It is important for management to understand how different departments and customers contribute to the profitability of a company. Profitability is comprised of both price and costs. Costs can be allocated using a variety of methods. Understanding cost flows and the various methods of allocating costs is important in ensuring profitability.
Evaluate potential cost allocation methods that would impact an organization’s selling prices, and provide examples.
Communicate decisions faced when collecting and allocating indirect costs to customers, and provide examples.
Elaborate on why costs for one customer might be different from that for another customer being sold the same product or service.
Full Answer Section
- Absorption costing: Absorption costing allocates both direct and indirect costs to products or services. This means that indirect costs are spread out across all products or services. This can result in higher selling prices, as the organization is charging customers for both the direct and indirect costs associated with the product or service.
- Activity-based costing (ABC): ABC allocates costs to products or services based on the activities that are performed to produce or deliver the product or service. This can result in more accurate selling prices, as the organization is charging customers for the specific activities that are required to produce or deliver the product or service.
Decisions faced when collecting and allocating indirect costs to customers
When collecting and allocating indirect costs to customers, management faces a number of decisions, including:
- Which indirect costs to allocate: Not all indirect costs are relevant to all customers. For example, the cost of advertising may not be relevant to customers who are already aware of the product or service. Therefore, management needs to decide which indirect costs are relevant to each customer.
- How to allocate indirect costs: Once management has decided which indirect costs to allocate, they need to decide how to allocate them to customers. There are a variety of methods that can be used to allocate indirect costs, such as direct cost method, sales basis, number of units produced, and machine hours used. The method that is chosen will depend on the specific circumstances of the organization and the industry in which it operates.
Examples of decisions faced when collecting and allocating indirect costs to customers:
- A company that sells two products, A and B, may decide to allocate indirect costs based on the sales volume of each product. This means that product A will be allocated more indirect costs if it has a higher sales volume than product B.
- A company that provides a service to multiple customers may decide to allocate indirect costs based on the number of hours that each customer uses the service. This means that customers who use the service more often will be allocated more indirect costs.
Why costs for one customer might be different from that for another customer being sold the same product or service
There are a number of reasons why costs for one customer might be different from that for another customer being sold the same product or service. These reasons include:
- Volume discounts: Customers who purchase large volumes of a product or service may be offered volume discounts. This means that they will pay a lower price per unit than customers who purchase smaller volumes.
- Customizations: Customers may request customizations to a product or service. These customizations can increase the cost of producing or delivering the product or service to the customer.
- Shipping costs: Shipping costs can vary depending on the location of the customer. Customers who are located further away from the company's warehouse will incur higher shipping costs.
- Payment terms: The payment terms that are offered to customers can also impact costs. Customers who are offered longer payment terms may be charged a higher price to compensate for the increased risk of non-payment.
By understanding the different cost allocation methods and the decisions that are faced when collecting and allocating indirect costs to customers, management can make informed decisions about how to price their products and services.
Sample Answer
Cost allocation methods that impact selling prices
The cost allocation method that an organization chooses can have a significant impact on its selling prices. For example, if an organization uses a cost-based pricing method, such as markup pricing or target pricing, the cost allocation method will directly impact the selling price of the product or service.
Here are some examples of how different cost allocation methods can impact selling prices:
- Direct costing: Direct costing allocates only direct costs to products or services. This means that indirect costs are not allocated to products or services. This can result in lower selling prices, as the organization is only charging customers for the direct costs associated with the product or service.