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Are You Properly Allocating Costs to Inventory?

Many people are confused over the extent to which overhead costs can be allocated to inventory. Current accounting standards allow for the allocation of variable production overhead to inventory based on actual use and fixed overhead based on the normal capacity of the production facilities. 

Allocating variable costs 

The allocation of overhead’s variable component is fairly straightforward:?allocate based on actual costs. Variable costs tend to rise and fall relatively consistent with production levels. Thus, these costs have little risk of being over- or under-allocated based on significant changes in production. Of course, some variable costs have a fixed component that must be acknowledged in performing allocations. 

Allocating fixed costs 

Fixed overhead costs are not as simple to allocate, as their allocation involves determining the normal capacity of the factory. Normal capacity refers to a range of expected production under normal circumstances over a number of periods. This range takes into account the loss of capacity from planned maintenance. Some variation from period to period is expected and actual costs can be allocated when production is within the normal range.

How is normal capacity determined?

Normal capacity is determined by using judgment tempered with knowledge of the business and the industry in which it operates. You also should attempt to anticipate shortages of labor and material, unplanned machine or facility downtime or declines in demand, as these can result in production levels outside of normal capacity.  

Determining normal capacity and allocating fixed overhead based on normal capacity will help ensure that you don’t over-capitalize cost to inventory during periods of abnormally low production.  

The standards are aimed at gaining consistency in allocating costs to inventory. The goal: to decrease—or not increase—the allocation of costs to inventory when production is lower or higher than normal, respectively. 

Questions about allocating costs to inventory?
     Contact Brian Wiedenhoeft at 312-980-3322.
     Our thanks to Phil Laycock for his contribution to this article.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.