Accounting for Managers: Interpreting Accounting Information for Decision Making, 4th Edition

Chapter 13

Overhead Allocation Decisions

This chapter explains how accountants classify costs and determine the costs of products/services through differentiating product and period costs, and direct and indirect costs. The chapter emphasizes the overhead allocation problem: how indirect costs are allocated to determine products/service profitability and assist in pricing decisions. In doing so, it contrasts variable costing, absorption costing and activity-based costing. The chapter includes an overview of contingency theory, a comparison between Western and Japanese approaches to management accounting and a consideration of the behavioural consequences of accounting choices.

Cost classification

Product and period costs

The first categorization of costs made by accountants is between period and product. Period costs relate to the accounting period (year, month). Product costs relate to the cost of goods (or services) produced. This distinction is particularly important to the link between management accounting and financial accounting, because the calculation of profit is based on the separation of product and period costs. However, the value given to inventory is based only on product costs, a requirement of accounting standards. The IFRS accounting standard on Inventories (see Chapter 6), IAS2, requires that the cost of stock should:

comprise that expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and ...