UPGRADING A TRADITIONAL ALLOCATION METHOD BY APPLYING MODERN TECHNIQUES FOR OVERHEAD ALLOCATION

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UPGRADING A TRADITIONAL ALLOCATION

METHOD BY APPLYING MODERN

TECHNIQUES FOR OVERHEAD ALLOCATION

By

Roderik Timmer

University of Groningen

Faculty of Economics and Business

Master of Science Business Administration

Specialization Organizational & Management Control

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H.J.C. Timmer | 2014 | Rijksuniversiteit Groningen

ABSTRACT

The management of SF initialized this research in order to find solutions for revising the format for costing information as well as the allocation method, which together must lead to increased accuracy and flexibility of information. They have stated that the costs involved in maintaining the costing system may not increase significantly. Although ABC is the method which offers the benefits we search for, implementation of ABC does not meet this requirement since it leads to a significant increase in time and effort required. Therefore, this thesis focused at more cost effective solutions to realize these benefits. The following research question is formulated: How can we increase the

accuracy and flexibility of costing information, without significantly increasing the costs and effort required for maintaining and updating the costing system? From the literature research we learned that

a hybrid form of cost allocation methods can lead to the desired effects. The study formulated 4 steps for upgrading a traditional allocation method, which contain the solutions offered by the literature study: First, decide which costs are treated as product and which as period costs. This decision is relevant for indirect manufacturing costs as well as non-manufacturing costs. Second, differentiate the costs absorbed in manufacturing overhead by using relevant cost classifications. We state that using the classifications traceable versus non-traceable costs and fixed versus variable costs lead to an increase in flexibility and accuracy of costing information. Third, choose allocation bases which are a driver of the costs allocated and use multiple allocation bases when this is relevant. Fourth, do not charge costs of idle capacity to products, this will result in fair cost prices on a competitive basis. The design must be in line with organizational preferences and the context and during these 4 steps a tradeoff must be made between accuracy, flexibility, understandability, timeliness of information and the costs involved. Furthermore, it is advised to base decisions on a proper analysis of costs and processes which improves understanding of the costs allocated. In order to determine how and to what extent the solutions can be implemented at SF and to determine whether or not this can lead to solving their practical problem, we carried out an empirical analysis in the form of a case study. Since the design must be in line with the organizational context, a case study is well suited here which provides a profound insight into objects or processes. We make use of existing documents and data from the ERP-system. Although communication with the internal stakeholders is important for the quality and direction of the research process we will not make use of, for example, interviews or questionnaires to collect new data. This minimizes costs and the available documents and data are considered to provide sufficient and reliable information regarding the costs and processes. With regard to missing data, assumptions are made in accordance with the internal stakeholders concerning a particular topic which will improve the reliability of these assumptions. The case study carries out the 4 steps for upgrading a traditional allocation method. Although the results are partly based on assumptions in accordance with the management of SF, it pointed out how the proposed solutions can be implemented at SF to realize the desired effects; an increase in flexibility and accuracy. Since many other companies are interested in improving quality of costing information without investing additional time and money, and the costing literature acknowledges the weaknesses of ABC and the reasons of companies for abandoning or neglecting ABC, this thesis provides a relevant contribution to the theory as well as to companies in practice. Whether or not the proposed solutions lead to the desired effects is dependent upon contextual variables. Future research and especially case studies can add additional knowledge here.

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CONTENT

ABSTRACT ... 1 CONTENT ... 2 1. Introduction ... 4 1.1 Problem Identification ... 4 1.1.1 Gap analysis. ... 5

1.1.2 The desired state of costing information. ... 5

1.1.3 The current state of costing information... 6

1.1.4 Problem statement. ... 7

1.2 Research Design ... 7

1.2.1 Requirements for the end result. ... 7

1.2.2 Research question. ... 8

1.2.3 Sub questions. ... 8

1.2.4 Research structure. ... 8

1.3 Theoretical Relevance of the Research ... 8

1.4 Thesis Structure ... 9

2. Cost Classifications ... 10

2.1 Relevant versus Sunk Costs... 10

2.2 Manufacturing versus Non-manufacturing Costs ... 10

2.3 Direct versus Indirect Manufacturing Costs ... 10

2.4 Product versus Period Costs ... 11

2.5 Traceable versus Common Overhead Costs ... 12

2.6 Fixed versus Variable Overhead Costs ... 12

2.7 Conclusion ... 13

3. Cost Allocation ... 15

3.1 Difficulties in Cost Allocation... 15

3.2 Cost Allocation Methods ... 16

3.2.1 Absorption costing... 16

3.2.2 Direct costing. ... 17

3.2.3 Activity-based costing. ... 17

3.3 Allocation Techniques of ABC ... 19

3.4 Upgrading Traditional Allocation Methods ... 19

4. Research Methodology ... 21

4.1 Research Strategy ... 21

4.2 Research Structure ... 21

4.3 Research Scope ... 22

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4.5 Reliability and Validity ... 23

5. Diagnosis - Phase ... 24

5.1 Background ... 24

5.1.1 Characteristics of the production process (KV). ... 24

5.1.2 Characteristics of the production process (MOV). ... 25

5.2 Costing Method KV-plant ... 26

5.2.1 The cost price of manufacturing (KV). ... 26

5.2.2 The allocation base (KV). ... 27

5.2.3 Period costs (KV). ... 27

5.3 Costing Method MOV-plant... 27

5.3.1 The cost price of manufacturing (MOV). ... 27

5.3.2 The allocation base (MOV). ... 28

5.3.3 Period costs (MOV). ... 28

5.4 Causations of Inadequate Costing Information at SF ... 29

6. Design - Phase ... 30

6.1 Product versus Period costs ... 30

6.2 Differentiation of Indirect Manufacturing Costs ... 31

6.2.1 Traceable costs versus common overhead costs. ... 32

6.2.2 Fixed versus variable costs. ... 32

6.2.3 Presentation of costing information. ... 33

6.3 Allocation Bases ... 33

6.3.1 Allocation base of machine costs. ... 34

6.3.2 Allocation base of common overhead costs. ... 34

6.4 Costs of Idle Capacity ... 35

6.5 Examples of the Results ... 35

7. Discussion and Conclusion ... 37

7.1 Theoretical Contribution of the Research ... 39

7.2 Practical Contribution of the Research ... 39

7.3 Perceived Limitations of the Research ... 40

7.4 Recommendations for Future Research ... 40

References ... 41

Appendix 1 ... 43

Appendix 2 ... 44

Appendix 3 ... 45

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1. Introduction

This thesis is initialized in order to provide solutions to the management of SF that can be used to solve a practical problem. Paragraph 1.1 will discuss the problem identification and problem statement. Paragraph 1.2 will elaborate the research design by presenting the research objective, managerial requirements, and the research question. Paragraph 1.3 discusses the theoretical relevance of the research. Paragraph 1.4 will outline the thesis structure.

1.1 Problem Identification

SF is an international producer of food products. The markets where SF is active (retail, foodservice and industry) can be characterized as highly competitive, with high price elasticity, declining margins and rising pressure on costs. Winning or losing tenders is decided on minimal price differences. Especially for the commodities customers base decisions mainly at price. As a result of several recent developments the pressure on costs has risen even further:

Customers increase negotiation power by combined purchasing, mergers and acquisitions The increased need of customers to diversify (mass production  flexible production) Demands with regard to quality and health have become more important and diverse The worldwide economic recession

Given the central role of costs in the food markets, costing information plays a crucial role in commercial decisions and activities at SF (e.g. pricing, investments, and profitability analysis). The management is dependent upon adequate information in order to differentiate between profitable and non-profitable activities and to take decisions beneficial for the organization. Given the frequency of commercial decisions, the standard cost price provided by the costing system must be reliable. On average, between 10 and 20 calculations of (new) products are made each day.

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1.1.1 Gap analysis.

The problem identification describes a gap between the desired state of costing information and the current state of costing information at SF; the information provided is not adequate for supporting commercial decisions. To specify this problem in more detail, a gap analysis (Verschuren and Doorewaard, 2007) is performed, which comprises two steps. First, the desired state of costing information is determined by providing the criteria for adequate costing information. Second, we determine whether the information currently generated meets these criteria, the current state. When we have defined the research gap in more detail, the research can be designed.

Figure 1: Research gap (Verschuren and Doorewaard, 2007)

1.1.2 The desired state of costing information.

The question that must be answered here is: what is adequate costing information? With adequate costing information is meant here what Snavely (1967) has presented as usefulness of information. According to him usefulness is the 1st level criteria which stands highest in the hierarchy. Information must be useful for dealing with the problem at hand. In this thesis the term adequate is used instead off useful. We have found several overlapping criteria for costing information in the literature. We have examined these and selected the following criteria that costing information must meet in order to be adequate for supporting commercial decisions:

1. Accuracy – The need for accurate costing information is often emphasized in the literature

(e.g. Barth et al., 2008; Garrison et al., 2003; Mishra and Vaysman, 2001; Drury, 2003). Inaccurate costing information leads to cross-subsidization of products and distorted profit analyses. However, Hwang et al. (1993) emphasize that allocation of indirect costs to products always result in some degree of cost distortion since the allocation process cannot fully reflect the actual relation between costs and products. Accuracy is closely related to reliability. According to Snavely (1967), reliability depends on the extent to which information is verifiable and free from bias. Verifiability means that 2 or more qualified persons would draw similar conclusions from the information presented. We assume here that increasing the accuracy of information would lead to an increase in verifiability and a decrease in bias. Thus, when information becomes more accurate it will also become more reliable.

2. Flexibility – In the costing literature is frequently referred to the adage “different costs for

different purposes” (e.g. Atkinson et al., 2004; Drury, 2003). It implies that costs that are relevant in a particular decision situation may not be relevant in another. Costing information

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can be considered flexible when a manager is enabled to examine the data at hand and extract the relevant costs for a particular decision. Thus, details with regard to the costs are needed.

3. Timeliness – If information is not available on a timely basis its ‘net usefulness’ will diminish

(Snavely, 1967). For SF this characteristic is of crucial importance with regard to the commercial process, since the time pressure on commercial decisions is often high. Normally, each tender requires new cost price calculations. This process must not consume too much time. Furthermore, for other purposes of costing information as for example external profit reporting, controlling and performance measurement, it is also crucial that the information is available quickly in order to detect deviations or problems quickly.

4. Understandability – Managers must understand the information generated in order to make

logical decisions (Snavely, 1967). Understandability is closely related to reliability. When two managers face the same information they must come to more or less the same conclusions. The difficulty of this characteristic is that it is interrelated to criteria 1 and 2; an increase in flexibility and accuracy will lead to more detailed and structured information and thus an increase in understandability. On the other hand, too much details and too complex allocation methods might negatively influence understandability (Homburg, 2001).

The interrelations, similarities and contradictions between these characteristics result in the fact that tradeoffs must be made during the design of the allocation method, which must align with the organizational context. Information cannot meet all these characteristics perfectly. Rather, it must meet a satisfying level for each in order to be adequate. However, the ‘problem’ with these characteristics is measurement. First, except for timeliness, it is difficult to rate the information generated on the basis of each of these criteria. Second, whether the information meets a satisfying level for each characteristic is dependent upon managerial needs (preferences) and the organizational context. For example, although the current allocation methods are not satisfying the needs of management currently, during the design of these methods (more than 20 years ago), these might have perfectly fitted to the managerial needs and the organizational context since these costs were less relevant (insignificant) at the time. Because of the difficulty of measuring, we will not attempt to measure the information in the current and future state on the basis of these criteria. We will only use these criteria as guidelines for decision making during this thesis.

Another criterion that will be relevant in this thesis is significance, which is defined as the extent to which the information presented affects a particular decision (Snavely, 1967). It is important to consider whether or not a change in allocation of a particular cost would lead to a significant change in the amount of costs assigned to products.

1.1.3 The current state of costing information.

The management considers the information currently generated only satisfactory with regard to one criterion: Timeliness. The information is lacking accuracy, flexibility and understandability. During the empirical section we will examine this is in detail.

Inaccuracy – The current cost allocation methods have become outdated with regard to the allocation

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Inflexibility – Currently, the management is not able to isolate the relevant costs from the information

generated for a particular decision. The current format for costing information does not present any details with regard to the indirect manufacturing costs and their behavior. Thus, the problem here is the presentation of the indirect manufacturing costs. As was stated above, which of these costs are relevant for a decision differs (‘different costs for different purposes’).

Understandability – The fact that no details are presented and the information is inaccurate results

also in low understandability of the information generated. As explained above, we assume that an increase in accuracy and flexibility of costing information at SF will lead to an increase in understandability. Therefore, this thesis will not explicitly focus on understandability. However, remind here that too much detail and too complex allocation methods will negatively influence the understandability (Homburg, 2001).

1.1.4 Problem statement.

According to Verschuren and Doorewaard (2007) a problem statement is complete when a clear answer is given to three questions:

What is the problem exactly?

The costing information is inadequate since it lacks accuracy, flexibility, and understandability, which results from improper allocation and presentation of indirect manufacturing costs.

Why is it a problem (effects)?

Inadequate costing information leads too faulty (commercial) decisions which have adverse effects on the organizational performance.

Who is the problem owner?

The problem owner is the top management. They are responsible for the organizational performance, which is currently suffering. They initialized this research to find proper solutions for the problem.

1.2 Research Design

The type of research carried out here is a design-oriented research (Verschuren and Doorewaard, 2007), focused at solving a practical problem. The inflexibility of costing information at SF is resulting from improper presentation of indirect manufacturing costs, and therefore the format for costing information needs to be revised. Inaccuracy is resulting from faulty allocation of indirect manufacturing costs, and therefore the allocation process needs to be revised.

Research objective – To provide solutions for revising the format for costing information and

the allocation process, which together result in more accurate and flexible costing information that empowers the management to take decisions beneficial to the organization

1.2.1 Requirements for the end result.

The management has formulated a functional, structural and user requirement (Verschuren and Doorewaard, 2007) for the end result.

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The structural requirement is that the costs involved in maintaining and updating the cost allocation system may not increase significantly.

The user requirement stated by the management is that the cost allocation process for both plants should be based on companywide principles. This means that the cost categories will be treated equally for both plants, unless there is a clear reason to deviate. This increases transparency and improves understanding of costing information throughout the organization.

1.2.2 Research question.

How can we increase the accuracy and flexibility of costing information, without significantly increasing the costs and effort required for maintaining and updating the costing system?

1.2.3 Sub questions.

We have defined two sub questions which will be answered in the literature section:

1. Which cost classifications can be used to differentiate indirect manufacturing costs in order to increase accuracy and flexibility of costing information?

2. Which solutions/techniques for overhead allocation differentiate ABC from traditional allocation methods?

1.2.4 Research structure.

The thesis will start with describing the findings from the literature study. Chapter 2 will deal with the first sub question and outline several cost classifications considered relevant for decision making in a manufacturing environment. Using these classifications is relevant for the presentation as well as allocation of indirect manufacturing costs. Then, chapter 3 will deal with the second sub question by focusing at the cost allocation process. It will discuss the cost allocation methods considered relevant for this thesis. The focus will be at determining what techniques for overhead allocation differentiate ABC from traditional allocation methods. Based on the findings in these two chapters, we will outline several steps for upgrading a traditional allocation method at the end of chapter 3. The literature study will be followed by a case-study, which determines how and to what extent the solutions offered by the literature study can be implemented at SF in order to increase the quality of costing information.

1.3 Theoretical Relevance of the Research

The structural requirement presented above has consequences for the research design as well as for the design of the allocation method. The management intends to revise the allocation methods and the format for costing information in order to generate more adequate costing information, without significantly increasing the costs involved in maintaining the costing system. Drury (2003) states that many companies face this paradox, choosing between on the one hand a simple low-cost allocation method which incurs high risks with regard to decision making, versus on the other hand a complex and costly allocation method which incurs less risks and strengthens decision making. Weighing these two options often leads to ending up somewhere in the middle, dependent upon managerial preferences and the context. Thus, although this research is focused at solving a practical problem at SF, the research may be relevant for many other companies also.

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implementing ABC, this thesis will search for solutions to realize these benefits without significantly increasing the costs and time involved in maintaining the system. A more cost effective solution would be an upgrade of the current methods by using more modern (ABC) techniques for allocation and presentation of indirect manufacturing costs, resulting in a hybrid form of allocation methods.

Although the literature has provided support for combined use of allocation methods (Drury, 2003; Cheatham and Cheatham, 2003; Marie et al. 2010), it is not described in detail in literature how these hybrid systems are designed. It is remarkable that although the reasons for many companies to neglect ABC are acknowledged in the literature, and many companies face the paradox described by Drury (2003), hardly any attention is given to those companies not willing to invest the extra time and money needed for implementing and maintaining an ABC system. One example of a modification of ABC is Time-driven activity-based costing (Kaplan and Anderson, 2004) which is stated to be less complex, and easier to maintain and update than ABC (Öker and Adigüzel, 2010). However, according to Öker and Adigüzel (2010) implementation of this method is also a time-consuming and costly process and they state that this method fits better to service companies than manufacturing companies. Furthermore, its benefits are especially relevant in relation to non-manufacturing costs, while we focus at manufacturing costs.

1.4 Thesis Structure

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2. Cost Classifications

This chapter will outline several cost classifications considered relevant for decision making in a manufacturing environment. We are especially interested in classifying the indirect manufacturing costs since this can help to increase flexibility as well as accuracy of costing information at SF. Flexibility will increase because differentiation of these costs enables the management to isolate the relevant costs for a particular decision. The current format for costing information does not show any details with regard to these costs, while these costs have a significant influence on commercial decisions at SF. Accuracy will be increased because classifying these costs helps to explain and predict these costs and their behavior and their relation to products and volume. This knowledge is beneficial when designing an allocation method, which will be discussed in chapter 3. This chapter will provide an answer to the first sub question: Which cost classifications can be used to differentiate

indirect manufacturing costs in order to increase accuracy and flexibility of costing information?

The chapter starts with relevant versus sunk costs in paragraph 2.1. Manufacturing versus non-manufacturing costs in paragraph 2.2. Direct versus indirect non-manufacturing costs (non-manufacturing overhead) in paragraph 2.3. Then, we focus at cost classifications that are relevant in relation to indirect manufacturing costs. Product versus period costs in paragraph 2.4 Traceable versus common overhead costs in paragraph 2.5, and fixed versus variable overhead costs in paragraph 2.6.

