Allocated Costs — Roadblock to Clarity

The use of allocations was one reason the conventional accounting statement was wanting. Accotmting systems use allocations as shortcuts to assure that the costs of production are fully absorbed. Most of the allocated costs fall into the category of indirect cost and become part of the cost of goods sold as shown in Table 25.2. Direct costs are those that, in a manufacturing company, are part of the bill of material and are based on standards for labor and material. These direct costs are the base for the allocation, and the indirect costs are assigned in proportion to the base. 

The arbitrariness of this practice wasn t always as great as it is today. In the early years of the 20th century, when current methods of cost accounting took shape, direct labor contribute heavily to manufacturing costs. There was little in the way of overhead to support these functions. The result was far less distortion from allocations. Today, factories are much less dependent on direct labor. So much more of a company s cost is allocated using these rules. 

We can illustrate the effect of cost allocation with the case of Old Line. Refer to Table 25.4. If this company is typical, factory direct labor is the base for allocating other internal costs. This could include factory indirect, much of 

Factory direct labor Factory indirect labor Clerical/administrative/sales Technical / professional Fixed costs Purchased item costs Services 

Accoimting procedure takes these costs, amounting to 45% of all costs, and divides them by direct labor to produce an overhead rate. In this case, the overhead rate is (45/25) x 100% = 180%. Thus, for each direct labor dollar incurred, an additional 1.80 would be charged, for a total of 2.80. This illustrates absorption accounting. This is because the direct cost in the form of labor has absorbed the indirect cost. 

Factory direct labor Labor that touches the product Usually has assigned work measurement standards 

Factory indirect labor Labor that does not have a work measurement standard but supports the direct labor component 

Clerical/ administrative/sales Secretaries, accounting staff, receptionists, clerks, and sales administration 

Technical/professional Design engineers, system engineers, procurement staff, and white-collar functions 

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