Question

Compare and contrast the three methods of cost-finding discussed in Chapter 12

-Cost-to-charge,

-Step-Down, and

-Activity-Based Costing.

How do they work?

What type of organizations might use each of the methods and why?

Answer 1

Cost-to-charge:

This is the ratio of cost to charges. This is a predetermined ratio of charging cost to a specified unit of activity. Suppose 17% of all indirect labor costs are charged to a dental unit.

Although this is easy to use but it carries some disadvantages too, like the system is not universal, mere assumption and expectation may lead to an inaccurate figure, if the variable part is very high the actual cost may deviate, etc.

Organizations like dental clinic, doctors’ clinic, etc use this method.

Step-down method:

This is the method of indirect cost (service department cost) allocation based on the ratio of allocation base; suppose utility cost (it is indirect in nature) should be allocated on the ratio of number of staffs in each department. In the process of doing so there would be allocation and reallocation again and again till the amount becomes zero.

Organizations having substantial amount of service department cost, like leather factory, should follow this system; because leather requires washing, electricity for swing machine, etc. These are all indirect costs since payments are not based on the production units. These costs could be allocated to the main units based on this system.

Activity-based costing:

A company may use ‘activity-based costing’ in light of ABM. Suppose there are so many indirect costs, better known as overhead costs, in an organization. These costs and organizational activities have some relations, which are established through activity-based costing. Making such relations are necessary for better allocation of costs to productions or services or any other sectors. This system reduces product cost for customers’ benefit.

Manufacturing industries mostly use this system, because there are so many indirect costs and these need to make relation or attached appropriately. Suppose the salary of supervisor should be allocated to job1, job3, and job4; there should not be any allocation to job2, since he didn’t supervise job2.