methods of allocation

1. Traditional Allocation Methods (Plantwide and Departmental Rates) 🏭

These methods rely on a single predetermined overhead rate or departmental rates based on a single activity base.

a. Plantwide Overhead Rate

This is the simplest method where all manufacturing overhead costs for the entire factory are pooled together and allocated using a single, company-wide predetermined overhead rate. This rate is calculated by dividing total estimated overhead costs by an estimated total of a single, common allocation base (e.g., total direct labor hours, total machine hours).

• Example: If a company estimates total overhead to be ₹500,000 and total direct labor hours to be 25,000, the rate would be ₹20 per direct labor hour. Each product then gets allocated ₹20 for every direct labor hour it consumes.
• Suitability: Best for businesses that produce a single product or have a highly uniform production process where all products consume overhead resources in a similar proportion.
• Limitations: Can lead to inaccurate product costing if different products consume overheads disproportionately, or if departments have different cost drivers.

b. Departmental Overhead Rates

This method refines the plantwide approach by calculating separate predetermined overhead rates for each production department. This recognizes that different departments may have different cost structures and use different primary cost drivers.

• Process:

  1. Allocate/Apportion Overheads to Departments (Primary Distribution): Overheads are first assigned to various production and service departments.
     • Allocation: Directly assigning an overhead cost to a specific department if it's solely incurred for that department (e.g., depreciation of a machine used only in Department A).
     • Apportionment: Distributing common overheads among various departments using a suitable basis (e.g., factory rent based on square footage, electricity based on machine hours or meter readings).
  2. Reapportion Service Department Costs to Production Departments (Secondary Distribution): Costs accumulated in service departments (e.g., maintenance, power, HR) are then distributed to production departments, as only production departments directly contribute to the final product. Common methods for this reapportionment include:
     • Direct Method: Ignores any services provided between service departments; directly allocates service department costs only to production departments.
     • Step-Down Method (Sequential Method): Allocates service department costs in a sequence, usually starting with the service department that provides services to the most other departments, or has the largest costs. Once a department's costs are allocated, no costs are allocated back to it.
     • Reciprocal Method: Fully recognizes the mutual services provided among all service departments by using simultaneous equations or repeated distribution to allocate costs. This is the most accurate but also the most complex.
  3. Calculate Departmental Overhead Rates: Once all overheads (including re-apportioned service department costs) are accumulated in production departments, a separate predetermined overhead rate is calculated for each production department using a relevant activity base.

• Example: Department A might use machine hours as its base, while Department B, which is more labor-intensive, uses direct labor hours.

• Suitability: More accurate than the plantwide rate for companies with diverse production processes or where different departments use different resources (e.g., one department is machine-intensive, another is labor-intensive).

• Limitations: Still assumes that a single activity base within a department drives all its overheads, which may not always be true, especially in highly diversified departments.

2. Activity-Based Costing (ABC) 🔄

ABC is a more sophisticated and often more accurate method of overhead allocation. Instead of using broad allocation bases, ABC identifies specific activities that consume resources (and thus incur overhead costs) and then allocates those costs to products or services based on the extent to which they use those activities.

• Process:

  1. Identify Activities: Break down the production process into various activities (e.g., machine setup, quality inspection, material handling, purchasing, engineering design).

  2. Form Cost Pools: Group overhead costs into activity cost pools based on the identified activities.

  3. Identify Cost Drivers: For each activity cost pool, identify a cost driver – a factor that causes or drives the cost of that activity (e.g., number of setups for machine setup cost, number of inspections for quality inspection cost, number of material moves for material handling cost).

  4. Calculate Activity Rates: Calculate a predetermined overhead rate for each activity by dividing the total estimated cost in the activity cost pool by the estimated total quantity of the cost driver.

  5. Allocate Overheads to Products: Allocate overhead costs to products or services by multiplying the activity rate by the actual consumption of the cost driver by each product.

• Suitability: Ideal for companies with diverse product lines, complex production processes, and where overheads are a significant portion of total costs. It provides more accurate product costs, which helps in better pricing decisions, product mix decisions, and cost reduction efforts.
• Advantages:
  • More accurate product costing, especially for complex products or those produced in small batches.
  • Provides better insight into the true costs of activities, aiding in cost control and process improvement.
  • Helps in identifying non-value-added activities.
• Limitations:
  • More complex and costly to implement and maintain due to the need to identify numerous activities and cost drivers.
  • Data collection can be extensive.
  • Still relies on some level of estimation and judgment.

3. Other Specific Allocation Bases 📏

While often part of traditional or ABC methods, specific allocation bases are chosen based on the nature of the overhead cost and the activities that drive it. Some common bases include:

• Direct Labor Hours (DLH): Used when overhead costs are primarily driven by the amount of labor time (e.g., indirect labor supervision, fringe benefits). Suitable for labor-intensive industries.
• Direct Labor Cost (DLC): Similar to DLH, but uses the cost of direct labor. Often simpler if labor costs vary but hours don't.
• Machine Hours (MH): Used when overhead costs are primarily driven by machine usage (e.g., power, depreciation of machinery, maintenance). Suitable for highly mechanized industries.
• Direct Materials Cost: Used when overheads are closely related to the cost or volume of materials (e.g., material handling costs, purchasing department costs).
• Number of Units Produced: Simple, but only appropriate if all units consume overhead resources uniformly.
• Number of Employees: Can be used for HR-related overheads or canteen costs.
• Square Footage/Floor Area: Often used for facility-related costs like rent, utilities, and building maintenance.
• Number of Setups: For setup-related costs in a batch production environment.
• Number of Inspections: For quality control overheads.
• Number of Purchase Orders: For purchasing department overheads.

The selection of the most appropriate overhead allocation method depends on the industry, the nature of the business, the diversity of its products/services, the materiality of overhead costs, and the desired level of accuracy versus the cost of implementation.