McDonald's Corporation: Recasting Unallocated Costs - Essay Example

Running Header: ABC COSTING Write you here here Your institute This paper talks about one the most widely used technique to apportion the costs among various departments and units of production on the basis of activity of the firm. This method has removed any discrepancy that the previous accounting methods have and now because of this method we have been able to comply with the accounting principle of “PRUDENCE”. In this paper we have crafted a strategy how McDonalds, which is one of the biggest fast-food chain, could use this method in their financial statement and how could they use this method to effectively calculate the cost of each product. In the end we have concluded that this method will be very useful for the company in apportioning overheads among various different products that McDonald’s outlets sell. ACTIVITY-BASED COSTING or ABC Costing Method: Activity based costing is one of the modern approaches that have been developed to apportion various indirect costs to a unit of production or process. These indirect costs are known as “Overheads” in the business terminology. These are also known as indirect costs because they cannot be associated with a particular production process and the entire organization has to bear these costs. Talking about McDonalds as part of our report, the overheads that McDonald restaurants incur are telephone bill, security costs, electricity bill and wages. Since, these costs cannot be absorbed in the direct costs of a food item, they are treated as overheads.1 Like many other organizations McDonalds also faces problems in apportioning these costs to the different units of products. ABC costing or Activity based costing is an ideal estimate of these costs that can be used by McDonalds to get rid of the problem. How is the ABC costing suitable for McDonalds: By using the ABC costing McDonalds will first calculate the entire data about these indirect costs or overheads. This data will be calculated from various sources such as electricity bills, telephone bills, wage slips, number of hours each employed worked, number of sales each employee made and other data which might help the company in getting the most accurate estimate of these overheads. This can be written in the form of an equation and will be represented by the following formula: C/A= HD+ M + E + S Where C/A = estimate cost of each activity H = Number of labor hours used in creating a product (in case of McDonalds it can be a burger) D = Prevailing Wage Rate of Employees M = Material Cost of the product (In case of McDonalds, it can be a cost of Burger) E = Equipment Cost (It can be cost of deep-fryer) S = Sub-Costs to perform the Activity) 2http://www.directives.doe.gov/pdfs/doe/doetext/neword/430/g4301-1chp24.pdf Activity-Based Costing or ABC costing is an ideal method of apportion from McDonalds because costs can divided between the number of units sold. In simple word the output of employees and costs of material is measurable. For e-g if each worker produces 4 burgers in an hour and takes a salary of $4/hr, we can easily come to the amount that will be apportion to a single unit. In this case this amount will be 4/4= $1 labor cost/ each burger. Similarly, other costs like cost of electricity can be calculated by dividing it with the number of items sold. Suppose that McDonald think that its main business is burger. Now it allocates 70% of its total electricity bill to burgers. The amount of bill, for example, in a certain month is $280. It will allocate $196 to burger. Now, it will look at the number of burgers sold this particular month. Let’s suppose that 196 burgers are sold, now it will allocate 196/196= $1 electricity overhead to each burger and will use this data in unit cost calculation. These were some of the examples. In the very same way McDonalds will calculate and apportion the costs of each product on the basis of activity. This is how McDonald can use ABC costing to calculate the real cost of overhead that each unit is incurring. If we calculate the overheads using this method, we will have to assume a lot of things for simplicity. First assumption is that McDonald selling only one product and that is burgers. The following bills/charges are received at the end of the month: Electricity Bill $200 Telephone Bill $100 Wages $200 Material Costs $500 If we total all these overhead, we will arrive at the total overhead figure of $1000. From the Cash register, it is discovered that McDonald has sold 300 burgers that month. Now McDonald will add the following figure in the cost calculation of each burger. Overheads = 200 + 100 + 200 +500 300 = 1000/300 = $3.33/ burger This is how McDonalds apportions overheads to each unit of burger it sells and calculates the consumer price of not only burgers but all the products it sells. What about those costs that are not absorbed: Since all businesses apportion these overheads on the basis of past data, there are chances that in a certain month these apportions are under-estimated or overstated. If these apportions are over-estimated it is a good thing and increase company’s profit on the ground that it has managed to use its resources efficiently. However, if these estimates are under-estimated then the company has to allocate these costs else where. These are usually included in the item of unrecognized losses or material wastage. They present a loss to the company and decrease the profitability of McDonalds corp. Reference Directives of Government, a Report on Absorption Costing. Visited on 21 June 2009 http://www.directives.doe.gov/pdfs/doe/doetext/neword/430/g4301-1chp24.pdf Harold Randall Accounting. 3rd Edition. Letts Educational. Read More