A report on the risk of overheads

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Overheads are indirect costs that a business incurs which cannot be economically attributed directly to a cost unit (Coulthurst 1998). It is important for businesses to know the costs that are incurred in producing different products and services as it provides management with useful information on cost control and profitability analysis (Student Accountant 2006). For example, it provides information on their relative cost and efficiencies which can then be examined and challenged, it aids management in controlling its cost if they are broken down as they can be monitored easily (Dyson 2007). In addition it aids management in setting selling prices that covers all costs and allows a margin of profit, and furthermore it helps establish the profitability of each product and service which may be useful for tactical and strategic planning (Coulthurst 1998). Overheads therefore need to be 'shared out' along with direct costs that are incurred among the various product or service in order to establish products/services cost (Student accountant 2006). The main principle of absorption costing is that overheads must be shared in a fair way over the different cost centres and cost units that are using the particular resource in question, it should be shared in a way that is administratively feasible so that the benefit of having or using the information exceeds the cost of its provision (Coulthurst 1998). This essay will explain the principles and methodology of absorption costing and answer the question to why overheads need to be absorbed upon pre-determined bases. In addition it will examine the development of technology that has replaced labour in the manufacturing industry and it will look at the advantages and disadvantages through of this process.

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The methodology of absorption costing arrives to three steps which are allocation, apportionment and absorption (Student Accountant 2006). However, the first stage is the analysis of production overheads in the in the selection of appropriate cost centres which depends on the level of control and the availability of information (Weetman 2006). Cost centres in this example of Zebedee plc compromises of production cost centres which are machining, assembly and paint shop as these are separable activities concerned with only the manufacturing of the product and service cost centres which are in this example, Engineering shop, stores and canteen as these are "separable activities within a manufacturing unit which provide a service to production activities and to each other" (Coulthurst 1998 p.1). Allocation is where costs are directly assigned to departments known as cost centres (Drury 2006). However cost allocation is only possible if the identified cost is specifically attributable to the cost centre (Weetman 2006).

Apportionment is where costs are divided up between several cost centres in a fair proportion (Drury 2006). This is only necessary if costs cannot be allocated to specific cost centres and as a result it has to be shared out over the cost centres according to the estimated benefit received by each cost centres. Therefore the basis of apportionment is selected to reflect the benefit received (Proctor 2006). In order to arrive at the total production cost of the three production cost centres the stores overheads have to be re-apportioned as stores, engineering shop and canteen are service departments that do not produce any products into which overheads can be absorbed (Drury 2006). For example for Zebedee plc's service cost centre of stores was apportioned according to the number stores (orders) occupied by each cost centre (Weetman 2006).

Establishing an overhead absorption rate for each production centre is the next step in absorbing indirect costs into the products (Drury 2006). The general principle of identifying the key driver of the cost i.e. what causes them to be incurred is used to absorb overheads (Student Accountant 2006). However, it is likely that there are going to be many causes and thus drivers that have traditionally been encapsulated for each production cost centre in a single basis of overhead absorption (Coulthurst1998). Typically this is achieved by using an activity measure based on machine hours, direct labour hours or direct labour costs as the production department of each product can be measured in this way and used to absorb overheads (Student Accountant 2006). On the basis of information provided for Zebedee plc, it was reasonable to calculate the budgeted overhead absorption rate for machining to machine hours as machine shops are machine intensive, thus machine usage which is measured using machine hours provides the best basis for the differential charging of overheads to products in the machine shop cost centre (Wood & Sangster 2005). On the other hand, the assembly cost centre is clearly labour intensive therefore; direct labour hours were used to absorb overheads. Alternatively, direct labour cost could also be used to absorb the assembly cost centre overheads (Drury 2006). The Paint shops cost centre is labour intensive and as a result labour cost is the most suitable in absorbing these overheads (Wood & Sangster 2005). In addition number of units produced, primes cost and direct material costs can be used as alternative bases of apportionment if these figures were available and if there is uniformity in production (Drury 2006).

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The predetermined absorption rate can be established and used, using the budgeted overhead (the estimate of overhead that are likely to be incurred) and the budgeted activity (the expected machine hours, labour hours and labour cost worked) (Dyson 2007). If these estimates are inaccurate, it would result in undercharging or over charging the businesses customers. Consequently this situation is very serious for a company to have low selling prices that are established from using a low absorption rate as it can increase the competitiveness of the company's product; however the increase in sales would not result to higher profits if the product is being sold at a loss. Similarly, a high absorption rate may result in a high selling price which would increase the profit for each unit sold. Nevertheless, the decrease n sales will not enable the company to make overall profits (Dyson 2007). It is expected that the actual activity will be different to the budgeted, therefore, the difference between the actual overhead incurred and the total overhead charged to production (calculated on a predetermined basis) consequently "gives rise to production overhead over-absorption or under absorption in each production cost centre resulting from the comparison of the actual overhead costs allocated and apportioned with the total costs absorbed (Student Accountant 2006: p.51). If the actual production exceeds the normal activity using the predetermined absorption rates, it will result in over-absorption of overheads which gives rise to higher profits (Dyson 2007). If however, the actual overhead incurred is in excess of the amount charged out, it will give an under-recovery of overheads and hence lower profits (Dyson 2007). These variances should be written off to the profit and loss statement at the end of the costing period (Dyson 2007). Therefore, the use of budgeted activity and expenditure in establishing predetermined overhead absorption rates not only helps focus attention on comparing the actual with budgeted to establish the recovery of overheads and determining profits, it also has an effect of normalising per unit product/service costs (Coulthurst 2001).

