166 ACCOUNTING FOR MANAGERS
The allocation of overhead based on cost centre rates (rounded to the nearest £)
would be:
Overhead allocation 304 231
Full (or absorbed) cost 489 471As can be seen in the above example, the overhead allocation as a percentage of
total cost can be very high. This is not unusual in business, particularly in those
organizations that have invested heavily in technology or (except for professional
services; see Chapter 9) in service businesses, where direct costs are a small
proportion of total business costs.
The cost centre rate is more accurate than the business-wide rate because it
does attempt to differentiate between the different cost structures of cost centres.
However, the three-stage method of allocating costs between cost centres and
then allocating those costs to products/services using a single activity measure
can be quite arbitrary. The absorption method of allocating overhead costs to
products/services has received substantial criticism because of the arbitrary way
in which overheads are allocated. Most businesses use allocation bases such as
direct labour hours, machine hours or production units, because that data is readily
available. The implicit assumption of absorption costing is that the allocation base
chosen is a reflection of why business overheads are incurred. For example, if the
allocation base is direct labour or machine hours, the assumption of absorption
costing is that overhead costs are incurred in proportion to direct labour or machine
hours. This is unlikely to be the case in most businesses as many overheads are
caused by the range and complexity of product/services.
Activity-based costing
As we saw in Chapter 10,activity-based costing(or ABC) is an attempt to identify
a more accurate method of allocating overheads to product/services. ABC uses
cost poolsto accumulate the cost of significant business activities and then assigns
the costs from the cost pools to products based oncost drivers, which measure each
product’s demand for activities.
Cost poolsaccumulate the cost of business processes, irrespective of the
organizational structure of the business. The costs that correspond to the formal
organization structure may still be accumulated for financial reporting purposes
through a number of cost centres, but this will not be the method used for product
costing. For example, the purchasing process can take place in many different
departments. A stores-person or computer operator may identify the need to
restock a product. This will often lead to a purchase requisition, which must
be approved by a manager before being passed to the purchasing department.
Purchasing staff will have negotiated with suppliers in relation to quality, price
and delivery and will generally have approved suppliers and terms. A purchase
order will be raised. The supplier will deliver the goods against the purchase
order and the goods will be received into the store. The paperwork (a delivery
note from the supplier and a goods received note) will be passed to the accounting
department to be matched to the supplier invoice and a cheque will be produced