BUSI 562

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BUSI 562

• Managerial Accounting

Allocating Overhead Costs ABC Costing
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Manufacturing Overhead
What is Manufacturing Overhead? Direct costs
can be traced directly to specific units of
products, such as Direct Materials and Direct
Labor. Direct Materials attach to and become part
of the end product. Direct Labor is the labor
cost of workers that convert Materials into the
finished product. Manufacturing Overhead
consists of Indirect costs related to the
production process. They are a mixed batch of
costs that, in total, can be traced to the entire
manufacturing process, but they are Indirect
because they cant be traced to individual units
of product. Manufacturing Overhead consists of
costs such as building rent or depreciation,
equipment depreciation, building and equipment
maintenance, production managers salaries,
utilities, and other costs related to the
production facilities or production process.
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Manufacturing Overhead
Allocating Manufacturing Overhead Since Overhead
is a mixed basket of Indirect costs it is
allocated across all products produced. There are
two general methods of allocating overhead
costs. Standard Method or One-Step
allocation ABC Costing or Two-Step
allocation The standard method of a allocating
overhead estimates total overhead costs and
divides total estimated overhead costs by some
reliable cost driver.
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Standard Allocation
Standard Method of Allocating Overhead Since
Overhead is a mixed basket of Indirect costs it
is allocated across all products produced. The
Standard Method or One-Step allocation projects
(estimates) total overhead costs and divides
total estimated overhead costs by some reliable
cost driver. Estimating is done at the start of
the year, but may be revised during the as
information changes. During the year, overhead
costs are collected in an account and allocated
on a regular basis, using the formula. Formula
for calculating the overhead allocation rate
Total Projected Annual Overhead Costs
Overhead Allocation Rate
Total Projected Overhead Driver
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Overhead Cost Drivers
Overhead Cost Drivers dont cause overhead.
Overhead is caused by the manufacturing process.
Even more correctly speaking, Overhead is caused
by customers who buy products. Overhead is all
the incidental and indirect costs of production
necessary to make products so customers can buy
them. Because of this distinction even some
accountants are confused about the real meaning
of Overhead Cost Drivers. An Overhead Cost
Driver is something we can measure directly and
easily, and which has a high correlation to the
production process, or rate of production. The
correlation between overhead costs and drivers
should provide a reliable way to allocate
overhead across many units of production over the
entire time period.
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Overhead Cost Drivers
Reliability and Predictive Value are the most
important features of a good Overhead Cost
Driver. Predictive Value we should be able to
predict the total Overhead Cost Driver for the
year, with a high degree of accuracy. We should
also be able to track the driver throughout the
year with relative ease. Reliability there
should be a high correlation between the Cost
Driver and rate that units are produced
throughout the year.
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Overhead Cost Drivers
Direct Labor Hours works well for many
labor-intensive situations, especially when
hourly workers are paid at different rates per
hour. Direct Labor Dollars works well for
service-type situations where workers are
salaried and hours are not tracked can be used
in other situations as well where total labor
dollars stay relatively stable from year to
year. Units of Production works well for
automated processes where labor is incidental to
the production process, or where units are a
significant production constraint, eg a machine
can produce X number of units per 8-hour
shift. Mileage used by trucking companies,
taxicabs Hours of Use engine hours used by
airlines, diesel locomotives Square footage
used to allocate occupancy costs to different
departments sharing the same building
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Standard Overhead Example
XYZ Company uses Direct Labor Hours to allocate
overhead. They estimate their total annual
overhead will be 120,000 for the coming year.
They have 20 workers who each work 2000 hours per
year, for a total of 40,000 direct labor hours.
Workers are paid at different rates, but the
total number of hours remains constant from year
to year.
120,000 overhead dollars
3.00 per DLH
40,000 DL Hours
In July the company records 3350 Direct Labor
Hours. They allocate overhead for July as
follows 3.00 per DLH times 3350 hours.
3.00 x 3350 10,050 total overhead allocated
to July production
During July they produce 6000 units of product.
10,050 / 6000 units 1.675 overhead per unit
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Unit Cost Analysis
XYZ Companys books show the following total
production costs for July Total Direct Materials
16,500 / 6000 2.750 per unit Total Direct
Labor 36,750 / 6000 6.125 per
unit Allocated Overhead 10,050 / 6000
1.675 per unit Total Costs
63,300 / 6000 10.550 per unit You should be
able to work with both total costs and unit costs
in managerial accounting. Products are priced and
sold on a per unit basis, so unit costing is
necessary to determine a correct selling price
and gross profit per unit. Lets assume XYZ
Company had total sales of 88,620 for the 6000
units produced in July.
Sales 110,775 COGS
63,300 Gross Profit 47,475
Gross Profit Rate 47,475 / 110,775 42.86
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ABC Costing
ABC Method of Allocating Overhead The ABC Method
of allocating overhead is similar to the standard
method. The main difference is that total
overhead costs are separated into two or more
Cost Pools, and each Cost Pool has its own Cost
Driver. We refer to this as a Two-Step Allocation
process. Step One separate overhead into cost
pools Step Two allocate each cost pool
overhead based on the relevant cost driver for
each cost pool Lets look at an example
calculating the Annual overhead allocations using
the Two-Step ABC Costing Method.
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ABC Costing Example
XYZ Company estimates a total of 120,000 in
overhead for the year. They separate total
overhead into two cost pools Occupancy Overhead
and Production Overhead. Occupancy Overhead
consists of the costs of occupying the building.
They allocate Occupancy costs based on the square
footage of each department within the building.
Part of the building is used by the
administrative and sales offices, which are not
involved in the production process. Part of the
occupancy costs are allocated to the
administrative and sales departments.
Production Overhead consists of indirect
production costs. None of these costs are
assigned to the administrative or sales
departments. Production Overhead is allocated
based on Direct Labor Hours (same method as in
the Standard overhead example presented above,
but a different dollar amount is allocated.
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ABC Costing Example
Total Occupancy Overhead 85,200 Total
Production Overhead 34,800 Total Overhead
Costs 120,000 There are 60,000
square feet in the building. Annual Occupancy
costs are allocated based on square footage as
follows. 85,200 / 60,000 square feet 1.42
per square foot Production Dept A 19,000
sq ft x 1.42 26,980 Production Dept B
29,000 sq ft x 1.42 41,180 Sales offices
8,000 sq ft x 1.42
11,360 Administrative offices 4,000 sq ft x
1.42 5,680 Total overhead
60,000 sq ft x 1.42 85,200
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ABC Costing Example
Total Occupancy Overhead 85,200 Total
Production Overhead 34,800 Total Overhead
Costs 120,000 The company uses
40,000 DLH per year. No Production Overhead is
allocated to the administrative or sales
departments. Under ABC Costing the Production
Overhead is allocated as follows 34,800 /
40,000 DLH 0.87 per DLH Production Dept A
16,000 DLH x 0.87 13,920 Production Dept B
24,000 DLH x 0.87 20,880 Total
40,000 DLH x 0.87 34,800
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Recap ABC Costing Example
Total Annual Overhead 120,000
Occupancy Cost Pool 85,200 / 60,000 1.42 sq
ft Dept A 26,980 Dept B 41,180 Sales
11,360 Admin 5,680 Total 85,200
Production Cost Pool 34,800 / 40,000 0.87
per DLH Dept A 13,920 Dept B
20,880 Sales 0 Admin
0 Total 34,800
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Drawbacks of ABC Costing
Overhead costs are indirect costs. Overhead
includes a large basket of costs which includes
things like depreciation on buildings and
equipment maintenance on building and
equipment real estate and property
taxes insurance, mangers salaries, utilities and
all other costs indirectly related to
production We might be able to use ABC Costing
to improve efficiency and identify some
unprofitable activities. But we must always
remember that ABC Costing is just another way to
allocate overhead costs. By itself ABC Costing
does not reduce costs, increase sales or increase
profits. To improve the bottom line we must
review all overhead costs carefully and identify
the ones that management can control. Most
overhead costs are not controllable in the short
run.
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Drawbacks of ABC Costing
ABC Costing is an allocation method, not a cost
control tool. The usefulness of ABC Costing
depends on the degree of correlation between
overhead costs and cost drivers. There should be
a high correlation between a cost driver and the
incurring of real costs. This can be difficult to
achieve because of the general nature of overhead
costs. ABC Costing also depends on correctly
identifying valid cost drivers. Any activity
could theoretically be considered a cost driver.
We should select activities that are significant
and have a high predictive value. ABC Costing is
often more useful for service providers. ABC
Costing can help service providers better
allocate costs to specific customers. We can also
use this approach to identify which customers are
more or less profitable, or to determine service
fees for different types of service or customer.