What’s it all about?
Techniques for ensuring that we consider the costs of running the business (indirect costs/overheads) as well as the direct costs of our products.
We generally recognise three categories of overheads.
The Factory Overhead which is all the indirect costs we incur in the place where we make the stuff.
The Sales & Distribution overhead which is the indirect costs of getting the customer and getting the product to the customer (essentially the cost of having a sales team and any delivery costs we don’t charge the customer for).
The Administration Overhead which is the cost of running the business as a whole, so that’s Head Office and any other departments we have that haven’t been covered already.
We are only considering the Factory Overhead when we worry about charging overheads to products. The other two (Admin and Sales & Distribution) are taken out as Expenses from the companies Gross Profit (we will see how later).
We will look at a number of ways of doing this, from simple but not terribly accurate to more time consuming but more accurate and therefore probably more useful.
Let’s have some data to illustrate the simplest versions.
We have worked out that the costs of running the Factory (the overheads, not the direct costs of making things) will be £22,000. We will make 10,000 tables in the year. Making all the tables will take us 5,500 Labour Hours and 11,000 Machine Hours.
What we do when we only have one product.
As we are making only one product we can use what is known as a Blanket Rate. We can use the same rate for every thing we make (the Blanket Rate) provided we make only one product or all the products we make are very similar (e.g red pens and blue pens).
So, if we have only one type of table we can divide the Factory Overhead by the number of tables to get a Factory Overhead absorbed per table.
£22,000 / 10,000 tables = £2.20 per table.
We would add this £1.50 to the Direct Costs of making a table (top, legs, labour etc.) to calculate the total cost per table.
What we do when we have more than one product.
We want to make sure that the costs we give each unit of our product in some way reflect how making that product has given us that overhead. So if our products are very different (say a big table and a small table), then doing it at the same rate for each would be inaccurate (‘unfair’).
Now we have to look for some difference between the products that we can use as an accurate way of sharing the costs.
Two very common methods (certainly in seminar and exam questions) are Labour Hours and Machine Hours.
Calculating the Labour Hour rate and the Machine Hour rate.
Simple in practice. We divide the total Factory Overhead by the total number of Labour Hours to get the Labour Hour rate.
£22,000 / 5,500 Labour Hours = £4.00 per Labour Hour.
We divide the total Factory overhead by the total number of Machine Hours to get the Machine Hour rate.
£22,000 / 11,000 Machine Hours = £2.00 per Machine Hour.
How we calculate the Factory overhead absorbed.
This is when we need to know the differences in our products. So let’s say we make two types of table. A big six legged one and a small three legged one.
The big tables take 1 Labour Hours each to make and 2 Machine Hours to make each and we make 1,000 big tables.
The small tables take 0.5 Labour Hours to make and 1 Machine Hours to make and we make 9,000 of them.
This explains our 10,000 tables (1,000 big + 9,000 small).
This explains our 5,500 Labour Hours (1,000 big tables x 1 hours + 9,000 small tables x 0.5 hour).
This explains our 11,000 Machine Hours (1,000 big tables x 2 hours + 9,000 small tables x 1 hour).
We then calculate the overhead absorbed by the tables either on a per Labour Hour basis or on a per Machine Hour basis.
I will explain why later, but it is vital that you apply the same rate to all the tables (so they will all be by Labour Hour or they will all be by Machine Hour). It is also vital that you don’t do both. For now, just obey!
A large table would be charged 1 hour at £4 = £4 if we use Labour.
A small table would be charged 0.5 hours at £4 = £2 if we use Labour.
A large table would be charged 2 hours at £2 = £4 if we use Machine.
A small table would be charged 1 hour at £2 = £2 if we use Machine.
The fact that each table gets charged the same under each method is just a quirk of this question, it won’t always be like that .. you’ll see.
How it explains the whole overhead.
1,000 large tables under Labour = 1,000 x 1 hour x £4 = £4,000.
9,000 small tables under Labour = 9,000 x 0.5 hour x £4 = £18,000.
Total £22,000 absorbed.
1,000 large tables under Machine = 1,000 x 2 hours x £2 = £4,000.
9,000 small tables under Machine = 9,000 x 1 hour x £2 = £18,000.
Total £22,000 absorbed.
Let’s compare now to the Blanket Rate
Under the blanket rate every one of the 10,000 tables, large or small, was charged £2.20 overhead.
Under Labour Hours, the large table is charged £4 and the small table £2. The whole £22,000 is still charged.
Under Machine Hours, the large table is charged £4 and the small table £2. The whole £22,000 is still charged.
You may be able to see now that if we charged for both Labour Hours and Machine Hours we would charge£22,000 twice. That’s twice as much as we actually had as a cost. Large table = 1,000 x £8 and small table = 9,000 x £4 for a total of £44,000.
