labor plus the manufacturing overhead costs required to use that labor (Conversion cost definition, 2010, Accounting for Management).