Introduction to Accounting IM51005B Lecture 8 Overhead allocation Dr Sarah Lauwo

Total Cost of a Product Direct Materials Quantity * Price Indirect Costs Rent Electricity Depreciation Insurance…. Direct Labour Hours * Rate Cost Tracing Traditional Costing Systems Activity-Based Costing (ABC) System Cost Allocation Total Cost of a Product

Overhead allocation Cost Allocation Activity Department Traditional Costing System Activity Based Costing (ABC) System Department Activity

The Traditional Costing System According to the traditional costing system: the company is divided into separate departments, each department is considered to be a cost centre. The departments are categorised into two major categories: Production departments; and Service departments. Overhead is allocated using a Plant-wider also called blanket rate OH rate = Total overhead /allocation base

Traditional Costing System Overhead cost accounts (for each individual category of expenses, e.g. rent) First Stage Allocations Cost Centre 1 (normally Departments) Cost Centre 2 (normally Departments) Cost Centre N (normally Departments) ….. Second Stage Allocations (Direct labour or machine hrs) Cost Objects (Products) Direct costs

Traditional Costing System: Applying the two-stage allocation process requires the following four steps: Assigning all manufacturing overheads to production and service cost centres; Reallocating the costs assigned to service cost centres to production costs centres; Computing separate overhead rates for each production cost centre; and Assigning production cost centre overheads to cost objects.

Traditional Costing System Manufacturing Overhead Step 1 Production Department A Production Department B Service Department C Service Department D Overhead Rate Reallocated Step 3 Step 2 Step 4 Direct Material Direct Labour

Traditional Costing System - Example KS Company makes floor and wall safes for storing valuables. The company applies manufacturing overhead to products on the basis of direct labour hours. Cost and production information on the two products follows: Compute the predetermined overhead rate per direct labour hour. How much of the total manufacturing overhead would be allocate to each product? Compute the total manufacturing cost per unit for each product. Unit Cost Information Floor Safe Wall Safe Direct materials £20 £15 Direct labour £10 Manufacturing o/h ? Production Information Units produced 35,000 10,000 Direct labour hours per unit 1 1.5 Total direct labour hours 15,000 Total manufacturing o/h £600,000

Activity-based Costing System In the mid-1980s researchers showed that output volume did not drive overhead costs in the new manufacturing environment They also demonstrated that overhead drivers were associated with organizational transactions such as logistics (moving materials), balancing (meeting purchasing, materials planning, and human resource requirements), quality (engineering and quality control), and change (engineering change orders). ABC emerged as a solution for the problems of product cost distortion associated with the traditional cost accounting systems

ABC System Activities represent all the actions performed to convert, and to support the conversion of, materials, labour, technology, and other resources into outputs.

Activity-based Costing System Overhead cost accounts (for each individual category of expenses, e.g. rent) First Stage Allocations (resource drivers) Activity Cost centre 1 Activity Cost centre 2 Activity Cost centre 3 ….. Second Stage Allocations (Activity cost drivers) Cost Objects (Products) Direct costs

Activity-based Costing System Both manufacturing and non-manufacturing costs may be assigned to products. There are a number of each of which is allocated using a unique measure of activity. cost pools Some manufacturing costs may be from product costs. excluded Allocation often differ from traditional costing systems. Overhead may be based on activity at capacity. bases rates

Definition ‘‘ABC is a two-stage procedure used to assign overhead costs to products and services produced.’’ The objective of activity-based costing is to understand overhead and the profitability of products and customers.

Activity-based Costing System ‘‘ABC is a two-stage procedure used to assign overhead costs to products and services produced.’’ ABC emerged at the end of the 1980s in the United States. Under this approach, the focus is on why the costs were incurred instead of where. Developed further with Activity-based Management.

How Costs are Treated Under ABC Activity Based Costing Departmental Overhead Rates Level of Complexity Plantwide Overhead Rate Overhead Allocation

Multiple-Stage ABC Approach This approach includes an understanding of the relationships between indirect work activities and other activities, as well as between those activities and cost objects Costs are traced from activity to activity in a series of stages, all based on cause-and-effect relationships. The multiple-stage approach differs in that it recognizes that the maintenance activity is not directly consumed by the final cost objects. The maintenance activity supports other activities.

The emergence of ABC systems Traditional systems were appropriate when: Direct costs were the dominant costs Indirect costs were relatively small Information costs were high There was a lack of intense global competition A limited range of products was produced

A comparison of traditional and ABC Both systems use the two-stage allocation process In the first stage traditional systems tend to allocate costs to departments whereas ABC allocate costs to activities: (ABC systems tend to have more cost centres/cost pools) In the second stage traditional systems rely on a small number of volume-based cost drivers (typically direct labour or machine hours) whereas ABC use many second stage cost drivers ABC systems seek to use only cause-and-effect cost drivers whereas traditional systems often rely on arbitrary allocation bases

A comparison of traditional and ABC. . . ABC systems seek to use only cause-and-effect cost drivers whereas traditional systems often rely on arbitrary allocation bases ABC systems tend to establish separate cost driver rates for support departments whereas traditional systems merge support and production centre costs Traditional costing systems use volume-based (e.g. direct labour and machine hours) second stage drivers but if volume bases are not the cause of indirect costs reported costs will be misleading.

A comparison of traditional and ABC Accuracy? Costly?

Activity-based Costing System Both manufacturing and non-manufacturing costs may be assigned to products. There are a number of each of which is allocated using a unique measure of activity. cost pools Some manufacturing costs may be from product costs. excluded Allocation often differ from traditional costing systems. Overhead may be based on activity at capacity. bases rates

ABC Adoption In Finland, Malmi (1997) conducted a survey to understand the diffusion process for ABC. The study enabled Malmi to conclude that capital-intensive firms, firms with a wide range of products, larger firms, and firms that export a more important proportion of their products tended to adopt ABC. Clark (1999) performed the first survey on ABC in Ireland. This study also demonstrated that subsidiaries of multinational firms and larger firms tend to adopt and implement more ABC.

ABC Adoption . . . Most surveys have clearly demonstrated that the ABC implementation rates are higher in manufacturing firms (Gosselin, 2007: 653). In Australia, Baines & Langfield- Smith (2003) examined the antecedents and found that a change towards a differentiation strategy would result in an increased use of advanced management practices such as ABC.

ABC Adoption Competition Environmental uncertainty Size Factors that affect the adoption of ABC. Others… Subsidiary of multinational firms Strategy

ABC Adoption Surveys on ABC that have been conducted between 1990 and 1995 demonstrated clearly that: there was at the time a strong interest for ABC but that the majority of firm managers in industrialized countries had not yet considered implementing an ABC system despite the large number of articles published on ABC during that period and the presence of several consulting firms the ABC adoption rate have not increased as much as the management accounting community would have expected. Overall surveys show that the adoption rates for ABC have been and remain low.

ABC Paradox “Regardless of the inclusion of ABC in most management accounting textbooks, the large number of ABC seminars, the consulting activities, the ABC softwares, and the large number of articles published on ABC, why firms are not implementing ABC and furthermore why some that have adopted ABC, have decided to abandon it.” (Gosselin, 2007:666)

ABC Diffusion and Implementation the lack of adequate role models the prevalence of computer-based accounting systems the emphasis on financial accounting the fact that top management do not emphasize the improvement of the relevance of their MAS ABC may not be suitable for every firm ABC may not, per se, add value Little evidence that ABC system increases firm profitability ABC is an additional costing system Kaplan (1986) and Kennedy & Affleck-Graves

Effectiveness of ABC Costing System “After almost 20[30] yr of presence of ABC, there is still not much empirical evidence that the adoption and implementation of ABC has an impact on performance. There is a need to better examine the relationships between contextual and organizational factors, success of ABC implementation and performance.”

Criticisms of ABC The concept of unused capacity within the resource consumption model is questionable. Reported costs may not significantly differ from a less costly traditional system if indirect costs are a low proportion of total costs ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools. Activity-cost rates also need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.

Practice questions Define a plant-wide overhead rate and a multiple overhead rates? Attached on VLE: E3-6 in Seal et al (2006)