The Methods Of Overhead Allocation

Published Date: 02 Nov 2017

To support management decisions, accountants go beyond simply determining the cost of products and services; they developed a cost management system Managers need accurate and timely cost information for: (1) Strategic management decision such as in-house or out-source, (2) Operational control and (3) external report to other stakeholders such as investors, creditors and internal managers (Horngren et al., 2008).

The fundamental information and data for CMS comes from cost accounting system (CAS). Companies adapt CASs that is match with their management requirements and their production and operation technology. Any inaccurate cost information reported to management can bring a downright harmful decision.

Also CAS must match with management requirements and any other changes to the company. e.g. when Borg Warner’s Automotive Chain System Operation switched to Just In Time manufacturing system, inevitably their cost accounting system has changed to show more accurate figures for cost (Horngren et al., 2008).

In recent years due to expansion of global competitions, the best match between manufacturing and cost accounting system will ‘Improve the overall reporting, control and efficiency dramatically ‘to the company (Horngren et al., 2008, pp150).

Below we reviewed and compared two common costing systems of Activity Based Costing (ABC) and Traditional costing systems for a motor manufacturing company based in Birmingham (BMI).

A) Activity Based Cost (ABC) model: Comparison the "Overhead cost and percentage" of two parts X & Y

What is ABC model?

ABC is a costing method that supports managers in making strategic decision on their operation by assigning the cost of each identified activity with all resources to all products and services according to the actual consumption (Drury, 2004).ABC has does promoted from simple cost accounting approach to management approach for decision makings labeled ‘ Activity-Based Management’(ABM) (Hopper et al., 2007).

The mechanics of ABC system

There are several steps in developing ABC systems (Innes and Mitchell, 1998) (1) identifying activities (2) costing activities (3) selecting activity cost drivers (4) allocating costs of activities to product (Hopper et al., 2007). Each step is described below.

The key step and the most difficult part in implementing ABC model is to identify activities that helps to explain the costs classified under indirect cost. An activity is a task, event or unit of work with a specific purpose such as setting up machines, operating machines and designing products.

The second step is to assign resource costs to each activity (Hopper et al.,2007).When costs are accumulated by activities they are known as activity cost (Drury, 2008).

Activity cost drivers are chosen in third step. This is when the system will accurately measure the various product’s consumption of activities (Hopper et al., 2007).

Based on the review on the overhead cost in Birmingham motor production line, the rate of each activity cost pool has been calculated in the table 1 below.

 

(a)

(b)

(c ) = (a ÷ b)

Activity Cost Driver/ Pool

Total Cost

Activity cost drivers

Activity Rates

Machine Department cost

360,000

4,800

Machine hour

£75

Per hours

Set-Up Costs

99,400

140

Production Runs

£710

Per runs

Inspection/Quality Control

25,900

140

Production Runs

£185

Per runs

Material Handling

156,800

280

Order executed

£560

Per order

Delivery

26,250

75

Shipments

£350

Per shipment

Total Overhead Cost

£668,350

 

 

 

 

Table 1: computation of activity rate (ABC system)

Finally , activity cost are attributable to each product by multiplying the activity rate calculated by dividing a period’s activity cost by period’s cost drivers (table 1, column (c )) by activity drivers of each product (Drury, 2008). Based on BMI given information of Product X & Y, the total overhead allocated to each product is shown on the table 2.

 

 

 

 

X

 

Y

 

(a)

(b)

(a) * (b)

(c )

(a)*(c )

Activity Cost Pool

Activity Rates

Activity drivers

Cost/£

Activity drivers

Cost/£

Machine Department cost

£75

Per hours

2,500

hours

187,500

2,300

hours

172,500

Set-Up Costs

£710

Per runs

65

runs

46,150

75

runs

53,250

Inspection/Quality Control

£185

Per runs

65

runs

12,025

75

runs

13,875

Material Handling

£560

Per order

135

order

75,600

145

order

81,200

Delivery

£350

Per shipment

40

shipment

14,000

35

shipment

12,250

Total Overhead Cost

 

 

 

 

 

£335,275

 

 

 

£333,075

Units Produced

 

 

 

 

 

13,000

 

 

 

15,000

Overhead cost per Unit

 

 

 

 

