Question

Assume that your company sells portable housing to both general contractors and the government. It sells jobs to contractors on a bid basis. A contractor asks for three bids from different manufacturers. The combination of low bid and high quality wins the job. However, jobs sold to the governments are bid on a cost-plus basis. This means price is determined by adding all costs plus a profit based on cost at a specified percent, such as 10%. You observe that the amount of overhead applied to government jobs is higher than that applied to contract jobs. These allocations concern you. How would you explain your concerns with overhead allocation to the company's chief financial officer?

Answer 1

When the Overhead is not uniformly incurred over all the products sold by the entity, then the management may opt for Activity-based costing method for Overhead allocation instead of traditional methods.

In Activity-based costing method, the Overhead is classified into different value added activities. Each activity is quantified with respective cost driver. And, the Overhead is allocated through activities made through various cost drivers for different products.