Financial Intelligence For HR Professionals: Manufacturing Overhead Costing

Conventional Approach for Overhead Allocation

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All the cost that is involved in the production process is known as manufacturing overhead. The manufacturing overhead is a wide term which comprises of various other factory cost also. However, the cost incurred with respect to direct material and direct labour is excluded from the manufacturing overhead. As there is no direct cost and it is a kind of overhead it is also known as indirect cost. Apart from the manufacturing cost there are also certain cost in relation to selling and distribution and various other general and administrative expenses that are not added to the product cost. These cost are shown in the income statement of the company as and when they are incurred. Such cost may include inspection cost, maintenance and repair of any asset, depreciation of an equipment, etc. Based on the general accounting principle, it is necessary to value the inventories and the cost of goods sold on the basis of direct cost and manufacturing overheads(Berman, Knight and Case, n.d.).

It is a common practise that the overhead has to be allocated and assigned to all the particular units if the company produces more than a single product. Manufacturing overhead is also distributed in this manner. For example, depreciation of the machine is calculated taking into consideration the value of the machinery, electricity is based on the units consumed and so on (Shim and Siegel, 2008).

There are a large number of ways by which the company can assign and allocate overhead.  These methods are chosen by the companies depending on the market forces and the nature of operations the company carries out. These can be divided into two broad groups- conventional approach and activity based method (modern).

Let us now understand the concept of conventional approach first, in this method the manufacturing overhead was simply allocated on the basis of machine hours or the labour hours or any changes in the degree of the prime cost (Bruner, Eades and Schill, 2017). It is observed that the manufacturing overhead is increased with the decrease in the labour hours or machine hours. When the accountant of the company does not use different cost drivers but uses a single cost driver for all the overheads, then the rate calculated is said it be single blanket rate (Saltelli, Chan and Scott, 2008).

In the question, we are asked to calculate the cost per unit using the single blanket rate. The formula for calculating the single overhead rate is budgeted cost divided by the number of hours required for production. On calculating on the basis of labour hours we have found out that the manufacturing rate is 48/product unit. This means that for Fred it costs $96 (48*2) as he took two hours to complete one unit whereas for Martha it costs $144 (48*3) as it took three hours for him to complete one unit.  

PARTICULARS	FRED	MARTHA
Production units	1000	5000
Direct materials	40	60
Direct labours	30	45
Manufacturing overheads	96	144
Total Cost Per Unit	166	249
Total Manufacturing Costs	$8,16,000
Total Hours Required	17000 hours
(1000 units of Fred *2 + 5000 units of Martha*3 hours)
Manufacturing Overhead Per Hour =	Total Manufacturing Costs
Total Hours
Manufacturing Overhead Per Hour =	816000
17000

Activity-Based Costing

In this question, we have been asked to calculate the cost involved in the cost activity based on different cost drivers. The word “cost activity” is a technical term used in cost accounting which can be explained as different types of activities that are involved in the manufacturing process. The cost activities together form a cost pool. Although these cost are not directly attributable to the product still they form a part of the cost. The other word used “cost driver” is a factor on which the cost of a activity is dependent (Taylor, 2008).

Following is the table that shows the rate of each activity as per the cost driver. For example, the expenses related to machine are $450000 which is divided by the budgeted cost driver of 9000 hours resulting in the rate of absorption $50/ machine hour. In the given table the rate of absorption has been calculated based on their respective cost drivers.

ACTIVITY	COST($)	COST DRIVER	Budgeted Level	RATE ($)
Machine Related Costs	450000	Machine hours	9000 hours	50/hour
Setup & Inspection	180000	Number of production runs	40 runs	4500/run
Engineering	90000	Engineering change orders	100 change orders	900/order
Plant Related Costs	96000	Square footage of space	1920 sq. ft.	50/sq.ft
TOTAL	816000

There is basically two approaches- conventional approach and activity based costing. The activity based costing is a practical as well as a logical approach in which the overhead is allocated in a more logical manner i.e. on the basis of the actual usage (Clarke and Clarke, 1990). This approach is adopted by the business having large scale of operations in which the there are a huge number of machineries and equipments used. Using a single blanket rate, is however very illogical as it does no determine the true overhead that should be allocated rather overhead is allocated on the basis of a one particular overhead rate. Therefore, the overhead allocated according to the single blanket rate is usually wrong. There is a direct relationship between the products and the activities undertaken and so the overhead calculated based on this approach is said to be appropriate. Hence, we can conclude that activity based costing is less arbitrary when compared to the conventional approach. As explained above, the activity based costing is used in the large businesses because there is a requirement of calculating true cost and also the proper classification of the cost has to be known (Fairhurst, 2015).

