Question

RE: Cost Allocation Sometimes overhead costs do not trace back to products or product lines. Should such costs like Executive Salaries, Legal Department Corporate Headquarters be charged out to divisions and ultimately product lines? How does this help with pricing decisions, Incentive compensation, performance evaluations?

Answer 1

Direct costs are the cost which are directly associated with the product. Usually direct costs associated with products are charged to respective products since it helps in calculating net income at product level. Examples of such cost include: salesman salary, rent for storage of product, advertising, etc. The common costs such as executive salaries, legal department and corporate headquarters are reduced from segment results to get net income. Common costs are not incurred for particular product and hence not charged to products as part of product level income statement. Such costs should not be charged to products since it will distort the product level profitablity and can lead to unreliable decision making like discontinue profitable product.

Charing out such common costs to product lines can help in below ways:

· It helps in pricing decision and recovery of full cost. For example: The pricing can be done based on full costing approach which helps in recovery of common cost.

· Allocating common cost to product helps in calculating breakeven point since product line break point is equal to total firm level breakeven point

· It brings a sense of accountability and responsibility among the departmental mangers to control common cost since it is allocated to products.

· It helps in performance evaluation since the cost are measured against target

· It helps in incentivising the compensation based on comparison of actual results with budgeted results.