 

£25.79

 

 

 

£22.21

Table2: Assigning overhead cost to products (ABC system)

Based on above calculation, ABC system allocates overhead costs caused by products to those products on a cause-and –effect basis (Garisson, 2005) or in other words work on relationships between work performed (activities) and the consumption of resources(costs)(Horngren et al., 2008).This means that the managers of each part have come up to conclusion that for production of 13,000 and 15,000 units of X & Y respectively, how much machine hour, product runs and order have each product taken to have more accurate cost allocation. This shows a split of total £668,350 overhead cost to £335,275 and £333,075 for product X & Y respectively. By dividing the calculated overhead cost of each product by the number of outputs, we can have a better understanding on the overhead cost per unit of production of X and Y. the above table shows a £25.79 (£335,275÷ 13,000) for each unit of X and £22.21 (£333,075÷ 15,000) for each unit of Y.

Analysis of production cost and percentages (Garisson et al., 2008):

Activity Cost Pool

X

 

Y

 

Total

(a)

(a ÷ c )

(b)

(b ÷ c )

(c )

Cost

%

Cost

%

Cost

Direct Costs:

Direct Material

585,000

41%

825,000

59%

1,410,000

Direct Labor

390,000

51%

375,000

49%

765,000

Indirect Costs:

Machine Department cost

187,500

52%

172,500

48%

360,000

Set-Up Costs

46,150

46%

53,250

54%

99,400

Inspection/Quality Control

12,025

46%

13,875

54%

25,900

Material Handling

75,600

48%

81,200

52%

156,800

Delivery

14,000

53%

12,250

47%

26,250

Total Cost

£1,310,275

46%

£1,533,075

54%

£2,843,350

Units Produced

13,000

46%

15,000

54%

28,000

Total cost per Unit

£100.79

£102.21

£101.55

Table3: Total cost per unit (ABC system)

The above table shows the total production cost and cost per unit to the BMI and percentages for comparison and evaluation of each of two products cost.

The situation for indirect cost is the same. Product X takes more machine hour per unit of output (2500 machine hour ÷ 13,000 output = 0.192) than product Y (2300 machine hour ÷ 15,000 output = 0.153) and therefore more cost 52% and depreciation than 48% for X &Y respectively.

In addition, the number of shipment in relatively higher for product X than Y in comparison to their outputs. Each shipment for product X contains 325 units (13000 unit ÷ 40 shipments (table2)) while this amount is higher for product Y (15000 unit ÷ 35 shipments (table2) = 428 unit). This can result a higher shipment cost for product X than Y. compare Material handeling

Conclusion

But in total, the comparison of total cost of production shows a fare portion of cost to both products which is equal to the output percentages of 46% and 54% for X and Y respectively.

Other methods of evaluation the ABC costing model

By evaluating the ABC system on the production line of BMI line, it shows the production cost per unit and its related cost percentage for each cost element (direct and indirect) in table4.

Unit Cost per ABC

X

Y

£

%

£

%

Direct Material……………….

45.00

45%

55.00

54%

Direct Labor……………………

30.00

30%

25.00

24%

Overhead per ABC…………..

£25.79

26%

£22.21

22%

Total cost per unit of output

100.79

 

100%

102.21

 

100%

Table4: unit cost in £ and %

The above analysis shows that 26% of total production cost of product X is overhead while this percentage for product Y is less, 22%. This is another way to access and approve that product X takes more concentration and cost on production line in comparison to the amount of output than product Y.

B) Traditional costing model (Machine Hour (MH)): Comparison the "Overhead cost and percentage" of two parts X & Y

What is Traditional costing model?

Many Manufacturing companies use one cost pool to allocate the indirect manufacturing cost to unit produced based on an approved cost –allocation basis such as Machine hour or direct Labor hour. This costing system is called Traditional costing system and was in use since 1900s.

Such system works well with simple production and manufacturing system and can achieve a high level of accuracy of product cost but when any extra activity added to the business or range of products grows wider; this system will lose its accuracy. Traditional costing is also aligns with Generally Accepted Accounting Principles (GAAP) and it make it useful for external reporting.

