Langfield Smith 8e IRM Ch07 PDF

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CHAPTER 7 A CLOSER LOOK AT OVERHEAD COSTS ANSWERS TO REVIEW QUESTIONS 7 When we refer to manufacturing overhead costs we are describing the indirect manufacturing costs of products. These are the factory costs that are incurred in producing products but cannot be traced directly to them. They includ...

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CHAPTER 7

A CLOSER LOOK AT OVERHEAD COSTS ANSWERS TO REVIEW QUESTIONS 7.1

When we refer to manufacturing overhead costs we are describing the indirect manufacturing costs of products . These are the factory costs that are incurred in producing products but cannot be traced directly to them. They include all manufacturing costs other than direct material and direct labour, such as the costs of supervision, power, factory security and so on. From a product costing perspective, we can expand our definition of overheads to include all product-related costs other than direct costs as managers may require comprehensive estimates of product costs for making product-related decisions (see Chapter 4). However, as Australian accounting standard AASB 102 Inventories requires that inventory valuations in external reports of manufacturing businesses only include manufacturing costs, a distinction is drawn between indirect costs within the manufacturing area, called manufacturing overhead, and other indirect costs incurred along the value chain, upstream and downstream, of the manufacturing or production area. Upstream costs and downstream costs, regardless of whether the entity is a manufacturer or a service provider include costs incurred before and after the production process, such as research and development, design and supply costs, marketing, distribution and customer service costs. The indirect costs of responsibility centres are costs assigned to a unit in an organisation such as a department or division where a manager is held accountable for performance. Indirect costs cannot be traced directly to the centre so they need to be assigned instead.

7.2

Cost object: is something that is assigned a separate measure of cost because management need such cost information; for example, responsibility centres, products, projects and so on. (The various production departments in a manufacturing firm also provide examples of cost objects. For example, the material handling cost pool may be allocated across the various production departments that use material handling services. In a hospital costs may be assigned to reception, a ward, a doctor, operating theatres or intensive care unit (ICU) and so on.) Cost pool: a collection of costs that are to be assigned to cost objects. Costs are often pooled because they have the same cost driver. (An example of a cost pool is all costs related to material handling in a manufacturing firm.) Cost allocation base: is some factor or variable that is used to allocate costs in a cost pool to cost objects. (An example of a cost allocation base may be the weight of materials handled for each production department that uses material handling services. This base would be used to assign the costs in the material handling cost pool to the production departments.) Cost driver: is a factor or activity that causes a cost to be incurred. (From the example above, the allocation base of weight of materials handled for each production department may be a cost driver depending on its causal relationship to the costs in the cost pool.) The difference between cost allocation bases and cost drivers is that cost drivers are allocation bases but not all allocation bases are cost drivers. Ideally allocation bases should be cost drivers; that is, there should be a cause and effect relationship between the costs in the cost pool and the allocation base. In practice, some allocation bases do not have this relationship, or the relationship is imperfect. Under these circumstances the accuracy of the cost allocations can be questioned.

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7.3

As shown in Exhibit 7.2 (Estimating the cost of a cost object), in estimating the cost of a cost object, direct costs are traced directly to the cost object and indirect costs (those with no direct linkage to the cost object) are collected into cost pools and assigned to the cost object by means of allocation bases, preferably cost drivers. Some possible examples of cost objects and their direct and indirect costs for the NGOs involved in the tsunami relief efforts (described in the ‘Real life’ in ‘Allocating indirect costs: some general principles’) follow:

Cost objects Programs to deliver immediate disaster relief

Direct costs  Campaign and administrative

costs that can be directly traced to specific program  Salaries of program designer and

planners  Salaries of appeal workers  Salaries of relief workers in

disaster area  Transport of staff and relief goods

to disaster area  Accommodation for relief

workers  Technical and logistical

consulting costs  Food and clean water  Medicines  Temporary shelter

Indirect costs  General office and administrative

costs of NGO (depreciation of office equipment, general stationery and postage, rent, cleaning, general accounting and office staff salaries, bank fees etc)  Salaries of CEO and top

management  Legal, insurance and risk

management costs not directly traceable  Marketing, advertising,

publishing and other costs for general awareness and fund raising campaigns  Consulting and advocacy activity

costs of seeking change in government and institutional policies  External audit and reporting costs

 Administrative costs that can be

Projects to:  rebuild after a disaster

 Salaries of project designers and

event  construct additional

planners  Salaries of staff involved in

infrastructure  deliver long-term

community development

directly traced to specific projects

project field work  Transport of staff and materials to

field  Accommodation for field staff  Technical and engineering

consulting costs  Building and infrastructure

materials

 General office and administrative

costs of NGO (depreciation of office equipment, general stationery and postage, rent, cleaning, general accounting and office staff salaries, bank fees etc)  Salaries of CEO and top

management  Legal, insurance and risk

management costs not directly traceable  Marketing, advertising,

publishing and other costs for general awareness and fund raising campaigns  Consulting and advocacy activity

costs of seeking change in government and institutional policies  External audit and reporting costs

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7.4

A cost allocation base is some factor or variable that allows us to allocate costs in a cost pool to a cost object. One possible allocation base for assigning marketing costs to the various attractions of a large theme park would be the number of people patronising the park’s attractions. This would assume that the number of people attending a certain part of the theme park would be an indication of the marketing resources consumed by each attraction. Notice that in most cases the sales revenue generated by the various components of the theme park would not be a viable allocation base since most theme parks have a single admission fee for the entire park. Note that some people would consider ‘corporate’ marketing of this nature should not be allocated to the various subunits of the business, as it is very hard to determine a causal cost driver. In activity-based costing terminology the marketing could be regarded as a facility cost.

7.5

The development of departmental overhead rates involves a two-stage process. In stage one, overhead costs are assigned to the firm’s production departments. First, overhead costs are distributed to all departments, including both support and production departments. Second, support department cost allocation takes place which involves costs being allocated from the support departments to the production departments. At the end of stage one, all overhead costs have been assigned to the production departments. In stage two, overhead application occurs as the costs that have been accumulated in the production departments are applied to the products that pass through the departments using the overhead rate set for each production department.

7.6

A support department is a unit in an organisation that is not involved directly in producing the organisation’s goods or services. However, a support department does provide services that enable the organisation’s production process to take place. Production departments, on the other hand, are units that are directly involved in producing the organisation’s goods and services. Examples of ‘production’ departments in a travel agency may include ticketing and bookings departments and so on. Examples of support departments in a cafe chain may include washing dishes (either manual or stacking and unstacking dishwashers), cleaning, ordering/buying (some franchises rely on ordering from a central unit and some require purchasing at the local market), bookings desk, head office, laundry and accounting.

7.7

Activity-based costing can be used to assign manufacturing overhead costs to products in two stages. In the first stage overhead costs are assigned to activity cost pools (that is, activities). In the second stage, activity costs are assigned from the activities to products in proportion to the products' consumption of each activity, measured by the amount of activity driver consumed. In traditional costing systems, when a two-stage allocation process is used, the first stage is to assign overhead costs to production departments and the second stage is to assign the overhead costs from the production departments to products in proportion to the products' consumption of the departmental overhead cost drivers.

7.8

Using departmental overhead rates instead of a single plantwide overhead rate can improve the accuracy of product cost information. The allocation bases used for each department are likely to be more realistic in representing the relationship between overhead costs and the product, compared to using just one plantwide rate. However, using departmental overhead rates requires the distribution of overhead costs to departments, the allocation of support department costs to production departments and the collection of cost driver data by production departments. While this approach usually provides more useful information than the single cost pool approach, it is more expensive to operate and still can provide misleading information. A problem with this approach is that costs with different behaviour patterns are added together before allocation to the product. It is difficult to identify a realistic cost driver for a cost pool that includes setup costs, space costs and indirect material costs, for example. Using activity-based costing should improve the accuracy of cost information. Allocating costs to activities rather than departments enables the identification of even more appropriate allocation bases. For example, ABC uses both volume and non-volume-based cost drivers as allocation bases and attempts to aggregate costs that have similar behaviour patterns. Again, however, there is an additional cost in analysing costs and cost drivers at an activity level rather than at a department level.

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7.9

A cost driver is an activity or factor that causes costs to be incurred. A volume-based cost driver is a cost driver that is a measure of or proxy for the volume of production. An assumption underlying the use of a volume-based cost driver is that costs are caused, or driven, by the volume of production . Examples include direct labour hours, machine hours and direct material volume. Non-volume-based cost drivers are cost drivers that are not directly related to the number of units produced. For example in manufacturing the set up costs are not driven directly by the units of output since each batch can vary in volume. In a bank, non-volume-based costs can include human resource management (driven by staff numbers), cleaning (driven by floor space or room numbers), and IT servicing (possibly driven by the number of computers).

7.10 Labour cost is a commonly used base for allocating overhead costs to cost objects including projects such as those undertaken by FFA. Although such projects may be self funded by the member countries they result in additional overhead costs being incurred by the FFA. As these overhead costs cannot be specifically traced cost effectively to the individual projects, an appropriate allocation base is needed to allocate them to the individual projects to avoid cross-subsidisation of projects from member contributions and donations. It is likely that there is some relationship between the level of salary costs for the projects and the increase in overhead costs incurred by the FFA (as larger, higher cost projects are likely to require more support from FFA), though the correlation is unlikely to be perfect. In the absence of a stronger logical connection and a more practical, cost effective allocation base the use of salary costs as the allocation base may be reasonable. However, it is not surprising that the member countries questioned and sought independent advice on the accountability of the seemingly high overhead recovery rate of 66% of salary costs, because to them the overhead recovery is an uncontrollable cost. 7.11

The primary benefit of using a predetermined overhead rate instead of an actual overhead rate is to provide timely information for decision making, planning and control. Also the predetermined rate removes fluctuations inherent in monthly actual overhead rates. While the use of actual overhead rates removes the need to account for over- or under-allocated overhead, this is because it relies on data that are not known until after the event, so it cannot be used in a timely fashion. Notice that in both approaches, it is necessary to calculate an overhead rate, as overhead costs cannot be traced directly to products.

7.12 The denominator volume is the measure of cost driver volume used to calculate the manufacturing overhead rate. The most common measure is the budgeted volume of cost driver for the coming year. Theoretical capacity is the maximum level of production that the plant can run at, without ever stopping. Practical capacity assumes the business operates at the maximum level that its resources allow under normal, efficient operating conditions. Product costs will be higher using practical capacity, as the denominator measure of cost driver volume will be lower, resulting in higher overhead rates. For a car manufacturer, the cost of the car would go up, bearing the cost of the overheads created by the excess capacity. Raising the price if demand is declining is unlikely, and managerial attention would be required. Using theoretical capacity as the denominator will result in lower overhead rates and product costs, but there will be higher levels of underapplied overhead. This scenario is usually untenable. 7.13 Management accountants allocate indirect costs to responsibility centres to help managers understand the effects of their decisions, to encourage particular patterns of resource usage and to support the product costing system. For example production departments may source services from support departments and where these services are supplied for ‘free’ there may be a tendency to over-consume them. Where they are charged to departments, the departmental managers are held responsible for these costs and need to be careful about the amount of these services they consume. Also, where departmental overhead rates are used for product costing, it is necessary to allocate the costs of support departments to production departments, to calculate departmental overhead rates for the production departments. The problems encountered in allocating a proportion of costs of the Prime Infrastructure Group (which changed its name to Babcock and Brown Infrastructure on 1 July 2005) to its responsibility centre of Dalrymple Bay Coal Terminal (DBCT) related to the disentanglement of overheads associated with DBCT’s operations from the costs of other activities within the Prime group. The amount of overhead allocated by Prime to DBCT affected the overhead cost per loaded tonne sought to be recovered by DBCT in the total price per loaded tonne of coal charged to terminal users. The terminal users have little option but to use the terminal facility because of its monopolistic nature. The competition authority, to ensure fair and reasonable access for terminal users, needed to approve the terms and conditions of terminal access. It sought an independent review of Prime’s method of allocating overhead to DBCT, which found that Prime had not reliably estimated the amount of overhead relating

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to DBCT. This ‘Real life’ example illustrates the impact that overhead cost allocation choices can have, not only on product costs and product prices, but also industry competitiveness.

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7.14 Budgeted support department costs should be allocated rather than actual support department costs. If actual costs were allocated, the activities of the department that provides the services could compromise the results of the department that uses these services as well as their ability to plan activities. The incentive for cost control in the department that provides the services may be reduced if they just transfer those excesses to the next department. The allocation on the basis of budgeted figures highlights the good or poor results in the sourcing department.

7.15 Under the direct method of support department cost allocation, all support department costs are allocated directly to the production departments, and none of these costs are allocated to other support departments. Under the step-down method, a sequence is first established for allocation of support department costs. Then the costs incurred in the first support department in the sequence are allocated among all other departments that follow in the sequence, including other support departments. The method proceeds in a similar fashion through the sequence of support departments, never allocating back to a support department that has had its costs allocated. Under the reciprocal services method, a system of simultaneous equations is established to reflect the reciprocal provision of services among support departments. Then, all of the support departments’ costs are allocated among all of the departments that use the various support departments’ output of services. The reciprocal services method of support department cost allocation is the only method that fully accounts for the reciprocal provision of services among departments.

7.16 As stated in the previous answer, under the reciprocal services method all of the support departments’ costs are allocated among all of the departments that use the various support departments’ output of services. It is the only method that fully accounts for the reciprocal provision of services among departments. However, this degree of accuracy may not be necessary for the purpose and sometimes makes very little difference to the resulting costings. The degree of inaccuracy of the reciprocal and step down methods depends on the amount of overhead in each cost pool and the leve...