Source: Horngren's Cost Accounting: A Managerial Emphasis, 16th ed. (Datar/Rajan), Chapters 4–9, 14–15
Tags: job-order costing, process costing, activity-based costing, ABC, overhead allocation, cost pool, cost-allocation base, predetermined overhead rate, normal costing, actual costing, equivalent units, spoilage, joint costs, support department allocation, ACCTMIS 3300
Difficulty: Intermediate | Prerequisites: Part 1 (Cost Concepts, Cost Behaviours, and Management Accounting Fundamentals). You need to be comfortable with direct vs. indirect costs and the manufacturing cost-flow sequence before tackling allocation methods.
Once you can classify costs, the next question is: how do you attach indirect costs to cost objects? This is the allocation problem, and it is one of the most practically important topics in cost accounting. Every organisation that produces more than one product or service has to decide how to spread shared costs across those outputs.
This unit covers three costing systems (job-order, process, and activity-based) and the mechanics of overhead allocation, including what to do with over- or under-applied overhead. It also addresses joint-cost allocation and support-department cost allocation, both of which appear regularly in corporate and public accounting.
The choices made here affect reported product costs, inventory values, pricing decisions, and profitability analysis. Two companies making identical products can report different unit costs purely because they chose different allocation methods.
Indirect costs must be allocated to cost objects because they cannot be traced directly. Job-order costing tracks costs by individual job or batch; process costing averages costs across large volumes of identical units. Activity-based costing (ABC) refines allocation by using multiple cost pools tied to the activities that cause costs. The allocation base you choose can significantly change reported product costs.
Predetermined overhead rate (POHR)
An estimated rate used to apply manufacturing overhead to production, calculated before the period begins. POHR = Estimated total manufacturing overhead / Estimated total amount of the allocation base.
In simple terms, because you cannot know actual overhead until the period ends, you use a budgeted rate to assign overhead to jobs or units as production happens.
Cost pool
A grouping of individual indirect-cost items. A single cost pool uses a single allocation base. A plant-wide overhead pool lumps all overhead together; departmental or activity-based pools break it into finer groups.
Think of it as a bucket: you toss related costs into the same bucket, then pour them out across cost objects using one allocation base.
Cost-allocation base
The factor used to link an indirect-cost pool to cost objects. Common bases include direct labour hours, machine hours, direct labour cost, and number of units. The base should have a plausible cause-and-effect relationship with the costs in the pool.
Normal costing
A costing method that uses actual direct material and direct labour costs but applies overhead using the predetermined overhead rate. This is the standard approach in most job-order systems.
Actual costing
A costing method that uses actual direct materials, actual direct labour, and actual overhead incurred. Rarely used in practice because actual overhead is not known until period-end.
Job-order costing (job costing)
A costing system that accumulates costs by individual job, batch, or contract. Each job has its own cost record (job-cost sheet). Used when products or services are distinct, such as custom furniture, legal engagements, or construction projects.
Process costing
A costing system that averages costs over large numbers of identical or near-identical units. Costs are accumulated by department (process) rather than by job. Used in industries like chemicals, food processing, oil refining, and semiconductors.
Equivalent units
A measure that converts partially completed units into the equivalent number of fully completed units. If 1,000 units are 40% complete for conversion costs, that equals 400 equivalent units of conversion.
In simple terms, equivalent units let you calculate a meaningful per-unit cost when some units are only part-way through production at period-end.
Weighted-average method
A process-costing method that merges beginning WIP costs with current-period costs and divides by total equivalent units (beginning work done plus current-period work). It does not separate the periods.
FIFO method (process costing)
A process-costing method that separates beginning WIP costs from current-period costs. It computes the cost per equivalent unit based only on current-period work, giving a more current unit cost.
Activity-based costing (ABC)
A costing approach that identifies activities as the fundamental cost objects, assigns costs to those activities, and then assigns activity costs to products or services using cost drivers specific to each activity.
