Direct material and direct labor are easily traced to a product or service. Overhead, on the other hand, must be accumulated over a period and allocated to the products manufactured or services rendered during that time. Cost allocation refers to the assignment of an indirect cost to one or more cost objects using some reasonable basis. This post discusses: underlying reasons for cost allocation, use of predetermined overhead rates, separation of mixed costs into variable and fixed elements, and capacity measures that can be used to compute predetermined overhead rates.
Why Overhead Costs Are Allocated
Many accounting procedures are based on allocations. Cost allocations can be made over several time periods or within a single time period. For example: in financial accounting, a building’s cost is allocated through depreciation charges over its useful or service life. This process is necessary to fulfill the matching principle. In cost accounting, production overhead costs are allocated within a period through the use of predictors or cost drivers to products or services. This process reflects application of the cost principle, which requires that all production or acquisition costs attach to the units produced, services rendered, or units purchased.
Overhead costs are allocated to cost objects for three reasons:
(1) to determine a full cost of the cost object.
(2) to motivate the manager in charge of the cost object to manage it efficiently.
(3) to compare alternative courses of action for management planning, controlling, and decision making.
The first reason relates to financial statement valuations. Under generally accepted accounting principles (GAAP), “full cost” must include allocated production overhead. In contrast, the assignment of non-factory overhead costs to products is not normally allowed under GAAP. The other two reasons for overhead allocations are related to internal purposes and, thus, no hard-and-fast rules apply to the overhead allocation process.
Regardless of why overhead costs are allocated, the method and basis of the allocation process should be rational and systematic so that the resulting information is useful for product costing and managerial purposes. Traditionally, the information generated for satisfying the “full cost” objective was also used for the second and third objectives. However, because the first purpose is externally focused and the others are internally focused, different methods can be used to provide different costs for different needs.
Predetermined Overhead Rates
In an actual cost system, actual direct material and direct labor costs are accumulated in Work in Process Inventory as the costs are incurred. “Actual Production Overhead Costs“ are accumulated separately in an Overhead Control account and are assigned to Work in Process Inventory at the end of a period or at completion of production.
The use of an actual cost system is generally considered to be less than desirable because all production overhead information must be available before any cost allocation can be made to products or services. For example, the cost of products and services produced in May could not be calculated until the May electricity bill is received in June.
An alternative to an actual cost system is a “normal cost system“, which uses actual direct material and direct labor costs and a predetermined overhead (OH) rate or rates. A predetermined overhead rate (or overhead application rate) is a budgeted and constant charge per unit of activity that is used to assign overhead cost from an Overhead Control account to Work in Process Inventory for the period’s production or services.
Three primary reasons exist for using predetermined overhead rates in product costing:
First, a predetermined Overhead rate allows overhead to be assigned during the period to the goods produced or services rendered. Thus, a predetermined overhead rate improves the timeliness (though it reduces the precision) of information.
Second, predetermined overhead rates compensate for fluctuations in actual overhead costs that are unrelated to activity. Overhead may vary monthly because of seasonal or calendar factors. For example, factory utility costs may be highest in the summer. If monthly productions were constant and actual overhead were assigned to production, the increase in utilities would cause product cost per unit to be higher in the summer than in the rest of the year. If a company produced 3,000 units of its sole product in each of the months of April and July but utilities were $600 in April and $900 in July, then the average actual utilities cost per unit for April would be $0.20 ($600 : 3,000 units) and $0.30 ($900 : 3,000) in July. Although one such cost difference may not be significant, numerous differences of this type could cause a large distortion in unit cost.
Third, predetermined overhead rates overcome the problem of fluctuations in activity levels that have no impact on actual fixed overhead costs. Even if total production overhead were the same for each period, changes in activity would cause a per-unit change in cost because of the fixed cost element of overhead.
For Example: If a company incurred $600 utilities cost in each of October and November but produced 3,750 units of product in October and 3,000 units of product in November, its average actual unit cost for utilities would be $0.16 ($600 : 3,750 units) in October but $0.20 ($600 : 3,000 units) in November. Although one such overhead cost difference caused by fluctuation in production activity may not be significant, numerous differences of this type could cause a large distortion in unit cost. Use of an annual, predetermined overhead rate would overcome the variations demonstrated by the examples above through application of a uniform rate of overhead to all units produced throughout the year.
To calculate a predetermined OH rate, divide the total budgeted overhead cost at a specific activity level by the related activity level for a specific period:
Predetermined OH Rate = Total Budgeted OH Cost at a Specified Activity Level [divide] Volume of Specified Activity Level
Overhead cost and its related activity measure are typically budgeted for one year “unless the production/marketing cycle of the entity is such that the use of a longer or shorter period would clearly provide more useful information”.
For example: the use of a longer period would be appropriate in a company engaged in activities such as constructing ships, bridges, or high-rise office buildings.
A company should use an activity base that is logically related to overhead cost incurrence. The activity base that may first be considered is production volume, but this base is reasonable if the company manufactures only one type of product or renders only one type of service. If multiple products or services exist, a summation of production volumes cannot be made to determine “activity” because of the heterogeneous nature of the items.
To most effectively allocate overhead to heterogeneous products, a measure of activity must be determined that is common to all output. The activity base should be a cost driver that directly causes the incurrence of overhead costs. Direct labor hours and direct labor dollars have been commonly used measures of activity; however, the deficiencies caused by using these bases are becoming more apparent as companies become increasingly automated. Using direct labor to allocate overhead costs in automated plants results in extremely high overhead rates because the costs are applied over a smaller number of labor hours (or dollars).
In automated plants, machine hours may be more appropriate for allocating overhead than either direct labor base. Other traditional measures include number of purchase orders and product-related physical characteristics such as tons or gallons. Additionally, innovative new measures for overhead allocation include number or time of machine setups, number of parts, quantity of material handling time, and number of product defects.
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