Tools for Business Decision Management Makers_3 potx

divid-Remember that there is no correct basis of charging overheads to jobs, so our frequent reference to the direct labour and machine hour bases should not be taken to imply that these

Segmenting the overheads in this way may well be seen as providing a better basis

of charging overheads to jobs This is quite often found in practice, usually by ing a business into separate ‘areas’ for costing purposes, charging overheads differentlyfrom one area to the next, according to the nature of the work done in each

divid-Remember that there is no correct basis of charging overheads to jobs, so our frequent reference to the direct labour and machine hour bases should not be taken

to imply that these are the correct methods However, it should be said that these two methods do have something to commend them and they are popular in practice

As we have already seen, a sensible method does need to identify something abouteach job that can be measured and which distinguishes it from other jobs There is also

a lot to be said for methods that are concerned with time, because most overheads aretime-related

Dealing with overheads on a cost centre basis

In general, as we saw in Chapter 1, all but the smallest businesses are divided intodepartments Normally, each department deals with a separate activity The reasons fordividing a business into departments include the following:

Taking the same business as in Example 4.2, on closer analysis we find that of the heads totalling £20,000 next month, £8,000 relates to machines (depreciation, main- tenance, rent of the space occupied by the machines and so on) and the remaining

over-£12,000 to more general overheads The other information about the business is exactly

as it was before.

How much of the total overheads will be charged to each job if the machine-related overheads are to be charged on a machine hour basis and the remaining overheads are charged on a direct labour hour basis?

Direct labour hour basis

Overhead recovery rate = £12,000/1,600 = £7.50 per direct labour hour

Machine hour basis

Overhead recovery rate = £8,000/1,000 = £8.00 per machine hour

Overheads charged to jobs

l Size and complexity Many businesses are too large and complex to be managed as a

single unit It is usually more practical to operate each business as a series of tively independent units with each one having its own manager

rela-l Expertise Each department normally has its own area of specialism and is managed

by a specialist

l Accountability Each department can have its own accounting records that enable

its performance to be assessed This can lead to greater management control andmotivation among the staff

As is shown in Real World 4.5, which we shall consider shortly, most businessescharge overheads to cost units on a department-by-department basis They do thisbecause they expect that it will give rise to a more useful way of charging overheads

It is probably only in a minority of cases that it leads to any great improvement in the usefulness of the resulting full cost figures Though it may not be of enormous benefit in many cases, it is probably not an expensive exercise to apply overheads

on a departmental basis Since cost elements are collected department by departmentfor other purposes (particularly control), to apply overheads on a department-by-department basis is a relatively simple matter

We shall now take a look at how the departmental approach to deriving full costworks, in a service-industry context, through Example 4.3

Autosparkle Ltd offers a motor vehicle paint-respray service The jobs that it undertakes range from painting a small part of a saloon car, usually following aminor accident, to a complete respray of a double-decker bus

Each job starts life in the Preparation Department, where it is prepared for thePaintshop In the Preparation Department the job is worked on by direct workers,

in most cases taking some direct materials from the stores with which to treat the old paintwork to render the vehicle ready for respraying Thus the job will

be charged with direct materials, direct labour and a share of the PreparationDepartment’s overheads The job then passes into the Paintshop Department,already valued at the cost that it picked up in the Preparation Department

In the Paintshop, the staff draw direct materials (mainly paint) from the stores, and direct workers spend time respraying the job, using sophisticated spraying apparatus as well as working by hand So, in the Paintshop, the job ischarged with direct materials, direct labour and a share of that department’s overheads The job now passes into the Finishing Department, valued at the cost of the materials, labour and overheads that it accumulated in the first twodepartments

In the Finishing Department, jobs are cleaned and polished ready to go back tothe customers Further direct labour and, in some cases, materials are added Alljobs also pick up a share of that department’s overheads The job, now complete,passes back to the customer

Figure 4.7 shows graphically how this works for a particular job

Example 4.3

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The passage of a job through the departments, picking up cost as it goes, can be pared to a snowball being rolled across snow: as it rolls, it picks up more and more snow.Where cost determination is dealt with departmentally, each department is known

com-as a cost centre This can be defined as a particular physical area or some activity orfunction for which the cost is separately identified Charging direct cost to jobs, in adepartmental system, is exactly the same as where the whole business is one single costcentre It is simply a matter of keeping a record of

l the number of hours of direct labour worked on the particular job and the grade oflabour, assuming that there are different grades with different rates of pay;

l the cost of the direct materials taken from stores and applied to the job; and

l any other direct cost elements, for example some subcontracted work, associatedwith the job

This record keeping will normally be done cost centre by cost centre in a mental system

depart-‘

The basis of charging overheads to jobs (for example, direct labour hours)might be the same for all three departments, or it might be different from onedepartment to another It is possible that spraying apparatus cost elements dom-inate the Paintshop cost, so that department’s overheads might well be charged

to jobs on a machine hour basis The other two departments are probably intensive, so that direct labour hours may be seen as being appropriate there

It is obviously necessary to break down the production overheads of the entire ness on a cost centre basis This means that the total overheads of the business must

busi-be divided busi-between the cost centres, such that the sum of the overheads of all of thecost centres equals the overheads for the entire business By charging all of their over-heads to jobs, the cost centres will, between them, charge all of the overheads of thebusiness to jobs Real World 4.5provides an indication of the number of different costcentres that businesses tend to use in practice

For purposes of cost assignment, it is necessary to distinguish between product cost centres and service cost centres Product cost centres are those in which jobs areworked on by direct workers and/or where direct materials are added Here jobs can

be charged with a share of their overheads The Preparation, Paintshop and FinishingDepartments, discussed above in Example 4.3, are all examples of product cost centres

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REAL WORLD 4.5 Cost centres in practice

It is not unusual for businesses to have several cost centres A recent survey by Drury andTayles of 186 larger UK businesses involved in various activities showed the following:

We can see from Figure 4.8 that 86 per cent of businesses surveyed had 6 or more costcentres and that 36 per cent of businesses had more than 20 cost centres Only 3 per cent

of businesses surveyed had a single cost centre (that is, there was a business-wide oroverall overhead rate used) Clearly, businesses that deal with overheads on a business-wide basis are very rare

Source: Based on information taken from Drury, C and Tayles, M., ‘Profitability analysis in UK organisations’, British Accounting Review, December 2006.

Analysis of the number of cost centres within a businessFigure 4.8

The service cost centre cost must be charged to product cost centres, and becomepart of the product cost centres’ overheads, so that those overheads can be recharged

to jobs This must be done so that all of the overheads of the business find their wayinto the cost of the jobs If this is not done, the ‘full’ cost derived will not really be thefull cost of the jobs

Logically, the cost of a service cost centre should be charged to product cost centres

on the basis of the level of service provided to the product cost centre concerned Forexample, a product cost centre that has a lot of machine maintenance carried out rela-tive to other product cost centres should be charged with a larger share of the main-tenance cost centre’s (department’s) cost than should those other product cost centres.The process of dividing overheads between cost centres is as follows:

l Cost allocation Allocate cost elements that are specific to particular cost centres.These are items that relate to, and are specifically measurable in respect of, indivi-dual cost centres, that is, they are part of the direct cost of running the cost centre.Examples include:

– salaries of indirect workers whose activities are wholly within the cost centre, forexample the salary of the cost centre manager;

– rent, where the cost centre is housed in its own premises for which rent can beseparately identified;

– electricity, where it is separately metered for each cost centre

l Cost apportionment Apportion the more general overheads to the cost centres.These are overheads that relate to more than one cost centre, perhaps to them all.They would include:

– rent, where more than one cost centre is housed in the same premises;

– electricity, where it is not separately metered;

– salaries of cleaning staff who work in a variety of cost centres

These overheads would be apportioned to cost centres on the basis of the extent

to which each cost centre benefits from the overheads concerned For example, therent cost might be apportioned on the basis of the square metres of floor area occupied by each cost centre With electricity used to power machinery the basis

of apportionment might be the level of mechanisation of each cost centre As with

charging overheads to individual jobs, there is no correct basis of apportioning eral overheads to cost centres.

gen-l Having totalled, allocated and apportioned the cost to all cost centres, it is now necessary to apportion the total cost of service cost centres to product cost centres.Logically, the basis of apportionment should be the level of service rendered by theindividual service cost centre to the individual production cost centre With per-sonnel cost centre (department) cost, for example, the basis of apportionment might

be the number of staff in each product cost centre, because it could be argued thatthe higher the number of staff, the more benefit the particular product cost centrehas derived from the personnel cost centre This is, of course, rather a crudeapproach A particular product cost centre may have severe personnel problems and

a high staff turnover rate, which may make it a user of the personnel service that isway out of proportion to the number of staff in the product cost centre

