One Year-End Overhead Calculation

Nov 13, 2015

At a recent seminar we were teaching concerning cost accounting, one of the participants started a conversation about how insignificant the application of overhead and other non-material costs of production was in the overall determination of their prices. In his operations, raw materials represented a huge portion of the total cost of their product and their conversion costs were a minor part of the overall cost.

This was important because this part of the classroom discussion was focused on methods of allocating overhead and other indirect costs of production. Specifically, we were discussing the methods which could be employed to make overhead application as accurate and as useful as possible. This participant had concluded conversion costs were such a small portion of their total overhead that the effort to adjust it every month was not worth the improved accuracy of results.

CalculatorI believe in his case, he thought activity costs associated with the overhead labor and other indirect costs of production were less than 5% of the total cost of the product. As a result, the company was setting up a standard inventory amount for activity cost and not changing it throughout the year unless there was an obvious and radical change in those costs. Every year-end the calculations were completed by December 31 and whatever minor modification were required in the conversion inventory were made at the same time. Thus, all of the other minor adjustments which could’ve been made throughout the year were ignored until¬†year-end.

This is a viable alternative, particularly in those businesses which have very low inventory changes and/or their conversion cost are a much lower part of their year-end inventory.

By not making any of the other conversion calculations during the year, the business loses the opportunity to help control indirect costs through variance analysis. Had they been monitoring and reporting on conversion costs to standard throughout the year, it would have been available.

Just because the company does not choose to make inventory adjustments monthly, does not mean they are not using the rest of the possible management tools associated with an efficient costing system. I would imagine they are utilizing tools related to activity levels and budgeted amounts compared to actual amounts on the spending side of the various computations. However, it was my impression during this discussion that that entire side of the calculation, meaning the entire activity measurement and variance analysis that would be otherwise associated with the calculation of a conversion cost inventory, was being ignored until the end of the year. The work associated with making those calculations and monitoring the results must be carefully weighed against the benefits of making those monthly changes. Another important measurement is the cost-benefit approach which should always be the final judgment tool to determine if these calculations should be made and posted. It may be adequate to hold off until year-end and use a standard amount every month as the minor modifications would not provide useful enough information to make it worthwhile.

Does anyone else do this with their overhead allocation? If so why, and what benefits/risks do you see?

Categories: Cost Accounting