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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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The most simplistic form of overhead allocation uses a single overhead rate for the whole business. As we previously calculated, the business-wide budgeted overhead rate is £25.00 per direct labour hour (£100,000/4,000). This rate would apply irrespective of whether the hours were worked in stages of production that had

–  –  –

high or low machine utilization, different levels of skill, different pay rates or required different degrees of support.

Under the cost centre budgeted overhead rate, the rate per direct labour hour varies from a low of £18.78 for Dept 3 to a high of £40.21 for Dept 2. This reﬂects the different cost structure and capacity of each cost centre.

Consider an example of two products, each requiring 10 machine hours. The extent to which each product requires different labour hours in each of the three departments will lead to quite different overhead allocations.

Assume that product A requires 2 hours in Dept 1, 5 hours in Dept 2 and 3 hours in Dept 3. The overhead allocation would be £303.77. If product B requires 5, 1 and 4 hours respectively in each department, the overhead allocation would be £231.25, as Table 11.4 shows. By contrast, the overhead allocation to both products (each of which requires 10 hours of production time) using a business-wide rate would be £250 (10 @ £25).

The total cost of a product comprises the prime cost (the total of direct costs) and the overhead allocation. Whether a business-wide or cost centre overhead allocation rate is used, the prime cost is unchanged. Assuming that the costs per

unit for our two example products are:

–  –  –

As can be seen in the above example, the overhead allocation as a percentage of total cost can be very high. This is not unusual in business, particularly in those organizations that have invested heavily in technology or (except for professional services; see Chapter 9) in service businesses, where direct costs are a small proportion of total business costs.

The cost centre rate is more accurate than the business-wide rate because it does attempt to differentiate between the different cost structures of cost centres.

However, the three-stage method of allocating costs between cost centres and then allocating those costs to products/services using a single activity measure can be quite arbitrary. The absorption method of allocating overhead costs to products/services has received substantial criticism because of the arbitrary way in which overheads are allocated. Most businesses use allocation bases such as direct labour hours, machine hours or production units, because that data is readily available. The implicit assumption of absorption costing is that the allocation base chosen is a reﬂection of why business overheads are incurred. For example, if the allocation base is direct labour or machine hours, the assumption of absorption costing is that overhead costs are incurred in proportion to direct labour or machine hours. This is unlikely to be the case in most businesses as many overheads are caused by the range and complexity of product/services.

Activity-based costing As we saw in Chapter 10, activity-based costing (or ABC) is an attempt to identify a more accurate method of allocating overheads to product/services. ABC uses cost pools to accumulate the cost of signiﬁcant business activities and then assigns the costs from the cost pools to products based on cost drivers, which measure each product’s demand for activities.

Cost pools accumulate the cost of business processes, irrespective of the organizational structure of the business. The costs that correspond to the formal organization structure may still be accumulated for ﬁnancial reporting purposes through a number of cost centres, but this will not be the method used for product costing. For example, the purchasing process can take place in many different departments. A stores-person or computer operator may identify the need to restock a product. This will often lead to a purchase requisition, which must be approved by a manager before being passed to the purchasing department.

Purchasing staff will have negotiated with suppliers in relation to quality, price and delivery and will generally have approved suppliers and terms. A purchase order will be raised. The supplier will deliver the goods against the purchase order and the goods will be received into the store. The paperwork (a delivery note from the supplier and a goods received note) will be passed to the accounting department to be matched to the supplier invoice and a cheque will be produced ACCOUNTING DECISIONS 167 and posted. This business process cuts across several departments. ABC collects the costs in all departments for the purchasing process in a cost pool.

A cost driver is then identiﬁed. The cost driver is the most signiﬁcant cause of the activity. In the purchasing example, the causes of costs are often recognized as the number of suppliers and/or the number of purchase orders. Cost drivers enable the cost of activities to be assigned from cost pools to cost objects. Rates are calculated for each cost driver and overhead costs are applied to product/services on the basis of the cost driver rates.

There are no rules about what cost pools and cost drivers should be used, as this will be contingent on the circumstances of each business and the choices made

by its accountants. Examples of cost pools and drivers are:

–  –  –

For example, a rate will be calculated for each cost driver (e.g. purchase order, set-up) and assigned to each product based on how many purchase orders and setups the product has consumed. The more purchase orders and set-ups a product requires, the higher will be the overhead cost applied to it. ABC does not mean that direct labour hours or machine hours or the number of units produced are ignored. Where these are the signiﬁcant cause of activities for particular cost pools, they are used as the cost drivers for those cost pools.

Using the same example as for absorption costing, assume for our two products that there are two cost pools: purchasing and scheduling. The driver for purchasing is the number of purchase orders and the driver for scheduling is the number of production orders. Costs are collected by the accounting system into cost pools and the measurement of cost drivers takes place, identifying how many activities are required for each product. The cost per activity is the cost pool divided by the cost drivers, as shown in Table 11.5.

Table 11.5 Overhead accumulated in cost pools and allocated by cost drivers

–  –  –

We can then calculate the overhead cost per product/service by dividing the total cost pool by the quantity of products/services produced. This is shown in Table 11.6.