The mechanics of Traditional system

The traditional allocation system is in two steps. Step one requires a business to pick one metric to use as a basis to allocate the overhead cost. Generally the business will chose a metric that is the underlying cause of overhead cost (Cromwell, 2013). The BMI uses machine-hours to assign manufacturing overhead costs to products. Therefore, as you can see in table 5, the total overhead expense of £668,350 has been divided by the total machine hours of 4,800 for the financial period.

Over head cost per machine hour

=

Total estimated manufacturing overhead

=

£668,350

=

£139.24 per machine hour

Total estimated machine-hours

4,800

Table 5: Overhead cost per machine hour (MH Costing system)

Using the per-machine hour overhead cost will be applied to each output item based on the number of machine hour used for their production (Cromwell, 2013).

Since 13,000 machine-hour were worked on Product X, this product line is assigned £348,098.95 (2,500 machine hours X £139.24 per machine-hour) of manufacturing overhead. Similarly, the product Y required 15,000 machine-hours, so this product line is assigned £320,251.04 (2,300 machine hours X £139.24 per machine-hour) of manufacturing cost (Garrison et al., 2008).

Analysis of production cost and percentages (Garisson et al., 2008):

Production cost centers

X

 

Y

 

Total

(a)

(a ÷ c )

(b)

(b ÷ c )

(c )

Cost

%

Cost

%

Cost

Direct Material

585,000

41%

825,000

59%

1,410,000

Direct Labor

390,000

51%

375,000

49%

765,000

Overhead Cost

348,099

52%

320,251

48%

668,350

Total Cost

1,323,099

47%

£1,520,251

53%

£2,843,350

Units Produced

13,000

46%

15,000

54%

28,000

Total cost per Unit

£101.78

£101.35

£101.55

Machine hour

2,500

52%

2,300

48%

4,800

Table 6: Total cost per unit (Traditional system)

Figures and percentages in table 6 show that although 46% of total production output is product X, but it took more machine hour for production in comparison to product Y 2500 and 2300 respectively. Just base on this metric, the total overhead have been divided between two products and therefore product X took more percentage and amount from total overhead amounting to £348,099 and 52% respectively. While product Y with higher amount of output (15000 units) use less machine hour for production (2300 machine hour per year) and therefore les overhead cost £320,251.

There are some other possible methods to look at traditional costing system as per below:

Output

Machine-hour per Unit

Machine hour

Units (a)

hour/unit (c )= (b) ÷ (a)

hour (b)

X

13,000

0.19

2,500

Y

15,000

0.15

2,300

Total

28,000

0.17

4,800

Table 7: Machine-hour work per unit of output (Traditional Model)

By using this method it is possible to figure out the production overhead of each produced unit. Table 7 shows the machine-hour per output unit in column (c ) which is 0.19 and 0.15 minutes for production of each unit of X and Y respectively. With having this information we can assign £26.78 (0.19 machine-hour per unit X £139.24 per machine-hour) of manufacturing overhead per unit of X and similarly £21.35 (0.15 machine-hour per unit X £139.24 per machine-hour) per unit of Y (Table 7).

Unit Cost per Machine Hour

X

Y

£

%

£

%

Direct Material…………………..

45.00

44%

55.00

54%

Direct Labor……………………….

30.00

29%

25.00

25%

Overhead per machine hour

26.78

26%

21.35

21%

£101.78

100%

£101.35

100%

Table 8: Unit cost per machine hour (Traditional model)

Table 8 will enables managers of BMI to have more information and better understanding of cost of each produced unit of X and Y based on traditional costing system. This information facilitate better decision making such as in-house or outsource production , profit margins of each product for the management of the company.

c) Comparison between ABC and Traditional costing system

Full costing system (ABC and Traditional) are always criticised because of lack of providing very relevant information for decision making. This system tends to use irrelevant past cost information and ignore opportunity cost which is significant for decision making (Atrill & Mclaney, 2007). Apart from this, these two systems show different results in allocation of overhead cost between to product of X & Y in BMI company as per below:

 

 

X

 

Y

Product Overhead - ABC

 

335,275

333,075

Product Overhead - Traditional

 

348,099

320,251

Difference in costing systems

 

(£ 12,824)

£ 12,824

Difference per unit

(£ 0.99)

£ 0.85

Table 9: A comparison of traditional and Activity-Based cost Assignments

The traditional cost system overcast the product X and consequently will affect the lower product margin for this product. The switch in ABC system, product X will take lest portion of total overhead cost and higher margins as a result of that. The difference between these two models shows £ 0.99 less estimation of overhead cost per unit as per ABC system. In contrast, the traditional cost system undercosts the product Y by £ 0.85 per unit and therefore, it will affect an artificially high product margin on product Y.

