A report on Accounting for overheads

Category: Accounting

In Cost and Management Accounting the collection and analysis of overheads, their distribution and allotment to different cost centers and absorption to units manufactured or services plays a vital role in deciding the cost and finding measures to control the costs. A proper system of better allocation of overheads can just make sure greater accurateness in determination of cost of services or products.

Overheads can be classified on account of functions to which the overheads are associated with:

- Production overheads

- Distribution overheads

- Selling overheads

- Administrative overheads

Overheads can also be categorized by their behavior such as variable overheads, semi-variable overheads and fixed overheads. Variable overheads can be referred to as expenses which vary in line with the change in volume of production. Such as, cost of utilities etc. Fixed overheads may be explained as expenses whose value remains unchanged when the production volume changes such as salaries, rent etc. Semi-variable overheads are those which are to a certain extent affected when the production volume changes. They are moreover divided into fixed and variable overheads. Any items of overheads arising out of abnormal situation in business activity should not be treated as overheads. They are charged to Costing Profit and Loss Account. Items not related to business activities such as donation, loss / profit on sale of assets etc are also not to be treated as overheads. Borrowing cost and other financial charges including foreign exchange fluctuations will not form the part of overheads. (Hall, 1999, 12-45)

Importance of Accounting for Overheads to Organizations

Every business concern has overheads. Overheads got this name to stand for assets that are essential for running the business, but don't directly add to the net profit. Such as, that building that managers work in is taken as overhead because managers need the building for running their business, but the building does not add directly to the bottom line. The buildings have the call center and house the staffs who bring in such consignments that do add to the bottom line directly.

A building is clearly overhead, but how to account for more slight things, such as when the staffs exercise their efforts on activities that don't add value. They might spend a large amount of time upon administration that might or might not actually be needed. This kind of issues sneak in to a company or business the as its size grows.

The overhead's issue is that they are inevitable to control. It is easy for a business concern to be involved too much in programs that do not add value, managers and assets that add nothing directly to the net income. Before the managers know it, their company is stuck with heavy expenses in their financial statements. (Geroski, 2005, 369-386)

Various approaches to Accounting for Overheads

Absorption Costing

The overheads are accounted for in the total number of units produced. Or we can say that, every single unit's cost of manufacturing includes the direct labor, the direct material and the overall overheads (both fixed and variable). Absorption costing is also known as full costing method.

Direct Costing

The above mentioned method is usually compared to direct costing or variable costing. In direct costing, the cost of units manufactured accounts for the variable overheads only that are the fixed overheads are not included in the production cost. For manager's decision making, variable costing is suitable. But when financial reporting is done, chiefly in case of income tax purposes, the absorption costing is preferred.

Activity Based Costing

Activity Based Costing (ABC) has factory overhead costs, the products in more responsible way than the traditional approach of simply allocating costs based on machine hours. Activity based costing first assigns costs for the activities that are the root cause of the overheads. It then assigns the costs for such activities only to the products that are actually challenging the activities.

Activity based costing recognizes that cause the particular technique, special tests, machine setups, and other activities, the costs they cause the companies are consuming resources. In ABC, the company will calculate the costs of the resources in each of these activities are used. Next, the cost for each of these activities will only be the products that the activities will be assigned required. (Friedman, 2003, 45-66)

Comparison of Accounting Approaches for Manufacturing and Service Companies

Accounting For Overheads for Manufacturing Firms

Manufacturing firms are involved in acquiring raw materials producing finished goods and then administrative, marketing and selling activities. All these activities require costs to be incurred. These costs are normally classified by manufacturing companies as manufacturing and non-manufacturing costs. In the following paragraphs we will see how these costs are classified as manufacturing and non-manufacturing.

Manufacturing costs are those costs that are directly involved in manufacturing of products and services. Examples of manufacturing costs include raw materials costs and salary of labor workers.

Manufacturing overhead encompasses all charges of constructing except direct material and direct labor. Examples of constructing overhead encompass pieces for example digressive material, digressive work, upkeep and fixes on output gear and heat and lightweight, house levies, depreciation, and protection on constructing facilities. Indirect components are secondary pieces for example solder and glue in constructing industries. These are not encompassed in direct components costs. (Dorward, 2006, 98-102)

Indirect work is a work cost that will not be finding to the creation of goods or that can be traced only at large cost and inconvenience. Indirect work encompasses the work cost of janitors, supervisors, components handlers and evening security guards. Costs acquired for heat and lightweight, house levies, protection, depreciation and so forward affiliated with trading and administrative purposes are not encompassed in constructing overhead. Studies have discovered that constructing overhead averages about 16% of sales revenue. Manufacturing overhead is renowned by diverse titles, for example digressive constructing cost, manufacturer overhead, and manufacturer burden. All of these periods are synonymous with constructing overhead.

