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Overheads
Aggregate of indirect materials, indirect labour and indirect expenses. Classification of Overheads : Functional Classification :
Manufacturing / factory / works / production Administration / general / office Selling and Distribution
Element-wise Classification :
Indirect materials Indirect Labour Indirect Expenses
Incidence-wise Classification :
Direct / relatable / allocable Indirect / general / common
Controllability :
Normal / Controllable Abnormal / non-controllable
Labour Hour Rate Useful only if labour is the most important element of job
Amount of overheads to be absorbed Labour hours required for production
Machine Hour Rate Useful only if machine use account for a large element of cost in overall production cost.
Amount of overheads to be absorbed Number of Machine Hours
Therefore least cost distortion among products because indirect costs are allocated to the products based on the
Type of activities used by the product and The extent to which the activity is used.
ABC System
1. Identify activities 2. Estimate the total indirect costs associated with each activity 3. Identify the allocation base for each activitys indirect costs primary cost driver 4. Estimate the total quantity of each allocation base 5. Compute the cost allocation rate for each activity i.e.
ABC System
Estimated total indirect cost of activity Rate = -------------------------------------------------------------------Estimated total quantity of cost allocation base
6. Obtain the actual quantity of each allocation base used by the cost object 7. Allocate the costs to each cost
Allocated activity cost = Activity cost allocation rate x Actual quantity of cost allocation base used by the cost object
Example
Chemtech is a chemical development and manufacturing firm. Most of the chemicals the company develops are licensed and sold to other manufacturers. However Chemtechs chemical manufacturing dept continues to produce two types of chemicals : Common chemical (Aldehyde) used for producing plastics and a specialty chemical (Phenylephrine Hydrochloride) used in a blood-pressure medication. Chemtech produces mass quantities of the common chemical for large customers. It produces small batches of the specialty chemical for only one customer (a pharmaceutical company). Last updated several years ago, the Chemical Manufacturing depts cost system uses a single plantwide overhead rate that allocates manufacturing overhead (5 mio for a year) at 200% of direct labour cost.
Because of the profitability of specialty chemical, the CEO wonders whether Chemtech should switch its focus to specialty chemical. However the production supervisor says that it takes no more time to mix a large batch of common chemical than it does to mix a small batch of the specialty chemical. The CEO is also puzzled because Chemtechs competitors seems to be earning good profits. He want to better understand manufacturing overhead what drives it and how it should be allocated.
ABC Example
Step 1 Identify activities The team identifies three primary activities in the Chemical Manufacturing Dept. Mixing Processing Testing Total 8,25,000 - 38,00,000 - 3,75,000 - 50,00,000