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Overhead cost pools. By: Lambert III, S.J., Chen, Kung H., Internal Auditor, 00205745, Oct96, Vol. 53, Issue 5

DATA BASE

Business Source Complete

Internal auditors who understand how cost allocation decision affect their organizations may be able to help their companies save money and improve decision-making.

Overhead is probably the most troublesome cost element to apply to manufacturing or merchandising activities and products. As a result, many companies have used the simplest methods for handling overhead costs, especially since overhead levels have been relatively low in past years.

While these uncomplicated methods may have been adequate at one time, the increasing significance of manufacturing overhead costs, coupled with shortened product lives and the variety of products in today's environment, have created different informational needs. Many traditional overhead allocation systems result in misleading data that may have a negative impact on management decision-making, budgeting, control, and performance evaluation.

In particular, overhead cost pool decisions affect the type of jobs a company wins in a competitive environment; a company's profitability pattern on different types of jobs; and, in some cases, the reputation and survival of the company. When the firm has audit rights over the costs in the contract, the cost pool allocation by the supplier or subcontractor is an important aspect of an internal auditor's review of contract awards. Internal auditors who are sensitive to signals that the overhead costing structure warrants examination and possible restructuring -- and who focus on the implications that multiple overhead cost pools may have for their organizations -- can definitely contribute to the organization's efficient and economical use of resources.

• Cost Pools

An overhead cost pool aggregates overhead costs and distributes them as a group to all products or production runs on some basis, such as direct labor hours, machine hours, or number of parts. For example, an organization could use separate cost pools for general overhead, set up costs, and material handling costs and apply each to production on a different basis. It could also place all manufacturing overhead costs in a common cost pool and use a single application rate to assign manufacturing overhead to production runs or products.

Once a costing system is in place, an organization tends not to change the system -- "If it ain't broke, don t fix it." While there is merit in this popular concept, management and internal auditors should be alert for signals from the current costing system that some aspect needs to be investigated.

Determining the appropriate number of cost pools is basically a cost-benefit decision. Overhead allocation is inevitably an imprecise procedure. Some overheads are allocated because their relationships with the cost objectives are ambiguous. Others are allocated because of the high cost of tracing them to their cost objectives. When the benefit from an alternative allocation procedure is less than the cost of the change, there is no reason for changing the overhead application process. In selecting an overhead application scheme, the deciding factor is not the degree of precision of the measurement; it is the weighing of the costs and benefits of the selected procedures as compared to those of alternative procedures.

• Red Flags

Although not conclusive by themselves, several signals may suggest the need for a finer or more detailed system for assigning overhead costs. When an overhead application rate becomes the most significant cost item among the manufacturing costs, the current costing system may have overburdened the activity basis used for the overhead application; thus a different or finer system for overhead applications may be needed. For example, in recent years many companies have seen large increases in their direct-labor-based overhead rates. These increases could be a result of escalating overheads, decreasing usage of direct labors, or both. If an overhead rate changes significantly over time, a change to multiple cost pool overhead rates or to a different cost driver basis for overhead application should at least be considered.

Another red flag may be waved when a firm is much more successful with some of the products in the same product line than with others, even though all products follow the same pricing scheme. Suppose, for example, that a firm wins most jobs it bids on that require special setups or machining, but is less successful in more routine areas. The success in jobs requiring special setups or machining may not be a result of the special expertise the firm possesses, but may rather be a result of using a single cost pool for all manufacturing overhead.

If all the setups and special machining costs are included in a general overhead cost pool and applied to all products, the company appears to have lower costs than its competitors on items that require special setup and machining. Costs associated with these areas are spread over all products, creating what is often called cross-product cost subsidies. In other words, products not requiring special setups and machining are charged some of the costs for products that do require special setups and machining. While winning most of the business it wants in the specialized area, the company may have higher costs than most of its competitors on other products that do not require special setup or machining. When a post-audit of jobs reveals that some jobs appear to earn higher profits than other products in the same market, management may want to examine the current costing system.

• An Example

Examining the calculations of a hypothetical scenario may help to reinforce key points regarding overhead costing. Assume that at the beginning of the year a company makes the following estimates to determine their overhead application rates for the year:

Budgeted overhead costs for the year totals $100,000. Of this amount, $60,000 varies primarily with direct labor hours; $40,000 varies primarily with machine hours. For the current year the company estimates that it will work on 50 jobs requiring 1,000 direct labor hours and 500 machine hours.

The company's average job uses twice as many direct labor hours as the number of machine hours. Several overhead rates are possible. If the company uses a single cost pool for applying overhead costs, they could use either of the following overhead rates:

$100,000/1,000 DLH = $100 per direct labor hour,

or

$100,000/500 MH = $200 per machine hour.

If, instead, the company uses two cost pools in developing their overhead rates, the following overhead rate would be derived:

($60,000/1,000 DLH) + ($40,000/500 MH) =

$60 per direct labor hour + $80 per machine hour As indicated in the exhibit, the overhead costs assigned to various jobs can be considered according to the three different overhead rates.

Assume the firm operates in a competitive environment where cost is a key factor in securing jobs. Job 4 is an "average" job in the sense that it uses the average ratio of direct labor to machine hours, two to one. Notice that an "average" job has the same amount of overhead ($2,000 in the case of Job 4) regardless of which overhead application rate the firm uses.

