Investigating impact of the order activity costing method on product cost calculations

Abstract

Inaccuracies in calculated product costs have existed since the development of costing systems. A key contributor to the issue is the use of inappropriate bases for the application of overhead costs. This research proposes and provides preliminary evaluation in a virtual environment for a new allocation base that is believed to be better matched to the consumption rate of the indirect costs being allocated. Using a generalized manufacturing operational framework incorporating multi-period simulation, this research investigates the relationship between allocated cost categories and production or sales order activity. The existing cost allocation methods of full absorption and activity based costing (ABC) are used for comparison to the proposed method. Results show that at the aggregate reporting level (that is, income statement), the use of sales order or production order activity as an allocation base tracks closely with performance levels experienced using more traditional allocation bases. However, the results indicate that the impact on calculated product costs would influence decision making within a firm in terms of sales emphasis, mix, and markets in which to expand and from which to exit. This approach toward cost allocation would be equal to other Enterprise Resource Planning system based solutions in terms of simplicity of maintenance while offering product cost accuracies relatively equal with unit-level focused ABC systems, without requiring the substantial maintenance costs.