Accounting for overhead

expenditure

Learning objectives====================
After studying this chapter, you should be able to:
• explain why departmental overhead rates should be used in preference to a single blanket overhead
rate;
• construct an overhead analysis sheet and calculate departmental overhead absorption rates;
• justify why predetermined overhead rates should be used in preference to actuaJ overhead rates;
• calculate and explain the accounting treatment of the under/over recovery of overheads;
• describe the three different capacity measures which can be used to calculate overhead absorption rates;
• record inter-service department transfers using one of the methods described in Appendix 4.1;
• describe the six different methods of overhead recovery.

In Chapter 3 we discussed the procedure for
assigning direct labour and material costs to
products. With direct costs, we can accurately
measure the resources consumed by products by
recording labour times engaged on specific
products or tracing the materials issued to a
particular product. In this chapter we are going
to focus on how overhead costs can be allocated
to products.
You will recall from Chapter 2 that overhead
expenditure consists of indirect labour, indirect
materials and indirect expenses. In other words,
overheads are those costs that cannot be directly
assigned to cost objectives such as a product,
process, sales territory or customer group. Some
examples of specific items of overhead
expenditure include supervision, lighting and
heating and rent and rates for produd
costing. These items may, however, be directly
attributable to another cost objective- for
example, if the cost objective is a sales territory
then they may be direct costs.
It is not possible to accurately measure the
overhead resources consumed by products, since
we cannot trace specific items of overheads to
individual products. Instead, we must estimate the
overhead resources consumed. Thus product
costs are likely to become more inaccurate as the
proportion of overheads in a firm's cost structure
mcreases.
Product costs are required for two
purposes: first, for financial accounting
requirements in order to allocate the
manufacturing costs incurred during a
period between cost of goods sold and
inventories; secondly, to provide useful
information for managerial decision-
making requirements. In order to meet
financial accounting requirements, it may not be
necessary to accurately trace costs to individual
products. Consider a situation where a firm
produces 1000 different products and the costs
incurr~d during a period are £10 million. A well-
designed product costing system should
accurately analyse the £10 million costs incurred
between cost of sales and inventories. Let us
assume the true figures are £7 million and £3
million. Approximate but inaccurate individual
product costs may provide a reasonable
approximation of how much of the £10 million
should be attributed to cost of sales and
inventories. Some product costs may be
overstated and others may be understated, but
this would not matter for financial accounting
purposes as long as the toto/ of the individual
product costs assigned to cost of sales and
inventories was approximately £7 million and £3
million.
For decision-making purposes, however, more
accurate product costs are required so that we

70 - - - - - - - - - - - - - - - - - - - - - - - - - - - - • ACCOUNTING FOR OVERHEAD EXPENDITURE

C. Drury, Management and Cost Accounting
© J.C. Drury 1992
 can distinguish between profitable and
unprofitable products. By more accurately
measuring the resources consumed by products,
a firm can identify its sources of profits and
losses. If the cost system does not capture
sufficiently accurately the consumption of
resources by products, the reported product costs
will be distorted, and there is a danger that
managers may drop profitable products or
continue production of unprofitable products.
According to Cooper and Kaplan (1988), cost
systems work satisfactorily for accumulating
product costs for financial accounting purposes
but fail to provide product cost information that is
useful for decision-making purposes. The
management accounting literature advocates that
product costs, based on the methods of tracing
overheads to products described in this chapter,
should not be used for decision-making
purposes. These product costs are only
appropriate for financial accounting purposes.
Nevertheless, there is a considerable amount of
evidence to suggest that product costs, computed
in the manner described in this chapter, are used
by firms for decision-making purposes (see e.g.
Cooper, 1990; Drury el a/., 1992).
Most firms use simplistic methods to allocate
overhead costs to products. These methods were
developed decades ago when most companies
manufactured a narrow range of products, and
direct labour and materials were the dominant
factory costs. Overhead costs were relatively
small and the distortions arising from using
simplistic methods were not significant.
Information costs were high, and it was therefore
difficult to justify the use of more sophisticated
methods.
Today companies produce a wide range of
products; direct labour cost represents only a
small fraction of total costs, and overhead costs
are of considerable importance. Simplistic
overhead allocations are difficult to justify,
particularly when information processing costs
have declined dramatically and ore no longer a
barrier to introducing more sophisticated cost
accumulation systems. Furthermore, the change
to a more competitive climate over the years has
made decision errors due to poor cost
information more probable and more costly.
The a im of this chapter is to describe a
cost system for accumulating product
costs for financial accounting purposes.
Thus approximate, but inaccurate,
product costs will suffice. These product
costs should not, however, be used for
decision-making purposes. In Chapters 10
and 11 we ore going to focus on the design of
cost systems that will generate information for
decision-making purposes.
For financial accounting and inventory
valuation purposes the Statement of Standard
Accounting Practice (SSAP 9) on Stocks and Work
in Progress states that all direct manufacturing
costs and overheads must be allocated to
products, and non-manufacturing overheads
recorded as period costs. The justification for this
is that all manufacturing overheads are incurred
in the production of the firm's output, and so each
unit of the product produced receives some
benefit from these costs. It follows that each unit
of output should be charged with some of the
overhead costs. For an explanation of why
period costs are not traced to products and
included in the stock valuation you should refer
back to the section relating to period and
product costs in Chapter 2.
In this chapter we a re going to
concentrate mainly on a llocating
manufacturing overhe ads to products.
However, some firms do allocate non-
manufacturing overheads to products for
decision-making purposes, and the procedures
they adopt are briefly described. Finally, it is
important to note that, since our objective in this
chapter is to design a cost system that assigns
costs between cost of goods sold and inventories,
approximate but inaccurate product costs should
suffice. The additional benefits arising from
designing cost systems that will generate more
accurate product costs may not exceed the
additional costs of implementing and operating
the system.

Most companies allocate overheads to products using a two-stage procedure. In the

first stage overheads are assigned to cost centres, while the second stage allocates An overview of
the costs accumulated in the cost centres to products. You will recall from Chapter 2
that a cost centre is a responsibility centre where managers are accountable for the the procedure
expenses that are under their control. Normally cost centres consist of departments, for allocating
but in some instance they consist of smaller segments such as groups of machines
within a department. In this chapter we are going to assume that cost centres consist overheads to
of departments. In the United States the term cost pool is used to describe any products
group of individual costs to which overheads are assigned to in the first stage of the

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