Allocation Method

Overview: What is Allocation Method?

In business studies, understanding this methodology aids in optimising operations and boosting your company's productivity. It helps determine the business costs and chart out the correct price for your goods or services. While using the Allocation Method, you need to consider the costing method, either traditional or modern, that best fits your business's needs.

Traditional Cost Allocation Methods

Traditional cost allocation methods are longstanding practices where costs are distributed based on simple metrics or ratios.

Cost Allocation in Manufacturing

In a manufacturing context, costs such as direct labour and material costs get attributed to specific products or product groups. Moreover, overhead costs are usually distributed based on direct labour hours or machine hours.

Job Order Costing: An Allocation Method Example

Job order costing is another example of a traditional allocation method. In this method, the costs are assigned to specific jobs or tasks rather than departments. Raw materials, labour costs, and overhead expenses are tracked for every job.

Modern Overhead Allocation Methods

Modern allocation methods were developed to overcome the limitations of traditional methods.

Activity-Based Costing: An Allocation Method Example

It captures the complexity of the cost structure better and hence is more accurate.

Difference Between Allocation Methods

Knowing the difference between these methods can greatly influence your decision while choosing an allocation method for your business.

Traditional vs. Modern Allocation Method

In terms of accuracy, modern methods like ABC outperform traditional methods due to granularity. Also, modern methods streamline the allocation of indirect costs better than traditional methods.

Benefits and Drawbacks of Different Allocation Methods

Here are key points to consider:

• Traditional methods are simpler, easier to implement, and work well in straightforward operations.
• Modern methods provide a more accurate and granular cost-structure, critical in complex operations.
• On the downside, modern methods can be complex, expensive, and demand a significant time investment.

Remember, the best allocation method varies as per your business type, size, and operational complexity.

Practical Applications of the Allocation Method

The Allocation Method is not just a theoretical concept but finds practical applications across various aspects of businesses. It is utilised in accounting practices for better analysis of cost structures and engages in shaping strategic business decisions.

Applying Cost Allocation Methods in Accounting

In every business, accounting plays a pivotal role. It provides a clear picture of the financial standing of the company. Within this discipline, cost allocation methods bear a special significance. It assists in budgeting, cost control, decision-making processes, and helps to devise the most profitable operational strategies.

How Allocation Method Influences Budgeting

Budgeting is a systematic approach to plan the financial use of resources in an organisation. The allocation method works as a framework that defines how costs are distributed across various departments, services or products. It forms an inherent part of the budgeting process, helping businesses to draft a sound fiscal plan. Through allocation methods, organisations can:

• Have a clear understanding of direct and indirect financial needs of every department or operation.
• Determine the overall budget required for every department or service with maximum accuracy.
• Engage in effective financial planning and control.

Allocation Method in cost control and decision making

Part of the power of allocation methods lies in their applicability to cost control and decision making. Good practice in cost allocation can lead to precise costing information. This detail is crucial in making strategic decisions such as pricing, budgeting, cost reduction strategies, and investment choices. For instance, an accurate allocation of manufacturing overheads helps provide a realistic cost structure for each product. This information is critical when the management needs to decide on discontinuing a product line or investing more in its expansion.

Overhead Allocation Methods: Practical Uses

Overhead allocation methods specifically focus on allocating indirect costs, such as administration or utility costs, to different operational units. Their application is practical and far-reaching within a business setup.

Using Overhead Allocation Methods for Product Pricing

One practical use of overhead allocation methods is their application to price products accurately. Correctly allocating overhead costs to each product can provide a clearer understanding of the total cost of producing each item. For example, if a business uses an activity-based allocation methodology, it may find out that certain products consume a larger proportion of overhead resources. These implications directly affect pricing strategies, profitability assessments, and product mix decisions.

Overhead Allocation: A Key for Business Efficiency

Overhead allocation is not just about accounting accuracy; it drives business efficiency. By delving into the details of overhead allocation, organisations become more cognizant of process inefficiencies, unproductive activities, or underutilised resources. Employing an effective overhead allocation method can:

• Reveal inefficiencies in operations and help businesses streamline processes.
• Facilitate a detailed understanding of the cost proportion consumed by overheads.
• Highlight departments or activities that are overusing resources.

Thus, overhead allocation plays a pivotal role in the strategic management of business operations. Through its practical application, companies can achieve higher operational efficiency and profitability.

Exploring Examples of Allocation Method in Business Studies

You can gain a clearer understanding of the allocation method by pondering real-life business scenarios. Through these practical examples of cost allocation methods, you may identify its significance in both the manufacturing and service industry. These examples also offer an insight into how overhead costs get productively allocated in business accounting practices.

Real-Life Examples of Cost Allocation Methods

In every business setup, cost allocation methods find important applications. Diverse industries use these methods to make sense of their cost structures, making it easy for you to uncover real-life examples in varied sectors.

