03 - Overhead Analysis

Question 1

What are the learning outcomes of the Overheads Analysis chapter?

Answer 1

• Prepare cost statements for allocation and apportionment of overheads, including reciprocal service departments.
• Calculate direct, variable and full costs of products, services and activities using overhead absorption rates to trace indirect costs to cost units.
• Apply cost information in pricing decisions.

Question 2

What are overhead costs?

Answer 2

Definition

An overhead cost is expenditure on labour, materials or services that cannot be economically identified with a specific saleable cost unit.

The synonymous term ‘burden’ is in common use in the US and in subsidiaries of American companies.

Other

Overhead costs are also referred to as indirect costs. Therefore, these costs comprise indirect material, indirect labour and indirect expenses.

Question 3

How can overhead costs be classified functionally?

Answer 3

Overhead costs may be classified according to the function of the organisation responsible for incurring the cost.

For example, the overhead costs may be functionally classified into production overhead, selling and distribution overhead and administration overhead.

It is usually possible to classify the majority of overhead costs in this way, but some overhead costs relate to the organisation in general and may be referred to as general overhead.

Question 4

What is production overhead?

Answer 4

In this module, we shall focus mainly on production overhead.

Production is that function of the business which converts raw materials into the organisation’s finished product.

The production department is usually divided into a number of smaller departments or cost centres.

Some of these cost centres are directly involved with the production process.

These are called production cost centres and examples include the cutting department and the finishing department.

Other cost centres in the production department are not directly involved with the production process, but provide support services for the production cost centres.

These are called service cost centres and examples include the maintenance department and the stores.

Question 5

What is absorption costing?

Why is absorption costing done?

Answer 5

Absorption costing (Costing Method)

The indirect nature of overhead costs means that they need to be ‘shared out’ among the cost units as fairly and as accurately as possible.

Reasons for absorption costing

One of the main reasons for absorbing overheads into the cost of units is for inventory valuation purposes. Accounting standards recommend that inventory valuations should include an element of fixed production overheads incurred in the normal course of business. Therefore, we have to find a fair way of sharing out the fixed overhead costs among the units produced.

Question 6

What is the process for analysing production overheads?

Answer 6

1. Selection of appropriate cost centres.
2. Determination of the overhead cost for each cost centre.
3. Absorption of overhead costs into saleable cost units.

The selection of appropriate cost centres depends on a number of factors, including the level of control required and the availability of information.

Question 7

How do you determine the overhead cost for each cost centre?

Answer 7

After the appropriate cost centres have been selected, the overhead cost for each cost centre has
to be determined.

This is achieved through the process of:

• allocation
• and apportionment.

Question 8

What is cost allocation?

Answer 8

Cost allocation is possible when we can identify a cost as specifically attributable to a particular cost centre.

Example

For example, the salary of the manager of the packing department can be allocated to the packing department cost centre, and it is not necessary to share the salary cost over several different cost centres.

Question 9

What is cost apportionment?

Answer 9

Cost apportionment is necessary when it is not possible to allocate a cost to a specific cost centre.

In this case, the cost is shared out over two or more cost centres according to the estimated benefit received by each cost centre.

As far as possible, the basis of apportionment is selected to reflect this benefit received.

Example

For example, the cost of rent might be apportioned according to the floor space occupied by each cost centre.

Question 10

What is the formula for cost apportionment?

Answer 10

Cost for a particular cost centre =

Total overhead cost ×

(Value of cost centre apportionment base / Total value of apportionment base)

Question 11

How is the absorption of overhead costs into saleable cost units done?

Answer 11

The last step in the analysis of overhead costs is their absorption into the cost units produced in the production cost centres.

This is sometimes referred to as overhead recovery.

After the level of production achieved is measured, the amount of overhead cost to be attributed to each unit is calculated by:

• dividing the overhead costs of each production cost centre
• by the quantity of production achieved.

This is the technique of overhead absorption.

Question 12

How do you measure the level of production achieved?

Answer 12

Before absorbing the overhead costs into the cost units, we first need to measure the level of production achieved.

It is quite likely that different production departments will measure their production in different ways.

