Primary overhead cost allocation methods

1.1 Introduction

Definition: Primary methods of allocation of overhead cost are an overhead assigning method which is used when the overhead cost driver to be used as the basis for the allocation is clear.

1.2 Overhead Allotment (Allocation) Procedure

Overhead costs allotment is as good as allocation and it entails a long procedure that one has to follow which include;

1.2.1 Procedure 1: Collection of Overhead Data

This process entails gathering information to do with all indirect cost/overheads namely; indirect raw materials, indirect labor cost and indirect expenses. Accessibility or the sources of these costs are;

i). Costing and financial accounting database. For instance, the overhead costs to do with wages will be collected or accessed from wage analysis book, indirect raw materials (i.e., overheads) will be gotten from stores requisitions and factory rent will be accessible from financial ledger/books.

1.2.2 Procedure 2: Overhead Analysis

Overhead analysis is a procedure that entails using a data analysis sheet to charge overhead costs on a particular cost Centre. The cost Centre can either be a location, person such as an employee, item of equipment (or a group of those) in respect of which costs may be attached or affiliated to cost units. A good example of cost Centre is production department X which is a part of an enterprise. So, all overhead costs incurred or paid in relation to this department will be ascertained to it. There are two ways of ascertaining costs, one is allocation and two apportionments of overhead costs. Then the third procedure is absorption of overhead.

1.2.3 Procedure 3: Absorption of Overhead

Overhead absorption procedure is the process of charging the overhead costs specifically to the units produced. Such that after all overhead costs have been assigned to a particular production department, then overhead cost per unit (charging) is determined.

Classification of primary overhead cost allocation method

2.1 Introduction

Overhead allocation process from the aforementioned short discussion is dividend int to FIVE mainstream categories, namely;

2.1.1 Rate of Total Direct Job Costs.

2.1.2 Rate of Specific Direct Job Costs.

2.1.3 Proportion of Direct Costs.

2.1.4 Weighted Proportion of Direct Costs.

2.1.5 Combination allocation method.

Advantages of primary overhead allocation methods

1). Simple to use

The method is simple to use for it may only involve one product or department or departments of production nature.

2). The allocation base is clearly identifiable

Unlike the apportionment approach, the base used for allocating the overhead costs are well known without struggling. This helps in appropriate assigning of the overhead costs to the right products or and departments.

3). Objective

Since the method is direct and well-articulated, there is no ambiguity in applying it and so no one can forge the outcome by using human interferences. Hence cases of human biasness are eliminated.

4). Cause-Effect approach model is applicable

Since the base used is on the criteria of the influence of the cost driver, there is low chances of doing the wrong matching. Hence no cases of misplaced costs in different departments which may result in to over or under absorb the overhead costs.

5). Applicable in large organizations.

The primary overhead cost distribution methods is applicable in large organizations for the production and non-production departments are well and distinctly differentiated. This aids in easy absorption of those costs.

Disadvantages of primary overhead allocation methods

1). Inappropriate for small businesses

Small businesses are not well structured and so the methods may not be applicable even if they exist.

2). Not fully reliable where there are service departments

Where the organization has both production and service departments where there are inter-service cost transfers, the method may not work on its own. Other methods become inevitable.

3). Misleading

The outcome may be misleading especially where wrong computations have been used. For example, a wrong expression of overhead absorption rate.

About the Author - Dr Geoffrey Mbuva(PhD-Finance) is a lecturer of Finance and Accountancy at Kenyatta University, Kenya. He is an enthusiast of teaching and making accounting & research tutorials for his readers.