What is the Adjusted Allocation Rate Approach?
Definition: The adjusted allocation-rate approach restates or corrects estimated overhead costs booked throughout the year, so that the actual overhead costs are recorded properly. It’s basically like a reconciliation of the estimated overhead costs booked and the actual overhead costs incurred.
In this approach, all entries in the general ledger, that are based on the predetermined application rate (normal costing), are restated using the actual overhead cost rate (actual costing). This latter rate must first of all be computed, then the indirect costs of every job entered in the ledger are recomputed using the actual rate.
What Does Adjusted Allocation Rate Mean?
Throughout the year, a company’s management pays close attention to costs of producing products and administrative expenses. These two types of expenses are fairly easy to track because they are set costs. Take employees’ salaries for example. The management knows or has a good understanding how much employees’ salaries will be next quarter. Management can look at the employees’ hourly rate and calculate what next quarter’s expenses will be.
Indirect costs, like company overhead, are not as easy to calculate estimated projections as direct costs are. Overhead costs like utilities can vary with the seasons. Most manufactures estimate overhead costs throughout the year in order to record the estimated overhead expenses. This estimate approach is good in the sense that the company is getting an idea of its expenses throughout the year, but these estimates don’t necessarily reflect reality.
For instance, a January heating bill might be estimated to cost $1,500. Management can then book the $1,500 as an estimated overhead expense. When January comes around, it turns out that this winter was colder than in years past. The actual January heating cost was $1,800. That’s much higher than the $1,500 of estimated costs recorded.
The adjusted allocation-rate approach goes back and fixes all of those estimate entries in the general ledger and subsidiary ledgers at the end of the year. This way all the overhead rates match the actual expenses for the year.