Systems and methods of product costing

 

     The Reciprocal Method

     The reciprocal method is the most accurate of the three methods for allocating service department costs, because it recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations.

     Example:

Maintenance Department costs equation is: 

M = 240,000 + 0,2W + 0,1T 

M - Maintenance Department costs; W - Warehouse costs; T - Transport costs.  

Warehouse costs equation is: 

W = 160,000 + 0,1T 

Transport costs equation is: 

T = 200,000 + 0,1W 

The system of equations is: 

M = 240,000 + 0,2W + 0,1T

W = 160,000 + 0,1T

T = 200,000 + 0,1W 

The solution of the system of equations:

W = 181,818

T = 218,182

M = 298,182 

     The next step is to allocate costs of service departments according to the volume (%) of services rendered by them.  

     Table 4.6 - Reciprocal allocating costs of service departments

 
 

     Table 4.7 presents the results of allocating manufacturing overheads using different methods.  

     Table 4.7 - Allocation of manufacturing overheads using different methods

 

     Table 4.7 shows that there is no significant difference in the results obtained. However in other cases the difference may be considerable. That’s why it is necessary to investigate them and choose the most appropriate method.  

     4.3.1 Secondary allocation of indirect costs to products

     After defining the whole amount of overheads of each production department, it is possible to calculate an overhead rate of the department to allocate overheads to products and orders.

Overhead rate = Department overhead costs/Total volume of the allocation base

     When identifying the overhead rate, it is important to choose an appropriate allocation base. Allocation base is a measure of activity such as direct labor-hours, machine-hours, direct labor costs, direct materials that is used to assign costs to cost objects.  

     Table 4.8 - Calculation of the manufacturing overhead rate

 

     Having finished the allocation of manufacturing overheads, it is possible to calculate the product cost (Table 4.9).  

     Table 4.9 - Product cost calculation

     4.4 Calculating a predetermined overhead rate

     Allocating overheads on the basis of actual indicators of activity causes some problems, especially in companies with cyclical or seasonal production. When the production volume changes the amount of overheads per unit of output also changes.

     When the production volume grows, fixed costs per unit of output decreases and vice versa when the production output decreases fixed costs per unit of output grows. In order to avoid the problem of fluctuating the product costs, a predetermined overhead rate is used. The formula for its calculating is given below:

Predetermined overhead rate = Total budgeted overhead costs/Expected volume of allocation base

     The application of the predetermined overhead rate allows to identify the product cost just after its production (without waiting for the end of the month when the total amount of overheads is calculated) and to avoid the fluctuating of the product cost as a result of fluctuations in activity levels.

     Example: Budgeted overheads are $450,000, budgeted direct labour costs are $300,000.

     = (450,000: 300,000) x100% = 150% of direct labour costs

     If actual direct labour costs for the order #924 is $1,000, the amount of overheads allocated to the order #924 is $1,500 ((1,000 x 150%): 100%).

     Hence, when using a predetermined overhead rate allocated overheads are calculated according to the following formula:

     Allocated overhead = Predetermined overhead rate x Actual volume of the allocation base

     The usage of predetermined overhead rates results in overapplied and underapplied overheads.

     Underapplied overhead means that the overhead applied is less than the actual overhead. Overapplied overhead means that the overhead applied is more than the actual overhead.

     If the amount of underapplied or overapplied overhead is not very big, it is written off to cost of goods sold. If the difference between the applied and actual amount of overhead is significant, it is apportioned among work-in-progress, finished goods and cost of goods sold.