Question

Explain the motivation for allocating factory overheads to goods; why do we bother?

Answer 1

Why is Factory overheads allocated to Goods?

Factory overheads, which is also known as Manufacturing overhead, burden, and indirect manufacturing costs, needs to be allocated to goods for the following reasons:

1. Some of the goods manufactured are not sold in the same period in which they were produced.
2. The goods not sold must be reported at their cost in the company's asset entitled Inventory.
3. Accounting principles require that each product's inventory cost include both direct and indirect manufacturing costs.
4. Indirect costs by definition mean they are not directly traceable to a product and will require an allocation.
5. Some companies set their products' selling prices based on their costs. In the long run, the products' selling prices must be large enough to cover all of a company's manufacturing costs (including the indirect manufacturing costs) plus the company's selling, general and administrative expenses and a profit for the company's owners.

However, in management point of view the three important reasons for allocating factory overheads to goods could be described as 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 labour. 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 labour, and overhead—be assigned to products for inventory costing purposes. This requires the allocation of overhead costs to products.

Coming to the point of major weakness or limitation of the aforesaid allocation, for why do we bother in allocating factory overheads to goods? The problems are:

(a). In Determining and calculating the factory overheads: Calculating manufacturing overhead is a little complex. We have to identify each factory expense that is indirect labour or another indirect expense. Then add up all the indirect costs to find the manufacturing overhead. Some examples of indirect labor are quality control personnel, equipment maintenance and repair workers and factory clerical staff. These labor costs include benefits and payroll taxes, not just wages or salaries. Other manufacturing overhead costs are depreciation of equipment and rent or depreciation of buildings. Expenses for utilities, general factory supplies and property taxes are also manufacturing overhead costs.

(b). In Accounting for factory overheads: It is also complex. GAAP standards call for manufacturing overhead to be added to the cost of materials and direct labour to determine the value of inventory and the cost of goods sold. Overhead must be included in the inventory valuation of work in progress as well as finished goods. Both inventory value and cost of goods sold must be reported on the firm’s balance sheet and income statement.

(c). In Allocating factory overheads: unit allocation is necessary to establish realistic figures for the cost of each unit manufactured – figures that are essential for setting process and determining if a product is generating enough revenue per unit to be profitable. Businesses can choose an allocation method for manufacturing overhead based on their particular circumstances. For example, if the manufacturing process is labour-intensive, a business can allocate manufacturing overhead in proportion to the number of labour hours required to produce one unit. In an industry that is highly automated and thus has relatively little direct labour cost, it may make more sense to allocate manufacturing overhead in proportion to machine hours per unit of production.