Overheads Explained

There are two main methods of attributing overheads to products or services, one is by way of establishing average overhead recovery rates (traditional), and one uses a technique called Activity Based Costing (ABC).

The ‘traditional’ way of attributing overheads to products began in the manufacturing industry when most manufacturing businesses had a small and narrow range of products, less reliant on automation, and direct material and labour costs formed a higher proportion of total product costs, support services and attendant overheads being not as significant. .

The manner in which overheads were attributed to products was not that sophisticated, the growth of marginal costing (see later) and impact of contribution theory diminished the focus on overheads.

When overheads are allocated to cost units it requires an allocation base or cost driver, these can be cause and effect allocations or arbitrary. The aim is to reflect the burden the product places on the overhead, traditional cost systems often use direct labour hours or machine hours. Activity-based-costing (ABC) systems only use cause and effect (often require more cost pools), this will be dealt with later.

The procedure of cost allotment – sharing/allotment of indirect costs to cost units can be summarised as follows:

  1. Collect production overhead costs by item
  2. Establish cost centres
  3. Allocate and apportion overhead costs to cost centres
  4. Apportion service cost centres to production cost centres
  5. Absorb production cost centre costs into cost units

Activity Based Costing is founded on the premise that it is activities that cause costs not products. Producing and selling products creates demand for activities, driven by various factors.

The conditions which influenced the development and application of traditional overhead cost attribution methods have long since gone; indeed changes in the manufacturing environment and beyond have been occurring at an increasingly faster rate for many businesses.

Within manufacturing, processes have become more complex with an increasingly diverse range of products, often with individual customer specifications. Technology has been a major driver, leading to increased automation. Support functions have expanded, not just in the production environment and not just in manufacturing industry, to meet the demands of more sophisticated customers, and the growing complexity and variety of business.

Cost structures have changed as a consequence. Direct labour costs have declined and been replaced by an increasing burden of overhead costs in all areas of business. ABC seeks to help businesses gain competitive advantage, in a rapidly changing business world, through better overhead cost attribution:

  • to enable better marketing and investment decisions as a consequence of more accurate and reliable product costs;
  • to enable better control of overhead costs, and thus enhancement of value for money, through greater understanding of the factors that drive them.

Activity Based Costing — principles ABC seeks to discover the causal factor, known as the cost driver, which determines the demand for each separate overhead activity i.e., what explains the activity to occur. Activity costs, and the instances of cost driver occurrence, are measured and are used to determine overhead absorption rates. The idea behind activity based costing is to develop an activity model (or series of linked cost centre activity models) of resource requirements. This model can then be flexed to affect different volume assumptions. It can also be used as a basis for identifying and producing performance improvement

In developing the activity based budgeting model it is important to understand and identify:-

  • What activities are being/need to be carried out.
  • How efficiently the activities are being carried out and to what quality and standard.
  • What is driving the level of resource required to perform this activity (the activity level volume driver).
  • The relationships between the activity level volume driver and its root cause.
  • How the root cause may be changed and how this can affect the activity resource required.

In summary, ABC is a five stage process:

  1. identify the various activities within an organisation;
  2. determine the key cost driver for each activity;
  3. create cost pools to collect activity costs having the same cost driver;
  4. measure the incidence of each cost driver for each product/service;
  5. attribute the cost of each pool (and activity) to products/services based on the cost drivers.

Usually, these inputs or variables are reflected in the individual cost centre activity model (or matrix) over which each individual manager has responsibility. However, the logic of having a budget model with an integrated set of product volumes and unit price assumptions is already established.