Allocated Overheads

Incremental analysis is a decision-making tool in which the relevant costs and revenues of one alternative are compared to the relevant costs and revenues of another alternative. Relevant costs may be defined as those future costs that are different between alternatives. Costs that are the same are considered irrelevant. Incremental analysis is sometimes called differential costing, marginal costing, or relevant costing. Incremental analysis is basically a worksheet technique in which the relevant costs of one alternative are listed in one column and the relevant costs of another alternative are listed in an adjacent column. Frequently, an optional third column is used to show the difference in the costs. The differences in relevant costs are called incremental costs. Technically, incremental cost may be defined as the difference between the sum of the relevant costs of two alternatives. In short, it is a tool for choosing between two alternatives. The best decision is the one with the least amount of relevant costs or the greatest relevant revenue.

Firms generally have a practice of allocating budgeted general overheads to projects, including the new projects under consideration. Since the general overheads will !)e incurred whether or not the new projects are undertaken, those allocated overheads should be ignored in computing the net cash flows of an investment However, some of the overheads may increase because of the new project; these should be charged to that project The incremental cash flow rule indicates that only incremental overheads are relevant

The allocation of overheads is a difficult question in practice. One or two investment projects may not cause any change in overhead items such as supervision, rent, employees’ welfare, or accounting. But the cumulative effect of many investments may ultimately result in increase in overheads. This creates a problem of cash flow estimation. It is difficult to know when the overheads will change. Efforts should be made to identify such changes so that they may be included in the calculation of net cash flows.

Allocation of overheads is the process of charging overhead costs to a particular department or cost centre. It is the allotment or assignment of an overhead cost to a particular cost unit. If the overhead cost is associated with a single department or cost centre, the whole amount is charged or distributed among the units of output of that particular department. For example, the whole amount of repair and maintenance expenses for a machine is charged or allocated to that department where the machine has been installed.