20 WEEK 6
A CLOSER LOOK AT OVERHEAD COSTS
Overhead costs: generally refers to indirect product costs
Indirect product costs Manufacturing overhead costs
• (factory burden costs or indirect manufacturing costs) are all manufacturing costs other than direct material and direct labour.
• These include production costs that:
o are incurred for a variety of products and cannot be traced to individual products (e.g. costs of occupying, maintaining and managing a production facility)
o could be traced to individual products, but is not worth the trouble (e.g. costs og glue used in furniture manufacture)
o could be traced to an individual product but are more appropriately treated as a cost of all output (e.g. overtime premiums and costs of idle time)
• Manufacturing overhead includes depreciation and insurance of factory and manufacturing equipment, utility costs such as electricity, as well as the costs of manufacturing support
departments (departments that do not work directly on producing products but are necessary for manufacturing process to occur e.g. maintenance department for cars if they break down)
• Also includes indirect materials and indirect labour
Non-manufacturing costs
• Costs incurred outside the manufacturing area
• Upstream costs
o Research and development o Design and supply
• Downstream costs o Marketing o Distribution o Customer service
• Management accountants may assign indirect costs to products
ALLOCATING INDIRECT COSTS: SOME GENERAL PRINCIPLES Using Cost Pools
• Cost pools: a collection of costs that are to be allocated to cost objects
• Cost assignments takes two forms o Direct costs
o Indirect costs – where costs are allocated
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• Cost allocation: the general process of allocating costs in a cost pool to cost objects
Determining cost allocation bases
• A cost allocation base is some factor or variable that allows us to allocate costs in a cost pool to cost objects
• Ideally, the allocation base should be selection on cause and effect grounds; that is, it should be a cost driver
22 ALLOCATING OVERHEAD COSTS TO PRODUCTS
Overhead consists of a heterogenous pool of indirect costs. We want them in product costs, but they cannot be traced directly. There are three different approaches to solve this problem:
1. Plantwide overhead rate
• A single overhead rate that is calculated for the entire production plant 2. Departmental overhead rates
• Recognises that overheads in each department may be driven by different cost drivers 3. Activity-based costing
• Used to allocated overhead costs to products
Plantwide overhead rate
This involves gathering all manufacturing overhead items into a single overhead cost pool and then working through three steps:
1. Identify the overhead cost drivers
• A factor or activity that causes overhead costs to be incurred 2. Calculating an overhead rate per units of cost driver
• This is usually a predetermined (or budgeted) rate, determined on a year basis
• For a plantwide overhead rate, we combine all manufacturing costs into one single cost pool and relate it to the amount of cost driver for the entire production plant
3. Applying manufacturing overhead costs to products
• Based on the predetermined overhead rate and the product’s consumption of the cost driver
Departmental rates
A two-stage allocation process:
1. Overhead costs are assigned to production departments (two steps)
• All manufacturing overhead costs are distributed to each department (cost distribution) and many involve both tracing and allocating costs
• All support department costs are reassigned to the overhead cost pools in the production departments (support department cost allocation)
2. Overhead costs are applied to products
23 Allocating support department costs
1. Overheads are allocated between support and production departments to assist managers with planning and controlling usage
2. Overheads are allocated using one of the three methods 1. Direct Method
▪ Support department costs are allocated directly to production departments which means costs is not allocated between two support departments
▪ Doesn’t recognise services between support departments
▪ Overheads only allocated to production departments
