Two questions with detailed responses

Managerial Accounting

Why do you think the division was profitable immediately under the new ownership?

An organization uses cost allocation methods to determine the cost of one unit of its product. Cost allocation refers to the process of linking all the cost incurred during the production process to the product. Direct costs and indirect costs are the cost associated with production of a product. Direct costs are those that are traceable to the product such as the price of wool in the production of shirts. Indirect costs are not traceable to the final product directly as taxes charged. Cost allocation enables the organization to determine the cost of its products by ensuring that a profit margin allocated to every unit produced.

In the case study, the manufacturer found that a component of the company was producing losses thus decided to sell. A group of workers bought the division and realized profit immediately after the sale. This change in profitability means the cost allocation method used by the organization did not cover the expenses. The use of traditional methods of cost allocation allocates indirect to products using predetermined overhead rates. The method uses many estimates thus prone to inaccurate determination of product overhead. The use of traditional costing methods results to under or over costing of products (Vanderbeck, 2012).

The workers who bought the division were aware of all the processes involved in the division thus could determine the cost to the product accurately. The workers adopted activity-based costing for the products, which assumes that the cause of costs is activity and activities are determined by cost objects. Activity-based costing provides an accurate way of determining the indirect costs associated with the product. Unlike traditional costing methods used by the previous management, under costing is avoided thus the immediate impact on the profitability of the organization. The use of activity-based costing is expensive to implement but improves cost allocation.

B. What kind of cost allocation method may have caused the sale of a profitable division, and can you suggest a better method of cost allocation? Explain why?

Activity-based costing ensures that the activities that consume more resources are allocated more costs thus accurate determination of overheads. Activity-based costing controls and improves the way the organization allocates overheads to all its products. The method enables the management to allocate all costs to the production process and not only to the product. The management is able to cater for all its operational cost accurately compared to the conventional cost allocation methods. The use of activity-based costing ensures that the management avoids under costing which is the main source of losses for the organization. The management is also able to avoid over costing which results to high prices, which may deter customers from purchasing the commodity.

The method uses activities used in product manufacture as building blocks for amassing costs for the product. This is the best cost allocation applicable for any organization. The demerits about the method of cost allocation are that the organization needs to have adequate resources to implement the costing method. The method of cost allocation is relatively more expensive compared to conventional costing methods. Another demerit is that the method requires skilled personnel to calculate and allocate costs to the products (Hansen Mowen & Guan, 2009).