Discussion for ACG610

Overhead costs are the indirect costs of a business operation. There are several methods of allocating resources to meet these costs. The most recent and advanced method is the ABC (Activity-Based Costing) one. In this paper, the ABC method will be discussed in comparison to other pre-existing costing methods.

Unit 1Overhead Allocation

The cost of overhead in many organizations is substantially higher than that of the direct costs, thus the accountants need to carefully evaluate the overhead allocation methods and decide which between the two is the best to apply. There are two main types of overhead: administrative and manufacturing (Hansen, Mowen & Hansen, 2006). Manufacturing overhead is incurred overall in the company, whereas administrative one is the costs devolved during the production and development of goods and services (Goektuerk, 2002). Administrative overhead is primarily not admissible in the manufacturing overhead category such as administration of the front office and sales.

Manufacturing overhead is only allocated to finished goods and those under processing, since the operations that result in overhead will only affect the production process and the finished goods. Items that are usually put under the manufacturing overhead are depreciation of production equipment, factory administration costs, supervision costs, indirect labor costs, repair expenses, inspection and quality control costs, rent and indirect supplies (Cokins & NetLibrary, 2001). Additionally, taxes related to production and maintenance costs can be included as well as un-capitalized tools and equipment, utilities, benefits of employees in production and salaries of personnel who are involved in production.

The procedure that is mostly applied in overhead allocation is to compound all manufacturing overhead into one pool and then use a particular activity measure when categorizing the overhead costs in inventory. Any measure can be used during overhead costs allocation as long as it is applied consistently to all periods of reporting (Drury, 2006). The number of machine hours used in production and the direct labor hours consumed are two common basis of overhead allocation. This amount of overhead charged per each unit is called the overhead rate.

In case that an allocation basis does not appear correct, the overhead can be split at the accountants’ discretion into two or even more pools of overhead costs and a different basis of allocation can be used. It is also allowed to have a standardized rate of overhead which can be used for several reporting periods based on the long-term objectives with respect to the amount of overhead which will be incurred and also to the number of product units that will be eventually produced (Cokins & NetLibrary, 2001). If a difference realized between the actual and the allocated overhead is not large, it can be expensed to the solid price of the goods.

When the amount is in material form, the difference is allocated to the inventory and the cost of sold goods (Cokins & NetLibrary, 2001). The steps of product costing are the following: identification of the cost object, direct costs that are associated with the cost object, and the overhead costs themselves; selection of the base of cost allocation to be used in assigning the cost object’s overhead, and finally, development of the overhead rate for allocation to the cost object per unit.

Unit 2: ABC Overhead Allocation

In ABC overhead allocation system cost pools are established for each level in the hierarchy of costs. The common costs used are unit, batch, product and facility level costs. There are costs that are difficult to place using this system such as management and the salaries of office staff. It is due to this reason that the ABC method is very commonly used in the manufacturing sector where it is easily applicable and highly efficient (Drury, 2007). The ABC method gives accurate information about the product cost since it breaks costs into a hierarchy instead of lumping them together like other methods. The process applied is quite straightforward.

The generally accepted principles in ABC overhead allocation are sometimes unable to refer to non-manufacturing costs, but the costs are posted as incurred ones. The system is, however, able to incorporate such costs into the inventory by factoring in salaries, insurance, marketing and advertising, benefits of personnel and other factors during the calculation of overhead. It also takes into account the volume of goods produced after the costs that are incurred as well as the labor and machine hours spent in the production process before the finished product is realized.

Unit 3: Overhead Allocation Systems

There are several methods used in the allocation of manufacturing overhead. It should be kept in mind that when the allocation method is not adequate in allocating the real amount of manufacturing overhead, the product cost per unit will be untrue and could potentially result in wrong decisions being made by the management (Leitner, 2007). In cases where there is no evident cause-effect relationship, one should evaluate any possible correlation between the basis of allocation and the manufacturing overhead, and if this still shows no relationship, then the method should be abandoned since it can give improper assignment of overhead amounts to products (Heisinger, 2008). During the calculation of the costs of production, both direct and indirect costs are included (Leitner, 2007). Good accounting considers all the costs and divides the total against the produced goods. This use of all the costs in production instead of only the direct costs could be the difference between a loss and a profit for an enterprise.

ABC (Activity-Based Costing) is a new method of overhead allocation which, according to each activity’s composition, assigns the cost of all activities with production resources to all the services and the output products in an organization (Wiese, 2009). It tends to assign more overhead (indirect costs) into direct costs when compared to other earlier methods of costing.

Unit 4

In predetermined overhead system of cost accounting, the stable factors for each item are determined and then multiplied by the sum of overhead costs (Hansen et al., 2006). This is a very crude method of overhead allocation, since the factors that affect the production process do not remain static over time (Baker, 1998). The inflexibility of this method also means that it cannot be adapted to meet new demands caused by changes within an organization’s structure.

Unit 5

In allocating overhead via direct labor costs, the labor hours are calculated and their costs are applied directly into the final products. This method is well applicable when the correlation is high between the amount of manufacturing overhead and the amount of labor used (Baker, 1998). This method is quite functional in industries where operations are not automated and there are little or no variations of the final products made (Hansen et al., 2006). The variation that came into being after this method became inadequate is the use of Departmental Machine Hours in overhead allocation (Lewis, 1995). In this method, the direct labor is replaced by machines. This was as a result of increased mechanization and automation of the production process. New factors of overhead came into play such as repair costs, depreciation of the machines, machine setup and other maintenance costs.

Conclusion

The various overhead allocation and accounting methods are used in calculating costs of products in businesses. The ABC method provides a means of counting the total inputs that go into the production process of goods and services. The advantage of this approach is that it takes into account all the factors of production and their overheads, and is applicable in a wide range of enterprises. The ABC system improves accuracy of information and managers working with it are able to come up with decisions from a well informed position.

References

Baker, J. J. (1998). Activity-based costing and activity-based management for health care. Gaithersburg, Md: Aspen.

Cokins, G., & Net Library, Inc. (2001). Activity-based cost management: An executive’s guide. New York: Wiley.

Drury, C. (2006). Management accounting for business. London: Thomson Learning.

Drury, C. (2007). Management and cost accounting. London: Thomson Learning.

Goektuerk, H. (2007). Activity-Based Costing (ABC) – advantages and disadvantages: How ABC can be applied to institutions of higher education. München: GRIN Verlag GmbH.

Hansen, D. R., Mowen, M. M., & Hansen, D. R. (2006). Managerial accounting. Mason, OH: Thomson/South-Western.

Heisinger, K. (2008). Introduction to managerial accounting. Boston, Mass: Houghton Mifflin.

Leitner, A. (2007). Activity Based Costing. München: GRIN Verlag GmbH.

Lewis, R. J. (1995). Activity-based models for cost management systems. Westport, Conn: Quorum Books.

Wiese, N. (2009). Activity-Based-Costing (ABC). München: GRIN Verlag GmbH.