As managers we need to know about cost accounting for various reasons. Mainly to achieve a greater control over what we are employing, to make better decisions and to get involved in the material pricing decision.
If management accounting is going to be used as part of a control system, it is necessary for all the costs to become the responsibility of the direct cost centre manager.
Stage 1. Allocating all costs to specific cost centres
"Allocation" is the step of charging the entire cost of an item to a "cost centre". All costs are first allocated to the cost centre as they become the responsibility of the manager of that centre. This requirement is very important because if not strictly monitored they will just go out of control.
Once all the costs have been allocated to a cost centre, we then classify them into two categories: production and service. Production cost centres are those units where the product is manufactured. Service are those units that provide service to other centres.
Stage 2. Share out the production service cost centre costs
This can be done in two ways:
* Take each cost in each cost centre and charge individually to all the other production cost centres and production service cost centres identified, for example factory rent.
* Charge out the total of each production service costs centre's costs to all other production cost centres and production service cost centres that have benefited from the service provided.
In practice the combination of both methods is usually adopted. Irrespective of which method is adopted the system used to share out the costs is simple:
Number of employees. For those service cost centres who provide service to individual employees i.e canteen, HR department. Costs are adopted then by employee working in the particular production department and proportion of the total number of employees working in all production cost centres.
Floor area. For example, centres such as cleaning and building maintenance.
Activity. For example R&D office, materials handling or transport department.
Example of sharing service cost centre costs
For example, if we are provided with the following indirect costs:
Cost centre
Production 1 Indirect expenses (to units) £24,000
Production 2 Indirect expenses (to units) £15,000
Service cost centre A: allocated expenses £20,000
Service cost centre B: allocated expenses £8,000
Service cost centre C: allocated expenses £3,000
The benefits provided by the 3 services are as follows:
Service cost centre A - Production 1: 50%, Production 2 30%, Service cost centre B 10%, Service cost centre C 10%.
Service cost centre B - Production 1 70%, Production 2 20%, Service cost centre C 10%
service cost centre C - Production 1 50%, Production 2 50%
To calculate the total amount of overhead to be charged to cost centre units for Production 1 and Production 2 we calculate:
Cost centre Production Service
1 2 A B C
Allocated indirect expenses £24,000 £15,000 £20,000 £8,000 £3,000
A: 50: 30:10:10 £10,000 £6,000 (£20,000) £2,000 £2,000
B: 70: 20: 0: 10 £7,000 £2,000 --------- (£10,000) £1,000
C: 50: 50: 0: 0 £3,000 £3,000 --------- -------- (£6,000)
Total overhead
absorbed by
specific unit £44,000 £26,000 -------- -------- --------
Units passing through Production cost centre 1 will have a share total overhead expenditure of £44,000 and Production cost centre 2 - £26,000.
The total amount of overhead to be shared amongst the units is £70,000 ( £44,000 + £26,00)
Stage 3: Absorb the production overhead
Once all the indirect costs have been collected the next step is to charge the total amount to specific units. This is known as "absorption".
The method of absorbing overhead into units is simple. There are six main methods that can be used for absorbing production overhead and all use the same equation:
Cost Centre Overhead Absorption Rate = Total cost centre overhead / Total cost centre activity
Specific units
This method is the simplest to operate but it only applies if all units are identical:
Absorption rate = Total cost centre overhead / Number of units processed in the cost centre
Direct materials cost
Absorption rate = (Total cost centre overhead / cost centre total direct material cost) X 100
The direct material cost of each unit is multiplied by the absorption rate.
Direct labour cost
Absorption rate = (Total cost centre overhead / Cost centre total direct labour hours) X 100
The direct labour hours of each unit are then multiplied by the absorption rate. This method is used on labour-intensive because the time spent in production is related to the overhead incurred.
Prime cost
Absorption rate = (Total cost centre overhead / Prime cost) X 100
The prime cost of each unit is then multiplied by the absorption rate.
