Overhead: Allocating your Costs Efficiently
Cost allocation is one of the more difficult tasks in running your business.Accurately understanding your costs, however, are imperative if you want your businessto succeed. You have to price your products or services in a way to be profitable andallocating costs is a major part of profitability.Costs are divided into three major categories of direct materials, direct labor, andoverhead. Direct materials and labor are easy to calculate because they are the coreactivities and substance of what your business does. If you are in construction then yourdirect materials are steel and concrete. Direct labor is the labor used to constructwhatever 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 outindirect costs is one of the biggest challenges in cost allocation and there are two methodsthat are used to allocate overhead in today’s business world.The first method is the direct method which uses a single cost driver to determineoverhead 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 overheadrate (POHR) is used and multiplied by the use of the cost driver for any given productthat a firm produces. For example, the POHR for a steel manufacturer may be $3.00 perlabor hour. This rate is used in every process throughout the company to determineoverhead, which is used to determine the firm’s costs.Unfortunately this method has a major drawback. Companies often make morethan one product and some products are made in higher volume than others. Using thedirect method with one cost driver to determine overhead subsidizes the lower volumeproducts. High volume products carry too much of the overhead burden and becomeoverpriced while the low volume products are under-priced. The activities used to makelow volume products are usually more specialized and time consuming. However sincethere 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. Highvolume products that need little to no specialized oversight are forced to share costs notassociated with them. Therefore, costs are being misallocated and prices are notaccurately set.The second method of cost allocation, Activity Based Costing (ABC), accuratelydetermines a firm’s costs. In its simplest form, ABC uses many cost drivers indetermining overhead. Firms closely monitor operations to determine which products usethe various activities conducted by the firm’s operations. A single product may have costdrivers such as: number of batches produced, number of inspections per batch, and costper machine setup. Cost drivers are then properly allocated to the products, and resourcesare measured as they are consumed by activity and product.ABC is a more accurate method of overhead costing because it measures a firm’sconsumption of resources by using multiple cost drivers. Using multiple cost drivers isadvantageous because higher volume products cease to subsidize the lower volumeproducts. Products that do not require certain activities are not forced to share the burdenof costs as they would in the direct method of costing. For example if a firm produces
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