Question

Why is it important that we establish pools of indirect costs – namely, those that cannot be directly associated with a unit or batch of product, like direct material and direct labor – and allocate them to products to achieve a total cost? How is this useful for estimating how much something could be made/sold for and for evaluating profitability of products / divisions? What are some options for doing this and criteria to be utilized in selecting the best methods?

Answer 1

It is important to establish pools of indirect costs as it helps in the eventual process of charging the indirect costs to the benefiting objectives through an allocation process. Establishing pools of indirect costs is necessary as indirect costs are not readily identified with a specific project or organizational activity and hence establishing pools of indirect costs will help in the allocation process and in the determination of indirect cost rates.

This is important for estimating how much something could be made/sold for and for evaluating profitability of products / divisions as the indirect costs (also known as overheads) have to be allocated to the cost object. For this allocation it is necessary to identify the overhead costs associated with the production of the object. This becomes easy when there are defined pools of indirect costs.

There are several ways in which it can be done. Usually a logical grouping is done of indirect costs that have similar relationships to the cost objectives. For example there can be a pool called the engineering overhead pool and this pool will include all indirect costs that are associated with an engineering effort. We then determine the indirect cost rate using the formula: Indirect cost rate = Indirect cost pool/Indirect cost allocation base. The criteria that is utilized in selecting the best methods is that the pool should allow allocation of the included indirect costs in such a manner that is similar to the allocation that would have occurred if the company allocated each indirect costs in a separate manner.