Chapter 7

A closer look at
overhead costs

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 Outline
• What are overhead costs?
• Allocating indirect costs
• Allocating overhead costs to products
• Evaluating the allocation alternatives
• Issues in estimating overhead rates
• Responsibility centre allocations
• Allocating support department costs
• Other issues in allocating support
department costs
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 What are overhead costs?
• For product costing
– Indirect manufacturing costs, also known
as manufacturing overheads
– Indirect costs, manufacturing overheads
and non-manufacturing costs
• For responsibility centres
– The indirect costs of responsibility centres

(cont.)

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 Manufacturing overheads
• Manufacturing overheads include
production costs that:
– are incurred for a variety of products and
cannot be traced to individual products
– could be traced to individual products but
there is little benefit in doing so
– could be traced to individual products but
it is more appropriate to treat this cost as
a cost of all outputs
– includes depreciation, factory insurance,
indirect labour, indirect materials
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 Allocating indirect costs:
Using cost pools
• Cost assignment can take two forms
─Direct costs can be traced directly to cost objects
(e.g. products)
─Indirect costs cannot be traced to cost objects,
therefore they need to be allocated
• A cost pool is a collection of costs that are to
be allocated to cost objects
─Have a common allocation base
─Often used to simplify the allocation process

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 Estimating the cost of
a cost object

(cont.)

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 Allocating indirect costs:
determining cost allocation
bases
• A cost allocation base is some factor
or variable that is used to allocate
costs in a cost pool to cost objects
• Ideally the allocation base should be
selected on cause-and-effect grounds
• A cost driver is an activity or factor
that causes a cost to be incurred (cont.)
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 Allocation bases for
indirect costs

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 Allocating overhead costs
to products
• Reliable product costs are important for
a range of management decisions
– Which products to produce, what prices to
charge, inventory valuation
• An important issue is how to allocate
indirect costs to obtain an accurate
estimate of a product’s cost
• Three possible approaches for allocation
(cont.)
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 Allocating overhead costs
to products (cont.)
• Using a plant-wide overhead rate
• Three steps
1. Identify the overhead cost driver
2. Calculate the overhead rate per unit of cost
driver
3. Apply the manufacturing overhead cost to
the products based on the predetermined
overhead rate and the product’s
consumption of the cost driver (cont.)

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 Allocating overhead costs
to products (cont.)
• Departmental overhead rates recognise
that overheads in each department may
be driven by different cost drivers
• Two-stage cost allocation process to
allocate overhead costs to products via
department overhead rates
• Stage one: overhead costs are
assigned to production departments
(cont.)

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 Allocating overhead costs
to products (cont.)
• Stage two: overhead costs are applied
to products
– Manufacturing overhead rates are
calculated for each production department

Predetermined Budgeted manufacturing overhead

manufacturing = Budgeted level of cost driver
overhead rate
Predetermined × Quantity of cost
Applied overhead = driver consumed by
overhead rate
the product
(cont.)
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 Allocating overhead costs
to products (cont.)

(cont.)

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 Allocating overhead costs
to products (cont.)
• Activity-based costing can be used to
allocate overhead costs to products
• Stage one: overhead costs are assigned to
activity cost pools for significant activities
(not departments)
• Stage two: activity costs are applied to
products using a rate, based on the
product’s consumption of the activity
• Activities are units of work performed (cont.)
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 Allocating overhead costs
to products (cont.)

(cont.)

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 Allocating overhead costs
to products (cont.)
• Traditional two-stage allocation process
– Stage one: allocation bases used are
ideally determined by causal relationships
– Stage two: one cost driver per department,
with cost drivers being measures of
production volume
• Activity-based costing
– Focuses on the costs of activities
– Identifies activity cost pools and cost
drivers
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 Evaluating the alternatives
for allocating overheads
• Plant-wide and departmental overhead
costing systems
– Overcost high-volume relatively simple
products and undercost low-volume
complex products
– Less costly to establish and operate
• Activity-based costing
– Multiple cost drivers and overhead rates
– More complicated and costly to operate
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 Issues in estimating
overhead rates
• Identifying overhead cost drivers: three
questions
1. What is the major factor that causes
manufacturing overhead to be incurred?
2. To what extent does the overhead cost
vary in proportion with the cost driver?
3. How easy is it to measure the cost driver?

(cont.)

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 Volume-based cost drivers
• Conventional costing systems assume
that overhead costs vary proportionally
with production volume
• Based on outputs and inputs
• For plant-wide rates, select a cost driver
that is common to all products
• Cost drivers that are measured in dollars
should not be used as cost drivers as
they are subject to price level changes

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Non-volume-based cost drivers
• Not all aspects of manufacturing
overhead costs vary with production
volume
• Need to be careful in assigning
volume-based cost drivers to fixed
costs, as they can lead to
misconceptions that these costs are
variable per unit
• Activity-based costing
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Distinguishing between fixed
and variable overhead costs
• Helps managers better understand the
behaviour of overhead costs
• Separate overhead rates may be
calculated
• Fixed costs have no accurate cost driver
• Variable product costing system
• Product costs will not be more accurate
if volume-based cost drivers are used
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 Budgeted versus actual
overhead rates
• Budgeted costs and amounts of cost
drivers are used to calculate overhead
rates
• Trade-off between timeliness and accuracy
• Budgeted rates calculated prior to the
commencement of the year
• Actual rates calculated after the end of the
year
• Actual costing versus normal costing
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 Period covering overhead rates
• Over what period should overhead rates
be set?
– Yearly rates are generally used
– Monthly rates not recommended as they
fluctuate due to price changes and seasonal
factors
– A normalised overhead rate is an overhead
rate calculated over a relatively long period

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 The effects of capacity
• Estimating the amount of a cost driver:
the effects of capacity
– Denominator volume: an estimate of the
quantity of the cost driver used or supplied,
to determine overhead rates
– Expected use of cost driver, based on the
budgeted volume or normal volume
– Expected supply of cost driver, based on
theoretical capacity or practical capacity

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 Allocating indirect costs to
responsibility centres
• Levels of cost allocation
– Corporate level, within business units and
manufacturing plant
– Reasons for allocating costs to responsibility
centres
– Helps managers understand the economic
effects of their decisions
– Encourages a particular pattern of resource
usage/behaviour
– Supports the product costing system (cont.)
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 Allocating indirect costs to
responsibility centres (cont.)
• General principles
– Allocation bases should be cost drivers,
where there is a clear and direct relationship
between the amount of cost driver and the
level of cost
– Other criteria that can be used
 Benefits received
 Ability to bear additional costs
(cont.)

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 Allocating indirect costs to
responsibility centres (cont.)
• Using budgeted, not actual, allocation
data
– Minimises the possibility that the activities
of one department will affect the costs
allocated to other departments
– Provides better information for managers
to plan and control their use of indirect
resources

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 Allocating support
department costs
• Informs user departments of the cost of the
services that they are using
• Allocation methods include:
– Direct: support department costs are allocated
directly to production departments
– Step-down: partially recognises the services
provided by one support department to another
– Reciprocal services: fully recognises the provision of
services between support departments
(cont.)
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 Allocating support
department costs (cont.)

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 Which allocation method
is best?
• Different recognition changes outcomes
• Choice is a costs versus benefits decision
• Where reciprocal relationships are strong,
greater benefits from the reciprocal services
method
• The arbitrary nature of cost allocation
methods limits the value of conventional
product costing systems
• Activity-based costing may provide more
reliable outcomes
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 Other issues in allocating
support department costs
• Service organisations do not need to
distinguish between production and non-
production areas for costs of service outputs
• In modern manufacturing systems
– Individual products are sometimes created
within the one defined work area
– When more costs are not directly traceable to
products the accuracy of allocation methods
becomes more critical
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 Summary
• Overhead cost can be allocated to products using a
plantwide rate, department rates or activity-based
costing methods
• Ideally, cost drivers should be used as allocation
bases
• As the number of overhead rates increases the
accuracy of the product cost is likely to increase
• Cost benefit considerations are relevant when
choosing a method for overhead allocation
• Indirect costs can be allocated to user departments
to encourage users to manage their resources

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