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Getting Cost Allocation Right
 Editor's note: This article continues a new series on the "best practices" FBS users have developed to improve effectiveness, efficiency, internal control and compliance from their information system. In theJune 2012 newsletter we illustrated the analysis opportunities created when actual overhead costs deviated from standard cost drivers used inActivity-Based Costing (A-B-C).
In order to make the transition from traditional to management accounting you must begin with some "heroic assumptions" regarding values to assign to Activity-Based cost drivers. The paradox is that a) you're converting to management accounting because you want to determine your internal costs, but b) in order to discover those costs (and produce reliable financial statements) you must first know and accurately allocate costs from segment to segment. In other words, in order to know your costs you have to know your costs.
The most practical solution is to use standard costs throughout the startup period. These "ballpark" costs are widely available throughout agriculture (custom rates, grower contracts, etc.). When and how, though, do we go beyond these "plugged" costs and get to "real" costs? And what do we do with the variances?
Variances are a reality of management/manufacturing accounting.
Here's a quote (with our emphasis) from Harvard Business School:
Since overhead allocation rates are predetermined, the amount of indirect costs actually applied to products or services will almost neverbe equal to the expenditures on resources consumed. The difference between the actual indirect costs and those assigned to products or services arises because of a failure to predict indirect cost expenditures and activity levels perfectly, and is usually called an overhead variance. If small, overhead variances are usually charged as period costs. If large, further cost analysis may be justified, and the entire process of allocating indirect costs may be repeated after the fact to allow managers to figure out what is really going on as they create products or services.
Understanding Costs
William J. Bruns, Jr.
When Do I Adjust My Allocations?
Be prepared to wait from three months to a year before adjusting cost drivers. That's because of the seasonal and "lumpy" nature of indirect costs.
Why use these longer time periods?
- The "Numerator Reason." The shorter the period, the greater the influence of seasonal patterns as well as the effects bynon-seasonal erratic costs that benefit future months. The classic examples in agriculture are equipment that are repaired and maintained in the winter months and used for only a month or two in the growing season. (See Figure 1 below.)Seasonal variations even occur with confinement livestock (heating in the winter and cooling in the summer).
- The "Denominator Reason." Unlike the numerator reason where costs for the period vary, in this situation, costs remain relatively constant, but output varies. For instance the operations costs of a cow herd may be relatively uniform from month-to-month, but the output ("weaned calves") may only occur once or twice during the year.
Minimum Time Periods Required To Determine and Adjust to "Actual" Costs:
- Annual Crops: Twelve months.
- Perennial Crops: Much longer if crops are just being established.
- Livestock: Initially, the duration of a feeding period or production cycle.
However, in production systems with historical cost accounting,uniform monthly output and appropriate month-end accruals you can achieve a high confidence level in activity costs on a monthly basis.
How To Adjust Allocations
In FBS E.CLIPSE Management Accounting the recommended report for monitoring and adjusting standard costs is the Standard Cost/Vendor Monitor Report. In the example below we chose a one year/four quarter view of costs for the Crop Harvesting Support Cost Center. Note the highest expenses were in the Quarter 1($19,665.61 due to maintenance and repairs) but no harvest activity occurred in that period. Quarters 3 and 4 did include internal harvesting and custom work income as a credit to the costs. When this activity is "closed" for the year the Standard costs are adjusted to equal the Actual costs of $36.58/harvest acre so that this cost center "breaks even" with the $49,065.54 costs "pushed" to crop work-in-process production centers.
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| Figure 1. Standard Cost/Vendor Monitor Report for Harvest Activity Cost Center. |
Next month we'll go over the process to automatically adjust overhead variances and learn about three approaches manufacturers use to handle end-of-period adjustments.
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