Compare the main issues with accounting for overheads within a manufacturing sector


Overheads, also known as indirect costs, are "costs that are incurred by an organisation that cannot be distinctly attributed to a cost object" i.e. something for which a cost is required. It is important for organisations to cover all costs that it creates; accounting for overheads has become more important in modern times as it takes up a larger percentage of the costs an organisation implicates. The main issue associated for accounting for overheads is that indirect costs are difficult to categorise and they cannot be easily traced to a specific cost. Overheads were traditionally, and still are accounted for using Marginal and Absorption Costing. However, the traditional system has its defects and more recently; Activity Based Costing was introduced for more accurate product and customer costing.

A cost can be classified via its behaviour and attribute. Costs that are classified by their behaviour are called variable and fixed costs. Variable costs are proportional to the amount of resources used whereas fixed costs are acquired and paid for in advance. Hence, fixed costs are related to predicted level of capacity while variable costs are related to actual level of activity. It is important that the management accountant identifies whether the cost is fixed or variable as it can under-estimate or over-estimate the costs. Once the cost is classified, you will be able to estimate cost per unit. Variable and Fixed cost can be direct or indirect depending on the Cost Object. Direct cost is the cost of a resource that is only used by one cost object. Variable costs are direct when you calculate the cost of material used making one type of product, however if the variable cost varies to the proportion to a activity that supports several products, then the variable cost will be indirect to the individual products. Similarly, fixed costs can be direct or indirect. The issue is that cost classification of a cost can change if the costs object changes. This makes it more difficult to allocate overheads. An example would be if Nokia, a mobile manufacture, decide to employ a factory supervisor. If the cost object is a product, then the salary for the supervisor would be indirect to the cost of the product. However, if the cost object is the factory, then the salary would be a direct cost.

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Overheads are traditionally accounted for by cost driver rates. Cost driver rates allocate the indirect costs accumulated by the organisation to a specific product/job/process etc. It is a necessity to cover overheads as they can make up a large proportion of total costs of the company. Each cost is linked with a specific cost driver and is referred to as a cost pool. Historically, cost driver rates were based upon Direct Labour Hours and Direct Machine Hours. However, organisations now recognise several factors could be driving support costs instead of one or two factors. (Atkinson et al. 2007 Page89 ) Cost Driver Rates are calculated as follows: "Normal Cost of Support Activity / Practical Capacity of Cost Driver". (Atkinson et al. 2007, Page89 )Normal Cost of Supporting Activity is the cost of the resources committed to a particular activity and practical capacity is "long term average usage capacity made available by the amount of resources committed to a support activity". The problem with Cost Driver Rate is that they remain constant overtime and thus do not take into consideration the fluctuations in demand over a short period of time. This is a problem because when demand is low, in the short run cost driver rates are going to be calculated at a higher rate pricing yourself out of the market. Similarly, in periods of high demand, your price would attract more business than usual which would test your capacity.

(Globusz, 2011) Marginal Costing is an "accounting system in which variable costs are charged to cost units and fixed costs of the period are written in full against aggregate contribution". Marginal cost is the extra cost incurred in the last unit of production. It is an approach that excludes overheads as they are seen irrelevant in the short run because they are to remain fixed regardless of the level of output. Assumption for marginal costing is that within the relevant range, fixed costs will remain the same for any amount of sales/production. Thus, in costing terms, when an extra unit of product is made, the extra costs incurred in its manufacture is variable production i.e. fixed costs will not change. When marginal cost is ascertained, contribution is the outcome which assists in the breakeven output as it goes towards recovering fixed costs. When fixed costs are equal to the contribution you reach breakeven output.

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(Tutor2u)Absorption costing is a "method that, in addition to direct costs, assigns all or a proportion, of production overhead costs to cost units by means of one or an number of overhead absorption rates". Absorption costing takes into account fixed, variable, direct & indirect costs as normal manufacturing costs are considered product costs and all costs are included in the inventory. Direct costs are directly linked to the output. Indirect costs are attributed to the service department of a business. Costs are then reallocated from service support departments to production departments where each aspect of overheads is absorbed separately, before an absorption recovery rate is calculated. The absorption recovery rates are based on pre-budgeted figures. (Atkinson, 2007) Absorption recovery rate is calculated by: budgeted fixed production overhead/budgeted level of activity. (Weetman 2010) Absorption costing also is usually required for inventory valuation under financial accounting.

Activity Based Costing established a link between activities that create overheads to set more appropriate cost driver rates. (Tollington and Wachter 2001) Activity based costing "assigns overhead cost to activities based on their consumption". Just like traditional systems, activity based costing uses a two stage allocation system. It is different to them in that it allocates cost to cost centres rather than departments in the first stage. In the second stage, activity based costs assigns cost of activities on their usage. It does by configuring what drives the cost before establishing volume of drivers to calculate the driver rate which is applied based on the usage of these resources. ABC does not provide information that can be used for decision making. (Drury and Tayles 1995)"However, ABC does provide information that would allow the companies to allocate more detailed special studies to ascertain their long term viability". Activity based costing includes a greater number of activities & cost driver rates than traditional approaches. (Otley 2007) ABC can be distinguished into process view and cost view, cost view is based on being more accurate with the costs whereas process view evaluates your performance measures for continuous measurement.

