Zimmerman approach
Upcoming SlideShare
Loading in...5

Like this? Share it with your network


Zimmerman approach



Absorption costing for decision making

Absorption costing for decision making



Total Views
Views on SlideShare
Embed Views



0 Embeds 0

No embeds



Upload Details

Uploaded via as Microsoft Word

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
Post Comment
Edit your comment

Zimmerman approach Document Transcript

  • 1. Absorption Costing for decision making by Mike Lucas REASONS FOR COST ALLOCATIONSCost allocation is an inescapable problem in nearly every organisation and every facet ofaccounting. It is the process of assigning costs when a direct measure does not exist for thequantity of resources consumed by a particular cost object.1. To provide information for economic decisions, e.g., to decide whether to add more menus in the canteen or to set new prices for customised product or service2. To motivate managers and other employees – Zimmerman mentioned that cost allocations are sometimes made to influence management behaviour and thus promote goal congruence and managerial effort, e.g., cost allocation helps to motivate and control managers.3. To justify cost or compute disbursement – Sometimes prices are based directly on costs, or it may be necessary to justify an accepted bid, e.g., government contracts often specify a price that includes reimbursement for costs plus some profit margin. In these instances, cost allocations become substitutes for the usual working of the market place in setting prices.4. To measure income and assets for reporting to external parties, e.g., to cost inventories for financial reporting to stockholders, bondholders etc. Under GAAP (Generally Accepted Accounting Principles), inventoriable costs include manufacturing costs but exclude R&D, marketing, distribution and customer-service costs. These allocations frequently service financial accounting purposes and the resulting costs are used by managers in planning and performance evaluation.However, the allocation of a particular cost may not necessarily satisfy the above fourpurposes, e.g., the third and fourth reasons demonstrates how cost allocations may differ forinventory costing and for setting prices. Ideally, all four purposes would be servedsimultaneously by a single cost allocation. 1|Page
  • 2. Absorption Costing for decision making by Mike Lucas ZIMMERMAN APPROACHZimmerman strongly agreed with Kaplan and Cooper approach that cost allocations play a vitalrole in motivating and controlling managers. ABC is a relatively new and widely-used approachin full AC as it allocates overhead costs ‘more fairly’.Zimmerman pointed out that some service/support costs are fixed in the short-run and thismay give rise to opportunity costs in form of delays/degradation of service which may add tobusiness costs but may change with the level of primary inputs (e.g. labour) in long term. Suchcosts are categorised under general overhead (e.g. works canteen) as shown in Figure 1. He alsoargued that these opportunity costs and consequent long-term incremental actual costs shouldbe taken into account by individual managers when deploying labour resources. Such costs arehard to observe/measure, but allocating current average cost can serve to proxy them.The following diagram will help the managers to take into account the additional costs of usinglabour to recover the burden of overhead costs.Figure 2: Selection of the optimal mix of input factors Isocost line 1 represents relative prices if the demands placed by labour on service departments (e.g. canteen) are neglected and only the actual cost of labour itself is considered. If the ‘true’ cost of using labour resource is understated, more labour hours will be used. As a result, managers will make decisions based on false price information. If labour is charged with the burden of service cost recovery, the least cost combination shifts to Point 2. Hence, the hidden costs of using labour are recognised at this point as it is nearer to real optimum. Overhead is included in unit product cost by charging labour hours with fixed overhead burden. At Point 2, capital-intensive method (C2) is adopted rather than labour one (L2). 2|Page
  • 3. Absorption Costing for decision making by Mike LucasZimmerman argued that actual cost of the service resource will rise with the number of labourhours worked and the allocated fixed cost is a proxy for these additional costs, i.e. one labourhour gives rise to £x canteen costs.DOES RENT MAKE A GOOD CASE FOR COST ALLOCATION?Usually long-run volume-related costs are allocated to product unit level. Zimmermanmentioned that additional consumption results to a rise of primary input (e.g. labour) whichleads to opportunity costs in form of delays/degradation of service that may raise actual costs inthe long-run. Therefore, it is not appropriate to allocate rent unless a huge increase in labourforce was being considered-necessitating a new factory. Works canteen, payroll and personnelcosts are considered to be a realistic possibility of good case for cost allocation. PRODUCT COSTING PROCEDURES IN ORGANISATIONS BY ZIMMERMAN TWO MAJOR TYPES OF ABSORPTION COSTING Job Order Costing Process Costing Definition: It estimates the Definition: It assesses the average average unit costs for each job unit cost for each service provided delivered. The costs are in a given time period. The costs accumulated separately by job. cannot be directly traced to each unit of product. Examples include: Building construction Examples include: Law suit Petrochemical refinery Processing a loan application Paint manufacturer Paper millIt is noted that AC allocates historical costs, and therefore the unit costs estimated by thissystem may or may not be reasonably good estimates of opportunity costs. 3|Page
  • 4. Absorption Costing for decision making by Mike LucasEconomic costs/opportunity costs/true costs reflect the value of the alternative use ofresources. Moreover, the measurement of opportunity costs could be difficult and resource-intensive because special studies are required to identify all the relevant alternatives ofpossible use of resources and estimate the costs and benefits of each alternative. As a result, anew decision problem may require a new costing study (Byford 2003, Zimmerman 2003).The AC system can produce inaccurate unit cost estimates partly due to the biases embodied inthe overhead allocation methods applied. If the overhead allocation method does notrepresent the cause-and-effect relationship between the final product (service or job) and theoverheads, the unit cost estimates could be more or less inaccurate especially in multi-productplants, e.g. hospital. ABC was introduced to improve the accuracy of unit cost estimates, but ithas its limitations.Both the product cost and the period cost include fixed, semi-variable and variable costs, andboth are historical costs. Moreover, the unit cost of a product could exclude period costs.Therefore, it is important to report both product and period costs for decision makers. 4|Page
  • 5. Absorption Costing for decision making by Mike Lucas REFERENCES1. Absorption costing for decision-making by Mike Lucas, University of Buckingham2. Management and cost accounting, Sixth edition, Colin Drury3. Journal: - The main methodological issues in costing health care services - Zsolt Mogyorosy, Peter Smith – University of York4. A Dissertation entitled The Impact of Time-Based Accounting on Manufacturing Performance by Robert Hutchinson5. Marginal and absorption costing by Khalid Aziz6. Management Accounting – www.financedoctors.net – Saima Iqbal7.Absorption costing is widely used for cost control purpose whereas marginal costing is used formanagerial decision-making and control. 5|Page