What are the three common approaches for assigning overhead costs to products?

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Job costing assigns overhead costs to a job based upon a predetermined rate, which is calculated as a ratio of total overhead (or a specific pool of overhead) to a specific type of activity (allocation base). 

Process costing requires assigning a percentage of overhead to the types of products produced by a given department. 

There are several approaches to determine the percentage of overhead to attribute to a particular product. 

Companies allocate overhead costs using either:  

• plantwide rate, 
• department rates, or 
• activity-based costing.

Regardless of the approach used to allocate overhead, a predetermined overhead rate is established for each cost pool.

What is a Cost Pool?

Groups of overhead costs are called cost pools. 

The plantwide allocation approach uses one cost pool to collect and apply overhead costs and therefore uses one predetermined overhead rate for the entire company. 

The department allocation approach uses several cost pools (one for each department) and therefore uses several predetermined overhead rates.

The activity-based costing approach uses several cost pools (one for each major activity) and therefore uses several predetermined overhead rates.

The choice of an allocation method depends on how managers decide to group overhead costs and the desired accuracy of product cost information. 

In general, the more cost pools used, the more accurate the allocation process.

Why Allocate Overhead Costs?

Three important reasons that managers allocate overhead costs to products are described in the following:

Provide information for decision making. Setting prices for products is one example of a decision that must be made by management. Prices are often established based on the cost of products. It is not enough to simply include direct materials and direct labor. Overhead must be considered as well.

Promote efficient use of resources. Several different activities are performed to produce a product, such as purchasing raw materials, setting up production machinery, inspecting the final product, and repairing defective products. All of these activities consume resources (consuming resources is another way of stating that a cost is associated with each of these activities). If products are charged for the use of these activities, managers will have an incentive to be efficient in utilizing the activities.

Comply with U.S. Generally Accepted Accounting Principles (U.S. GAAP). U.S. GAAP requires that all manufacturing costs—direct materials, direct labor, and overhead—be assigned to products for inventory costing purposes. This requires the allocation of overhead costs to products.

Question: Managers at companies such as Hewlett-Packard often look for better ways to figure out the cost of their products. When Hewlett-Packard produces printers, the company has three possible methods that can be used to allocate overhead costs to products—plantwide allocation, department allocation, and activity-based allocation (called activity-based costing). How do managers decide which allocation method to use?

Answer: The choice of an allocation method depends on how managers decide to group overhead costs and the desired accuracy of product cost information. Groups of overhead costs are called cost poolsA collection of overhead costs, typically organized by department or activity.. For example, Hewlett Packard’s printer production division may choose to collect all factory overhead costs in one cost pool and allocate those costs from the cost pool to each product using one predetermined overhead rate. Or Hewlett Packard may choose to have several cost pools (perhaps for each department, such as assembly, packaging, and quality control) and allocate overhead costs from each department cost pool to products using a separate predetermined overhead rate for each department. In general, the more cost pools used, the more accurate the allocation process.

Department Allocation

Question: Assume the managers at SailRite Company prefer a more accurate approach to allocating overhead costs to its two products. As a result, they are considering using the department allocation approach. How would SailRite form cost pools for the department allocation approach?

Answer: The department allocationA method of allocating costs that uses a separate cost pool, and therefore a separate predetermined overhead rate, for each department. approach is similar to the plantwide approach except that cost pools are formed for each department rather than for the entire plant, and a separate predetermined overhead rate is established for each department. Remember, total estimated overhead costs will not change. Instead, they will be broken out into various department cost pools. This approach allows for the use of different allocation bases for different departments depending on what drives overhead costs for each department. For example, the Hull Fabrication department at SailRite Company may find that overhead costs are driven more by the use of machinery than by labor, and therefore decides to use machine hours as the allocation base. The Assembly department may find that overhead costs are driven more by labor activity than by machine use and therefore decides to use labor hours or labor costs as the allocation base.

