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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.
