Chapter 3 - Cost Assignment

1) Assignment of direct & indirect costs

2) Assignment of indirect costs
3) Budgeted overhead rates vs actual overhead rates
4) Under / over-recovery of overheads
5) Non-manufacturing overheads
 Cost & Management Accounting Information Systems

1) Cost allocation via costing systems

Costs are allocated to COGS and inventory for internal &

external profit reporting

2) Provides information for relevant decision making to

distinguish between profitable & unprofitable activities
3) Cost assignment
3.1) Assignment of direct & indirect costs

 Costs Direct costs

: specifically and exclusively
traced to cost object
(cost tracing) : no need for cost
assignment

Indirect costs (overheads)

: cannot be directly traced to a cost object
: assigned to cost objects (cost assignment) using cost
allocations

Note: for the purpose of understanding, “product” will be used to illustrate

understanding of a cost object.
3.2) Assignment of indirect costs

Indirect costs
Costs are assigned to the product using an allocation base (cost driver)
Eg 1.: Quality inspection cost

this cost is strongly influenced by no. of inspections

the allocation base used to assign this cost to product will be no. of
inspections.

since this allocation base is a significant determinant of inspection cost

“ cause-and-effect-allocation” ( results in accurate cost assignment)

3.2) Assignment of indirect costs (cont’d)

Eg 2.: Quality inspection cost

this cost is not strongly influenced by direct labour hours

however allocation base used to assign this cost to the product is direct
labour hours.

since this allocation base is not a significant determinant of inspection

cost

“ arbitrary allocation” ( results in inaccurate cost assignment)

• Traditional costing systems - rely on arbitrary allocations to a
significant extent
• ABC systems - rely mainly on cause-and-effect allocations
3.2) Assignment of indirect costs (cont’d)

Traditional ABC

Co.s operate this system if: Co.s operate this system if:
: total costs includes low indirect : total costs includes high
costs indirect costs
: product range is fairly standard : product range is quite diverse
: products consume resources : products consume resources in
in similar proportions diverse proportions
3.2) Assignment of indirect costs (cont’d)

Traditional Absorption System

 Overhead (indirect) costs are assigned to products

using overhead absorption rates

(a)Blanket Rate / Plant-wide rate

(one overhead absorption rate for the whole co.)
or
(b)Departmental Rate
(different rates used for each department in co.)
3.4a
3.2) Assignment of indirect costs (cont’d)

a) Blanket overhead rate

Eg.: Co. X uses direct labour hours as allocation base to assign indirect
costs to its products with following information:

Total manufacturing overheads = £900 000

Direct labour (or machine hours) = 60 000
Single blanket overhead rate = £15 per hour (£900 000
/ 60
000)

Blanket overhead rate can be used here since all manufacturing

overhead is located in 1 cost centre!
3.4b
3.2 Assignment of indirect costs (cont’d)

b) Departmental Rate
From earlier eg., now assume now that the company has 3 separate overhead
cost departments (centres) and costs and hours are analysed as follows:

 Product Z requires 20 hours (all in department C)

Separate departmental rates should be used since product Z only consumes

overheads in department C. If a blanket rate is used there will be inaccurate
costing of product Z!
3.4c
3.2) Assignment of indirect costs (cont’d)

Conclusion made from eg. above:

If a diverse range of products are produced consuming departmental

resources in different proportions separate departmental (or cost centre)
rates should be established, or else product cost will be inaccurate!

A blanket overhead rate can only be used if all products consume

departmental overheads in approximately the same proportions

Eg.: Product X spends 1 hour in each department and product Y spends 5

hours in each department

: Blanket rates would allocate £45 to X and £225 to Y

: Departmental rates would allocate £45 to X and £225 to Y
Ie. Both can be used here for accurate product costing!
3.2) Assignment of indirect costs (cont’d)
2-stage allocation process
Similarities / Differences between Traditional & ABC systems

Traditional Absorption Costing Activity-Based Costing (ABC)

-Use of 2-stage allocation process - Use of 2-stage allocation process

- 1st stage: allocates indirect costs (o/h) - 1st stage: allocates o/h to each
to production and service dept.s & then major activity in co. (rather than
reallocates service dept. costs to dept.s)
production dept.

- Production process activities & support - Production process activities &

activities : e.g. production scheduling; support activities: e.g. production
purchasing raw material; inspect quality; scheduling; purchasing raw material;
machine set-up; machining; assembly etc. inspect quality; machine set-up;
machining; assembly etc.

- Lesser cost centres (dept.s) : all - More cost centres (activities): all
categorised under production or service categorised under its related
activities
3.2) Assignment of indirect costs (cont’d)
2-stage allocation process
Similarities / Differences between Traditional & ABC systems

Traditional Absorption Costing ABC

-2nd stage: allocates cost centre o/h - 2nd stage: allocates activity cost
to products (cost object) using o/h centre o/h to products using activity
allocation allocation base / rates cost drivers

- O/H allocation base / rates are volume- - Volume-based activity cost drivers
based (i.e. changes with volume & non-volume-based activity cost
produced) drivers (≠ change with volume)
: DL hrs; machine hrs; units of output ; : units of output; DL hrs; machine
machine costs; direct material costs; hrs; no. of production runs; no. of
DL costs purchase orders etc.

