Accounting Best Practices, Fifth Edition

9–3. Eliminate High-Leverage Overhead Allocation Bases

There is nothing more damaging to a company than to make a management decision based on inaccurate information. Though the accounting department is devoted to presenting the best possible information to senior management at all times, there is one area in which it continues to provide inaccurate data: overhead costs. This is an increasingly large proportion of the costs of many companies, and it is critical to allocate it to various activities and products properly. To be blunt, most accountants do a very poor job of allocating these costs, resulting in cost reports that show inordinately high or low overhead costs being assigned to various items. When a manager acts upon this information, the decision may be a wrong one because the overhead cost component of the information was wrong. The reason why overhead costing information is incorrect in so many instances is a faulty allocation base. For example, the most common allocation base is to assign overhead costs to a product based on the amount of labor cost used to build it. The trouble is that labor is an increasingly small component of total labor costs, resulting in large overhead amounts being allocated based on tiny labor costs. The ratio of overhead to labor costs can reach absurd levels, such as $10 for every $1 of labor. When there are large differences between the proportion of overhead to the allocation base, even a slight change in the allocation base will result ...