Assume that SailRite is considering using the department approach rather than the plantwide approach for allocating overhead. The cost pool in the Hull Fabrication department is estimated to be $3,000,000 for the year, and the cost pool in the Assembly department is estimated at $5,000,000. Note that total estimated overhead cost is still $8,000,000 (= $3,000,000 + $5,000,000). Machine hours (estimated at 60,000 hours) will be used as the allocation base for Hull Fabrication, and direct labor hours (estimated at 217,000 hours) will be used as the allocation base for Assembly. Thus two rates are used to allocate overhead (rounded to the nearest dollar) as follows:

1. Hull Fabrication department rate: $50 per machine hour (= $3,000,000 ÷ 60,000 hours)
2. Assembly department rate: $23 per direct labor hour (= $5,000,000 ÷ 217,000 hours)

As shown in , products going through the Hull Fabrication department are charged $50 in overhead costs for each machine hour used. Products going through the Assembly department are charged $23 in overhead costs for each direct labor hour used.

Figure 3.3 Using Department Rates to Allocate SailRite Company’s Overhead

The department allocation approach allows cost pools to be formed for each department and provides for flexibility in the selection of an allocation base. Although shows just two rates, many companies have more than two departments and therefore more than two rates. Organizations that use this approach tend to have simple operations within each department but different activities across departments. One department may use machinery, while another department may use labor, as is the case with SailRite’s two departments. This approach typically provides more accurate cost information than simply using one plantwide rate but still relies on the assumption that overhead costs are driven by direct labor hours, direct labor costs, or machine hours. This assumption of a causal relationship is increasingly less realistic as production processes become more complex.

The plantwide and department allocation methods are “traditional” approaches because both typically use direct labor hours, direct labor costs, or machine hours as the allocation base, and both were used prior to the creation of activity-based costing in the 1980s.

Key Takeaway

• Regardless of the approach used to allocate overhead, a predetermined overhead rate is established for each cost pool. The plantwide allocation approach uses one cost pool to collect and apply overhead costs and therefore uses one predetermined overhead rate for the entire company. The department allocation approach uses several cost pools (one for each department) and therefore uses several predetermined overhead rates.

Review Problem 3.2

Kline Company expects to incur $800,000 in overhead costs this coming year—$200,000 in the Cut and Polish department and $600,000 in the Quality Control department. Total annual direct labor costs are expected to be $160,000. The Cut and Polish department expects to use 25,000 machine hours, and the Quality Control department plans to utilize 50,000 hours of direct labor time for the year.

Required:

1. Assume Kline Company allocates overhead costs with the plantwide approach, and direct labor cost is the allocation base. Calculate the rate used by the company to allocate overhead costs.
2. Assume Kline Company allocates overhead costs with the department approach. Calculate the rate used by each department to allocate overhead costs.

Solutions to Review Problem 3.2

1. The plantwide rate is calculated as follows:

   Predetermined overhead rate=Estimated overhead costsEstimated activity in allocation base=$800,000$160,000=$5 per $1 in direct labor cost=500% of direct labor cost

2. The department rates are calculated using the same formula as the plantwide rate. However, overhead costs and activity levels are estimated for each department rather than for the entire company, and two separate rates are calculated:

   What are the three methods of allocating overhead costs?

   What Are the Methods of Overhead Allocation?.

   Rate of Total Direct Job Costs..

   Rate of Direct Job Costs..

   Proportion of Direct Costs..

   Weighted Proportion of Direct Costs..

   Combination..

   What are three common activity bases used to allocated factory overhead?

   The three most common allocation bases—direct labor hours, direct labor costs, and machine hours—are relatively easy to measure. Direct labor hours and direct labor costs can be measured by using a timesheet, as discussed earlier, so using either of these as a base for allocating overhead is quite simple.

   What are the four hierarchical levels of activity discussed in the chapter?

   Four Levels of Activity With activity-based costing, sometimes referred to as ABC, companies account for expenses by categorizing the source of the cost into one of four general groups: unit-based, batch-based, product-based, and facility-based costs.

   What are three reasons that overhead must be allocated to products?

   Answer: Three important reasons that managers allocate overhead costs to products are described in the following:.

   Provide information for decision making. ... .

   Promote efficient use of resources. ... .

   Comply with U.S. Generally Accepted Accounting Principles (U.S. GAAP)..