The reason for the differences between overhead costs calculated based on two costing methods shown in two columns of percentages are revealed in table10. The top part of the table includes the direct and indirect cost calculations based on ABC system. Similarly, the bottom part summarizes the direct and indirect cost of Traditional system.

Apart from direct cost allocation of two models which does have the same basis of calculation and same results, below we will compare the differences overhead cost abortion between the two mentioned models.

Direct Cost

An overall view of the tables will show that , although 46% of total production units is product X it doesn’t necessarily means that the cost of production (direct or indirect) will take the same percentage. The percentages shows that product X is cheaper in material (41% of total direct material cost), but it takes more labor cost for production, 51% of total direct labor. In contrast, product Y with taking 54% of total outputs per annum is more expensive in material but consumes less direct labor cost, 59% and 49%, in comparison to total direct production cost and product X.

Activity-Based Costing System

X

 

Y

 

Total

(a)

(a ÷ c )

(b)

(b ÷ c )

(c )

Amount

%

Amount

%

Amount

Direct Costs:

Direct Material

585,000

41%

825,000

59%

1,410,000

Direct Labor

390,000

51%

375,000

49%

765,000

Indirect Costs:

Machine Department cost

187,500

52%

172,500

48%

360,000

Set-Up Costs

46,150

46%

53,250

54%

99,400

Inspection/Quality Control

12,025

46%

13,875

54%

25,900

Material Handling

75,600

48%

81,200

52%

156,800

Delivery

14,000

53%

12,250

47%

26,250

Total Indirect

£335,275

50.16%

£333,075

49.84%

£668,350

Total Cost

£1,310,275

46%

£1,533,075

54%

£2,843,350

Units Produced

13,000

46%

15,000

54%

28,000

Total cost per Unit

£100.79

£102.21

£101.55

Traditional Cost System

X

 

Y

 

Total

(a)

(a ÷ c )

(b)

(b ÷ c )

(c )

Amount

%

Amount

%

Amount

Direct Material

585,000

41%

825,000

59%

1,410,000

Direct Labor

390,000

51%

375,000

49%

765,000

Overhead Cost

348,099

52%

320,251

48%

668,350

Total Cost

1,323,099

47%

£1,520,251

53%

£2,843,350

Units Produced

13,000

46%

15,000

54%

28,000

Total cost per Unit

£101.78

£101.35

£101.55

Table 10: A detailed comparison of traditional and Activity-Based cost Assignments.

Indirect Cost

There are three Reasons why traditional and ABC system report different overhead cost and therefore product margins.

First, Traditional cost system allocates all manufacturing overhead cost to products. This means, regardless of whether the product actually consumed that cost, it forces both products to absorb all overhead cost. The ABC system is so specific and close in assigning any cost to product unless it directly affects the production of that unit. From ABC point of view, assigning the unused capacity costs and manufacturing overhead cost consumed by Customer Relations activity to products is inherently and counterproductive (Garrison, 2008).

Second, Traditional cost system allocates all manufacturing cost using a volume based metric such as machine-hour. That may or may not affect what actually causes the cost. In other world, in traditional system, 52% of manufacturing overhead costs implicitly assigned to product X and 48% is assigned to product Y. For example, Traditional cost system inappropriately allocates 52% of cost of the Setup or Quality Control activity to product X, even though the ABC system revealed that product X caused by 46% of these costs. Conversely, the traditional cost system assigns 48% of the total Setup or Quality Control cost to product Y even though this product caused 54% of these costs. Similarly, the same thing happened to Material Handling cost for both products with the 48% and 52% cost allocation based on ABC system for products X & Y respectively. The result is that the traditional cost system overcost high machine hour products (product X) and undercost low machine-hour products (product Y) because they assigned batch-level and orders-level costs using volume related allocation (Garrison, 2008) while ABC system create more cost pools linked to different activities (Horngren et al., 2005).

(a)Unit Cost per ABC system

X

Y

£

0

£

%

Direct Material…………………………………………………………

45.00

45%

55.00

54%

Direct Labor……………………………………………………………..

30.00

30%

25.00

24%

Overhead per ABC……………………………………………………

25.79

26%

22.21

22%

100.79

100%

102.21

100%

(b)Unit Cost per Traditional cost system

X

Y

£

%

£

%

Direct Material…………………………………………………………

45.00

44%

55.00

54%

Direct Labor……………………………………………………………..

30.00

29%

25.00

25%

Overhead per machine hour…………………………………….

26.78

26%

21.35

21%

101.78

100%

101.35

100%

(a)-(b) Unit Cost Comparison

X

Y

 

£

%

£

%

Direct Material…………………………………………………………

-

0%

-

0%

Direct Labor……………………………………………………………..

-

0%

-

0%

Overhead per machine hour……………………………….……

- 0.99

-1%

0.85

1%

- 0.99

0%

0.85

0%

Table 11: Unit cost comparison between two costing systems

This over and under costing of traditional model have also be shown in above table. The table 11 shows that the unit cost of production in both system are close to each other and this shows that these two products (X & Y ) does have the same system of production and close machine hour and number of runs per order, that’s why two costing system doesn’t show a huge variance between two system. But with having critical view, the under (£ 0.99 for product X) and over (£ 0.85 for product Y) costing for BMI company , can bring a strategic decision when it comes to highly competitive market and a decision of in-house or out-sourcing of each products , or mass production of each of them which can bring a huge difference in total for the company.

The third reason the product costing differ between two systems is that ABC system assign the overhead cost on cause-and-effect basis (see appendix A – the cause-and-effect allocation basis of BMI) e.g. directly trace and assign shipping or set up cost to the related product and includes other overhead costs caused by products in its product related cost pool. The traditional cost system look at all overhead cost as a period cost and put all of them in one pool (Garrison, 2008).

Although above evaluations and discussions proof the accuracy of ABC system but this system does also have its negative impacts to the business. One of the critics is time consuming and costliness of ABC system. Defining the activity cost pool and analysis overheads in order to identify cost drivers of each product makes this system to be the less popular in UK companies (see table 12)(Atrill & Mclaney, 2007).

1994

1999

Currently using ABC

21.0 %

17.5%

Currently considering using ABC

29.6%

20.3%

Rejected using ABC after assessing it

13.3%

15.3%

Table 12: Survey results from ABC in the UK’s largest companies (Innes et al., 2000)

d) Organisational Decenteralisation advantages and Disadvantages

Centralisation Vs. Decentralisation

Every organisation made up of more than one person will need some form of organisation structure. There are variety of structure model dependant on organisation’s objectives and culture (Learn Management 2, 2013). An effective organizational structure is hidden in the answer to a key question of "Authority"? Whether the authority should rest with senior management at the center of the business (Centralised) or it should diversified away from centre of an organisation to lower tiers (Decentralisation) (Riley, 2012).

Decentralisation

Unlike Centralised organisations, in Decentralised organization, decision-making is spread out to include junior managers in the hierarchy, as well as individual business units rather than being confined to a few to executives (Garisson et al., 2008). A decentralized organisation shows a wider span of control and a bottom-to-top flow of decision-making and flow of idea (Vitez, 2013).

There are three types of decentralisation: Deconcentration, Delegation and Devolution.

Deconcentration is noted as the weakest form of decentralisation as decision-making still resides with higher ranking or top managers.

Delegation is more extensive as authority is passed down to front line levels.

Devolution is most extreme as local levels or front line stores make most critical decisions with autonomy ( Kokemulle, 2013).

Decentralised approach does have pros and cons like any other structure and each company has to decide which approach works more effective and efficient to them.

Advantages & Disadvantages

The main advantages and disadvantages of this approach are:

Advantages

Disadvantages

A major benefit of a decentralized structure in terms of power to make decision is inherent in its ability to improve the level of customer satisfaction as managers are given the autonomy to respond to their needs swiftly (Joseph, 2013). For example, Zara store managers are giving power to make decisions on the types of fashion that will be supplied to their stores base on their observed fashion trend.

