Overhead and Everywhere Ian Janes looks at techniques used to account for overhead expenditure and stresses the increased depth of the topic as you move through the management accounting papers of BA2, P1 and P2. As you approach and enter your place of work or your college, it may not be instantly obvious but with a little thought you ll realise that overhead expenditure (overheads) is just about everywhere. The building itself may be rented, the organisation would probably have to pay a form of business rates to local government and that is before you step inside the door! Once inside, you may meet a receptionist at the front desk, or a porter or caretaker, and a little further on you may see a coffee bar or a refectory. Of course, these are just a few examples of the many types of overheads incurred by an organisation. Overheads are, in this illustration, a form of expenditure not directly connected with the product (good or service) being provided i.e. indirect, but which nonetheless must be accounted for in arriving at the full cost for a unit of that product. Taking a wider view, it is important to more formally distinguish between direct costs, "costs that can be specifically and exclusively identified with a particular cost object" and indirect costs, which, cannot be identified specifically and exclusively with a given cost object (Drury p24, 2012). Crucial to these definitions is the notion of a cost object, which often in exam questions we assume to be a unit of a good or service, but which can be a department or geographical area or indeed anything for which one wants to measure the cost of resources used (Drury p23, 2012).
BA2 This is seen first in your CIMA studies in the Certificate in Business Accounting BA2 paper, Fundamentals of Management Accounting (Learning Outcome Cost identification and behaviour : Calculate direct, variable and full costs of products, services and activities using overhead absorption rates to trace indirect costs to cost units. Let s look at a typical example to illustrate the fundamental principles. The following information is given for Dee Co, which has one department, machining: Budget Machining Department Production overheads $180,000 Machine hours 45,000 Direct labour hours 7,500 Actual results Production overheads $175,000 Machine hours 42,500 Direct labour hours 8,000 One product, the Exe, has a direct cost totalling $15 per unit, and each unit requires 2 machine hours and 3 labour hours. So before production commences, and perhaps before a price is set, Dee Co would like to know the full cost of a unit of Exe. Firstly, we need to determine an overhead absorption rate (OAR) for the department. The general form for doing so is to divide the budgeted overhead by the budgeted activity for the department or cost centre. Budgeted OAR = Budgeted Overhead Budgeted Activity Level Then, given that we are talking about a machining department, using machine hours as the basis for absorption will be the most appropriate.
Budgeted OAR = $180,000 45,000 machine hours = $4 per machine hour This enables Dee Co to obtain its budgeted full cost per unit of Exe: Direct cost 15 Overhead (2 hours x $4 per machine hour) 8 Full cost 23 Of course, the OAR is based upon budgeted figures. The actual level of machine hours worked and the actual overheads may well differ from those budgeted. Where this is the case, the over/under absorption of overheads will occur and this is commonly tested in the C01 computer based examination. So for Dee Co; Actual overhead 175,000 Absorbed overhead 42,500 actual machine hours x $4 per machine hour = 170,000 Therefore overhead has been under absorbed by (5,000) There are two reasons for this. Less machine hours have been worked than expected, 2,500, which has caused under absorption of 2,500 x $4 = $10,000. This is partially offset by the fact that actual overhead is $5,000 less than expected. In summary: Under absorption due to less hours worked (10,000) Over absorption due to less than budgeted overhead 5,000 Under absorption (5,000) $ $ $ P1 Be aware that fundamentals in management accounting, such as accounting for overheads, don t end with the BA2 examination. Rather, the knowledge is built upon in future papers.
