Various cost allocation methods are used to allocate factory overhead costs to units of production. Allocations are performed in order to create financial statements that are in compliance with the applicable accounting framework. The most common allocation methods are noted in the following bullet points, along with commentary about their advantages and disadvantages:
- Direct labor. Overhead is applied based on the amount of direct labor consumed by a unit of production. This is an easy calculation, for there is usually an industrial engineering standard already in place that documents the amount of direct labor associated with a product. However, the amount of direct labor consumed may be far smaller than the amount of factory overhead, which can result in large allocations based on small amounts of direct labor cost.
- Machine time. Another favorite is cost allocations based on the amount of machine time used by a product. As was the case for direct labor, the reason for this popularity is that the standard amount of machine time used is already available in the form of industrial engineering documentation.
- Square footage. It may be useful to separate out those overhead costs related to inventory storage, and allocate these costs based on the number of square feet of storage space used by each product. While this is a more accurate way to associate certain overhead costs with products, it can be difficult to track, especially when inventory levels are constantly changing. Another concern is that square footage is only two dimensional. A more accurate approach would be to allocate costs based on cubic feet of storage space consumed.
It is also possible that corporate headquarters costs are to be allocated to the subsidiaries of a multi-division company. If so, a number of possible allocation methods have been used, including:
- Sales. Costs are apportioned based on the net sales reported by each entity. Since high sales volume does not necessarily equate to high profits, this approach can result in a low-profit entity being burdened with a substantial corporate allocation.
- Profits. Costs are allocated based on the profits generated by each subsidiary. A problem is that high-profit entities will be charged with the bulk of all corporate expenses, so their inherent profitability will not be overly apparent when their results are viewed on a fully-burdened basis.
- Headcount. This is the most specious basis of allocation, for some entities can generate sales and profits with few staff, while others require massive numbers of employees. Also, a large number of low-paid employees might attract a large cost allocation, while another subsidiary with a much smaller number of higher-paid employees would attract a comparatively smaller charge.
When deciding upon which cost allocation method to use, keep in mind that none of these methods will achieve a close relationship between the allocated costs and the cost objects to which they have been applied. Consequently, it is best to use the simplest method available, and not worry about a high level of allocation precision.