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Tracking direct labor and materials that have been used in a job can be done with a fair degree of precision. That is not the real problem when it comes to costing. The real problem is with allocation of overheads. Usually, they have very little correlation to any specific activity. They are the result of many small activities which result in costs being incurred over a period of time but cannot be directly traced to any specific cost object. Job order costing uses the following system to allocate these overheads amongst jobs.
In job order costing, the allocation of overheads is done on the basis of an allocation base. This means that the cost accountants use a known cost as a proxy for allocating the unknown costs. For example, direct labor hours are known for the manufacturing of each product. If the accountants assume that the amount of overheads spent by each product is proportional to their labour hours, then the direct labour hours are an allocation base.
Once the allocation base is decided, overheads are split amongst different cost objects(products) based on their consumption of the allocation base. For example, a company produces three products A, B and C. A consumes 10 hours of direct labour, B consumes 20 hours and C consumer 30 hours. The total amount of overheads spent is $12000.
Since the direct labour hours are in the ratio 1:2:3, the overheads must be split according to the rate 1/6, 2/6 and 3/6. This rate which is derived from the allocation base is called the allocation rate.
When using allocation rates to split the overhead cost, we are assuming that there is a direct relationship between the amount of overheads incurred and the allocation base. In simple words this would mean that the more the labour hours are increased, the more the overheads would increase in roughly the same proportion. This is not usually the case as overheads do not bear a directly proportional relationship with any other costs.
But this is the best approach possible since overheads usually do not have a cause effect relationship that can be traced directly to any cost object. The best that can be done in such a scenario is to reduce the amount of arbitrariness.
The overhead allocation approach suggested by job order costing is a little bit arbitrary. Management must try and reduce the arbitrary nature of this relationship. This can be done by ensuring that there is some amount of correlation between the allocation base and the overheads.
Choosing of allocation base becomes most important and must be done very carefully. Ideally, companies must make a list of the direct cost that they incur. They must then compile the increase and decrease in overheads from previous year’s data. A correlation must be statistically established based on the past data. The direct cost which consistently has the maximum correlation with the overheads must be used as the allocation base.
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