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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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There may be other materials of little value that are used in production, such as screws, adhesives, cleaning materials etc., which do not appear on the bill of materials because they have little value and the cost of recording their use would be higher than the value achieved. These are still costs of production, but because they are not traced to particular products they are indirect material costs.

While the cost of materials will usually only apply to a retail or manufacturing business, the cost of labour will apply across all business sectors. Direct labour is traceable to particular products or services via a time-recording system. It is the labour directly involved in the conversion process of raw materials to finished goods (see Chapter 9). Direct labour will be clearly identifiable from an instruction list or routing, a detailed list of all the steps required to produce a good or service.

In a service business, direct labour will comprise those employees providing the service that is sold. In a call centre, for example, the cost of those employees making and receiving calls is a direct cost. Other labour costs will be incurred that do not appear on the routing, such as supervision, quality control, health and safety, cleaning, maintenance etc. These are still costs of production, but because they are not traced to particular products, they are indirect labour costs.

Other costs are incurred that may be direct or indirect. For example, in a manufacturing business, the depreciation of machines (a fixed cost) used to make products may be a direct cost if each machine is used for a single product or an indirect cost if the machine is used to make many products. The electricity used in production (a variable cost) may be a direct cost if it is metered to particular products or indirect if it applies to a range of products. A royalty paid per unit of a product/service produced or sold will be a direct cost. The cost of rental of premises, typically relating to the whole business, will be an indirect cost.

Prime cost is an umbrella term to refer to the total of all direct costs. Production overhead is the total of all indirect material and labour costs and other indirect costs, i.e. all production costs other than direct costs. This distinction applies equally to the production of goods and services.

However, not all costs in an organization are production costs. Some, as we have seen, relate to the period rather than the product. These other costs (such as marketing, sales, distribution, finance, administration etc.) are not included in production overhead. These other costs are classed generally as overheads, but in the case of period costs they are non-production overheads.


–  –  –

Distinguishing between production and non-production costs and between materials, labour and overhead costs as direct or indirect is contingent on the type of product/service and the particular production process used in the organization.

Contingency theory is described later in this chapter. There are no strict rules, as the classification of costs depends on the circumstances of each business and the decisions made by the accountants in that business. Consequently, unlike financial accounting, there is far greater variety between businesses – even in the same industry – in how costs are treated for management accounting purposes.

Figure 11.1 shows the relationship between these different types of costs.

Calculating product/service costs We saw in Chapter 8 the important distinction between fixed and variable costs and how the calculation of contribution (sales less variable costs) was important for short-term decision-making. However, we also saw that in the longer term, all the costs of a business must be recovered if it is to be profitable. To assist with pricing and other decisions, accountants calculate the full or absorbed cost of product/services.

As direct costs by definition are traceable, this element of product/service cost is usually quite accurate. However indirect costs, which by their nature cannot be traced to products/services, must in some way be allocated over products/services in order to calculate the full cost. Overhead allocation is the process of spreading production overhead (i.e. those overheads that cannot be traced directly to products/services) equitably over the volume of production. The overhead allocation problem can be seen in Figure 11.2.


–  –  –

The overhead allocation problem is a significant issue, as most businesses produce a range of products/services using multiple production processes. The most common form of overhead allocation employed by accountants has been to allocate overhead costs to products/services in proportion to direct labour. However, this may not accurately reflect the resources consumed in production. For example, some processes may be resource intensive in terms of space, machinery, people or working capital. Some processes may be labour intensive while others use differing degrees of technology. The cost of labour, due to specialization and market forces, may also vary between different processes.

Further, the extent to which these processes consume the (production and non-production) overheads of the firm can be quite different. The allocation problem can lead to overheads being arbitrarily allocated across different products/services, which can lead to misleading information about product/service profitability. As production overheads are a component of the valuation of inventory (because they are part of the cost of sales), different methods of overhead allocation can also influence inventory valuation and hence reported profitability.

An increase or decrease in inventory valuation will move profits between different accounting periods.

Shifts in management accounting thinking In their book Relevance Lost: The Rise and Fall of Management Accounting, Johnson and Kaplan (1987) emphasized the limitations of traditional management accounting

systems that failed to provide accurate product costs:


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. (p. 2) Management accounting, according to Johnson and Kaplan (1987), failed to keep pace with new technology and became subservient to the needs of external financial reporting, as costs were allocated by accountants between the valuation of inventory and the cost of goods sold. Johnson and Kaplan claimed that ‘[m]any accountants and managers have come to believe that inventory cost figures give

an accurate guide to product costs, which they do not’ (p. 145). They argued that:

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, traditional financial measures such as periodic earnings and accounting ROI become less useful measures of corporate performance. (p. 16)

Johnson and Kaplan claimed that the goal of a good product cost system:

should be to make more obvious, more transparent, how costs currently considered to be fixed or sunk actually do vary with decisions made about product output, product mix and product diversity. (p. 235) Johnson and Kaplan also argued against the focus on short-term reported profits and instead for short-term non-financial performance measures that were consistent with the firm’s strategy and technologies (these were described in Chapter 4).

