Allocation and Apportionment of Overheads in The Home - Case Study Example

The Home: Analysis of costing methods - Allocation and apportionment of overheads Terms of reference what the report is about This report aims at providing costing methods with appropriate procedure of allocation and apportionment cost to understand different costing methods and its deployment in management's decision making process. This will assist the managers of "The Home" to adopt and implement a sound management accounting system that will further give support to them in planning, organising, and controlling their nursing home business. The Home is a residential and day care nursing home in Newport, South Wales owned in partnership by Gary Salvage and Ryan Speed. 2. Procedures: Primary and secondary evidence gathered e.g. books, journals internet Primary and secondary information are gathered from the following sources: www.managementparadise.com www.ezinearticles.com http://blog.accountingcoach.com/absorption-costing/ http://www.globusz.com/ebooks/Costing/00000012.htm http://www.accountancy.com.pk/articles_students.aspoffset=80&id=67 3. Findings: Cost allocation and cost apportionment are the two procedures which describe the identification and allotment of costs to cost centres or cost units. Cost allocation refers to the allotment of all the items of cost to cost centres or cost units whereas cost apportionment refers to the allotment of proportions of items of cost to cost centres or cost units Thus, the former involves the process of charging direct expenditure to cost centres or cost units whereas the latter involves the process of charging indirect expenditure to cost centres or cost units. For example, the cost of labour engaged in a service department can be charged wholly and directly but the canteen expenses of the factory cannot be charged directly and wholly. Its proportionate share will have to be found out. Charging of costs in the former case will be termed as "allocation of costs" whereas in the latter, it will be termed as "apportionment of costs." 3.1 Introduction Management Accounting is an indispensable tool for any business unit to set budgets. It sets standard costs and actual costs of processes, departments or products and through variance analysis measure the profitability and social use of funds. This assists the management to attract more investors and tap potential funding sources. The main aim of costing is the providing crucial management information to ascertain costs, proper allocation of costs to a centre of responsibility, cost planning and control. Further, it provides the necessary information to plan the cost of operation and ability to monitor and control those cost against the plan. Costing can provide all the information required for the effective management decisions. The effective costing is therefore essential for survival of any business. 3.2 Methods of costing Costing can be defined as the procedure and technique of ascertaining costs. The principles in every method of costing are same but the methods of analyzing and presenting the costs differ with the nature of business. The methods of costing are as follows: Absorption Costing Marginal Costing Job Costing Activity Based Costing Batch Costing 3.2.1 Absorption Costing Absorption costing means that all of the manufacturing costs are absorbed by the units produced. In other words, the cost of a finished unit in inventory will include direct materials, direct labour, and both variable and fixed manufacturing overhead. As a result, absorption costing is also termed as full costing or the full absorption method. 3.2.2 Marginal costing Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. Marginal costing may be defined as the technique of presenting cost data wherein variable costs and fixed costs are shown separately for managerial decision-making. Marginal costing technique has given birth to a very useful concept of contribution where contribution is given by: Sales Revenue less Variable Cost (Marginal Cost) Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P). In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). This is known as break even point. 3.2.3 Job Costing The system of job costing is used where production is not highly repetitive and in addition consists of distinct jobs so that the material and labour costs can be identified by order number. This method of costing is very common in commercial foundries and drop forging shops and in plants making specialized industrial equipments. In all these cases, an account is opened for each job and all appropriate expenditure is charged thereto. 3.2.4 Activity based costing Activity based costing (ABC) is a more sophisticated and logical way to allocate a company's costs to its products (or other objects) than traditional costing. (Traditional costing might allocate all of the overhead costs solely on the basis of machine hours.) Activity based costing identifies the many activities that actually cause the company to consume resources. Next, it calculates the cost of each of the activities. Then it assigns each activity's cost only to the products that actually use the activities. Obviously this is important when some products require few activities, and other products require many activities. Activity based costing is useful for service businesses as well as manufacturers. The process of identifying and determining the cost of activities can lead to improvements in a company's operations. 