Question

Mannon Company’s accountant exclaimed, “Our cost accounting system allocates overhead based on direct labour hours, but our overheads cost appear to be more related to setup activities than to the use of direct labour. It seems as though our costing system allocates too much cost to large batches of product and not enough cost to small batches. Explain what she means.

Answer 1

In the given case Company's accountant is trying to correct the inappropriate cost accounting system in her point of view.

Let me explain this with an example,

Let, Total overhead cost be 100

Large Batch product = 80 units

Small batch product = 20 units

Setup Activities for Large batch product = 80% and Small batch product = 20%

Use the direct labour, in Large batch product = 90% and small batch product = 10%

As per the current cost accounting system allocates overhead based on direct labour that means overhead is allocated as follows:- Direct labour = 90 : 10

Overhead for Large Batch product = 100 X 90% = 90

Overhead for Small Batch product = 100 X 10% = 10

But the problem is, in large batch product units are 80 but the overhead cost allocated is 90 which is higher than actually incurred. whereas in small batch product units are 20 but the overhead cost is only 10 which is very less

That is why accountant is suggesting allocation of overhead should be made on the basis of setup activities which is appropriate as per her, that is allocation will be :- Setup activities = 80:20

Overhead for Large Batch product = 100 X 80% = 80

Overhead for Small Batch product = 100 X 20% = 20

Here, in large batch product units are 80 and the overhead cost allocated is 80 which will be appropriate to actually incurred. whereas in small batch product units are 20 and the overhead cost is 20 which is correct.

This is what she means by the above statement.