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At your request, this memorandum provides information about the importance of a good cost system and the manner in which Tennyson's system may be improved.
It is essential that a company's cost system reflect accurately the costs of production.Product cost information is a very important input into a number of business decisions, including those involving product pricing, inventory levels, and allocation of productive resources.Historically, the company has allocated service department costs on the direct method.This method simply allocates the costs of each service department to production departments based on the relative level of use.The direct method can result in inaccurate costing when service departments provide significant amounts of services to other service departments.
Two methods of cost allocation are superior to the direct method: the step method and the reciprocal method.The step method allocates service department costs to other service departments as well as the production departments, starting with the service departments that provide the most services to other service departments.The reciprocal method uses simultaneous equations to allocate costs to production departments, resulting in the most accurate allocation of costs when service departments provide services to other service departments.
Because of the importance of developing accurate cost information, I encourage you to evaluate your current system of costing.As described, the step and the reciprocal methods of allocation of service department costs are superior to the direct method which is currently being used by the firm.
Keywords: cost, system, production, pricing, inventory, resources, direct, department, step, reciprocal, allocation