3 reasons for Overhead Costs Allocation

Many accounting procedures are based on allocations. Cost allocations can be made over several time periods or within a single time period. For example, in financial accounting, a building’s cost is allocated through depreciation charges over its useful or service life. This process is necessary to fulfill the matching principle.
In cost accounting, production overhead  costs are allocated within a period  through  the use of predictors or cost drivers  to products or services. This process  reflects application  of  the  cost  principle, which  requires  that  all  production  or  acquisition costs attach to the units produced, services rendered, or units purchased.

Overhead costs are allocated to cost objects for three reasons: (1) to determine a full cost of the cost object, (2) to motivate the manager in charge of the cost object  to manage  it efficiently, and  (3)  to compare alternative courses of action  for management planning, controlling, and decision making.

The first reason relates to  financial  statement valuations. Under generally  accepted  accounting principles (GAAP),  “full  cost” must  include  allocated  production  overhead.  In  contrast,  the assignment of nonfactory overhead costs  to products  is not normally allowed under GAAP.
The other  two  reasons  for overhead allocations are  related  to  internal  purposes  and,  thus,  no  hard-and-fast  rules  apply  to  the  overhead  allocation process.

Regardless of why overhead costs are allocated,  the method and basis of  the allocation process should be rational and systematic so that the resulting information  is useful  for product  costing  and managerial purposes. Traditionally,  the  information  generated  for  satisfying  the  “full  cost” objective was  also used  for  the second and  third objectives. However, because  the  first purpose  is externally  focused and the others are internally focused, different methods can be used to provide different costs for different needs.
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