The Importance of Cost Allocation in Decision Making - Example

The Importance of Cost Allocation in Decision Making Submitted by: ACC 612: Spring American Table of contents The role of decision making process ………………………………………………………..3 The importance of the cost allocation……………………………………………………….5 Cost allocation methods…………………………………………………………………….6 Types of decisions………………………………………………………………………….7 Categories of decision-making process…………………………………………… ….…..9 The Role of Cost Allocation in Decision Making Process………………………………...9 References…………………………………………………………………………………11 The Role of Decision Making Process In business environment decision making process has to be fulfilled by many individuals every day. Making of the decisions emerges when there are several alternatives and the choice is to be made. All the available information must be treated with care and thorough consideration due to the fact that a certain attitude towards data is sure to result in long-term consequences that sometimes might be irreversible (Kidane, 2012). Talking about the decision making process itself it is a complex arrangement and it involves a number of steps to be made in order to fulfill this task in the most efficient way. First of all the specific situation is to be considered separately and a certain decision must be determined in order to achieve the desired aim (Kidane, 2012). Secondly, it is essential to determine the relevant data to be used when considering possible alternatives that are available. Thirdly it is important to collect all the necessary information to measure the possible consequences of all the alternatives. And finally a certain chain of actions has to be chosen in order to achieve primary aims. The global management experience shows that scarce economic resources are involved in the process of decision making (Kidane, 2012). Nevertheless there are a lot of factors which are as influential as the economic ones such as human, environmental, social, moral and religious factors along with policy of the government have to be taken into consideration. The decisions in the economic sphere often feel the need of the both inwards and outwards monetary flows. Such decisions can be fulfilled in a vast range of markets no matter whether it is international or local level. Consequently in order to make an adequate decision based on relevant information a certain amount of skills and knowledge of systems of measurement in accounting such as cost allocation process with its concepts and standards is vital (Kidane, 2012). The necessity of the financial data can hardly be overestimated prior any decision is undertaken. Accounting is the organ that is to record and assess the actual events of any institution and this is its basic focus. In the process of making decisions a past experience along with facts and figures plays a crucial role and serves as guidance for the managerial decisions as well as assessment of the possible consequences in the future (Kidane, 2012). The accounting information is to lend a helping hand in such spheres as budgeting, research, interpretation of the final results to be utilized by managers on external and internal level. The accountant can help significantly in the areas of budgeting, investigating, interpreting and communicating results for use by both internal and external decision makers. Cost allocation plays a very important role as this particular information is essential in assistance of managerial decision making and further supervision (Kidane, 2012). The commonly used definition of the management in the sphere of accounting is as follows: it is the process of application of professional data in a certain manner in order to help the managers of any level to form the guidance and policies as well as to fulfill the planning and supervision of the operations. Thus this kind of management has bee considered as the important component of the overall management environment with its processes and more than that management accounting has been viewed as a firm partnership in question of strategic planning of an organization (Kidane, 2012). Hilton (1999) made a hypothesis that the team engaged in management process is in pursuit of formation of the value for the institution by certain allocation of resources as well as activities and people in order to fulfill the tasks of the institution in the most sufficient way. In this connection managers do demand the data to be used in making the appropriate decision and in future supervision and monitoring processes. Consequently decision making process occupies the central place in management. Fullan (1982) states in his research that the basis of the decision making process is in the determination and identification and then followed by making a choice among the alternative routes of actions to fit the demands of a particular situation. The making of the choice means that all the available alternatives should be assessed, weighed through sharing; this is basically a human operation which includes social and individual factors which stand on value and factual background; this results in choosing single behavioral measure out of a number of other paths and this is aimed at moving forward to circumstances that are desired. It is a certain course which includes activities or manners of behavior that should and should not be done. To sum it up I have to admit that decision making is a special art and it provides managers with a diversity of tools, methodologies, schemes that stand to help in making decisions of high quality. A manager engaged in process of decision making is to be seen as an individual is in the same time a member of the team and this person s sure to have his own paradigm, a