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 divid- ing a business into separate ‘areas’ for costing purposes, charging overheads differently from one area to the next, according to the nature of the work done in each. 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 about each 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 are time-related. Dealing with overheads on a cost centre basis In general, as we saw in Chapter 1, all but the smallest businesses are divided into departments. Normally, each department deals with a separate activity. The reasons for dividing a business into departments include the following: CHAPTER 4 FULL COSTING 108 Taking the same business as in Example 4.2, on closer analysis we find that of the over- 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 £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 Job 1 Job 2 ££ Direct labour hour basis £7.50 × 800 6,000 £7.50 × 800 6,000 Machine hour basis £8.00 × 700 5,600 £8.00 × 300 2,400 Total 11,600 8,400 We can see from this that the expected overheads of £20,000 are charged in total. Activity 4.9 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 108 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 rela- tively independent units with each one having its own manager. 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 and motivation among the staff. As is shown in Real World 4.5, which we shall consider shortly, most businesses charge overheads to cost units on a department-by-department basis. They do this because 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 department for 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 cost works, in a service-industry context, through Example 4.3. MULTI-PRODUCT BUSINESSES 109 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 a minor accident, to a complete respray of a double-decker bus. Each job starts life in the Preparation Department, where it is prepared for the Paintshop. 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 Preparation Department’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 is charged 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 two departments. In the Finishing Department, jobs are cleaned and polished ready to go back to the customers. Further direct labour and, in some cases, materials are added. All jobs 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 ‘ M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 109 The passage of a job through the departments, picking up cost as it goes, can be com- 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 as a cost centre. This can be defined as a particular physical area or some activity or function for which the cost is separately identified. Charging direct cost to jobs, in a departmental system, is exactly the same as where the whole business is one single cost centre. 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 of labour, 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, associated with the job. This record keeping will normally be done cost centre by cost centre in a depart- mental system. CHAPTER 4 FULL COSTING 110 ‘ 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 one department 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 labour- intensive, so that direct labour hours may be seen as being appropriate there. Example 4.3 continued A cost unit (Job A) passing through Autosparkle Ltd’s process Figure 4.7 As the particular paint job passes through the three departments, where work is carried out on it, the job ‘gathers’ costs of various types. M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 110 It is obviously necessary to break down the production overheads of the entire busi- ness on a cost centre basis. This means that the total overheads of the business must be divided between the cost centres, such that the sum of the overheads of all of the cost 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 the business to jobs. Real World 4.5 provides an indication of the number of different cost centres 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 are worked 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 Finishing Departments, discussed above in Example 4.3, are all examples of product cost centres. MULTI-PRODUCT BUSINESSES 111 ‘ ‘ REAL WORLD 4.5 Cost centres in practice It is not unusual for businesses to have several cost centres. A recent survey by Drury and Tayles 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 cost centres 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 or overall 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 business Figure 4.8 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 111 The service cost centre cost must be charged to product cost centres, and become part 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 way into the cost of the jobs. If this is not done, the ‘full’ cost derived will not really be the full 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. For example, 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, for example the salary of the cost centre manager; – rent, where the cost centre is housed in its own premises for which rent can be separately 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, the rent 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 CHAPTER 4 FULL COSTING 112 ‘ ‘ Can you guess what the definition of a service cost centre is? Can you think of an example of a service cost centre? A service cost centre is one where no direct cost is involved. It renders a service to other cost centres. Examples include: l General administration l Accounting l Stores l Maintenance l Personnel l Catering. All of these render services to product cost centres and, possibly, to other service cost centres. Activity 4.10 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 112 charging overheads to individual jobs, there is no correct basis of apportioning gen- eral overheads to cost centres. 