1. 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 Chapter 7 A closer look at overhead costs

2. 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? 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

3. 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 What are overhead costs? 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

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 7-4 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

5. 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

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 7-6 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)

7. 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

8. 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 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

9. 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 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

10. 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 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

11. 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 Allocating overhead costs to products Predetermined manufacturing overhead rate = Budgeted manufacturing overhead Budgeted level of cost driver Applied overhead Predetermined overhead rate Quantity of cost driver consumed by the product = ×

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 7-12 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

13. 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

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 7-14 Allocating overheads using activity-based costing 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

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 7-15

16. 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

17. 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 Activity-based costing compared with the two-stage cost allocation process 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 non- volume related

18. 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 Evaluating the alternatives for allocating overheads 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

19. 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 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

20. 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 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

21. 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 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

22. 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 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

23. 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 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

24. 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 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

25. 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 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

26. 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 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

27. 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 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  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

28. 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 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

29. 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 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

30. 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 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