philosophy with a particular perception of an institution and its perspective; it is his job to make uneasy choice of the values among those being enforced by the institution. The Importance of the Cost Allocation In recent years a cost allocation process has been viewed as irredeemable due to the fact that it is practically impossible to find a single determination of the grounds to describe the connection between the cost objective and the cost itself (Garrity, 2006). Taking into consideration subjective nature in the process of selection of the base on which cost allocation stands, it has been a difficult task for a manager to decide a specific time for cost allocations as well as the basis of the cost allocations. The fundamentals of these decisions can be found in the major principles and the nature of the cost allocations (Avercamp, 2014). Thus there are several main purposes which cost allocations are aimed at. First of all it is to achieve motivation that is desired (Garrity, 2006). Costs are allocated when there is a need in influencing behavior of the management in order to promote aim coherence with efforts of managers. In addition it happens that some institutions do not have cost allocations due to the fact that senior managers feel the need of encouragement in their utilization. Some institutions do have cost allocations to stimulate management to ensure the profit of the particular services overreaches the costs (Avercamp, 2014). Cost allocations are meant to calculate the valuations of assets and income. Thus costs are allocated to certain services or products to assess costs of the invention and sold commodities cost. This type allocation is intended for purposes of accounting and the costs in result are commonly utilized in process of planning, assessment of the performance and managerial motivation as well. The other aim of cost allocations worth mentioning is the cost justification or gaining the compensation. It may happen that prices are grounded on costs in direct manner or there might appear a necessity of justification of an application being accepted. For instance contacts provided by government tend to set a specific price that is to include compensation for costs as well as some benefit (Avercamp, 2014). In these cases the cost allocation is considered as an alternative for the marketplace in process of creating prices. To trace the costs has been the vital process for any kind of business. The allocation of costs is basically utilized as the accounting instrument which stands to assist the gaining adequate outline of costs related to diversified departments inside a particular company (Garrity, 2006). Allocation of costs in a proper way is sure to encourage companies to run business in the best way possible with maximum effectiveness and efficiency. This process empowers companies and organizations to establish a transparent idea of products and services actual cost. These numbers are very important in their turn when it comes to establishing sound accounts for adequate clients billing. The accounting management experience has records of the situations when costs are calculated as costs related to product making and costs related to administration and services are not taken into account and are not viewed as an important part (Avercamp, 2014). Thus the perception of the real product cost becomes misleading and very unclear. The methods of cost allocations are created to assist cost distribution in order to allocate minor costs which might not be in direct relations to a product in a proper way so that real cost of product would result in a proper price. The costs of departments related to maintenance should be taken into account as it is impossible to create product in a building that is damaged so thus these costs must be taken into account when establishing a final price (Garrity, 2006). In addition the same is to be done with the human resources costs and in result proper allocation will lead to adequate view of benefit and loss of the company. Cost allocation methods In pursuit of making a sound price there are numerous schemes and methods created for proper costs allocation to be applied inside the company. These methods are as follows: the direct method the step down method The first method known as direct one is the most commonly used within organizations. It is designed to allocate costs of all the departments related to services to costs related with production and does not take into consideration that departments of service suggest their services to another department (Avercamp, 2014). The direct approach also ignores the fact of the offering services to all the other departments as for instance HR department’s job is to employ workers for the maintenance department which in its turn stands to maintain equipment used by HR department. Talking about the step down approach it is necessary to admit that it considers that particular costs are made of maintenance department along with HR. Basically this method stands to create a range of departments of service based on importance scale and afterwards utilizes numerous schemes for costs allocation to certain products involved in the production process (Garrity, 2006). This very method turn out to be much more complex compared to the direct one and experience shows that despite of its complexity its results in accurate allocation of costs. Taking into consideration the descriptive method of the major characteristics of the management in sphere of accounting and its perception of business it can be seen with the naked eye that the process of decision making plays the core role in management accounting and as for its concept it is implied as a complicated