COST AND MANAGEMENT

ACCOUNTING
Contents
1. Introduction .......................................................................................................................................... 2
2. Accounting for overhead ...................................................................................................................... 2
2.1. Overhead costs allocation issues .................................................................................................. 2
2.2. Strategies for accurate allocation of Overheads........................................................................... 4
3. The costing of services .......................................................................................................................... 5
3.1. Cost information needs of service organizations managers ......................................................... 5
3.2. Difficulties association with calculation of service costs .............................................................. 7
3.3. Recommendations for allocation of costs in service industry ...................................................... 8
4. Conclusion ............................................................................................................................................. 9
5. References .......................................................................................................................................... 10

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 1. Introduction
Manufacturing businesses rely on their production units for quality operations and long term
survival in market. The production units of manufacturing companies have high cost contribution
in total expenses of a company. Initially these costs comprised of direct costs of goods sold
including labour wages, direct material consumed expenses and overhead costs (Freedman,
2015). However, due to advancement in information technology, the man efforts are replaced by
machines leading to increased overheads of other departments as well for manufacturing
companies.

Due to intense competition in market, the marketing and promotion expenses have become a
significant and integral part of a production company. Besides marketing and IT overhead
expenses, companies allocate administrative, financial, procurement and distribution expense in
other overheads. This report has discussed the problems in accurate allocation of overheads and
strategies to classify and allocate costs to respective departments. This report has also include the
information needs of costing department managers for proper functioning.

2. Accounting for overhead

Overhead cost allocation has become the significant component of cost measurement in
manufacturing companies and factories. Overhead costs has also increased due to automation of
systems and increasing use of machines in factories and manufacturing units. However, cost
allocation needs consideration and proper understanding from finance department for proper
allocation of costs to each head for accurate measurement of expenses other than cost of goods
sold. Different methods are used for allocation of cost such as direct method, step down method
and Reciprocal Method. Each method has different limitations, for proper allocation and
measurement of costs.

2.1. Overhead costs allocation issues

Proper overhead allocation is a big challenge for manufacturing units. Different approaches and
methods are used for apportionment and allocation of cost to different departments. It involves
several records including cost simulation models, engineering analysis, demand forecasts and
management accounting records. The two challenges involved in overhead cost allocation
include cost measurement and cost classification (Hanser, 2011). The traditional methods of cost

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allocation such as direct labor, reciprocal or step down methods are obsolete and has several
limitations for accurate cost measurement and cost classification.

2.1.1. Cost burden

Due to lack of efficiency and accuracy of traditional methods of cost allocation, the cost is
allocated to all departments on the basis of a single factor i.e. direct labour hours or machine
hours. It ignores other important drivers such as unique inspection, machine setups, special
storage and special handling. It draws all the overhead expense charged to one head in a single
cost pool (Accounting Coach, 2016). It calculates a single rate for allocation of costs to each
production unit. Due to inaccurate allocation of cost, the results of overhead cost allocation are
misleading.

2.1.2. Functional classification of cost

The classification of overheads to different departments such as selling and distribution,

production, administration and marketing is done on inadequate basis. The classification basis
and criteria are not sufficient for proper allocation of costs (Martin, 2015). The cost classification
criteria lacks proper cost control which allocates each overhead to a cost center to which it does
not accurately belongs.

2.1.3. Simplistic Allocation Bases

In order to create convenience in cost allocation process, the bases have kept too simplistic from
traditional accountants. The overhead cost are allocated by using simple and old criteria instead
of allocation done through proper measurement and taking into account different factors
involved in cost making (Accounting Coach, 2016). The cost allocation systems used lack
combinations of cost classification such as maintenance and servicing cost, inspection units and
storage capacity of a machine.

2.1.4. Inadequate focus on service departments

The overhead cost allocation process in manufacturing units majorly allocate maximum costs to
production units. Service departments are ignored despite of grand share in cost rise due to these
areas such as general administration, marketing, distribution and procurement. There is not
significant process initiated in manufacturing companies for analysis of cost contribution to

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service departments (Accounting financial tax, 2009). Service departments of manufacturing
companies require overhead allocation which is not integrated properly. It leads to misleading
allocation of cost to manufacturing units only.

