Common Allocation Bases For Factory Overhead Costs Are

Common Allocation Bases for Factory Overhead Costs Are… A Deep Dive

Allocating factory overhead costs accurately is crucial for effective cost management and accurate pricing decisions in manufacturing. Understanding the various allocation bases available is key to selecting the method that best reflects the consumption of overhead resources by different products or departments. This article delves into the common allocation bases used, their strengths, weaknesses, and considerations for selection.

What are Factory Overhead Costs?

Before diving into allocation bases, let's define factory overhead. Factory overhead, also known as manufacturing overhead, encompasses all indirect costs associated with the production process. These costs are not directly traceable to a specific product but are necessary for its production. Examples include:

• Indirect Labor: Salaries of supervisors, maintenance personnel, and quality control inspectors.
• Factory Rent: Cost of renting or owning the factory building.
• Utilities: Electricity, gas, and water used in the factory.
• Depreciation: Depreciation of factory equipment and machinery.
• Factory Supplies: Consumables like lubricants, cleaning supplies, and small tools.
• Insurance: Insurance premiums for factory buildings and equipment.
• Property Taxes: Taxes levied on the factory property.

Why Allocate Factory Overhead Costs?

Accurate allocation of factory overhead is essential for several reasons:

• Product Costing: Determining the true cost of manufacturing a product requires including overhead costs. This information is vital for pricing decisions, profitability analysis, and inventory valuation.
• Performance Evaluation: Tracking overhead costs allocated to different departments or production lines helps in identifying areas for improvement and cost reduction.
• Decision Making: Accurate cost data enables informed decisions regarding product mix, capacity planning, and investment in new equipment.
• Inventory Management: Proper allocation ensures that inventory values reflect the true cost of goods produced, impacting financial statements.

Common Allocation Bases for Factory Overhead Costs

The choice of allocation base significantly influences the accuracy and fairness of cost allocation. The ideal base should have a strong correlation with the consumption of overhead resources. Here's a breakdown of common allocation bases:

1. Direct Labor Hours (DLH)

Definition: This method allocates overhead costs based on the number of direct labor hours worked on a product or in a department.

Strengths:

• Simplicity: Easy to understand and implement.
• Widely Used: A common and well-established method.

Weaknesses:

• Automation Bias: Underestimates overhead costs for automated processes with low labor hours but high machine usage.
• Skill Level Differences: Doesn't account for differences in skill levels among workers; highly skilled labor might not consume overhead proportionally to hours worked.
• Labor-Intensive Focus: May not be appropriate for highly automated industries.

2. Direct Labor Cost (DLC)

Definition: This method allocates overhead based on the total cost of direct labor, rather than just the hours worked.

Strengths:

• Considers Skill Levels: Addresses the skill level issue present in the DLH method by incorporating wages. Higher-skilled, higher-paid labor might consume more overhead due to the complexity of their tasks.
• Simpler than Machine Hours: Relatively easier to track than machine hours, particularly in less automated factories.

Weaknesses:

• Still Labor-Focused: Similar to DLH, this method remains biased towards labor-intensive processes and may underestimate overhead costs in automated factories.
• Wage Inflation Impact: Overhead rates can fluctuate significantly with changes in labor wages, making cost estimations less stable.

3. Machine Hours (MH)

Definition: This method allocates overhead costs based on the number of machine hours used in production.

Strengths:

• Suitable for Automated Processes: A much better choice for automated factories where machine usage is a primary driver of overhead costs.
• Accurate Reflection of Overhead: Provides a more accurate allocation for processes heavily reliant on machinery.

Weaknesses:

• Data Collection Challenges: Tracking machine hours requires robust systems and can be more complex than tracking labor hours.
• Multiple Machines: Difficult to apply when multiple machines with varying overhead consumption are used.
• Machine Idle Time: Doesn't account for idle machine time, potentially overestimating overhead costs for less efficient production lines.

4. Direct Material Cost (DMC)

Definition: This method allocates overhead based on the cost of direct materials used in production.

Strengths:

• Simple and Widely Used: Similar to labor-based methods, it's straightforward to calculate and widely understood.
• Relevant for Material-Intensive Processes: Appropriate for industries where the cost of raw materials is a significant portion of total product cost.

Weaknesses:

• Inaccurate for Some Industries: May not accurately reflect overhead consumption in industries where direct materials cost is less relevant to overhead usage.
• Price Fluctuations: Subject to fluctuations in raw material prices, influencing the accuracy of overhead allocation.

5. Number of Units Produced

Definition: This method allocates overhead based on the total number of units produced.

Strengths:

• Simplicity: Very easy to calculate and understand.
• Suitable for Standardized Products: Works well for production environments with standardized products and consistent processes.

Weaknesses:

• Ignores Resource Consumption: Completely ignores differences in resource consumption between units, leading to inaccurate cost allocation.
• Low Accuracy for Diverse Products: Produces inaccurate results when diverse product lines with varying resource demands are produced.

6. Plantwide Overhead Rate vs. Departmental Overhead Rates

Beyond choosing an allocation base, businesses must also decide on the level of allocation. A plantwide overhead rate uses a single allocation base and rate for the entire factory. This is the simplest approach but can be inaccurate if different departments consume overhead resources disproportionately. Departmental overhead rates, on the other hand, use different allocation bases and rates for each department, leading to more accurate cost allocation but increased complexity.

Choosing the Right Allocation Base

The selection of the appropriate allocation base depends on several factors:

• Industry: The nature of the industry and its production processes significantly influence the choice of allocation base. Highly automated industries might favor machine hours, while labor-intensive industries may prefer direct labor hours or cost.
• Cost Structure: The relative importance of different cost components (direct labor, materials, machine use) impacts the choice.
• Product Complexity: The complexity and variety of products being manufactured influence the accuracy and suitability of different methods.
• Data Availability: The ease of collecting and tracking data for different allocation bases should also be considered. Some methods might require significant investment in data tracking systems.
• Accuracy Requirements: The level of accuracy required for cost allocation will determine whether a simple plantwide rate or more complex departmental rates are appropriate.

Addressing Limitations and Improving Accuracy

While the common allocation bases provide a reasonable approach to cost allocation, they have inherent limitations. To improve accuracy, consider these strategies:

• Activity-Based Costing (ABC): ABC is a more sophisticated method that allocates overhead based on activities performed, rather than simply using a single allocation base. This offers a more accurate reflection of resource consumption.
• Refinement of Allocation Bases: Using multiple allocation bases or combining them can improve accuracy. For instance, a weighted average of DLH and MH could provide a more balanced allocation in some cases.
• Regular Review and Adjustment: Overhead allocation methods should be regularly reviewed and adjusted to reflect changes in the production process, technology, and cost structure.

Conclusion

The selection of an appropriate allocation base for factory overhead costs is crucial for accurate product costing, performance evaluation, and informed decision-making. While simple methods like direct labor hours or direct material cost are widely used, they might not accurately reflect overhead consumption in all scenarios. More sophisticated methods like machine hours or activity-based costing should be considered when greater accuracy is needed. Careful consideration of the specific industry, cost structure, product complexity, and data availability will guide the selection of the most appropriate allocation base for optimal cost management and business success. Remember, the goal isn't just to allocate costs, but to do so in a manner that accurately reflects resource consumption and provides valuable insights for strategic decision-making. Continuous monitoring and adjustments ensure the chosen method remains relevant and effective.