The World without Bankruptcy Laws
Bankruptcy is one of the natural states which a company may find itself in. Entrepreneurship is primarily about taking risks. When companies take risks, some of them succeed, whereas others fail. Hence failure is a natural part of the business. However, many critics of bankruptcy laws believe that there isn’t a need for an elaborate […]
The Wirecard and Infosys Scandals are a Lesson on How NOT to Treat Whistleblowers
What is the Wirecard Scandal all about and Why it is a Wakeup Call for Whistleblowers Anyone who has been following financial and business news over the last couple of years would have heard about Wirecard, the embattled German payments firm that had to file for bankruptcy after serious and humungous frauds were uncovered leading […]
Why the Digital Age Demands Decision Makers to be Like Elite Marines and Zen Monks
How Modern Decision Makers Have to Confront Present Shock and Information Overload We live in times when Information Overload is getting the better of cognitive abilities to absorb and process the needed data and information to make informed decisions. In addition, the Digital Age has also engendered the Present Shock of Virality and Instant Gratification […]
Why Indian Firms Must Strive for Strategic Autonomy in Their Geoeconomic Strategies
Geopolitics, Economics, and Geoeconomics In the evolving global trading and economic system, firms and corporates are impacted as much by the economic policies of nations as they are by the geopolitical and foreign policies. In other words, any global firm wishing to do business in the international sphere has to be cognizant of both the […]
Why Government Should Not Invest Public Money in Sports Stadiums Used by Professional Franchises
In the previous article, we have already come across some of the reasons why the government should not encourage funding of stadiums that are to be used by private franchises. We have already seen that the entire mechanism of government funding ends up being a regressive tax on the citizens of a particular city who […]
Tracking direct labor and materials that have been used in a job can be done with a fair degree of precision. That is not the real problem when it comes to costing. The real problem is with allocation of overheads. Usually, they have very little correlation to any specific activity. They are the result of many small activities which result in costs being incurred over a period of time but cannot be directly traced to any specific cost object. Job order costing uses the following system to allocate these overheads amongst jobs.
In job order costing, the allocation of overheads is done on the basis of an allocation base. This means that the cost accountants use a known cost as a proxy for allocating the unknown costs. For example, direct labor hours are known for the manufacturing of each product. If the accountants assume that the amount of overheads spent by each product is proportional to their labour hours, then the direct labour hours are an allocation base.
Once the allocation base is decided, overheads are split amongst different cost objects(products) based on their consumption of the allocation base. For example, a company produces three products A, B and C. A consumes 10 hours of direct labour, B consumes 20 hours and C consumer 30 hours. The total amount of overheads spent is $12000.
Since the direct labour hours are in the ratio 1:2:3, the overheads must be split according to the rate 1/6, 2/6 and 3/6. This rate which is derived from the allocation base is called the allocation rate.
When using allocation rates to split the overhead cost, we are assuming that there is a direct relationship between the amount of overheads incurred and the allocation base. In simple words this would mean that the more the labour hours are increased, the more the overheads would increase in roughly the same proportion. This is not usually the case as overheads do not bear a directly proportional relationship with any other costs.
But this is the best approach possible since overheads usually do not have a cause effect relationship that can be traced directly to any cost object. The best that can be done in such a scenario is to reduce the amount of arbitrariness.
The overhead allocation approach suggested by job order costing is a little bit arbitrary. Management must try and reduce the arbitrary nature of this relationship. This can be done by ensuring that there is some amount of correlation between the allocation base and the overheads.
Choosing of allocation base becomes most important and must be done very carefully. Ideally, companies must make a list of the direct cost that they incur. They must then compile the increase and decrease in overheads from previous year’s data. A correlation must be statistically established based on the past data. The direct cost which consistently has the maximum correlation with the overheads must be used as the allocation base.
Your email address will not be published. Required fields are marked *
Why are Corporations Hoarding Trillions in Cash?
February 7, 2025
Why College Education Should Not Be Free?
February 7, 2025
Why Do Mutual Funds Lend To Promoters?
February 7, 2025
