In my previous blog I was providing information on the apportionment and absorption of production overheads. Many companies, however, will generate costs of activities not directly connected with production. For example, selling and distribution costs, R&D costs or head office administrative expenses. These costs can also be absorbed in the unit costs.
Before we calculate those, we need to determine why we should do that:
* Control. It is easier to monitor costs that are broken down. An accounting system should be in place that is centralised including unit cost level. Manager's however take no responsibility for costs not relating to their cost centre.
* Selling price. In some cases the production overhead costs are being added the non-production overhead costs for specific unit in order to determine selling price that covers all costs and allows margin for profits. In may cases, however, selling price is determined by the market and companies are not in the position to fix selling prices based on costs and adding margin to the profits (cost-plus pricing).
* Stock valuation. We might think that non-production overheads may need to be included in the stock valuation exercise but much work would be involved in the management accounting to suit this requirements.
Although there is no many benefits of calculating of the non-production overheads, it is an interesting exercise to know the actual cost of the units produced. The only time when it can be useful is when the selling price is based on costs. Even then, an arbitrary estimates are calculated. It will depend on the company's pricing policy.
Determining absorption rates
Absorption costs can be calculated on historical basis or we can predetermine it and calculate it in advance. We can only apportion them on a reasonable basis as there is no direct correlation with production activities. If we know the total overheads incurred we can make sure that it is charged to a specific unit.
We need to know the actual cost of overheads and the actual activity level ( machine hours, direct labour hours or some other basis). The adoption of historical costs is generally not very practical as we need to wait for the information for a particular period. Therefore we can use calculated in advance absorption rates. This involves estimating the overheads likely to be incurred and the direct labour hours (or machine hours). If the estimates are not accurate then we will either undercharge our customers or overcharge them.
This situation can be very serious for a company. Low selling prices could make the product very competitive but they may be sold at loss. High absorption rate may result in high selling price and each unit making large profit but not enough units sold to make the overall profit.
The difference between the actual overheads costs and the total overheads charged to production gives raise to "variance". If the actual overheads incurred is in excess of the amount charged out the variance will be "adverse" and profit less then expected. If the total overhead charged to production is less then estimated then the variance will be "favourable".
A variance should be written off to the profit and loss account at the end of costing period.
Activity-based costing is currently being advocated to provide more accurate absorption costs.
Activity-based costing
We know that the calculation of product costs involves identifying the direct costs and indirect costs (overheads). This method was used in twentieth century. It was discovered in 1980s that this methods are not appropriate in advanced manufacturing environment. The methods assume that more time spent on production, the more overheads is incurred. This assumes that no distinction is made between fixed and variable overheads. Additionally the calculations imply that no matter what costs are incurred in production, the overheads are charged as the proportion of those costs.
Activity-based costing allocates overheads to "cost pools" i.e similar areas of activity and relevant 'cost driver" is determined for each pool selected. By dividing the total cost for relevant cost pool by the cost driver, an overhead cost per driver can be calculated. The final step is to charge the approximate amount to each unit benefiting from the service provided by the cost pool.
For example, a company identified four cost pools: parts, maintenance, stores and administration. The cost drivers identified are: the total number of parts, maintenance hours, number of materials requisitions and number of employees.
Cost pool Total overhead (£000)
Parts £10,000
Maintenance £18,000
Stores £10,000
Administration £2,000
Activity Quantity
Number of parts 500
Number of maintenance hours 600
Number of requisitions 20
Number of employees 40
In one month, 500 units of products were produced. It required 100 parts, 200 maintenance hours, 6 material requisitions and 10 employees working on these units.
We can calculate the total amount of overhead absorbed for each unit.
Cost pool Overhead Cost driver Cost driver Usage by product Cost charged
(£000) rate to product
Parts £10,000 500 parts £20 100 parts £2,000
Maintenance £18,000 600 hours £30 200 hours £6,000
Stores £10,000 20 requisitions 500 6 requisitions £3,000
Administration £2,000 40 employees £50 10 employees £500
Total overheads absorbed by product £11,500
1. The cost driver rate has been obtained by dividing the "Overhead" by "Cost driver"/
2. The "Overhead cost charged to product" has been obtained by multiplying the "Cost driver rate" by "Usage by product".
3. The total amount of £11,500 is the total amount of overhead to be absorbed by the product.
Summary
Activity-based costing is an attempt to absorb the overhead on the demands that the particular unit in production makes to the various resources before it is completed and becomes "finished stock". In traditional methods of absorption costing, a unit is charged with the average charge of the overheads irrespective of what proportion relates to a specific unit. This means that some units are charged with more then their fair share of overheads, while others may be charged with much less.
ABC looks at closer relationship between individual activities and the specific unit
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