3.2.5 Batch Costing This method is employed where orders or jobs are arranged in different batches after taking into account the convenience of producing articles. The unit of cost is a batch or a group of identical products instead of a single job order or contract. This method is particularly suitable for general engineering factories which produce components in convenient economic batches and pharmaceutical industries. In the context of our given case study Activity Based Costing suits the nature of business. The below calculations of costs apportionment explains apportionment of depreciation of equipment value, rent & rates, heat &light, manager's salary , insurance of equipment, insurance of building , consumables and allocation of maintenance salary on the basis of activity based costing. The big advantage of ABC is that it is able to reduce the distortions in costs that result from the arbitrary assignment of indirect costs in standard job order costing (i.e., overhead). Activity Based Costing Advantages Assesses costs of individual activities, based on their use of resources Enables accurate costing of all activities to be obtained throughout an organization. A valuable tool for both business and process improvement. Easy to identify where high (and low) costs are being incurred and the cause. Helps with future product planning e.g. the cost of all activities associated with a product or service can be accurately determined before it is launched. This can then help with determining pricing, and any associated expenditure. Activity Based Costing Disadvantages It may be difficult to set up and establish, particularly if an organization is using more traditional accounting methodologies. (barriers to change) Can be time consuming if all activities are to be costed. May provide too much detail - obscuring the bigger picture. 3.3 Fixed overhead recovery rate Fixed overhead recovery rate involves the assigning, applying, or allocation of fixed manufacturing overhead costs to the units produced by a manufacturer. Depreciation on equipment is apportioned on the basis of equipment value used at four cost centres. Rent & rates is apportioned on the basis of area occupied. Heat & light is apportioned on the basis of area occupied by each cost centre. The calculations of overhead recovery rates are important to apportion costs according to activity taking place at each centre and this signifies the importance of Activity Based Costing. Apportion and Allocation DEPRECIATION Apportionment of Equipment Value 100,000 Residential 35,000 Catering 43,000 Housekeeping 2,000 Maintenance 180,000 Total Equipment Value Equipment value per cost centre () x Budgeted cost () = Cost Centre () Total Equipment Value () Residential 100,000 x 18,000 = 10,000 180,000 Catering 35,000 x 18,000 = 3,500 180,000 Housekeeping 43,000 x 18,000 = 4,300 180,000 Maintenance 2,000 x 18,000 = 200 180,000 RENT & RATES Apportionment of Area Occupied (Sq.m) 300 Residential 100 Catering 75 Housekeeping 25 Maintenance 500 Total Square Meters of Area Occupied Area Occupied per cost centre (Sq.m) x Budgeted cost = Cost Centre Total Sq.m of Area Occupied Residential 300 x 30,000 = 18000 500 Catering 100 x 30,000 = 6000 500 Housekeeping 75 x 30,000 = 4500 500 Maintenance 25 x 30,000 = 1500 500 HEAT & LIGHT Apportionment of Area Occupied (Sq.m) 300 Residential 100 Catering 75 Housekeeping 26 Maintenance 500 Total Square Meters of Area Occupied Area Occupied per cost centre (Sq.m) x Budgeted cost = Cost Centre Total Sq.m of Area Occupied Residential 300 x 5,200 = 3,120 500 Catering 100 x 5,200 = 1040 500 Housekeeping 75 x 5,200 = 780 500 Maintenance 25 x 5,200 = 260 500 MANAGERS SALARY Apportionment of Number of Employees 12 Residential 8 Catering 4 Housekeeping 2 Maintenance 26 Total Square Meters of Area Occupied No. Employees per cost centre x Budgeted cost = Cost Centre Total No. of Employees Residential 12 x 32,000 = 14,769 26 Catering 8 x 32,000 = 9,846 26 Housekeeping 4 x 32,000 = 4,923 26 Maintenance 2 x 32,000 = 2,462 26 MAINTENANCE SALARY Direct Allocation to Maintenance 17,500 Maintenance. CONSUMABLES Apportionment of Number of Employees 12 Residential 8 Catering 4 Housekeeping 2 Maintenance 26 Total Square Meters of Area Occupied No. Employees per cost centre x Budgeted cost = Cost Centre Total No. of Employees Residential 12 x 3,750 = 1731 26 Catering 8 x 3,750 = 1154 26 Housekeeping 4 x 3,750 = 577 26 Maintenance 2 x 3,750 = 288 26 INSURANCE EQUIPMENT Apportionment of Equipment Value 100,000 Residential 35,000 Catering 43,000 Housekeeping 2,000 Maintenance 180,000 Total Equipment Value Equipment value per cost centre () x Budgeted cost () = Cost Centre () Total Equipment Value () Residential 100,000 x 2,500 = 1389 180,000 Catering 35,000 x 2,500 = 486 180,000 Housekeeping 43,000 x 2,500 = 597 180,000 Maintenance 2,000 x 2,500 = 28 180,000 INSURANCE BUILDINGS Apportionment of Area Occupied (Sq.m) 300 Residential 100 Catering 75 Housekeeping 25 Maintenance 500 Total Square Meters of Area Occupied Area Occupied per cost centre (Sq.m) x Budgeted cost = Cost Centre Total Sq.m of Area Occupied Residential 300 x 4,100 = 2,460 500 Catering 100 x 4,100 = 820 500 Housekeeping 75 x 4,100 = 615 500 Maintenance 25 x 4,100 = 205 500 REAPPORTIONMENT After the process of primary apportionment or distribution, the loading