Chapter 13
Overhead Allocation Decisions
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Overview
• Product & period costs; Direct & indirect costs
• The overhead allocation problem
• Alternative methods of overhead allocation
– Variable, absorption & activity-based costing
– Under or over recovery of overhead
• Contingency theory
• Western and Japanese approaches
• Behavioural consequences of accounting choices
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Product & period costs
• Gross profit = sales - cost of sales
– Cost of sales is the product (or service) cost
• The cost of providing a service
• The cost of buying goods sold by a retailer
• The cost of raw materials and production costs
for a manufacturer
• Net (operating) profit = gross profit expenses
– Expenses are the period costs
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Costs associated with production of
goods/services
• Production costs
– Direct
– Indirect
• Non-production costs
– Period costs
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Direct & Indirect costs
• Direct costs
– traceable to product/ services
• materials or labour
– prime costs
• Indirect costs
– necessary, but not readily traceable to particular
product/ services
• Material, labour, or other expenses
– production overhead
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Cost classification
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Overhead allocation
• The process of spreading production
overhead (i.e. indirect costs) equitably
over the volume of production
• Overhead allocation problem
– Overheads can be arbitrarily allocated across
products/services which can lead to
inappropriate pricing and misleading
information about product/service profitability
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Overhead allocation process
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Shifts in management accounting
thinking
• ‘Costs are distributed to
products by simplistic and
arbitrary measures, usually
direct-labor based, that do not
represent the demands made
by each product on the firm’s
resources … the methods
systematically bias and distort
costs of individual products …
[and] usually lead to enormous
cross subsidies across
products’
– Johnson & Kaplan (1987)
• ‘many accountants and
managers have come to
believe that inventory cost
figures give an accurate guide
to product costs, which they do
not’
• ‘as product life cycles shorten
and as more costs must be
incurred before production
begins … directly traceable
product costs become a much
lower fraction of total costs’
– Johnson & Kaplan (1987)
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Primary function of cost systems
• Valuation of inventory and measurement of the
cost of goods sold for financial reporting
• Estimation of the costs of activities, products,
services and customers
• Provision of feedback to managers about
process efficiency
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Cost systems should also be used to ...
• Design products/services that are profitable
• Identify where improvements can be made
• Inform product/service mix, distribution &
investment decisions
• Choose among alternative suppliers
• Negotiate prices, etc.
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Methods of overhead allocation
• Variable costing
• Absorption costing
• Activity-based costing
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Comparison of methods
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Variable costing
• Product cost includes only variable production
costs
• All fixed costs treated as period costs
• As accounting standard IAS2 requires ‘all related
production overheads’ to be included in the value
of inventory, so this method cannot be used for
inventory valuation, although it can be used for
management decision-making where the focus is
on contribution margin
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Absorption costing
• All (fixed and variable) production costs are
charged to cost centres and then to
product/services using an allocation base that
reflects activity, e.g. labour hours
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Calculating the overhead rate
• Budgeted overhead rate
– business-wide
– by cost centre
Estimated overhead expenditure
Estimated activity
 Apply budgeted overhead rate to product/services based
on activity in each cost centre
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Absorption costing
- business-wide rate
• Budgeted overhead £100,000
• Activity level 4,000 direct labour hours (DLH)
• Business-wide budgeted overhead rate of £25
(£100,000/4,000) per DLH
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Product costs –
business-wide overhead method
Product A
Product B
110
150
75
90
Prime cost
185
240
Overhead allocation
– 10 hours @ £25
250
250
Total product cost
435
490
Direct materials
Direct labour
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Absorption costing
- cost centre (or departmental) rate
• Three stage process:
1. Identify indirect costs with particular cost
centres where possible
2. Determine a suitable method of allocating
other costs across the cost centres
3. Allocate service cost centre costs to
production cost centres
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Departmental overhead allocations
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Cost centre overhead rates
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Overhead allocation to products
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Product costs – cost centre overhead
method
Product A
Product B
110
150
75
90
Prime cost
185
240
Overhead
allocation
Total product
cost
304
231
489
471
Direct materials
Direct labour
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Comparison of product costs under
two methods of absorption costing
Business-wide rate
Cost centre rate
Product A
£435
£489
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Product B
£490
£471
24
Over/under recovery of overhead
• Overhead rate is budgeted cost & budget
level of activity
– Actual costs & actual levels of activity may
differ
Cost
Hours
Cost/hour
Budget
£100,000
4,000
£25
Actual
£102,000
3,850
Under
recovery
Cost recovery
3,850 x 25 =
£96,250
£102,000 – £96,250 = £5,750
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Activity-based costing
• An alternative method to absorption
costing
• Uses cost pools to accumulate the cost of
significant business processes or activities
and then assigns the costs from the cost
pools to products based on cost drivers,
which measure each product/ service’s
demand for activities
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Cost pools
• Business process
– A sales order from customer to delivery and
invoicing
– A purchase order on a supplier to receipt of
goods and payment
• Cost pool
– Costs accumulated for the horizontal business
process NOT for each department (cost
centre)
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Cost drivers
• The most significant cause of activity in a
cost pool, e.g.
