Examining methods for allocating overhead costs

Examining regularitys for completelyocating command processing budget items time shape upsOverhead damage is an ongoingexpenseof operating a business and is comm unless utilise to group expenses that argon infallible to the continued functioning of the business, but good deal non be immediately associated with the outputs/ proceedss being offered as in the embodys do non sendly generateprofits.Overhead toll includes indirect harvest-festival bell or indirect embody of tariff centre. Indirect harvest-festival terms is known as manufacturing all overhead whereas indirect cost of responsibility centre is known as non-manufacturing cost. Manufacturing overhead is those manufacturing be that argon incurred to a variety of products. It cannot be traced to individual products like depreciation and amends of manufacturing equipment, cost of occupying, managing and maintaining a merchandise facility. Manufacturing overhead is the cost that could be traced to individu al product but it is not worth the trouble to like cost of lubricants and gingiva employ. Manufacturing overhead withal include cost that is more(prenominal) appropriately to be treated as cost of all outputs like overtime premium, cost of idle time, utilities cost.Non-manufacturing cost includes customer function, marketing and query development cost.ALLOCATING smash COSTSNormally, nevertheless manufacturing overhead is assignd to products. However, depending on the industry the business is in and to obtain more comprehensive estimates of product cost, management accountant whitethorn allocate non-manufacturing cost to products. One example is Apple Co. with high look development cost, to obtain accurate product cost, they allocate part of the research development cost to product cost.ABSORPTION COSTINGProduction overhead, or usually refer to as manufacturing overhead, is recovered by absorbing them into the cost of a product. This process is known as engrossment costi ng. Absorption costing means that all of the manufacturing be arabsorbedby the units produced. In former(a)wise words, the cost of a finished unit in enumeration will include direct materials, direct labor, and both variableand located manufacturing overhead. As a result, absorption costing is besides referred to as full phase of the moon costing or the full absorption order.Absorption costing is much contrasted with variable costing or direct costing. The fixed manufacturing overhead be are not allocated or assigned to (not absorbed by) the products manufactured razestairs variable or direct costing. Variable costing is often profitable for managements decision-making. However, absorption costing is often required for external financial reporting and for income tax reporting.Absorption costing includes 3 stages, namely apportionment of overheads, reapportionment or allocation of gain (non- business) cost centre overheads and also absorption of overhead.For apportionm ent of overheads, in that respect are no hard and fast rules for which land of apportionment to use except that whichever rule is used to apportion overheads, it moldiness be fair. Unlike direct cost, indirect cost is usually allocated to cost objects and is not now traced to cost objects. Cost object is defined as item that is assigned separate measure of cost. To facilitate allocation of overhead cost, overhead cost that induct common allocation base is pooled together and is known as cost pool. For each cost pool, bases of apportionment are chosen. Bases of apportionment are approximately factors or variables that allow us to allocate cost in a cost pool to cost objects. The endurance of the base of apportionment should be on causal-and-effects grounds, which mean it should be a cost driver. some examples of bases of apportionment include floor area, net obligate value of fixed as hardeneds and consider of employees. Floor area is usually used for rent and rates overhe ad. It is as make senseed that the greater the floor space assiduous by the fruit centers, the more rent, cleaning and electricity usage are consumed. Net book value of fixed assets is used for depreciation and insurance of machinery. It is based on the self-reliance that Number of employees is used for canteen cost. The assumption is when the number of employees increases, the canteen cost will increase. congressmanABC Ltd has devil deed segments ( fictionalisation and Finishing) and two armed serve well parts (Maintenance and Canteen). The following are budgeted costs for the contiguous periodThe second stage of absorption costing is reapportionment or allocation of swear out cost centre costs overhead to takings cost centers. Service cost centers ( discussion sections) are not directly snarled in making products. wherefore the fixed production overheads of usefulness cost centers must be per centumd out between the production cost centers using suitable basis. Ex amples of do cost centers or also referred to as advocate section cost centers include maintenance discussion section, payroll segment, stores and canteen. In contrast to operating or production segment which engages in production of the products and directly adds value to a product or overhaul, life or suffice segment offers the supporter that assist and complements the smooth functioning of the production departments in the company.Methods of allocating support or service department cost to production department include direct method, step down method and reciprocal method. postulate sendThedirect methodis the closely