of overheads for all the departments i.e. production as well as service departments can be obtained. Next step is to transfer the overheads of non-production departments to production departments, as the various cost centres move through the production departments only. This is in the form of 'Reapportionment or secondary apportionment'. If it is decided to consider the services rendered by one service department to another, the first problem will be to decide the percentage in which services are given by service departments. After such percentage is decided the re-apportionment can be made either of the following methods: Simultaneous Equation Method: Under this method the amount of overheads of each production department can be obtained by solving simultaneous equation. Repeated Distribution Method: Under this method service department overheads are distributed to other departments, production as well as service, on agreed percentage and the process is repeated till the figures of service departments are exhausted or are too small to consider further apportionment. In our example Maintenance department is a non-production department, thus the overhead costs needs to be reapportioned among Residential, Catering and Housekeeping departments. The base taken up for this is direct labour hours employed by the three production departments. Here we take up repeated distribution method as there is only one department whose overhead costs needs to be reapportioned. Cost and Profit Centres Overheads Total Apportioned Cost Basis of Apportionment /Allocation Residential Catering Housekeeping Maintenance Total 113,050 Table 1 51,469 22,846 16,292 22,443 Maintenance Department 22,443 Direct labour hours 12,825 6,412 3,206 -22,443 Total 64,294 29,258 19,498 NIL REAPPORTIONMENT OF MAINTENANCE DEPARTMENT Basis: Direct labour hours 8000 Residential direct labour hours 4000 Catering direct labour hours 2000 Housekeeping direct labour hours 12000 Residential 22443 x 8000 = 12,825 14000 Catering 22443 x 4000 = 6,412 14000 Housekeeping 22443 x 2000 = 3,206 14000 4. Conclusions Budget and Budgetary Control The term 'Budget' can be classified as a quantitative and/or financial statement, prepared prior to a defined time period, of the policy to be pursued during that period for the sole purpose of achieving a given objective. The analysis of this definition reveals the following Budget characteristics: It is prepared for a fixed period of time. It may be prepared in terms of money or quantity or both. It is prepared before the defined time period commences. It spells out the objects to be achieved and the position to be pursued to achieve that objective. The term 'Budgetary Control' is classified as the establishment of budgets, relating the executives' responsibilities to the policy requirements and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide the basis for its revision. Advantages of Budgetary Control It is a powerful tool available to the management for the purpose of cost control and maximisation of profits through the same. It enables the management to utilise the available resources in the most profitable manner. The budgetary control systems act as the means of declaration of the policies of the management. It acts as a means of improving the coordination. The budgets prepared in the various functional areas of operations are prepared in such a way that the efforts are coordinated in the direction of achievement of common and defined objectives. The comparison between the budgeted results and the actual results may reveal the areas where there are adverse variations which may be identified as weak or delicate areas. As such, efforts can be made to remove these adverse variations, keeping aside the areas where there are no variations. This enables the concentration of efforts of the management on a smaller portion of activities which facilitates "management by exception". Budgetary control system enables the delegation of authority and makes possible the principles of responsibility accounting. It is a powerful tool available to the management for performance appraisal. Pre-requisites for the implementation of Budgetary Control: If the organisation decides to install the budgetary control system as a cost-control technique, it will have to comply with the following preliminaries. Deciding the budget centre Deciding the budget period Establishment of accounting records Organisation of budgetary control Preparation pf budget manual Determination of budget key factor ANALYSIS: Keeping in view the nature of business of "THE HOME", the most appropriate budget will be Overheads Cost Budget. This budget indicates the various types of overheads to be incurred during the budget period. For the correct establishment of overheads cost budget, it will be necessary to classify the various overheads. In the case of "THE HOME", the overheads are already classified into depreciation of equipments, rent and rates, heat and light, insurance of buildings, insurance equipment, consumables and manager's salary. In order to exercise proper control on the overheads, it will be imperative to analysis the overheads as fixed, variable and semi-variable. The semi-variable overheads are further required to be split into fixed and variable elements. In our example, depreciation of equipments can be classified as fixed overheads while consumables as variable overheads. Read More