Costs incurred by cost centers are classified into two types
a) Direct Costs
b) Indirect Costs
Costs which can be traced to the finished products manufactured are called ‘direct costs’. In other words a relationship between costs and finished products manufactured can be established.
Costs which cannot be traced to the finished products manufactured are called ‘indirect costs’. They are also known as ‘Overheads’. This implies overheads can only be apportioned to the finished products.
Example: A unit manufactures two products – Leather shoes & Leather wallets
Material (Leather) used for both the products is traceable to them individually. However, expenditure of a common machine used in making both the products cannot be traceable to them.
Therefore in the above case ‘Material’ would be a direct cost and ‘Machine expenses’ would be indirect cost.
Importance of overhead allocation
Total cost of product constitutes Direct Material, Direct Labor & Overheads. Direct Material and Direct Labor are directly traceable to the products manufactured. Accuracy of product cost computation depends on accurate distribution of overheads to products. Inaccuracies would lead to incorrect decisions – especially the pricing decisions.
However, the method of overhead distribution should be chosen by considering time and cost factors in addition to accuracy.
Traditionally overhead apportionment to products was made in the following three step approach
I) Primary Distribution (Allocation & Apportionment)
II) Secondary Distribution (Re-apportionment)
Allocation & Apportionment (Primary Distribution)
Primary distribution of overheads which is also called as ‘Departmentalization’ of overheads involves allocation & apportionment. Allocation of overheads is made when they are traceable to cost centers. Overheads are apportioned when they are not traceable to cost centers. Apportionment is made using the most suitable bases.
Re-apportionment (Secondary Distribution)
Cost centers are two types:
a) Production Cost Centers: They are cost centers where finished products are manufactured
b) Service Cost Centers: They are cost centers that support the production cost centers in manufacture of a product
Ex: Stores, Engineering, Purchase etc.
Re-apportionment is a process where service centers costs are transferred to production centers.
Methods of re-apportionment
The following are the methods used to re-apportion service department costs to production departments.
|Scenario||Method for re-apportionment|
|No service between service cost centers||Direct re-distribution method|
|Non reciprocal service between service cost centers||Step ladder method|
|Reciprocal service between service cost centers||1) Repeated distribution method
2) Trial & Error method
3) Simultaneous Equation method
The process of recovering overheads to cost of products is called ‘absorption’. In other words all the overheads allocated & apportioned to a department are finally absorbed by the units produced.
Absorption of overheads can be made based on some suitable basis. The following are some of widely used methods of absorption:
a) On the basis of ‘Production units’
b) As a % of ‘Direct Labour Cost’
c) As a % of ‘Direct Material Cost’
d) As a % of ‘Prime Cost’
e) On the basis of ‘Direct Labour Hours’ i.e. Labour Hour Rate
f) On the basis of ‘Machine Hours’ i.e. Machine Hour Rate
Overhead absorption rates are determined based on any one of the above methods. This rate is applied to individual cost units (products, services etc) to derive the total overhead absorbed.
When actual overhead rate is applied on actual cost units, the actual and absorbed overheads would be equal. However if a pre-determined rate is applied on the actual base, it would result in a difference between actual and absorbed overheads. This would happen either because the actual base deviated from the budgeted base or the actual expenses deviated from the budget.
If the absorbed overhead is more than the actual, it is called ‘over absorption’. On the other hand if the actual overhead is more than the absorbed overhead then it is called ‘under absorption’.
Budgeted Overhead – $ 50,000
Budgeted Volume (units) – 25,000
Actual Overhead – $ 48,000
Actual Volume (units) – 26,000
Absorbed overheads = 26,000 X 50,000 / 25,000 = 52,000
Absorbed overheads – Actual overheads = 52,000 – 48,000 = 4000
Therefore Over Absorption = $ 4000
Activity Based Costing
Traditionally cost accountants had arbitrarily added a percentage of expenses into the direct costs to include overheads. This method is quite satisfactory when the overhead costs are a small percentage compared to direct labor component in actual making of products. However as the percentages of overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products.
For example, one product might take more time in one machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad ‘on-cost’ percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another
Therefore, using an arbitrary percentage leads to distortion of costs resulting in the following problems:
a) Fixation of wrong selling prices (By pricing low profitable opportunities may be missed or by pricing high customers may be lost)
b) Taking wrong decisions (product sales mix decisions etc)
Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity.
Cost drivers are used to measure the use of activities by different products / services.
For example the cost of the activity ‘purchasing’ is measured by the number of purchase orders placed.
Overhead Allocation – Traditional vs Activity Based Costing
Steps involved in ABC model
a) Pick resource wise cost data financial accounting records
b) Identify activities
c) Map resource costs to activities
d) Identify activity cost drivers
e) Compute overhead costs of the products / services
Map resource costs to activities
Identify cost drivers & compute cost driver rates
|Machining||# of production runs||$ 100 per production run|
|Purchase||# of purchase orders||$ 50 per purchase order|
|Quality||# of inspections||$ 282 per inspection|
|Material Handling||# of components||$ 6150 per component|
Selling and Distribution Overhead
Selling is a common function in both manufacturing companies as well as trading companies. Thus selling and distribution costs are incurred both manufacturing and trading companies. Most of the selling and distribution costs are not identifiable to products; therefore they are in the nature of indirect costs.
Selling overhead and distribution overhead are two different terms. Selling overhead represents indirect costs incurred for: i) Creation and simulation of demand ii) Securing orders.
Distribution overhead is incurred after the completion of the manufacture process. They are incurred to move the product the customer (or customer’s place).
It is difficult to lay down an exhaustive list of groups under which selling and distribution overheads may be classified. Below is an illustrative classification.
Process of absorption
The process of collection and distribution of selling & distribution overheads has three stages of analysis as below
Bases for analysis by function / cost center
Some of the commonly used bases for apportionment of selling & distribution overheads to functions / cost centers are
|Type of overhead||Base|
|Advertisement||Sales value or sales units|
|Depreciation||Value of assets used|
|Credit monitoring||# of sales orders|
|Warehouse rent||Floor area|
|Transportation||Weight and distance carried|
|Insurance of stock||Value of stock|
Bases for analysis by products or group of products
Functional costs that cannot be directly allocable to the products are apportioned using one or more of the following bases -
1) Overhead rate per unit of the product: This method is used for allocation of Advertisement costs, warehouse costs etc.
2) As per the number of orders delivered: This method is often used to distribute Transportation costs.
3) As a percentage of sales value: This method is used to allocate Sales Commission, Salesman travel costs etc.
4) As a percentage of cash collected: This method is used to allocate bad debts, collection expenses etc.