ACCOUNTING MYTHS —No. 6 Must overheads be allocated for accounts to be useful?

Press, 2 June 1984, Page 22

ACCOUNTING MYTHS —No. 6 Must overheads be allocated for accounts to be useful?

By

ALAN J. ROBB,

a senior lecturer in accounting at the University of Canterbury

One of the myths of accounting which continues to be repeated concerns the allocation of costs, especially overheads. It is necessary, so the myth runs, for costs to be allocated if accounting is to be useful. The usual arguments raised for cost allocation are: • Allocation is necessary for pricing decisions. • Allocation is necessary for inventory valuation. • Allocation is necessary for managerial control. Let us consider each of these in turn and see whether the myth has any validity. At the root of the first argument lies the assumption that management must calculate the cost of production before prices are set. This is doubtful. Many firms are price-takers. That is, they must accept the going rate for their product, either because they cannot influence prices, or because demand for their products would fall if they attempted to charge more than their competitors. Price-takers accept the going rate for their product as given and then set about producing within that price. If the company controls costs it will make profits, if it does not then losses will result. Cost control is achieved by careful budgeting and timely reporting. It is a separate issue from pricing.

It involves no allocation. In fact, cost control is best achieved when costs are clearly identified by areas of responsibility, something which is the antithesis of cost allocation. Companies which are not price-takers may be called “price-makers." By reason of either their size or the nature of their product they are able to set prices without loss of market share. As any marketing person will recognise, a price leader sets prices by considering the product, its competition, and such factors as “what the market will bear.” Price is not determined by costs; rather the reverse is the case. The price is set and the task is then to manufacture the product within that price. In budgeting for production all costs of production must be allowed for. That is, direct costs — such as materials and labour — as well as indirect costs, such as overheads, must be included in the budget as well as in the reports of actual costs. This does not mean that the overhead costs mustbe allocated to production. They must be budgeted for, and they must be accounted for. That is all. They have nothing to do with pricing, and so the first alleged justification for allocating costs can be rejected. Now to consider the claim that allocation is

necessary for inventory valuation. At the end of a period unsold inventory constitutes a part of the assets of a business and so influences the calculation of financial position. If one accepts the meaning of financial position as being the ability to take part in exchanges in the market place the only relevant valuation of inventory is its market price. This we have seen above is influenced by many factors, but it is not determined by any allocations of costs the accountant may make. If accounting were logical and not influenced by the myth of conservatism it would accept market prices as being the only valid measure of financial position. But accounting is not logical in the matter of inventory valuation. When the market value of inventory falls below cost accountants happily accept market value as giving a truer indication of financial position than does cost; but when market value is greater than cost they ignore the fact in the name of conservatism. They also re-value fixed assets above cost occasionally on the ground that to do so gives a true and fair value of the state of affairs of the business. Clearly, whether accountants admit it or not, the important determinant of

inventory valuation is its market value, not whether or how any overhead costs have been allocated. We have thus disposed of the second alleged necessity for allocating costs. Third, it is claimed that cost allocation is necessary for managerial control. Managers are judged and evaluated on their ability to forecast and to attain budgets. The ability of a business to survive and prosper depends on its adaptability to foresee the foreseeable and react to the unforeseeable. Good management is that which can predict revenues and costs accurately, and this includes both direct costs and overheads. Good management does not arise from, nor does it depend on, the way overheads are allocated. It is sufficient that they have been budgeted for, that actual costs have been controlled if they are controllable, and that they have been recovered in total. When managers study cost-volume-profit charts they look at costs in total, not on an allocated basis. When they consider marginal costs they ignore allocated costs. And when their performance is evaluated it is on the basis of costs and activities for which they are responsible. In all these cases allocated costs are irrelevant. Thus the third argument in

favour of allocated costs is, like its predecessors, found to be invalid. A classic example of the futility of allocating costs can be found in the annual reports of the Railways. Before its reformation as a corporation on April 1, 1982, the Railways Department had for three years published an.annual estimate of the net cost of providing various social services. These were described as being calculated on “a fully allocated basis.” Among the costs calculated for the March, 1982, year were ?2.29M for the ChristchurchPicton rail service, ?2.75M for the Christchurch-Grey-mouth service, and ?4.43M, for the Southerner service. These are the amounts by which the allocated revenue falls short of the fully allocated costs. They were calculated, it was stated, to illustrate the impact of social services on operating results. But it is also stated “these amounts do not represent costs saved or revenue which would be lost if the services were terminated.” In other words, this is an example of allocation for its own sake. Having read the detailed procedure which is followed in allocating costs within the Railways one is left with the question: “Why bother with all this work?” There is one indication that I am- not on my own in questioning the futility of cost allocation. I was delighted to read recently that the Treasury controller of accounts, Mr Dick Wood, is quoted as saying of interdepartmental allocations that, “the best way to improve them is to get rid of them.” I can only say that this should happen to all allocations in accounting.