2.1 Relevant versus Sunk Costs

The differentiation between relevant and sunk costs determines whether or not a cost should be taken into account for a particular decision. Relevant costs are costs that do differ between the alternatives when a particular decision is being made (Garrison et al., 2003). Remind here that costs that are relevant in a particular decision situation may not be relevant in another, which refers to ‘different costs for different purposes’ (e.g. Atkinson et al., 2004). Therefore, flexibility of costing information is crucial for decision making. Garrison et al. (2003) describe sunk costs as costs “that have already been incurred and cannot be avoided regardless of what a manager decides”. No matter what alternative is chosen, these costs are always the same. Therefore these costs are irrelevant and must be ignored. Relevant costs are also referred to as avoidable costs, incremental costs, or differential costs.

2.2 Manufacturing versus Non-manufacturing Costs

The focus of this thesis is at the costs incurred at both production plants, referred to as manufacturing

costs (Garrison et al., 2003). A broad range of costs might fall into this category differing from labor

and ingredients to depreciation, energy, warehousing and maintenance. The non-manufacturing costs are mainly incurred at the head office. Atkinson et al. (2004) differentiate 6 categories; distribution, sales, marketing, after-sales service, R&D, and general and administrative costs. In a multi-product and multi-process manufacturing company, there is often no cause-and-effect relation between these costs and the production process. However, some of these costs make part of the value chain of a product (Garrison et al., 2003), e.g. marketing and after-sales service.

2.3 Direct versus Indirect Manufacturing Costs

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often classified as indirect, can also be classified as direct costs when these costs are dedicated to a specific product. Direct costs do normally not cause problems with regard to costing information because of the clear link with individual products. The higher the percentage of direct costs in the cost price, the more accurate the cost calculation is (Drury, 2003).

Indirect costs of manufacturing, often referred to as manufacturing overhead, are costs of resources

and activities that cannot be related exclusively to a particular product (Atkinson et al., 2004), and the exact amount of these costs related to an individual product is not precisely measurable (Baxter, 2004; Atkinson et al., 2004; Greer, 1952). The allocation of these costs to products is often based on estimates and averages, which causes inaccuracy and cross-subsidization (Garrison et al., 2003). The allocation of these costs is dealt with in chapter 3. However, as explained, not only the allocation of these costs is a problem at SF, also the presentation is lacking which is the result of the fact that the current format for costing information does not provide details with regard to these costs. As was explained, in order to improve accuracy and flexibility of costing information it is important to differentiate the indirect costs of manufacturing. We will discuss three cost classifications for indirect manufacturing costs which can influence the accuracy and flexibility of costing information; product versus period costs, traceable versus common overhead and fixed versus variable overhead.

2.4 Product versus Period Costs

The decision which costs are treated as product costs and which as period costs has significant influence on (the relevance of) costing information. Classifying costs as either product or period costs has also consequences for financial accounting purposes as it concerns the moment that a particular cost is incurred (Garrison et al., 2003). The longer the products are held in stock, the more influence this decision has on profit reporting. However, the time that product are held in stock at SF is low, thus the influence here is rather low. Garrison et al. (2003) describe the difference between these costs.

Product costs – In a manufacturing environment these are the costs involved in making a product.

These costs are assigned to products, remain attached to the units of product when these go into stock, and are incurred when a product is produced or sold.

Period costs – These are all costs not included in product costs and are expensed on the profit and loss

account in the period in which they are incurred.

This decision is especially relevant with regard to indirect costs since direct costs are nearly always treated as product costs. Drury (2003) states that, in general, in manufacturing companies all manufacturing related costs are treated as product costs while other costs are treated as period costs. Garrison et al. (2003) add that this is different when using Activity-based costing (ABC): “A cost is assigned to a product only if there is reason to believe that the cost would be affected by decisions concerning the product”. Consequently, companies applying ABC often treat relevant non-manufacturing costs as product costs also. On the contrary, companies applying direct costing only treat variable costs as product costs. There is no evidence found that either one will always lead to a significantly better performance. Thus, this decision mainly depends upon managerial preferences and the organizational context.

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allocating these costs to products always leads to inaccuracy to some extent (Hwang et al., 1993), which can be minimized by designing a proper allocation method (chapter 3), the following arguments are found to treat indirect manufacturing costs as product costs:

Allocation of indirect costs to products increases the insight into profitability of products, product groups and segments and is beneficial for flexibility of costing information. For many important activities and decisions (e.g. budgeting, pricing, profit and investments analysis), managers are interested in the amount of overhead costs related to products. Dugdale and Jones (1995) state that most important costing decisions are long term issues and that ignoring fixed costs leads to faulty decision making in the long run. Dudick (1969) emphasized the importance of these costs in relation to investments since managers are interested whether an investment in machinery or technology is paying off. In recent decades, the relevance of these costs has increased further since overhead costs have grown sufficiently, which mainly is the result of an enormous increase in technology and automation (Atkinson et al., 2004). Baxter (2005) states that for many companies, the impact of overhead costs has become significant, sometimes far exceeding direct costs. For these companies it is advisable to treat manufacturing overhead as product costs in order to ensure coverage of these costs. Overhead can be considered significant when the amount involved can make the difference between profit and loss. According to the management, overhead has a significant influence on commercial decisions at SF.

2.5 Traceable versus Common Overhead Costs

The differentiation between traceable and common overhead costs is especially beneficial for the accuracy of costing information (Garrison et al., 2003). Cross subsidization as a result of averaging indirect costs over products is minimized. Traceable costs are indirect costs that can be traced directly to cost objects other than products (e.g. processes, machines, customers, segments etc.). For example, the salaries of supervisors of a particular department or segment are traceable costs of the department or segment. Instead off averaging these over the whole product range, which according to Garrison, et al. (2003) is one of three main hindrances to proper cost accounting, these are traced to a specific cost object (e.g. a process or segment). Common costs are the overhead costs not specifically related to the cost objects chosen, or those costs for which it is not cost effective (too complex or an insignificant amount) to allocate these more specifically will be absorbed in common overhead and from there on allocated to products. For example, the costs of the plant manager can only be traced to the plant as a whole and is a common cost of the plant.

Another cost type which often is referred to in relation to common costs are joint costs. Garrison et al. (2003) define joint costs as the costs incurred in producing joint products (two or more products produced from a common input) up to the split-off point. They mention pork as an example. Several end products are made of a common input, e.g. bacon, ham and spare-ribs. These products are produced in fixed proportions (Williams and Kennedy, 1983). Although this is often is a relevant cost type in a manufacturing environment, this cost type is not present at SF currently.