Best buy Europe operates Carphone warehouse. Carphone warehouse sells products and services through retail outlets and the internet. (Carphone Warehouse,2010) A significant proportion of revenue is derived from the mobile network operates in the firm of commissions for delivering new customers and renewals. With the consumer market valued at £9b In 2009, Carphone Warehouse have diversified into fixed line and broadband line whilst selling subsidised laptop with fixed line and broadband connections. They are also looking to further diversify into the market by including gaming and audio. Considering the points, I believe that the likely operating environment a Service company such as Carphone Warehouse would operate in is marginal costing. Marginal costing is not a method of costing like process or job costing; rather it is a technique of cost information for the guidance of management. Marginal costing would allow Carphone Warehouse to ascertain the concept of contribution to its products and use break even analysis to work out how much of each product they have to sell. The key feature of marginal costing is that it classifies costs, creates stock inventory valuation and configures marginal contribution. Cost classification would allow Carphone Warehouse to differentiate between its variable and fixed costs and use its variable costs to design its sales technique. Profit measurement for stock/inventory is also valued at marginal cost (cost of producing one extra unit) which is in sharp contrast to the total unit cost under absorption costing method. Marginal Contribution would allow Carphone Warehouse you to judge the profitability of different products/departments.

Whereas a service company such as Nokia would use absorption costing. Absorption costing is based on the assumption that all fixed costs have to be recovered and included in product costs. This would allow company's such as Nokia to incorporate all fixed and indirect costs to the products they make. They do this via assigning all overheads by means of a budgeted overhead absorption rate allowing them to allocate costs accordingly. Absorption costing calculates the unit cost of an item by taking into account all the company costs including fixed/variable and direct/indirect costs. If an overhead cannot be directly allocated to a unit then it has to be absorbed separately via cost centres on an equitable base.

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The advantage of Carphone Warehouse using Marginal Costing is that it is a simple method where all overheads (indirect/fixed costs) are taken of at the end of the balance sheet. Marginal Costing helps in short-term profit planning via breakeven & profitability analysis is available because of contribution. Contribution can be used by Carphone Warehouse to make comparative profitability and performance between two or more products that they sell, so they can work out how much is needed to sell in order for them to break even and which products they may be making a loss on. Also, by avoiding allocation of fixed costs, it can concentrate on making marginal costing more consistent and more accurate. However the drawbacks for Carphone Warehouse using marginal costing, as all costs are technically variable in the long run, it is difficult to separate costs in to variable and fixed costs. Thus, marginal costing is always seen as a short term solution because in the long run, sales price, fixed and variable costs per unit can vary making marginal costing unrealistic. It avoids taking into account semi-variable costs. Also, it is relatively easy to manipulate figures (Kaplan 1984 pg.20)"that do not enhance the long term competitive position of the firm".

The advantages of Nokia using absorption costing is that it incorporates total costs ensuring fixed costs are recovered in to the product, i.e. fixed and variable, direct and indirect costs per unit into a product. It is good for the managers as it allows them the option to set a selling price using a cost mark up rate. It treats each cost individually and applies an absorption rate to each overhead. It also would allow Nokia to analyse the profitability of different products it sells so it would help in the decision making of which products to drop and which products to carry on producing. The disadvantages of absorption costing is that the absorption rates are forecasted, thus there is a danger of over or under absorption which illustrates that the overheads that have been absorbed can be greater or less than the actual overhead. Furthermore, the capacity levels chosen by Nokia for an overhead absorption rates is based on an historical event and thus subject to change. Absorption costing is quite a complex, expensive and times consuming method.

My recommendation for both organisations is to adopt activity based costing (ABC). ABC uses a costing system similar to traditional cost systems but it traces it costs to activities instead of cost centres. ABC involves setting up activity cost drivers and assigning costs based on their usage. ABC is different from absorption costing as it utilises unit cost rather than total costs. ABC also allows for accurate costing for all activities through out an organisation instead of basing it on historical figures. ABC asses the cost of individual products based on their usage of resources. ABC can also be used in service companies such as Carphone warehouse, as it will allow them to focus on customer costs and profitability. Virtually all costs in a service company are indirect and appear to be fixed. Customer behaviour determines the basic operating costs of products in service companies whereas in manufacturing companies they are customer independent. In service companies, there is a greater variation in demand and the service company can only determine and control the efficiencies of its internal activities. Carphone warehouse has to take into account total relationship profitability with its customers as they may have more than one service with the company.

Activity based costing would allow manufacturing companies such as Nokia to more accurately allocate costs more than ever before. In recent times manufacturing overheads relating to increase usage of machines has increased, this has led to overheads becoming a higher proportion of manufacturing costs. Activity Based Management is better than the traditional methods of allocating costs on the basis of machine hours. It allows managers to allocate costs to products that demand the activity. Managers are able to use the information gained on activity costs to improve the profitability of their business. They can look at what really needs improving by identifying high cost and inefficient processes.

In conclusion, the main issues and problems with accounting for overheads can be partially solved by ABC for both manufacturing and service companies. However, surprisingly, ABC is still not implemented as much and according to a survey, (Abdel-Kader and Luther 2006) 76% never or rarely use ABC or absorption costing. There is a lot of resistance around ABC from individuals from organisations. This is partially due to managers and individuals being against change and the implications of ABC model revealing cases of bad management of products/customers which would force managers to deny the validity of the new approach.