overhead: allocating your costs efficiently printable version

Cost allocation is one of the more difficult tasks in running your business. Accurately understanding your costs, however, are imperative if you want your business to succeed. You have to price your products or services in a way to be profitable and allocating costs is a major part of profitability.

Costs are divided into three major categories of direct materials, direct labor, and overhead. Direct materials and labor are easy to calculate because they are the core activities and substance of what your business does. If you are in construction then your direct materials are steel and concrete. Direct labor is the labor used to construct whatever it is you are building. These costs are traceable. Overhead, on the other hand, is not so easily figured out.

Overhead consists of every other activity or material that you use to do business. Overhead is your business’s indirect costs and is not easily managed. Figuring out indirect costs is one of the biggest challenges in cost allocation and there are two methods that are used to allocate overhead in today’s business world.

The first method is the direct method which uses a single cost driver to determine overhead costs. A cost driver is any activity in a business used to determine cost. Examples of cost drivers are labor hours or machine hours. A predetermined overhead rate (POHR) is used and multiplied by the use of the cost driver for any given product that a firm produces. For example, the POHR for a steel manufacturer may be $3.00 per labor hour. This rate is used in every process throughout the company to determine overhead, which is used to determine the firm’s costs.

Unfortunately this method has a major drawback. Companies often make more than one product and some products are made in higher volume than others. Using the direct method with one cost driver to determine overhead subsidizes the lower volume products. High volume products carry too much of the overhead burden and become overpriced while the low volume products are under-priced. The activities used to make low volume products are usually more specialized and time consuming. However since there is only one cost driver to determine the overhead cost, specialized activity costs, such as inspections, are spread throughout every product manufactured at the firm. High volume products that need little to no specialized oversight are forced to share costs not associated with them. Therefore, costs are being misallocated and prices are not accurately set.

The second method of cost allocation, Activity Based Costing (ABC), accurately determines a firm’s costs. In its simplest form, ABC uses many cost drivers in determining overhead. Firms closely monitor operations to determine which products use the various activities conducted by the firm’s operations. A single product may have cost drivers such as: number of batches produced, number of inspections per batch, and cost per machine setup. Cost drivers are then properly allocated to the products, and resources are measured as they are consumed by activity and product.

ABC is a more accurate method of overhead costing because it measures a firm’s consumption of resources by using multiple cost drivers. Using multiple cost drivers is advantageous because higher volume products cease to subsidize the lower volume products. Products that do not require certain activities are not forced to share the burden of costs as they would in the direct method of costing. For example if a firm produces low grade steel at high volume with little need for inspection, and high grade steel at lower volume with high need for inspection, the high grade steel will carry the burden of the inspection cost. The low grade steel does not use inspection activity and therefore should not be required to include the cost in its overhead allocation.

The advantages of using ABC are clear. ABC allows for more accurate costing and pricing of goods and services. With this knowledge firms can lower prices on the products they make most, and be more price competitive in the market. This is especially true for firms that practice cost leadership as a part of their overall business strategy. But this method is not limited to cost leadership alone, ABC works for product differentiation also. Low volume goods and services are no longer under-costed and under-priced when using this method. Businesses can be confident that they are costing premium products correctly and can earn deserved profits for them. The overall advantage to using ABC is that firms get the most for their money and maximize profits in the long term.

There are disadvantages to using ABC, however. ABC is very complex. Managerial accountants have been perfecting this method of costing for years. It is also often difficult to figure out what a firm’s cost drivers are. Moreover, monitoring firm activities and assigning cost drivers can be a very time consuming and costly endeavor. Oftentimes, accounting experts are required to initiate and manage the system. This is especially true for service industry firms. Such businesses may conduct hundreds of activities in a given business day and pinpointing which activities are the most important can be very mind-numbing. Most firms implementing ABC use 15 to 20 cost drivers at the most.

Though using Activity Based Costing may seem daunting, it is a very useful method to track costs. If properly implemented, ABC can be very cost effective and profitable.

Overhead allocation is one of the more confusing and complex issues facing many businesses. Yet, figuring out how to best determine overhead is very important to a firm’s profitability. While using the direct method of cost allocation is simple, its simplicity makes it very inaccurate and costly to the bottom line. ABC is complex, but if used properly, can pay off greatly in a businesses long term.