Question

1) Why is overhead allocation important?

2) Why do we need to compute overhead allocation using either the traditional method or ABC? In other words, why can't we just take our total overhead for the current period and divide it by the total number of units produced to get overhead per unit.

Answer 1

ans 1 )

The allocation of certain overhead costs to produced goods is required under the rules of various accounting frameworks. In many businesses, the amount of overhead to be allocated is substantially greater than the direct cost of goods, so the overhead allocation method can be of some importance.

There are two types of overhead, which are administrative overhead and manufacturing overhead. Administrative overhead includes those costs not involved in the development or production of goods or services, such as the costs of front office administration and sales; this is essentially all overhead that is not included in manufacturing overhead. Manufacturing overhead is all of the costs that a factory incurs, other than direct costs.

Overhead Allocation Examples

Mulligan Imports has a small golf shaft production line, which manufactures a titanium shaft and an aluminum shaft. Considerable machining is required for both shafts, so Mulligan concludes that it should allocate overhead to these products based on the total hours of machine time used. In May, production of the titanium shaft requires 5,400 hours of machine time, while the aluminum shaft needs 2,600 hours. Thus, 67.5% of the overhead cost pool is allocated to the titanium shafts and 32.5% to the aluminum shafts.

Three important reasons that managers allocate overhead costs to products are described in the following:

• Provide information for decision making. Setting prices for products is one example of a decision that must be made by management. Prices are often established based on the cost of products. It is not enough to simply include direct materials and direct labor. Overhead must be considered as well.
• Promote efficient use of resources. Several different activities are performed to produce a product, such as purchasing raw materials, setting up production machinery, inspecting the final product, and repairing defective products. All of these activities consume resources (consuming resources is another way of stating that a cost is associated with each of these activities). If products are charged for the use of these activities, managers will have an incentive to be efficient in utilizing the activities.
• Comply with U.S. Generally Accepted Accounting Principles (U.S. GAAP). U.S. GAAP requires that all manufacturing costs—direct materials, direct labor, and overhead—be assigned to products for inventory costing purposes. This requires the allocation of overhead costs to products.

ans 2)

Understanding Traditional Costing

Many manufacturing companies use the traditional costing system to assign manufacturing overhead to units produced. Users of the traditional costing method make the assumption that the volume metric is the underlying driver of manufacturing overhead cost. Under traditional costing, accountants assign manufacturing costs only to products. Traditional accounting fails to allocate nonmanufacturing costs that also are associated with the production of an item, such as administrative expenses. Companies commonly use traditional accounting in external financial reports because it provides a value for the cost of goods sold.

Pros and Cons of Traditional Costing

An advantage of using traditional-based costing is that it aligns with Generally Accepted Accounting Principles, or GAAP. Easy implementation for companies that provide one product also is a plus. However, traditional costing is an outdated costing system in many companies because those manufacturing companies now use machines and computers for much of their production. Computers and machines make the system outdated because it often uses direct labor hours to calculate cost. Cost is not appropriately assigned because direct labor hours is not the best cost driver to use. Traditional costing negates other cost drivers that may contribute to the cost of an item. Another disadvantage of solely using the traditional costing system is that it can lead to bad management decisions because it excludes certain nonmanufacturing costs.

Understanding Activity-Based Costing

Activity-based costing provides a more accurate view of product cost, but companies typically use it as a supplemental costing system. The allocation bases used in activity-based costing differ from those used in traditional costing. Activity-based costing determines every activity associated with producing an item and allocates a cost to the activity. The cost assigned to the activity is then assigned to products that require the activity for production.

Activity-based costing provides a more accurate view of product cost, but companies typically use it as a supplemental costing system. The allocation bases used in activity-based costing differ from those used in traditional costing. Activity-based costing determines every activity associated with producing an item and allocates a cost to the activity. The cost assigned to the activity is then assigned to products that require the activity for production.

Pros and Cons of Activity-Based Costing

Greater costing accuracy is the primary benefit of activity-based costing. Companies assign cost only to the products that require the activity for production. This method eliminates allocating irrelevant costs to a product. Other advantages of activity-based costing include an easy interpretation of cost for internal management, the ability to enable benchmarking and a greater understanding of overhead costs. Implementing an activity-based costing system within a company requires substantial resources. This can prove a disadvantage for companies with limited funds. Another disadvantage of using activity-based costing is that it is easily misinterpreted by some users.

this is the reason why we only use ABC or traditional method.