Think of it as replacing one big overhead bucket with many small, activity-specific buckets, each with its own allocation base. The result is more accurate product costs, especially when products consume activities in very different proportions.
Over-applied overhead
The amount by which overhead applied to production (using the POHR) exceeds actual overhead incurred. The overhead account has a credit balance at period-end.
Under-applied overhead
The amount by which actual overhead incurred exceeds overhead applied to production. The overhead account has a debit balance at period-end.
Joint costs
Costs incurred in a single process that simultaneously produces two or more products (joint products) up to the split-off point. These costs cannot be traced to individual products before split-off.
Split-off point
The point in a joint production process at which individual products become separately identifiable.
Support department (service department)
A department that provides services to other departments but does not work directly on the product sold to customers. Examples: maintenance, IT, human resources. Support department costs must be allocated to operating (production) departments.
Direct method (support department allocation)
Allocates each support department's costs directly to operating departments, ignoring any services that support departments provide to each other.
Step-down method (sequential method)
Allocates support department costs one department at a time, in a specified sequence. Once a support department's costs are allocated out, no subsequent support department allocates costs back to it.
Reciprocal method
Allocates support department costs simultaneously, recognising that support departments serve each other. Uses simultaneous equations or matrix algebra. Conceptually the most accurate of the three methods.
Each job (a single unit or a batch) receives its own job-cost sheet that tracks direct materials, direct labour, and applied overhead.
Direct materials are traced using materials requisition forms.
Direct labour is traced using time tickets or labour logs.
Overhead is applied using the predetermined overhead rate: Overhead Applied = POHR x Actual amount of allocation base used by the job.
The job-cost sheet is the subsidiary ledger for WIP inventory.
When the job is complete, its total cost moves from WIP to Finished Goods.
POHR = Estimated total MOH for the period / Estimated total allocation base for the period.
Common allocation bases: direct labour hours, machine hours, direct labour cost.
A single plant-wide rate uses one base for the entire factory.
Departmental rates use different bases for different departments (e.g., machine hours in a machining department, direct labour hours in an assembly department).
The rate is set at the start of the period and used throughout. It does not change mid-period.
At year-end, compare actual overhead incurred to overhead applied.
If applied > actual, overhead is over-applied (credit balance in the overhead account).
If actual > applied, overhead is under-applied (debit balance).
Disposal options:
Write off to COGS: simplest; appropriate when the amount is immaterial.
Prorate across WIP, Finished Goods, and COGS in proportion to the overhead applied in each account's ending balance. More accurate; required when the amount is material.
Used when large volumes of identical units flow continuously through one or more processes.
Costs are accumulated by department, not by job.
Per-unit cost = Total costs assigned to the department / Number of equivalent units.
The five-step process:
Summarise the physical flow of units.
Compute equivalent units of production.
Summarise total costs to account for.
Compute cost per equivalent unit.
Assign total costs to completed units and ending WIP.
Weighted-average blends beginning WIP costs with current costs. Equivalent units include all work (prior period plus current period). Simpler to calculate.
FIFO keeps beginning WIP costs separate. Equivalent units reflect only current-period work. Gives a more up-to-date unit cost, which matters when costs are changing over time.
Both methods yield the same total cost to account for; they differ in how that total is split between completed units and ending WIP.
Traditional systems use one or two allocation bases (typically volume-based). ABC uses many.
ABC steps:
Identify the major activities performed (e.g., machine setups, quality inspections, purchase-order processing, material handling).
Assign costs to each activity's cost pool.
Identify the cost driver for each activity (e.g., number of setups, number of inspections).
Compute the activity rate: Activity Rate = Total cost in pool / Total quantity of cost driver.
Assign costs to products: Product cost from activity = Activity Rate x Quantity of cost driver consumed by the product.
ABC tends to shift costs away from high-volume products (which tend to be over-costed by traditional systems) and toward low-volume, complex products (which tend to be under-costed).