widely-used method where it allocates each service departments total costs directly to the production departments. It ignores the fact that service departments may also provide function to other service departments. Under this method, in that respect is no interaction between service departments preceding to allocation.ExampleMachining and Assemb ly are the only production departments that used the work of the Human Resources division in March. Costs from Human Resources are allocated based on the number of new hires. Machining leased seven employees in March and Assembly hired three employees. Human Resources incurred total costs of RM93, 000 in March.Allocation of H.R. subdivision costs to Machining70% of RM 93,000 = RM 65,100Allocation of H.R. Department costs to Assembly30% of RM 93,000 = RM 27,900No information is necessary about whether any service departments use function of the Human Resources Department is the characteristic feature of the direct method. It does not take account whether no other service department hired anybody, or whether three other service departments each hired tailfin employees (implying that more than 50% of the hiring occurred in the service departments). Service department to service department serve are ignored, and no costs are allocated from oneness service department to another when using the direct method.STEP-DOWN METHODThe leave methodor known as sequential method allocates the costs of some service departments to other service departments. However, once a service departments costs get under ones skin been allocated, no subsequent costs are allocated back to it.The choice of which department to stir up with is very important. The sequence in which the service departments are allocated usually effects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually prefer over the sequence. The most defensible sequence is to start with the service department that provides the highest percentage of its total services to other service departments, or the service department with the highest costs, or the service department that provides services to the most number of service departments, or some similar criterion.ExampleHuman Resources (H.R.), info bear upon (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each otherThe amounts in the far left editorial are the costs incurred by each service department. Any services that a department provides to itself are ignored, so the intersection of the row and column for each service department shows zero. The rows sum to 100%, so that all services provided by each service department are charged out.The company decides to allocate the costs of Human Resources send-off, because it provides services to two other service departments, and provides a greater percentage of its services to other service departments. However, a case could be made to allocate entropy bear on first, because it has greater total costs than either of the other two service departments. In any case, the company decides to allocate Data Processing second.In the tabl e below, the row for each service department allocates the total costs in that department (the original costs incurred by the department addition any costs allocated to it from the previous allocation of other service departments) to the production departments as well as to any service departments that nurse not yet been allocated.After the first service department has been allocated, in order to derive the percentages to apply to the production departments and any remaining service departments, it is necessary to normalize these percentages so that they sum to 100%. For example, after H.R. has been allocated, no costs from D.P. can be allocated back to H.R. The percentages for the remaining service and production departments sum to 92% (7% + 30% + 55%), not 100%. therefore, these percentages are normalized as followsFor example, in the table above, 59.78% of RM136,000 (= RM 81,304) is allocated to Assembly, not 55%.The characteristic feature of the step-down method is that once t he costs of a service department have been allocated, no costs are allocated back to that service department. As can be seen by adding RM 105,522 and RM 134,478, all RM 240,000 incurred by the service departments are in the long run allocated to the two production departments. The intermediate allocations from service department to service department improve the accuracy of those final allocations.RECIPROCAL METHODThereciprocal method is the most accurate among the three methods for allocating service department costs. It is because it secernates reciprocal services among service departments. However, it is also the most complicated method, because it requires solving a set of cooccurring linear equations.Using the data from the step-down method example, the simultaneous equations areH.R. =RM80,000 + (0.08 x D.P.)D.P. =RM 120,000 + (0.20 x H.R.)R.M. = RM40,000 + (0.10 x H.R.) + (0.07 x D.P.)Where the variables H.R., D.P. and R.M. represent the total costs to allocate from each of these service departments. For example, Human Resources receive services from Data Processing, but not from Risk Management. 