| by Nigel Coulthurst
01 Sep 1998
Many students struggle with the concept of overheads and with the process of overhead cost sharing. This article seeks to cover basic principles as well as provide an illustration of the traditional overhead cost sharing process, both of which are fundamental aspects of the paper 3 syllabus. A second article in a subsequent issue will review challenges to the traditional process, and more recent developments in overhead cost analysis, which are particularly relevant to students studying papers 8 and 9.
Overheads Overheads are those costs (expense types) which cannot be economically attributed directly to a cost unit. Put another way, they are those costs incurred by a business which are not discretely associated with a particular product or service which that business provides for its customers.
Overheads may alternatively be termed ‘indirect’ costs (in relation to cost units) in contrast to ‘direct’ costs which can be discretely associated with a particular end product or service. The overhead cost sharing process provides the basis for attaching indirect costs to a business’ products/services.
This applies to each and every business, whatever the particular sector of industry in which the business operates, whether in the public or private sector and whether involved in manufacturing or service. It also applies to indirect costs incurred in each functional area of business i.e., to selling, distribution, general administration and research, as well as to production.
Overhead cost sharing: why? Knowledge of the costs of different end products or services may be useful to a business:
For a complete cost picture, all overheads have to be shared out. The process of sharing out overhead costs, along with the attribution of direct costs, to end products/services is termed absorption costing. If nothing else, a manufacturing business has to share out production overhead costs in order to establish stock values. A service industry business is not so obliged to share out overheads but would not obtain any of the other benefits listed above without doing so.
Further benefits arise from the better control of costs that should be enabled at cost centre (as well as at cost unit) level. So much for the whys. What about the wherefores? How is the cost sharing to be done?
Overhead cost sharing process:principles Overhead costs should be shared:
Several questions arise regarding such an approach to overhead cost sharing:
It is preferable, therefore, to set up several cost centres, and to establish for each both a fair share of overhead costs and the best way of attaching such costs to the end products, based upon expected costs and activity.
Cost centres, within a factory, will comprise both production cost centres (separable activities concerned only with stages in the manufacture of a product, e.g., a finishing process) and service cost centres (separable activities within a manufacturing unit which provide a service to production activities and to each other, e.g., materials storage, canteen, machine maintenance).
Overhead cost sharing process: steps There are three main steps in the process of production overhead cost sharing:
Each of these three steps is traditionally sub-divided into further stages:
The remainder of this article provides an illustration of this traditional approach. A second article, in a subsequent issue, will raise questions about the approach and will consider alternatives.
The following problem, which has been adapted from a previous ACCA cost accounting examination question, provides a good illustration of most of the stages in the production overhead cost sharing process. Other questions in paper 3 may examine particular aspects/stages (e.g., aspects of the absorption stage only).
A company is preparing its production overhead budgets and determining the apportionment of these overheads to products. Cost centre expenses and related information have been budgeted as in Figure 1.
Determine budgeted overhead absorption rates for each of the production departments, using bases of apportionment and absorption which you consider most appropriate from the information provided.
The question already indicates the different overhead cost types, the level at which they are allocated (cost centre or total establishment) and the cost centres involved.
Five cost centres (fewer than would be expected in practice in order to make the question manageable) have been established for the collection of overhead costs. Three of the cost centres represent production activities (Machine Shop A, Machine Shop B and Assembly) and two cost centres are service activities (Canteen and Maintenance). This can be judged from the descriptions of the cost centres and from the information provided about direct wages/labour. Direct costs (e.g., direct labour) are likely to occur only within production (as opposed to service) activities, where they will be incurred, and can be associated, directly with individual products.
