AN ILLUSTRATION OF THE TWO- STAGE PROCESS FOR A

TRADITIONAL COSTING SYSTEM

Applying the two-stage allocation process requires the following four steps:

1. Assigning all manufacturing overheads to production and service cost

centres;
2. Reallocating the costs assigned to service cost centres to production cost
centres;
3. Computing separate overhead rates for each production cost centre;
4. Assigning cost centre overhead to products or other chosen cost object.

Step 1- Assigning all manufacturing overheads to production and service cost

centres

 Using the information given in Example 4.1 our initial objective is to assign all
manufacturing overheads to production and service cost entries. This require the
preparation of an overhead analysis sheet, which is shown in Exhibit 4.1.
 If you look at Example 4.1 you will see that the indirect labour and indirect
material costs have been directly traced to cost centres.
 The remaining costs in Example 4.1 cannot be traced directly to the cost centres
and must be allocated to the cost centre using appropriate allocation bases.
 The term ‘first-stage allocation bases’ is used to describe allocations at this point.
The following list summarizes commonly used first stage allocation bases:

Cost Basis of allocation

- Property taxes, lighting and heating Floor area of cost centres
- Employee-related expenditure: Number of employees per cost centre
work management, work canteen,
payroll office
- Depreciation and insurance of plant Value of items of plant and machinery
and machinery
 Where utility consumption, such as lighting and heating, can be measured by
separate meters located in each department, departmental consumption can be
measured and the cost directly traced to the user departments.
 To allocate the overheads listed above to the production and service centres we
must prepare an overhead analysis sheet, as shown in Exhibit 4.1. which it
occupies.
 The floor area of the factory shown in Example 4.1 is 50 000 square meters;
machine centre X occupies 20% of this and machine centre Y a further 10%.
 Therefore, if you refer to the overhead analysis sheet in Exhibit 4.1 you will see
that 20% of property taxes, lighting and heating and insurance of buildings are
allocated to machine centre X, and 10% are allocated to machine centre Y.
 The book value of machinery for machine centre X is 8/15 of total book value
and machine centre Y is 5/15 of the total book value then 8/15 and 5/15 of
insurance and deprecation of machinery is allocated to machinery centre Y.
 Since 30% of the total employees are employed in machine centre X, 30 % of
salaries of works management will be allocated to this centre

Step 2- Reallocating the costs assigned to service cost centres to production cost
centres

 The next step is to reallocate the costs that have been assigned to service cost
centres to production cost centre.
 Service department, sometimes called support department (i.e. service cost
centres) are the departments that exist to provide services of various kinds to
other units within organization.
 The enterprise company has two services centres. They are materials procurement
and general factory support.
 50% of the value of materials is issued to machine centre X, resulting in 50% of
the total costs of materials procurement being allocated to this centre
Step 3- Computing separate overhead rates for each production cost centre

 The second stage of the two-stage process is to allocate overheads of each

production centre to products passing through that centre by establishing cost
centre/departmental overhead rates.
 The allocation bases most frequently used by traditional costing systems for
computing production cost centre rates, are based on the amount of time products
spend in each production centre- for example direct labour hours, machine hours
and direct wages.
 Direct labour hours is the most frequently used allocation base.
 We shall assume that the Enterprise Company uses a machine hour rate for the
machine production centres and a direct labour hour rate for the assembly centre.
The overhead rates are calculated by applying following formula:

Cost centre overheads

Cost centre direct labour hours or machine hours

The calculations (i.e. step 3) using the information given in Exhibit 4.1 are as follows:

Machine centre X= 4 300 000 / 2 000 000 machine hours = ₤2.15 per machine hour

Machine centre Y= 3 800 000 / 1 000 000 machine hours = ₤3.80 per machine hour

Assembly department = 3 600 000/2 000 000 direct labour hours =₤1.80 per direct labour hour

Step 4- Assigning cost centre overhead to products or other chosen cost object

 The final step is to allocate the overheads to products passing through the
production centres.
 If a product spends ten hours in machine cost centre A., overheads of ₤21.50 (10
x ₤2.15) will be allocated to the product.
Product A ₤
Direct costs (100 units X ₤100) 10 000
Overhead allocations
Machine centre A (100 units x 5 machine hours x ₤2.15) 1 075
Machine centre B (100 units x 10 machine hours x ₤3.80) 3 800
Assembly (100 units x 10 direct labour hours x ₤1.80) 1 800
Total cost 16 675
Cost per unit (₤16675/100 units)= ₤166.75

 Product A is a low sales volume product with direct costs of ₤100. it is

manufactured in batches of 100 units and each unit requires five hours in machine
centre A, ten hours in machine centre B and ten hours in the assembly centre.

Product B ₤
Direct costs (200 units X ₤200) 40 000
Overhead allocations
Machine centre A (200 units x 10 machine hours x ₤2.15) 4 300
Machine centre B (200 units x 10 machine hours x ₤3.80) 15 200
Assembly (200 units x 20 direct labour hours x ₤1.80) 7 200
Total cost 66 700
Cost per unit (₤66700/200 units)= ₤333.50

 Product B is a high sales volume product thus enabling it to be manufactured in

larger batches. It is manufactured in batches of 200 units and each unit requires
ten hours in machine centre A, 20 hours in machine centre B and 20vhours in the
assembly centre. Direct cost of ₤200 have been assigned to product B.
EXTRACTING RELEVANT COSTS FOR DECISION-MAKING

 For decision making, non-manufacturing costs should also be taken into account.
In addition some of the costs that have been assigned to the products may not be
relevant for certain decisions.
 For example, if you look at the overhead analysis sheet in Exhibit 4.1 you will
see that property taxes, depreciation of machinery and insurance of buildings and
machinery have been assigned to cost centres, and thus included in the costs
assigned to products. If these costs are unaffected by a decision to discontinue a
product they should not be assigned to products when undertaking product
discontinue reviews.
 If cost information is used to determine selling prices these costs may need to be
assigned to products.

BUDGETED OVERHEAD RATES

 The actual overheads for an accounting period have been allocated to the
products. However, the use of actual figures can be problematic.
 Information on product costs is required more quickly if it is to used for monthly
profit calculations and inventory valuations or as a basis for setting selling prices.
 Consider Example 4.2. the monthly overhead rates of ₤2 and ₤5 per hour are not
represent of typical, normal production conditions.

Example 4.2

The fixed overheads for the Euro Company are ₤24 million per annul, and
monthly production varies from 400 000 to 1 000 000 direct labour hours. The
monthly overhead rate for fixed overheads will therefore fluctuate as follow:

Monthly overhead ₤2 000 000 ₤2 000 000

Monthly production 400 000 hours 1 000 000 hours
Monthly overhead rate ₤5 per hour ₤2 per hour
 Overhead expenditure that is fixed in the short term remains constant each month,
but monthly production fluctuates because of holiday periods and seasonal
variations in demand. Consequently the overhead rate varies from ₤2 to ₤5 per
hour. It would be unreasonable for a product worked on in one month to be
allocated overheads at a rate of ₤5 per hour and an identical product worked on in
another month allocated at a rate of only ₤2 per hour.

UNDER-AND OVER-RECOVERY OF OVERHEADS

 The effect of calculating overhead rates based on budgeted annual overhead

expenditure and activity is that it will be most unlikely that the overhead allocated
to product manufactured during the period will be the same as the actual overhead
incurred.
 There will be an under- or over-recovery of overheads whenever actual activity or
overhead expenditure is different from the budgeted overheads and activity used
to estimate the budgeted overhead rate.
 An under-or-recovery of fixed overheads arising from actual activity differing
from budgeted activity is also called a volume variance and any under- or over-
recovery arising from actual fixed overhead expenditure differing from budget is
also called a fixed-overhead expenditure variance.
 Volume variance- the difference between actual activity or overhead expenditure
and the budgeted overheads and activity used to estimate the budgeted overhead
rate.
 Fixed-overhead expenditure variance- the difference between the budgeted
fixed overheads and the actual fixed overhead spending.

NON-MANUFACTURING OVERHEADS

 For financial accounting purposes, only manufacturing costs are allocated to

products. Manufacturing overheads are regarded as period costs and are therefore
dealt with in exactly the same way as the under- or over-recovery of
manufacturing overheads outlined in Figure 4.4
 For external reporting it is therefore unnecessary to allocate non-manufacturing
overheads to products
 For decision- making, non-manufacturing costs should be assigned to products.

Example 4.3

The estimated non-manufacturing overhead and manufacturing costs of a

company for the year ending 31 December are ₤500 000 and ₤1 million respectively.
The non-manufacturing overhead absorption rate is calculated as follows:

Estimated non-manufacturing overhead

Estimated manufacturing cost

In percentage terms each product will be allocated with non-manufacturing

overheads at a rate of 50% of its total manufacturing cost.

COST ASSIGNMENT IN NON-MANUFACTURING ORGANIZATIONS

 The same basic cost assignment procedures that are used by manufacturing
organizations can be applied were there is a need to track the cost of the service
provided to each individual customer. Where a job-order costing system is
inappropriate, cost information is required for profitability analysis by products,
services, departments, etc. Organizations may choose to assign only direct cost to
cost objects using a direct costing system.
 Alternatively, they may also use only the first stage of two-stage overhead
allocation procedure to assign indirect costs to departments that are synonymous
with the products/services that are sold by the organization.

THE INDIRECT COST ASSIGNMENT PROCESS

 The following is a summary of the process of assigning indirect costs to cost

objects for a traditional job-order costing system:
1. Identify the production departments (or their equivalent in service
organizations)
2. Identify the support departments that provide essential support services for
the production department;
3. Assign all indirect (overhead) costs in the firm to a producing or support
department;
4. Reallocate the support department costs to the production department;
5. Calculate predetermined overhead rates for each producing department;
6. Allocate the departmental overhead costs to the units of the individual
products or services using the predetermined overhead rates.