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The problem of indirect cost allocation to products — selection of an adequate allocation base

Category: Budgeting Methodology

A cost calculation which aims to give management adequate information to act in the market economy (where the precise knowledge of product cost is essential), realizes this allocation by choosing allocation bases which as close as possible reflect the cost intensity of the processes and of the auxiliary services which they require. To achieve this, the following has to be taken into account:

If the activity of an operation consists of assembling piece parts essentially through manual labour, the labour time spent on assembling, generally, is an adequate allocation base. This is the case because it can be considered that the products cause indirect cost (energy cost, workshop administration, use of tools, machines, building space materialized through amortization, maintenance, use of utilities etc.) proportional to the time which is needed to perform the assembling work. Operator hours have been selected in the example for productive activity 4 (budgeted volume 18,000 operator hours, i.e. 10 direct workers in one shift). One labour hour, in the example, carries 120.46 indirect cost.

With increasing mechanization, labour hours or labour cost are less and less suitable for allocating indirect cost to products. This is due to the fact that the «human work», even where it still exists, less and less determines the pace of the production process and increasingly has merely an assisting function. If this situation applies, machine hours should be used for indirect cost allocation. This has been done for production activities 1 and 2 in the example. The example shows for the two activities 36,000 and 9,000 budgeted machine hours respectively. This corresponds to an active machine pool of approximately 15 machines in the case of activity 1, and of 3 or 4 machines in the case of activity 2. In the example, the machine hour calculation carries 355.05 respectively 441.64 indirect cost.

As an example of a more simple allocation base, metres have been chosen in the case of activity 3. Such a basis assumes that a product is produced and the output is measured in metres (e.g. rope). Whether indirect cost allocation on the basis of metres is possible in such a case depends on the manufacturing process. If the metre output per machine hour is constant independent of the type of rope which is produced, metres can be used as the absorption base. If this is not the case, machine hours have to be applied.

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