Financial Accounting: Proper Overhead Allocation Report Analysis

This report delves into the critical concept of overhead allocation, a fundamental aspect of financial and managerial accounting. It begins by defining overhead allocation as the distribution of indirect costs to goods or services, emphasizing its importance in budgeting and pricing decisions. The report highlights the significance of informed decision-making in this process, involving accountants, managers, and the board of directors, for efficient resource utilization and adherence to Generally Accepted Accounting Principles (GAAP). It then explores two primary methods of overhead allocation: the plant-wide allocation approach, which uses a single cost driver, and the department allocation approach, which employs multiple cost drivers, often utilizing the Activity-Based Costing (ABC) system. The report outlines the pros and cons of each method, providing a comprehensive overview of their applications and limitations. The report concludes with a discussion of the ABC system, and its effectiveness, offering a detailed analysis of overhead allocation strategies.

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Proper Overhead Allocation
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Proper Overhead Allocation
Introduction
Overhead allocation is the distribution of the indirect costs to the finished goods or
services that a company provides. In simple terms, it is the overall day to day to expenses that
assist in the running of a business (Weetman, 2019). There are three types of overheads, i.e.,
administrative overhead costs such as the salary and wages, selling and distribution overheads
such as delivery vans, and general expenses such as utilities (water, electricity, and telephone
bills) (Bromwich & Scapens, 2016). Decision making of proper overhead allocation is quite
essential, for budgeting purposes, as well as the determination of what a business would charge
for its goods and services. This paper seeks to evaluate the importance of decision making in
overhead allocation, methods used in overhead allocation, and their pros and cons.
Importance of Decision Making In Proper Overhead Allocation
Proper overhead allocation is dependent on the efficiency and effectiveness of the team
in-charge of budgeting. The team mostly comprises of the accountant, the managers, and the
board of directors in the company (Weetman, 2019). The first reason is to provide proper
information that will assist in the decision making of other aspects of the company. For instance,
as an accountant, decision making is quite essential when coming up with the budget as the
overhead allocation as the management will use this information in setting the prices for the
finished product among other decisions (Weetman, 2019).
Moreover, proper overhead allocation ensures the efficient use of the resources that are
available to the company. Decision making is important as the accountant needs to determine
what needs are important to others due to the limited amount of resources when preparing the

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budget (Saylor Academy, 2012). Furthermore, it is the fact that the accountant has to comply
with the Generally Accepted Accounting Principles (GAAP) in the United States (Saylor
Academy, 2012). These principles require that all manufacturing costs inclusive of the overhead
costs be assigned to the specific products for inventory costing purposes. To do this, proper
decision making is very vital.
Methods of Overhead Allocation;
There are various methods used for overhead allocation, such as the plant-wide allocation
approach and the department allocation approach (Saylor Academy, 2012). The plant-wide
allocation approach uses only one cost driver as its basis of allocation hence one predetermined
overhead rate for the whole company. This approach relies mostly on the job costing method
(Burney & Malina, 2019). The pros include the fact that it is less costly, and quite easy to
implement in the operations. Some of the cons and limitations include that it is not specific to
each good hence the prices set is not based on the specific cost of the good.
The department allocation approach uses multiple cost drivers for each of the
departments hence various predetermined overhead rates in the different departments. It relies
mostly on the Activity-based Costing (ABC) system. ABC system, helps accountants to identify
all the specific overhead operations that are related to the manufacture of each product (Saylor
Academy, 2012). Additionally, there are several pros to the ABC system such as; it provides
more accurate information on the manufacturing costs, the basis of allocation differs due to the
multiple cost drivers, it is more accurate, and it allocates the overhead, directly to the products
hence a positive relationship between the two. Some of the cons and limitations are; the fact that
some of the manufacturing costs are not included in the product cost as they may not fit into the

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activity driven cost pools, it is more expensive due to the multiple cost drivers, and it takes too
much time to implement and operate properly.
References
Bromwich, M., & Scapens, R. W. (2016). Management accounting research: 25 years
on. Management Accounting Research, 31, 1-9.
Burney, L. L., & Malina, M. A. (Eds.). (2019). Advances in Management Accounting. Emerald
Group Publishing.
Saylor Academy. (2012). Managerial Accounting. Saylor Academy. Retrieved from
https://saylordotorg.github.io/text_managerial-accounting/
Weetman, P. (2019). Financial and management accounting. Pearson UK.