It is vitally important to see the syllabus as a whole, knowledge gained in BA2 will be used in P1 Performance Operations, and similarly, knowledge gained in BA2 and P1 will be used in P2 Performance Management. Do not think that once you have passed a paper, you can forget what has gone before!. Similarly, where an exemption has been granted from Certificate in Business Accounting papers such as BA2, students must be aware that a number of areas including Accounting For Overheads, Standard Costing, Variance Analysis and Budgeting may all be retested. To paraphrase one examiner at a Teachers Conference; Having an exemption means that the student is exempt from the examination, not exempt from the knowledge. Let s look at an example, in the P1 November 2010 exam, Question 3 Part (a) illustrates the fundamental principle of using a blanket overhead absorption rate (covered in BA2) whilst Part (b) covers Activity Based Costing (of which a detailed knowledge is not required in BA2 but most certainly are in P1). See, Learning Outcome A Cost Accounting Systems : discuss activity-based costing as compared with traditional marginal and absorption costing methods, including its relative advantages and disadvantages as a system of cost accounting; NB: This question also illustrates that the Section C questions in P1 aren t always on Standard Costing and Investment Appraisal respectively! A healthcare company specialises in hip, knee and shoulder replacement operations, known as surgical procedures. As well as providing these surgical procedures the company offers pre operation and post operation in-patient care, in a fully equipped hospital, for those patients who will be undergoing the surgical procedures. Surgeons are paid a fixed fee for each surgical procedure they perform and an additional amount for any follow-up consultations. Post procedure follow-up consultations are only undertaken if there are any complications in relation to the surgical procedure. There is no additional fee charged to patients for any follow up consultations. All other staff are paid annual salaries. The company s existing costing system uses a single overhead rate, based on revenue, to charge the costs of support activities to the procedures. Concern has been raised about the inaccuracy of procedure costs and the company s accountant has initiated a project to implement an activity-based costing (ABC) system. The project team has collected the following data on each of the procedures.
Procedure Information Fee charged to patients per procedure Number of procedures per annum Average time per procedure Number of procedures per theatre session In-patient days per procedure Surgeon s fee per procedure % of procedures with complications Surgeon s fee per follow up consultation Cost of medical supplies per procedure Hip Knee Shoulder $8,000 $10,000 $6,000 600 800 400 2.0 hours 1.2 hours 1.5 hours 2 1 4 3 2 1 $1,200 $1,800 $1,500 8% 5% 10% $300 $300 $300 $400 $200 $300 The project team has obtained the following information about the support activities. Activity Cost Driver Overheads $000 Theatre preparation for each session Number of theatre preparations 864 Operating theatre usage Procedure time 1,449 Nursing and ancillary services In-patient days 5,428 Administration Sales revenue 1,216 Other overheads Number of procedures 923 Total 9,880 Part (a) asked you to calculate the profit per procedure for each of the three procedures, using the current basis for charging the costs of support activities to procedures. The current basis being a single overhead rate, based on revenue. i.e. Budgeted OAR = Budgeted Overhead Budgeted Sales Revenue
Budgeted OAR = $9,880,000 $[(8,000 x 600) + (10,000 x 800) + (6,000 x 400)] = $9,880,000 $15,200,000 = $0.65 per $1 of revenue Therefore for a hip procedure the cost can be shown as follows: Surgeon s fee 1,200 Surgeon s fee for follow up procedure (8% x $300) 24 Medical supplies 400 Overhead cost ($8,000 x 0.65) 5,200 Cost of hip procedure under blanket OAR 6,824 When this is compared to the revenue from a hip procedure of $8,000, it gives a profit of $1,176. Now work out the cost of the other two procedures using this method and work out their respective profits per procedure; check your answer against past Q&As available in MY CIMA. Part (b) of the question is where we really move into P1 territory, namely the nuts and bolts operation of an ABC system. The idea here (first proposed by Kaplan and Cooper in the Harvard Business Review in 1988) is that traditional blanket overhead absorption is too simple for modern manufacturing environments, leading to inaccurate costing, and that overheads need to be broken down into pools according to how they are driven. In other words, not all types of overhead expenditure are driven in the same way, to assume so leads to inaccurate unit costs. But it s not just manufacturing environments which experience this problem. In fact, it could be argued that it is in service environments, where overheads are often a greater proportion of total costs, that ABC is needed even more. It is in a service environment, namely that of healthcare, which is used to illustrate this development in this past paper question. In examination questions such as this, the cost pools are usually clear for you to see and here we have five, all driven in different stated ways. The first of these pools covers theatre preparation activity. Note the similarity to the Budgeted OAR formula when we say: $
