Module 10 Allocating Costs to Jobs and Processes 10 1 Introduction It is only through the understanding the details of cost gathering and allocation that managers can review alternative systems which may be more in tune with their objectives This module concentrates on the tracking and controlling functions of cost systems only when managers are aware of how these requirements are satisfied will they be in position to assess their informational needs for planning and choosing 10 3 1 Where do Materials Costs come from Materials are drawn from inventory and this action triggers the raising of a stores requisition slip On this slip is quantity and time the withdrawal took place but not price this would be too time consuming to work out for each slip Instead of the stores people tracking the purchase price of each item of material a standard price would be used over say three months that would attempt to take into account price fluctuations Any differences between actual purchase price and standard price would be accounted for in P L at end of the given period 10 3 2 Where do Labor Costs come from For each identifiable cost item a time record would be attached on which each individual working directly on the job would enter the time spent When different workers receive different hourly rates of pay for working on the same cost item a standard wage rate is used similar to standard price for materials above 10 3 3 Where do Overhead costs come from Both Manufacturing and Non Manufacturing costs are indirect as they cannot be linked directly to the outputs of production Manufacturing Overheads include supplies of low value high use components such as screws glue factory heating and lighting machine maintenance and depreciation Non Manufacturing Overheads include administration selling and distribution bank interest managerial salaries Overhead cost must first be gathered into cost centers pockets of activity for which individual managers may be held responsible A expenditure level would be set for each cost center beyond which an individual manager may not go without approval Allocating overhead cost is more difficult than gathering it accountants use a predetermined overhead rate to spread overheads across the units of production Predetermined Overhead Rate Budgeted Overhead for Accounting Period Budgeted Production Units Example A business sells one product which contains 5 direct material and 10 direct labor The plan is to manufacture 10 000 units of the product and the estimate of total overheads is 100 000 The predetermined overhead rate 100 000 10 000 10 per unit So Cost Profile for product Direct Material Direct Labor Share of Overhead Total Cost 5 10 10 25 Difficulties arise when a company is producing multiple products which each consume different proportions of the factors of production including overhead Cost accountants then search for causal factors or activity bases the one factor which prompts the incidence of most of the headings of cost which make up overhead Examples of activity bases include direct labor hours used where the overhead is people related or machine hours used where machines have replaced people The resulting predetermined rate expressed in terms of the activity base is applied to individual products using these products consumption of the causal factor Example Same example as above let s use direct labor hours as the causal factor The business plans to spend 25 000 direct labor hours next year and that this product one of several takes 2 hours to construct by direct labor staff Predetermined overhead rate 100 000 25 000 4 per Direct Labor Hour Note this overhead rate applies to all products not just this one Share of overhead 2 hours x 4 hour 8 per unit Cost Profile for product Direct Material Direct Labor Share of Overhead Total Cost 5 10 8 23 It is virtually impossible to estimate accurately the total overheads for next year the 100 000 and the level of production expressed in terms of the activity base the 25 000 The difference between actual and planned overhead is accounted for in the P L Example Lets say in the example above the actual overhead figure was 105 000 and that production was equivalent to 26 000 direct labor hours Overhead applied to products 26 000 x 4 104 000 Actual Overhead 105 000 Underapplication charged to P L as an increase in cost of goods 1000 10 4 Plantwide versus Departmental rates It is unrealistic to assume that one activity base can explain more than a handful of overhead costs far less the majority or them For example direct labor hours may be a good activity base for supervision costs but it is not good for selling and distribution costs Departmental overhead rates allocate overheads to particular departments and then identify the activity base for each department Example Three service depts and two production depts are used to manufacture heavy lifiting gear Here are their cost estimates for next year Overhead Square Meters Service Hours Forging Welding Personnel Computing Site Maintenance 252 500 113 750 218 000 100 750 73 500 758 500 Occupied 4500 3000 1800 12 000 16 500 37 800 No of employees 50 100 30 20 10 210 450 75 225 4500 1500 6750 The aim of overhead cost allocation is to apply costs to the products of the business Since cost flow through production depts and not service depts the first step is to transfer service dept costs to production dept so as to attach them to products The are two main methods of doing this direct and step methods 10 4 1 The Direct Method In the direct method of overhead allocation costs for each of the service depts are emptied out into the production depts and added to the overheads already there to calculate two predeteremined overhead rates Take each service dept and use a suitable activity base to allocate its overhead costs to the two production depts Personnel number of employees Forging 50 Welding 100 Computing service hours Forging 450 Welding 75 Site Maintenance square meters occupied Forging 4500 Welding 3000 Now empty overhead costs from service dept into production Initial Allocation Personnel Computing Site Forging Welding Personnel Computing 252 500 113 750 218 000 100 750 Site Maintenance 73 500 72 667 86 357 44 100 455 624 145 333 14 393 29 400 302 876 218 000 100 750 0 0 73 500 0 Total 758 500 0 0 0 758 500 Allocating Personnel 50 150 x 218 000 72 667 goes to Forging 100 150 x 218 000 145 333 goes to Welding Allocating Computing 450 525 x 100 750 86 357 to Forging 75