Question

Briefly discuss how the production department overhead costs should be allocated to products manufactured by the company.

Answer 1

Answer:- Overhead costs are allocated to products to provide information for internal decision making, to promote the efficient use of resources, and to comply with the U.S. Generally Accepted Accounting Principles.

Overhead allocation is the apportionment of indirect costs to produced goods. It is required under the rules of various accounting frameworks. In many businesses, the amount of overhead to be allocated is substantially greater than the direct cost of goods, so the overhead allocation method can be of some importance.

There are two types of overhead, which are administrative overhead and manufacturing overhead. Administrative overhead includes those costs not involved in the development or production of goods or services, such as the costs of front office administration and sales; this is essentially all overhead that is not included in manufacturing overhead. Manufacturing overhead is all of the costs that a factory incurs, other than direct costs.

The following items are usually included in manufacturing overhead:

Depreciation of factory equipment	Quality control and inspection
Factory administration expenses	Rent, facility, and equipment
Indirect labor and production supervisory wages	Repair expenses
Indirect materials and supplies	Rework labor, scrap, and spoilage
Maintenance, factory and production equipment	Taxes related to production assets
Officer salaries related to production	Uncapitalized tools and equipment
Production employees’ benefits	Utilities

Overhead costs are allocated to products by multiplying the predetermined overhead rate for each activity by the level of cost driver activity used by the product. The term applied overhead is often used to describe this process.

The departmental overhead rate is an expense rate calculated for each department in a factory production process. The departmental overhead rate is different at every stage of the production process when various departments perform selected steps to complete the final process.

Allocation:- The Complete distribution of an item of overhead to the departments or products on a logical or equitable basis is called allocation. Where a cost can be clearly identified with a cost center or cost unit, then it can be allocated to that particular cost center or unit. In other words, the allocation is the process by which cost items are charged directly to a cost unit or cost center. For example, electricity charges can be allocated to various departments if separate meters are installed, depreciation of machinery can be allocated to various departments as the machines can be identified, the salary of stores clerk can be allocated to stores department, cost of coal used in the boiler can be directly allocated to boiler house division. Thus the allocation is a direct process of identifying overheads to cost units or cost centers. So the term allocation means allotment of the whole item of cost to a particular cost center or cost object without any division.

Methods of Distribution

(a) Direct Distribution Method:- This method is based on the assumption that one service department does not give service to other service departments/s. Thus between service departments there is no reciprocal service exchange. Hence under this method, service costs are directly loaded on to the production departments. This is simple, but the assumption may not be correct. Can we say that the canteen service is not available to other service departments like the labor office or stores or maintenance department? This is incorrect and thus the method should not be used as far as possible.

(b) Step Distribution Method This method does away with the assumption made under the above method, but only partly. It recognizes that a service department may render service to the other service department, but does not receive service from it. In the above example, S1 may render services to S2 but not vice versa, i.e. S2 may not render service to S1. In such a situation, the cost of that service department will be distributed first which render services to the maximum number of other service departments. After this, the cost of the service department serving the next large number of departments is distributed. This process is continued until all service departments are over. Because it is done in steps, it is called a Step Method of Distribution.

(c) Reciprocal Service Method: This method takes cognizance of the fact that service departments may actually give as well as receive services from and to the other service departments on a reciprocal basis. Such an inter-departmental exchange of service is given due weight in the distribution of the overheads. There are two methods used for distribution under this logic. One is called the Repeated Distribution Method and the other Simultaneous Equation Method.

(d) Repeated Distribution Method: This is a continuous distribution of overhead costs over all departments. The decided ratios are used to distribute the costs of service departments to the production and other service departments. This is continued until the figures for service departments become ‘nil’ or ‘negligible’.

(e) Simultaneous Equations Method: Under this method, simultaneous equations are formed using the service departments’ share with each other. Solving the two equations will give the total cost of service departments after loading the interdepartmental exchange of services. These costs are then distributed among production departments in the given ratios.

(f) Trial and Error method:- This method is to be followed when the question of distribution of costs of service cost centers that are interlocked among them arises. In the first stage, the gross costs of services of service cost centers are determined. In the second stage cost of service, centers are apportioned to production cost centers.