The final total for each product cost centre is that cost centre’s overheads These can

be charged to jobs as they pass through The process of applying overheads to costunits on a cost centre (departmental) basis is shown in Figure 4.9

We shall now go on to consider Example 4.4, which deals with overheads on a costcentre (departmental) basis

The steps in having overheads handled on a cost centre basisFigure 4.9

There are seven steps involved in taking the overall business overheads to their effect on vidual cost units, when dealt with on a cost centre basis.

indi-A business consists of four cost centres:

l Preparation department

l Machining department

l Finishing department

l General administration (GA) department

The first three are product cost centres and the last renders a service to theother three The level of service rendered is thought to be roughly in proportion

to the number of employees in each product cost centre

Overheads, and other data, for next month are expected to be as follows:

Each direct worker is expected to work 160 hours next month The number ofdirect workers in each department is:

All of the machinery is in the machining department Machines are expected

to operate for 120,000 hours next month

The floorspace (in square metres) occupied by the departments is as follows:

Example 4.4

Total Prep’n Mach’g Fin’g GA

number of staff (including

17,400 4,269 10,361 2,770 –

Assume that the machining department overheads (in Example 4.4) are to be charged

to jobs on a machine hour basis, but that the direct labour hour basis is to be used for the other two departments What will be the full (absorption) cost of a job with the fol- lowing characteristics?

Preparation Machining Finishing

Hint: This should be tackled as if each cost centre were a separate business, then

departmental cost elements are added together for the job so as to arrive at the total full cost.

First, we need to deduce the indirect (overhead) recovery rates for each cost centre:

Preparation department (direct labour hour based):

= £44.47Machining department (machine hour based):

= £86.34Finishing department (direct labour hour based):

= £34.63

£2,770,000

500 × 160

£10,361,000120,000

£4,269,000

600 × 160

Activity 4.11

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The cost of the job is as follows:

Direct labour:

Preparation department (10 × £10) 100.00Machining department (7 × £12) 84.00Finishing department (5 × £10) 50.00

234.00Direct materials:

104.00Overheads:

Preparation department (10 × £44.47) 444.70Machining department (6 × £86.34) 518.04Finishing department (5 × £34.63) 173.15

The following additional information is available:

(i) Each of the four departments is treated as a separate cost centre.

(ii) All direct labour is paid £6 an hour for all hours worked.

(iii) The administration department renders personnel and general services to the duction departments.

pro-(iv) The area of the premises in which the business manufactures amounts to 50,000 square metres, divided as follows:

On the basis of this information:

(a) Allocate and apportion overheads to the three product cost centres.

(b) Deduce overhead recovery rates for each product cost centre using two different bases for each cost centre’s overheads.

(c) Calculate the full cost of a job with the following characteristics:

Direct labour hours:

Machine hours:

(a) Overheads can be allocated and apportioned as follows:

Note: The direct cost is not included in the above because it is allocated directly to jobs.

(b) Overhead recovery rates are as follows:

Basis 1: direct labour hours

Forming = = £8.18 per direct labour hour

Machining = = £14.05 per direct labour hour

Finishing = = £11.49 per direct labour hourBasis 2: machine hours

Forming = = £49.07 per machine hour

Machining = = £18.73 per machine hour

Finishing = = £28.72 per machine hour(c) Full cost of job – on direct labour hour basis of overhead recovery

Direct materials (£40 + £9 + £4) 53.00Overheads:

Machining (4 × £14.05) 56.20Finishing (1 × £11.49) 11.49 100.41

£143,6005,000

£281,06015,000

£245,3405,000

(d) The reason for using the direct labour hour basis rather than the machine hour basiswas that labour is more important, in terms of the number of hours applied to output,than is machine time Strong arguments could have been made for the use of thealternative basis; certainly, a machine hour basis could have been justified for themachining department

It would be possible, and it may be reasonable, to use one basis in respect of one duct cost centre’s overheads and a different one for those of another For example,machine hours could have been used for the machining department and a direct labourhours basis for the other two

pro-Batch costing

The production of many types of goods and services (particularly goods) involves producing in a batch of identical, or nearly identical, units of output, but where eachbatch is distinctly different from other batches For example, a theatre may put on

a production whose nature (and therefore cost) is very different from that of other productions On the other hand, ignoring differences in the desirability of the varioustypes of seating, all of the individual units of output (tickets to see the production) are identical

In these circumstances, the cost per ticket would normally be deduced by using a jobcosting approach (taking account of direct and indirect costs and so on) to find the cost

of mounting the production, and then dividing the cost of mounting the production

by the expected number of tickets to be sold to find the cost per ticket This is known

as batch costing.Figure 4.10 shows the process for deriving the cost of one cost unit (product) in a batch

Deriving the cost of one cost unit where production is in batches

Figure 4.10

The cost for the batch is derived using a job-costing basis and this is divided by the number in the batch to determine the cost for each cost unit.

