Once again, this common costing mistake comes from our experience working with clients and from those who attend our cost forums. I would rank this issue near the top of all the issues. If not number one or two, certainly in the top three of the most common problems we see with cost accounting systems. So what is the issue: businesses falling into a pattern of selecting how to apportion their overhead to their products based on past history. Often times the logic we hear is: “we’ve always done it this way, therefore it must be right!” This leads many businesses to make improper selections from the start, or to continue with their selections long after operations have significantly changed to result in severs inaccuracies.
This also is one of the greatest areas of concern for business managers when questioning the validity of their cost accounting system and how they are apportioning overhead. In a study done a few years ago by Ernst & Young, they concluded that 98% of business managers do not believe that overhead is being apportioned to products via their cost system in a way that is correct or accurate. With that high of a percentage of managers questioning the methods being used to allocate overhead, it would be obvious to all that this is certainly an area that deserves attention.
I believe part of the mistrust derives from literature concerning activity based costing (ABC) and the promise that ABC could bring to the cost accounting field. ABC states that all costs can be accurately attributed to products if enough time is spent determining what activity creates the cost and tracking that back in to the product. There are certainly benefits to be gained by accurately measuring the activity and the cost that is created from that activity and tracking that back to the individual product. However, the presumption that all costs can be traced back to the individual product via some method of activity and cost measurement is absurd. There are some costs that irrespective of how carefully they are analyzed, cannot be apportioned to products in any other way other than an arbitrary allocation.
Having said that, I want to be clear that I don’t believe that such an allocation gives rise to inaccuracies or bad costing theory, but it is a fact of life in cost accounting that some cost bands must be attributed on some pre-determined base.
How to select the base, what attributes the base brings to the allocation process, and the relevancy of the base to accurate cost accounting are all decisions to be made by the cost managers. We frequently help businesses make those calculations using mathematical techniques which improve the overall relevancy of the allocation base to the overhead apportioned to inventory. However, at the end of the day, it is still an allocation based on a professional’s best judgment and certainly subject to continuous review by future cost accountants as they attempt to improve the process of allocating overhead to products.
The one recommendation I can always make in this process is that if you have been relying on the same reoccurring allocation base to apportion your overhead to your product, now would be a good time to review your process. Then, make a plan to have an annual review by a knowledgeable cost accountant. I assure you this would be time well spent, and would make your allocations a lot more relevant and accurate.