Accounting for Managers: Interpreting accounting information for decision-making

ACCOUNTING DECISIONS 159

Direct costs Variable costs

Materials, labour etc. directly traceable to

+

Electricity, consumables etc.

Indirect manufacturing costs Product costs

Fixed costs

Rent, depreciation etc. allocated to

+

Non-manufacturing costs Period costs

=

Total costs

Figure 11.2 The overhead allocation problem

Theoverhead allocation problemis a significant issue, as most businesses produce
a range of products/services using multiple production processes. The most
common form of overhead allocation employed by accountants has been to allocate
overhead costs to products/services in proportion to direct labour. However, this
may not accurately reflect the resources consumed in production. For example,
some processes may be resource intensive in terms of space, machinery, people
or working capital. Some processes may be labour intensive while others use
differing degrees of technology. The cost of labour, due to specialization and
market forces, may also vary between different processes.
Further, the extent to which these processes consume the (production and
non-production) overheads of the firm can be quite different. The allocation
problem can lead to overheads being arbitrarily allocated across different prod-
ucts/services, which can lead to misleading information about product/service
profitability. As production overheads are a component of the valuation of inven-
tory (because they are part of the cost of sales), different methods of overhead
allocation can also influence inventory valuation and hence reported profitability.
An increase or decrease in inventory valuation will move profits between different
accounting periods.

Shifts in management accounting thinking.....................

In their bookRelevance Lost: The Rise and Fall of Management Accounting, Johnson and
Kaplan (1987) emphasized the limitations of traditional management accounting
systems that failed to provide accurate product costs: