A closer look at overhead costs

Chapter 7A closer look atoverhead costs 7-1Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOutlineWhat are overhead costs?Allocating indirect costs: some general principlesAllocating overhead costs to productsActivity-based costing compared with the two-stage cost allocation processEvaluating the alternatives for allocating overheadsIssues in estimating overhead ratesAllocating indirect costs to responsibility centresOther issues in allocating support department costs7-2Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithWhat are overhead costs?For product costing these are indirect product costsFor responsibility costing these are the indirect costs of responsibility areasManufacturing overhead costsAll manufacturing costs other than direct material and direct labour costs7-3(cont.)Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithWhat are overhead costs? (cont.)Incurred for a variety of products and cannot be traced to individual products Can be traced to individual products but it is more appropriate to treat this cost as a cost of all outputsIncludes depreciation, factory insurance, factory electricity costs, cost of manufacturing support departments, indirect materials, indirect labourNon-manufacturing costs are all costs incurred outside of manufacturing7-4Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAllocating indirect costs: some general principlesUsing cost poolsCost assignment can take two formsDirect costs can be traced directly to productsIndirect costs cannot be traced to cost objects; therefore they need to be allocatedA cost pool is a collection of costs that are to be allocated to cost objectsHave a common allocation baseOften used to simplify the allocation process7-5Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)7-6Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAllocating indirect costs: some general principles (cont.)Determining cost allocation basesA cost allocation base is some factor or variable that allows us to allocate costs in a cost pool to cost objectsShould be a cost driverA cost driver is an activity or factor that causes a cost to be incurred7-7Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAllocating overhead costs to productsReliable product costs are important for a range of management decisionsAn important issue is how to allocate indirect costs to obtain a reliable estimate of a product’s costThree possible approachesA plantwide rateDepartmental ratesActivity-based costing7-8Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Allocating overhead costs to products (cont.)Using a plantwide rate A plantwide rate is a single overhead rate that is calculated for the entire production plantThree stepsIdentify the overhead cost driverCalculate the overhead rate per unit of cost driverApply the manufacturing overhead cost to the product based on the predetermined overhead rate and the product’s consumption of the cost driver7-9Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Allocating overhead costs to products (cont.)Departmental overhead rates recognise that overheads in each department may be driven by different cost driversTwo-stage cost allocation for department overhead ratesStage one: Overhead costs are assigned to production departmentsAll manufacturing costs are distributed to each department, involving tracing and allocatingSupport department costs are reassigned to overhead cost pools in the production departments7-10Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Allocating overhead costs to products (cont.)Stage two: overhead costs are applied to productsManufacturing overhead rates are calculated for each production department7-11Predetermined manufacturing overhead rate=Budgeted manufacturing overheadBudgeted level of cost driverApplied overheadPredetermined overhead rateQuantity of cost driver consumed by the product=×Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)7-12Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAllocating overhead costs to products (cont.)Activity-based costing can be used to allocate overhead costs to productsStage one: Overhead costs are assigned to activity cost pools for significant activities (not departments)Stage two: Activity costs are applied to products using a rate, based on the product’s consumption of the activityActivitiesA unit of work performance within the organisation7-13Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith7-14Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithActivity-based costing compared with the two-stage cost allocation processDepartmental ratesStage one: allocation bases used are ideally determined by causal relationshipsStage two: one cost driver per department, with cost drivers being measures of production volumeActivity-based costingFocuses on the costs of activitiesHas many activity cost pools and cost drivers which may be volume or non-volume related7-15Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithEvaluating the alternatives for allocating overheads Plantwide and departmental overhead costing systems tend to overcost high-volume relatively simple products and undercost low-volume complex productsA system with multiple cost drivers and overhead rates is more complicated and costly to operate, compared with a single plantwide rate, but may produce more accurate and useful information for decision making7-16Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithIssues in estimating overhead ratesIdentifying overhead cost driversWhat is the major factor that 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 level7-17Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Issues in estimating overhead rates (cont.)Volume-based cost driversConventional costing systems assume that overhead costs vary proportionally with production volumeBased on output: number of units producedBased on inputs: direct labour hours, direct labour cost, machine hours, direct material quantityFor plantwide rates, select a cost driver that is common to all productsCost drivers that are measured in dollars should be avoided7-18Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Issues in estimating overhead rates (cont.)Non-volume-based cost driversNot all aspects of manufacturing overhead varies with production volumeNeed to be careful in assigning volume-based cost driver to fixed costsActivity-based costing recognises both volume-based and non-volume-based cost drivers7-19Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Issues in estimating overhead rates (cont.)Distinguishing between fixed and variable overheadsHelps managers to understand the behaviour of overhead costs if fixed and variable overheads are separatedDual overhead rates may be calculatedVariable costing allocates only variable overhead costs to productsProduct costs will not be more accurate if volume-based cost drivers are used to allocate both fixed and variable overheads to products 7-20Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Issues in estimating overhead rates (cont.)Budgeted versus actual overhead ratesBudgeted costs and amounts of cost drivers, rather than actual costs and cost drivers, are used to calculate overhead ratesTrade-off between timeliness and accuracy Budgeted rates calculated prior to the commencement of the yearMore timelyActual rates calculated after the end of the yearMore accurateNormal costing includes predetermined overhead rates, whereas actual costing uses actual overhead rates7-21Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Issues in estimating overhead rates (cont.)Over what period should overhead rates be set?Yearly rates are generally used Monthly rates tend to fluctuate due to price changes and seasonal factorsA normalised overhead is an overhead rate calculated over a relatively long periodSmooths out fluctuations in overhead rates, therefore smoothing out product costs7-22Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Issues in estimating overhead rates (cont.)Estimating the amount of a cost driver: the effects of capacityDenominator volume: an estimate of the quantity of the cost driver used to determine overhead ratesExpected use of cost driver, based on the budgeted volume or normal volumeNormal volume: volume that will satisfy demand over the normal business cycle (several years)Expected supply of cost driver, based on theoretical capacity or practical capacityTheoretical capacity: maximum capacity that can be achievedPractical capacity: allows for normal downtime 7-23Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAllocating indirect costs to responsibility centresLevels of cost allocationCorporate level: some head office costs are allocated to business unitsWithin business units: administrative costs of business units may be allocated to operating unitsManufacturing plant: indirect manufacturing costs may be allocated to production departments Reasons for allocating costs to responsibility centresHelps managers understand the economic effects of their decisionsEncourages a particular pattern of resource usageSupports the product costing system7-24Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Allocating indirect costs to responsibility centres (cont.)General principlesAllocation bases should be cost drivers, where there is a clear and direct relationship between the amount of cost driver and the level of cost. Other criteria includeBenefits receivedAbility to bear additional costsUsing budgeted, not actual, allocation dataMinimises the possibility that the activities of one department will affect the costs allocated to other departments Provides better information for managers to plan and control their use of indirect resources 7-25Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAllocating support department costs Informs user departments of the cost of the services that they are using, to assist them with planning and control of that usageAllocation methods include Direct: support department costs are allocated directly to production departmentsStep-down: partially recognises the services provided by one support department to anotherReciprocal services: fully recognises the provision of services between support departments7-26Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Allocating support department costs (cont.)Which allocation method is best?Each method gives slightly different outcomesChoice should be based on costs versus benefitsConsider allocation bases and their accuracyBeware of arbitrary and inaccurate cost allocationWhere reciprocal relationships are strong, the reciprocal services method may be more appropriateThe arbitrary nature of these cost allocation methods is a limitation of conventional product costing systemsActivity-based costing may provide more reliable outcomes7-27Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOther issues in allocating support department costsIn service organisations, there is no need to distinguish between production and non-production areas in determining the costs of service outputsIn flexible manufacturing systems, individual products are created within the one defined work area, so there is reduced need to allocate indirect production costs to products7-28Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithSummaryOverhead cost can be allocated to products using a plantwide rate, department rates or activity-based costing methodsIdeally, cost drivers should be used as allocation basesAs the number of overhead rates increases the accuracy of the product cost is likely to increaseCost benefit considerations are relevant when choosing a method for overhead allocationIndirect costs can be allocated to user departments to encourage users to manage their resources7-29Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith