OVERHEADS Allocation Apportionment Absorption Objective Relationship with cost

OVERHEADS Allocation, Apportionment & Absorption

Objective

Relationship with cost object • Direct • Indirect Factors influencing classification

Objectives of Allocation* § To obtain a mutually agreeable price § To compute product-line profitability § To predict the economic effects of planning and control § To value inventory § To motivate managers *As identified by the IMA

Overheads/Burden Indirect Material + Indirect Labour + Indirect other expenses= OHs Cannot be conveniently charged to any job, process or cost unit

Types of Departments Producing departments are directly responsible for creating the products or services sold to customers.

Types of Departments Supporting departments provide essential support services for producing departments. Maintenance, engineering, personnel, storage

Departmentalisation For collection, allocation and apportionment of overheads Allocation: charging identifiable cost items to cost centers or cost units Examples: Depreciation of a machine in machining department - machining department Salary of stores clerk - stores department

Examples of Departmentalisation for a Manufacturing Firm Production Departments Assembly: Supervisors’ salaries Small tools Indirect materials Depreciation on machinery Finishing: Sandpaper Depreciation on sanders Support Departments Materials Storeroom: Clerk’s salary Depreciation on forklift Cafeteria: Food Cooks’ salaries Depreciation on stores Maintenance: Janitors’ salaries Cleaning supplies Machine oil and lubricants

Apportionment Common costs (non-allocable) allotted to two or more cost centers or cost units on some rational basis (a matter of judgment)

Sample apportionment OH Item: Rent, rates, heating, repairs, depreciation of building Lighting Power Depreciation, repair, insurance and maintenance of plant Personnel, staff welfare, canteen Carriage inwards Marketing and distribution Delivery expenses Remuneration of works director Basis: Floor Area / number of light points HP of machines Book value or original cost Number of employees Value of material Sales value Weight, volume, miles DLHs/Wages/Number of employees

Criteria for allocation and apportionment • Neutrality: should not distort decision making • Ability to bear: sales value, gross profit, asset value, total costs • Cause and effect relationship: maintenance cost on the basis of hours spent for different cost objects • Benefits received: cost of power plant on the basis of power used by diff. cost objects • Equity/fairness

Apportionment of service center costs • OH allocated or apportioned to production and service departments: primary distribution • Service department costs apportioned to production departments: secondary distribution

Secondary distribution • Direct method • Step-down (sequential) • Reciprocal

Direct Method of Allocation Power Support Departments Grinding Assembly Producing Departments Maintenance

Step-down Method of Allocation STEP 1: Rank service departments 2 1 Maintenance Grinding 3 Assembly

Step-down Method of Allocation STEP 2 Power Maintenance Grinding Assembly

Sequential Method of Allocation STEP 2 Maintenance Grinding Assembly

The reciprocal method of allocation recognizes all interactions among support departments.

Absorption Allocated or apportioned overhead absorbed by cost units Methods: Production unit method: Budgeted/Actual OH Budgeted/Actual units % of DM cost Budgeted/Actual OH Budgeted/Actual DM cost % of DL cost % of Prime cost DLH rate MH rate

Praxis Manless Limited does job order processing which involves manual and machine operations. The budgeted P&L Account is as under: Sales 75 lacs Cost: DM 10 DL 5 Prime cost 15 Production overhead 30 Production cost 45 Admin, S&D cost 15 60 Profit 15 Other budgeted data: LHs: 2500, MHs: 1500, Number of jobs: 300 A job enquiry has come and the prime cost estimation is as under: DM: Rs. 2, 500; DL: Rs. 2, 000; DLHs: 8, MHs: 5 Use different methods of OH absorption and recommend to the company.

Blanket rate v Departmental rate • A plant wide rate for every job irrespective of the department in which it is processed • Not correct in case all jobs don’t pass through all departments/ different jobs spend unequal time in different departments • Then departmental rates are required

Praxis Refer to excel Sheet - 2

Predetermined OH rate • Actual OH will be known after the time period is over • So absorbed on estimated basis taking expected level of activity

Under/Over absorption • Predetermined rate X actual production = absorbed amount • May be less than or more than the actual OH Treatment: Application of supplementary rate Transfer to costing P&L Account Carry forward to the next period

Support department cost allocation to operating departments Support department Cost pool Cost object (operating department) • Single rate (no distinction between variable and fixed cost) • Dual rate (variable cost pool + fixed cost pool) Under both the rate methods, allocation can happen by using i) Budgeted rate and budgeted hours to be used by operating division ii) Budgeted rate and actual hours used by operating divisions iii) Actual rate and actual hours used by operating divisions

Data for both the methods Sand Hill Company’s Central Computer Department renders service to Microcomputer division and Peripheral equipment division Budgeted Fixed cost for 2009 for operating central computer dept. : Rs. 30, 000 and variable cost per hour: Rs. 200 (relevant range: 6000 to 18750 hours) Practical capacity: 18750 hours Budgeted usage in hours: Microcomputer division: 8, 000 Peripheral equipment division: 4, 000 Actual usage in 2009: Microcomputer division: 9, 000 Peripheral equipment division: 3, 000

Single rate Sand Hill uses budgeted rate and actual usage Total budgeted cost = Rs. 30, 000 + 12000 X Rs. 200 = Rs. 54, 000 Budgeted hours= 12, 000 Rate per hour = Rs. 450 Allocation: Microcomputer: 9, 000 X Rs. 450 = Rs. 40, 50, 000 Peripheral equipment: 3, 000 X Rs. 450 = Rs. 13, 50, 000 Single rate sends a signal that Rs. 450 is VCU. What if an outside vendor offers the same service @Rs. 340?

Dual rate Sand Hill uses actual hours for VC and budgeted hours for FC Allocation: Microcomputer: 8, 000 X Rs. 250 + 9, 000 X Rs. 200 = Rs. 38, 000 Peripheral: 4, 000 X Rs. 250 + 3, 000 X Rs. 200 = Rs. 16, 000

Allocation based on supply of capacity Budgeted FC per hours (18750 hrs): Rs. 160/hr Budgeted VC per hr. : Rs. 200/hr Single rate method: Microcomputer: 9, 000 X Rs. 360 = Rs. 32, 40, 000 Peripheral equipment: 3, 000 X Rs. 360 = Rs. 10, 80, 000 Fixed cost of unused capacity: 6750 X Rs. 160 =Rs. 10, 80, 000

Cont. . Dual Rate Method: Microcomputer: Fixed cost: 8, 000 X Rs. 160 = Rs. 12, 80, 000 VC: 9, 000 X Rs. 200 = Rs. 18, 000 Rs. 30, 80, 000 Peripheral equipment: Fixed cost: 4, 000 X Rs. 160 = Rs. 6, 40, 000 VC: 3, 000 X Rs. 200 = Rs. 6, 000 Rs. 12, 40, 000 Fixed cost of unused capacity: 6750 =Rs. 10, 80, 000 X Rs. 160

Cont… • Using practical capacity highlights the unused capacity cost and its management • It also reduces the burden on the users • But if FC is allocated on budgeted or actual use, total FC is passed on to users! • In case unused capacity arises only because of one division, it makes sense for allocating the unused capacity cost to that department

Budgeted v. Actual rate • Affects the uncertainty faced by user departments • Budgeted rate: users know the rate in advance and decide whether to use internal service or external service cost variance or inefficiency to be borne by supplier of service

Budgeted and Actual usage, Practical Capacity level allocation See excel Sheet 3

Common cost allocation A cost of a common facility, activity or cost of cost object shared by more than one user Stand-alone cost-allocation method Incremental cost allocation: primary user, incremental users (everybody claims to be incremental user) Cost plus contracts: fertile ground for litigation (bring clarity)

Revenue allocation & Bundled Products When department managers have revenue or profit responsibilities, allocation is called for Shaving gel + shaving brush + razor Stand-alone price 30 25 15 Bundled price: gel + brush Rs. 50 gel + razor Rs. 38 gel + brush + razor: Rs. 64

Stand-alone allocation methods • Selling price: considers customers’ willingness to pay • Unit cost • Physical units: used when selling prices are unstable and unit costs are difficult to calculate

Incremental allocation method Products to be ranked by: Product in the bundle with most sales can be ranked first Customer survey can reveal importance of the products Stand-alone performance of individual products Top managers knowledge or intuition