ABC is more accurate but more expensive to implement and maintain. The cost-benefit trade-off is a key exam topic.
Unit-level activities: performed each time a unit is produced (e.g., machining, direct labour).
Batch-level activities: performed each time a batch is processed (e.g., machine setup, purchase-order processing).
Product-sustaining activities: support a specific product line regardless of batches or units (e.g., product design, engineering changes).
Facility-sustaining activities: support the organisation as a whole (e.g., plant security, general administration). These are often allocated arbitrarily because no single product causes them.
Joint products emerge from a single process up to the split-off point. Before split-off, you cannot tell the products apart, so the joint costs cannot be traced.
Allocation methods:
Sales value at split-off: allocates joint costs based on each product's relative sales value at the split-off point. Preferred when market prices exist at split-off.
Net realisable value (NRV): allocates based on final sales value minus separable costs after split-off. Used when there is no market for the product at split-off.
Physical-measure method: allocates based on physical quantities (litres, kilograms, tonnes). Simple but ignores the economic value of the products.
Joint-cost allocations are relevant for financial reporting and inventory valuation but are irrelevant for the sell-or-process-further decision (that decision depends only on incremental revenue vs. incremental separable cost after split-off).
Support departments (maintenance, IT, HR) serve operating departments.
Three methods, in order of increasing accuracy:
Direct method: ignores inter-support-department services. Simplest.
Step-down method: allocates one support department at a time; partially recognises inter-department services.
Reciprocal method: uses simultaneous equations to fully recognise inter-department services. Most accurate.
Predetermined overhead rate:
POHR = Estimated Total MOH / Estimated Total Allocation Base
Overhead applied to a job:
Overhead Applied = POHR x Actual Allocation Base Used by the Job
Over- or under-applied overhead:
Difference = Overhead Applied – Actual Overhead Incurred
(Positive = over-applied; negative = under-applied)
Equivalent units (weighted-average):
EU = Units Completed and Transferred Out + (Ending WIP Units x % Complete)
Equivalent units (FIFO):
EU = (Beginning WIP Units x % Needed to Complete) + Units Started and Completed + (Ending WIP Units x % Complete)
Cost per equivalent unit:
Cost per EU = Total Costs to Account For / Total Equivalent Units
ABC activity rate:
Activity Rate = Total Cost in Activity Pool / Total Quantity of Cost Driver
NRV at split-off (for allocation):
NRV = Final Sales Value – Separable Costs after Split-Off
A construction company tracking costs per building project is using job-order costing. An oil refinery that processes crude into petrol, diesel, and jet fuel and needs to value each product's inventory is dealing with joint-cost allocation. A hospital that wants to understand why certain procedures cost more than others might implement ABC to trace overhead to specific activities (operating-room time, lab tests, nursing hours) rather than spreading it evenly across all patients.
The choice of allocation method can change whether a product line appears profitable or not, which directly influences managerial decisions about pricing, discontinuation, and resource investment.
"A plant-wide overhead rate is always good enough." It is acceptable when products consume resources similarly, but when one product is machine-intensive and another is labour-intensive, a single rate distorts costs. Departmental or ABC rates give more useful numbers.
"ABC eliminates arbitrary allocations." ABC reduces them at the unit, batch, and product-sustaining levels, but facility-sustaining costs still get allocated somewhat arbitrarily because no single product causes them.
"Joint-cost allocation tells you which product is more profitable." Joint-cost allocations are necessary for inventory valuation, but the allocated amounts are meaningless for deciding whether to sell a joint product at split-off or process it further. That decision rests on incremental revenues vs. incremental costs beyond split-off.
"Equivalent units and physical units are the same thing." They are not. Equivalent units adjust for the degree of completion. 500 units that are 60% complete equal 300 equivalent units, not 500.
⚠️ Be ready to compute the POHR, apply it to a job, and determine over- or under-applied overhead at year-end. Know both disposal methods (write-off to COGS vs. proration).
