1. 1 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678 Chapter 13 Overhead Allocation Decisions

2. Overview Product & period costs; Direct & indirect costs The overhead allocation problem Alternative methods of overhead allocation –Variable, absorption & activity-based costing –Under or over recovery of overhead Contingency theory Western and Japanese approaches Behavioural consequences of accounting choices 2 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

3. Product & period costs Gross profit = sales - cost of sales –Cost of sales is the product (or service) cost The cost of providing a service The cost of buying goods sold by a retailer The cost of raw materials and production costs for a manufacturer Net (operating) profit = gross profit - expenses –Expenses are the period costs 3 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

4. Costs associated with production of goods/services Production costs –Direct –Indirect Non-production costs –Period costs 4 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

5. Direct & Indirect costs Direct costs –traceable to product/ services materials or labour –prime costs Indirect costs – necessary, but not readily traceable to particular product/ services Material, labour, or other expenses – production overhead 5 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

6. Cost classification 6 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

7. Overhead allocation The process of spreading production overhead (i.e. indirect costs) equitably over the volume of production Overhead allocation problem –Overheads can be arbitrarily allocated across products/services which can lead to inappropriate pricing and misleading information about product/service profitability 7 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

8. Overhead allocation process 8 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

9. Shifts in management accounting thinking ‘Costs are distributed to products by simplistic and arbitrary measures, usually direct-labor based, that do not represent the demands made by each product on the firm’s resources … the methods systematically bias and distort costs of individual products … [and] usually lead to enormous cross subsidies across products’ –Johnson & Kaplan (1987) ‘many accountants and managers have come to believe that inventory cost figures give an accurate guide to product costs, which they do not’ ‘as product life cycles shorten and as more costs must be incurred before production begins … directly traceable product costs become a much lower fraction of total costs’ –Johnson & Kaplan (1987) 9 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

10. Primary function of cost systems Valuation of inventory and measurement of the cost of goods sold for financial reporting Estimation of the costs of activities, products, services and customers Provision of feedback to managers about process efficiency 10 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

11. Cost systems should also be used to... Design products/services that are profitable Identify where improvements can be made Inform product/service mix, distribution & investment decisions Choose among alternative suppliers Negotiate prices, etc. 11 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

12. Methods of overhead allocation Variable costing Absorption costing Activity-based costing 12 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

13. Comparison of methods 13 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

14. Variable costing Product cost includes only variable production costs All fixed costs treated as period costs As accounting standard IAS2 requires ‘all related production overheads’ to be included in the value of inventory, so this method cannot be used for inventory valuation, although it can be used for management decision-making where the focus is on contribution margin 14 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

15. Absorption costing All (fixed and variable) production costs are charged to cost centres and then to product/services using an allocation base that reflects activity, e.g. labour hours All (fixed and variable) production costs are charged to cost centres and then to product/services using an allocation base that reflects activity, e.g. labour hours 15 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

16. Calculating the overhead rate Budgeted overhead rate –business-wide –by cost centre Estimated overhead expenditure Estimated activity  Apply budgeted overhead rate to product/services based on activity in each cost centre 16 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

17. Absorption costing - business-wide rate Budgeted overhead £100,000 Activity level 4,000 direct labour hours (DLH) Business-wide budgeted overhead rate of £25 (£100,000/4,000) per DLH 17 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

18. Product costs – business-wide overhead method Product AProduct B Direct materials110150 Direct labour7590 Prime cost185240 Overhead allocation – 10 hours @ £25 250 Total product cost435490 18 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

19. Absorption costing - cost centre (or departmental) rate Three stage process: 1.Identify indirect costs with particular cost centres where possible 2.Determine a suitable method of allocating other costs across the cost centres 3.Allocate service cost centre costs to production cost centres 19 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

20. Departmental overhead allocations 20 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

21. Cost centre overhead rates 21 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

22. Overhead allocation to products 22 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

23. Product costs – cost centre overhead method Product AProduct B Direct materials110150 Direct labour7590 Prime cost185240 Overhead allocation 304231 Total product cost 489471 23 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

24. Comparison of product costs under two methods of absorption costing Product AProduct B Business-wide rate£435£490 Cost centre rate£489£471 24 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

25. Over/under recovery of overhead Overhead rate is budgeted cost & budget level of activity –Actual costs & actual levels of activity may differ CostHoursCost/hourCost recovery Budget£100,0004,000£25 Actual£102,0003,8503,850 x 25 = £96,250 Under recovery £102,000 – £96,250 = £5,750 25 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

26. Activity-based costing An alternative method to absorption costing Uses cost pools to accumulate the cost of significant business processes or activities and then assigns the costs from the cost pools to products based on cost drivers, which measure each product/ service’s demand for activities 26 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

27. Cost pools Business process –A sales order from customer to delivery and invoicing –A purchase order on a supplier to receipt of goods and payment Cost pool –Costs accumulated for the horizontal business process NOT for each department (cost centre) 27 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

28. Cost drivers The most significant cause of activity in a cost pool, e.g. –Number of sales orders –Number of purchase orders 28 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

29. Activity-based costing (ABC) Three stage process 1.Trace costs for business processes to cost pools 2.Identify cost drivers for each cost pool 3.Determine number of activities for each cost driver 29 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

30. Overhead rates using activity-based costing Cost driver rate Cost pool Number of cost drivers  Apply cost driver rate to product/services based on number of cost drivers for each business process 30 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

31. Activity-based costing: cost pools and cost drivers 31 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

32. Product costing using activity- based costing 32 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

33. Comparison of product costs under the three methods 33 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

34. Comparison of absorption and activity- based methods Under both methods, direct labour and material costs are the same and the total overhead incurred is the same Under absorption costing, overheads are allocated in proportion to an arbitrary allocation base, typically direct labour hours - the more labour hours allocated to a product/service, the more overhead will be allocated to it. 34 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

35. Comparison of absorption and activity- based methods Under activity-based costing, overheads are traced through their drivers (the causes of activity) to the product/services that consume those activities - the more overheads a product/service causes to be incurred, the more overheads will be allocated to it. 35 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

36. Cost behaviour under activity- based costing Distinction between production and non- production overhead is less relevant Distinction between fixed & variable costs is too simplistic Unit-level activities Batch-related activities Product (or customer) sustaining activities Facility sustaining activities 36 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

37. Contingency theory Situation specific: unique characteristics of each organization Universalist: optimum control system Contingency: no control system is applicable to all organizations –generalizations in control systems design can be made for different classes of business circumstances 37 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

38. Contingency theory Control systems design affected by – External environment – Competitive strategy & product life cycle stage – Technology – Size, diversification and structure – Knowledge and observability of outcomes and behaviour Fisher (1995) 38 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

39. International comparisons Differences between nations: Differences between nations: – legal systems; – commercially-driven, government-driven or professional regulation; – strength of equity markets Alexander & Nobes (2001) 39 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

40. Management accounting in Japan –Keiretsu –Strategic planning rather than financial control Emphasis on production planning & quality Long term focus –Accounting systems are used to motivate employees Traditional costing methods not important 40 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

41. Behavioural implications ‘What is accounted for can shape organizational participants' views of what is important‘What is accounted for can shape organizational participants' views of what is important’ –Burchell et al. (1980) ‘to calculate and record the costs of an activity is to alter the way in which it can be thought about and acted upon’‘to calculate and record the costs of an activity is to alter the way in which it can be thought about and acted upon’ –Miller (1994) Accounting is not a neutral device that merely reports ‘facts’ but a set of practices that affects the type of world in which we live, the way in which we understand the choices able to be made by individuals and organizations and the way in which we manage activities. –Eurail case study (see Reading in Text) 41 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

42. Alternative perspectives on management accounting Chapters 10-13 take a rational-economic perspective –Cost links to shareholder value & profit calculations However, different interpretations are possible –Different views of ‘cost’: marginal, average and total cost, relevant cost, opportunity cost –Alternative approaches to pricing –Different methods of identifying the best use of capacity –Different treatments for overhead costs The power of the dominant management coalition determines the choices made –Contingent factors; Western/Japanese approach; Organizational strategy; Managerial preferences. 42 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678

43. Key points Product/period, direct/indirect costs The overhead allocation problem Alternative methods of overhead allocation Variable costing, absorption costing, activity-based costing Under/over recovery of overhead in absorption costing Comparison of approaches Theoretical perspectives Contingency, international comparisons, behavioural implications 43 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, 9781119979678