N.B. A frequent source of student error is the inclusion of direct costs as part of overheads. The direct costs may be relevant as a basis on which to absorb the overheads into the cost of products (see later), but are not part of the overhead costs themselves. Unlike direct product costs, overheads (e.g., indirect labour) will be incurred in all areas of a business’ manufacturing facility ( i.e., across all cost centres). In the above question there are seven indirect cost types (again there are likely to be significantly more in practice). Two of the cost types (indirect wages and consumable materials) can be allocated directly to cost centres. The remaining five cost types (rent & rates, buildings insurance, heat, power and light, depreciation of machinery) are termed ‘establishment costs’ because they can only be attributed to the factory (establishment) as a whole. In practice it may be possible, and justified, to allocate other cost types to cost centres, via investment in further data capture systems. It should be noted that the value of machinery is not an overhead cost (the depreciation of machinery represents the overhead cost); rather, the value provides the basis for the apportionment of the overhead cost to cost centres.
(ii) Apportionment — Stage 1
The remaining five cost types, which can only be allocated to the total factory (i.e., the establishment costs), have to be apportioned to the five cost centres. The important principle, for each cost type, is to identify the key driver of the cost. In the context of the question, drivers need to be selected from the information available.
It seems most appropriate to apportion costs as follows:
The first three cost types are closely driven by space occupancy, and the fourth by power usage, whilst the fifth (depreciation) is likley to be driven both by machinery value and by machinery usage. A case could certainly be made for the use of machine hours as the basis of depreciation cost apportionment but this would result in no allocation to the canteen or to maintenance where some machinery is used. In practice, machine depreciation should be easily allocated directly to cost centres, rather than be treated as an establishment cost. For apportionment of all the establishment costs to the five cost centres, along with the directly allocated indirect labour and consumable materials overhead costs, see Figure 2.
(iii) Apportionment — Stage 2
The second stage of the traditional approach to production overhead apportionment is the sharing of the service cost centre overhead costs amongst the production cost centres. This is necessary because it is out of the production departments that products pick up overhead costs, via overhead absorption, as production occurs. A common failing amongst students is to ignore this second apportionment stage, resulting in the undercharging of production overhead costs to products. Examination questions frequently restrict the analysis to two service cost centres in order that the apportionment is reasonably manageable, especially where reciprocal servicing between cost centres exists (e.g., canteen provides a service to maintenance and vice versa). Either the ‘repeated distribution method’ or the ‘algebraic method’ may be used to apportion service cost centre overheads to production cost centres where reciprocal servicing occurs (which is the case in the above question). Both methods are illustrated below.
Repeated distribution method The repeated distribution method involves apportioning, in turn, each service cost centre’s overheads to all other cost centres. This apportionment should start with the service cost centre having the most significant apportionment to the other service cost centre, and should continue until relatively insignificant amounts are involved.
First, the basis of apportionment of each service cost centre’s overheads needs to be determined. In the case of the Maintenance cost centre, percentage shares are provided in the question. Canteen costs would seem to be most appropriately apportioned to other cost centres on the basis of labour (direct and indirect) as the canteen provides a service for the benefit of, and driven by, the number of employees.Value, rather than numbers employed or hours worked, will have to be used in this case. Canteen labour costs need to be excluded from the apportionment base, and thus the apportionment percentages for canteen costs are as in Figure 3.
Algebraic Method The algebraic method uses simultaneous equations to establish service cost centre totals (including the share of the other service cost centre):
The re-apportionment, coupled with the previously allocated/apportioned costs, would be as in Figure 5.
Students need to be capable of applying either of the above apportionment methods in paper 3, in situations where reciprocal servicing occurs between service cost centres. A simpler situation could arise (in examination questions) where there is either no reciprocal servicing or where only one of the service cost centres provides a service to the other. In such situations repeated re-apportionments (or simultaneous equations) are not required.
(iv) Absorption Rates
Once all production overhead costs have been allocated/apportioned to production cost centres, the question of how best to attach these overheads to the products that are produced in each of the centres can be addressed.
