Topic 3 Cost assignment

3.1 Introduction

Overview of costing system

- In this module we take the analysis of costs deeper in order to gain an understanding
of where individual costs come from and how they are spread over the output of a
business.

- It is only through an understanding the details of cost gathering and allocation that
managers can review alternative systems which may be more in tune with their
objectives.

The information gathering is through a costing system.

We can recall that managers use cost accounting for the following purposes:
(a) controlling actual performance against planned performance;
(b) planning next year’s costs;
(c) tracking the consumption of resources;
(d) choosing among alternative courses of action.

Two of these roles (controlling and tracking) are backward looking while the other two (planning
and choosing) are forward looking. To ask one costing system to cater for all information
requirements is unreasonable, but we fear that many managers do indeed expect their systems to
produce answers to every requirement they have.

This topic will concentrate on the tracking and controlling functions of cost systems. Only when
managers are aware of how these requirements are satisfied will they be in a position to assess
their informational needs for planning and choosing.

The main product/service costs are materials, labour and overheads.

Materials

Materials are perhaps the easiest cost to trace to a cost item because of their visible, physical
nature. Materials are drawn from inventory and this action triggers the raising of a stores
requisition slip.

Just in time system (procedures) are also used in other firms for individual departments to order
their parts direct from the supplier for using in the production cycle. Such a procedure has the
positive effect of reducing inventories of raw materials to almost zero

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Labour
- Labour is also a relatively easy cost to identify and measure, particularly if the persons
involved can be seen to be directly involved in the construction of the cost item.

- Labour cost is a multiple of time spent on a job and rate of pay earned by those involved.

Some relevant cost definitions

Cost drivers

A cost driver is a factor such as the level of activity or volume that causally affects costs usually
over a given time span. IE a cause and effect relationship exists between a change in the level of
activity or volume and a change in the level of total costs of that object.

The cost driver of variable costs is the level of activity or volume whose change causes the
variable costs to change proportionately. Eg the number of vehicles assembled is a cost driver of
steering wheels.

Costs that are fixed in short run have no cost drivers in the short run but may have a cost driver
in the long run. EG adjustment to pn facility to support future changes in volumes.

Cost object

Anything for which a separate measurement of costs is desired eg a good or a service

Cost pool

This is a grouping of individual cost items. Cost pools can range from a very broad eg company
wide total cost pool for operating costs of all cars owned by a company to the very narrow e.g.
the cost of operating one particular car used by a sales person.

Cost allocation base.

A factor that is a common denominator for systematically linking an indirect cost or a group of
indirect costs to a cost object-can be financial e.g. direct labour costs or non financial e.g. the
number of miles traveled. Companies often seek to use the cost driver of the indirect costs as the
cost allocation base.

Overheads- Manufacturing and non manufacturing (Indirect)

Both items of cost are indirect, that is, there is no close relationship that can be traced between
the outputs from production and the various headings of cost which comprise overheads

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Examples of Manufacturing Overheads
Manufacturing overheads include supplies of low value high use components such as screws,
hinges, glue and adhesives, factory heating and lighting, power for productive machinery,
machine maintenance and depreciation, production supervision, space costs of factory and
warehouse.

Examples of Non-Manufacturing Overheads

Non manufacturing overheads include administration, selling and distribution, financial costs
such as bank interest on borrowed money and audit fee, heating and lighting of offices, space
costs of offices, managerial salaries, depreciation on car fleet, R&D laboratory.

Before spreading the overheads to units of production, these costs must first be gathered.
Overheads are notoriously difficult to control. By definition they are not directly linked to
output.

Overhead costs should be gathered initially into cost centers, that is, pockets of activity for which
individual managers may be held responsible.

Because these overheads are not directly attributable to cost units in the same manner as direct
materials and direct labour where the actual usage of resources can be tracked precisely,
accountants use a predetermined overhead rate with which to spread overheads across the units
of production. The pre-determined overhead allocation rate:

Allocation and apportionment of overheads (Primary distribution

Allocation means assigning of indirect costs to cost center or departments. Allocation of
overheads is done only is they can be directly identified with the cost center or department.

Apportionment of overheads refers to the distribution or the sharing of indirect cost centers using
appropriate bases. The bases to be use will be influenced by the nature of costs to be
apportioned.

The purpose of allocation and apportionment is to ensure that all indirect costs are directly
identified with the cost centers at the end of the exercise.

Absorption of overheads to units

After all departments’ overheads have been apportioned/allocated to production departments, the
next step is to spread overheads to different products or cost units or jobs. This is called ‘over
absorption’, ie the allotment of overheads to cost units.

This means that the overhead absorption ensures that overhead incurred in production become or
constitute part of the cost of the product or service provided.

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Stages in overhead absorption

i) Calculation of overhead absorption rates

ii) Charging of overheads to cost units.

Since these overheads are not directly attributable to cost units in the same manner as direct
materials and direct labour where the actual usage of resources can be tracked precisely,
accountants use a predetermined overhead rate (Overhead Absorption Rate- OAR) with which
to spread overheads across the units of production. This rate is based on the following
calculation:

The pre-determined overhead allocation rate:

This rate sometimes called ‘blanket’ rate assumes one product and should not be used unless the
output is in the unit of measurement.

Where a business produces more that one product and that these products have different
production characteristics (I.e. consume differing proportions of the factors of production
including overheads) Cost Accountants use causal factors or activity bases.

Typical activity bases include direct labour hours, direct labour cost, and machine hours.

The multiple product rates:

OAR = Budgeted/Actual overheads of a cost center

Budgeted/Actual base applicable to a cost center

Methods

1. Units of Output method

OAR = Overheads of cost center

Units of output of the cost center

This means that the o/h will be absorbed basing on the units of o/p of each production
department.

2. Machine hours method

OAR = Overheads of cost center

Machine hours of the cost center

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 Used where the work is performed primarily on machines.

Same applies to direct labour hours, wages etc.

Simple example- one product (plant wide)

A business manufactures and sells one product which contains £5 direct material and £10 direct
labour. Over the forthcoming year management plans to manufacture 10 000 units of the product
and the estimate of total overhead amounts to £100 000.

The predetermined OAR will be

Taking in to account activity bases:

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Under- and Over- absorption of overheads

Overheads are either greater or less than predicted; output is more or less than planned. The
difference between the actual figure of overhead incurred and that allocated to the product is
accounted for directly in the profit and loss account.

Over absorption is when o/h absorbed is greater than the actual o/h incurred. This represents a
gain and will be treated as additional income in the P&L.

Under absorption is where o/h absorbed is lower than the actual o/h incurred. This represents a
loss and will be charges to P&L as a cost/expense.

Plant wide versus Departmental Rates

The above single plant wide predetermined overhead rate described above, formulated for either
a one product firm or a more than one product firm using only one activity base, is overly
simplistic

- One activity base can not explain more than a handful of overhead costs, far less a majority of
them.

- Management must design a cost allocation system which reflects each product’s actual usage of
overheads rather than adhere to the blunt instrument of a plant wide rate.

Example- Allocation and absorption

A company uses two production departments and three service departments to manufacture
heavy lifting gear for the offshore oil industry. After a detailed examination of costs and
activities the company’s management consultants produced the following estimates for next
year:

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The aim of overhead cost allocation is to apply costs to the products of the business.

Since products flow through production departments and not service departments, the first step
in the allocation process must be to transfer service department overheads to the production
departments so that they can be ‘attached’ to the products as they go through.

Cost accountants use many methods which revolve around two principal techniques, the direct
method and the step method. Others are repeated distribution (continuous apportionment until
figures become insignificant), and equation method

The Direct Method

In the direct method, the overhead costs for each of the three service departments are emptied out
into the production departments and added to the overheads already there to calculate two
predetermined overhead rates. Each service department is taken in turn using a suitable activity
base (the numbers in brackets are drawn from the above table):

• Personnel: number of employees (Forging, 50; Welding, 100);

• Computing: service hours (Forging, 450; Welding, 75);
• Site maintenance: square metres occupied (Forging, 4500; Welding, 3000).

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Every order which goes through Forging will be allocated £10.125 overhead for each machine-
hour spent on the order in Forging; when the order moves to Welding, overhead of £3.029 will
be allocated for every direct labour hour spent on the order.

The direct method of overhead cost allocation is a straightforward approach to emptying out
service department overhead costs.

The direct method ignores the interdepartmental services provided by each service department
before the ultimate allocation to production department.

Some companies prefer to use the second technique, the step method, which recognizes this
interdependency among departments. A sequence to close down service departments’ costs must
be established. Two of the most common are: (a) select service departments in descending order
of magnitude of overhead spend, and (b) select first the department that renders the highest
percentage of its total services to other service departments and end with the one that renders the
lowest percentage of service to other service departments. We adopt sequence (a).

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The Step method

Notes
1 Personnel. When allocating any service department’s costs, always ignore its consumption of
its own resources. Thus the total activity base for allocating personnel overhead is 180 persons,
not 210 persons. This produces an overhead allocation of £1211.11 per person.

2 Computing. Once a service department has been closed down (in our example, Personnel) no
further service department’s allocations are given to it. Therefore the number of service hours
used to allocate Computing overhead is 2025 (6750 less those consumed by Computing and
Personnel).The total overhead to be allocated is £124 972, being Computing’s original
allocation of £100 750 plus £24 222 stemming from Personnel.

3 Site maintenance. Use square metres occupied by Forging and Welding

respectively.

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Note that the difference between the two methods is very small and it would therefore be
unlikely that the company would resort to the step method. But the principle of detailed overhead
analysis and allocation must remain a sound one.

Overheads should fall on the products which have caused them. If management can install cost
systems which are capable of regular review and which can be updated for resource usage among
products it will avoid burdening some products with overheads which should clearly fall on
others and which could lead to damaging pricing and marketing decisions.

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