In addition, absorption costing is used for long term decision making under stable market conditions and treats manufacturing fixed costs as part of the unit cost of production. As a result the closing stock is valued on the basis of full cost per unit and therefore, it includes the portion of overhead which is carried forward into the next period to be charged against the profit of that period (Drury 2008).

In recent years, the management accounting practise has changed with advances in information technology (Inman 2001). The progress of robots in the manufacturing industry in the past 30 years is rapidly increasing (Weimer, 2001). The plant floor of auto making and other manufacturing industries were highly labour intensive, however, in today's world; this is where most of the robots do their work (Weimer 2001). "Ninety percent of the robots in the world work in factories" (Weimer 2001: p.1). Labour has been replaced by machinery in the manufacturing industry and as a result the manufacturing industry has declined over the past century. This has lead the labour market to find jobs in the service sector (BBC 2003). These changes in technology have had a significant impact on the overhead absorption rates. In recent years, many companies are adopting a lean business model of minimizing costs and maximizing efficiency, in addition to achieving enhanced output and quality standards. In the past decade, the degree of mechanisation has been increasing. Product fabrication and assembly have been improved through virtually error free robotic and as a result, these improvements in technology have reduced the amount of labour input required thus reducing wage costs (The Commercial Toolkit 2009). Therefore, using direct labour as a basis of overhead allocation and absorption for the assembly cost centre is less relevant as it is no longer a key driver and as a result, machine hours would be a more suitable basis to absorb overheads (Kaplan, 1983). The classification of costs into fixed and variable is less valid due to the computerised production control, robotic production lines and other technological developments. In addition, the emphasis on better quality and customised design and the increase in speed or ordering and delivery would result in the expansion of overheads of these activities. The increasing complexity of the business with the introduction of new technology and constantly changing markets require firms to have a management accounting system that can accurately identify product cost (Wink 2010).

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The advantages of absorption costing are that it does not understate the importance of fixed costs and therefore, it recognises the fact that they cannot be ignored in the long run and they must be covered eventually in order to make a profit. As fixed costs are an important aspect of production, they should be included in stock valuation. For external reporting purposes, stock must be valued at full cost, including both fixed and variable costs that have incurred in bringing the product to its present location and condition. In addition, pricing decision can be made with reference to fixed costs (Drury, 2008). Absorption costing avoids the possibility of fictitious losses being reported. Furthermore, fixed manufacturing overheads are essential to production and therefore, they should be incorporated into the product cost. Another advantage is that fixed costs are allocated to products by an absorption rate on the basis of the product that receives the greatest service, incurs the most costs. As a result this s a reasonable and appropriate method in apportioning costs (Drury 2008).

A disadvantage of absorption costing is that the choice of an appropriate absorption base is subjective. Therefore, if an inappropriate apportionment or absorption method is used, the total cost is likely to be inaccurate. As a result, method must be continually reviewed (Drury 2008).As overhead absorption rates are pre-determined; there is a danger of under and over recovery. In addition, the complexity of today's businesses means that to use just once cost driver to absorb overheads into products is inappropriate (Drury, 2008). Absorption costing is not useful in planning control and managerial decision making as costs are not differentiated into fixed and variable costs (Drury 2008).

To conclude, absorption costing is used for making long-term decision making under stable market conditions and it is used as a basis from which to apply selling prices, value stocks and to compare profitability of different products. Its principle is that all costs must be covered and a satisfactory profit has to be made if the company is to survive. The methodology of absorption costing is to allocate direct costs to products and services and apportion indirect costs to cost centres. The overheads are then absorbed into products using an appropriate base. A predetermined absorption rate is calculated from using the budgeted activity and overhead to establish the under and over recovery resulting from the comparison of actual overhead costs. This essentially aids companies in determining their profits and finding out if they have undercharged or overcharged their customers, therefore, it is a toolkit for establishing the right price for its products. Companies are now working towards a lean business model in minimizing costs and increasing efficiency by using robotics to achieve the quality demanded and required. Due to these changes in technology, the manufacturing industry is dominated mainly by robotics now days and therefore machine hour is a more appropriate base to absorb overheads. This is because labour hours are now less relevant in the manufacturing industry to the decline in labour employed in this sector. Overall, absorption costing is an appropriate method to use as it does not underestimate the importance of fixed costs; however, the choice of using an appropriate absorption base is subjective.