What’s is all about?
How we decide how much to include in the costs when we have decided that the Factory Overheads are part of the cost of making units.
The bases for absorbing overheads.
Anything that can’t be directly allocated (because it doesn’t belong in just one place) needs to be ‘absorbed’ using some ‘base’ that allows you to share it fairly (that’s what we will argue anyway) across the various departments.
Essentially, you take the overhead of that category for the Factory as a whole and divide it by some measure that applies to all of the departments that are likely to have contributed to the overhead arising in the first place.
A really standard one would be to take the Rent and Rates (£15,000 in the question below) and divide it by the total number of square metres (1,000 + 5,000).
£15,000/ 6,000 = £2.50/square metre.
Type Set will get 1,000 x £2.50 = £2,500 and Printing will get 5,000 x £2.50 = £12,500 so absorbing the total of £15,000 between them.
Usually in a question it is pretty obvious how the examiner expects you to decide to absorb overheads. The ‘base’ to use is usually clear.
I like this question from a colleague of mine (Barry McCarthy) as it offers alternatives for absorbing overheads. In that regard it is much more like reality than most exam or seminar questions.
How would you absorb the Manager’s salary?
You could do it on the number of employees (preferred answer), but you could have done it on the number of Direct Labour hours as an alternative. How about equally across the two Departments?
The same could be said of the Secretary’s salary. does the secretary’s time mirror that of the manager? Or does it get divided equally between the two departments as the role is administrative?
Also, take a look at the Power bill. We are told the proportion used by each department, but without that we could have used Machine Hours. That would have given a different ratio.
What this shows is there is no absolute list of bases for you to memorise. the golden rule would be when we don’t know, look for the simplest base to use. In reality, you might absorb on the basis of something completely different.
There will be blood….
In reality, whatever base you use is likely to be challenged by Departmental Managers. They will think of better ways for you to do it. better because it reduces their overhead charge and increases their chances of meeting targets. That’s just one of the ‘behavioural aspects of budgeting’. The trick is to either 1) have a method that is apparently fair and difficult to argue against or 2) be a dictator. I always like the idea of loading the overhead onto the Departmental Manager who annoys me most, but it can be a bit difficult to hide that one!
I wished I’d kept the email trail….
A true story from my university. The cost of classrooms is charged to teaching departments on the basis of the size of the room. Departments are not truly different as in a factory, because they all do the same thing – teach. We can leave the argument about the pointlessness of overhead charging on this basis for another time.
Suffice to say, departments and eventually courses get charged on the basis of the number and size of the rooms that they use. Rooms are charged on the number of chairs they hold instead of square metres and this sounds a sensible way as each chair theoretically = a student.
I said there would be blood. One Course Director who will remain nameless, but only because I can’t remember his name wanted to keep control of the overheads being charged to his course.
He pointed out that for three weeks there were three chairs fewer in his teaching room than there should have been and that, therefore, he had been overcharged overhead at the rate of 70p per chair per week. An argument over an overhead cost of a couple of pounds! Think of the cost of his time in writing the email, never mind, think of the cost of the time I spent reading it, net alone everyone else including the accountants who had to find a way of telling him to shut up about it.
The moral, they will argue about their overhead charge, just try to make it as hard as possible for them.
I wish I’d kept the emails.
Watch this.
(Remember, videos like these that are produced to cover whole topics may include material that isn’t relevant to your own exam at your institution. don’t get hung up on it).
Further Reading
Practice Questions
(These aren’t mine, but should be useful for you. Do remember that different teachers may use different techniques and different terms).