Overview of Allocation Bases
Most products need to go through various stages of production. Therefore, managerial accountants allocate costs to each product as it goes through the different processes. In the case of a custom-ordered car, costs will be added in the engine shop, transaxle shop, press shop, weld shop, paint shop, and trim chassis final shop. Direct material, direct labor, and overhead allocation costs can be added in each area, but it is not necessary to add each type of cost at each production stage.
The job cost sheet accumulates the direct costs during the production process. Direct labor is accounted for by recording employees' time to the job. Timekeeping can be done manually on a time sheet or through a computer program. In each case, both the time the employee worked and the job the employee worked on need to be recorded. The accountant adds the time and cost from the time sheet to the job cost sheet to calculate the total cost of the job. Direct materials are also accumulated using a similar process. For example, the paint shop would add the cost of the gallons of paint it used to the job cost sheet for a custom order.
Next, the accountant calculates manufacturing overhead costs and shows them on the job cost sheet. The allocation base, which is the standard unit that provides the system for the way overhead costs of a product or service are divided, determines how manufacturing overhead costs are accumulated for the specific product or job. In manufacturing, the most common way overhead costs are applied to a job is through the use of direct labor hours or direct labor dollars because those hours and dollars make up a high percentage of total costs. Allocation bases are often expressed in square footage or kilowatt-hours.Overhead application means assigning a fixed cost to a product based on a predetermined overhead rate or other calculation, such as actual costs. To do this, the accountant establishes a predetermined overhead rate, which is the estimated ratio established before an accounting period begins and used to allocate costs involved in producing goods or services. The accountant calculates it by dividing the estimated manufacturing overhead costs for the accounting period by the allocation base. To calculate this estimated amount, the accountant divides the estimated manufacturing fixed cost for the accounting period by the allocation base. A fixed cost is the amount in which the total spent for the period stays the same no matter how many sales were completed. The accountant could use another calculation instead, such as actual costs if they are available.
In the example of a custom car, managers selected direct labor hours as the allocation base. Then the accountant divided the total estimated manufacturing overhead costs by an estimation of direct labor hours to set the predetermined overhead rate. As the car moves from the engine shop to the transaxle shop, press shop, weld shop, paint shop, and trim chassis final shop, the accountant will allocate overhead costs based on the direct labor hours worked in that shop multiplied by the predetermined overhead rate.For example, if the predetermined overhead rate is set at $5 per hour and workers in the engine shop spent 3 hours working on the car, then the accountant would allocate $15 of overhead costs to the cost of the car as part of that process. The accountant would repeat this process in each department. These costs are considered part of the work in process (WIP) inventory, which is an asset account representing the costs in inventory that have not yet been completed as of the end of the accounting period.
Job Order Cost Flow
Explanation of Allocation Base Choices
In many cases, managers decide how to allocate costs to work in process (WIP) inventory. This includes differentiating between manufacturing overhead and sales and administrative costs.
Indirect manufacturing overhead costs are those that are not directly related to the product or job but that are necessary for manufacturing to occur. These costs can be allocated to the product or job and included in valuing work in process inventory. The salaries of production supervisors are an example of manufacturing overhead costs. Unlike with direct labor, it is difficult to say how many products a production supervisor helped make. However, without the production supervisors, assembly-line workers may not be able to complete any products.
In contrast to manufacturing overhead costs, sales and administrative costs are those related to marketing and management of the overall organization. These costs might include salaries for front-office staff and commissions for salespeople. Sales and administrative costs cannot be included in work in process inventory.
Managers determine how to apply manufacturing overhead costs to the product or job cost. Companies set predetermined overhead rates at the start of a fiscal year. Prices can range widely, so determining a rate based on annual expenses removes any possible seasonal fluctuations.
How companies determine what is manufacturing overhead versus what is a direct expense may differ depending on industry. For example, some companies treat testing and quality control as a separate production department. Normally this is done in industries that test each product before selling it. When companies do testing and quality control on a sampling basis, they typically consider it to be part of manufacturing overhead.
The selection of the allocation base is a management decision. The requirement of an allocation base is only that it is evident across all areas of production, making it a cost driver for all products. A cost driver is a factor that causes a company to spend money because it affects volume or activity levels or both. The most common allocation base selected for a manufacturing firm is direct labor hours.
Using direct labor as an allocation base does not mean using a specific type of direct labor. Instead, the company considers all direct labor hours or dollars in the calculation. For example, a company that produces custom cars would most likely consider labor that is directly tied to the car as direct labor for the allocation base. That labor would take place in the engine shop, transaxle shop, press shop, weld shop, paint shop, and trim chassis final shop. If direct labor did not happen in one of these departments, then the company could not use it as an allocation base. The cost driver needs to affect the cost of the product in all manufacturing areas for a company to select it as the allocation base.
Using direct labor as an allocation base works well for most manufacturers. However, managers can select an allocation base that best fits their operation. Managers should strive to find a strong relationship between the allocation base and the overhead cost when selecting a base for the predetermined overhead rate. For example, a university's physical plant department is responsible for keeping all areas of campus clean and free of hazards. That department might use square footage as its allocation base. In contrast, a training department might use the number of employees in each department as its allocation base. Still other companies use kilowatt-hours or machine hours.