Full (absorption) cost as the break-even price

For decision-making purposes, it can be helpful to allocate non-manufacturing costs, aswell as manufacturing costs, to products using some sensible basis of allocation Whenthis is done and everything goes according to plan (so that direct cost and overheadsprove to be as expected), selling the output for its full cost should cause the business

to break even exactly Therefore, whatever profit (in total) is loaded onto full cost toset actual selling prices will, if plans are achieved, result in that level of profit beingearned for the period

The forward-looking nature of full (absorption) costing

Though deducing full cost can be done after the work has been completed, it is oftendone in advance In other words, cost is frequently predicted Where, for example, fullcost is needed as a basis on which to set selling prices, it is usually the case that pricesneed to be set before the customer will accept the job being done Even where no par-ticular customer has been identified, some idea of the ultimate price will need to beknown before the business will be able to make a judgement as to whether potentialcustomers will buy the product, and in what quantities There is a risk, of course, thatthe actual outcome will differ from that which was predicted If this occurs, correctionsare subsequently made to the full cost originally calculated

Hector and Co Ltd has been invited to tender for a contract to produce 1,000 clotheshangers The following information relates to the contract

£ per metre £ per sq metre

an hour to do nothing if the contract does not proceed The pool of skilled labour is cient to complete the contract

suffi-The business charges jobs with overheads on a direct labour hour basis suffi-The productionoverheads of the entire business for the month in which the contract will be undertaken

Self-assessment question 4.1

We saw at the beginning of the chapter that full (absorption) cost information may beused for four main purposes Now that we have seen how full cost is deduced, let usconsider in more detail how this information may be used.

l Pricing and output decisions Full cost can be used as the starting point for

determin-ing prices An amount is simply added to the full cost of a product or service forprofit in order to derive the selling price The amount of profit is often calculated as

a percentage of the full (absorption) cost figure This approach to pricing is known

as cost-plus pricing Garages carrying out vehicle repairs typically operate in thisway Solicitors and accountants doing work for clients often use this approach aswell Where there is a competitive market, however, it is not possible to set prices on

a cost-plus basis Businesses will usually have to accept the price that the market is

prepared to pay Thus, they are usually price takers rather than price makers The

prices at which businesses are able to sell their output will usually be a major minant of the quantity that they make available to the market We shall take a closerlook at pricing and its relationship to cost and output in Chapter 5

deter-l Exercising control Full (absorption) cost seems often to be used as the basis of

bud-geting and comparing actual outcomes with budgets, enabling action to be taken toexercise control It can be useful in this context, though care needs to be taken totry to ensure that individual managers are not being held responsible for cost ele-ments, say overhead costs, that they are unable to control This point will be raisedagain in Chapter 5, where we consider another approach to dealing with overheads

in full costing We shall look at budgeting and control in some detail in Chapters 6and 7

l Assessing relative efficiency Full cost seems to be used as the basis of comparing

rela-tive efficiency in terms of the compararela-tive cost of doing similar things For example,

as we saw in Real World 4.1(p 94), the cost of carrying out a standard surgical cedure seems often to be compared on the basis of full cost between one hospitaland another The objective of this may well be to identify the cheaper hospital andencourage other hospitals to take steps to copy the cheaper hospital’s approach

pro-As we saw in Chapters 2 and 3, including all aspects of cost (as full costing does)can lead to incorrect decisions It is necessary to identify that part of the cost that isstrictly relevant to a decision and ignore the rest, be it direct or indirect in the full-costing context Similarly, comparing the full cost of doing something, particularly

Using full (absorption) cost information

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are estimated at £50,000 The estimated total direct labour hours that will be worked are12,500 The business tends not to alter the established overhead recovery rate to reflectincreases or reductions to estimated total hours arising from new contracts The totaloverheads are not expected to increase as a result of undertaking the contract

The business normally adds 12.5 per cent profit loading to the job cost to arrive at afirst estimate of the tender price

Required:

