Chapter 6 A closer look at overhead costs

What are overhead costs? §Product costing perspective l indirect manufacturing costs, or l all indirect costs §Responsibility centre perspective l 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) departments §Indirect materials §Indirect labour

Non-manufacturing costs §Costs incurred outside of manufacturing l upstream costs research and development and product design costs l downstream costs selling, distribution and customer support costs

Allocating indirect costs: general principles §Using cost pools l direct costs can be traced directly to cost objects l indirect costs are allocated to cost objects §Cost pools are often used to simplify the allocation process l 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 l cost allocation base - some factor or variable that is used to allocate costs in a cost pool to cost objects l should be selected on cause-and-effect grounds: a cost driver l 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 l plantwide approach l departmental overhead rates l 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 l step 1 - identify the overhead cost driver l step 2 - calculate an overhead rate per unit of cost driver l step 3 - apply manufacturing overhead costs to products using a predetermined overhead rate

Departmental overhead rates §Two-stage cost allocation process l 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 l 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 l overhead costs are assigned to activities l activity costs are applied to products using a rate, based on the activity cost per unit of cost driver §Activities l a unit of work done within the business

Departmental overhead rates vs activity-based costing §Departmental l stage 1 - allocation bases used are ideally determined by causal relationships l stage 2 - one cost driver per department, with cost drivers being measures of production §Activity-based costing l focuses on costs of activities l 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 l what major factor causes manufacturing overhead to be incurred? l to what extent does the overhead cost vary in proportion with the cost driver? l how easy is it to measure the cost driver? Cont.

Issues in estimating overhead rates §Volume-based cost drivers l need to select a cost driver that is common to all products §Non-volume-based cost drivers l need to take care not to assign volume-based cost drivers to fixed costs l leads into using activity-based costing which recognises both volume-based and non-volume- based Cont.

Issues in estimating overhead rates §Budgeted vs actual overhead rates l issue of timeliness and accuracy l budgeted - calculated prior to the commencement of the current year l actual - calculated after the end of the year Cont.

Issues in estimating overhead rates §Over what period should overhead rates be set? l generally yearly, as monthly rates tend to fluctuate too much with price changes and seasonal factors l 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.

Issues in estimating overhead rates §Estimating the amount of cost driver: the effects of capacity l the denominator volume - an estimate of the quantity of cost driver used to determine overhead rates l expected use - budget volume or normal volume l expected supply - theoretical capacity or practical capacity Cont.

Issues in estimating overhead rates §Dual overhead rates: fixed and variable l helps managers understand their behaviour l variable costing - allocates only variable overhead costs to products l 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 centres §Levels of cost allocation l corporate level - some head office costs are allocated to business units l within business units - administrative costs of business units may be allocated to operating units l in the manufacturing plant - indirect manufacturing costs may be allocated to production departments Cont.

Allocating indirect costs to responsibility centres §Reasons l helps managers understand the economic effects of their decisions l encourages a particular pattern of resource usage l supports the product costing system Cont.

Allocating indirect costs to responsibility centres §General principles l 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 l using allocation bases that are not cost drivers needs to be handled with extreme caution Cont.

Allocating indirect costs to responsibility centres §Using budgeted, not actual, allocation data will l 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 l 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.

Allocating support department costs to production departments §Allocation methods include l direct - support departments costs are allocated directly to production departments l step-down - partially recognises services provided by one support department to another l reciprocal services - fully recognises the provision of services between support departments Cont.

Allocating support department costs to production departments §Which allocation method is best? l costs versus benefits consider allocation bases and their accuracy be wary of arbitrarily and inaccurate cost allocation l where reciprocal relationships are strong, the reciprocal services method may be more appropriate Cont.

Allocating support department costs to production departments §Other issues l budgeted or actual costs l fixed and variable costs and their behaviour l 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