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.
Issues in estimating overhead rates
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.
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
Cont.
Issues in estimating overhead rates
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.
Issues in estimating overhead rates
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.
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
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.
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
Cont.
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
• 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.
Allocating 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
Cont.
Allocating support department costs to production departments
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.
Allocating support department costs to production departments
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