Overhead allocation methods

In manufacturing costs are incurred, these costs represents the cost of production that will be used in determining the price that will be charged by the company to make profit or to breakeven. There are two forms of costs Direct and indirect costs. Before one attempts to charge costs to cost centre or cost units it is important to consider why costs are incurred. Direct costs are costs that are traceable to a specific production center, service, products or department. Raw materials will be direct cost as regards the finished product, and a time clerk’s wages are a direct cost for a particular department.

indirect cost is one which arise during the course of operations of the business but it is very difficult to attribute it specifically to a single unit. For example rates paid to a local authority is an expense which benefits a number of cost centre’s, and the time clerk’s wages referred to above would be an example of an indirect (wages) cost of the units produced by his department. Overhead allocation methods Direct costs normally present little difficulty in being allocated to cost units; materials requisitions and workers’ time-sheets will give sufficient indication of where the costs are to be changed.

With indirect costs, however, whole items of costs may need to be divided between various cost centers and accumulated cost centre costs will then be allotted to costs units. These costs will first be classified according to function, i. e. production, general administration, marketing, research and development between functions. Each particular cost centre will then be allotted with its own costs and a cost centre total obtained. While apportioning indirect variable overhead to various production units or cost centers, cost and management accountants have many methods to use.
One of the methods that is used is traditional methods and they give distorted costs where at times customers may be charged high prices due to over allocation of the productions costs. They include method of allocating costs using direct labor, direct machine hours ,volume produced and other many other methods in most instances they give wrong results which at times may undervalue or overvalue produced units which may cause the firm to make less profits or abnormal profits from some units. It may also if they over value the produced product cause customers to shy away from the company.
Therefore, the method used in apportionment of overhead used should be accurate in order to give the firm good profitability at the same time maintain the customers by charging them the right price. In order to overcome the shortcoming of the traditional method of cost allocation modern methods are used. One of the methods that assist in overhead allocation with minimal shortcomings is costs is activity based costing. Activity based costing reduces the shortcomings by focusing on individual activities as the fundamental cost objects in allocation of costs. An activity is defined as an event, task, or unit of work with a specified purpose; e.
g. designing products, setting up machines, operating machines, and distributing products. This method uses costs of each activity and assigns this costs to costs units such as products or services as per the activities incurred while producing those units. Activity based costing focuses on individual costs, refining the assignment of indirect costs to departments, processes, products, and other cost objects that are to certain organization. To identify these activities, the company may organize a team from design, manufacturing, distribution, accounting and administration or in various production units such as product A, B, C, D and so on.
This method uses the following producers in identifying the activities:- 1. Direct cost tracing – a feature of Activity based costing systems is aiming to indentify some costs or cost by subdividing existing cost pools. Costs in some new pools may qualify as direct costs. Direct tracing of costs improves cost accuracy and is simpler because, unlike indirect costs, cost pool and allocation bases do not have to be identified. 2. Indirect cost pools- Activity based costing systems create smaller cost pools linked to the different activities. 3.
The apportionment bases-activity of each cost pool is used to measure not the direct labor as the traditional method for the apportionment of indirect overhead. The level of activity therefore is an economic factor which affects the calculation of the unit costs of output produced. Since fixed and overhead costs remain constant as output fluctuates, the greater the output, the lower will be the fixed overhead cost per unit. This problem does not affect the variable overhead rate; variable costs per unit remain constant at all levels of activity, assuming always that prices remain stable.
For management decision –making based on full unit costs, however, the level of activity is an important ingredient which must be taken into account when providing relevant information for such decisions. Based on an activity based costing allocation method of the overhead costs, each of the activity that goes into the product is computed its own overhead rate based on that activity’s driver which is the activity charge/unit. Given this overhead rate, the total overhead cost allocated to the production of the original version other system i. e. other than the overhead allocated using the direct labor hours method.
From the foregoing discussion activity based costing approach method identifies activities and Cost centers that allocations with which costs may conveniently be associated for the purpose of product costing. Basically, there are two types of cost centers for which cost are accumulated – production and service cost centers. Production cost centers are those actually involved in production, such as machining and assembling departments. Service cost centers are those which exist to facilitate production, for example, maintenance, stores and canteen.
The first stage in the allotment of the factory overheads costs to production costs centers is o collect and classifies factory overhead costs to production and service cost centers. Then it is apportioned the costs of the services cost centers to the production cost centers. If I assume that a firm has three service cost centers and two production cost centers, the apportionment of the service cost center costs involves selecting appropriate methods for apportioning these costs to the production cost centers. The accounting system of resource allocation am familiar with is activity based coating.
