Overhead Allocation and Departmental Rates

Overhead Allocation: Departmental Rate

Introduction

• Blanket Rate: A single overhead absorption rate is used throughout the entire organization, irrespective of the product or department. It is also called Overhead Absorption Rate (OAR).

  • $OAR = \frac{Manufacturing \space Overhead}{Total \space Allocation \space Base}$

  • The allocation base varies across organizations and departments. Common bases include units sold/produced, labor hours, machine hours, and sales value. The choice of allocation base should reflect the factor that drives overhead costs.

  • Example: If total manufacturing overhead is $500,000$ and total labor hours are 25,000, the blanket OAR is \frac{500,000}{25,000} = $20 per labor hour.

• Drawbacks of Blanket Rate:

  • It can lead to incorrect planning, profit, revenue, and selling price because it does not account for the specific resources used by different products or departments.

  • It is an inaccurate method of unit cost calculation, potentially leading to a planning disaster and failure of management accounting. This inaccuracy arises from the assumption that all products consume overhead resources in the same proportion as the allocation base.

  • The purpose of management accounting is to collect and analyze relevant data to help managers in decision-making. Blanket rates undermine this purpose by providing misleading cost information.

Departmental Rate

• Departmental rate is used to allocate overhead costs focusing on departmental rate, allocation, and reallocation. This method recognizes that different departments incur different overhead costs and use resources differently.

• It helps to understand the concept of operating and service departments in an organization, which is crucial for accurate cost allocation.

• It helps to calculate the unit costs, using departmental rates to absorb overheads. This provides a more accurate cost per unit compared to blanket rates.

• It helps to understand the implications of using departmental rates, including the need for detailed departmental cost information and the potential for more accurate decision-making.

Direct vs. Indirect Costs

• Direct Costs: Related to a particular cost object and can be traced to it in a cost-effective way. Examples include direct materials and direct labor.

• Indirect Costs: Cannot be traced directly and are allocated to the cost object using a cost allocation method with allocation bases. Examples include rent, utilities, and administrative costs.

  • Cost allocation is the process of assigning costs to cost objects using surrogate measures. The choice of allocation base should reflect the factor that drives the indirect costs.

  • The distinction between direct and indirect costs depends on the cost object. A cost that is direct for one cost object may be indirect for another.

Cost Allocation

• Cost Object: Any item for which cost is measured, such as a product, department, or project.

  • Direct Cost: Cost Tracing (assigning direct costs to the cost object)

  • Indirect Cost: Cost Allocation (distributing indirect costs to the cost object using an allocation base)

• Total indirect costs are calculated and then allocated to cost centers. Cost centers are specific areas within an organization to which costs are assigned.

Organizational Costs

• Production Cost: DM (Direct Materials) + DL (Direct Labor) + MOH (Manufacturing Overhead)

• Manufacturing Cost: All costs incurred in the manufacturing process, including direct materials, direct labor, and manufacturing overhead.

• Non-manufacturing Cost: Selling + Marketing + Admin. Costs not directly related to the production process.

• Product Cost: Costs associated with the production of goods. These costs are inventoried until the product is sold.

• Period Cost: Costs that are expensed in the period in which they are incurred, such as selling, marketing, and administrative expenses.

• Costing Methods:

  • Absorption Costing: A method of costing that includes all manufacturing costs (direct materials, direct labor, variable overhead, and fixed overhead) in the cost of a product.

  • Marginal Costing: A method of costing that includes only variable costs (direct materials, direct labor, and variable overhead) in the cost of a product.

  • Job Order Costing: A costing method used when producing unique or custom-made products.

  • Process Costing: A costing method used when producing large quantities of homogeneous products.

  • Blanket Rate, Departmental Rate, Activity-Based Costing (ABC Method).

Departmental Rate: A Better Solution

• Blanket rate is like ‘one size fits all’, making people unhappy in the organization because it does not accurately reflect the resources consumed by different departments or products.

• Departmental rate proposes as many rates as there are departments. This allows for a more accurate allocation of overhead costs.

• Rates are customized across the organization, making it more representative of the actual costs incurred in each department.

Types of Departments

• Operating Departments: Units where the central purposes of an organization are carried out. These departments directly contribute to the creation of goods or services.

  • Examples: surgery department in a hospital, dying department in a readymade garment company, assembling department in a car company, etc.

• Service Departments: Units that provide services to the operating departments and do not directly participate in the operating activities of an organization. These departments support the operating departments.

  • Examples: cafeteria, personnel, purchasing, cost accounting, etc.

Overall Allocation Method

• Service departments complicate the allocation, making it a two-stage process. This is because service departments provide services to other departments, and their costs need to be allocated accordingly.

  • Stage 1: Service department OH (Overhead) costs are allocated to operating departments (Apportion). This allocation is typically based on some measure of service usage, such as labor hours or square footage.

  • Stage 2: OH costs are applied to the cost object, i.e., product. The overhead costs, now including the allocated service department costs, are applied to the products using a departmental overhead rate.

Interdepartmental Services

• Some service departments serve other service departments along with the operating departments. This creates a reciprocal relationship.

• This situation is called interdepartmental or reciprocal services. It requires a more complex allocation method to accurately distribute costs.

• Example: Cafeteria, HR department, Greenwich Business School. The cafeteria provides services to both the HR department and other operating departments, while the HR department provides services to the cafeteria and other departments.

Summary of Departmental OH Allocation

• Production Cost includes Direct Cost and Indirect Cost. Unit Cost includes Production A, Production B, and Service C.

• Direct Cost: Direct assignment to cost objects.

• Indirect Cost: Allocation to cost centers using appropriate allocation bases.

