Overheads and Their Recovery

1 The costs of a business are of two types – direct and indirect. The direct costs vary directly with production. If one additional unit of production is made, there will be a measurable increase in direct cost. When one unit less is made, there will be similar measurable decrease in direct cost. Direct – or raw – material is normally the largest component of direct cost. It includes all items of material that are of sufficient size to warrant the effort of charging directly to the job. Small items, such as glue, paint and small quantities of nails, screws and rivets, do not merit the clerical effort involved in charging directly to the job, and would be recovered as an overhead.

2 Direct wages will vary directly with production where remuneration is based upon piecework only. This means that a specific amount is paid when a production operation is successfully finished. If it is not finished, no payment is made. Direct labour is of this nature. Many organisations remunerate labour on the basis of a large basic wage, topped up with a productivity bonus. The basic element is paid regardless of the level of production. In such cases wages will not vary directly with production, and fall into the category of an indirect cost or overhead.

3 Overhead is a general term applied to all the costs involved in running a business, other than direct costs. It covers the costs of running the works organisation; product research and development; the administration of the business; selling and distributing the product; and the cost of raising finance. Overheads are diverse, covering the whole of the business organisation. The management accountant has the problem of allocating these costs to the individual product lines being manufactured.

Cost centres

4 To help in this task, the organisation is split up into cost centres. These are areas of activity to which are gathered all costs of a like nature. A maintenance department, canteen and stores are examples of cost centres. Normally centres will identify with physical areas of the organisation. A stores cost centre is a physical area in which materials are kept, while awaiting issue to production. A centre may also not be identifiable with a physical area. The finance cost centre will gather together all the costs of raising finance for the business, other than from owners or shareholders. It is a function of the administration department, and cannot be identified with a physical area of the business.

5 Where a cost centre has a product which is being manufactured, it is known as a product centre. Examples are a machine shop which is machining parts for assembly into the saleable product in an assembly shop. Where a centre has a product that is saleable, thus giving rise to an income, it is also known as a profit centre. It is capable of showing a profit or loss on its overall activities.

Cost allocation

6 The management accountant's task is to allocate the many, diverse overheads, onto the cost of each product manufactured. It is a major task requiring the use of many different bases of allocation. The allocation of direct cost to a product can be precise. In the case of overhead allocation an element of logical guesstimation enters. There is a two-fold process, firstly to collect all overhead costs onto the product or profit centres; and secondly to load the overheads onto each product passing through the centre.

2. Scan the text again and complete these sentences according to the information in the text.

1) The largest element of direct costs is usually _______.

2) All raw material costs are included in the direct costs of a product except _______.

3) Those raw materials of which only very small quantities are used ________.

3. Finish the statement below with the best ending according to the text. Wages are part of direct costs when…

1) they are linked to the speed of production.

2) they are related to the quantity of output started.

3) they depend entirety on the quantity produced.

4) they are partly fixed and partly linked to output.

4. Which of the following statements are not true about overheads?

1) They include all costs of a business.

2) They exclude those costs which can be directly related to a product's production.

3) They relate to certain aspects of the business only.

4) They are difficult to relate to individual products of a company.

5. Answer the following questions:

1) How do management accountants use 'cost centres' in dividing a company's costs?

2) What important division can be made between types of cost centre within a business?

3) According to the text, what is the difference between a 'product centre' and a 'profit centre'? Can a product centre also be a profit centre?

6. The following sentences make up a short text about Cost accounting. Decide which order they should go in:

a. But to this have to be added all the factory's overheads - rent or property taxes, electricity for lighting and heating, the price of the machine used, the maintenance department, the stores, the canteen, and so on.

2. Finally, where a company does not want to calculate the price of specific orders or processes, it can use full costing or absorption costing, which allocates all fixed and variable costs to the company's products.

3. For example, if you produce 500 wooden door-knobs, each one requiring 100 grams of wood and taking the machine operator two minutes to make, you can easily calculate the direct cost.

