Allocation of nonmanufacturing overhead costs is an important service you can provide to your clients. Generally accepted accounting principles do not allow you to assign them to products as manufacturing overhead costs for financial reports, but small business owners need this information to include these costs in the price of their products so they earn a profit.
Clients also need this information to make important business decisions when choosing which products are the most profitable and which cost the most. You need to accurately match administrative costs with the products that use them. A product that requires a lot of support and administrative overhead may seem like a big moneymaker when it’s not, and a product that is very profitable may not appear to be a good choice. You can add value to the services you provide your client by preparing reports that allocate nonmanufacturing overhead for their own internal use.
Traditional vs. Activity-Based Costing
The traditional accounting method develops an average overhead cost rate and applies it to a cost driver such as units produced, hours worked, or machine hours. The problem with this method is that it uses an average overhead rate, so some costs are overrepresented in the product price, making the product seem less profitable. Conversely, some costs are underreported, making the product seem more profitable.
Activity-based costing is a method of allocating overhead costs with the activities that lead to these costs.
You start by identifying every activity associated with producing an item and allocate a cost to that activity. The cost assigned to the activity is then assigned to products that require the activity for production. This method can be summarized as:
1. Identify activities related to nonmanufacturing costs.
2. Determine the cost of these activities.
3. Identify the products associated with these activities.
4. Assign the cost of the activities to these products and customers.
Activity-based costing is more accurate for allocating nonmanufacturing costs because it matches costs with the activities that drive them and keeps overhead costs from being assigned to products that don’t use them. This gives management a better idea of a product’s profitability and helps it decide whether to continue certain products in light of their nonmanufacturing costs.