Accounting For Non-accounting Students 9th Edition By John Dyson – Test Bank

CHAPTER 14
Indirect costs
Tutorial questions
14.1
1. Overhead absorption is an attempt to work out the cost of a particular unit of production.
The process depends upon by identifying direct costs, i.e. those costs that can be easily and
economically identified with particular units. However, this initial stage is questionable
because any cost that cannot be easily and economically identified is treated as an indirect
cost.
2. Indirect costs can be classified into two categories: production and non-production.
Traditionally, indirect production costs are shared out among those units that are supposed
to benefit from the services provided on a time basis (either direct labour hours or machine
hours). It is assumed that there is a relationship between time and cost so that the more time
that a particular unit spends in production, the more cost it should be charged.
3. Although this process is somewhat crude and increasingly irrelevant in modern
manufacturing industry, it is an attempt to charge units with a fair share of the costs that
they have incurred. While the method may be questioned, therefore, there is a purpose
behind it and it can hardly be regarded as ‘precision for precision’s sake’.
4. Non-production overhead or indirect costs (by definition these must be indirect) are another
matter. It is difficult to trace any meaningful relationship between production units and
administrative, research and development and selling and distribution overheads. So to
apportion such costs to current productive activity may appear to be ‘precision for
precision’s sake’.
5. Nevertheless, all costs have eventually to be charged to customers, so some attempt has to
be made to cover such overheads. The problem is that the text book methods appear to be
far removed from reality, e.g. research and development overheads as a proportion of total
production cost, and the apportioned costs do not appear to be related to the production
level of activity.
6. It follows that absorption exercises must be treated with caution and any total cost assigned
to any particular unit should only be used as a general guide.
14.2
1. By definition, service industries will not have any production activities because they will
not manufacture any products. They provide a service which in many cases may be
intangible, e.g. the advice given by a solicitor.
2. Nevertheless, even service industries will need to have some idea what it ‘costs’ to provide
a particular service. This will involve identifying any direct costs, such as labour and then adding a share of the entity’s indirect costs. In some service industries, they may form a
substantial part of the total cost.
3. It follows that absorption costing in service industries is of considerable relevance.
However, the absorption method cannot be based on how long a ‘unit’ has spent in a
particular production facility. Rather, it will probably be based on the relationship that the
total overhead cost bears to the total direct labour costs.
4. In practice, therefore, absorption costing is still relevant in service industries, although it
will probably be much simpler. Furthermore, the relationship between the services provided
and the total overhead incurred is likely to be more distant and so even cruder than overhead
absorption in the manufacturing sector.
14.3
1. Accountants are viewed with some cynicism by non-accountants, probably because it is
always assumed that they make a lot of money, and nobody else understands what they do
to earn it.
2. Accounting is a service industry and if it provides no useful purpose to its customers then it
cannot be expected to survive in business for very long. This particularly applies to
management accounting, because it is not supported by any statutory or professional
requirements.
3. Overhead absorption costing does involve a great many assumptions to be made in
apportioning costs to individual units, and it can sometimes be dealt with very pedantically.
However, its aim is to provide information for managers in order to help them take
decisions, e.g. in controlling costs, and in pricing goods.
4. If the results are not helpful to management then the technique should be abandoned and the
accountants asked to look for another job. To do otherwise merely indicates weak and
ineffective management. Managers should not be afraid to act simply because it means
arguing with a powerful group of professional experts.
14.4
1. There is a choice: (1) ignore them; (2) re-apportion them using some logical progression
method, e.g. in the order of the widest provision of service; and (3) apportion them using
algebraic techniques.
2. Method (1) may be the simplest and easiest to operate. Method (2) involves determining a
specified order of closure; and Method (3) may be mathematically attractive but the results
may not be worth the effort.
3. Accountants probably like Method (3) because it does smack of precision but it requires a
number of assumptions to be built on assumptions. It is, therefore, somewhat misleading
because it does give a false impression.

14.5
1. Activity-based costing (ABC) is a refinement of the more traditional method of absorbing
overhead costs. Overhead costs are classified into similar groups of activities of ‘cost
pools’. The main activity that drives each cost pool is identified and the cost per activity
(e.g. the cost per material requisition) is then calculated.
2. The proponents of ABC claim that it enables a fairer share of overheads to be charged to
products, thereby enabling more realistic product costs to be determined. If selling prices
are then based on cost, it is likely that they will be more representative of the cost incurred
and that they offer a more competitive price in the market place.
3. So, ABC is probably more useful to managers when it comes to decision making than the
more traditional method of absorbing overheads because it may result in the determination
of more accurate product costs.
14.8 CLOUGH LIMITED
(a) Overhead absorption for March 2017 – production department:
(i) Direct labour hours:
Total cost centre overhead 1,50, 000 = = £5 per DLH Direct labour hours 30,000
Therefore, for order number 123: £5 × 5 = £25
(ii) Machine hours:
Total cost centre overhead 1,50,000 = = £15 per MH Machine hours 10,000
Therefore, for order number 123: £15 × 2 = £30
Selling price of order number 123:
Direct labour Machine
hours hours
£ £
Direct materials 20 20
Direct wages 25 25
Prime costs 45 45
Overhead 25 30
Total cost 70 75
Administration + profit (50%) 35 7.50
Selling price 105 112.50

(b) As the department appears more labour intensive than machine intensive, use the direct
labour hour method.
14.9 BURNS LIMITED
Overhead absorption schedule – April 2018:
Departments
Processing Assembling Finishing Administration Work
study
£ £ £ £ £
Direct labour – – – 65,000 33,000
Allocated costs 15,000 20,000 10,000 35,000 12,000
100,000
Apportion:
Administration
(50:30:15:5)
50,000 30,000 15,000 (100,000) 5,000
50,000
Work study
(70:20:10) 35,000 10,000 5,000 – (50,000)
Overhead to be
absorbed 100,000 60,000 30,000 – –
Calculation of absorption rates:
TCCO 100,000 Processing department : = = £4 per MH Machine hours 25,000
TCCO 60,000 Assembling department : = = £2 per DLH Direct labour hours 30,000
TCCO 30,000 Finishing department : ×100 = ×100 = 25% Direct labour cost 120,000
Total cost of producing unit XP6:
£ £
Prime cost 47
Overhead:
Processing (£4 × 6 MH) 24
Assembling (£2 × 1) 2
Finishing (25% × £12) 3 29
Total cost 76
14.10 OUTLANE LIMITED
(a) Overhead charge – direct labour cost method:
Contract 1 Contract 2
Direct labour cost:
DLH × rate per hour = 100 × £3.00 £300 £300
Therefore, overhead to be absorbed (100%) = £300 £300
(b) Overhead charge – machine hour rate method:
Overhead absorption schedule:
Department
Apportionment L M N O
Method £000 £000 £000 £000
Administration Total number of
employees 40 30 20 10
Depreciation of
machinery
Depreciation rate
22 8 10 40
Employer’s
National
Insurance
Total number of
employees
4 3 2 1
Heating and light Cubic capacity 6 3 1 5
Holiday pay Total number of
employees 8 6 4 2
Indirect labour
cost
Number of indirect
employees 4 3 2 1
Insurance:
machinery
Capital cost
11 4 5 20
property Floor space 4 3 2 2
Machine
maintenance
Maintenance
hours 15 12 9 6
Power Kilowatt hours 30 50 90 60
Rent and rates Floor space 20 15 10 10
Supervision Total number of
employees 20 15 10 5
Overhead to be absorbed 184 152 165 162
÷ Machine hours 92 38 165 27
= Overhead absorption rate £2 £4 £1 £6