8% of the services that Data Processing provides, it provides to Human Resources. Therefore, the total costs allocated from Human Resources should include not only the RM 80,000 incurred in that department, but also 8% of the costs incurred by Data Processing. Solving for the three unknowns (which can be performed using spreadsheet software)To illustrate the deriving of the amounts in this table, the RM36,423 that is allocated from Human Resources to Machining is 40% of H.R.s total cost of RM 91,057.DIFFERENCES BETWEEN METHODS AND PROBLEMS development THE METHODSDirect method allocates support cost only to operational departments and there in no interaction between support departments prior to allocation. On the other hand, step down method allocates support costs to other support departments and to operating departments that partially recognizes the mutual services provided among all support departments. Under this method, there is one-way interaction between support departments prior to allocation. Reciprocal method allocates support department costs to operating departments by fully recognizing the mutual services provided among all support departments. It is full bipartizan Interaction between support departments prior to allocation.Direct, step-down and reciprocal methods of support department cost allocation gave slightly different total overhead cost and overhead rates for each production department. It is because of the different acknowledgment that each method gives to support relationships. The direct method does not recognize any relationships that exist between support departments whereas step-down method gives only partial recognition to these relationships.Reciprocal method gives the most accurate results when allocating of triplex service departments costs to operating departments. The power of reciprocal method over other methods (direct method, step-down method) lies in its considering the mutual services provided among all service departments which means the costs of service departments are allocated to each service department (except the service provider) besides operating departments.However the application of this more powerful method is rare. It is because it is more complicated than other methods and it requires sophisticated computing device aid. Some firms that use ERP software since this method requires additional modification in coding. Therefore most of the companies prefer employing either of direct or step down methods. Reciprocal method considers mutual services provided among all service departments, direct method and step-down method ignore this point. Moreover service department cost used by other service departments are also ignored in direct method. The drawback of direct method is partially trim back by step-down method by following a hierarchy among service department s while considering cost allocation.There is a rank among service departments as to which department to begin allocation according to different rules which in turn yields different allocation figures. The drawback of step-down method to reciprocal method is that once the cost accumulated in the first in be service department is allocated, that department does not take any share from other service departments. Two main rules determine the raking. The first approach considers the number of departments served by the service departments to judge on which service department to begin allocation and which ones to move on. The service department that serves to the highest number of departments is the first department to begin allocation. In case of more than one department serve the highest number of departments, the department with highest accumulated costs is the first in the ranking and so on.The second approach adopts the percentage of service in determining the ranking of service depa rtment to begin with and to carry on. The service department with highest percentage of service to other departments is the first in the ranking and so on. In case of more than one department with oppose the highest service percentage, the one with higher accumulated costs is set as the first and so on.Lastly reciprocal method or algebraical allocation method (REC) considers all served departments including service departments and operating departments by a service department except the one whose costs are allocated. There is a two way interaction among service departments unlike step-down method. The method yields equations with multiple unknowns which are equal to the number of service departments since the method considers all the costs of the service departments to be allocated. As the number of service departments increase the number of equations with multiple unknowns increase and hence a figurer aid is required to solve the equations simultaneously.CONCLUSIONOut of the 3 al location methods to allocate service/ support department cost to production department cost, reciprocal method is said to be the most precise method. It is also the most complicated method as it requires solving a set of simultaneous linear equations. However, direct and step-down methods are simple to compute and easy to understand. Nonetheless, direct method is the most widely used in industry. Direct method allocates each service departments total costs directly to the production departments, and ignores the fact that service departments may also provide services to other service departments. The direct method and step-down method have no advantages over the reciprocal method except for their simplicity, and the step-down method is sometimes not very simple. Nevertheless, the reciprocal method is not widely used. Given advances in computing power, the reciprocal method would seem to be accessible to many companies that are not using it. Presumably, these companies believe that th e benefits obtained from more accurate service department cost allocations do not guarantee the costs required to implement the reciprocal method.