Overhead Allocation refers to the process of identifying specific overheads of a particular cost centre and charging them. For example, in this case wages paid to truck drivers is an overhead cost which is directly identifiable with the Cost Centre i.e. ACF. In case of expenses which cannot be directly identified with that cost centre or which are used by many cost centres allocation will be made on a suitable basis. For example, rent on the basis of floor area.
The above mentioned methods are called as direct method (in case of direct identification with cost centre) and cost-driver method (i.e. allocation on a suitable basis). Both these methods holds good only in case of firms dealing with single line products. In case of multiple products or different class of products these methods cannot be used for the following reasons:
a) A single product may have a different cost driver. For example in this case wages paid to plant maintenance staff can be allocated on the basis of inspection time or production of the plant or on the basis of number of products.
b) Also the high volume products but less significant products will be over-priced if we use direct method of allocation overheads.
The suitable method for firms dealing with multiple products is Activity Based Costing (ABC) Method. Under this method Overheads of a particular activity or product is related using cost drivers and common overheads are allocated on a suitable basis. In case of multiple cost drivers ,the most prominent or dominant cost driver is used.
In the given case, the ACF’s products were classified into three classes to analyze its cost competitiveness. Let us first relate the overheads with the product class.
Identification of Overheads with products
|Account Head |Nature of Overheads |Related Class of Product |Reason | |1000 |Wages to Non-skilled personnel |Class III |Less skilled employees will be employed for less | | | | |important tasks | |1500 |Salary for all plant employees except |Class I and Class II |Assumed to be relevant to these classes and | | |engineers setting up machines | |apportioned based on their direct labour cost | |2000 |Gloves, safety googles and packing |Class II and Class III |As these items are more relevant for semi-skilled| | |material | |and unskilled labour | |3000 |loose tools and spare parts |- |Common expense to be allocated to all classes | |4000 |Indirect material (Purchased utilities) |Class II |Assumed as to be relevant to Class II | |5000 |Wages for skilled Non-Production |Class I |The degree of supervision required for this class| | |employees for supervision and maintenance| |is more than other classes | |8000 |Property Taxes and Depreciation |- |Common expense to be allocated to all classes | |9000 |Other Expenses |- |Common expense to be allocated to all classes | |11000 |Setup Cost of machinery |Class I |More relevant for low volume but highly important| | |...