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 the individual 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 that the higher the number of staff, the more benefit the particular product cost centre has derived from the personnel cost centre. This is, of course, rather a crude approach. 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 is way 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 cost units 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 cost centre (departmental) basis. MULTI-PRODUCT BUSINESSES 113 The steps in having overheads handled on a cost centre basis Figure 4.9 There are seven steps involved in taking the overall business overheads to their effect on indi- vidual cost units, when dealt with on a cost centre basis. M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 113 CHAPTER 4 FULL COSTING 114 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 the other 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: £000 Rent 10,000 Electricity to power machines 3,000 Electricity for heating and lighting 800 Insurance of premises 200 Cleaning 600 Depreciation of machines 2,000 Total salaries to be paid to indirect workers next month are as follows: £000 Preparation department 200 Machining department 240 Finishing department 180 General administration department 180 The General administration department has a staff consisting of only indirect workers (including managers). The other departments have both indirect workers (including managers) and direct workers. There are 100 indirect workers within each of the four departments and none does any ‘direct’ work. Each direct worker is expected to work 160 hours next month. The number of direct workers in each department is: Preparation department 600 Machining department 900 Finishing department 500 Machining department direct workers are paid £12 an hour; other direct workers are paid £10 an hour. 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: Preparation department 16,000 Machining department 20,000 Finishing department 10,000 General administration department 2,000 Deducing the overheads, cost centre by cost centre, can be done, using a sched- ule, as follows: Example 4.4 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 114 MULTI-PRODUCT BUSINESSES 115 Total Prep’n Mach’g Fin’g GA £000 £000 £000 £000 £000 £000 Allocated cost: Machine power 3,000 3,000 Machine depreciation 2,000 2,000 Indirect salaries 800 200 240 180 180 Apportioned cost Rent 10,000 Heating and lighting 800 Insurance of premises 200 Cleaning 600 Apportioned by floor area 11,600 3,867 4,833 2,417 483 Cost centre overheads 17,400 4,067 10,073 2,597 663 Reapportion GA cost by number of staff (including the indirect workers) 202 288 173 (663) 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 Direct labour hours 10 7 5 Machine hours – 6 – Direct materials (£) 85 13 6 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): = £44.47 Machining department (machine hour based): = £86.34 Finishing department (direct labour hour based): = £34.63 £2,770,000 500 × 160 £10,361,000 120,000 £4,269,000 600 × 160 Activity 4.11 ‘ M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 115 CHAPTER 4 FULL COSTING 116 The cost of the job is as follows: ££ Direct labour: Preparation department (10 × £10) 100.00 Machining department (7 × £12) 84.00 Finishing department (5 × £10) 50.00 234.00 Direct materials: Preparation department 85.00 Machining department 13.00 Finishing department 6.00 104.00 Overheads: Preparation department (10 × £44.47) 444.70 Machining department (6 × £86.34) 518.04 Finishing department (5 × £34.63) 173.15 1,135.89 Full cost of the job 1,473.89 Activity 4.11 continued The manufacturing cost for Buccaneers Ltd for next year is expected to be made up as follows: £000 Direct materials: Forming department 450 Machining department 100 Finishing department 50 Direct labour: Forming department 180 Machining department 120 Finishing department 75 Indirect materials: Forming department 40 Machining department 30 Finishing department 10 Administration department 10 Indirect labour: Forming department 80 Machining department 70 Finishing department 60 Administration department 60 Maintenance cost 50 Rent and rates 100 Heating and lighting 20 Building insurance 10 Machinery insurance 10 Depreciation of machinery 120 Total manufacturing cost 1,645 Activity 4.12 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 116 MULTI-PRODUCT BUSINESSES 117 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 pro- duction departments. (iv) The area of the premises in which the business manufactures amounts to 50,000 square metres, divided as follows: Sq m Forming department 20,000 Machining department 15,000 Finishing department 10,000 Administration