Direct labour hours
Absorption rate = Total cost centre overhead / Cost centre total direct labour hours
The direct labour hours of each unit are then multiplied by the absorption rate.
Machine hours
Absorption rate = Total cost centre overhead / Cost centre total machine hours
The total machine hours used is then multiplied by the absorption rate. This is most appropriate method for the departments which are machine intensive.
Example of calculating the overheads absorption rates
As an example, we can calculate the overheads absorption rates for an assembling department:
Direct materials cost incurred - £400,000
Direct labour incurred - £200,000
Total factory overhead incurred - £100,000
Number of units produced - 100,000
Direct labour hours worked - 50,000
Machine hours used - 80,000
a) Specific unit absorption rate = £100,000 / 10,000 = £10.00 per unit
b) Direct material cost = (£100,000 / £400,000) X 100 = 25%
c) Direct labour cost = (£100,000 / £200,000) X 100 = 50%
d) Prime cost = (£100,000 / (£400,000 + £200,000)) X 100 = 16.67%
e) Direct labour hours = £100,000 / 50,000 = £2 per direct labour hour
f) Machine hours = £100,000 / 80,000 = £1.25 per machine hour
In practice only one method would be used depending on circumstances for each production centre.
Exercise by J.R Dyson
Let's say that we have a small manufacturing company producing a variety of pumps for oil industry. The factory is geographically separated from the head office. Their assembly department assemble the components of the product, then they are passed to the finishing department where they are painted and then they are packed. There are some service cost centres: administration, stores and study department.
The cost centres overhead costs and average number of employees are as below:
Administration - £70,000 - average number of employees: 15
Assembling - £25,000 - average number of employees: 25
Finishing - £9,000 - average number of employees: 40
Stores - £8,000 - average number of employees: 2
Study department - £18,000 - average number of employees - 3
We also know that:
The allocated cost centre overheads costs are indirect costs for specific units
35,000 machine hours were worked in the assembling department and 60,000 direct labour hours in the finishing department.
During that year stores department received 15,000 requisitions from the assembling department and 10,000 requisitions from the finishing department. The stores department did not provide service to any other department.
The study department carried out 2,000 chargeable hours for the assembling department and 1,000 chargeable hours to the finishing department
One special pump was produced during that year and it took 10 machine hours, 15 direct labour hours were worked in the finishing department. It's total direct costs ( materials and labour) was £100.
We will calculate the total absorption rate for the assembling department and the finishing department. we will also calculate the total factory cost for special pump.
Production Service
Cost centre Assembling Finishing Administration Stores Study
Overhead costs £25,000 £9,000 £70,000 £8,000 £18,000
Production
Apportion
Administration
25: 40: 2: 3 (2) £25,000 £40,000 (£70,000) £2,000 £3,000
Apportion
stores
3: 2 (3) £6,000 £34,000 --- (£10,000) ---
Apportion
study
2: 1 (4) £14,000 £7,000 --- --- (£21,000)
Total overhead
to be absorbed £70,000 £60,000 --- --- ---
Administration costs have been apportioned on the basis of employees. 85 employees in the factory, but 15 employed in administration. Administration costs have been therefore apportioned on the total of 70 employees or £1,000 per employee. The administration department is the only service department to provide service to other service departments.
The stores costs have been apportioned on the number of requisitions made by by the two production centres £15,000 + £10,000 = £25,000 or 3: 2
The study cost have been apportioned on the basis of chargeable hours, 2,000 X 1,000 = 3,000, or 2: 1
Calculation of chargeable rates
Assembling department = TCCO/ Total machine hours = £70,000 / 35,000 = £2.00 per machine hour
Finishing department = TCCO / Total direct labour hours = £60,000 / 60,000 = £1.00 per direct labour hour
The finishing department is a labour-intensive department and the assembling department is the machine intensive department.
Special pump: calculation of total factory cost
Direct cost - £100
Finishing department - 15 labour hours X £1.00 per direct labour hours - £35
Total: £135
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