1. A closer look at overhead costs
Chapter 7
A closer look at overhead costs

2. What are overhead costs?
For product costing, these are indirect product costs
For responsibility costing, these are indirect costs of responsibility areas
Manufacturing overhead costs
All manufacturing costs other than direct material and direct labour
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

3. What are overhead costs?
Manufacturing overhead costs
Incurred for a variety of products that cannot be traced to individual products
Can be traced to individual product but it is not worth the trouble
Can be traced to individual produce but where it is more appropriate to treat this cost as a cost of all output
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

4. What are overhead costs
Manufacturing overhead includes the cost of manufacturing support departments
Includes the cost of indirect material and indirect labour
Non-manufacturing costs are all costs incurred outside of manufacturing
May be included in product costs for use in internal product-related decisions, but not for external reporting
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

5. Allocating indirect costs: general principles
Using cost pools
Cost assignment can take two forms
Direct costs can be traced directly to products
Indirect costs cannot be traced to cot objected, so need to be allocated
A cost pool is a collection of costs that are to be allocated to cost objects
Have a common allocation base
Often used to simplify the allocation process
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

6. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

7. Allocating indirect costs: general principles
Determining cost allocation bases
A cost allocation base is some factor or variable that allows us to allocate costs in a cost pool to cost objects
Ideally should be a cost driver
A cost driver is an activity or factor that causes costs to be incurred
Ideally cost should increase or decrease in direct proportion to the allocation case (or cost driver)
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

8. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

9. Allocating overhead costs to products
Reliable product costs are important in a range of management decisions
An important issue is how to allocate indirect costs to obtain a reliable estimate of a product’s cost
Three possible approaches
A plantwide rate
Departmental rate, or
Activity-based costing
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

10. Allocating overhead costs to products
Using a plant-wide rate
A plantwide rate is a single overhead rate that is calculated for the entire production plant
Identify the overhead cost driver
Calculate the overhead rate per unit of cost driver
Apply manufacturing overhead cost to product based on the predetermined overhead rate
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

11. Allocating overhead costs to products
Using departmental overhead rates to allocate overhead to products
Two-stage cost allocation for department overhead rates
Stage one, where overhead cost are assigned to production department, and
Stage two, overhead cost are applied to products
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

12. Allocating overhead costs to products
Predetermined manufacturing overhead rate
Budgeted manufacturing overhead =
Budgeted level of cost driver
Quantity of cost driver consumed by the product
Predetermined overhead rate
Applied overhead = x
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

13. Departmental overhead rates
Two-stage cost allocation process
Overhead costs allocated to products via departments
Overhead costs assigned to production and support departments
Overhead costs applied to products
Separate manufacturing overhead rates are calculated for each production department, using different cost drivers
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

14. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

15. Activity-based costing to assign overhead costs
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 performance within the organisation
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

16. Slides prepared by Kim Langfield-Smith
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

17. Activity-based costing vs. two-stage allocation
Departmental
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
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

18. 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 are more complicated and costly to operate, but produce more accurate information for decision making
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

19. 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?
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

20. Issues in estimating overhead rates
Volume-based cost drivers
Include output and input drivers
Need to select a cost driver that is common to all products
Non-volume-based cost drivers
Need to be careful in assigning volume based cost driver to fixed costs
Activity-based costing recognises both volume-based and non-volume-based cost drivers
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

21. Issues in estimating overhead rates
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
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

22. Issues in estimating overhead rates
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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

23. Issues in estimating overhead rates
Over what period should overhead rates be set?
Generally a year, as monthly rates tend to fluctuate too much with price changes and seasonal factors
A normalised overhead rate smooths out fluctuations in overhead rates and product costs
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

24. Issues in estimating overhead rates
Estimating the amount of cost driver: the effects of capacity
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
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

25. Allocating indirect costs to responsibility centres
Levels 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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

26. 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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

27. Allocating indirect costs to responsibility centres
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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

28. Allocating indirect costs to responsibility centres
Using budgeted, not actual, allocation data will
Minimise the possibility that the activities of one department will affect the costs allocated to other departments
Provide better information for managers to plan and control their use of indirect resources
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

29. Support department costs to production departments
To inform users of the costs of using services, to assist in planning and control activities
To form part of the predetermined overhead rates used to cost products
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

30. Support department costs to production departments
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
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

31. Support department costs to production departments
Which allocation method is best?
Costs versus benefits
Consider allocation bases and their accuracy
Beware of arbitrary and inaccurate cost allocation
Where reciprocal relationships are strong, the reciprocal services method may be more appropriate
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

32. Support department costs to production departments
Other issues
In service organisations there is no need to distinguish between production and non-production areas in determining the costs of service outputs
In flexible manufacturing systems individual products are performed within the one defined work area, so the need to allocate indirect production costs to products declines
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith