AFIN210 – COST AND

MANAGEMENT ACCOUNTING
ACCOUNTING FOR OVERHEADS

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 CONTENTS
• Nature of overheads
• Absorption costing
• Marginal costing
• Activity Based Costing (ABC)

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 NATURE OF OVERHEADS
• Overheads are all the indirect costs. The sum of
the indirect costs what is what is called
overheads. Overheads consist of:
– Indirect materials
– Indirect labour
– Indirect expenses
• The overheads will fall in any one of the following
categories:
– Production overheads
– Administration overheads
– Selling and distribution overheads

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 ABSORPTION COSTING
• This is a method of cost accumulation under
which all the costs of production are charged
to the units of products.
• The main reason is to ensure that the costs
are charged to the products on a fair basis.
Each product is charged with a share of the
organisation’s total production overheads.

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 ABSORPTION COSTING
• The other reasons why it is important to use
absorption costing are as follows:
– Inventory valuation
– Pricing decisions
– Profit measurement
– Compliance with IAS2 - Inventory

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 ABSORPTION COSTING
• The stages of dealing with production
overheads under absorption costing is as
follows:
– Allocation
– Apportionment
– Service cost centre reapportionment
– Calculation of predetermined overhead
absorption rates
– Absorption of production overheads into products

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 OVERHEAD ABSORPTION RATES
• These are the rates that are used to charge
production overheads to units of products.
• Predetermined overhead absorption rates are
used
• The predetermined overhead absorption rates
should be departmental overhead absorption
rates

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 OVERHEAD ABSORPTION RATES
• Predetermined OARs (based on budgeted figures)
are used for the following reasons:
– Many overheads are not known until the end of a
period and to wait until then to calculate overhead
absorption rates would produce unacceptable delays
in invoicing, pricing, stock valuations and so on.
– Because of random fluctuations in overheads from,
for example, month to month, absorption rates
calculated on a monthly basis would vary, which
would produce misleading information for costing
purposes and would be administratively and clerically
inconvenient to deal with.

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 OVERHEAD ABSORPTION RATES
• Departmental overhead absorption rates
rather than blanket overhead absorption rates
should be used so as to reflect the different
times different products spend in production
cost centres and, consequently, the different
resources put into making them.
• The use of blanket (plant wide) overhead
absorption rates cannot reflect these
differences.

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 OVERHEAD ABSORPTION RATES
• Overhead absorption rates (OAR) are
therefore calculated using the formula:
OAR = Budgeted overheads
Budgeted activity
• Budgeted activity upon which the calculation
may be based may be any suitable activity.

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 OVERHEAD ABSORPTION RATES
• Commonly used bases of absorption are as
follows.
– Units basis (if all units are identical)
– Direct labour hour basis (appropriate for a labour
intensive production cost centre)
– Machine hour basis (appropriate for a machine
intensive production cost centre)
– Percentage of prime cost (appropriate if prime cost
forms a greater proportion of total cost)
– Percentage of direct materials cost
– Percentage of direct labour cost

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 OVER/ UNDER ABSORPTION
• The OAR is predetermined from budget estimates
of overhead cost and the expected volume of
activity. It is quite likely that one of the following
will occur.
– Actual overheads are different from budgeted
overheads
– Actual activity level is different from budgeted activity
level
– Both actual overheads and actual activity level are
different from the budgeted overheads and budgeted
activity level.
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 OVER/ UNDER ABSORPTION
• There may be discrepancy (under/over
absorption of overheads) between actual
overheads incurred and overheads absorbed
using the predetermined OAR.
• This discrepancy is an adjustment in the
statement of profit or loss at the end of the
period.
– Over absorption means that the overheads charged to
the cost of production are greater than the overheads
incurred.
– Under absorption means that insufficient overheads
have been included in the cost of production.
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 MARGINAL COSTING
• This is a method of cost accumulation under
which only the variable production costs are
charged to the units of product.
• The fixed costs are treated as period costs and
charged to the profit and loss account of the
period in which they are incurred.

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 MARGINAL COSTING
• Cost and profit concepts in marginal costing are:
– Marginal cost is the cost of one unit of a product/service
which would be avoided if that unit were not produced /
provided. This is the same as the variable cost. Therefore, the
marginal cost in this context is the variable cost.
– Contribution is the amount by which sales revenue exceeds
the total variable (marginal) costs. In marginal costing,
profitability of products or services is generally measured
using the contribution. A product that earns a contribution is
said to be more profitable than that which earns no
contribution at all. The level of fixed costs is the same for all
activity levels. As such, the higher the contribution, the
higher the profit is expected to be.

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 MARGINAL COSTING
• The principles of marginal costing are:
– Only variable costs are charged as cost of sales
– Closing stocks are valued at marginal (variable)
production cost
– Fixed costs are treated as period costs, are deducted
from profit and hence are charged in full against profit
of the period in which they are incurred.
– If the volume of sales rises/falls by one item, profit
will rise /fall by the contribution earned from the
item.
– Contribution per unit is constant at all levels of output
and sales (whereas profit per unit varies)

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 MARGINAL COSTING COMPARED
WITH ABSORPTION COSTING
• Arguments in favour of marginal costing and
therefore against absorption costing are:
– Absorption costing information is irrelevant when
making short-run decisions.
– It is simple to operate.
– There are no arbitrary fixed cost apportionments.
– Fixed costs in a period will be the same regardless of
the level of output and so it makes sense to charge
them in full as a cost of the period.
– It is realistic to value closing stock items at the
(directly attributable) cost to produce an extra unit.
– Under/over absorption is avoided.
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 MARGINAL COSTING COMPARED
WITH ABSORPTION COSTING
• Arguments in favour of absorption costing and
therefore against marginal costing are:
– Fixed production costs are incurred in order to make
output and so it is only ‘fair’ to change output with a share
of these costs.
– Closing inventory will be valued in accordance with IAS 2.
– Appraising products in terms of contribution gives no
indication of whether fixed costs are being covered.
– Where stock building is necessary fixed overheads should
be included in stock valuation. If this is not the case, then a
series of losses will be reported in earlier years.

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 ACTIVITY BASED COSTING (ABC)
• This is a method of cost accumulation under which
overheads are charged to products using the cost
drivers. Arbitrary bases of absorption of overheads are
not used under activity costing.
• ABC has been developed to overcome the inability of
absorption costing to deal with features of the modern
manufacturing environment.
• The developments in industry and commerce have
changed the nature of operations from being highly
labour intensive to machine intensive.

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 FEATURES OF THE MODERN
MANUFACTURING ENVIRONMENT
• Features of a modern manufacturing
environment are:
– An increase in the cost of service support
functions which are unaffected by changes in
production volume, varying instead with the range
and complexity of production.
– An increase in overheads as proportion of total
costs.

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 INADEQUACIES OF ABSORPTION
COSTING
• Implies all overheads are related primarily to production
volume.
• Developed at a time when organisations produced only a
narrow range of products and when overheads were only a
small fraction of total costs.
• Developed at a time when organisations produced only a
narrow range of products and when overheads were only a
small fraction of total costs.
• Tends to allocate too great proportion of overheads to high
volume products (which cause relatively little diversity) and
too small a proportion of overheads to low volume
products (which cause greater diversity and therefore use
more support services).

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 PRINCIPLES OF ABC
• The major ideas behind ABC are as follows.
– Activities cause costs. Activities include ordering, materials
handling, machining, assembly, production scheduling and
despatching.
– Producing products creates demand for the activities.
– Costs are assigned to a product on the basis of the product's
consumption of the activities.
• Activity based costing (ABC) involves the identification of
the factors which cause the costs of an organisation's major
activities.
• Support overheads are charged to products on the basis of
their usage of the factor causing the overheads.

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 COST DRIVERS
• In order to operate an activity based costing system,
cost drivers should be identified.
• The CIMA’s management Accounting Official
terminology defines a cost driver as ‘any factor which
causes a change in the cost of an activity e.g., the
quality of parts received by an activity is a determining
factor in the work required by that activity and
therefore affects the resources required.
• An activity may have multiple cost drivers associated
with it. A cost driver may also be defined as an activity
or transaction that is a significant determinant of a
cost.

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 COST DRIVERS
• Two types of cost drivers are:
– Volume based cost drivers
– Transaction based cost drivers
• Volume based cost drivers are things such as direct labour hours
and machine hours. These cost drivers are the primary
determinants of conventionally based variable costs.
• Transaction based cost drivers include such things as number of
production runs, purchase requisitions issues, invoices processed
and so on. These are determinants of cost that do not vary in the
short run with the level of output but tend to vary in the longer
term as the increasing complex nature of the production process
places additional burdens on support departments.

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 COST DRIVERS
• In the development of a set of cost drivers it
may be useful to use cooper’s classifications of
the activities that drive expenses at the
product level. These are:
– Unit level activities
– Batch related activities
– Product sustaining activities

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 COST DRIVERS
• Unit level activities
– These take place every time a unit of the product is made. They
vary in direct proportion with the output of the product.
• Batch related activities
– These are activities that take place every time a batch is
produced but do not vary with the size of the batch.
• Product sustaining activities
– These are performed to enable a product to be produced and
sold. They are independent of the volume of output and the
number of production runs.
– The costs associated with these product sustaining activities
tend to vary with the number of products. They can be traced to
product cost using cost drivers.

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 COST POOLS
• Cost drivers define cost pools. However the
problem is that many categories of overheads
may be influenced by more than one activity.
• The cost pool can therefore be defined with
reference to the dominant activity.
• The proponents of Activity Based Costing have
stated its uses as to include the following:
– Presentation of information for planning,
– Presentation of information for controlling and
– Presentation of information for decision making.
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 ADVANTAGES OF ABC
• ABC recognizes the fact that manufacturing
processes are now complex. Cost drivers are
used to charge costs to products fairly,
• ABC is concerned with all overhead costs
including non-manufacturing costs,
• ABC enables companies to be able to asses
product profitability realistically,

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 ADVANTAGES OF ABC
• ABC can be of assistance in cost reduction
campaigns,
• ABC can be used in conjunction with customer
profitability analysis to determine more
accurately the profit earned for serving particular
customers,
• ABC can also be applied in service businesses as
these businesses have characteristics which are
similar to those of modern manufacturing
businesses.
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 DISADVANTAGES OF ABC
• The cost of obtaining and interpreting the information
may be considerable and as such, ABC should only be
introduced if it would lead to additional management
information for planning and controlling.
• Some measure of arbitrary cost apportionment may
still be required at the cost pooling stage for certain
items.
• There will have to be a tradeoff between accuracy, the
number of cost drivers and complexity.
• ABC tends to burden low volume products with a
punitive level of overheads and hence threatens
opportunities for successful innovation.

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 DISADVANTAGES OF ABC
• The fundamental assumption that activities cause
costs does not appear to be true as it can be
argued that there may not be a clear cause of
cost since so many factors, not only activity,
cause costs.
• A single cost driver may not explain fully the cost
behaviour of all the costs in its associated pool.
• It can only be used in where cost drivers can be
quantified. There is no scope for dealing with
qualitative cost drivers.
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