Question

3. What are the three methods of allocation and what are the differences between them? Why might a company choose one method over another?

4. After allocation of overhead to a producing department, how are overhead costs tied to production?

Answer 1

3. Three methods of allocating overheads are

• Direct method
• Step method
• Reciprocal method

Direct method of overhead allocation is done without considering service rendered by one service department to another. It means cost is directly allocated to production department based on the ratio of services consumed.

Step method of overhead allocation allocates overhead in a sequence for all the departments. Usually service department which renders highest amount of service is allocated first and then next service department in a sequence

Reciprocal method of allocation considers the service rendered by service departments to each other. Hence it considers mutual allocation of overheads between service departments. It can solved through algebraic method or trial and error method

Summary

Method Consideration for Service department Direct method no allocation between service departments Step method Allocation to service departments in a sequence Reciprocal method Mutual allocation between service departments

Company might choose one method over the other if service rendered by department is significant and they want to give due consideration for the same in overhead allocation. If company does not want to allocate overheads between service department Direct method may be preferred else it may prefer Step method or Reciprocal method.

4. After allocation of overheads the production department uses its cost driver to calculate overhead cost per cost driver and then allocate to the products produced

The cost driver in production department can be machine hours or labor hours. Based on cost driver rate – labor hour rate or machine hour rate cost is allocated to products based on actual usage of labor hours or machine hours