Write a 2-page paper describin

Write a 2-page paper describing the importance to decisionmaking of proper overhead allocation. Discuss the various methodsavailable to accountants to allocate overhead to products andservices. Include the limitations of these methods as well as thepros and cons for each method.

Answer:

Solution:-

1. Describing the importance to decision making ofproper overhead allocation:-

Allocating manufacturing overheaddirectly impacts your small business’s balance sheet and incomestatement. You have those expenses no matter what, and youraccounting system requires you to keep track of them. Manyaccounting systems require you to allocate the costs to the goodsyou produce. By understanding how to assign those costs in aresponsible and reasonable manner, you ensure your records areaccurate and not distorted.

Beyond accounting requirements,allocating overhead helps you make decisions for your company,especially pricing. If you base your product pricing only on thedirect costs, you cut into your profits. You still need to pay forall of those normal overhead costs. That means you have less leftover from each product sale. By incorporating indirect costs intopricing, you can increase the pricing to cover them effectivelywithout slashing your profits. Allocating overhead can also helpyou look for ways to cut your costs. It can be a motivator fordifferent departments to improve the efficiency of their productsto reduce overhead costs.

One of the main purposes forallocating costs is to provide information for decisionmaking. Knowing what department or product is taking agreater proportion of funds is important for weighing alternativesin both the short and long run. Cost allocation is an importantplanning tool for reducing costs and increasing profits. It canalso be a cost motivator, giving managers incentives for makingsure that costs are not accumulated carelessly. Managers will bemore likely to operate their departments with greaterefficiently.

Let’s look at BOA Fruits and how ituses cost allocation for decision making. Before the fiscal yearends, BOA Fruits has to make decisions about where we are going todistribute our produce for the next year.

A cost allocation tells us twoimportant things. First, our costs for producing bananas has beenreduced due to a new type of banana plant that extends how long abanana will stay ripe. Second, our fruit stand doubled its salesfrom the previous year.

We decide to double the size of thefruit stand and double the number of bananas produced. This is anexample of how cost allocation is vital for explaining growthoptions for BOA Fruits.

2. Discuss the various methods available to accountantsto allocate overhead to products and services. Include thelimitations of these methods as well as the pros and cons for eachmethod.:-

Small businesses that manufacture products are required toaccount for all of the costs of production. One of these costs,overhead, is the cost of production that cannot be individuallytraced to products. For small-business owners, overhead costs canrepresent a large portion of total product costs. Understandingsome of the major methods for calculating and assigning overheadcosts to products can help you choose the right method for yourcompany.

Job-order Costing

Small businesses that manufacture more than a few models ofgoods usually use job-order costing. This costing method assignsoverhead costs to products based upon a predetermined overheadrate. Company management calculates this rate at the beginning ofthe year by dividing the total estimated overhead costs for theyear by an allocation base chosen by the company. An allocationbase is a measure of activity that is expected to change inrelation to overhead. For example, a company that makes a productthat is labor-intensive would expect to incur more overhead costsas labor costs rise. In this case, management may choose to usedirect labor cost as the allocation base, because direct labor costconsiders the cost of the employee who’s operating themachinery.

Pros and Cons of Job Order Costing

One advantage of job order costing is that it allows managers tocalculate the profit earned on individual jobs, helping them tobetter ascertain whether specific jobs are desirable to pursue inthe future. This is best for businesses that do highly custom work,such as construction contractors and consultants.

Job order costing also gives managers the advantage of beingable to keep track of individuals’ and teams’ performance in termsof cost-control, efficiency and productivity.

A disadvantage of job order costing is that employees arerequired to track all materials and labor used during the job. Asan example, consider a construction contractor using a job ordercosting system. The contractor has to keep track of all the wood,nails, screws, electrical fixtures, paint and other materials usedon the job, as well as tracking workers’ lunch breaks and hoursworked.

Process Costing

Companies that make one homogenous product, such as orange juiceor gasoline, tend to use process costing to assign overhead coststo products. Under this system, overhead costs are assigned toproducts based upon processing departments. For example, a juicecompany might have four processing departments: sorting, washing,juicing and packaging. In each department, the company wouldestimate the total overhead expected for the year in thatdepartment and then divide this amount by an allocation basesuitable for that department. If sorting was done by machine, wewould expect an allocation base such as machine hours to be usedfor sorting. However, if packaging is done by hand, we would expecta labor-based measure in the packaging department. This methodallows for the most suitable allocation base to be used during eachpart of the manufacturing process.

Pros and Cons of Process Order Costing

Process costing simplifies record keeping by relying onstatistical calculations rather than actual inputs. Anotheradvantage of process costing is that it allows managers to getdetailed information on the production statistics of individualdepartments or work groups. This is best suited for continuousmanufacturing settings, such as factories and utilitycompanies.