2.1.5. Lack of proper training and accounting knowledge

The cost and management accountants employed by companies are not properly trained for
proper and accurate allocation of overheads to different manufacturing units and service
departments (Mohan, 2016). The cost of goods, processes and servicing cycle is not properly
handled by cost accountants leading to miss-allocation of costs.

2.2. Strategies for accurate allocation of Overheads

Overhead cost allocation should be improved in order to allocate costs of each manufacturing
and servicing unit accurately and precisely. The traditional methods of cost accounting should be
replaced by the finance department of manufacturing units. The areas which are missed by
traditional method of accounting should be incorporated by management accountants of
manufacturing units for more accurate and precise allocation (Cooper & Kaplan, 2000). For
effective and accurate allocation, the following strategies should be adopted by accountants:

2.2.1. Use of modern methods of overhead allocation

The modern production units are just in time even for those manufacturing units where products
take time for production. In order to make overhead costs more accurate and precise, the activity
based costing (ABC) method should be used. It helps in proper breakdown of in-direct costs
leading to accurate allocation (Wilkinson, 2013). Though ABC system is costly and complex, but
it generate feasible and reliable results regarding accurate allocation of overhead costs.

2.2.2. Allocation to service departments

Service departments now a days make up significant part of overhead costs of manufacturing
units. Such as logistics, distribution, marketing and sales, general administration and financial
administration. These departments play a direct role in setting strategies for proper functioning of
manufacturing units.

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 2.2.3. Hiring trained accountants

Lack of proper training for use of cost formulas and methods is an essential part for effective and
accurate allocation of overhead cost. Manufacturing companies have high production leading to
division of cost between manufacturing units and service departments (Cooper & Kaplan, 2000).
Qualified cost and management accountants should be hired for application of modern
accounting systems. The staff members should also be trained time to time for proper
implementation of cost processes.

2.2.4. Proper record of cost data

Cost data plays a direct role for measurement, classification and allocation of overhead costs to
different departments. Cost data should be recorded using different software and automated
systems instead of manual transaction records. Despite of automation of systems, there are many
departments in a manufacturing companies where cost record is still maintained using obsolete
and traditional ways. Accounting software such as Peachtree, Quick book and SAP should be
used for automated recording of cost data (Martin, 2015). These software not only provide an
accurate and digital cost record but also help in cost allocation with proper analysis, graphical
representations and charts.

3. The costing of services

Cost accounting is an essential part of any company whether it is manufacturing company or a
service business. In case of manufacturing companies, it is easy for management to account for
different costs related to overheads. The service companies like health care suppliers, lawyer or
accountancy firms and educational institutions, it is difficult to measure cost of services as it has
variable marketing values (Dawonauth, 2015). The calculation of cost of services has no accurate
and definite criteria, due to no accurate market rates for skills and expertise. The managers in
service industry need detailed market knowledge in order to assign costs to different services and
areas for measurement of total cost.

3.1. Cost information needs of service organizations managers

Service organizations have wide operations despite of non-existence of manufacturing units.
Cost information plays a significant role in effective operations of service organizations. It is

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essential for efficient decision making process. Managers of service organizations need
information in order to control several processes and operations. Service organization have not
accurate costing systems which makes it difficult for managers to make crucial decision for
costing methods, operational processes and demand forecasts. Cost information is also required
for accurate calculation of service costs, estimate of work efficiency, quantification of skills and
expertise etc. (Lepădatu, 2011). Some of the important cost information needs of service
organization managers include:

3.1.1. Knowledge and expertise

Managers in service organizations need cost information to get command over costing systems.
For successful operations of any company, it is necessary to minimize costs to maximize profits.
It also helps in cutting down service rates leading to competitive advantage over rivals in
respective industry (Miko, 2011). Manager need understanding of cost trends and factors which
impact costing systems for successful operations.