The key issue is fairness, which begs the question again as to what drives the various cost types, i.e., what causes them to be incurred. The answer is that there are likely to be many different causes, and thus many drivers, which traditionally have been encapsulated, for each production cost centre, in a single basis for overhead absorption. This has been typically achieved by using an activity measure based on direct labour hours, direct labour cost or machine hours, because the production activity of each product can be measured in this way and used to absorb overheads. More than one basis could be used in each cost centre where there are clearly different drivers.
The possible introduction here of elements of direct costs is often a source of confusion to students. It is important to realise that the use of direct costs (e.g., direct labour) as the basis for absorption is simply a way of attaching indirect costs to products (i.e., via a direct element of a product’s costs).
On the basis of the information provided in the question, it would seem reasonable to suggest that the two machine shops are machine (as opposed to labour) intensive, and thus machine usage (measured as machine hours) provides the best basis for the differential charging of overheads to products in each of the machine shop cost centres. The assembly cost centre, on the other hand, is clearly labour intensive and thus direct labour hours, or direct labour cost, would be used to absorb overheads. It is assumed here that labour hours would be used.
The absorption rates, using the budgeted overheads and budgeted activity to establish predetermined rates, become:
Machine Shop A
Machine Shop B
Absorption of overhead occurs whenever machine hours are worked on product manufacture in the two machine shop cost centres, and whenever direct labour hours are worked in assembly.
Let us assume that the following information is available about actual activity in each cost centre in the period.
Activity measured in terms of machine usage is relevant for machine shop overhead absorption, whist direct labour hours are relevant for the assembly cost centre. Production overheads absorbed in the period are:
A total of £338,205 in production overheads will be absorbed into product costs (via the work-in-progress account) during the period. Control account bookkeeping entries are;
debit Work-in-progress Control A/c
(vi) Over/Under Absorption
It is inevitable that overhead incurred in a period, which is what ultimately must be charged as production overhead costs in the determination of profit, will not be the same as overhead absorbed, which is based, as demonstrated above, on the use of a predetermined rate applied to actual hours (machine or labour) worked. This is because both overhead expenditure incurred and actual hours worked will almost certainly differ from budget and not in an exactly compensating way. This results in overhead being over or under absorbed (i.e., the debit to the Production Overhead Control Account for costs incurred is not the same as the credit to that account upon the absorption of overhead into work-in-progress) and a requirement to adjust the amount charged against profit, as product cost of sales, when goods are sold.
If it is assumed, in our example, that actual production overhead expenditure (was £335,976) in the period, in excess of budget due to the above budget activity in each production cost centre, then there will be an over-absorption of overhead in the period. As previously calculated, a total of £338,205 would be absorbed out of the Production Overhead Control Account (credit), whereas £335,976 would be charged to this account (debit) for expenditure incurred. The over-absorption is £2,229 (338,205 – 335,976). £2,229 would be debited to the Production Overhead Control Account, to balance the account, with a credit of the same amount to the Profit and Loss Account. From month to month during a financial year, the over or under-absorbed balance may be held on the overhead account as there may be fluctuations from month to month that largely even themselves out.
The over-absorbed overhead balance thus adds to profit to compensate for the overcharging of overhead via absorption into product cost. The complete entries in the Production Overhead Control Account are illustrated below:
Production Overhead Control Account
If, on the other hand, production overhead expenditure had exceeded overhead absorbed (either because of over-spending or reduced activity), then overheads would have been under-absorbed and an additional charge against profit would have resulted (Cr. Production Overhead Control A/c: Dr. P & L A/c) in order to ensure that, ultimately, actual costs incurred are charged against profit.
Summary Overhead expenditure, incurred by a business, needs to be apportioned as fairly as possible to that business’ end products/services. Within production, the traditional process of overhead allocation, apportionment and absorption, via cost centres and based upon the establishment of predetermined overhead absorption rates, involves a number of steps. These steps lead ultimately to a comparison of overhead incurred with overhead absorbed, with any difference being Cr./Dr. to profit/loss.
It is important that students are familiar with each step in the process, which this article has sought to explain and illustrate.
Nigel Coulthurst is the paper 3 Examiner
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