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Activity-based costing is a managerial accounting system that estimates the cost of products and services by allocating overhead costs to direct costs. Activity based costing system represents a modified absorption costing system in which the indirect costs are traced to their cost pools to mirror resource utilization of indirect resources by the cost object. Activity-based costing (ABC) represents a two-stage product costing method that first allocates costs to activities and then allots them to products based on the product's consumption of activities. Activity-based costing mainly incorporates four steps: first, identifying the activities that consume resources and assign cost to them; second, highlighting the cost drivers associated with each activity; third, computing a cost rate per cost driver unit/transaction (each activity should possess multiple cost drivers); fourth, establishment of output metrics and assigning costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product.
Since product mix has grown more diverse, activity based costing has evolved to become a useful tool. Activity-based costing enables managers to make decisions using product cost information that only encompass those activities that contribute to the production of the specific product. Nevertheless, ABC demands more detailed analysis of the activities within the plant that require additional resources from the company. The major advantage of activity based costing is the capability to estimate the cost of individual products and services accurately. ABC aids to highlight inefficient or non-profitable products or activities that impact on the profitability of efficient processes.
Marginal costing is an approach that employs only variable costs. All costs incurred must first be categorized into fixed costs or variable costs. Variable costs represent those costs that remain the same per unit, but change in total as per the total number of units produced. Fixed costs essentially remain the same in total irrespective of the number of units produced. Nevertheless, fixed costs per unit decreases as the number of units increases. Fixed costs, in this case, are ignored for costing purposes and will be expensed during the period. Since variable costs are mainly controlled costs, marginal costing enables mangers to make decisions devoid of being swayed by uncontrolled data such as fixed costs. Marginal costing is also an effective tool to use when the business environment is highly competitive. Selling prices can be set that recover the variable costs of the products, besides marginal costing eliminates confusion dwelling on allocation of fixed costs. Nevertheless, ignoring fixed costs may alter the revenue to recover total costs of the business. Marginal costing is not approved for GAAP accounting since it fails to include fixed costs.
The Role of Alternative Methods of Product Costing in Supporting Evaluation of Strategy and Cost Control
Alternative methods of product costing are critical to the evaluation of company strategy and overall cost control. In the contemporary competitive business environment accurate product costing is essential to a business survival. Such methods are critical in supporting such areas as the evaluation of strategy and cost control. The approaches are critical in determining accurate departmental and product costs as a basis for evaluating the cost efficiency of departments and the profitability of diverse products. Cost allocation plays a strategic role in shaping competitiveness, especially in informing the effectiveness of the decision-making.
Alternative methods of transfer pricing
The rapid advances in technology, communication, and transportation have yielded to a large number of multinational enterprises that bear the flexibility to place their enterprises and activities anywhere in the world. The core purpose of transfer pricing is to induce optimal decision making within a decentralized organization so as to maximize the profit of the organization. A transfer price incorporates the price one subunit of an organization charges for a certain product or service supplied to another subunit of the same organization. The two segments can be profit centres, cost centres, or investment centres.
Pear Ltd central management's adoption of alternative transfer prices may possess significant impact on aspects such as motivation, performance indication and autonomy across the range of Pear Ltd's responsibility centres. Motivation in this case combines goal congruence and effort and encompasses the desire to attain a selected goal specified by top management combined with the pursuit of those objectives. Ideally, alternative transfer prices should possess properties such as promoting goal congruence, motivating management effort, useful in evaluating subunit performance, and preserving an enhanced level of subunit autonomy in decision making.
The advantages of transfer pricing across Pear Ltd's range of responsibility centres include better, timely decisions owing to the manager's proximity to local conditions; top managers are not distracted by routine, local decision problems; managers' motivation increases since they have better control over results; and enhanced decision making that avails better training for mangers for enhanced level positions within the future. Some of the disadvantages that can be cited include lack of goal congruence among mangers within diverse parts of the organization; inadequate information available to top management; and, lack of coordination among managers in diverse parts of the organization.