Cost driver rate for theatre preparation = Overhead attributable to theatre preparation Number of theatre preparations = $864,000 (600/2) + (800/1) + (400/4)* [*note that if there are 2 procedures per theatre session, 600 procedures needs 300 preparations and so on] = $864,000 1,200 preparations = $720 per theatre preparation This means that each Hip procedure would be charged with $360 since 2 procedures can be performed per session. The second pool is operating theatre usage; Cost driver rate for operating theatre usage = $1,449,000 (600x2) + (800x1.2) + (400x1.5) = $1,449,000 2,760 hours = $525 per hour It s really important for examination technique that you show workings such as this, and express the cost driver rate in full e.g. per theatre preparation or per hour. Performing these calculations for the other three pools gives us: Nursing and ancillary services Administration Other overheads $5,428,000 (3x600) + (2x800) + (1x400) $1,216,000 $15,200,000* $923,000 1,800 procedures = $5,428,000 3,800 days *see earlier calculation of total revenue = $513 per procedure
= $0.08 per $1 of revenue = $1,428 per in-patient day We can now use the five cost driver rates to complete the computation of the overhead cost per Hip procedure: $ Theatre preparation per session Operating theatre usage Nursing and ancillary services Administration Other overheads Total overhead cost per procedure $720 / 2 (as above) $525 x 2 hours of procedure time $1,428 x 3 in-patient days $0.08 x $8,000 fee charged per procedure $513 per procedure 360 1,050 4,284 640 513 6,847 Of course, the direct costs of a procedure which we showed earlier remain the same. Therefore, the full cost of a Hip procedure under ABC is: Surgeon s fee 1,200 Surgeon s fee for follow up procedure (8% x $300) 24 Medical supplies 400 Overhead cost ($8,000 x 0.65) 6,847 Cost of hip procedure under ABC 8,471 If we compare this cost to the fee charged to patients of $8,000, it shows that there is a loss per procedure of $471. Earlier we thought that there was a profit on each procedure of $1,176. Now work out the cost of the other two procedures using the ABC method and work out the revised profit (or loss) per procedure; check your answer against the past Q&A in MY CIMA. The sort of information provided by these calculations can assist management in the running of the business. For instance, in our example above, it would seem that the fee charged to patients for a hip procedure would need to be raised to generate a profit from the procedure. It is also important to understand the reasons why there are such differences in the overhead costs of each procedure. We can see from our calculations that a Hip procedure gets charged with more overhead under ABC, $6,847, than it was under the single overhead rate, $5,200. This contrasts with the knee procedure which gets charged with $5,519 under ABC, but $6,500 under the single overhead rate. $
This change is explained by the way in which the respective procedures make use of the activities. For example, the hip procedure needs 3 in-patient days (at $1,428 per day) compared to 2 days for a knee procedure, which clearly has a significant impact. Other similar comparisons can be performed, but the important general point is that the overhead is now not being driven solely by the revenue from each procedure, which results in the knee procedure getting charged more overhead than a hip procedure, rather it is being driven by each procedure s use of activities, which results in the reverse effect. What you re actually doing by performing this sort of analysis is a form of Strategic Activity Based Management which can be described as doing the right things. By using the ABC information, management can decide which products to develop and which activities to use. It can focus on profitability analysis, identifying which products (in the case of the healthcare company) and / or customers are the most profitable and for which sales volume should be developed. P2 Activity Based Management (ABM) is a concept that you are more likely to encounter in detail in P2 notably listed under; Learning Outcome B Cost planning and analysis for competitive advantage apply the techniques of activity-based management in identifying cost drivers/activities More formally, CIMA s Official Terminology defines Strategic ABM as; actions based on activity-based analysis, that aim to change the demand for activities so as to improve profitability. Or as stated earlier, doing the right things. Whereas Operational ABM is defined as; actions based on activity driver analysis, that increase efficiency, lower costs and improve asset utilisation, In other words, operational ABM is more a case of doing things right;. For the purposes of your P2 examination, ABM generally acts as a collective term for a number of techniques which can be used to gain competitive advantage. They include: Direct Product Profitability, which focuses on key products; Cost reduction, which focuses on key activities and; Customer Profitability Analysis, which focuses on, you ve guessed it, key customers. Although activity based management sounds like a new concept, you are in fact applying principles learnt earlier in your studies which are used in order to improve the management of performance in the business. So, once again, remember, just because you have passed or are exempt from an earlier paper, the knowledge you have (or are deemed to have) is still relevant as you move up the Management Accounting Performance Pillar; you need to carry that knowledge from C01 and P1 with you into P2. The P2 examination in September 2010 contained an excellent illustration of the use of one of the ABM techniques, Customer Profitability Analysis:
ST is a distribution company which buys a product in bulk from manufacturers, repackages the product into smaller packs and then sells the packs to retail customers. ST s customers vary in size and consequently the size and frequency of their orders also varies. Some customers order large quantities from ST each time they place an order. Other customers order only a few packs each time. The current accounting system of ST produces very basic management information that reports only the overall company profit. ST is therefore unaware of the costs of servicing individual customers. However, the company has now decided to investigate the use of Direct Customer Profitability Analysis (DCPA). ST would like to see the results from a small sample of customers before it decides whether to fully introduce DCPA. The information for two customers, and for the whole company, for the previous period was as follows: Customer Customer Company B D Factory contribution ($000) 75 40.5 450 Number of: Packs sold (000) 50 27 300 Sales visits to customers 24 12 200 Orders placed by customers 75 20 700 Normal deliveries to customers 45 15 240 Urgent deliveries to customers 5 0 30 Activity costs: $000s Sales visits to customers 50 Processing orders placed by customers 70 Normal deliveries to customers 120 Urgent deliveries to customers 60 In your C01 studies the costs provided above would have been bundled together into one pot of $300,000 of overhead expenditure, absorbed on a blanket basis like so: OAR = $300,000 300,000 packs sold OAR = $1 per pack Therefore customer B would absorb $50,000 of the overhead, and customer D $27,000. Armed with your ABC knowledge from P1 and now applying it to the ABM concepts learnt in P2, you can provide a different analysis by looking at the four different types of overhead and using the four different types of cost driver to calculate four cost driver rates: Sales visits to customers = $50,000 = $250 per visit 200 visits
Processing orders placed by customer Normal deliveries to customers Urgent deliveries to customers = $70,000 = $100 per order 700 orders = $120,000 = $500 per delivery 240 deliveries = $60,000 = $2,000 per urgent delivery 30 urgent deliveries Remember to continue to practice good examination technique by showing these cost driver rates, and then use them to obtain a measure of the profitability of each customer Costs Customer B D $000 $000 Sales visits ($250 x 24) 6.0 ($250 x 12) 3.0 Processing orders($100 x 75) 7.5 ($100 x 20) 2.0 Normal deliveries ($500 x 45) 22.5 ($500 x 15) 7.5 Urgent deliveries ($2,000 x 5) 10.0 ($2,000 x 0) 0 46.0 12.5 Contribution 75.0 40.5 Profit 29.0 28.0 You can see now that the overhead attributed to customer B ($46,000) is not substantially different from that under blanket absorption ($50,000) but for customer D it is ($12,500 under ABC, compared to $27,000 previously). Given that the customers appear to be profitable and there appears to be no immediate consideration to cease supplying them, such information can assist management to take better operational decisions and improve profitability. Looking more specifically at the results, we may wish to consider why the profit from each customer is similar, yet the contribution from customer B is almost double that of D. Of course, the difference is the level of overhead attributed to each customer. ST s management may wish to investigate why B generates three times the number of normal deliveries (and therefore three times the cost of this activity) compared to Customer D, yet it
generates less than double the factory contribution. This may indicate that Customer B is one of the customers that places many small orders, rather than a few large ones. This would be a prompt for ST to attempt to improve profits by encouraging (incentivising) Customer B to make fewer, but larger, orders. Similarly, why does customer B require 5 urgent deliveries ($2,000 per occurrence, total $10,000) whereas customer D doesn t? Management may wish to investigate how the supplier / customer interaction and communication can be improved so as to avoid urgent deliveries. In other words, what we have here is a good illustration of Operational ABM, i.e. what we called earlier doing things right. Those activities which add value to the service given to the customer can be identified and improved. Activities that do not add value should be reduced in order to cut costs without reducing the customer experience. Where, for example, customers are placing urgent deliveries, we should ascertain the reasons why and reduce the instances of this happening. Similarly every effort should be made to find ways of reducing the cost of activities such as the cost of normal deliveries. Conclusion So from blanket OARs in C01 to a discussion of both strategic and operational management issues in P1 and P2, hopefully you can now see that a sound understanding of accounting for overheads is absolutely essential if you are to conquer the management accounting pillar. Overheads really are everywhere, both in your syllabus and in the world around you. To summarise, we have moved from calculating and using OARs to showing how the idea of absorbing and attributing overheads should be a more sophisticated exercise where the existence of such overheads is so prevalent and the causes of them so varied. Indeed, it s been shown that applying this idea through ABM can lead to better business decision making and management of performance. Ian Janes is CIMA Course Leader at Newport Business School. Reference Drury, C. (2012) Management and Cost Accounting (8 th Edition), Cengage Learning Kaplan Official Study Texts (2016) BA2 Fundamental of Management Accounting, P1 Performance Operations and P2 Performance Management