The prime cost (the total of direct costs) is not affected by the method of overhead allocation. The total cost of each product using ABC for overhead allocation is shown in Table 11.7. Table 11.8 compares the cost of each product calculated using absorption costing with that using ABC.

Although this is an extreme example, signiﬁcant differences can result from the adoption of an activity-based approach to overhead allocation. In this example, overheads allocated using direct labour hours under absorption costing do not reﬂect the actual causes for overheads being incurred. Product A not only uses more purchasing and production order activity (the drivers of overheads), but also has a lower volume. Reﬂecting the cause of overheads in overhead allocations more fairly represents the cost of each product. Under absorption costing, Product B was subsidizing Product A. Cross-subsidization can be hidden where a business sells a mixture of high-volume and low-volume products/services.

The distinction between ﬁxed and variable costs and between production overhead and non-production overhead that applies to absorption costing is not

so important under ABC. Costs under an ABC approach are identiﬁed as follows:

Table 11.7 Product costing under ABC

–  –  –

ž Unit-level activities: These are performed each time a unit is produced, e.g. direct labour, direct materials and variable manufacturing costs such as electricity.

These activities consume resources in proportion to the number of units produced. If we are producing books, then the cost of paper, ink and binding, and the labour of printers, are unit-level activities. If we produce twice as many books, unit-level activities will be doubled.

ž Batch-related activities: These are performed each time a batch of goods is produced, e.g. a machine set-up. The cost of these activities varies with the number of batches, but is ﬁxed irrespective of the number of units produced within the batch. Using our book example, the cost of making the printing machines ready, e.g. washing up, changing the ink, changing the paper etc., is ﬁxed irrespective of how many books are printed in that batch, but variable on the number of batches that are printed.

ž Product-sustaining activities: These enable the production and sale of multiple products/services, e.g. maintaining product speciﬁcations, after-sales support, product design and development. The cost of these activities increases with the number of products, irrespective of the number of batches or the number of units produced. For each differently titled book published, there is a cost incurred in dealing with the author, obtaining copyright approval, typesetting the text etc. However many batches of the book are printed, these costs are ﬁxed. Nevertheless, the cost is variable depending on the number of books that are published. Similarly, customer-sustaining activities support individual customers or groups of customers, e.g. different costs may apply to supporting retail, that is end-user, customers compared with resellers. In the book example, particular costs are associated with promoting a textbook to academics in the hope that it will be set as required reading. Fiction books may be promoted through advertising and in-store displays.

ž Facility-sustaining activities: These support the whole business and are common to all products/services. Examples of these costs include senior management and administrative staff, premises costs etc. Under ABC these costs are ﬁxed and unavoidable and irrelevant for most business decisions, being unrelated to the number of products, customers, batches or units produced.

Because costs are assigned to cost pools rather than cost centres under ABC, and as business processes cross through many cost centres, the distinction between production and non-production overhead also breaks down under ABC. While the distinction is still important for stock valuation (as SSAP9 requires the inclusion of production overheads), this distinction is not necessary for management decisionmaking. The more (production and non-production) overheads that are able to be allocated accurately to product/services, the more accurate will be the information for decision-making about relevant costs, pricing and product/service proﬁtability.

The ABC method is preferred because the allocation of costs is based on causeand-effect relationships, while the absorption costing system is based on an arbitrary allocation of overhead costs. However, ABC can be costly to implement because of the need to analyse business processes in detail, to collect costs in cost pools as

ACCOUNTING FOR MANAGERS

well as cost centres, and to identify cost drivers and measure the extent to which individual products/services consume resources.

Survey research by Drury and Tayles (2000) suggested that 27% of companies reported using ABC, although this was affected by business size and sector, being especially evident in larger organizations and the ﬁnancial and service sectors.

However, the extent to which organizations use ABC for decision-making rather than stock valuation has not been fully explored.

Why, then, do different organizations adopt different methods of management accounting? One explanation is provided by contingency theory.

Contingency theory The central argument of contingency theory is that there is no control system (which, as described in Chapter 4, includes accounting systems) that is appropriate to all organizations. Fisher (1995) contrasts contingency with situation-speciﬁc and universalist models. The situation-speciﬁc approach argues that each control system is developed as a result of the unique characteristics of each organization.

The universalist approach is that there is an optimal control system design that applies at least to some extent across different circumstances and organizations.

The contingency approach is situated between these two extremes, in which the appropriateness of the control system depends on the particular circumstances faced by the business. However, generalizations in control systems design can be made for different classes of business circumstances.

Fisher (1995) reviewed various contingency studies and found that the following variables have been considered in research studies as affecting control

systems design:

ž External environment: whether uncertain or certain; static or dynamic; simple or complex.

ž Competitive strategy: whether low cost or differentiated (e.g. Porter, see Chapter 8) and the stage of the product lifecycle (see Chapter 9).

ž Technology: the type of production technology (see Chapter 9).

ž Industry and business variables: size, diversiﬁcation and structure (see Chapter 13).

ž Knowledge and observability of outcomes and behaviour: the transformation process between inputs and outputs (see Chapter 4).

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