Question

Why aren’t actual manufacturing overhead costs traced to jobs just as direct materials and direct labor costs are? Accountants are generally rather exact ( after all, all debris have to equal credits) but there is a lot of estimating involved in overhead application. Should this overhead application process be reconsidered? Should be around 200-250 words.

Answer 1

Direct material costs and direct labor costs are traceable to units of production and hence can be assigned to jobs or products with exactness. In contrast overhead costs (indirect manufacturing costs) are not traceable to units of products or services and hence cannot be assigned with exactness. But, as they are product costs, they need to be assigned to the different products or services.

The traditional system of allocation, is to first assign the overheads to different production departments.

Where any item of overhead cost is traceable directly to any of the departments, it is assigned to that department alone. For common costs, some basis is adopted for each item of overhead, which is, then assigned to the different departments. Once the total overheads of each department are ascertained, a suitable base is used to assign each of the departmental overheads to the various products. The basis used can be direct material cost, direct labor hours or direct labor cost, machine hours etc.

The shortcoming of such an allocation of overhead is that the departments are broad cost pools and the work done in them may comprise of different activities. Each product passing through a particular department may be getting processed by these activities differently. Hence, using departmental overhead rates will not lead to reasonable allocation of the resources consumed by the different products.

In this context, a more refined system of assigning OH costs would be the Activity based costing system under which, the overhead costs are at first assigned to activities instead of to departments and then assigned to products. When this is done, there would be more number of cost pools as each department would comprise of more than one activity.

The overhead of each activity is then assigned to the products based on an activity cost driver (base). As more number of cost pools are used, it would result in a more rational allocation of overheads than under the traditional cost allocation.