Question

Write a 2-page paper describing the importance to decision making of proper overhead allocation. Discuss the various methods available to accountants to allocate overhead to products and services. Include the limitations of these methods as well as the pros and cons for each method.

Answer 1

Solution:-

1. Describing the importance to decision making of proper overhead allocation:-

Allocating manufacturing overhead directly impacts your small business’s balance sheet and income statement. You have those expenses no matter what, and your accounting system requires you to keep track of them. Many accounting systems require you to allocate the costs to the goods you produce. By understanding how to assign those costs in a responsible and reasonable manner, you ensure your records are accurate and not distorted.

Beyond accounting requirements, allocating overhead helps you make decisions for your company, especially pricing. If you base your product pricing only on the direct costs, you cut into your profits. You still need to pay for all of those normal overhead costs. That means you have less left over from each product sale. By incorporating indirect costs into pricing, you can increase the pricing to cover them effectively without slashing your profits. Allocating overhead can also help you look for ways to cut your costs. It can be a motivator for different departments to improve the efficiency of their products to reduce overhead costs.

One of the main purposes for allocating costs is to provide information for decision making. Knowing what department or product is taking a greater proportion of funds is important for weighing alternatives in both the short and long run. Cost allocation is an important planning tool for reducing costs and increasing profits. It can also be a cost motivator, giving managers incentives for making sure that costs are not accumulated carelessly. Managers will be more likely to operate their departments with greater efficiently.

Let's look at BOA Fruits and how it uses cost allocation for decision making. Before the fiscal year ends, BOA Fruits has to make decisions about where we are going to distribute our produce for the next year.

A cost allocation tells us two important things. First, our costs for producing bananas has been reduced due to a new type of banana plant that extends how long a banana will stay ripe. Second, our fruit stand doubled its sales from the previous year.

We decide to double the size of the fruit stand and double the number of bananas produced. This is an example of how cost allocation is vital for explaining growth options for BOA Fruits.

2. Discuss the various methods available to accountants to allocate overhead to products and services. Include the limitations of these methods as well as the pros and cons for each method.:-

Small businesses that manufacture products are required to account for all of the costs of production. One of these costs, overhead, is the cost of production that cannot be individually traced to products. For small-business owners, overhead costs can represent a large portion of total product costs. Understanding some of the major methods for calculating and assigning overhead costs to products can help you choose the right method for your company.

Job-order Costing

Small businesses that manufacture more than a few models of goods usually use job-order costing. This costing method assigns overhead costs to products based upon a predetermined overhead rate. Company management calculates this rate at the beginning of the year by dividing the total estimated overhead costs for the year by an allocation base chosen by the company. An allocation base is a measure of activity that is expected to change in relation to overhead. For example, a company that makes a product that is labor-intensive would expect to incur more overhead costs as labor costs rise. In this case, management may choose to use direct labor cost as the allocation base, because direct labor cost considers the cost of the employee who's operating the machinery.

Pros and Cons of Job Order Costing

One advantage of job order costing is that it allows managers to calculate the profit earned on individual jobs, helping them to better ascertain whether specific jobs are desirable to pursue in the future. This is best for businesses that do highly custom work, such as construction contractors and consultants.

Job order costing also gives managers the advantage of being able to keep track of individuals' and teams' performance in terms of cost-control, efficiency and productivity.

A disadvantage of job order costing is that employees are required to track all materials and labor used during the job. As an example, consider a construction contractor using a job order costing system. The contractor has to keep track of all the wood, nails, screws, electrical fixtures, paint and other materials used on the job, as well as tracking workers' lunch breaks and hours worked.

Process Costing

Companies that make one homogenous product, such as orange juice or gasoline, tend to use process costing to assign overhead costs to products. Under this system, overhead costs are assigned to products based upon processing departments. For example, a juice company might have four processing departments: sorting, washing, juicing and packaging. In each department, the company would estimate the total overhead expected for the year in that department and then divide this amount by an allocation base suitable for that department. If sorting was done by machine, we would expect an allocation base such as machine hours to be used for sorting. However, if packaging is done by hand, we would expect a labor-based measure in the packaging department. This method allows for the most suitable allocation base to be used during each part of the manufacturing process.

Pros and Cons of Process Order Costing

Process costing simplifies record keeping by relying on statistical calculations rather than actual inputs. Another advantage of process costing is that it allows managers to get detailed information on the production statistics of individual departments or work groups. This is best suited for continuous manufacturing settings, such as factories and utility companies.