– Number of sales orders
– Number of purchase orders
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Activity-based costing (ABC)
• Three stage process
1. Trace costs for business processes to cost
pools
2. Identify cost drivers for each cost pool
3. Determine number of activities for each cost
driver
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Overhead rates using activity-based
costing
• Cost driver rate
Cost pool
Number of cost drivers
 Apply cost driver rate to product/services based on
number of cost drivers for each business process
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Activity-based costing: cost pools
and cost drivers
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Product costing using activitybased costing
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Comparison of product costs under
the three methods
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Comparison of absorption and activitybased methods
• Under both methods, direct labour and
material costs are the same and the total
overhead incurred is the same
• Under absorption costing, overheads are
allocated in proportion to an arbitrary
allocation base, typically direct labour hours the more labour hours allocated to a
product/service, the more overhead will be
allocated to it.
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Comparison of absorption and activitybased methods
• Under activity-based costing, overheads are
traced through their drivers (the causes of
activity) to the product/services that consume
those activities - the more overheads a
product/service causes to be incurred, the
more overheads will be allocated to it.
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Cost behaviour under activitybased costing
• Distinction between
production and nonproduction overhead
is less relevant
• Distinction between
fixed & variable costs
is too simplistic
 Unit-level activities
 Batch-related
activities
 Product (or customer)
sustaining activities
 Facility sustaining
activities
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Contingency theory
• Situation specific: unique characteristics of
each organization
• Universalist: optimum control system
• Contingency: no control system is
applicable to all organizations
– generalizations in control systems design can be
made for different classes of business circumstances
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Contingency theory
• Control systems design affected by
– External environment
– Competitive strategy & product life cycle stage
– Technology
– Size, diversification and structure
– Knowledge and observability of outcomes and
behaviour
• Fisher (1995)
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International comparisons
• Differences between nations:
– legal systems;
– commercially-driven, government-driven or
professional regulation;
– strength of equity markets
• Alexander & Nobes (2001)
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Management accounting in Japan
– Keiretsu
– Strategic planning rather than financial control
• Emphasis on production planning & quality
• Long term focus
– Accounting systems are used to motivate
employees
• Traditional costing methods not important
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Behavioural implications
• ‘What is accounted for can shape organizational
participants' views of what is important’
– Burchell et al. (1980)
• ‘to calculate and record the costs of an activity is to alter
the way in which it can be thought about and acted upon’
– Miller (1994)
• Accounting is not a neutral device that merely reports ‘facts’
but a set of practices that affects the type of world in which
we live, the way in which we understand the choices able to
be made by individuals and organizations and the way in
which we manage activities.
– Eurail case study (see Reading in Text)
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Alternative perspectives on
management accounting
• Chapters 10-13 take a rational-economic perspective
– Cost links to shareholder value & profit calculations
• However, different interpretations are possible
– Different views of ‘cost’: marginal, average and total cost,
relevant cost, opportunity cost
– Alternative approaches to pricing
– Different methods of identifying the best use of capacity
– Different treatments for overhead costs
• The power of the dominant management coalition
determines the choices made
– Contingent factors; Western/Japanese approach; Organizational
strategy; Managerial preferences.
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Key points
• Product/period, direct/indirect costs
• The overhead allocation problem
• Alternative methods of overhead allocation
• Variable costing, absorption costing, activity-based costing
• Under/over recovery of overhead in absorption costing
• Comparison of approaches
• Theoretical perspectives
• Contingency, international comparisons, behavioural
implications
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9781119979678
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