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A lot of developing countries do not have the finances required to build large scale infrastructure projects. However, these countries do have large parcels of lands in urban areas. There is a dire need for infrastructure projects in the developing world. Cities like Beijing, Mumbai, Karachi and Bangkok are bursting at their seams due to […]
How Does The Failure of Silicon Valley Bank Affect Stakeholders
The fall of the Silicon Valley Bank happened very suddenly. The bank had gone from a healthy functioning bank to near bankruptcy within 48 hours! As a result, the credibility of the entire American banking system has been brought into question. This is because commercial banks are not like regular organizations. In most cases, they […]
What are STRIP Bonds?
STRIP is an acronym that is commonly used to denote Separate Trading of Registered Interest and Principal of securities. This is a complex-sounding term however, in reality, the meaning is quite simple. It is important to understand that when we buy a bond that pays regular coupon payments, we are actually buying the right to […]
Accounting for Convertible Debt
In the previous article, we have established the fact that convertible debt is advantageous to some types of companies. We also know that this financial instrument can be quite complex. It is a known fact that investors who are not well versed in investing in bonds have a hard time understanding the functioning of convertible […]
History of Modern Banking
Banking in old times was not the tightly monitored and tightly regulated business that it is today. Instead, earlier banking was completely a free market operation. Any entrepreneur could enter and exit the banking business without any restriction or licenses. In this article, we will trace the evolution of banking i.e. how banking changed to […]
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.
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