subject with a huge number of literature in the field of management. Types of decisions In recent years the vast range of methods and tools used in decision making have become objects of severe research and studies. In the sphere of management accounting the decisions are categorized as tactical and strategic long-run and short-run When managers begin to form the major objectives and aims of the company it is essential for them to draw the line between tactical and strategic decisions. Decisions connected with strategy are generally wide-based and this is seen as qualitative type decisions which are to reflect the main purposes of an organization and they are not quantitative. The grounds of strategic decisions are in thinking on a subjective basis of the managers about the objectives and aims of the company (Avercamp, 2014). In other words the feature of strategic decision is that it is made within a certain period of time and its effects will be experienced much further; these decisions are to influence structure of organization. Decisions related to tactics of the firm are also connected with the routine and they are characterized with repetitiveness and are viewed as minor size solutions with a little number of alternatives (Garrity, 2006). The people engaged in decision making process are senior and middle managers and it is important to point out that there is no place for uncertainty or higher risk. The feature of tactical decisions is that they are to assist and support strategy. This kind of decisions actually can be delegated to lower levels in comparison to strategic ones. The other categories of the decisions are long-term and short-term and it is very important to take into consideration decisions in both directions. Drury (2000) described short-term decisions as those intended for a year pr less. In this kind of decisions the time value importance appears to be low. The major basis of short-term decisions is current information. The feature of these decisions is that they can be easily transformed and undergo some changes in comparison to long-term ones. So practically it is a set of activities managers are supposed to fulfill on every day scale. When talking about long-term decisions they are to effect performance on periods much longer and as a result these decisions require resources of an organization for episode significantly longer and they are to effect other decisions in future (Garrity, 2006). The procedure of strategic planning refers to long-term issues and is intended to give guidance for companies to position itself and distinguish from other competitive organizations. In practice long-term decisions deal with the issues such as the location of plants or other objects, possible investment into equipment involved in production process, innovations in range of services or products and these questions are a major part of sound strategic planning. In addition this approach also deals with establishing and determination of performance on long-term basis and measures aimed at profitability. Categories of decision-making process The process of decision-making can be classified by several categories: making of the appropriate decision is not the end: the process is extended up to desired result achievement and its further progress account managers are influential in the process of strategic planning and framework of governance within a company this is to establish main objectives and prospects of competitiveness. Personal attitude and perception might deteriorate the process of decision making but there is always a chance for business partners to interfere and present evidence-based participation. More than that business partners may assist to form decisions through providing information on management and are free to help managers by analyzing available alternatives (Garrity, 2006). The Role of Cost Allocation in Decision Making Process In cost allocation operation it is important to justify decisions being made in this matter. It is meant to prove that the method being chosen and applied is the only way to allocate costs in best way possible as particular situation is considered. And in case manager is successful at defending his approach of choice it indicates that this particular path is the most appropriate one. In order to succeed managers are expected to take into account a number of criteria to assist decision making process and there are several of them that are commonly used among organizations: It is important to make records of the activities that appear to be the causes of the costs Determine the profits gained as the consequences of cost incurrence The other party on the contract must be able to prove the reasonability of the cost To make sure that the object is capable of bearing the cost The sufficient methodology designed for cost allocation gives a chance for the organization to determine the number of services provided along with their cost and apart from that to distribute costs to business departments and to deal with cost compensations. Due to this approach the company that provides services along with clients become informed of certain requirements and utilization and the way these factors influence incurrence of the cost (Garrity, 2006). The availability of this data to a great extent enhances the level of discipline inside different departments along with financial order throughout the company. And thus in case an organization pays necessary attention and gives appropriate attitude towards costs of the services that are provided managers at all levels are empowered and are stimulated to create well-informed decisions about particular situations with the products and services. Finally, it is evident