3.1.2. Demand and cost forecasts

Costing of service organizations is required for advance idea of estimated costs including direct
costs and overheads charged to different departments. Managers of service organizations rely on
demand and cost forecasts for allocation of funds to each department. For demand purpose, the
service company management makes an attempt to get an idea of value of its provided services
in market with respect of cost of return and input costs (Dawonauth, 2015). Cost information is
required for making a complete analysis of expected growth of a service company business in
future.

3.1.3. Comparative analysis

Service organizations have tough competition in market due to availability of rival companies
and their significant strategic measures. Cost managers need complete information to make
comparative analysis of strategies adopted by the service company and its rival organizations in
order to make improvement in its processes (Ray, 2016). Comparison is done through extraction
of cost data from accounting software in the form of graphical or quantitative analysis. It helps in
identification of weak areas of an organization for proper allocation of funds for effective
operations.

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 3.1.4. Operational and strategic decision making

Managers are involved in decision making process of a company. In case of a service company,
the systems rely over market information for short and long term decision making process. The
decision making involves budgeting, strategic policy setting and cost processes (Cooper &
Kaplan, 2000). Manager need complete market and cost information to make prudent decisions
which may benefit an organization in long term.

3.2. Difficulties association with calculation of service costs

Calculating cost of services in a service company is a challenging process due to unavailability
of specific formulas and market price for skills and expertise. Costing methods are different for
service industry comparatively such as target costing or job costing (Garcia, 2009). Besides
selection of correct costing methods, there are several other difficulties for managers to allocate
costs in service organizations such as

3.2.1. Primary identification

Overhead costs are based on money invested in setting up and operations of a business whether
manufacturing or service company. It is difficult to measure the value of skills and services
invested in setting up a service company (Weedmark, 2014). The lack of identification of critical
services which should be prioritized over others is also a major challenge for service companies
leading to overvalued or undervalued overheads.

3.2.2. Lack of balance

The costs and overheads in service companies are not to be allocated to materials and
manufacturing units (Ray, 2016). The managers are required to offset the revenue earned against
efforts invested as input. Maintenance and proper offsetting of revenue against expenses from
different areas in a service organization is challenging due to lack of proper classification of cost
to each head. It lead to imbalance allocation of cost between different departments.

3.2.3. Non-availability of costing method

For costing of manufacturing activities, there are several old and new methods devised by cost
experts. For service costing, there is not a single specific method which can meet the needs of
this areas precisely and specifically. Different approaches are customized such as markup

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pricing, absorption pricing, target costing, job costing and marginal cost pricing is used for
service costing (NCBI, 2013). These methods don’t meet the exact costing needs for service
industry due to assumption based calculations, lack of competitiveness and irrational approaches.

3.2.4. Synchronization of service and costing method

The design of services may vary for the conditions and information required for different costing
methods. In case complete data is not available, it becomes challenging and sometimes
impossible for managers to calculate cost of services accurately (Riewpaiboon, et al., 2007). For
proper synchronization of services from design context with costing method requires huge
expenses and efforts.

3.2.5. Lack of transparency of accounts

In case cost of services is not properly measured, it may lead to wrong offsetting of expenses
against revenues which misleads the financial statements of a service company. The transparency
of cost accounts also impact financial accounts due to inclusion of cost of sales and overhead
expenses (Askarany, 2011). It has become challenging for cost department managers to maintain
presentation of fair view of accounts.

3.3. Recommendations for allocation of costs in service industry

For effective costing of services, manager should take effective strategies to support service
designs and costing processes in order to measure total costs accurately. Higher management
should choose between target costing and job costing whichever suits best to the service
company structure (Askarany, 2011). Costing methods should be customized according to
services design in order to generate desired costing results. In order to survive in long term,
managers of service organizations should take significant steps like selection of right costing
method, proper training sessions and know-how of technical knowledge and synchronization of
cost and financial accounts. In order to overcome the cost allocation issues, strategies adopted by
rival companies should also be examined which are operating in same industry. It helps in
selection of most suitable costing method.

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 4. Conclusion
This report has concluded the problems in accurate allocation of overheads and strategies to
classify and allocate costs to respective departments. Proper overhead allocation is a big
challenge for manufacturing units. Different approaches and methods are used for apportionment
and allocation of cost to different departments. The strategies recommended for accurate cost
allocation in this report include use of modern methods of overhead allocation, hiring trained
accountants and proper record of cost data. The report has stated that overhead allocation is a
challenging process which requires considerable strategies to allocate cost effectively.