• Reallocation of service department cost and absorbing into the unit, resulting in a more accurate unit cost.

Case Study: Raj & Nikita Inc.

• Raj & Nikita Inc. produces two products – P12 and P34.

• Both products are produced 1,000 units each with a total of 1,000 labor hours.

• Two departments, D1 and D2, with a total overhead cost of £20,000.

• Overhead costs divided into building related (£10,000), plant related (£3,000), and employee related (£7,000).

• P12 is produced at D1, and P34 is at D2.

• Area (m2): D1 - 5,000, D2 - 3,000, Total - 8,000

• Plant value (£m): D1 - 3, D2 - 4, Total - 7

• No of employees: D1 - 45, D2 - 35, Total - 80
  

  Direct materials cost for P12 is £10 and £5 for P34.
  

  Direct labor cost for P12 is £4 and £1 for P34.
  

  P12 uses 0.8 labor hours per unit and P34 uses 0.2 hours.

Requirements

• Calculate the product cost per unit using the departmental rate of OH cost allocation. This involves allocating overhead costs to each department and then to each product.

• Scenarios:

  • With blanket rate: Calculate the product cost using a single overhead rate for the entire company.

  • Department rate without service department: Calculate the product cost using departmental overhead rates without considering service departments.

  • Department rate with service department: Calculate the product cost using departmental overhead rates, including the allocation of service department costs to operating departments.

Blanket Rate Calculation

• $OAR = \frac{∑ Manufacturing \space Overhead}{∑ Allocation \space Base} = \frac{£20,000}{1,000 \space h} = £20/h$

Issue with Blanket Rate

• There is one rate for both products, assuming both use overhead at the same rate. This assumption is often incorrect.

• Different products use different overhead resources. Blanket rates do not account for these differences.

• A single rate penalizes products using fewer overheads and rewards products using more overheads, leading to inaccurate cost information.

Departmental Rate Basics

• Uses as many rates as there are departments to calculate the cost. This provides a more accurate allocation of overhead costs.

• Two-step process:

  • Calculate overheads for each department. This involves identifying and allocating overhead costs to each department.

  • Absorb overheads to the product the department is producing. This involves applying the departmental overhead rate to the products based on some measure of activity, such as labor hours or machine hours.

• If there are service departments, their overhead is reallocated to operating departments before absorbing to products. This ensures that all overhead costs are ultimately allocated to the products.

Departmental Rate Calculation (Two Departments)

• Calculate the overhead for each of the overheads of D1 and D2.

Departmental Rate (Solution 2)

Departmental Rate (Solution 3)

Departmental Rate (Three Departments)

Raj & Nikita Inc. has three departments, D1, D2, and D3, with D3 being a service department.

• Calculate the product cost per unit after allocating overhead with departmental rate
  

  Cost/unit of P12 Cost/unit of P34
  

  Direct materials £10 £5
  

  Direct labor £4 £1
  

  Labour hours 0.8 hrs 0.2 hrs
  

  D1 D2 D3 Total
  

  Area (m2) 5,000 3,000 2,000 10,000
  

  Plant value (£m) 3 4 1 8
  

  No of employees 45 35 20 100

Solution

• If there is a service department, their overhead cost needs to be transferred to the production department to calculate product/production cost per unit. This ensures that the cost of services provided to the production departments is included in the product cost.

• overhead cost from D3 will be reapportioned to D1 and D2 based on some allocation base, such as labor hours or square footage.

Solution 2 Apportioning

Workings:

Total allocation base excluding service department = 3m+4m = 7m;

OH/unit = 3,775.00/7000000 = £0.000539.

This rate is applied to calculate the share of D3 overheard for D1 and D2.

Share of D1 = 30000000.000539 = £1617.86 Share of D2 = 40000000.000539 = £2,157.14

Solution 3 and 4

Comparison of All Scenarios

Issues with Departmental Rate

• Use of direct labor hours to absorb the overhead may not be accurate if departments are not labor intensive. In such cases, machine hours or other activity measures may be more appropriate.

• Blanket and departmental overhead rates are traditional methods and may not reflect the complexities of modern manufacturing environments.

• Johnson and Kaplan (1987) stated that the way costs are allocated has not changed much, ignoring the changed economic environment. This suggests that traditional methods may not be keeping pace with changes in technology and business practices.

• Using direct labor and machine hours to allocate costs can result in distorted costs, especially in highly automated environments where direct labor is a small portion of total costs.

Issues with Departmental Rate (2/2)

• Otley (2001): Distorted costs result in decisions being based on wrong information. This can lead to suboptimal pricing, production, and investment decisions.

• In modern corporate environments, overheads are no longer linked to direct labor hours. Automation, technology, and other factors have changed the relationship between overhead costs and direct labor.

• Incorrect costing methods can result in departments being allocated costs they have no control over. This can create resentment and discourage cost reduction efforts.

• Incorrect cost allocation can result in companies not competing effectively because they may be mispricing their products or making poor decisions about resource allocation.

Departmental Rate and Contemporary Business World

• Modern corporate environments have resulted in more customer orientation and marketing costs. Companies are increasingly focused on meeting customer needs and building brand awareness.

• Global competition has increased advertising costs. Companies are spending more on advertising to compete in global markets.

• The manufacturing sector has reduced in size compared to the service sector. This shift has implications for cost accounting, as service companies often have different cost structures than manufacturing companies.

• There are now a number of factors that drive costs, including technology, innovation, and customer service.

Activity Based Costing (ABC)

• ABC only allocates costs that are directly related to the unit. This provides a more accurate picture of the costs associated with each product or service.

• Uses different cost drivers to absorb different overheads to individual