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Direct material and direct labor are easily traced to a product or service. Overhead,
on the other hand, must be accumulated over a period and allocated to the products
manufactured or services rendered during that time. Cost allocation refers to
the assignment of an indirect cost to one or more cost objects using some reasonable
basis. This section of the chapter discusses underlying reasons for cost
allocation, use of predetermined overhead rates, separation of mixed costs into
variable and fixed elements, and capacity measures that can be used to compute
predetermined overhead rates.
Why Overhead Costs Are Allocated
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.11 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.12 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.
Predetermined Overhead Rates
In an actual cost system, actual direct material and direct labor costs are accumulated
in Work in Process Inventory as the costs are incurred. Actual production
overhead costs are accumulated separately in an Overhead Control account and
are assigned to Work in Process Inventory at the end of a period or at completion
of production.
The use of an actual cost system is generally considered to be less than desirable
because all production overhead information must be available before any cost
allocation can be made to products or services. For example, the cost of products
and services produced in May could not be calculated until the May electricity bill
is received in June