Traditional Method of Calculating Overhead
The traditional allocation system assigns manufacturing overhead based on a single cost driver, such as direct labour hours, direct labour dollars, or machine hours, and is ideal when the activity base and overhead have a relationship.
This is especially common when direct labour accounts for a significant portion of the product’s cost. According to the idea supporting the single cost driver, the selected cost driver rises as overhead costs rise, and additional analysis is more costly than it is beneficial.
Each approach has its benefits and drawbacks. These are the benefits of the conventional approach:
- Regardless of whether they drive or are driven by production, all manufacturing costs are categorised as material, labour, or overhead and allocated to goods.
- In contrast, nonmanufacturing expenditures are not considered production costs and are not assigned to goods, regardless of whether they are product-based. The machines used to receive and process client orders, for instance, are required since product orders must be taken, but their expenses are not tied to specific products.
- The traditional technique is straightforward and inexpensive to operate because there is just one overhead cost pool and a single measure of activity, such as direct worker hours. The overhead rate is defined based on projected expenditures at the budgeted activity level. Therefore, the overhead rate is similar across all goods, yet overhead may be imposed excessively or insufficiently.
Among the disadvantages of the conventional approach are:
- Utilizing a single cost driver to assign overhead is less precise than using many cost drivers.
- The usage of a single cost driver may over-allocate overhead to one product and under-allocate overhead to another, resulting in inaccurate total costs and possibly an improper sales price.
- The traditional allocation approach distributes costs as a period or product costs, and all product costs are included in the cost of inventory, making it acceptable under generally accepted accounting principles (GAAP).