Because the rates here per unit are the same which ever method you use, if we mixed the rates (e.g. large at Labour Hours and small at Machine Hours) we would get all of our money back, but that is very, very unusual. It won’t happen in our next example.
We will do calculations where it doesn’t all work out so smoothly shortly.
Labour versus investing in overheads.
There is increasing use of equipment and automation (robots!) instead of people both because it could be cheaper and also to cope with the lack of expertise available. Considering the challenges the dairy farmers face with payments for milk lower than the cost of production, it’s not surprising larger farms are automating.
Weaknesses with Traditional Overhead Allocation.
I met someone who had been involved with the rescuing of a major metal working company in the 1990s in the north of England which had come unstuck because they were applying traditional methods of overhead allocation when Activity Based Costing would have been more appropriate.
The company was probably the largest in the country at the time able to produce parts for other machines by cutting parts on lathes.
Traditionally lathes had been manually operated, the skilled factory worker setting the measurements for the precise cutting of the parts.
The factory and the expensive machines gave a considerable overhead, and the most appropriate way of sharing this across production was by the traditional method of allocation per labour hour. the more complicated a job, the longer it would take and therefore the more overhead it would accumulate.
So far, so good.
Then this factory became one of the first to invest in computer operated lathes. Now, the precise measurements could be set up more quickly and would be consistently applied. These lathes were therefore quicker to operate than the more manual ones and required less setting up.
the new lathes were very much more expensive, so as the company acquired more of them, the total overhead of the factory increased. The company continued to use Labour Hours for the calculation of overhead to be charged to jobs. As the total Factory Overhead went up, so did the rate per hour charged for overhead.
Where it all went wrong:
1. The now higher overhead absorption rate meant that the company was now comparatively expensive for the production of work that could be done on the manually operated lathes. They lost a considerable amount of work to competitors.
2. The use of Labour Hours for overhead allocation meant that the computer controlled machines had a low overhead charge, after all, the whole point of these machines was that they were quicker, more accurate and needed very little worker involvement. The company was getting large amounts of work because they were much cheaper than anyone else for computer controlled lathe work.
By applying a Labour Hours based rate, the company was now too expensive for the basic work and too cheap for the computer controlled work.
When you have read about Activity Based Costing you will see why this was the approach used to save the business.
Bearing in mind that ABC was developed in the 1970s, I asked why the company got into this problem in the first place… “Things like that didn’t get to the North in those days”.
How overheads affect sales prices in practice.
In mid-2015 there was an outcry about WH Smith charging more for products in its hospital based shops than their High Street stores.
Is this profiteering or just reflecting the increased costs of operating in those locations? Should retailers subsidise the products in hospitals from their sales elsewhere?
Note in the article the rental agreements that charge a percentage of sales rather than a fixed rent – how would you treat this as a cost in your calculations? Note: “occupation costs up to 40 % of sales”.
How a Council was accused of manipulating costs to justify an increase in parking charges – or were they just incompetent at overhead allocation?
1 August – Resident’s Parking Permit price increases. No justification
This month the price of a Residents’ Parking Permit rises to £100. Just over a year ago it was £35 and making a profit but councillor Peter Craske wished to raise revenue and needed to prove that the permit scheme was making a loss. To this end he made up a host of fanciful figures. Among his figures and the conclusions that can be drawn from them are…
• The permits ran up £258,000 in total staff costs. That’s nearly 60% of the whole office – for about 5% of total activity.
• It cost £49,000 to print 3,081 permits.
• White line painting within Controlled Parking Zones (CPZs) cost £36,000 a year.
• On-street enforcement costs for CPZs is £328,000 a year. That’s 45% of total enforcement costs according to an FOI response – for what is generally a two hours a day restriction, compared to all day outside the CPZs over a vastly wider area.
• Computers for Parking Permit administration amounts to £11,000 a year. That’s exactly half the total office computer costs according to an FOI response – for about 5% of the total work.
• Accommodation overheads related to CPZ admin. amount to £71,200 and the FOI says that premises costs for the whole office adds up to £110,000. 65% for 5% of the activity.
• Craske said that every cost related to Residents’ Parking Permits adds up to £783,200. That’s more than a third of the entire parking enforcement office to deal with 3,081 permits and around 12% of the total PCNs issued.
That expenditure is offset by income from fines but it formed the basis for councillor Craske’s claim that the price needed to rise steeply. He emailed the numbers to several enquiring residents. When asked why he couldn’t reduce costs he never replied. When asked to justify individual figures, he couldn’t and when pressed said he wasn’t going to comment any more. The figures looked wrong to anyone who thought about them for five seconds and many came to the conclusion that Craske was simply lying to the electorate. And now there is more evidence that the councillor really didn’t know what he was talking about.