2.6 Fixed versus Variable Overhead Costs

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2003). Consequently, variable cost can be traced to products or processes easily. Because of this direct relation with products, Atkinson et al. (2004) conclude that, in theory, variable manufacturing overhead does not exist since overhead costs have an indirect relation with production. However, in practice, many companies classify some variable costs as indirect costs for convenience, since allocating these costs more specifically is too complex or it is not cost effective to allocate these directly to products (Garrison et al., 2003; Atkinson et al., 2004; Drury, 2003). These costs often have insignificant influence on decision making.

On the contrary, fixed costs are not influenced by fluctuations in the production volume. Rather, these costs have a cause-and-effect relationship with capacity (e.g. Atkinson et al., 2004), remaining fixed as long as the capacity level remains constant. The fixed costs per unit are inversely proportional to the production volume (Drury, 2003); an increase in volume results in a decrease in fixed costs per unit. Examples of fixed costs are rental of machinery, depreciation, insurance, and executive salaries. Often fixed costs are indirect costs incurred by a segment or plant, although, for example, depreciation can also be classified as a direct cost when it can be related exclusively to a particular product.

Important to emphasize here that the distinction between variable and fixed costs often is vague and depends on the circumstances (Drury, 2003; Greer, 1952). For example, salaries of manufacturing personnel are often treated as variable costs (direct labor), although in reality these are partly fixed costs (employees) and partly variable (e.g. temporary employees and overtime). Costs that contain a variable and a fixed element are referred to as mixed costs (Garrison et al., 2003). Furthermore, the

time horizon also determines whether a cost is considered fixed or variable (Drury, 2003). In the long

term (>1 year) almost all costs can be considered variable, because over this period it is possible to make changes with regard to capacity or other ‘fixed’ elements.

The use of this classification improves the flexibility of costing information since it provides details with regard to the behavior of these costs in relation to the production volume and product decisions. For commercial decisions, companies often make use of relevant concepts as cost-volume-profit analysis and marginal pricing (Garrison et al., 2003). These concepts help to maximize the total contribution of the organization and are especially useful in relation to short-term quantity decisions, known as in/out products at SF. “Short-term quantity decisions are not made so as to cover costs but to maximize profits” (Karmarkar and Pitbladdo, 1994). For short-term decisions fixed costs are often irrelevant (sunk costs) since these do not differ between the alternatives.

2.7 Conclusion

In this chapter we have outlined several cost classifications considered relevant for decision making in a manufacturing environment. Special attention was given to classification of indirect manufacturing costs, in order to increase accuracy and flexibility of costing information. We will conclude this chapter with answering the first sub question: Which cost classifications can be used to differentiate

indirect manufacturing costs in order to increase accuracy and flexibility of costing information?

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that there is no right or wrong for this decision and that decision must be in line with managerial preferences and the organizational context. We state that in order to increase flexibility of costing information, the indirect costs of manufacturing must be treated as product costs. This means these costs will be allocated to products, and we can show a relation between these costs and products. Although based on averages and assumptions, which decreases accuracy to some extent, the management is interested in this relation for many important business decisions (e.g. budgeting, pricing, and profit and investment analysis). The use of both classifications mentioned here will lead to an increase in flexibility and enable the management to extract relevant costs from the information and ignore sunk costs.

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3. Cost Allocation

This chapter will focus on the allocation of indirect manufacturing costs to products. The allocation methods currently used by SF have become outdated. These methods are based too much on averages, which results in inaccuracy and lead to faulty commercial decisions. To improve insight into profitability of products, the management intends to revise the allocation methods. The management has stated several requirements (paragraph 1.2.1), and especially the structural requirement has consequences for this research. They intend to revise the allocation methods (including the format for costing information) in order to generate more adequate costing information, without significantly increasing the costs involved in maintaining the costing system.

Activity-based costing (ABC) is the method that offers the benefits we search for. ABC is stated to be more accurate and flexible approach to cost allocation than traditional methods (e.g. Babad and Balachandran, 1993; Homburg, 2001; Ittner et al, 2002) and leads to better understanding of costs and cost drivers. However, ABC leads to a significant increase in the costs and time required to maintain the system (Barth et al., 2008; Kaplan and Anderson, 2004; Öker and Adigüzel, 2010). Consequently, it does not meet the structural requirement of the management of SF. The increase in costs and time required is one of the most cited reasons by other companies who have abandoned or neglected ABC (Dowless, 2007). The purpose of this chapter is to determine how we can realize the benefits of ABC without significantly increasing the costs and time involved in maintaining the system. The topic discussed in the previous chapter, classification of costs absorbed in manufacturing overhead, will play an important role during this chapter also. The chapter will provide an answer to the second sub question: Which solutions/techniques for overhead allocation differentiate ABC from traditional

allocation methods?

Paragraph 3.1 will discuss the difficulties concerning the allocation of indirect manufacturing costs to products. Paragraph 3.2 will discuss three allocation methods. First the traditional allocation methods (absorption costing and direct costing), and then the ABC-method. Paragraph 3.3 will determine what differentiates ABC from traditional allocation methods with regard to allocation of indirect manufacturing costs. Paragraph 3.4 will provide 4 steps for upgrading a traditional allocation method.

3.1 Difficulties in Cost Allocation

As explained allocation of indirect costs always result in some degree of cost distortion since the allocation process cannot fully reflect the actual relation between costs and products (Hwang et al., 1993), unless we describe and trace all activities in minute detail. Such information is enormously costly to collect and process (Babad and Balachandran, 1993; Koltai et al., 2000). Garrison et al., (2003) have outlined three major difficulties with regard to allocation of indirect manufacturing costs.

1. Overhead costs are either difficult or impossible to trace to products:

Overhead costs are indirectly related to a product group or sometimes all products. There is no cause-and-effect relation with products, which leads to allocating these costs based on assumptions or averages.

2. Manufacturing overhead consists of many different kinds of costs:

Overhead costs have grown in amount as well as in diversity in many companies. Each of these costs can show different behavior and often has different cost drivers.

