Question

Why is it important that we allocate overhead costs to products? What might we use this information for? How do you think a company chooses an overhead allocation method?  

Answer 1

Overhead costs are indirect costs incurred in manufacturing a product which can't be directly allocated to the manufacturing process. Since, these costs form a major part of the income statement, they can't be ignored in calculating the overall profitability of the organization. Overhead costs are allocated to products to understand the net profitability after absorbing all costs.

We can use this information for the following:

• Decision making on most profitable & least profitable products
• Cost break-up for direct & indirect cost % of total cost
• Contribution margin vs Operating margin
• Fixed and variable cost segregation
• Cost optimization options to reduce indirect costs

A company chooses a cost allocation method based on the nature of expenses and it's underlying factors.

Key methods of allocating overhead costs are:

1. Direct Labour
2. Machine Time
3. Square Footage

For costs based on area covered such as rent, warehouse charges, painting charges, it's best to allocate based on the area of each department.

For costs based on number of units produced, it's best to allocate costs based on proportion of units produced by each department.

For costs based on headcount such as salary, costs are allocated based on the number of people required for supervision and maintenance of the concerned deprtments.