In a factory setting, for instance, materials are calculatedusing an average of units produced, and salaries expenses are oftenrelatively consistent between pay periods. Process costing in thisscenario gives managers the advantage of being able to ascertainthe same qualities in entire departments and compare performanceover time.

Activity-based Costing

While activity-based costing, or ABC, is not suitable forexternal reporting, small-business owners may find that accountingfor overhead under an activity-based approach can provide betterinformation for making production decisions. Under activity-basedcosting, managers first determine the activities that go intoproducing a product. For example, a trophy manufacturer might haveproduct design, batch setup, production, packaging and customersupport activities. For each activity, the company estimates theamount of overhead related to the activity and assigns these coststo products based upon what drives the activity. In our trophymanufacturer, we can imagine that a certain type of trophy wouldonly incur product design costs once, but each batch of thesetrophies will incur a batch setup charge and each individual trophywill need to be packaged. Activity-based costing systems providesmall-business owners flexibility in being able to apply overheadcosts to products at a granular level.

Advantages

The major advantage of activity based costing is the ability toestimate the cost of individual products and services precisely. Bytransferring overhead costs to individual units of products orservices, ABC helps identify inefficient or non-profitable productsor activities that eat into the profitability of efficientprocesses or highly profitable products.

Disadvantages and Limitations

The major disadvantage of activity based costing is thatalthough activity based costing is a scientific approach, themethod of implementation is complex, time consuming, and costly.The process of data collection and data entry requires substantialresources, and remains costly to maintain

ABC reports do not conform to generally accepted accountingprinciples (GAAP), and as such, firms following ABC need tomaintain two cost systems and accounting books, one for internaluse and another for external reports, filings, and statutorycompliance. This is a cumbersome duplication of efforts.

A primary disadvantage of ABC is that it is not possible todivide some overhead costs such as the chief executive’s salary ona per-product usage basis. Similarly, employees rarely devote 100%of their working hours to productive activities, and not allproductive activities add value to the product or process of thefirm. For instance, the ABC method fails to account for the timeemployee takes part in a first aid awareness campaign, leading tosubstantial ‘cost leaks.’ There is no meaningful way to assign such’business sustaining’ costs to products on a proportionate basis,and products and services share such costs equally.

Finally, too much attention to detail and control might obscurethe bigger picture or make the firm lose sight of strategicobjectives in a quest for small savings, making the firm “pennywise and pound foolish.” For instance, ABC might identify onedistribution channel as non-remunerative, or an inspection asnon-value adding. Such channeling or processes might benon-profitable, but placed in the first place to achieve some otherstrategic objectives.

Variable Costing

Variable costing techniques, which are not appropriate forexternal financial reporting, allow managers to remove the effectsof changing production levels on net income to make betterdecisions about the profitability of their company. Under job-ordercosting and process costing, all overhead costs are included ascosts of production. However, changing production levels candistort the amount assigned to each individual item produced. Forexample, if a company were to produce one widget in a month and thecompany’s rent was $1,000, the widget would be assigned $1,000 ofrent expense as a cost of production. However, if the companyproduced 1,000 widgets in that month, each widget would only beassigned $1 of expense. In both cases, the rent expense is thesame, but the product cost is wildly different. Variable costingdoes not assign these fixed overhead costs to products and does nothave the same cost distortion.

Advantages

  1. Variable costing provides a better understanding of the effectof fixed costs on the net profits because total fixed cost for theperiod is shown on the income statement.
  2. Various methods of controlling costs such as standard costingsystem and flexible budgets have close relation with the variablecosting system. Understanding variable costing system makes the useof those methods easy.
  3. Companies using variable costing system prepare incomestatement in contribution margin format that provides necessaryinformation for cost volume profit (CVP) analysis. This data cannotbe directly obtained from a traditional income statement preparedunder absorption costing system.
  4. The net operating income figure produced by variable costing isusually close to the flow of cash. It is useful for businesses witha problem of cash flows.
  5. Under absorption costing system, income of different periodschanges with the change of inventory levels. Sometime income andsales move in opposite directions. But it does not happen undervariable costing.

Disadvantages

  1. Financial statements prepared under variable costing method donot conform to generally accepted accounting principles (GAAP). Theauditors may refuse to accept them.
  2. Tax laws of various countries require the use of absorptioncosting.
  3. Variable costing does not assign fixed cost to units ofproducts. So the production costs cannot be truly matched withrevenues.
  4. Absorption costing is usually the base for evaluating topexecutive’s efficiency.

Please Rate or comment if you have any doubtregarding this solution.


 
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