Activity based accounting system is an accounting system that is used in resource allocation to various activities in multinational manufacturing firms and is yet to adopted by small firms. The allocation of total general overhead by this system is allocated based on direct labor hours and machine hours in my organization. The activities of production for the company are allocated the total overhead using calculated overhead rates per hour of machine and labour. Then the figure obtained is multiplied per the number of hours each activity is using. The Labour and machine hours are taken as cost drivers for each activity.
This method has assisted the company reduce customer complains of over charging in prices. Activity based costing system of accounting considers a number of activities that takes place in various production units. It is considered the best method of allocating overhead within production unit. In my organization direct cost are those cost which are directly and easily costs that are attributable to production and indirect costs are those costs which arise during the existence of the business as whole. Indirect cost can not be attributed to any production unit it is only distributed various production units based on activity based system.
The underlying principles, conventions and objects of this method similar to other methods, but the application of those principle and the methods by which the objects are to be achieved must vary with circumstances. This does not mean, however, that the processes and procedures of a business must remain unaffected by the introduction of a system of cost accounts. This method of costing influences price because they affect supply. The lower the cost of producing a product relative to the price customers pays for it, the greater the quantity of a product the company is willing to supply.
Managers who understand the cost of producing their companies’ products set prices that make the products attractive to customers while maximizing their companies’ operating incomes. In computing the relevant costs for a pricing decision the manager must consider relevant costs in all value. This method is also used in assessing the performance of manager responsible for running production units independently. The best criteria according to my view are the one without the allocation of indirect costs. This is because of manager should be held responsible for the costs that is under their direct control.
They are free to make decisions that could increase or decrease the cost of operation of a unit. The efficiency and effectiveness of a manager should be judged from his ability to generate maximum revenue from operation and to keep the cost associated with this revenue at a minimum level. This will present a clearer picture to evaluate the performance of a manager of a unit. Although each unit produce certain amount of indirect costs but these cannot be directly attributed to the unit from which it had originated.
So the company devised a formula of allocating this cost to each unit based on unit’s revenue producing capability. However as said earlier, there is no set criterion to allocate indirect cost to different units and it varies from business to business. This allocation of indirect costs is discretionary and could create distortion in evaluating the performance of a manager. So in order to help manager accountable for results they are evaluated on the basis of operation under their direct control. Activity based costing considers a number of activities that takes place to allocate different types of costs unlike other methods.
Activity based costing method is considered the best way in overhead allocation and allotment within production units. It considers a variety of activities and it gives a more accurate answer as compared to other methods of allocation. Case Study It is the policy of Dealogic, LLC to give their managers a high level of independence to make decisions for which they are held accountable for the results. That means they are free to run their units as they like. They are responsible to generate maximum revenue from unit under their command and to restrict cost incurred during the year.
There are two type of costs generated at each unit. 1) Direct costs ( Traceable consulting costs) 2) Indirect costs (Non-Traceable consulting costs) Direct costs in this case is that cost which can be directly and easily attributed to revenue generating operations of the business and indirect cost is one which arise during the course of operations of the business but it is very difficult to attribute it specifically to a single unit. So whole of the indirect costs from all the units are combined and then allocated a fair portion of this cost to each unit based on some criteria.
In case of Dealogic, LLC, this criterion is based on revenue generation from each unit and indirect cost is then allocated to each unit depending upon the amount of revenue generated from each unit. This criterion varies from business to business. But the purpose is to allocate this indirect cost based on a criteria that has some direct relationship with this indirect costs. Conclusion The choice of one particular overhead rate as against the others may substantially affect the amount of overhead costs apportioned to a unit of product.
Consequently, variations in full- product costs may result simply from the manner in which the overhead rate is selected. The rate to use depends on the particular circumstances facing the firm. The ‘direct labor cost, base is easy to use since the necessary information is usually readily available. There may be no relationship, however between direct labor costs and overhead costs; indeed, most factory overhead costs are incurred on a time basis and are not related to the labor payroll. However Activity based Accounting is the most appropriate has it allocates accurately than the other methods. References
Atril, P. F. and McLaney, E. J. (2002). Management accounting for non-specialists, 3rd edn (financial times prentice Hall) pp. 102-108 Drury C; (2000); Management and cost Accounting;5th edition ,business press Thomson Learning78-85 Horngren, C. T. , Bhiman A. , foster G. , and Datar, S. M. (1999). Cost accountin: A managerial Emphasis, (prentice Hall Europe) pp. 135-160 Larson D, Kermit, Wild, J. john & Chippetta Barbara;(1996); fundamentals of accounting principle; London; Irwin. Wald J (2000) Biggs’s Cost accounting; The English Language Book Society and MacDonald and Evans Ltd London & Plymouth pp 98-136

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