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How To Allocate Overhead Costs Into Inventory

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How to Allocate Overhead Costs to InventoryRather than being recognized in the cost of goods sold or some other expense category within the current period, some overhead costs can be charged off to inventory. The proper allocation of these costs can have a large impact on the level of reported income in any given period. Therefore, it is important for the accountant to fully understand which costs can be shifted to a cost pool for eventual allocation, and how this allocation is to be accomplished. This post addresses the issue. Follow on…

 

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Which Costs Exactly Can Be Shifted Into A Cost Pool

The only cost category about which there is some uncertainty is rework labor, scrap, and spoilage. This cost can be charged in either direction. The rule in this case is that any rework, scrap, or spoilage that falls within a normally expected level can be charged to a cost pool for allocation, whereas unusual amounts must be charged off at once. This is clearly a highly subjective area, where some historical records should be maintained that will reveal the trend of these costs, and which can be used as the basis for proving the charging of costs to either category.

Expense the following items right away:

  • Advertising expenses
  • General and administrative expenses (related to overall operations)
  • Income taxes
  • Interest
  • Marketing expenses
  • Other distribution expenses
  • Pension contribution related to past service costs
  • Research and experimental expenses
  • Rework labor, scrap, and spoilage
  • Salaries of officers related to overall operations
  • Selling expenses

 

You can allocate the following items to inventory:

  • Depreciation and cost depletion
  • Factory administration expenses
  • Indirect labor and production supervisory wages
  • Indirect materials and supplies
  • Maintenance
  • Officers’ salaries related to production services
  • Production employees’ benefits
  • Quality control and inspection
  • Rent
  • Repair expenses
  • Rework labor, scrap, and spoilage
  • Taxes other than income taxes related to production assets
  • Tools and equipment not capitalized
  • Utilities

With the above list, you can easily construct a cost pool into which the correct costs can be accumulated for later distribution to inventory as allocated overhead costs. Next is how to make the allocation. Read on…

 

Smoothing Out Sudden Changes In The Cost Pool

It is quite common to see an unusual expenditure cause a large jump or drop in the costs accumulated in the cost pool, resulting in a significant difference between periods in the amount of per-unit costs that are allocated out. This can cause large changes in overhead costs from period to period.

Though perfectly acceptable from the perspective of generally accepted accounting principles, one may desire a more smoothed-out set of costs from period to period. If so, it is allowable to average the costs in the cost pool over several months, as long as the underlying inventory is actually in stock for a similar period of time. For example, if the inventory turns over four times a year, then it is acceptable to allocate overhead costs each month based on a rolling average of the costs for the preceding three months.

 

Basis Used when Allocating Costs

The accounting literature has bemoaned the allocation of costs based on direct labor for many years. The reason for this judgment is that direct labor makes up such a small component of total product cost that small swings in the direct labor component can result in a large corresponding swing in the amount of allocated overhead. To avoid this issue, some other unit of activity can be used as the basis for allocation that not only comprises a larger share of total product cost, but that also relates to the incurrence of overhead costs.

Another criterion that is frequently overlooked is that the accounting or manufacturing system must have a means of accumulating information about this activity measure, so that the accountant does not have to spend additional time manually compiling the underlying data. An example of an activity measure that generally fulfills these three criteria is machine hours, since standard machine hours are readily available in the bill of materials or labor routing for each product, many overhead costs are related to machine usage, and the proportion of machine time used per product is commonly greater than the proportion of direct labor.

An even better alternative than the use of machine hours (or some similar single measure) as the basis for allocation is the use of multiple cost pools that are allocated with multiple activity measures. This allows a company to (for example) allocate building costs based on the square footage taken up by each product, machine costs based on machine time used, labor costs based on direct labor hours used, and so on. The main issue to be aware of when using this approach is that the financial statements must still be produced in a timely manner, so one should not go overboard with the use of too many cost pools that will require an inordinate amount of time to allocate.

 

How To Calculate The Overhead Allocation

When allocating overhead costs, they are not simply charged off in total to the on-hand inventory at the end of the month, since the result would be an ever-increasing overhead balance stored in the on-hand inventory that would never be drawn down. On the contrary, much of the overhead is also related to the cost of goods sold.

In order to make a proper allocation of costs between the inventory and cost of goods sold, the accountant must:

  • Step-1. Determine the total amount of each basis of activity that occurred during the reporting period
  • Step-2. Divide the amount in the first step into the total amount of overhead in the cost pool, yielding an overhead cost per unit of activity.
  • Step-3. Overhead cost per unit (on step-2) should then be multiplied by the total amount of the basis of activity related to the period-end inventory to determine the total amount of overhead that should be charged to inventory.
  • Step-4. Compare “total amount of overhead that SHOULD BE charged to inventory” (you get on the step-3) to the amount of overhead ALREADY charged to inventory in the previous reporting period to see if any additional overhead costs should be added or subtracted to arrive at the new allocated overhead figure.
  • Step-5. All other overhead costs, by default, are charged to the cost of goods sold.

 

Case Example

Say, there is a cost pool of $100,000 to be allocated, and a total of 25,000 machine hours were used in the period, then the overhead cost per hour of machine time is $4. According to the standard labor routings for all inventory items in stock, it required 17,250 hours of machine time to create the items currently stored in inventory. Using the current cost per machine hour of $4:

Overhead cost to be charged to inventory

= 17,250 hours x $4/hour

= $69,000

 

However, the inventory overhead account already contains $52,000 of overhead that was charged to it in the preceding month, so the new journal entry you will need to make is:

[Debit]. Inventory Overhead ($69,000 – $52,000) = $17,000
[Debit]. Cost of goods sold ($100,000 – $17,000) = $83,000
[Credit]. Cost pool = $100,000

 

Adjusting Under-allocated (unallocated) Or Over-allocated Costs

You could smooth out the cost totals in a company’s overhead cost pools by averaging the costs on a rolling basis over several months. The only problem with this approach is that the amount of costs allocated each month will differ somewhat from the actual costs stored in the cost pools. How do we reconcile this difference?

The annual financial statements should not include any differences between actual and allocated overhead costs, so the variance should be allocated between inventory and the cost of goods sold at that time, using the usual bases of allocation. If shareholder reporting occurs more frequently than that (such as quarterly), then the accountant should consider making the same adjustment on a more frequent basis. However, if the amount in question will not have a material impact on the financial statement results, the adjustment can be completed just once, at the end of the fiscal year.

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