3. Overhead costs show a fixed pattern:

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For these reasons, some companies decide to treat (fixed) indirect costs as period costs. However, as we have argued in the previous chapter, it is beneficial for the flexibility of costing information to treat (the major part) of these costs as product costs, although this leads too inaccuracy to some extent. In order to minimize these difficulties, the design of the allocation process and understanding of the (behavior of) costs absorbed in manufacturing overhead is crucial in order to allocate these costs accurately. According to Barth et al. (2008), poor knowledge of overhead costs and the allocation process leads to inaccuracy in costing information and poor decisions.

3.2 Cost Allocation Methods

This paragraph will discuss the characteristics of three cost allocation methods. It will start with the two traditional cost allocation methods, absorption costing and direct costing, since the current allocation methods of SF are a hybrid form of these two methods. Then, the ABC-method is discussed since this is the method that offers the benefits we search for.

3.2.1 Absorption costing.

The current allocation methods of SF are most close to absorption costing. Absorption costing absorbs the fixed and variable costs of manufacturing in the cost price of products. The non-manufacturing costs are treated as period costs. In many countries this method is required for both tax reporting and external financial reporting (Ajinkya et al., 1986; Garrison et al., 2003). Consequently, absorption costing is a common used method for product costing, because the information is already needed for external purposes (Dudick, 1969; Geri & Ronen, 2005).

Allocation of manufacturing overhead

Indirect manufacturing costs are allocated to products by using one (or more) allocation bases, which result in overhead rates. This method is easy for data gathering, storing and processing, but may cause severe distortion (Babad and Balachandran, 1993; Hwang et al., 1993) since the overhead rates will in practice always involve averages or estimates across products and time periods (Garrison et al., 2003).

Benefits

The main benefit is that this method shows a relationship between indirect costs and products which is often interesting for decision making, as was explained earlier. Furthermore, absorption costing provides more insurance to management that all costs will be covered ultimately since the manufacturing costs are covered within the cost price. Furthermore, many important costing decisions are long term issues in which fixed costs are often relevant and ignoring these costs easily leads to faulty decisions. According to Baxter (2005), absorption costing can be defended solely on the grounds that it seems to be working well in practice, since many firms are still using a form of absorption costing despite the widespread knowledge of its limitations.

Weaknesses

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predetermined (budgeted) volumes (Sizer, 1966). Actual levels of output are not taken into account. Consequently, product costs will only be correct if actual output meets the predetermined output.

3.2.2 Direct costing.

Direct costing differs from absorption costing in its treatment of fixed manufacturing costs as period costs instead off product costs (Geri and Ronen, 2005). The main thought of the proponents of this method is that the figures remaining unchanged by fluctuations in the production volume are irrelevant for costing and should be ignored (Baxter, 2005). The strength of the method is the differentiation between fixed and variable costs, which is needed for relevant concepts as marginal pricing and CVP analysis (Garrison et al., 2003). These concepts are especially relevant in relation to short-term quantity decisions, which mainly occur in relation to in/out products at SF. These decisions are not made to cover costs but to maximize profits (Karmarkar and Pitbladdo, 1994). However, most organizations prefer absorption costing (Geri and Ronen, 2005). Assigning only variable costs to products might lead to all individual sales showing a surplus over its cost price, but costs of overhead not covered fully in the end (Dugdale and Jones, 1995; Geri & Ronen, 2005). Thus, it is not advisable to use this method as a guide in firms where indirect costs have significant influence (Baxter, 2005).

3.2.3 Activity-based costing.

Often, the reason for implementing a modern cost allocation method is that traditional methods have become outdated with regard to treatment and allocation of indirect costs (Drury, 2003). In recent decades, markets moved from mass production to flexible production and the systems established in the mass market era have become outdated (Fernie et al., 2001). These methods do not properly respond to the growth in manufacturing overhead in many companies, which was one of the main reasons for development of ABC (Koltai et al., 2003). Essentially ABC is a refinement of absorption costing, which leads to better understanding of costs and cost drivers (Geri and Ronen, 2005). According to Garrison et al. (2003), the objective of ABC is focused at managerial interests; understanding overhead and determining profitability of products and customers, while traditional methods are focused at financial reporting by properly valuing stocks and costs of goods sold. Since the objectives differ, the techniques used to allocate costs and the presentation of costs also differ. Although ABC is more than an allocation method, we will focus here solely on the allocation process.

Product costs

The allocation of indirect cost to products is a main point of differentiation for ABC in comparison to other methods (Stratton et al. 2009). In order to determine the profitability of products, ABC treats some non-manufacturing costs as product costs also. Those costs of which it is reasonable to believe that these are affected by decisions concerning a particular product are allocated to products (Garrison et al., 2003), e.g. shipping costs, warranty repair costs, commissions and discounts.

Allocation of indirect manufacturing costs

The allocation process under ABC is more complex than under absorption costing. ABC starts with identifying activities (manufacturing and non-manufacturing) which cause consumption of overhead resources and defining activity cost pools and cost objects (products, processes, customers, orders, etc.). Examples of activities are, order entry, setup of machinery, cleaning, ICT, and sales calls. Some of these activities can be traced directly to the cost objects. In chapter 2 we mentioned these costs as traceable overhead costs. The remaining activities are numerous and often grouped into several

activity cost pools which contains the costs related to these activities under one header. The costs per

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rather than the budgeted level. Consequently, products are charged for costs of the capacity used, not for the costs of idle capacity (Dowless, 2007; Garrison et al., 2003).

Benefits

ABC is stated to be more accurate and flexible than the traditional methods (e.g. Babad and Balachandran, 1993; Homburg, 2001; Ittner et al, 2002) and leads to better understanding of costs and cost drivers. Geri and Ronen (2005) stated that managers at all organizational levels perceive information generated by ABC as more accurate and reliable than information generated by traditional methods. This empowers managers to make better decisions (Mishra and Vaysman, 2001). Rather than a companywide overhead rate, ABC uses for example departmental overhead rates, each with an individual allocation base that fits to the nature of the department. Inaccuracy is minimized by choosing allocation bases that are a cost driver of the costs in question (Atkinson et al., 2004; Garrison et al., 2003). Often, multiple allocation bases are needed to allocate costs accurately to cost objects since not every cost type has the same cost driver (Dugdale and Jones, 1995), and often a large variety of costs is encompassed in overhead (Garrison et al., 2003). Another difference that positively influences accuracy of information is that ABC does not charge costs of idle capacity to products. This results in fair cost prices on a more competitive base.

Weaknesses

Since it is essentially a refinement of absorption costing, the ABC-method suffers from the same weaknesses as absorption costing according to Geri and Ronen (2005): “ABC creates a more complicated costing system, but not necessary an accurate or useful one”. They state that allocation of indirect costs is also based on subjective arbitrary cost allocations. Homburg (2001) argues that a major issue in implementing an ABC system is the selection of allocation bases since accuracy must be traded off against the understandability: On the one hand, high accuracy in overhead allocation often requires a high number of allocation bases. On the other hand, to minimize costs of the allocation and data collection process and to make the system easier to understand, a small number of allocation bases is desirable. To maintain the original purpose of ABC and to improve understandability at the same time, firms comprise at some point by combining activities with similar resource consumption characteristics in activity cost pools (Hwang et al., 1993; Koltai et al., 2000). Consequently, for ABC,

just as for other methods, it depends on the design of the method whether the information generated is adequate (Mishra and Vaysman, 2001).

Furthermore, for designing and maintaining the system, research and interviews with employees are conducted in order to determine how employees spend their time between various activities they perform. Öker and Adigüzel (2010) state that these surveys are time consuming, require high data-processing costs, and are biased. This is supported by Dowless (2007) who states that one of the most cited reasons for neglecting ABC includes the high cost of design, implementation, maintenance and the need for new systems for data processing. Barth et al. (2008) add that the determination of activities relies on experience of management and the structure of the interviews employed, and thus is subjective. Furthermore, a firm as SF faces continually changing processes, customers and activities, which means that the system must be updated continually. In practice this is rarely done because of the high costs associated with it (Öker and Adigüzel, 2010).

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3.3 Allocation Techniques of ABC

We are now able to answer the second sub question: Which solutions/techniques for overhead

allocation differentiate ABC from traditional allocation methods?

We have outlined 5 techniques/solutions that differentiate ABC from traditional methods. Garrison et al. (2003) have described several differences and we have found some additions in other literature.

1. Allocation is based on a thorough analysis of costs, cost drivers and processes

ABC implementation involves a thorough analysis which results in better understanding of costs, cost drivers and processes, and draws attention to aspects and activities which are often neglected (Geri and Ronen, 2005). This analysis includes interviews with the actors of the processes. The additional data improves accuracy, flexibility and understandability of information and strengthens decision-making.

2. Assign a cost to a product only if there is a good reason to believe that the cost would be affected by a decision concerning the product

In order to determine the profitability of products, ABC treats relevant non-manufacturing costs as product costs, while some manufacturing costs may be excluded from product costs when these are irrelevant for decisions concerning a product.

3. Use of several overhead cost pools

ABC uses several overhead cost pools, which are allocated to products or other costing objects by using a unique allocation base (activity measure). Since the objective of ABC is to understand indirect costs and determine profitability of products, ABC differentiates these costs instead off absorbing these all into one bucket and averaging these over products. To ensure understandability and timeliness while maintaining the original objective of ABC, firms must comprise at some point and costs or activities with similar consumption characteristics are grouped in cost pools (Koltai et al., 2000; Babad and Balachandran, 1993).

4. Use multiple allocation bases which are a cost driver of the costs allocated

ABC uses multiple allocation bases since not all costs have the same cost drivers (Hwang et al., 1993). Using allocation bases that are cost driver of the costs allocated is beneficial for the accuracy of the process. Dugdale and Jones (1995) state that many companies have oversimplified their costing method by using a single allocation base. Furthermore, the allocation bases used under ABC often differ from those used under absorption costing. The use of improper allocation bases is a main hindrance to proper cost accounting (Garrison et al., 2003). Babad and Balachandran (1993) have advised to identify and track only the cost drivers that are related to the bulk of costs. This ensures understandability and timeliness.

5. Products are charged the costs of capacity they use, not for the costs of idle capacity

Overhead rates are based on the level of activity at capacity. Costs of idle capacity are treated as losses instead of product costs. The cost price does not cover costs of idle capacity. Instead, this price will provide coverage for overhead costs on a more competitive basis (Dudick, 1969). This results in more stable unit costs and is consistent with the objective of assigning only those costs to products that are actually caused by the products (Garrison et al., 2003).

3.4 Upgrading Traditional Allocation Methods

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to abandon or neglect it. Rather, companies choose to adapt their current systems to their specific needs by using more rigorous schemes, instead of employing newer and costlier systems (Marie et al., 2010). Cheatham and Cheatham (2003) add that upgrading a standard allocation method can provide the extra information that is required for managerial decisions. For SF we have chosen to upgrade the current allocation methods (which includes revising the format for costing information).

Below we have diversified 4 steps to upgrade a traditional allocation method. During these 4 steps, the allocation techniques described above, in combination with the findings from chapter 2, can be used to design the allocation methods in line with managerial preferences and the organizational context. During this design-phase tradeoffs must be made between accuracy, flexibility, understandability, timeliness and the costs involved in collecting and maintaining information. Thereby, we learned from ABC that it is beneficial for the quality of the information generated to base decisions concerning the design of the allocation process on a comprehensive analysis of costs, cost drivers, and processes.

1. Product versus period costs – The first step in the process of designing or upgrading an

allocation method is to decide which costs will be treated as product costs, and which as period costs. This decision is especially focused at the indirect costs of manufacturing as well as some of the relevant non-manufacturing costs. It mainly depends upon managerial preferences and the context how these costs are divided.

2. Differentiate manufacturing overhead – Classify the costs absorbed in manufacturing

overhead by using relevant cost classifications, which results in multiple overhead cost pools. This enables the management to extract the relevant costs (flexibility) from the information, improves understanding of these costs, and is helpful during the design of the allocation process (accuracy). Together with step 1 above, this will result in a new format for costing information. Chapter 2 discussed the cost types that can be used here. However, while increasing accuracy and flexibility, also consider the understandability and timeliness of costing information, and the costs involved in collecting and maintaining data.

3. Choose allocation bases – Use multiple allocation bases for allocation of indirect

manufacturing costs when this is relevant and choose allocation bases which are a cost driver of the costs allocated. Again, consider the understandability and timeliness of costing information, and the costs involved in collecting and maintaining the data. It is advisable to choose allocation bases that are related to the bulk of the costs in a particular cost pool.

