Download continued 7-3 What are overhead costs?

Chapter 7
A closer look at
overhead costs
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-1
What are overhead costs?
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For product costing, these are indirect product
costs
For responsibility costing, these are the indirect
costs of responsibility areas
Manufacturing overhead costs
– All manufacturing costs other than direct material and
direct labour
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-2
What are overhead costs?
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•
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Incurred for a variety of products that cannot be
traced to individual products
Can be traced to individual product but not worth
the trouble
Can be traced to individual products but it’s more
appropriate to treat this cost as a cost of all output
Includes depreciation, factory insurance, factory
electricity costs, cost of manufacturing support
departments, indirect materials, indirect labour
Non-manufacturing costs are all costs incurred
outside of manufacturing
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-3
Allocating indirect costs: some 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 cost objects; therefore,
they 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
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-4
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-5
Allocating indirect costs: some 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  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-6
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-7
Allocating overhead costs to products
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•
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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
– Activity-based costing
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-8
Allocating overhead costs to products
•
Using a plantwide rate
– A plantwide rate is a single overhead rate that is
calculated for the entire production plant
•
Three steps
– Identify the overhead cost driver
– Calculate the overhead rate per unit of the cost driver
– Apply the manufacturing overhead cost to the product
based on the predetermined overhead rate
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-9
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 costs are assigned to
production department
– Stage two: overhead costs are applied to products
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-10
Allocating overhead costs to products
Predetermined
manufacturing
overhead rate
Applied overhead
=
Budgeted manufacturing overhead
Budgeted level of cost driver
Predetermined
= overhead rate
Quantity of cost
× driver consumed by
the product
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-11
Departmental overhead rates
•
Two-stage cost allocation process
– Overhead costs are 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  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-12
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-13
Allocating overheads using activity-based
costing
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Focuses attention on the costs of the activities that
are 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  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-14
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-15
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-16
Activity-based costing compared with the
two-stage cost allocation process
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Departmental rates
– Stage 1: allocation bases that are 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
– Has many cost drivers, which may be volume or nonvolume related
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-17
Evaluating the alternatives for allocating
overheads
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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  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-18
Issues in estimating overhead rates
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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?
– It is difficult to identify one factor that is a dominant cause
of manufacturing costs, particularly at the plant or
department level
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-19
Issues in estimating overhead rates
•
Volume-based cost drivers
– Based on output: number of units produced
– Based on inputs: direct labour hours, direct labour cost,
machine hours, direct material quantity
– Need to select a cost driver that is common to all
products
– Cost drivers that are measured in dollars should be
avoided
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-20
Issues in estimating overhead rates
•
Non-volume-based cost drivers
– Not all aspects of manufacturing overhead varies with
production volume
– 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  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-21
Issues in estimating overhead rates
•
Distinguishing between fixed and variable
overhead
– Helps managers to understand the behaviour of overhead
costs if fixed and variable overhead is separated
– Dual overhead rates may be calculated
– 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 overheads to
products
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-22
Issues in estimating overhead rates
•
Budgeted versus actual overhead rates
– Generally, budgeted rates, rather than actual costs and
cost drivers, are used to calculate overhead rates
– Trade-off between timeliness and accuracy
– Budgeted rates calculated prior to the commencement of
the current year

Timely
– Actual rates calculated after the end of the year

Actual
– Normal costing includes predetermined overhead rates,
whereas actual costing uses actual overhead
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-23
Issues in estimating overhead rates
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Over what period should overhead rates be set?
– Generally, yearly rates are used
– Monthly rates tend to fluctuate too much due to price
changes and seasonal factors
– A normalised overhead is an overhead rate calculated
over a relatively long period

Smooths out fluctuations in overhead rates and, therefore,
product costs
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-24
Issues in estimating overhead rates
•
Estimating the amount of a cost driver: the effects
of capacity
– Denominator volume: an estimate of the quantity of the
cost driver used to determine overhead rates
– Expected use: budget volume or normal volume
– Expected supply: theoretical capacity or practical capacity
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-25
Allocating indirect costs to responsibility
centres
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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
•
Reasons
– Helps managers understand the economic effects of their
decisions
– Encourages a particular pattern of resource usage
– Supports the product costing system
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-26
Allocating indirect costs to responsibility
centres
•
General principles
– Allocation bases will be cost drivers with clear and direct
relationships between the amount of cost and the level of
activity. Other criteria include
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Benefits received
Ability to bear
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  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-27
Allocating support department costs
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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
Allocation methods include
– Direct: support departments costs are allocated directly to
production departments
– Step-down: partially recognises the services provided by
one support department to another
– Reciprocal services: fully recognises the provision of
services between support departments
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-28
Allocating support department costs
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Which allocation method is best?
– Each method gives slightly different outcomes
– Choice should be based on 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
– The arbitrary nature of these cost allocation methods is a
criticism of conventional product costing systems
– Activity-based costing may provide a more reliable
method
continued
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-29
Allocating support department costs
•
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
created within the one defined work area, so the need to
allocate indirect production costs to products declines
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e
Slides prepared by Kim Langfield-Smith
7-30