that the role of cost allocation is very important as it can affect the decisions and consequently influence overall performance of the company. The importance of cost allocation cannot be underscored—how an organization allocates its shared costs can have a significant impact on its management and financial well being. The selection and use of proper cost allocation methods will aid in the management of the organization. Among other things, it helps in the identification of inefficient program management or ineffective fundraising. Additionally, when establishing indirect cost rates for contract reimbursement, a properly determined rate will help assure that the organization is being reimbursed for the maximum amount that is allowable. If the organization is responsible for establishing indirect cost reimbursement rates, it is extremely important that the rate be properly calculated in compliance with the requirements of the grantor. Organizations may potentially be underreimbursed if the indirect rate is lower than what it should be. If the organization’s calculation of the indirect cost rate is more than what is allowable, it could potentially need to return funds received and possibly face penalties. There are several reasons why cost allocation is important. One has to do with accurately assigning costs within an organization, so that it is possible to know exactly what types of costs were incurred in the operation of a given area in the organization. This is not only important information to consider when creating an operating budget, but is also key in calculating taxes that must be paid to local, state, and federal tax agencies. In a number of countries around the world, the way that costs are allocated can have an impact on how much the organization pays in taxes, making it necessary to comply with any government regulations that have to do with the allocation of costs within the organization. Another benefit of cost allocation has to do with simply keeping track of expenses for internal planning purposes. While some expenses are indirect costs and benefit more than one area of the operation, there is still a need to allocate direct costs in a manner that is logical and accurate. Even when the costs are incremental, meaning they are stretched out over several accounting periods, making sure the costs are assigned properly can make a big difference in how well each unit within the business or other entity works within their share of the overall budget. When it is apparent that one unit will exceed its assigned budget, steps can be taken to implement cutbacks on non-essential service costs, while finding ways to adjust the overall budget to allow for the continuing support of essential functions. Organizations of all types and sizes engage in the task of cost allocation. Businesses use this strategy as a tool for planning and keeping within a budget. Non-profit entities utilize the tool as a way of providing as many services to its members as possible, while still making the most effective use of its resources. Even households can make use of the concept of cost allocation when planning the operating budget for the family. As a means of identifying and properly assigning costs, this approach to allocation helps to provide focus and structure to financial planning in a way that would be extremely difficult otherwise. Cost allocations have incentive effects. They determine how a division is charged for use of a common resource, and thus become an instrument for the firm to indirectly control the behavior of its decentralized divisions. The main message is that any efficient allocation will reflect the firm’s underlying costs. As the cost of a common resource increases, the firm would like to discourage use of the common resource (to mitigate the negative externalities of resource consumption) and therefore will accelerate the allocation, relative to the linear rule. Similarly, if the cost of a common resource decreases, the firm can afford to encourage more use of the resource, and therefore will decelerate the allocation, relative to the linear rule. The efficient rule will thus vary with the firm’s cost structure. This drives home the broader point that an efficient accounting system will reflect the firm’s underlying economic environment. For firms with sufficiently many divisions, the polynomial allocation is efficient and exactly budget balancing. Large, multi-divisional firms may experience significant negative externalities from incorrect cost allocation; therefore getting the allocation “right” in terms of achieving efficiency is perhaps more important for large, rather than small, firms. References Avercamp, H. "What Is Cost Allocation?” .Accounting Coach. Bhattacharjee, P., 2011. "Cost Management: From Accounting to Accountability." CEB Blogs. Brooks, C., 2012. "Decision-Making Techniques and Tools." Small Business. Garrity, R., 2006. Cost Allocation Techniques. Hoggett, J.R. "DECISION MAKING AND THE ROLE OF ACCOUNTING." Jan, I., 2014. "Cost Allocation." Cost Allocation. Jan, I., 2014. "Direct Allocation Method." Direct Allocation Method. Kidane, F., 2012. "DECISION MAKING AND THE ROLE OF MANAGEMENT ACCOUNTING FUNCTION–A REVIEW OF EMPIRICAL LITERATURE." DECISION MAKING AND THE ROLE OF MANAGEMENT ACCOUNTING FUNCTION–A REVIEW OF EMPIRICAL LITERATURE. Schwulst, B., 2014. "Cost Allocation Methods For Accurate Costing to Maximize Profits." Udemy Blog. Stinson, J., 2002. "Cost Allocation— From the Simple to the Sublime." "Types of Decision Making | Levels, Styles, Processes." The Happy Manager. Waterhouse, P., 1987. "Fully Allocated Cost Analysis." Weisman, D., 1991. How Cost Allocation Systems Can Lead Managers Astray. Read More