- Lesser allocation base / rates - Variety & more activity cost

drivers

- Indirect cost allocated to cost object - Indirect costs allocated to cost

is less accurate as allocation base object is more accurate as activity
used to assign support costs to cost cost driver used to assign all overhead
objects has no cause-and-effect costs to cost object has a cause-
relationship and-effect relationship
3.2) Assignment of indirect costs (cont’d)
2-stage allocation process
Similarities / Differences between Traditional & ABC systems

Separate dept. Separate dept.

rates rates
3.2) Assignment of indirect costs (cont’d)
2-stage allocation process
Similarities / Differences between Traditional & ABC systems

Separate cost Separate cost Separate cost

driver rates driver rates driver rates
3.2) Assignment of indirect costs (cont’d)
Illustration of traditional system

The annual overhead costs for a company which has three production centres
(Mach.centre X, Y & Assembly) and two service centres (Materials procurement and
General factory support) are as follows:
3.2) Assignment of indirect costs (cont’d)
Illustration of traditional system (cont’d)
The following information is also available
3.2) Assignment of indirect costs (cont’d)
Illustration of traditional system
1st stage allocation of overheads to cost centres
3.2) Assignment of indirect costs (cont’d)
Illustration of traditional system
1st stage: reallocation of service cost centres to production centres
2nd stage: computation of dept. overhead rates to allocate overheads to products
3.2) Assignment of indirect costs (cont’d)
Illustration of traditional system
2nd stage: using overhead rates – assign overhead costs to products

Assume that Co produces product A & B with following information:

Product A: 100 units p/batch; direct cost p/ut £100; std. unit requirement 5 hrs in
centre X; 10 hrs in centre Y; 10 hrs in assembly centre.
Product B: 200 units p/batch; direct cost p/ut £200; std. unit requirement 10 hrs in
centre X; 20 hrs in centre Y; 20 hrs in assembly centre.

Product A (£) Product B (£)

Direct costs(100 uts x £100) 10,000 40,000
O/h:Centre X(100 uts x 5 m.hrs x £2.15) 1,075 4,300
Centre Y(100 uts x 10 m.hrs x £3.80) 3,800 15,200
Assembly(100 uts x 10 dl.hrs x £1.80) 1,800 7,200
Total manufacturing cost 16,675 66,700
No. of units 100 uts 200 uts
Total manufacturing cost p/ut 166.75 333.50
3.2) Assignment of indirect costs (cont’d)
Illustration of ABC system
3.2) Assignment of indirect costs (cont’d)
Illustration of ABC system

(continued)
3.2) Assignment of indirect costs (cont’d)
Traditional vs ABC systems

Traditional (£) ABC (£)

Product A 166.75 205.88
Product B 333.50 301.03

From the above:

Product A: Low volume product (batch of 100 units) are under-
costed in traditional system as support costs are allocated to product
(via reallocation) using direct labour and machine hours (arbitrary /
unrelated base). Hence inaccurate costing.

Product B: High volume product (batch of 200 units) are over-

costed in traditional system for the same reason. Inaccurate costing.
3.3) Budgeted overhead rates vs actual overhead rates

 Most co. use budgeted overhead rates instead of actual overhead rates

1) To avoid delay in product costs which is needed quickly for monthly

profit measurement; inventory valuation & setting selling prices – (actual
data can only be secured at end of accounting period)

2) To avoid fluctuating overhead rates – fixed o/h is fixed in short tem,

however activity volume changes from month to month – these
changing rates are not representative of normal production as it
affects product cost from month to month!
3.3) Budgeted overhead rates vs actual overhead rates (cont’d)

 If budgeted rates are used: £2,000,000 / 200,000 hrs = £10 p/hr. Here, identical
product costs will be fair and stable through all months - suited for normal
production

 However, from above eg.,if actual rates are used (changing and moves with
actual activity) identical product costs will be volatile – not suited for normal
production
3.4) Under-and over recovery of overheads

If actual activity or overhead spending is different from that used to

compute the estimated overhead rates there will be an under or over
recovery of fixed overheads.

Eg.:
Estimated fixed overheads = £2 million
Estimated activity = 1 million direct labour hours
Budgeted overhead rate = £2 per DLH
3.4) Under-and over recovery of overheads

 Assume actual activity is 900 000 DLH ’s and actual overheads are £2
million:

Overhead allocated to products = £1.8 million

(900 000 × £2)
Under-recovery (fixed costs under used) = £200 000

 Assume actual overheads are £1 950 000 and actual activity is 1 million
DLH ’s:

Overhead allocated to products = £2 million

(1 million ×£2)
Over-recovery (fixed costs over used) = £50 000

 External financial accounting principles (GAAP) require that under/over

recoveries are treated as period costs (unused capacity / volume variance).
3.5) Non-manufacturing overheads

Simplistic methods, such as using a percentage of total manufacturing cost, are

frequently used as allocation bases with traditional systems.

Example
Manufacturing cost = £1 million
Non-manufacturing overheads = £500 000
Overhead rate = 50% of manufacturing cost

Simplistic methods do not provide a reliable measure of the

non-manufacturing overheads consumed by products.

ABC is advocated for providing a more accurate measure of

resources consumed by products.