Analyzing overheads

Cost/Management Accounting notes

Overheads are of different types
There are overheads that are directly identifiable with a single cost center, for example, wages paid to indirect workers who work solely in one cost center such as finishing department. Such costs are entirely allocated to that department.

There are overheads arising in one department as a result of giving service to other departments or cost centers. Such costs, incurred as a single figure, are shared amongst cost centers that use them, for instance the rates payable to the local authority. If such rates apply to the whole organization, then the cost centers I, II and III in the diagram below will be the production cost centers, the service centers and other non-production cost centers respectively to which the cost shall be apportioned.

There are other overheads that arise in a service department or cost centers which are a composition of many other costs. For instance, in the diagram, the total cost of a service department, will have various costs charged to it for material, labor and other expenses.

Reasons for absorbing overheads
There are a number of situations in which the analysis of overhead costs will assist in the satisfactory evaluation of the relevant cost data. These include
a) The control of overhead expenditures
There must be a link between overhead costs and the manager responsible for its control. This is best achieved by having the planned level of overhead costs for each cost center compared to the actual cost incurred in order that any differences may be investigated and corrective measures taken. Where the actual cost incurred is less than the budgeted expenditure, it may give a sign of less activity being undertaken thus not achieving the targeted performance. On the other hand, the overhead cost per unit of output may be less than budgeted thus giving a favorable variance.
Where the actual expenditure is more than the budgeted, there may be more activity than anticipated (more than the target output) or the overhead cost per unit may be more than the budgeted thus giving an adverse expenditure variance. These need to be investigated.
b) Charging of overheads to cost units
Just as direct costs are charged to the product, overheads relating to a specific job must be charged to that product, job or process in order to come up with the correct cost of the cost object or unit. Each product or job should share a part of indirect costs of the business. This may be done by assessing the benefits extracted from each cost center through which the product or job passes and then choosing a suitable absorption basis.
c) Valuation of work in progress
At any point in time, there may be partly completed goods in the production cycle. Such work in progress must be valued at the end of an accounting period to enable calculate profit and derive a balance sheet. To calculate profit, the cost of goods manufactured must be determined. A statement of goods manufactured (Manufacturing account) is prepared, which incorporates both opening and ending work in progress in order to determine cost of goods manufactured.
Inventory is a major current asset, which appears in the balance sheet, especially for manufacturing and merchandising firms. For manufacturing firms, work in progress (work in process) forms part of the inventory. Therefore, it becomes necessary to determine with accuracy the value of the work in process which comprises prime cost and manufacturing overheads.
d) Valuation of abnormal losses
This is a similar procedure to that for work in progress. Abnormal losses arise when the actual output given the budgeted input yields less than the expected output. (Abnormal loss = Expected
output – actual output) In other words, the actual loss incurred exceeds the expected or normal loss. (Abnormal loss = Actual loss – Normal loss). They arise due to unanticipated inefficiencies in production. Such losses need to be charged to the departments that incur them for efficiency analysis purposes.
e) Profit measurement
The valuation of work in progress and finished goods stock will affect the profit reported. The basis on which production overhead has been absorbed by cost units will, therefore, have a direct influence on the level of profit reported during the period.
f) Decision making
It is vital that relevant costs are used in any decision making situation. Production overhead costs may be allocated to a department (cost center) or apportioned to it using some arbitrary apportionment basis. In addition, overhead cost may be a fixed or variable behavior pattern as activity changes. The total costs associated with cost centre and the organization as a whole affect the kind of decisions made by the management. But such relevant costs need to be incremental (making a difference) and future costs (not sunk costs) that are controllable (not uncontrollable) by management.

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