Traditional Method of Allocating Indirect Costs

The traditional practice of general ledger costing involves estimating all overhead costs for the upcoming year in a single cost pool (e.g., FO, utilities, safety program, training, and salaries of foremen and factory managers). This total is then divided by the estimated number of labor hours to be worked. The result is an hourly overhead rate. For each product, the required labor hours are estimated. The total overhead cost for the product is then equal to the required labor hours multiplied by the hourly overhead rate.

For example, let us assume that a factory has $800,000 in overhead (e.g., salary of manager, benefits, and other general charges), 2,000 direct hours per employee per year, and 20 employees. The hourly overhead rate is then $20 per hour (= 800,000/ (2,000 x 20)).

The major deficiency of this method of allocating indirect costs is that it does not reflect the true relationship between the indirect costs and the applicable cost object (such as products, services, and customers). Therefore, the allocation is often improper, as diverse types of overhead costs are lumped together, making an in-depth analysis impossible (Cooper and Kaplan 1988).

A better method of allocating indirect costs is activity-based costing (ABC), which is introduced next.