Volume Based Allocation
Allocating factory overhead expenditures on the basis of volume, as opposed to cost, is known as volume-based allocation. Examples of such allocation criteria include the amount of floor space utilized, the number of labor hours, the number of machine hours, and the quantity of units produced. When many overhead cost pools are established and the expenses in each one are allocated using the most pertinent basis of allocation, an increased level of allocation accuracy can be attained.
Traditional product costing was created when the majority of product expenses incurred within a company or factory were made up of direct material costs and direct labor costs. The general tendency of factory overheads is to serve all production, so they cannot be immediately linked to or connected to goods or services.
Labor-related activities used to be a significant manufacturing activity. Direct materials costs, the second significant component of production expenses, are made to vendors rather than incurring costs directly at the factory. Volume-based costing systems concentrate on measuring and controlling direct labor costs because they are a key component of manufacturing expenses and the main activity in producing a product.
Factory overheads are considered resources used to support labor activities even though they only make up a minor portion of the labor cost. A conventional overhead costing system becomes a volume-based costing system by tying to direct labor costs. Direct labor expenses and overhead costs vary proportionally to changes in production units when volumes (or units) change.
- It makes the simple labor-based production norm and a minimal amount of mechanization assumptions.
- Direct costs, such as direct labor and direct material, account for a bigger share of overall production costs.
- Because support or service functions like planning, purchasing, accounting, finance, administration, etc. are less common, overhead expenses are relatively low.
- In general, it is assumed that standardized items are produced.
Limitations Of Volume-Based Costing System
- Traditional costing methodologies do not take into account how many resources different products use.
- Overheads increasingly account for the largest portion of costs, frequently exceeding 50%, and are frequently applied to items as a proportion of the smallest cost (direct labor), substantially distorting the cost of the final product.
- Traditional costing systems do a poor job of accurately portraying supporting costs for production and distribution of goods or services since they rely on volume-related indicators to establish product costs. A growing amount of industrial overheads, including setup expenses, materials handling costs, and costs associated with product design and R&D, are unrelated to the volume of units produced.
- Conventional costing methods frequently undercost low volume products and overcost standard, high volume products, which results in inaccurate pricing and product mix decisions.
- As a result, there is a tendency towards direct labor reduction as a cost-cutting strategy rather than increased total productivity.
- It offers no data that may be used to find opportunities for productivity improvement or to determine whether productivity improvement efforts have produced meaningful outcomes. In fact, a typical costing system frequently suggests greater costs when productivity improvements are present or vice versa.
When a company firm possesses the following traits, a volume-based costing method may offer reasonably accurate costs:
- Product and service lines are few and highly comparable.
- Low operating costs.
- Similar client expectations, distribution methods, and customers.
- The conversion method is the same for all goods and services.
- Hefty profit margins for goods and services.