⚠️ Equivalent-unit calculations, under both weighted-average and FIFO, are a staple exam problem. Set up the physical-flow analysis first; the rest follows from it.
⚠️ ABC questions often ask you to compare the product cost under a traditional single-rate system vs. ABC. Expect the high-volume product to get cheaper and the low-volume product to get more expensive under ABC.
⚠️ For joint costs, remember: allocation method matters for inventory valuation, but the sell-or-process-further decision uses only incremental data after split-off. The exam will try to trick you into including joint costs in that decision.
⚠️ Know the three support-department allocation methods and what distinguishes each. The reciprocal method is the most accurate but the most computationally intensive.
True or false: Normal costing uses actual overhead costs to charge jobs.
Fill in the blank: Under process costing, partially completed units are converted to __________ for the purpose of computing a per-unit cost.
True or false: Under ABC, batch-level costs are driven by the number of units produced.
Fill in the blank: The point in a joint process where individual products become identifiable is called the __________.
True or false: The direct method of support-department allocation ignores services provided between support departments.
Answers: 1. False (normal costing uses the predetermined rate). 2. Equivalent units. 3. False (batch-level costs are driven by the number of batches, not units). 4. Split-off point. 5. True.
Q: A company estimates total manufacturing overhead of £600,000 and total machine hours of 40,000 for the year. Job #207 uses 120 machine hours. How much overhead is applied to Job #207 under normal costing?
A: POHR = £600,000 / 40,000 MH = £15 per MH. Overhead applied to Job #207 = £15 x 120 = £1,800.
Q: At year-end, a firm applied £500,000 of overhead but incurred £520,000 of actual overhead. Is overhead over- or under-applied, and by how much? If the amount is immaterial, how is it disposed of?
A: Overhead is under-applied by £20,000 (actual exceeds applied). If immaterial, the £20,000 is added to Cost of Goods Sold (increasing COGS).
Q: Explain why ABC tends to increase the reported cost of low-volume, complex products compared to a traditional volume-based overhead system.
A: Low-volume products consume a disproportionate share of batch-level and product-sustaining activities (setups, inspections, engineering changes) relative to their unit volume. A traditional system spreads overhead using a volume base like direct labour hours, which under-costs these products because they use few labour hours. ABC assigns costs based on actual activity consumption, revealing the true cost of the complexity these products require.
Q: A joint process produces Product A (selling price £10/unit at split-off) and Product B (selling price £30/unit at split-off). Total joint costs are £100,000. Output is 5,000 units of A and 2,000 units of B. Allocate joint costs using the sales-value-at-split-off method.
A: Total sales value at split-off: A = 5,000 x £10 = £50,000; B = 2,000 x £30 = £60,000; Total = £110,000. Allocation to A = (£50,000 / £110,000) x £100,000 = £45,455. Allocation to B = (£60,000 / £110,000) x £100,000 = £54,545.
The POHR and overhead application mechanics here feed directly into the variance analysis in Part 3, where you will compare applied overhead to actual overhead in more detail (spending and efficiency variances). ABC also connects to pricing decisions and customer profitability analysis. The cost-flow understanding from Part 1 (Raw Materials → WIP → Finished Goods → COGS) underpins every journal entry in both job-order and process costing.
job-order costing, job costing, job-cost sheet, process costing, activity-based costing, ABC, overhead allocation, predetermined overhead rate, POHR, normal costing, actual costing, cost pool, cost-allocation base, cost driver, equivalent units, weighted-average method, FIFO method, over-applied overhead, under-applied overhead, proration, joint costs, split-off point, joint products, by-products, sales value at split-off, net realisable value, NRV, physical-measure method, support department allocation, service department, direct method, step-down method, reciprocal method, activity hierarchy, unit-level, batch-level, product-sustaining, facility-sustaining, Horngren chapter 4, Horngren chapter 5, ACCTMIS 3300