However, in a decentralised system, managers could make use of power to satisfy their own interest other than that of stakeholders (Garisson et al., 2008) as in the case of Kewku Adoboli of UBS investment banking arm, Enron, Aurthur Andersen.

By eliminating layers of decision making and approvals, Local leaders have more ability to adapt quickly to changes in the local market and respond to customers (Garisson et al., 2008). It will increase administrative efficiency when they can react quickly and effectively especially in situations where fast action can mean the difference between gaining and losing customers. This is the story that made Marks & Spencer to lose their market and downscale in their Europe market (Joseph, 2013).

More difficult to ensure consistent practices and policies (customers might prefer consistency from location to location).Decentralized organizations can struggle with multiple individuals having different opinions on a particular business decision. As such, these businesses can face difficulties trying to get everyone on the same page when making decisions ((Joseph, 2013).

This strategy may works well when the segments are relatively independent of one another, that’s when the decision of one segment manager won’t affect other segments (Horngren et al.,2008)

Consistent with aiming for a flatter hierarchy

Lack of strong leadership at the emergency times. e.g. crisis

The bottom to top flow of information allows officials of the organisation to be well informed about lower tier operations. This is good way of developing and training junior managers by knowing their needs (Joseph, 2013) and train them for higher-level positions (Garisson et al.,2008). This is the Audit firms strategy for improving their employees e.g. E&Y.

This can be a cost consuming model. Cost of accumulating and processing information often rise under decentralisation due to additional accounting reports required by top management to learn about and evaluate decentralised units and their managers (Hongren et al., 2008).

Should improve staff motivation by empowering lower-level managers to make their own decisions, giving them a sense of importance and making them feel like their own company (Garisson et al., 2008)

Spreading Innovative ideas may be hard to be managed in decentralised organisations. Someone in one unit/segment may have terrific idea that would benefit other parts but due to lack of strong central direction, the idea may not be shared and adopted by others. This problem can be reduced by effective use of intranet system that makes flow of information easier across departments (Hongren et al., 2008).

Ease the market development by allowing the new unit to operate as an independent entity and make more appropriate decision by considering the local market/barriers and customers’ need. Nike and Zara make themselves differentiate by understanding the local market needs and market developments (Hongren et al., 2008).

For every Nike/Zara that finds the benefits of increased decentralisation exceeding the costs, another company finds the benefit of exceeding the costs in increasing the centralization (Hongren et al., 2008).

In addition possible inconsistency across the brand poses another challenge (Kokemuller, 2013).

reduces workload of head office be delegating the burden of daily business operation to the second line of executives and top management can concentrate on big picture items such as overall strategy and expansion plans (Garisson et al., 2013).The CEO of Johnson&Jhonson believes that the magic around their company is decentralization. Some segment presidents see their bosses as few as four times a year.

Top managers have to hand over control and put significant faith in the hands of other leaders. There is risk of missed Mission and Vision of the company and this must be constantly repeated to the employees through transferring the culture and big picture (Garisson et al., 2008). Also Decision-making is more spread out. This means more people are involved and decisions are not concentrated with your strongest leaders (Kokemuller, 2013) which will also bring downfall of expenses because of duplications in many overhead costs (Hongren et al., 2008).

With expansion and diversification of organization a decentralised structure will provide a better chance that the organisation will maintain self sufficiency in an emergency or long absence of the business owner or top management team situations (Joseph, 2013).

Possible lack of centralisation in non routine and emergency works.

In addition, decentralisation complicates management and integration and communication amongst different levels become tough (Joseph, 2013).

makes administration more responsive

increases administrative abuses like corruption, maladministration, nepotism etc.

Conclusion

The issue is really how much independence do business units or groups within a business have when it comes to the key decisions? Business owners may need to consider changing the organizational structure depending on the growth and expansion of business operations.

Once a large organisation has come into being, it normally goes through alternating phases of centralising and decentralising, like swings of a pendulum. Maybe what we really need is not either/or but "the one and the other at the same time"

"In Search of Excellence", Peters and Waterman discussed that excellent companies are both centralised and decentralised. Also Chandler, in 1990, argues that strategy and responsibility for head office should be centralised, while day-to-day operations should be left to decentralised units.