Question

Explain the three common methods of assigning overhead to the cost of a product. Be sure to discuss the advantages and disadvantages of each method. Which method do you feel is the best one to use and why. Give a specific type of product/production in your answer. " Managerial Accounting"

Answer 1

Three common methods of overhead allocation

1) Plantwide allocation

Plantwide allocation of overheads is based on estimated overheads at plant level and estimated total cost driver activities. Cost driver can be machine hour, labor hour or direct labor cost.

Advantages:

· Easy and simple to calculate the pre-determined overhead rate

· Applicable for firms having only one department

Disadvantages:

· Firms having multiple departments using plantwide allocation can lead to significant variations in product cost

· It is not recommended when there are multiple cost drivers for the overheads

2) Departmental allocation:

Departmental allocation of overheads is based on computing overhead rates for each department based on cost driver incurring cost. For example Department A can have machine hours as cost driver and department B can have labor hours as cost driver

Advantages:

· Useful for firms having multiple departments in product manufacture

· The product cost is fairly accurate and reflects the actual usages of resources in production

Disadvantages:

· This method does not give accurate cost allocation when there are multiple cost drivers for the overheads

3) Activity Based Costing

Activity based costing is an improved method of costing which allocates cost based on activities consumed by product rather than conventional methods like labor hours or machine hours

Advantages:

· It helps in accurate product costing and product pricing

· It helps in reliable decision making like continue or discontinue of products or services, bidding for jobs, product pricing, etc

· It helps in better cost management through cost control and cost reduction.

· It helps in analysing all the activities and elimination of non-value adding activity and thereby improving process efficiency.

Disadvantages:

· ABC costing method is time consuming since it needs identification of activities and calculating activity cost driver rates.

· Management needs to invest time and efforts in the implementation of ABC cositng

· ABC method is not useful if cost is more than benefits involved in implementing it.

· ABC method is not useful when there are no multiple cost drivers driving the costs of products or services.

Recommendation:

ABC method is recommended since it gives a competitive edge to the firm in product costing and product pricing. This method of overhead allocation is reliable and suggested for implementation.

The Product can be electronic items like laptops, computer, mobile phones, etc

The production involved is manufacturing activity.

The firm can allocate overheads based on activities consumed for each product like for example: machining cost allocated on machine hours, Production setup allocated on set up hours, inspection cost allocated on inspection hours, etc