On the other hand, if the firm, labeled as Firm A in the exhibit, applies overhead costs based on direct labor hours (DLH), and its competitor, Firm B, applies overhead costs based on machine hours (MH), the DLH firm, Firm A, will most likely win jobs that use less than the average mix of direct labor hours (Jobs 1, 2, and 3). Because the DLH firm has lower applied overhead costs on these jobs, their estimated total costs for the jobs will be lower than that of its MH firm competitor, Firm B. The DLH firm may even gain a reputation as the firm to go to for machine intensive jobs. This reputation may not be due to any real advantage the firm possesses but solely due to the scheme it uses to distribute overheads.

On the other hand, the competitor, Firm B, that uses a machine hour basis to apply overhead will most likely win jobs that require more than the average mix of labor hours. If firms choose cost drivers for applying manufacturing overhead corresponding to their expertise in their production processes (labor intensive or machine intensive), the single cost pool overhead structure may result in each firm not winning jobs in their particular areas of expertise.

As the illustrative figures show, the DLH firm, Firm A, with its labor intensive process, wins mostly machine intensive jobs. The MH firm, Firm B, on the other hand, handles mostly direct labor intensive jobs. With increasing amounts of work requiring the use of machine hours, the DLH firm could conceivably feel the need to acquire additional machine hours. For the same reason, the MH firm may spend additional resources to acquire additional labor hours.

The two cost pool overhead structures should represent a more accurate measure of the overhead costs on each job. The DLH firm will find that their actual profits on the type of jobs they typically win (Jobs 1, 2 and 3) are consistently less than their estimated profits because they will have underestimated their overhead costs on these jobs. If the industry is very competitive and profit margins are tight, losses on many jobs of types 1, 2, and 3 may result.

In examining jobs, firms should be alert to instances of increasing sales on jobs that require less than the average mix of the activity the firm uses for applying overhead costs, or instances of decreasing demand on jobs using more than the average mix of the activity basis the firm uses for overhead applications. In either situation the firm should examine its cost allocation system to determine if an alternative overhead application system is appropriate and the change can be cost-benefit justified in a cost-benefit analysis.

Suppose a firm has recently bought additional machinery and, recognizing their more machine intensive manufacturing environment, has changed to an overhead rate based on machine hours. Using machine hours as the basis to apply overheads increases the total costs of jobs that require more than the average mix of machine hours. As a result, the firm may not be very successful in winning this type of job. If the firm retains some of the old equipment, the firm may find itself continuing to use the old machinery that applies overhead costs using direct labor hours. Worse, the firm may reject jobs that the new machinery is designed for.(those with higher MH hours than the average job) because they are viewed as too costly.

If the firm continues to estimate overhead costs for jobs using the old machinery based on direct labor hours, managers may decide that such jobs are profitable jobs using the old machinery. This occurs because these jobs require a higher-than-average mix of machine hours and appear unprofitable when the firm assigns overhead to them based on machine hours. At the same time, these jobs require a less-than-average mix of labor hours and hence appear to be profitable jobs if the firm assigns overhead based on direct labor hours. Managers may then schedule such jobs on the older equipment to make these jobs profitable and, as a result, over-utilize this older equipment while leaving the newer equipment idle.

Such practices may lead to conflicts between top management and lower management. Lower management may become frustrated and complain about the new equipment. The problem, however, is not the equipment but how the firm is applying overhead costs. Management should be alert to such lost profit opportunities and should consider the benefits of finer overhead cost measures possible with multiple cost pools.

• Degree of Detail

The degree of detail a company chooses to use in an overhead cost allocation system is a decision based on a comparison of the benefits of a finer, more accurate measure of the cost of a product with the cost of developing and operating such a system. The emphasis in activity costing is on identifying cost drivers, the activities that generate costs, and the cost pools that accompany them. With activity costing it is not uncommon to use six or more overhead cost pools.

However, the same problems can occur with multiple cost pools. Even a company using several cost pools can find itself winning or losing jobs of a certain type because their accounting system does not provide an accurate enough measure of the cost of those jobs.

In general, the more competition a firm faces, the lower its profit margin and the greater the firm's need for more accurate cost information. The more valuable cost information becomes, the more a company is willing to invest in an improved cost measurement system.

• Conclusion

Decisions regarding how to assign overhead costs to a firm's products can have a significant impact on success. Internal auditors need to be alert to the signals from a firm's existing costing system and act when there is an indication that the firm's methods for applying overheads should be evaluated. Though not conclusive by themselves, these signals should be considered carefully for any underlying problems they imply.

Exhibit

Legend for Chart:

A - Job

B - Hours Used: [a]DLH

C - Hours Used: [a]MH

D - Ratio: DLH

E - Ratio: MH

F - One Cost Pool: (Firm A) [a]OH=$100/DLH

G - One Cost Pool: (Firm B) OH=$200/MH

H - Two Cost Pools: OH=$60/DLH+$80/MH

A B C D E

F G H

1 5 35 1/8 7/8

$500 $7,000 $3,100

2 5 10 1/3 2/3

500 2,000 1,100

3 10 10 1/2 1/2

1,000 2,000 1,400

4 20 10 2/3 1/3

2,000 2,000 2,000

5 60 10 6/7 1/7

6,000 2,000 4,400

6 70 10 7/8 1/8

7,000 2,000 5,000

Total 170 85 -- --

$17,000 $17,000 $17,000

* DLH = direct labor hours; MH = machine hours; OH = overhead

costs.

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By S. J. LAMBERT III, KUNG H. CHEN, AND JOYCE C. LAMBERT

S. J. Lambert III, PhD, CPA, is Professor of Accounting at the University of New Orleans in Louisiana

Rung H. Chen, PhD, is Professor of Accounting at the University of Nebraska-Lincoln

Joyce C. Lambert, PhD, CIA, CPA, is Professor of Accounting at the University of New Orleans in Louisiana.