department 5,000 (v) The maintenance employees are expected to divide their time between the pro- duction departments as follows: % Forming department 15 Machining department 75 Finishing department 10 (vi) Machine hours are expected to be as follows: Hours Forming department 5,000 Machining department 15,000 Finishing department 5,000 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: Forming department 4 hours Machining department 4 hours Finishing department 1 hour Machine hours: Forming department 1 hour Machining department 2 hours Finishing department 1 hour Direct materials: Forming department £40 Machining department £9 Finishing department £4 Use whichever of the two bases of overhead recovery, deduced in (b), that you con- sider more appropriate. (d) Explain why you consider the basis used in (c) to be the more appropriate. ‘ M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 117 [...]... Promptprint Ltd, a printing business, has received an enquiry from a potential customer for the quotation of a price for a job The pricing policy of the business is based on the plans for the next financial year shown below Sales revenue (billings to customers) Materials (direct) Labour (direct) Variable overheads Advertising (for business) Depreciation Administration Interest Profit (before taxation) £ 196,000... the budgeted overheads for next year, analysed between the two cost centres This should be in the form of three columns: one for the total figure for each type of overhead and one column each for the two cost centres, where each type of overhead is analysed between the two cost centres Each column should also show the total of overheads for the year (b) Derive the appropriate rate for charging the overheads... practice A recent survey of 41 UK manufacturing businesses found that 68 per cent of them used a variable-costing approach to management reporting Many would find this surprising It seemed to be widely believed that the requirement for financial statements in published annual reports to be in full cost terms has led those businesses to use a full cost approach for management reporting as well This seems not,... made for the use of the alternative basis; certainly, a machine hour basis could have been justified for the machining department It would be possible, and it may be reasonable, to use one basis in respect of one product 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 labour hours basis for the... chapter that full (absorption) cost information may be used for four main purposes Now that we have seen how full cost is deduced, let us consider 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 for profit in order to derive the selling... Fabric £ per sq metre 1.00 1.10 0.40 The metal wire is in constant use by the business for a range of its products The fabric has no other use for the business and is scheduled to be scrapped Unskilled labour, which is paid at the rate of £7.50 an hour, will need to be taken on specifically to undertake the contract The business is fairly quiet at the moment, which means that a pool of skilled labour... costing quite possibly misused it For example, three-quarters of those that used it treated labour cost as variable Possibly in some cases the cost of labour is variable (with the level of output), but it seems likely that this is not true for most of these businesses At the same time, most of the 68 per cent treat all overheads as a fixed cost It seems likely that, for most businesses, overheads have a... batch If the full (absorption) cost is charged as the sales price and things go according to plan, the business will break even Full cost information is seen by some as not very useful because it can be backward-looking: it includes information irrelevant to decision making, but excludes some relevant information Full (absorption) costing versus variable costing l With full costing, both fixed and variable... complete the contract The business charges jobs with overheads on a direct labour hour basis The production overheads of the entire business for the month in which the contract will be undertaken M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:36 AM Page 121 USING FULL (ABSORPTION) COST INFORMATION are estimated at £50,000 The estimated total direct labour hours that will be worked are 12,500 The business tends not... break-even price For decision- making purposes, it can be helpful to allocate non-manufacturing costs, as well as manufacturing costs, to products using some sensible basis of allocation When this is done and everything goes according to plan (so that direct cost and overheads prove to be as expected), selling the output for its full cost should cause the business to break even exactly Therefore, whatever . 11,600 3, 867 4, 833 2,417 4 83 Cost centre overheads 17,400 4,067 10,0 73 2,597 6 63 Reapportion GA cost by number of staff (including the indirect workers) 202 288 1 73 (6 63) 17,400 4,269 10 ,36 1 2,770. department (6 × £86 .34 ) 518.04 Finishing department (5 × 34 . 63) 1 73. 15 1, 135 .89 Full cost of the job 1,4 73. 89 Activity 4.11 continued The manufacturing cost for Buccaneers Ltd for next year is. 130 52 39 26 13 Machine insurance 10 Machine depreciation 120 Machine hours 130 26 78 26 – 670 205.5 254.5 127 83 Admin. Direct labour 39 .84 26.56 16.6 ( 83) 670 245 .34 281.06 1 43. 6 – Note: The