Lets consider costing for a service organization Assume you

Let\'s consider costing for a service organization. Assume you are a consultant for a law firm. The firm currently has no traditional cost accounting system in place. A partner has taken a course in management accounting and wants to understand traditional and activity based costing. Explain to the partner how a traditional overhead rate is determined and what would be a good denominator activity to use as the base. Also explain what is meant by activity- based costing and how it would might lead to better decisions for the firm If you have worked for a company that employed a cost accounting system, share your personal experiences with us

Solution

The traditional method uses all indirect cost and one appropriate cost driver like machine hours to calculate the overhead rate per hour.

The most appropriate driver would be machine hours in case of manufacturing unit, for service unit labor time incurred on each service to be provided would be suitable.

Example- X company expects to incur $1000000 overheads and labor cost will be 500000 then the overhead per labor hour will be = 1000000 / 500000 = $2.00 per labor hour.

Activity based costing- This method refers the activities that a firm performs. In this method, cost is assigned to the particular product produced. This analysis is used in target costing, product line, profitability analysis, this is mostly used in the production industry. This system of costing is more accurate as it takes into consideration many factors before assigning a cost to a particular product. This system is complicated and time-consuming but still very accurate.

This helps in reducing the extra cost that is not required. Managers can reduce fixed as well as variable cost if any production process is not required. By this process, more accurate cost of a product can be determined for better decision making.