(a) Price this job on a traditional job-costing basis

(b) Indicate the minimum price at which the contract could be undertaken such that thebusiness would be neither better nor worse off as a result of doing it

when the two things are being done in different organisations, can be confusing andlead to bad decisions.

l Assessing performance The conventional approach to measuring a business’s income

for a period requires that expenses must be matched with the sales revenue to which

they relate in the same accounting period Thus, where a service is partially rendered

in one accounting period but the revenue is recognised in the next, or where factured inventories are made, or partially made, in one period but sold in the next,the full cost (including an appropriate share of overheads) must be carried from thefirst accounting period to the second one Deducing full cost is important because,unless we know the full cost of work done in one period that is sold in the next, theprofit figures for each of the two periods concerned will be meaningless Managersand others will not have a reliable means of assessing the effectiveness of the busi-ness as a whole, or the effectiveness of individual parts of it We shall take a quick look

manu-at an alternmanu-ative approach to income measurement, where full cost is not used, shortly.The way in which full cost information is used to measure income can be illustrated

by Example 4.5

During the accounting year that ended on 31 December last year, IT Modules Ltddeveloped a special piece of computer software for a customer, Kingsang Ltd Atthe beginning of this year, after having a series of tests successfully completed by

a subcontractor, the software was passed to Kingsang Ltd IT Modules’s normalpractice (which is typical of most businesses) is to take account of sales revenuewhen the product passes to the customer The sale price of the Kingsang softwarewas £45,000

During last year, subcontract work costing £3,500 was used in developing theKingsang software and 1,200 hours of direct labour, costing £24,300, were worked

on it The business uses a direct labour hour basis of charging overheads to jobs,which is believed to be fair because most of its work is labour-intensive The totalproduction overheads for the business for last year were £77,000, and the totaldirect labour hours worked were 22,000 Testing the Kingsang software this yearcost £1,000

How much profit or loss did IT Modules make on the Kingsang software duringlast year? How much profit or loss did it make on the software during this year?

At what value should IT Modules have included the software on its statement offinancial position (balance sheet) at the end of last year so that the correct profitwill be recorded for each of the two years?

The answers to these questions are as follows:

l No profit or loss was made during last year This is because of IT Modules’s (andthe generally accepted) approach to recognising revenues (sales) and the need

to match expenses with the revenues to which they relate The cost incurredduring last year is carried forward to this year, which is the year of sale

l As the sale is recognised this year, the cost of developing the software is treated

as expenses in this year This cost will include a reasonable share of overheads.Were IT Modules to draw up a ‘mini’ income statement for the Kingsang con-tract for this year, it would be as follows:

Example 4.5

Full costing has been criticised because, in practice, it tends to use past cost and torestrict its consideration of future cost to outlay cost It can be argued that past cost isirrelevant, irrespective of the purpose for which the information is to be used This isbasically because it is not possible to make decisions about the past, only about thefuture Similarly, it is argued that it is wrong to ignore opportunity costs Advocates offull costing would argue, however, that it provides a useful guide to long-run average cost.Despite the criticisms that are made of full costing, it is, according to research evid-

ence, very widely practised An international accounting standard (IAS2 Inventories)

requires that all inventories, including work in progress, be valued at full cost in thepublished financial statements This means that virtually all businesses that have work

in progress and/or inventories of finished goods at the end of their financial periods areobliged to apply full costing for income measurement purposes This will include themany service providers that tend to have work in progress Whether they use full costinformation for other purposes is not clear

An alternative to full (absorption) costing is variable (marginal) costing We may recallfrom Chapter 3 that this approach distinguishes between fixed and variable costs, andthis distinction may be helpful when making short-term decisions Where a businessdivides its cost between fixed and variable, it will measure its income differently to thatdescribed so far in this chapter A variable-costing approach will only include variablecost, including any variable indirect elements, as part of the cost of the goods or ser-vice Fixed cost, both direct and indirect elements, is treated as a cost of the period inwhich it is incurred Part of the philosophy of variable costing is that fixed cost is notlinked to cost units in the way that it is with full costing Thus, inventories of finishedproducts, or work in progress, carried from one accounting period to the next, are valued only on the basis of their variable cost

Full (absorption) costing versus variable costing Criticisms of full (absorption) costing

This year’s profit from the software 12,000

l The software needs to be shown as an asset of the business (valued at £32,000)

in the statement of financial position (balance sheet) as at 31 December lastyear It represents the work in progress that is carried forward to this year