The objective is to use a measure which reflects the nature of the work involved. The most commonly-used measures are as follows:

• physical units produced
• labour hours worked
• machine hours operated.

Question 13

How do you apply the overhead absorption rate to calculate the cost attributed to each unit?

Answer 13

When using an absorption method based either on direct labour hours or on machine hours, the cost attributed to each unit is obtained by multiplying the time taken per unit by the absorption rate per hour.

Multiply number of production units required to build product by cost per production unit.

Question 14

What is an alternative method for overhead costs into saleable cost units?

Answer 14

% rate on other costs such as:

• Direct material costs
• Direct labour costs
• Prime costs

Once this % is established, then calculate the direct cost per unit created and multiply it with the % rate in order to get the overhead costs that should be absorbed.

Example

Assume that the % is 80% and the direct labour costs for a unit is R20.

Then the overhead absorption per unit is R20 * 80% = R16.

Question 15

What is a common mistake in choosing an absorption method to apply?

Answer 15

A common mistake is thinking that the best absorption method is the one which results in the lowest overhead charge to the cost unit.

However, the same total cost centre overhead is being shared out over the cost units produced, no matter which absorption method is selected.

Therefore, if a particular unit is given a lower charge for overhead, the other cost units will be charged with a higher amount so that the total overhead is absorbed overall.

Question 16

What are factors to take into account when choosing an absorption rate?

Answer 16

The calculated total production cost of a particular cost unit can be dramatically different, depending on the overhead absorption method selected.

Therefore, it is important that the selected method results in the most realistic charge for overhead, reflecting the incidence of overheads in the cost centre as closely as possible within the limits of available data.

A major factor in selecting the absorption rate to be used is a consideration of the practical applicability of the rate. This will depend on the ease of collecting the data required to use the selected rate.

It is generally accepted that a time-based method, that is, the machine hour rate or the labour hour rate, should be used wherever possible.

This is because many overhead costs increase with time, for example, indirect wages, rent and rates. Therefore, it makes sense to attempt to absorb overheads according to how long a cost unit takes to be produced. The longer it takes, the more overhead will have been incurred in the cost centre during that time.

Question 17

What are the advantages and disadvantages of the Rate per unit method?

Answer 17

This is the easiest method to apply, but it is only suitable when all cost units produced in the period are identical.

Because this does not often happen in practice, this method is rarely used.

Question 18

What are the advantages and disadvantages of the Direct labour hour rate method?

Answer 18

This is a favoured method because it is time-based.

It is most appropriate in labour-intensive cost centres, which are becoming rarer nowadays and, therefore, this method is less widely used than it was in the past.

Question 19

What are the advantages and disadvantages of the Machine hour rate method?

Answer 19

This is also a favoured method because it is time-based.

This method absorbs the time-based overheads, however, it is more appropriate for absorbing the overheads related to machine activity, such as power, maintenance, repairs and depreciation.

It is most appropriate in cost centres where machine activity predominates and is, therefore, more widely used than the direct labour hour rate.

Question 20

What are the advantages and disadvantages of the Direct wages cost percentage method?

Answer 20

This method may be acceptable because it is to some extent time-based.

A higher direct wages cost may indicate a longer time taken and, therefore, a greater incidence of overheads during this time.

However, this method will not produce equitable overhead charges if different wage rates are paid to individual employees in the cost centre.

If this is the case, there may not be a direct relationship between the wages paid and the time taken to complete a cost unit.

Question 21

What are the advantages and disadvantages of the Direct materials cost percentage method?

Answer 21

This is not a very logical method because there is no reason why a higher material cost should lead to a cost unit apparently incurring more production overhead cost.

The method can be used if it would be too costly and inconvenient to use a more suitable method.

Question 22

What are the advantages and disadvantages of the Prime cost percentage method?

Answer 22

This method is not recommended because it combines the:

• direct wages cost percentage method
• and the direct materials cost percentage method

and, therefore, suffers from the combined disadvantages of both.

Question 23

What is Activity-based costing?

Answer 23

Activity-based costing (ABC) is a recent development in cost analysis. It is based on the idea that using a single absorption base of either labour or machine hours does not accurately reflect the cause of the overhead costs being incurred.

Using an ABC approach, overhead costs are initially accumulated in activity cost pools, which might include, for example, order placing or material handling. Costs are then collected and analysed for each activity cost pool and a cost driver is identified for each activity. Cost drivers are the factors which cause the cost of an activity to increase. Using estimates of the costs attributed to each activity cost pool and the number of cost drivers associated with it, a cost driver rate is calculated.

Example

This is similar in principle to the calculation of absorption rates.

For example, if the total cost of the activity of setting up a machine for a period is $5,000 and the number of machine set-ups for the period is 250, the cost per set-up is $20 ($5,000/250). Each product that requires the use of this machine is regarded as having incurred $20 of overhead cost each time the machine is set up for the product.

Question 24

Why would Activity-based costing be used?

Answer 24

Supporters of ABC argue that overhead costs are only loosely related to time and are not often related to the volume of production.

They argue that overheads in a modern manufacturing environment are related to the complexity of production.

The more complex the production process for a product, the higher are the overheads incurred on its behalf.

For example, a product might require a number of complicated machine set-ups, or more intense quality control activity than other products.

An ABC approach attempts to ensure that overheads are traced to a product in a way that more adequately reflects the overhead cost which has been incurred on its behalf.

This analysis of overhead costs into activities, and their absorption using a variety of cost drivers, is believed to produce more accurate product costs.

Question 25

What is the process for Activity-based costing?

Answer 25

1. Overhead costs are accumulated in activity cost pool.
2. Costs are collected and analysed for each activity cost pool.
3. A cost driver is identified for each activity.
4. A cost driver rate is calculated.
5. The cost driver rate is attributed to a product each time the machine is set up for the product.

Question 26

What are overhead absorption rates predetermined?

Answer 26

Overhead absorption rates are usually predetermined, that is, they are calculated in advance of the period over which they will be used.

There are two reasons for this:

• Overcome the problem of fluctuating product costs
• To provide managers with a permanently-available overhead rate

Overcome the problem of fluctuating product costs

Overhead costs may not be incurred evenly throughout the period. In some months the actual expenditure may be very high and in others it may be relatively low. Therefore, the actual overhead rate per hour or per unit will be subject to wide fluctuations. If the actual rate was used in product costing, then product costs would also fluctuate wildly. Such fluctuating product costs would be very difficult to use for planning and control purposes.

Fluctuations in the actual level of production would also cause the same problem of fluctuating product costs.

To overcome the problem of fluctuating product costs, the absorption rate is determined in advance of the period, using estimated or budget figures for overhead and for the number of units of the absorption base (labour hours, machine hours and so on).

To provide managers with a permanently-available overhead rate

The actual overhead costs and activity levels are not known until the end of the period. However, it would not be desirable for managers to have to wait until after the end of the period to have a rate of overhead that they can use on a day-to-day basis.

Using predetermined rates provides managers with a permanently-available overhead rate which they can use in product costing, price quotations and so on.

Question 27

How does under-absorption and over-absorption arise?

Answer 27

The problem with using predetermined overhead absorption rates is that the actual figures for overhead and the absorption base are likely to be different from the estimates used in calculating the absorption rate.

It is this difference which causes an under-absorption or over-absorption of production overhead.

Question 28

What are the specific reasons for under-absorption or over-absorption?

Answer 28

The actual number of hours (machine or direct labour) was different from the number contained in the budget data

If this had happened, the variable element of the overhead would be expected to vary in direct proportion to the change in hours, so this part of the absorption rate would still be accurate.

However, the fixed overhead would not alter with the hours worked and this means that the actual overhead cost per hour would be different from the predetermined rate.

The actual production overhead incurred was different from the estimate contained in the predetermined rate—If this had happened, the variable element of the overhead would be expected to vary in direct proportion to the change in hours, so this part of the absorption rate would still be accurate.

However, it would also cause an under-absorption or over-absorption of overhead.

Question 29

What problems are caused by under-absorption or over-absorption?

Answer 29

Under-absorbtion

Managers would have been working with unit rates for overheads which are too low.

Prices might have been set too low and other similar decisions may have been take based on inaccurate information.

If the under-absorption is significant, this can have a dramatic effect on reported profit.

Over-absorbtion

A common mistake is thinking that over-absorption is not such a bad thing because it leads to a boost in profits at the period end.

However, if overhead rates have been higher than required, managers may have been selling at prices unnecessarily high, leading to lost sales.

Other similar decisions would also have been based on inaccurate information.

Question 30

Can under-absorption and over-absorption be avoided?

Answer 30

Although it is almost impossible to avoid under-absorption and over-absorption altogether, it is possible to minimise the amount of adjustment necessary at the year end.

This is achieved by conducting regular reviews of the actual expenditure and activity levels which are arising.

The overhead absorption rate can thus be reviewed to check that it is still appropriate to accurately absorb the overheads to a sufficient level by the year end.

If necessary, the overhead absorption rate can be adjusted to reflect more recent estimates of activity and expenditure levels.

Question 31

Which methods are available for reciprocal servicing?

Answer 31

There are two methods which can be used to account for reciprocal servicing:

• the repeated distribution method
• and the algebra method.

The syllabus requires you to be able to use only the repeated distribution method. The algebra method is outside the scope of the syllabus.

Question 32

What is reciprocal servicing?

Answer 32

In a particular factory, there are two service cost centres - the canteen and the stores.

The stores personnel make use of the canteen and, therefore, it is equitable to charge some of the canteen costs to the stores cost centre.

However, the canteen also makes use of the stores facilities and so some of the stores costs should be allocated to the canteen.

We can therefore say that reciprocal servicing is taking place, that is, that the service cost centres each use the other’s facilities.

This can lead to a complicated situation because we do not know the total of the stores costs until a proportion of the canteen costs has been charged to it.

Similarly, we do not know the total of the canteen costs until the total of the stores costs has been apportioned.

Question 33

What is the repeated distribution method?

Answer 33

Iterative process of apportioning 100% of the remaining cost of a reciprocal cost centres in an alternating sequence until the costs remaining in the reciprocal cost centres are negligible.

Question 34

When is the accounting for reciprocal servicing valuable?

Answer 34

The task of accounting for reciprocal servicing can be fairly laborious, particularly if it must be performed manually. Therefore, managers must ensure that the effort is worthwhile.

• Generally, if the service centre costs are significant and they make considerable use of each other’s services, accounting for reciprocal servicing is probably worthwhile. In other cases, the reciprocal servicing could be ignored.
• Alternatively, the service centre which does the most work for the other service centres could be apportioned first and the other service centres could then be apportioned direct to the production cost centres.

The overriding consideration must be the usefulness of the resulting information to the managers. If the improved accuracy of the overhead absorption rates is deemed to be worthwhile, then reciprocal servicing should be taken into account in service cost reapportionment.

NB

In the exam, you must never ignore the existence of reciprocal servicing unless you are specifically instructed to do so.

Question 35

What is marginal cost pricing?

Answer 35

The knowledge of the extra or marginal cost of making and selling a product can provide a manager with important information when deciding what selling price should be charged for a special order.

If the price charged is higher than the marginal or incremental cost of making and selling a cost unit then some contribution is earned towards the costs which are being incurred anyway, such as certain production and administration overheads.

The problem with marginal cost pricing is that it is difficult to decide on the mark-up that must be added to the marginal cost in order to ensure that the other costs, such as administration overheads, are covered and that the organisation makes a profit.

Marginal cost pricing is useful in a one-off special price decision, but it does not help in routine product-pricing decisions, where the price to be charged in order to cover all costs and earn a profit has to be decided.

Question 36

What is full cost-plus pricing?

Answer 36

The overhead absorption rate can be used to trace indirect costs to cost units in order to obtain the unit’s full cost.

Full cost-plus pricing involves adding a mark-up to the total cost of a cost unit in order to arrive at the selling price.

Full cost-based prices can be calculated to generate:

• A specified return on sales:
  
  • This involves determining the full cost of a cost unit and then adding a mark-up that represents a specified percentage of the final selling price.
• A specified return on investment:
  
  • This involves determining the amount of capital invested to support a product (for example, some fixed or non-current assets and certain elements of working capital, such as inventory and trade receivables, can be attributed to individual products) and then setting a selling price to achieve a specified return on the capital invested on behalf of the product.

Question 37

Unit synopsis

What is an overhead cost?

Answer 37

An overhead cost is expenditure on labour, materials or services that cannot be economically identified with a specific saleable cost unit. The synonymous term burden is in common use in the US and in subsidiaries of American companies.

Question 38

Unit synopsis

What is the purpose of absorption costing?

Answer 38

The indirect nature of overhead costs means that they need to be ‘shared out’ among the cost units as fairly and as accurately as possible.

This is achieved using a costing method known as absorption costing.

Question 39

Unit synopsis

How are production overheads analysed?

Answer 39

The analysis of production overheads consists of three steps:

1. Selection of appropriate cost centres
2. Determination of the overhead cost for each cost centre
3. Absorption of overhead costs into saleable cost units

Question 40

Unit Synopsis

Describe how the overhead cost for each cost centre is determined.

Answer 40

The overhead cost for each cost centre is determined through the process of allocation and apportionment.

Question 41

Unit Synopsis

Describe the process of allocation and apportoinment.

Answer 41

Allocation

Allocation involves allotting whole items of cost to a single cost centre.

It is possible only when we can identify a cost as specifically attributable to a particular cost centre.

Apportionment

Apportionment is necessary when it is not possible to allot the whole cost to a single cost centre.

The cost must then be apportioned between cost centres according to the estimated benefit received by each cost centre.

Question 42

Unit Synopsis

What are primary and secondary apportionments?

Answer 42

The primary apportionment of production overheads involves apportioning the overhead costs to all cost centres.

The secondary apportionment is then necessary to reapportion the service cost centre costs to the production cost centres.

Question 43

Unit Synopsis

What should the absorption base reflect?

Answer 43

The absorption base should reflect the type of activity undertaken within each production cost centre.

The most commonly-used measures are physical units produced, labour hours worked and machine hours operated.

Question 44

Unit Synopsis

What is a major factor in the selection of an absorption rate?

Answer 44

A major factor in selecting the absorption rate to be used is the ease of collecting the data required to use the selected rate.

It is generally accepted that a time-based method, that is, the machine hour rate or the labour hour rate, should be used wherever possible.

Question 45

Unit Synopsis

What is activity based costing?

Answer 45

Activity-based costing uses a variety of cost drivers to trace overhead costs to products and services.

Question 46

Unit Synopsis

Why are overhead absorption rates usually predetermined?

Answer 46

Overhead absorption rates are usually predetermined, that is, they are calculated in advance of the period over which they will be used.

This is for two reasons:

• To overcome the problem of fluctuating product costs
• To provide managers with a permanently-available overhead rate

Question 47

Unit Synopsis

Why does under-absorption and over-absorption occur?

Answer 47

Under-absorption or over-absorption arises at the end of a period when the amount of production overhead absorbed into cost units is lower than or higher than the actual production overhead incurred during the period.

Question 48

Unit Synopsis

What is the problem with under-absorption and over-absorption?

Answer 48

Under-absorption

If overheads are under-absorbed, managers would have been working with unit rates for overheads which are too low.

Therefore, prices may have been set too low and this can have a dramatic effect on reported profit.

Over-absorption

If overheads are over-absorbed, managers may have been setting selling prices unnecessarily high, leading to lost sales.

Question 49

Unit Synopsis

When does reciprocal servicing occur?

Answer 49

Reciprocal servicing occurs where service cost centres each do work for the other.

In this situation, the service cost centre overheads are reapportioned using the repeated distribution method.

Question 50

Unit Synopsis

What is marginal cost pricing?

Answer 50

Marginal cost pricing is useful in a one-off special price decision, but it does not help in routine product-pricing decisions, where the price to be charged in order to cover all costs and earn a profit has to be decided.

Question 51

Unit synopsis

What is full cost-plus pricing

Answer 51

Full cost-plus pricing involves adding a mark-up to the total cost of a cost unit in order to arrive at the selling price.

The required return from each cost unit can be calculated to achieve a

• specified return on sales
• or return on investment.