4. Do not charge costs of idle capacity to products – With regard to the fixed costs (capacity

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4. Research Methodology

As was stated in the introduction chapter, the type of research carried out here is a design-oriented research (Verschuren and Doorewaard, 2007). The previous chapters discussed the findings from the literature study and presented solutions for upgrading traditional allocation methods in order to increase accuracy and flexibility of costing information. We will now determine how and to what extent the solutions can be implemented at SF in order to solve their problem by carrying out an empirical research. This chapter will describe the methodology used for this empirical research. It will discuss the research strategy, structure, scope and issues concerning validity and reliability.

4.1 Research Strategy

The strategy chosen to conduct the empirical analysis is a case study. According to Verschuren and Doorewaard (2007), a case study is an in-depth research which is used when the researcher intends to gain a profound and integral insight into one or several objects or processes that are bounded in time and space. The choice for a case study is logical given the fact that this thesis is written in order to solve a practical problem, and how and to what extent solutions can be implemented and lead to the desired results is highly dependent upon contextual variables. Thus, research towards the organization and its context is required. Verschuren and Doorewaard (2007) state that a case study can be beneficial for a practically oriented research since it provides a comprehensive view of the research object, especially when the purpose of the research is to intervene or change a practical situation.

Since the thesis is focused at indirect manufacturing costs, the case study context is formed by the both production plants. Both plants currently have their own method for cost allocation and their own format for costing information, which will be analyzed separately. However, one of the requirements for the end result stated by the management is that the cost allocation process for both plants should be based on companywide principles in order to increase transparency and understandability of information. This means that the different cost categories must be treated equally for both plants, unless it is reasonable to deviate. Thus, the new method will be mainly similar for both plants.

4.2 Research Structure

The research follows the structure of the DOV-model (De Leeuw, 2002), which describes 3 phases that must be passed through in order to realize a change; diagnosis, design and change.

Phase 1: Diagnosis

A proper diagnosis is necessary in order to solve a problem. A diagnosis consists of a study towards the background and the emergence of the problem (Verschuren and Doorewaard, 2007). This phase will start with analyzing the current allocation methods of SF in more detail. Although the introduction already provided a diagnosis of the problem, during this phase of the empirical research this will be discussed in more detail. Relating this to the research model that was presented in the introductory chapter (paragraph 1.1), this phase will determine the current state of the costing information at SF.

Phase 2: Design

This phase determines how and to what extent the solutions presented in the literature study can be implemented at SF in order to upgrade the current allocation methods. The 4 steps for upgrading a traditional allocation method presented at the end of chapter 3 will be followed here. This phase determines how the desired state of costing information can be realized.

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This phase entails the implementation of the solutions offered by the design phase and the collection of missing data needed for implementation

4.3 Research Scope

The scope of this research is limited by the fact that we focus on solutions regarding the presentation and allocation of indirect manufacturing costs. Other costs (direct manufacturing costs and non-manufacturing costs) are not explicitly dealt with in this thesis.

Furthermore, during this research we will focus on data that from existing documents or data that that can be generated from the ERP system. We will not make not make use of, for example, interviews, surveys or questionnaires to gather missing data. Paragraph 4.4 provides argumentation for this choice. Furthermore, the empirical section of this thesis will focus at the diagnosis- and design-phase of the DOV-model described above. The change-phase will not be dealt with here. This study was initialized to provide solutions to the management of SF regarding the presentation and allocation of manufacturing costs in order to improve the quality of costing information. Whether or not these will be implemented and to which extent is a decision that will be made by the management afterwards.

4.4 Data Sources

Although we conduct a case study here, the emphasis will be on using existing materials in the form of (internal) documents (desk research). Additional data can be gathered from the ERP-system.

Literature – The findings from the literature study towards product costing and the related topics are

used during the empirical research to analyze the current state of costing information at SF (diagnosis), and also to determine how we can realize the desired state of costing information.

Documents – During the design-phase, empirical information will be gathered from (financial)

business documents: the budget (versus actuals), the balance sheet, and performance reports. We will use documents from the period 2011-2014. Documents reflecting the years before 2011 have become outdated as a result of the modernization of the KV-plant and the structural changes at both plants.

Empirical data – Missing (quantitative) data can be obtained from databases provided by the

ERP-system.

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system provide reliable data regarding costs in relation to processes. Third, the managerial demands with regard to costing information are known for a major part, thus interviews are not necessary here. During the empirical research it is important to communicate with the most important internal stakeholders at SF; Albert Beekhuizen (Manager Finance & ICT), John Klinkhamer (Commercial manager), Jeroen van Dijk (Plant manager KV), Hans Koopal (Plant manager MOV), Arend Korf (Project manager). These discussions will take place on ad-hoc basis and are needed in order to ensure that we are thinking and working the right direction during the design-phase. Also, it is helpful to discuss the interpretation of the documents and the data from the ERP-system with these stakeholders.

4.5 Reliability and Validity

According to Cooper and Schindler (2003), validity refers to the extent to which we measure what we actually wish to measure. They refer to external and internal validity. External validity of findings refers to the ability to generalize these across persons, settings, and times. As was mentioned earlier, the influence of contextual variables and managerial preferences on the design of an allocation method is high, and therefore we realize that the external validity is low. This is in general a weakness of all case-studies (Verschuren and Doorewaard, 2007). However, this empirical analysis does provide a relevant example of the (re)design of an allocation method in a manufacturing company, which might be interesting for other companies. Furthermore, external generalizability of outcomes is not relevant for this thesis since it focused at solving a practical problem at SF. On the other hand, a potential benefit of a case study is that the flexibility and depth result in more internal validity (Verschuren and Doorewaard, 2007). According to Cooper and Schindler (2003), internal validity is concerned with the discussion whether a research instrument measures what it is purported to measure. Since we do not directly measures data, but we mainly use existing documents concerning costs and processes to collect information, internal validity is not really in question. The information provided by these documents is valid and it is possible to zoom in more specifically on the data by using the ERP-system. With regard to the design of the allocation method we must however realize that designing an allocation process for indirect costs is always based on assumptions to some extent since the allocation process cannot fully reflect the actual relation between costs and products (Hwang et al., 1993). Furthermore, when the management decides to implement the proposed solutions, additional data can be obtained by using surveys, interviews or observations. This will have a positive influence on the validity of the information used to implement these changes.