Accounting Allocation the Easy Way (#119)
/In this podcast episode, we talk about allocating overhead costs as quickly and easily as possible. Key points made are noted below.
The Reason for Overhead Allocation
Overhead allocation means that we apportion expenditures among the cost of goods sold and inventory, which means that we’re delaying some expense recognition until a later period. We do this because we have to. If you look at the GAAP accounting standards, in Section 330-10-30 of the accounting standards codification, it says: The cost of inventory is the sum of the applicable expenditures directly or indirectly incurred to bring a product to its existing condition and location. The bit about “indirectly” is what concerns us the most.
The Objective Behind Overhead Allocation
So let’s look at this from a high level. We’re being required to allocate overhead. We probably wouldn’t do it otherwise, since it doesn’t do anything for us from the perspective of improving management decision making. Instead, we’re just complying with an accounting standard. This means that the real objective here is to allocate overhead as quickly and efficiently as we can.
Now don’t confuse this objective with allocating overhead in order to actually use the resulting information, as you would with an activity-based costing system. That’s a different situation that involves a different objective, and also a whole lot more work.
Quick and Efficient Overhead Allocation
Now, let’s get back to how we’re going to meet this objective of allocating overhead as quickly and efficiently as possible. The first consideration is which expense accounts need to be included in overhead. The simplest path is to go over the expenses list with your auditors, and agree with them whenever they want to include something in overhead. And if they want to exclude something, agree right away. Don’t forget the objective here – quick and efficient allocations. Therefore, if you adopt a list of expenses to include in overhead that the auditors are completely comfortable with, then you’ll never waste time in the future having to re-calculate your overhead allocations because the auditors started getting picky about what to include in overhead.
Next up, consolidate some of those expense accounts that are now going to be included in the overhead allocation. The reason is that auditors do a variance analysis as part of their audit work each year, where they bug you about changes in the general ledger accounts if they exceed a certain percentage change. If you consolidate accounts, then it’s going to take a hell of a large change to trigger an inquiry from an auditor – and that saves you time. Again, we’re meeting the objective of quick and efficient.
Next, you need to figure out how many cost pools to use for the allocation. If you were doing an activity-based costing analysis, you’d have a ton of cost pools, so that you could allocate overhead with great precision. But – this is not activity-based costing, it’s just a lousy overhead allocation. So what we want to do is get away with the smallest possible number of cost pools. Again, ask the auditors what they want. If they try to get all precise on you and want some extra cost pools, this is a good place to push back a little, and try to knock down the number of pools. If you can get away with just one or two cost pools, then that’s very good. Again, the objective is quick and efficient. And slicing and dicing overhead into lots of cost pools is not quick or efficient.
And finally, there’s the basis of allocation, like machine hours or direct labor hours, or square footage used. With the objective in mind, you want an allocation base that easily measured and defended (by you) and easily verified (by the auditors). Whether it’s the most appropriate allocation base is not the point, believe it or not. You’re simply complying with an accounting standard. For example, if you want to allocate overhead based on machine hours used because it’s the most appropriate method, that’s not going to be your best allocation base if you have to set up a machines hours measurement system from scratch. All you’re doing is wasting the company’s time and money, when you could be using a somewhat less appropriate allocation base that’s already being measured.
For example, there’s been a lot of discussion in the accounting press for years about how direct labor is a bad allocation base, because you may allocate a massive amount of overhead based on a pretty small amount of direct labor cost.
The people saying this are entirely correct. But if direct labor is all that you’re measuring, then use it to allocate overhead. The results may not be pretty, but if you can justify the decision, it may still be the quickest and most efficient way to allocate overhead.
I fully realize that what I’ve just said may have outraged any accounting purists who are listening. But just keep in mind what you’re trying to accomplish here. It’s about compliance, not decision making. Never confuse the two, or you’ll spend far too much time making unnecessary overhead calculations.