Lomoarcpsd1909977 chapter 7 a closer look at overhead

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lOMoARcPSD|1909977 CHAPTER 7: A CLOSER LOOK AT OVERHEAD COSTS VERY IMPORTANT TOPIC!!! – DO PRACTICE QUESTIONS + LECTURE ILLUSTRATIONS Learning objective o Explain the nature of overhead costs o Describe general principles for allocating indirect costs to cost objects o Allocate overhead costs to products using plant-wide and departmental rates o Allocate support department costs to production department using direct, step- down and reciprocal methods o Recognise costs and benefits of alternative approaches to allocating overheads o Identify best practice in overhead allocation o Understand why overhead cost allocation is important and useful to managerial decision making o Critically analyse different options for allocating overhead costs and assess which would be most applicable to different contexts The fundamental question to think about when allocating overhead costs is – what cost driver are you going to use? Manufacturing overhead costs : all manufacturing costs other than direct material and direct labour costs Cannot be traced economically to individual products Non- manufacturing costs : all costs incurred outside of manufacturing – for example research & design, human resources, customer support Both of these are indirect costs Cost assignment can take two forms : - Direct costs can be traced directly to products - Indirect costs (for example, those above) cannot be traced to cost objects; therefore, they need to be allocated A cost pool is a collection of costs that are allocated to cost objects: - Have a common allocation base (ie common cost driver) - Often used to simplify the allocation process \
lOMoARcPSD|1909977 Note: Not all managers will use cost driver as a way to allocate the overhead cost to products. And that other factor may be seen as an allocation base even though it might be predominant. Ideally, we hope that the factor chosen to do the allocation is the cost driver, if it does not merge, we still have to accept the manager’s decision. Allocation base is very broad and not necessarily a true factor in cost allocation. Determining cost allocation bases o A cost allocation base is some factor or variable that allows us to allocate costs in a cost pool to cost objects - Preferably a cost driver - But can be a manager’s choice o A cost driver is an activity or factor that causes a cost to be incurred o For example: quality control cost pool - Cost driver could be # of inspections - Product A is inspected more often than Product B - So… more quality control overhead is allocated to Product A Identifying overhead cost drivers 1. What is the major factor that causes the overhead cost to be incurred? helps increase accuracy of cost prediction 2. To what extent does the overhead cost vary in proportion with the cost driver? helps increase accuracy of cost prediction 3. How easy is it to measure the cost driver? helps keep cost prediction manageable Managers should concern the tension between increasing the accuracy of cost prediction and keeping the cost prediction manageable.

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