Allocation Method Example in the Manufacturing Industry

Imagine a clothing manufacturing company producing different types of products such as shirts, trousers, and jackets. The raw materials, labour cost, and direct costs are easy to assign to each product line. However, the overhead costs like rent, utilities, and salaries of management staff (indirect costs) need to be appropriately allocated to each product line to ensure accurate costing information. Here, the organisation might make use of an allocation base - such as labour hours or machine hours – to distribute the overheads. For instance, if the overhead costs amount to £100,000, and the machine hours for the production of shirts, trousers, and jackets are respectively 5000, 3000, and 2000 hours, you can allocate the overheads as follows: Overhead Cost per Machine Hour = Total Overhead Cost / Total Machine Hours In LaTeX, this is represented as: \[ \text{{Overhead Cost per Machine Hour}} = \frac{{\text{{Total Overhead Cost}}}}{{\text{{Total Machine Hours}}}} \] Hence, if we plug in our values we get: \[ \text{{Overhead Cost per Machine Hour}} = \frac{{£100,000}}{{10,000 hours}} = £10 \] Consequently, the overhead cost for each product line would be: \[ \begin{aligned} & \text{{Overhead cost for Shirts}} = £10 \times 5000 = £50,000 \\ & \text{{Overhead cost for Trousers}} = £10 \times 3000 = £30,000 \\ & \text{{Overhead cost for Jackets}} = £10 \times 2000 = £20,000 \\ \end{aligned} \]

Allocation Method Example in the Service Industry

In the service industry too, cost allocation methods bear relevance. Consider an advertising firm offering services like graphic design, copywriting, and market research. Direct costs (labour cost, specific software for a service) are assigned to each service, and overhead costs such as rent and administrative salaries need to be distributed across different services. If the firm decides to use the proportion of direct labour cost for allocating overhead costs, and the total overhead costs are £150,000 and the direct labour costs for graphic design, copywriting, and market research are £50000, £40000, and £30000 respectively, the allocation of overhead would look like this: Percent Allocation for Each Service = Direct Labour Cost of Service / Total Direct Labour Costs This gives us: \[ \begin{aligned} & \text{{Percent Allocation for Graphic Design}} = \frac{{£50,000}}{{£1,20,000}} \approx 42\% \\ & \text{{Percent Allocation for Copywriting}} = \frac{{£40,000}}{{£1,20,000}} \approx 33\% \\ & \text{{Percent Allocation for Market Research}} = \frac{{£30,000}}{{£1,20,000}} \approx 25\% \\ \end{aligned} \] The overhead cost for each service would be: \[ \begin{aligned} & \text{{Overhead cost for Graphic Design}} = 42\% \times £1,50,000 = £63,000 \\ & \text{{Overhead cost for Copywriting}} = 33\% \times £1,50,000 = £49,500 \\ & \text{{Overhead cost for Market Research}} = £25\% \times £1,50,000 = £37,500 \\ \end{aligned} \]

Overhead Allocation Methods: Practical Examples

Overhead allocation is a particular aspect of cost allocation that specifically deals with the distribution of indirect costs. A couple of examples could help you understand how overhead costs such as administrative and manufacturing overheads are split across different operational units.

Allocation Method Example: Allocating Administrative Overhead

For example, let's consider a multi-department organisation. The administrative overheads, such as CEO's salary or administrative staff salaries, would have to be allocated to the different departments. The base for allocation could be the percentage of total employee count or total revenue of each department. If the organisation decides to allocate based on the number of employees and the total administrative overhead is £200,000, and the employee count in Department A, B, and C are 50, 30, and 20 respectively, the administrative overhead would be allocated as follows: Percent Allocation for Each Department = Number of employees in the department / Total Employees This results in: \[ \begin{aligned} & \text{{Percent Allocation for Department A}} = \frac{{50}}{{100}} = 50\% \\ & \text{{Percent Allocation for Department B}} = \frac{{30}}{{100}} = 30\% \\ & \text{{Percent Allocation for Department C}} = \frac{{20}}{{100}} = 20\% \\ \end{aligned} \] And so, the overhead for each department would be: \[ \begin{aligned} & \text{{Overhead allocation for Department A}} = 50\% \times £200,000 = £100,000 \\ & \text{{Overhead allocation for Department B}} = 30\% \times £200,000 = £60,000 \\ & \text{{Overhead allocation for Department C}} = 20\% \times £200,000 = £40,000 \\ \end{aligned} \]

Allocation Method Example: Allocating Manufacturing Overhead

A company engaged in the manufacturing of multiple products has to deal with various manufacturing overheads, such as factory rent, electricity, and indirect labour. These overheads have to be spread across different products to ascertain the true cost of each product. Suppose, if they choose to allocate based on machine hours and the total manufacturing overhead is £250,000, with machine hours for Product X, Y, and Z being 5000, 3000, and 2000 hours respectively, the overheads would be allocated as: Overhead Cost per Machine Hour = Total Manufacturing Overhead / Total Machine Hours Thus, we obtain: \[ \text{{Overhead cost per machine hour}} = \frac{{£250,000}}{{10,000 hours}} = £25 \] And so, the manufacturing overhead for each product is: \[ \begin{aligned} & \text{{Overhead cost for Product X}} = £25 \times 5000 hours = £125,000 \\ & \text{{Overhead cost for Product Y}} = £25 \times 3000 hours = £75,000 \\ & \text{{Overhead cost for Product Z}} = £25 \times 2000 hours = £50,000 \\ \end{aligned} \] All these detailed examples underline the importance of the allocation method in capturing accurate cost structures, thereby acting as an aid in making informed business decisions.