Once materials have been valued, direct materials can be charged out to the cost units by using the relevant job or batch number. Indirect materials are charged to the cost centre incurring them, to be charged to cost units later as part of the total overhead recovery.
ᔢ use one single global overhead recovery rate;
ᔢ use multi-department overhead recovery rates;
ᔢ use activity-based overhead recovery rates.
Global overhead recovery rate
Consider how a local garage charges each customer with a share of its overheads for service or repair work. Normal practice is that it combines overheads with direct labour costs, and charges an enhanced hourly rate to recover the cost of mechanic’s time and overheads – and an element of profit!
This obviously is an easy and cheap way to deal with the costing of overheads. At the beginning of a year the garage estimates the cost of all its overheads and the number of mechanics’ hours it will normally be able to charge out. The hourly overhead charge is worked out by divid- ing the estimated overheads for the year by the number of mechanics’
hours in that same time.
Example
A garage estimates that its total overheads for the coming year will amount to
£200,000. It also estimates that chargeable time will amount to 10,000 hours. The overhead charge/recovery rate is £20 per hour.
If all customers were having similar work done then this system is likely to be as fair as any other. Most overheads accumulate with time as does rent, rates, office salaries, heating, etc, so to include overheads at £x per hour seems fair at first glance. However, in some circumstances this might not be regarded as a fair way to charge customers for different kinds of work. What this global overhead recovery system does not allow for is that some customers may need the use of special equipment for a certain kind of repair while other customers do not. If the over- heads include charges for the depreciation and maintenance of this equipment then the first customers are being subsidized by other customers who are being overcharged.
Many small firms use the above approach of putting all overheads into one big pot and then charging them out to cost units at an hourly rate according to the direct labour hours going into each product. This approach is shown in Figure 11.4.
Multi-department overhead recovery rates
Larger organizations with diversified products and more diverse production or operation systems find the global approach to overheads inappropriate due to its lack of discrimination. They cannot afford to undercharge some products, so gaining market share on less profitable lines, and then overcharge on other products, so losing market share on the more profitable lines.
For this reason they channel all overheads into their relevant cost centres wherever they arise. Cost centres providing a service to other oper- ational cost centres have all their overheads recharged to them on the basis of the amount of service provided. All overheads are now in operational cost centres which charge them out to cost units, but onlythose passing through that cost centre. In this way equity is established between differ- ent products. This more equitable system is illustrated in Figure 11.5.
Costing basics
Direct Costs Indirect Costs
Total cost of each cost unit Coded to charge the
individual cost unit directly
Recharged at £x per direct labour hour
Figure 11.4 Global method of overhead recovery
Coded to charge the
individual cost units directly
Cost centre
A
Total cost of each cost unit Cost centre
B Indirect costs Direct costs
Overhead charged to only those cost units passing through each cost centre
Cost centre
C
Figure 11.5 Multi-department overhead recovery method
Activity-based overhead recovery method
A subtly different means of overhead apportionment has appeared in recent years based on the principles of activity-based costing(ABC). The impetus for this approach derives from the need for manufacturing companies to have reliable valuations on their finished stocks and work- in-progress to prepare the financial accounts. Accounting standards decree that these stocks are valued on the basis of direct costs plus some appropriation of production overheads only.
The traditional method of absorbing production overheads into product costs (as in Figure 11.5 above) has been to relate those over- heads to the direct labour cost or to the direct labour or machine time involved. As a result, production overhead charges of x per cent of direct labour cost or £y per direct labour hour or £z per machine hour have been used to calculate product costs and satisfy financial account- ing needs for stock valuations.
In many cases, though, the direct labour cost is now a very small proportion of total production costs and production overheads are a much higher proportion because of the technology now being used. To base the overhead recovery of a large amount on a small base is fraught with danger. Added to this is the problem of variable sizes of production runs, where the time taken on actual production takes no account of the overheads incurred on pre-production set up and production schedul- ing. Direct labour cost reflects the volume of production, but not the complexity of the overhead functions supporting that production. The end result was that product costs in some manufacturing companies became discredited for pricing and profitability purposes and the search was on for a better method.
ABC analyses overhead costs into activities, which probably tran- scend departmental boundaries, and are collected in cost pools.
Examples of activities might be:
ᔢ estimating;
ᔢ set-up;
ᔢ materials handling;
ᔢ invoicing.
The prime cause of demand for a particular activity is identified as a cost driver. If, say, quality inspections is an activity and the number of inspec-
tions is the cost driver, then the cost driver rate will be determined by dividing the cost pool for the inspection activity by the total number of inspections carried out in the period. The end result might seem little different to the traditional method of departmental/cost centre over- head recovery rates, but this is not the case. There are far more activities than there are cost centres/departments and ABC does a better job in identifying overhead costs with the products that incur them.
ABC is not limited to production overheads only and can be applied to administrative, selling and distribution functions where activity cost pools and cost drivers can be established. In fact, ABC is not limited to manufacturing companies and is now frequently applied to service organizations. Nor is its use limited to product costing, but extends to customer profitability analysis, activity-based budgeting and other management applications.
We can now see how the total cost of any product or service is built up.
Direct labour, direct material and direct expenses can all be coded with a job number to identify a particular cost unit. Indirect labour, indirect materials and indirect expenses have to be shared out over cost units in a way that does not favour one product line at the expense of another. This may be by use of one global overhead recovery rate; or along traditional department/cost centre overhead recovery rate lines; or, in more complex situations, by use of activity cost pools and their associated cost drivers.
Costing basics
Coded to charge the
individual cost units directly
Activity 1 Cost pool
Total cost of each cost unit Activity 2 Cost pool Indirect costs Direct costs
Overheads charged to cost units in proportion to volume of transactions generated
for each cost driver
Activity 3 Cost pool
Figure 11.6 ABC method of overhead recovery
The next chapter continues the costing story by examining the way busi- nesses use cost information to help fix their prices.
Further reading
CIMA (1996) Management Accounting: Official Terminology, CIMA, London.
Drury, C (1996)Management and Cost Accounting,ITP, London.
Innes, J and Mitchell, F (1998) Activity-based Costing, Kogan Page, London.
Lucey, T (1996) Costing, Letts, London.
Northrup, CL (2004) Dynamics of Profit-focused Accounting, J Ross Publishing, Boca Raton, FL.
Turney, PBB (1998) Activity-based Costing: the Performance Breakthrough, Kogan Page, London.
Self-check questions
1. Is costing primarily concerned with revenue or capital costs?
2. Which documents typically convey basic cost data to accountants in an organization?
3. Distinguish a cost unit from a cost centre.
4. Define indirect costs.
5. Give an example of a variable cost for:
ᔢ a leisure centre;
ᔢ a firm making cosmetics; and ᔢ an electricity supply company.
6. In what ways can direct labour be remunerated?
7. What bases can be used to price materials drawn from an internal store?
8. In what ways does an activity-based costing system differ from a departmental overhead recovery system?
Costing and pricing
INTRODUCTION
Organizations need to know the total cost of each product or service they provide to their customers for the following reasons:
ᔢ to value work-in-progress and completed work as current assets in the balance sheet;
ᔢ to determine the cost of sales to enter in the profit and loss account;
ᔢ to control product costs by comparing them with a predetermined target or standard cost;
ᔢ to know what profit is made at any particular selling price;
ᔢ to fix selling prices based on total cost, although it should always be borne in mind that there are other non-cost influences on prices.
When prices are cost based, this calculation usually takes place before the order is received from the customer. This is the case when an esti- mate or quotation is requested for one-off or purpose-built items. Where standardized products are concerned, the normal selling price is usually based on the total cost incurred on producing the product or providing the service. An element of profit is added in both cases for profit-seeking enterprises.
Sometimes work may be undertaken on a cost plus basis, meaning that the supplier will be reimbursed for all legitimate direct costs plus an
12
agreed percentage for overheads plus a further agreed profit percent- age. Some government contracts are let out on this basis. The selling price in these cases can only be worked out after the event. The costing procedure for working out the production cost of any product or service is the same, irrespective of whether it takes place before or after the work is completed. This procedure is called absorption costing by accountants and is a key step towards full costor total costpricing.