Chapter 6 A closer look at overhead costs. What are overhead costs? §Product costing perspective l indirect manufacturing costs, or l all indirect costs

Chapter 6

A closer look at overhead costs

What are overhead costs?

Product costing perspective indirect manufacturing costs, or all indirect costs

Responsibility centre perspective indirect costs of responsibility centres

Manufacturing costs

All manufacturing costs, other than direct material and direct labour costs

Production costs which cannot be traced to individual products

Support (or service) departmentsIndirect materials Indirect labour

Non-manufacturing costs

Costs incurred outside of manufacturing upstream costs

• research and development and product design costs downstream costs

• selling, distribution and customer support costs

Allocating indirect costs: general principles

Using cost pools direct costs can be traced directly to cost objects indirect costs are allocated to cost objects

Cost pools are often used to simplify the allocation process a collection of costs that are to be allocated to cost

objects, with a common allocation base

Cont.

Allocating indirect costs: general principles

Determining cost allocation bases cost allocation base - some factor or variable

that is used to allocate costs in a cost pool to cost objects

should be selected on cause-and-effect grounds: a cost driver

costs should at least show strong correlation between the costs and the allocation base

Allocating overhead costs to products

Reliable product costs are important to many decisions

Three approaches to allocating overhead costs to products plantwide approach departmental overhead rates activity-based costing

Plantwide approach

All manufacturing overhead costs form a single cost pool and one overhead rate is calculated for the entire production plant step 1 - identify the overhead cost driver step 2 - calculate an overhead rate per unit of

cost driver step 3 - apply manufacturing overhead costs to

products using a predetermined overhead rate

Departmental overhead rates

Two-stage cost allocation process overhead costs allocated to production departments,

by• tracing and allocating all manufacturing overhead costs

to production and support departments

• reassigning all support department costs to production departments

separate manufacturing overhead rates are calculated for each production department, using different cost drivers

Activity-based costing (or ABC) system

Focuses attention on the costs of activities required to produce a product or service overhead costs are assigned to activities activity costs are applied to products using a rate,

based on the activity cost per unit of cost driver

Activities a unit of work done within the business

Departmental overhead rates vs activity-based costingDepartmental

stage 1 - allocation bases used are ideally determined by causal relationships

stage 2 - one cost driver per department, with cost drivers being measures of production

Activity-based costing focuses on costs of activities many cost drivers which may be volume or non-

volume related

Costs and benefits of alternative approaches Plantwide and departmental overhead

costing systems tend to overcost high-volume relatively simple products and undercost low-volume complex products

ABC systems using multiple cost drivers and overhead rates are more complicated and costly to operate, but produce more accurate information for decision making

Issues in estimating overhead rates

Identifying overhead cost drivers what major factor causes manufacturing

overhead to be incurred? to what extent does the overhead cost vary in

proportion with the cost driver? how easy is it to measure the cost driver?

Cont.


Volume-based cost drivers need to select a cost driver that is common to all

products

Non-volume-based cost drivers need to take care not to assign volume-based cost

drivers to fixed costs leads into using activity-based costing which

recognises both volume-based and non-volume-based

Cont.


Budgeted vs actual overhead rates issue of timeliness and accuracy budgeted - calculated prior to the commencement

of the current year actual - calculated after the end of the year

Cont.


Over what period should overhead rates be set? generally yearly, as monthly rates tend to fluctuate

too much with price changes and seasonal factors a normalised overhead rate allows us to smooth out

fluctuations in overheads and, therefore, product costs that would occur over a period of a year or more

Cont.


Estimating the amount of cost driver: the effects of capacity the denominator volume - an estimate of the

quantity of cost driver used to determine overhead rates

expected use - budget volume or normal volume expected supply - theoretical capacity or practical

capacity

Cont.


Dual overhead rates: fixed and variable helps managers understand their behaviour variable costing - allocates only variable

overhead costs to products product costs will not differ if volume-based

cost drivers are used to allocate both fixed and variable overhead overheads to products

Allocating indirect costs to responsibility centresLevels of cost allocation

corporate level - some head office costs are allocated to business units

within business units - administrative costs of business units may be allocated to operating units

in the manufacturing plant - indirect manufacturing costs may be allocated to production departments

Cont.

Allocating indirect costs to responsibility centres

Reasons helps managers understand the economic

effects of their decisions encourages a particular pattern of resource

usage supports the product costing system

Cont.


General principles ideally allocation bases will be cost drivers

with clear and direct relationships between the amount of cost and the level of activity, other criteria include

• benefits received

• ability to bear using allocation bases that are not cost drivers

needs to be handled with extreme caution

Cont.


Using budgeted, not actual, allocation data will minimise the possibility that the activities of one

department will affect the costs allocated to other departments

• stops the efficiencies or inefficiencies of one department affecting the results of another

provide better information for managers to plan and control their use of indirect resources

Allocating support department costs to production departments

Allocation of support department costs to user departments can inform users of the costs of using services, to assist in planning and control activities

Cost of support departments are allocated to production departments to form part of the predetermined overhead rates used to cost products

Cont.


Allocation methods include direct - support departments costs are allocated

directly to production departments step-down - partially recognises services

provided by one support department to another reciprocal services - fully recognises the

provision of services between support departments

Cont.


Which allocation method is best? costs versus benefits

• consider allocation bases and their accuracy

• be wary of arbitrarily and inaccurate cost allocation where reciprocal relationships are strong, the

reciprocal services method may be more appropriate

Cont.


Other issues budgeted or actual costs fixed and variable costs and their behaviour in service organisations there is no need to

distinguish between production and non-production areas in determining the costs of service outputs

Cost allocation in modern manufacturing environments

Changes in technology may cause changes in cost allocation practices

Flexible manufacturing systems: both production and support operations on individual products are performed within one defined work area, called a cell, so the need to allocate indirect production costs to products declines

Exhibit 6.1

Exhibit 6.4

Exhibit 6.6

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Chapter 6 A closer look at overhead costs. What are overhead costs? §Product costing perspective l indirect manufacturing costs, or l all indirect costs