ALLOCATION OF OVERHEAD COSTS

Overhead costs are the ongoing business expenditure that is not directly caused by the creation of a product or service. It is important to allocate overhead costs because this helps in decision-making. Setting prices, for instance, requires the consideration of overhead costs. Prices are usually set depending on the cost of the product. Along with direct materials needed for production and direct labor, overhead also contributes to the cost of a product or service. Allocating overhead costs facilitates the effective use of resources. Many activities take place when producing a commodity. These activities include the purchase of raw materials, setting up machinery for production, repairing products that are deficient, and inspection (Lewis, 2013). The activities use resources; considering the overhead costs as part of the cost of production gives managers the incentive to be more effective when conducting the activities.

Further, allocating the overhead costs ensures uniformity of accounting procedures. This makes it easier to present public reports and work with other organizations (Lewis, 2013). The U.S. Generally Accepted Accounting Principles (U.S.U.S. GAAP) demands the manufacturing costs that include direct materials, overhead, and direct labor to be assigned to commodities for the purpose of creating inventory.

There are are different methods of calculating as well as assigning overhead costs to commodities. Job order costing is among the method of calculating overhead. The approach is best suited for a business that has different models of commodities. The method attributes overhead to a product depending on an overhead rate that is predetermined. The predetermined overhead is calculated at the start of the year. The accountant divides the total approximated overhead for that year by the allocation base that is identified by the company (Haroun, 2015).  The allocation base refers to the anticipated change and its relation to the overhead costs.

One of the main advantages of job order costing is the allowance it gives managers who want to understand the profits garnered from particular jobs. Through job costing, managers can calculate the profit generated from a certain job specification (Haroun, 2015). This helps the manager decide whether pursuing a particular job description benefits the company.

Another advantage of job order costing is the method's ability to illuminate team and individual performances with respect to cost control, productivity, and level of efficiency when completing company processes (Freedman, 2021). The main disadvantage of job order costing is the workload involved, as employees are required to keep track of all materials as well as labor when on the job. The workload can overwhelm the employees and impede their productivity.    

Process Costing is the second method. Process costing is ideal for companies that manufacture homogenous commodities. In process costing, overhead costs are attributed to products depending on the departments. For instance, a juice manufacturing company that has the departments of packaging, sorting, washing, and juicing can calculate overhead costs for each department. The company estimates the total expected overhead of a particular department and divides the value by a base figure suiting the department (Freedman, 2021). The main advantage of the process costing system is the relative ease of application when working with homogenous commodities. The cons of using the process costing method include the historical value of its outcomes since the outcomes can be obtained at the close of an accounting period. Also, the valuation of work in progress is usually done on an estimate basis; this increases inaccuracies in the total costs arrived at. In addition, a mistake when calculating the average cost can affect the valuation of the entire work in process and the finished products.

The third method is Activity-based Costing: In activity-based costing, companies initially determine activities that are necessary to produce a product. For every activity identified, companies approximate the capacity of overhead linked to that activity and assign costs to the products depending on the factors that drive the activity.  One key advantage of activity-based systems is the flexibility the method offers to small businesses who can apply overhead costs to their businesses at a granular standard (Haroun, 2015). Activity-based costing is also ideal for the service industry that has nearly non-existent direct costs. Activity-based systems further present relatively accurate product costs because the method acknowledges the impact of activities on costs.

Activity-based costing is more complex and costly compared to other overhead allocation methods because it can have several cost pools. The selection of drivers can be problematic when implementing an activity-based costing system. Identifying cost drivers, assigning common costs, and variation of the cost drivers can cause difficulties when implementing the activity-based approach.

Allocation of Overhead Costs. Outline

Importance of Overhead Costs

It is important to allocate overhead costs because this helps in decision making.

Allocating overhead costs facilitates effective use of resources.

Further, allocating the overhead costs ensures uniformity of accounting procedures.

Methods of Calculating overhead

Job order costing: Job order costing is among the method of calculating overhead, the approach is best suited for business that have different models of commodities.

            Advantages

• When using the job order costing approach, managers can calculate the profit generated from a certain job specification
• The Job costing approach illuminates team and individual performances with respect to cost control, productivity and level of efficiency when completing company processes

            Disadvantages

• High workload that impedes productivity

           

           

Process Costing: Process costing is ideal for companies that manufacture homogenous commodities. In process costing, overhead costs are attributed to products depending on the departments.

            Advantages

• Relative ease of application when working with homogenous commodities

            Disadvantages

• Outcomes have historical value
• Inaccuracies in the total costs arrived at
• Mistakes when calculating the average costs effect valuation of whole work process

Activity based costing: In activity-based costing, companies initially determine activities that are necessary to produce a product.

            Advantages

• • • Flexibility
    • Ideal for the service industry that has nearly non-existent direct costs
    • Relatively accurate product costs

            Disadvantages

• Complex and costly
• Difficulty when identifying cost drivers

References