Question

A client that has been allocating Overhead just based on Square Footage in the Plant and office. For example, if the purchasing department uses 100 square feet to a total of 1000 sq feet, they will get 10% of overhead allocated to the purchasing department. A recently added employee discussed ABC accounting for overhead allocation. My question is, what might be one advantage over all of the new work required? The costs do not change.

Answer 1

The biggest disadvantage of allocating overhead on the basis of traditional costing is that the allocation may be on some arbitrary basis, without direct cause-and-effect relationship between the cost and the cost center.This leads to distortion of cost information,i.e undercosting or overcosting of products and services. Poor cost information leads to poor pricing decisions, which might in turn lead to loss of market share, or loss of profitability of a product line.

The total overhead costs would definitely not change on the implementation of ABC system. But, since the allocation under the system is a two stage process ( Overhead costs are first allocated to activities on the basis of appropriate cost drivers, and then to the cost centers on the basis of volume of cost driver consumed), an attempt is made to directly trace the overhead costs to products and/or services. Therefore, much of the cost distortion is taken care of, and correct pricing decisions can be made. Therefore, it becomes worth the effort and the costs of implementation of an ABC system.

But an ABC accounting system would be worthwhile and cost effective only if there are multiple product lines, production processes are complex, demands on resources are diverse and the overhead costs are substantial. Otherwise, it is better to stick to the conventional method.