In their latest book, Kaplan and Cooper (1998) describe how activity-based cost (ABC) systems:

emerged in the mid-1980s to meet the need for accurate information about the cost of resource demands by individual products, services, customers and channels. ABC systems enabled indirect and support expenses to be driven, first to activities and processes, and then to products, services, and customers. The systems gave managers a clearer picture of the economics of their operations. (p. 3) ABC systems were introduced in Chapters 9 and 10 and are further developed in the next section of this chapter.

Kaplan and Cooper (1998) argued that cost systems perform three primary


1 Valuation of inventory and measurement of the cost of goods sold for financial reporting.

2 Estimation of the costs of activities, products, services and customers.

3 Provision of feedback to managers about process efficiency.

ACCOUNTING DECISIONS 161 Leading companies, according to Kaplan and Cooper (1998), use their enhanced

cost systems to:

ž design products and services that meet customer expectations and can be produced at a profit;

ž identify where improvements in quality, efficiency and speed are needed;

ž assist front-line employees in their learning and continuous improvement;

ž guide product mix and investment decisions;

ž choose among alternative suppliers;

ž negotiate price, quality, delivery and service with customers;

ž structure efficient and effective distribution and service processes to targeted market segments.

There are two methods of overhead allocation: absorption costing (the traditional method) and activity-based costing. These are compared in the next section, together with variable costing, a method that does not allocate overheads at all.

Table 11.1 shows a comparison between the three methods.

Alternative methods of overhead allocation Variable costing We have already seen (in Chapters 8, 9 and 10) the separation of fixed from variable costs. A method of costing that does not allocate fixed production overheads to Table 11.1 Alternative methods of overhead allocation

–  –  –

products/services is variable (or marginal) costing. Under variable costing, the product cost only includes variable production costs. Fixed production costs are treated as period costs and charged to the Profit and Loss account. This method avoids much of the overhead allocation problem, as most production overheads tend to be fixed rather than variable in nature.

However, variable costing does not comply with SSAP9, the UK accounting profession’s Statement of Standard Accounting Practice on Stocks. SSAP9 requires

that the cost of stock should:

comprise that expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and condition. Such costs will include all related production overheads.

The effect of SSAP9 is to require companies to account – for financial reporting purposes – on an absorption costing basis, as ‘all related production overheads’ include both fixed and variable production costs.

Absorption costing Absorption costing is a system in which all (fixed and variable) production overhead costs are charged to product/services using an allocation base (a measure of activity or volume such as labour hours, machine hours, or the number of units produced etc.). The allocation base used in absorption costing is often regarded as arbitrary.

Under absorption costing, a budgeted overhead rate can be calculated as either:

ž a business-wide rate, orž a cost centre overhead rate.

A business-wide budgeted overhead rate is calculated by dividing the production overheads for the total business by some measure of activity. Overhead rates can also be calculated for each cost centre separately. A cost centre is a location within the organization to which costs are assigned (it may be a department or a group of activities within a department, see Chapter 2). A cost centre budgeted overhead rate is a result of determining the overheads that are charged to each cost centre and the activity of that cost centre. It is preferable to calculate a separate overhead rate for each cost centre, as the costs and activity of each may be quite different.

The overhead charged to each cost centre must then be recovered as a rate based on the principal unit of activity within a cost centre, typically direct labour hours, machine hours or the number of units produced. We therefore calculate a direct labour hour rate or a machine hour rate or a rate per unit produced for each production cost centre, or for the business as a whole.

Under both methods, the budgeted overhead rate is:

estimated overhead expenditure for the period estimated activity for the period ACCOUNTING DECISIONS 163 For example, a business with budgeted overhead expenditure of £100,000 and an activity level of 4,000 direct labour hours would have a business-wide budgeted overhead rate of £25 per hour (£100,000/4,000). Most businesses are able to identify their overhead costs and activity to individual cost centre levels and determine

cost centre overhead rates. This can be achieved using a three-stage process:

–  –  –

Of the five departments, two are service departments. Their costs can be allocated

as follows (stage 3):

Service cost centre Method of allocation Canteen Number of employees Scheduling Number of production orders Table 11.2 shows the figures produced to support the allocation process.

Once the costs have been allocated, a reasonable measure of activity is determined for each cost centre. While this is often direct labour hours (the most common measure of capacity), the unit of activity can be different for each cost centre (e.g. machine hours, material volume, number of units produced etc. For non-manufacturing businesses the unit of activity may be hotel rooms, airline seats, consultancy hours etc.) Using the above example and given the number of labour hours in each cost centre, we can now calculate a cost centre overhead rate, i.e. a budgeted overhead rate for each cost centre, as shown in Table 11.3.

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