Which of the three approaches of dealing with under- or overallocated overhead is the best one to use? When making this decision, managers should consider the amount of the under- or overallocated overhead costs and the purpose of the adjustment, as the following table indicates.
| If the purpose of the adjustment is to . . . | and the total amount of underallocation or overallocation is . . . | then managers prefer to use the . . . |
|---|---|---|
| state the balance sheet and income statements based on actual rather than budgeted manufacturing overhead rates | big, relative to total operating income, and inventory levels are high | proration method because it is the most accurate method of allocating actual manufacturing overhead costs to the general ledger accounts. |
| state the balance sheet and income statements based on actual rather than budgeted manufacturing overhead rates | small, relative to total operating income, or inventory levels are low | write-off to cost of goods sold approach because it is a good approximation of the more accurate proration method. |
| provide an accurate record of actual individual job costs in order to conduct a profitability analysis, learn how to better manage the costs of jobs, and bid on future jobs | big, relative to total operating income | adjusted allocation-rate method because it makes adjustments in individual job records in addition to the general ledger accounts. |
Many management accountants and managers argue that to the extent that the underallocated overhead cost reflects inefficiency during the period, it should be written off to the Cost of Goods Sold account instead of being prorated to the Work-in-Process and Finished-Goods inventory accounts. This line of reasoning suggests applying a combination of the write-off and proration methods. For example, the portion of the underallocated overhead cost that is due to inefficiency (say, because of excessive spending or idle capacity) and that could have been avoided should be written off to the Cost of Goods Sold account, whereas the portion that is unrelated to inefficiency and that is unavoidable should be prorated. Unlike full proration, this approach avoids including part of the cost of current-period inefficiencies in inventory assets.
As our discussion suggests, choosing which method to use and determining the amount to be written off is often a matter of judgment. The method managers choose affects the operating income a company reports. In the case of underallocated overhead, the method of writing off to cost of goods sold results in lower operating income compared to proration. In the case of overallocated overhead, proration results in lower operating income compared to writing the overhead off to cost of goods sold.
Do managers prefer to report lower or higher operating income? Reporting lower operating income lowers the company’s taxes, saving the company cash and increasing company value. But managers are often compensated based on operating income and so favor reporting higher operating incomes even if it results in higher taxes. Managers of companies in financial difficulty also tend to report higher incomes to avoid violating financial covenants. Shareholders and boards of directors seek to motivate managerial actions that increase company value. For this reason, many compensation plans include metrics such as after-tax cash flow, in addition to operating income. At no time should managers make choices that are illegal or unethical. We discuss these issues in more detail in Chapter 24.
Robinson’s managers believed that a single manufacturing overhead cost pool with direct manufacturing labor-hours as the cost-allocation base was appropriate for allocating all manufacturing overhead costs to jobs. Had Robinson’s managers felt that different manufacturing departments (for example, machining and assembly) used overhead resources differently, they would have assigned overhead costs to each department and calculated a separate overhead allocation rate for each department based on the cost driver of the overhead costs in each department. The general ledger would contain Manufacturing Overhead Control and Manufacturing Overhead Allocated accounts for each department, resulting in end-of-year adjustments for under- or overallocated overhead costs for each department.
Instructors and students interested in exploring these more detailed allocations can go to Chapter 16, where we continue the Robinson Company example.