At this point I shall hand over the blog to Bonkers‘ accounting friend who went to Bexley’s Civic Offices a week or so ago (†) to inspect their accounts…
One of the basic fundamentals of accounting is to allocate costs in order to establish where money is being spent. Bexley council tried to do this when it told residents in July 2010 it estimated the costs to run and enforce Controlled Parking Zones across the borough was approximately £780,000.
As the council had only issued 3,081 Parking Permits and an unknown number of visitors tickets – yes that’s right, they have no idea how many are printed and issued – this was then used by councillor Craske to justify raising the price of a Residents’ Parking Permit from £35 to £70 in September 2010 and then hiking it up to £100 this month.
A reasonable person would assume that there must be a cost code within Bexley’s accounts to which all the CPZ costs can be allocated. Only then might it be possible to make any sort of claim about subsidising Controlled Parking Zones and decide whether there is a need to raise more funds to cover the supposed costs, and indeed in any organisation fit for purpose it would be the norm. However, if the real purpose is to justify a preconceived premise and the sole goal is to ‘Maximise Income’ – as the council has stated in its own documents – then the last thing you actually require is a real breakdown of what was spent and where. The priority becomes making up numbers to suit the objective. If good accounting practice can be used against you it makes perfect sense not to know what the true figures are as then you can claim in your defence that you believed the estimates were reasonable.
So it won’t surprise you to know that there appears to be absolutely no verifiable basis whatsoever for the council’s own figures as no cost code exists within Bexley council’s accounting system to which any CPZ related expenditure can be allocated. So how did the council arrive at their numbers?
Bexley council has refused for over nine months to provide any sort of justification for its estimates. Any normal organisation would fall over itself to do so and prove its integrity, but Bexley council is neither a normal nor a reasonable institution and is an integrity-free zone.
I was able to inspect an analysis of relative activity of the Controlled Parking Zones and the Controlled Parking Account for on-street parking and this indicated that there would have been a surplus during 2009-10 (the most recently available figures) if permits were charged at £35 each – as they were that year. Bexley council knows this, they have been in possession of the figures for many months. They will not comment on them and the Parking Manager, Tina Brooks, claims she finds some of the numbers hard to follow! Well if she is incapable of working out and applying percentages then I guess they are.
So now I know unequivocally that the council has plucked its costs from outside of the published accounts and wishes to avoid at all costs sharing any rationale with concerned residents about how it arrived at them in the first place. Par for the course at Bexley council who once again demonstrate that they are not working for us and most definitely not prepared to listen either!
When I asked what sort of things had been loaded into the costs for operating CPZs I was told that they not only guessed the proportions of the overall parking costs to apply to CPZ in the outrageous and unrealistic way indicated in the opening summary, but they lumped in chunks of library operating costs and disproportionate amounts for building maintenance. Not once could they refer to documentation to substantiate their figures because Bexley council had failed at the first hurdle, there is no accounting code for CPZs. Councillor Craske couldn’t tell the truth because he doesn’t have a clue what the truth is. Telling residents that they must pay more for Parking Permits because the cross-subsidies must be stopped when the truth is totally different, is exactly what you might expect from a council that elected Ian Clement to be their leader and without exception never noticed the financial abuses going on right under their noses.
If when paying £100 for your next Parking Permit you feel you are being cheated by a council not untainted by fraud then you will have the consolation of knowing that your grasp of accounting is on an altogether higher plane than councillor Peter Craske’s.
† From 4th to 29th July councils had a statutory obligation to open their accounts for inspection.
Overhead absorption affecting prices when you aren’t busy enough.
Not many articles crop up on this topic, but it is the key element in this discussion why solar power generation is more expensive to install in the USA rather than Australia.
Although it talks about a red tape (bureaucracy cost) problem too, the main issue is that solar installers do fewer systems so have to apply a bigger overhead charge in the USA than they do in Oz.
The ‘Internet of Things’ reducing overheads.
Article on how the internet is bringing down costs of production through the ‘Internet of Things’
Working with Distributors to bring down costs.
Article discussing how working with distributors can improve profitability. you don’t need to do it all yourself. If nothing else, if the stock is in their warehouse and not yours, you are going to save money.
Possible Written Questions.
(No indication of marks – the more marks a question gets, the more you are expected to write – detail that is, not just words!) If you can’t answer these, you need to do some more reading. I do ‘find’ questions elsewhere, so these aren’t all questions I have used myself.
Explain why you cannot absorb overheads from a department on the basis of both labour and machine hours.
Explain what information you would look for to determine whether a department’s overhead should be absorbed on a per unit, a per labour hour or a per machine hour basis.
Explain why under Departmental Allocation of Overheads the overhead costs in Service Departments have to be apportioned to Production Departments.