In a factory setting, for instance, materials are calculated using an average of units produced, and salaries expenses are often relatively consistent between pay periods. Process costing in this scenario gives managers the advantage of being able to ascertain the same qualities in entire departments and compare performance over time.

Activity-based Costing

While activity-based costing, or ABC, is not suitable for external reporting, small-business owners may find that accounting for overhead under an activity-based approach can provide better information for making production decisions. Under activity-based costing, managers first determine the activities that go into producing a product. For example, a trophy manufacturer might have product design, batch setup, production, packaging and customer support activities. For each activity, the company estimates the amount of overhead related to the activity and assigns these costs to products based upon what drives the activity. In our trophy manufacturer, we can imagine that a certain type of trophy would only incur product design costs once, but each batch of these trophies will incur a batch setup charge and each individual trophy will need to be packaged. Activity-based costing systems provide small-business owners flexibility in being able to apply overhead costs to products at a granular level.

Advantages

The major advantage of activity based costing is the ability to estimate the cost of individual products and services precisely. By transferring overhead costs to individual units of products or services, ABC helps identify inefficient or non-profitable products or activities that eat into the profitability of efficient processes or highly profitable products.

Disadvantages and Limitations

The major disadvantage of activity based costing is that although activity based costing is a scientific approach, the method of implementation is complex, time consuming, and costly. The process of data collection and data entry requires substantial resources, and remains costly to maintain

ABC reports do not conform to generally accepted accounting principles (GAAP), and as such, firms following ABC need to maintain two cost systems and accounting books, one for internal use and another for external reports, filings, and statutory compliance. This is a cumbersome duplication of efforts.

A primary disadvantage of ABC is that it is not possible to divide some overhead costs such as the chief executive's salary on a per-product usage basis. Similarly, employees rarely devote 100% of their working hours to productive activities, and not all productive activities add value to the product or process of the firm. For instance, the ABC method fails to account for the time employee takes part in a first aid awareness campaign, leading to substantial ‘cost leaks.’ There is no meaningful way to assign such 'business sustaining' costs to products on a proportionate basis, and products and services share such costs equally.

Finally, too much attention to detail and control might obscure the bigger picture or make the firm lose sight of strategic objectives in a quest for small savings, making the firm “penny wise and pound foolish.” For instance, ABC might identify one distribution channel as non-remunerative, or an inspection as non-value adding. Such channeling or processes might be non-profitable, but placed in the first place to achieve some other strategic objectives.

Variable Costing

Variable costing techniques, which are not appropriate for external financial reporting, allow managers to remove the effects of changing production levels on net income to make better decisions about the profitability of their company. Under job-order costing and process costing, all overhead costs are included as costs of production. However, changing production levels can distort the amount assigned to each individual item produced. For example, if a company were to produce one widget in a month and the company's rent was $1,000, the widget would be assigned $1,000 of rent expense as a cost of production. However, if the company produced 1,000 widgets in that month, each widget would only be assigned $1 of expense. In both cases, the rent expense is the same, but the product cost is wildly different. Variable costing does not assign these fixed overhead costs to products and does not have the same cost distortion.

Advantages

1. Variable costing provides a better understanding of the effect of fixed costs on the net profits because total fixed cost for the period is shown on the income statement.
2. Various methods of controlling costs such as standard costing system and flexible budgets have close relation with the variable costing system. Understanding variable costing system makes the use of those methods easy.
3. Companies using variable costing system prepare income statement in contribution margin format that provides necessary information for cost volume profit (CVP) analysis. This data cannot be directly obtained from a traditional income statement prepared under absorption costing system.
4. The net operating income figure produced by variable costing is usually close to the flow of cash. It is useful for businesses with a problem of cash flows.
5. Under absorption costing system, income of different periods changes with the change of inventory levels. Sometime income and sales move in opposite directions. But it does not happen under variable costing.

Disadvantages

1. Financial statements prepared under variable costing method do not conform to generally accepted accounting principles (GAAP). The auditors may refuse to accept them.
2. Tax laws of various countries require the use of absorption costing.
3. Variable costing does not assign fixed cost to units of products. So the production costs cannot be truly matched with revenues.
4. Absorption costing is usually the base for evaluating top executive’s efficiency.

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