Question

What are the difficulties in determining appropriate cost allocation of a firms overhead costs?

Answer 1

1.Traceability

Perhaps the biggest impediment to cost tracing is that some costs are inherently difficult to trace. For example, tracing the cost of lumber to a house being built isn't very difficult. The cost of all of the boards used in construction can be added together and the cost applied to the house. However, assigning the cost of a factory security worker's wages to an individual computer being manufactured is much more difficult. In this case, managerial accounting staff would likely allocate a portion of the security worker's salary to each computer. However, even that can become difficult if multiple products or types of products are being produced simultaneously.

2.Materiality

When looking at cost tracing and allocation, company owners need to determine how closely to allocate individual costs. With modern computer systems, it is often possible to track every cost down to the gram of glue or individual screw. However, the cost involved with this level of tracking often outweighs the benefit. This question of what extent to account for things is known as materiality to accountants. The idea is that pursuit of information is not costless. Therefore, accountants must decide what amount of information is optimal as it pertains to company profitability.

3.Time.The most urgent problem is time. Allocations take a lot of time for big complex organizations. This drags out the time for financial close, which is so critical for timely internal and external reporting.

4.Accuracy. Another big problem. Without Reciprocal Allocation and without sufficient flexibility, allocations are not as accurate as they should be.

5.Transparency. It is difficult to understand where allocations come from and how they are derived.