Why Allocate Overhead Costs?

Learning Objective

  1. Understand why organizations allocate overhead costs to products.

Question: Recall that costs for direct labor and direct materials are easily traced to products. When SailRite produces a sailboat, the direct materials include items such as fiberglass to build the hull, mast, sails, and rope. Direct labor includes the employees building the boat. Accounting for these costs is fairly simple. Indirect manufacturing costs (also called manufacturing overhead or overhead) include electricity to run the factory, rent for the factory building, and factory maintenance. These costs are not easily traced to products and pose a much more complicated challenge for SailRite. Accounting for indirect manufacturing costs typically requires allocating overhead using predetermined overhead rates. Why do managers insist on allocating overhead costs to products?

Answer: 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.

Key Takeaway

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

Review Problem 3.1

For each scenario listed as follows, identify which of the three important reasons presented in this section best explains why managers choose to allocate overhead costs to products.

  1. Financial statements are prepared for the annual report that is provided to shareholders.
  2. Management is considering the addition of a new product line.
  3. The production manager decides to decrease the frequency of raw materials purchases to reduce the allocated portion of the purchasing department’s costs.
  4. Profits are calculated for each product so management can decide which products to promote.
  5. Quality control inspections are reduced to cut down on the allocated portion of the quality control department’s costs.
  6. Financial statements are prepared for the company’s bondholders.
  7. Management asks for cost information to assist in bidding for a contract.

Solutions to Review Problem 3.1

  1. Comply with U.S. GAAP
  2. Provide information for decision making
  3. Promote efficient use of resources
  4. Provide information for decision making
  5. Promote efficient use of resources
  6. Comply with U.S. GAAP
  7. Provide information for decision making