Overhead Allocation

Topics: Costs, Variable cost, Cost Pages: 3 (888 words) Published: November 30, 2011
In order to price a product or service competitively, we need to determine the correct cost of the product /service. Costs can be classified as Production Costs and Non-production costs. Production costs are those costs that are associated with the manufacture of goods or production of services. Non –production costs are those costs associated with R & D, selling and administration. The Production Cost components are direct material, direct labour and overheads. Direct material: Cost of material that can be directly traced to the product/service through physical observation. Direct labour: The cost of labour involved in the production which can be physically observed. Overheads: All production cost other than direct material and direct labour are assigned as overheads. COST MEASUREMENT

2 methods are used to measure the cost incurred: Actual and Normal. Actual Costing uses actual values of all 3 components (direct material, direct labour and overheads) to determine the unit cost. Problems associated with Actual Costing:

* The problem with this is while direct material and direct labour can be directly eye-balled to the units produced, it is difficult to obtain a cause-effect relationship between the overheads and the product/service. * Timely availability of data also becomes a problem as the bills for overhead areas are often received only after fixed time periods. * Averaging actual overhead costs will lead to fluctuations in monthly overheads and monthly production of units. Another more effective method is the Normal Costing. Here, the costs of direct material and direct labor are taken as actuals while a pre-determined rate is taken for overhead. The RATE EQUATION is given by:

Overhead Rate= Budgeted annual overhead (estimated overhead cost) -------------------------------------------------------------------------...
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