Accounting for overheads for service firms

The overhead for service firms can involve nearly any kind of management cost. Allocating overhead to service activities generally involves factoring an overhead rate into the billing rate used to charge customers. Such as, accountants, lawyers, consultants, computer programmers, and automotive repair shops often charge by the hour. The huge rate per hour does not solely represent the salary of the professional who gives the service. This rate has been enhanced to cover all the overheads and supplies necessary to support the work done by the service professional.

Similarly, doctors, trainers, entertainers and transportation companies usually charge by event. A doctor's fee for an event not only goes to the doctor, but also goes to costs of staff, equipment, and building occupancy. Assigning overhead costs to a service event follows a similar pattern as accounting for manufacturing firms. The total overhead for the service organization is estimated for a period of time, generally a year. This estimated overhead is then divided by an appropriate activity measure.

Strengths and Weaknesses of Each Approach

The absorption method of accounting for overheads is also referred to as the traditional or conventional method. This method implies that the hours consumed to manufacture a certain number of units are a part of the manufacturing cost. This gives an impression that the factory overheads are caused mainly due to these hours consumed. Conversely, there are many other factors as well that contribute to the manufacturing overheads. Such as, some clientele may like to demand additional mechanized operations for their assorted manufactured goods. Other buyers merely ask for huge quantities of identical items.

To compute the actual cost of overheads while looking for specific items and specific buyers, the manufacturing firms cannot rely on the conventional method. To rectify the limitations of the absorption method, financial experts came up with activity based costing.

In ABC, the overheads are charged by taking more than one cost drivers into account. These cost drivers may include the hours consumed, the amount of material purchased or consumed, the number of plant setups, etc.

ABC costing does not satisfy many of the conditions proposed in the essay, so that, "ABC cannot easily tackle economies of scope and common or joint costs. ABC costs are shown to be incremental costs and distortions in decision making may be introduced if attempts are made to allocate these costs to cost objects below the point in the organizational and product hierarchy where these costs are incremental. Additional problems include difficulties of linking activity outputs with revenues and that production volume related costs and the costs of production oriented activities may be interdependent. (Barback, 2009, 1-16)

Recognition of the first problem requires that ABC costs be traced to events in the product and organizational hierarchies at which they become incremental and attempts to allocate below this should be resisted. Attempts should also be made to link activities to the benefits which they provide to the customer for which the customer is willing to pay. The second problem can be overcome by reporting volume and activity related costs together as a combined class with a title such as production programme costs"

On a variable-costing income statement, costs are separated into the major categories of fixed and variable. Revenue less all variable costs (both manufacturing and non-manufacturing) is the contribution margin. On an absorption-costing income statement, costs are separated into the major categories of manufacturing and non-manufacturing. Revenue less manufacturing costs (both fixed and variable) is gross profit or gross margin. Variable Costing must be preferred in my opinion. One reason is that absorption-costing income is affected by production volume while variable-costing income is not. Another reason is based on which system the company believes gives a better signal about performance.

The Potential Uses for Managers

Mangers need to effectively identify which items in their organization's overhead. As already mentioned, this is not always easy to make, but there are a number of accounting methods that help managers to determine what percentage of their business overhead can. Simply put accounting, every asset class, staff or activity that produces a product that produces and revenue for the company rather than overhead, and vice versa, everything that is not directly produce revenue view to the overhead will be.

A simple example, if the accountant their small businesses as they contribute their accounting of all costs and labels those who is immediately to increase sales of the company, and those labels do not directly do, then the calculation of the managers share the overhead costs by Division of non-revenue producing costs of total costs. Through the knowledge and the pursuit of its overhead from year to year, managers will be better able to know whether the ball and the chain is growing or shrinking.

As mentioned above, overhead has a tendency to grow as a company grows. One way to know whether these costs are essential to the business, it has a portfolio review process have a year (of course this work also upside down). Regularly check whether or not a business process, asset, job function, database system and product range are the desired results. Say, for example, that a group of managers have project managers. Your portfolio review could determine whether this activity was cost effective. If it was effective, then they would probably rule that this is a necessary expense activity. But if it does not manage projects, or not very many, it may order that their time is better spent doing something else. Change as the business and the circumstances, needs and their overhead. For example, if the need to lease an office building changes due to the acquisition of more floors in an office building in a cheaper part of town, then they are getting rid of managers, leasing, and can reduce their expenses.

Managing overhead is not a complicated process; it only requires common sense, a little math and the courage to make changes as needed. (Atkin, 2005, 150-156)

How Managers Can Increase Their Value?

When looked at in the context of managerial decision making with imperfect information, overhead allocations seek to achieve a number of pricing objectives. Firstly, they give unit cost standards from which 'fair' or 'market acceptable' prices can be targeted. Secondly, in oligopolistic markets the resultant full cost prices serve as reference points for the establishment and maintenance of ordered markets. By charging full cost prices the strategically interdependent economists can hope to avoid setting prices which could be interpreted by competitors as deliberate attempts to undermine their market shares. Thirdly, accountants have seen full costing as providing a systematic plan for the recovery of total outlay in that the price charged is systematically related to total unit cost. The conventional view is that the alternative 'marginalist' contribution approach based on unit direct cost will more likely lead to an under-recovery of overheads. Consequently, 'full cost pricing' appears to offer a procedure which enables the complex problem of pricing, which involves considerable uncertainty, to be reduced to a rather simple problem with a minimum of uncertainty' (Sizer, 1997, p. 467).

However, such a simplistic approach to uncertainty is not necessarily compatible with economic efficiency in the sense of meeting the requirements of either profit or wealth maximization. This is particularly so when actual output differs from estimated output. As will be explained later, an economically efficient overhead allocation would require the proportion of the total overhead allocated to vary directly with changes in product demand. Thus, an efficient overhead allocation formula should incorporate a demand adjustment term to account for any significant difference between actual and budgeted output. From a management perspective, it would transform the standard overhead allocation rate from a constant to a demand determined unit variable cost.

However, the problem of devising an efficient overhead allocation is essentially one of trying to predict an ex post 'optimal' full cost price from an ex ante position when subject to imperfect information. Given that the allocation of overheads is popularly seen as a behaviorally satisfying response to uncertainty, this paper will investigate the conditions under which two simple allocation rules of thumb can correspond with optimal pricing decisions. What is being attempted is a contribution approach to overhead allocation and full cost, or cost plus, pricing. This requires the ex ante full, or partial, cost allocation to correspond with the ex post gross profit contribution that would have resulted at the profit maximizing output in the absence of any allocation. In this way, the full cost allocations estimate the opportunity costs of production and permit a management accounting pricing system to be an economically rational surrogate for a marginalist market price.'

Conclusion

There seems little doubt that a profit-orientated management would adopt the marginalist contribution approach to pricing if its decision-making scenarios were as well specified as those of the abstract models of economic and accounting theory. In practice they are not, and so management generally has reacted to the resultant uncertainty by using full costing to estimate selling prices when taking pricing decisions. In this context we have found the most profitable pricing strategy to be that of a full cost allocation rule of thumb when engaged in collusive economy and a proportional allocation rule when competing in non-collusive economy subject to demand fluctuations.

The 'full cost pricing' appears to offer a procedure which enables the complex problem of pricing, which involves considerable uncertainty, to be reduced to a rather simple problem with a minimum of uncertainty' (Sizer, 1997, 300- 467).

A contribution approach is attempted to overhead allocation and full cost, or cost plus, pricing. This requires the ex ante full, or partial, cost allocation to correspond with the ex post gross profit contribution that would have resulted at the profit maximizing output in the absence of any allocation. In this way, the full cost allocations estimate the opportunity costs of production and permit a management accounting pricing system to be an economically rational surrogate for a marginalist market price.'

The resultant optimal prices are dependent on the allocation rules fully incorporating the influence of demand. This is achieved directly by the use of demand adjustment terms either to provide for constant market shares (collusive case) or to incorporate changing capacity utilization (non-collusive economy). Of course, full cost pricing indirectly accounts for demand conditions when estimating the best feasible standard net income. However, by failing to adjust for changes in demand, non-collusive full cost pricing cannot be optimal in conditions of fluctuating demand.

When applied to their specific market types, the two rules of thumb give results which equate with the profit maximizing total contribution when subject to the information constraints of estimated demand functions and accounting cost data. Furthermore, the demand determined nature of the allocations provides a contribution approach to overhead allocation. Although not based on direct or variable costing, this approach gives the same results as would emerge from a contribution margin approach, subject to the higher informational requirements of the latter having been satisfied. Thus, the rules of thumb adopt the contribution approach to meet the perceived needs of economists for a full cost base for pricing. These results only apply when management perceives its unknown marginal cost and demand functions to be linear. When marginal costs rise, as is likely at outputs in excess of efficient practical capacity, the rules of thumb result in over-production and prices which do not respond to changes in demand elasticities.

In terms of the three pricing objectives mentioned in the introduction, collusive full cost pricing clearly meets the second and third objectives of stable economy markets and an optimal rate of overhead recovery. In the case of the first objective, the full cost price will not be seen as a fair price when demand contracts and output falls. However, this reflects the joint monopoly nature of market power rather than the specific pricing policy.

The non-collusive proportional allocation rule meets the first and third objectives of fair prices and an optimal rate of overhead recovery. In providing a mechanism for an ordered series of price reductions in the face of significant contractions in demand, it could prevent destabilising price wars from breaking out. Thus it meets the second objective better than conventional full cost pricing does.