Alternative methods of transfer pricing
Market-based transfer pricing
Market-based transfer pricing details when the outside market for the product is well-defined, competitive, and stable, organizations frequently tend to employ market price as an upper bound for the transfer price. This approach, however, attracts some concerns, especially when the outside company is neither competitive nor stable. This may distort internal decision making for relying on market-based transfer prices that mirror distress prices or a variety of "special" pricing strategies. Transferring products or services at market prices generally yields to optimal decisions, especially when: a) the market for the intermediate product market is perfectly competitive; b) interdependencies of subunits are minimal; and, c) there are no additional costs or benefits to the organization as a whole from buying or selling within the external market rather than transacting internally. Using market prices for transfers in certain conditions leads to goal congruence. Division managers will be acting in their own best interests to make decisions that are also in the best interests of the company as a whole. However, one can argue that setting transfer prices based on cost will likely cause Pear Ltd to pay no attention to controlling costs since all costs incurred amid production will be recovered.
Negotiated transfer pricing
This approach features a firm specifying rules for the determination of transfer prices. Divisional managers, in this case, are encouraged to negotiate a mutually agreeable transfer prices. If two divisions were to negotiate a transfer price, the range of the possible transfer prices will be known giving the divisions' excess capacity that can be employed to supply to other division. The exact transfer price in this case depends on the bargaining strengths of the two divisions. The negotiated transfer price possess the following properties: attainment of goal congruence; critical for evaluating division performance since the transfer is the result of direct negotiations between the two divisions (the transfer prices will be influenced by the bargaining strengths of the two divisions; motivating management effort since once negotiated, the transfer price is independent of actual costs of division (the divisions in this case possess every incentive to manage efficiently to enhance profits; and, preserving subunit autonomy since the transfer is grounded on direct negotiations between the two divisions and is not specified be headquarters on the basis of some rule.
Cost-based transfer pricing
In the absence of a well developed market-price, majority of the companies base their transfer price on the production cost of the supplying division. The most dominant methods employed include: full cost, cost-plus, variable cost plus lump sum charge, dual transfer prices, variable cost plus opportunity cost. One potential limitation of full-cost-based transfer prices hinges on the fact that they can lead to suboptimal decisions for the company as a whole. Transferring products internally at incremental cost possess the following properties: attains goal congruence; not useful for evaluating subunit performance since transfer price fails to exceed full costs.
Transferring products internally at incremental cost fails to preserve subunit autonomy since it is rule-based and some divisions have no say in and, thus, no capability to set the transfer price. However, transferring products internally at incremental cost will motivate management effort if based on budgeted costs (actual costs are comparable to budgeted costs). If, however, the transfers are grounded are based on actual costs, Pear Ltd possess little incentive to control costs. Although, neither approach can be cited to be perfect, negotiated transfer pricing possesses more favourable properties compared to the cost-based transfer pricing. Both transfer-pricing approaches attain goal congruence, although negotiated transfer pricing facilitates the evaluation of division performance, motivates management effort, and preserves division autonomy, whereas the transfer price grounded in incremental costs fails to attain these objectives.
The benefits of utilization of alternative methods of transfer pricing between responsibility centres is that the operating managers possess the incentives to closely weigh and conduct cost-benefit analysis prior to requesting group's services or products. Similarly, the operating managers possess an incentive to follow the work and the progress undertaken by the responsibility ceentres. Decentralization would encourage plant managers to enhance output so as to attain the greatest profitability, and motivate plant managers to pursue cost cutting measures that would increase margins. Manufacturing managers would be equally motivated to design their operations as per the criteria that satisfy the marketing manager's approval, hence enhancing cooperation between the responsibility centres.
The problem that emanate from adoption of alternative transfer pricing by Pear Ltd's central management is that the contract may necessitate extensive internal negotiations with regard to cost, time, and technical specification. Similarly, Pear Ltd's divisions need to consistently "sell" their services or products to the operating division and this could possibly result in loss of morale. To the extent that the focus of the responsibility centres is on short-run projects demanded by the operating divisions, the present structure would yield goal congruence and motivation. Goal congruence is attained since both the central management (operating divisions) and the responsibility centres are motivated to work the organizational goals such as enhancing the environment. The operating divisions would be highly motivated to utilize the services of the responsibility centres so as to attain the goals set for them by top management. The responsibility centres will be equally motivated to deliver high-quality services in a cost-effective so as to continue to create a demand for their services.