Chapter 6

1. Chapter 6 A closer look at overhead costs

2. What are overhead costs? • Product costing perspective • indirect manufacturing costs, or • all indirect costs • Responsibility centre perspective • indirect costs of responsibility centres

3. 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

4. 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

5. 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.

6. 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

7. 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

8. 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

9. 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

10. 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

11. Departmental overhead rates vs activity-based costing • 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

12. 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

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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

19. 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 Cont.

20. 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.

21. 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.

22. 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

23. 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.

24. 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.

25. 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.

26. 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

27. 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

28. Exhibit 6.1

29. Exhibit 6.4

30. Exhibit 6.6