4. It is fairly easy to calculate the prime cost or direct cost of a manufactured article.

5. One of these is job-order cost accounting, which involves establishing a price for an individual item or a particular batch (a quantity of goods assembled or manufactured together).

6. There are also lots of other expenses of running a business that cannot be charged to any one product, process or department, and companies have to price their products in such a way as to cover their administration and selling expenses, the finance department, the research and development department, and so on.

7. This is the sum of the direct costs of the raw materials or components that make up the product and the labour required to produce it, which, of course, vary directly with production.

8. This is impossible where production involves a continuous process as with steel, flour, or cement. In this case companies often use process cost accounting, which determines costs over a given period of time.

i. Various methods can be used to allocate all these expenses to the selling price of different products.

Note: British English overheads and labour = American English overhead and labor.

DEVELOPING VOCABULARY

1. Fill in the missing words in the terms below.

apportionment centre conversion direct fixed integrated indirect interlocking labour marginal

Term	Definition
direct______ costs	Costs which are directly related to making a product (e.g. materials, labour and expenses).
___________ costs	Costs of changing materials into products.
___________ costs	Costs which are not directly related to a product, e.g. rent, administration.
___________ costs	This could be a location, a function, a piece of equipment or a group of employees where you can identify and allocate costs for control purposes.
___________ costs	You divide the common overhead costs between the various activities which use them according to how much they use.
costs ___________	Costs which always stay the same even if the number of items produced changes.
_____________ costs	The cost of paying workers to make the product
_____________ cost	The cost of making a single extra unit above the number already planned.
9. ___________ cost accounts	You don't separate financial and cost accounting.
10. __________ cost accounts	Separate cost and financial accounts which are reconciled sometimes.

2. Take one word from the left-hand column and one from the right to complete each of the following sentences; the first has been done for you.

financial prime functional consumable maximum business arbitrary manufacturing

facilities analysis decisions process data profit materials cost

1) Accountancy provides financial_data which is used to make future business decisions.

2) In order to succeed, company managers try to make ________ because this is where capital growth comes from.

3) Because accountants rely on estimates rather than 'true costs', they often have to make _______.

4) _________ are used up in the manufacturing process but are not part of the final product.

5) All the direct costs of manufacturing are referred to as ________.

6) Overhead is the cost of providing ________ which you need to produce goods.

7) The management accountant should understand the ________ used to make a product in the factory.

8) Cost accounting uses _______ which looks at where each transaction comes from.

3. Fill in the missing words in the sentences below. Choose from the following.

appropriate cost driver overhead overstate selling

Costing methods are used to decide product _______ prices and profitability. _______ costs are charged to products. A mistake in the method of calculating could ________ the cost of the product. The activity costing method means allocating the ________ share of activities to each product. A factor which influences the cost of an activity is known as a ________ and is used to calculate how much should be apportioned to each product.

DISCOVERING LANGUAGE

1. Complete these sentences by putting the verbs in brackets into the correct form. Pay attention to the sentences with the Absolute Participial Construction.

The A nation (to have) its own set of assets and liabilities, a national balance sheet (to be) not simply the sum of the balance sheets of individuals and firms. A nation's assets also (to consist) of national capital. Such public buildings as public libraries, royal palaces and government offices (to know) (to belong) to the national capital. Publicly (to own) parts of the transportation infrastructure or certain natural assets, such as raw material deposits or natural forests (to consider) (to be) national capital as well. These items (may not) (to include) in the balance sheet of any other entity. Economists also (to argue) that since the most important asset of a nation (to be) its labour force, it (should) (to include) in the balance sheet in some way. Both obligations and liabilities between firms and individuals in the same country to cancel out) (нейтрализовать, сбалансировать) each other, as one person's liability to pay (to be) another person's asset. It is known that practically every nation (to own) either physical or financial assets abroad, foreigners (to own) physical or financial capital within a nation. The accounting of a nation's wealth, therefore, should (to take) into account net liabilities to the citizens, firms and governments of other countries.

FOCUS ON FUNCTIONS