This report has also discussed the information needs of costing department managers for proper
functioning. The calculation of cost of services has no accurate and definite criteria, due to no
accurate market rates for skills and expertise. Service organizations need advanced costing
systems in order to allocate costs properly to each department.

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 5. References
Accounting Coach, 2016. What is the major weakness of the traditional method of allocating factory
overhead?. [Online]
Available at: https://www.accountingcoach.com/blog/traditional-method-allocating-overhead
[Accessed 6 Sep 2017].

Accounting financial tax, 2009. OVERHEAD COST ALLOCATION TO INVENTORY. [Online]

Available at: http://accounting-financial-tax.com/2009/11/overhead-cost-allocation-to-inventory/
[Accessed 6 Sep 2017].

Askarany, D., 2011. Interaction between Target Costing and Activity-Based Costing: Is Target Costing a
True Costing Technique?. SSRN Electronic Journal, pp. 56-58.

Cooper, R. & Kaplan, R. S., 2000. Measure Costs Right: Make the Right Decisions. [Online]
Available at: https://hbr.org/1988/09/measure-costs-right-make-the-right-decisions
[Accessed 6 Sep 2017].

Dawonauth, P., 2015. The difficulties of using target costing in service industries. Academia.edu, 2 Nov,
pp. 32-35.

Freedman, J., 2015. What Are the Issues Associated With Cost Tracing & Cost Allocation?. [Online]
Available at: http://yourbusiness.azcentral.com/issues-associated-cost-tracing-cost-allocation-
25409.html
[Accessed 6 Sep 2017].

Garcia, M., 2009. Cost Accounting Practices in the Service Industry. [Online]
Available at: http://yourbusiness.azcentral.com/cost-accounting-practices-service-industry-26920.html
[Accessed 6 Sep 2017].

Hanser, P. Q., 2011. Issues in Cost Allocation. The Brattle Group, 25 July, pp. 21-23.

Lepădatu, G., 2011. The Importance Of The Cost Information In Making Decisions. Journal of Information
Systems & Operations Management, 6(1), pp. 52-66.

Martin, M. J., 2015. What Are the Issues Associated With Cost Tracing & Cost Allocation?. [Online]
Available at: http://smallbusiness.chron.com/issues-associated-cost-tracing-cost-allocation-35501.html
[Accessed 6 Sep 2017].

Miko, L., 2011. ACCOUNTING MANAGEMENT INFORMATION USED FOR STRA TEGIC DECISIONS. Original
scientific paper, pp. 23-25.

Mohan, A., 2016. Problems of Cost System in Indian Companies. [Online]

Available at: http://www.accountingnotes.net/cost-accounting/problems-cost-accounting/problems-of-
cost-system-in-indian-companies/5709
[Accessed 6 Sep 2017].

NCBI, 2013. Social and Economic Costs of Violence: Workshop Summary. [Online]
Available at: https://www.ncbi.nlm.nih.gov/books/NBK189995/
[Accessed 6 Sep 2017].

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Ray, L., 2016. Overhead Costs in a Service Industry. [Online]
Available at: http://smallbusiness.chron.com/overhead-costs-service-industry-20984.html
[Accessed 6 Sep 2017].

Riewpaiboon, A., Malaroje, S. & Kongsawatt, S., 2007. Effect of costing methods on unit cost of hospital
medical services. Tropical Medicine & International Health, 12(4), pp. 554-563.

Weedmark, D., 2014. How to Calculate Service Company Labor & Overhead Rates. [Online]
Available at: http://smallbusiness.chron.com/calculate-service-company-labor-overhead-rates-
81487.html
[Accessed 6 Sep 2017].

Wilkinson, J., 2013. Activity-based Costing (ABC) vs Traditional Costing. [Online]

Available at: https://strategiccfo.com/activity-based-costing-abc-vs-traditional-costing/
[Accessed 6 Sep 2017].

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