The price per unit of Fred was $199.20 whereas the price per unit of Martha was $298.8 when the firm was pricing its product @ 120% of the total manufacturing cost i.e. when it was selling its products at a margin of 20%. Earlier, the cost was calculated based on the conventional approach but after calculating the cost as per activity based costing, the product cost will be as follows (it will still price it product @120% of the manufacturing cost) (Galbraith, Downey and Kates, 2002)-

Product Cost Calculation using ABC Costing

Price per unit of Fred = 120%*504.30= $605.16 per unit.

Price per unit of Martha= 120%*181.34= $217.60 per unit.

After this calculation is made , it has been observed that the profit of Fred has increased from $33.20 per unit to $100.86 per unit whereas the profit of Martha has fallen from $49.80 per unit to $36.28 per unit on adopting the ABC approach.

According to the conventional approach of costing, the overhead is allocated on the basis of the volume of production. These may be dependent on the volume of the production hours or even the machine hours consumed. Let us consider an example to understand this better, suppose there is a small manufacture whose volume of production is a little low but there is a huge expenditure of engineering cost, inspection cost, setup cost etc. If the manufacturer directly allocates the overhead on the basis of production hours then the result derived from it may be not reliable and may mislead them (Galbraith, Downey and Kates, 2002). This approach is usually adopted by the manufacturers whose scale of operations is simple and there are very less number of activities in which it is engaged. In such a situation where there is no complexity, a manufacturer may use the single blanket overhead rate for valuation. In case the manufacture is engaged in a number of complex activities, then it should not go for conventional approach rather separate cost drivers is developed in order to carry out proper valuation. If the overhead rate is wrongly charged from the customer then there may be arise in price which could harm the business, therefore the decision of the management in regards to selection of the method should be taken very carefully (TULSIAN, 2016). The conventional approach prevents the true and fair presentation of cost of resource consumed by the final product.

Conventional approach splits the total cost in two categories i.e. fixed cost as well as variable cost  which is not considered realistic in the case when the business grows. This approach is not favourable for the manufacturing sectors as the valuation done by them is based on the degree of completion (Holland and Torregrosa, 2008).

• The activity based costing system helps the company to know its position to earn the maximum margin of profit that it can earn. This analysis helps to determine the profits that could be earned on the basis of different product lines, cost of the product and the whole subsidiaries (Khan and Jain, 2014).
• The activity based costing helps to evaluate and identify all the cost that will be incurred if the firm takes the decision of in-house manufacturing. Therefore, it enables to compare between the manufacturing and outsourcing and helps to take a decision that would prove to be reasonable.
• The segregation of the overhead at the plant wide level is considered to be better than the cost of production between the different facilities.
• All the cost incurred in the manufacturing process forms a part of the product cost, some cost that are abnormal in nature also forms a part of the product cost such as customer service cost, handling cost and others (Reilly and Brown, 2012). These cost are then properly identified using the ABC approach and then it is seen whether the customers are paying them sufficient profits.
• The activity based costing enables a comparability between the cost incurred at industry standards and the cost incurred individually by the firms. This helps the company to have clear knowledge of the cost that is being incurred and the ways to reduce the wasteful cost (Reilly and Brown, 2012).

The above advantages provide enough proof to say that the activity based costing is more logical and reliable than the conventional approach. There are also certain limitations of the activity based costing. They are-

1. There are a large number of cost pools used in this approach and therefore there is a huge cost incurred in managing these cost pools. Therefore, we can say that although this system has various advantages, it also expensive at the same time.
2. There Isa difficulty in the installation of the activity based costing system because the system has to be installed across all the product lines and the facilities. The installation requires an involvement of huge time which makes difficult for the company to gain management support as well as budgetary support.
3. Activity based costing requires many relevant information from the various departments of the company. As we know, the company has a large number of departments therefore it becomes difficult to collect the input data.
4. ABC follows the project basis which means that the information is collected only once and the such information is not used by any other operational situation other than the current operational situation. Therefore, the ABC is used once and then it is discarded.
5. It is a normal practise among the employees to report that the time spent on any particular activity is equal to 100% of the time they have worked. But we all know that they do not work 100% because there is a good idle time involved in it as well, for example- lunch time, gossiping with the other employees, administrative meetings, internet surfing and many more. In such a situation , the time for which they have not actually worked also gets involved in the total time spent on an activity.

Therefore, we can draw a conclusion that even though ABC system has many advantage it also has certain disadvantages. Now, it totally depends on the scale of operations as well as the nature of business to decide the compliance of various standards and principles. It is however important for every company whether small or large to give a clear picture of the costs and to charge a correct price from the customers as they are considered as the king of the business and no business can survive in the long run without their support.

References

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