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Overhead in Manufacturing, Administration, Retail Selling
Overhead Expense Defined, Meaning Explained, Examples

 

In traditional cost accounting, the term overhead refers to salaries and other expenses not associated directly with specific product units, service engagements, or sales. Overhead therefore refers to the cost of supporting manufacturing, service delivery, or selling.

Some businesspeople count all operating expenses below the Gross Profit line as overhead.

What is Overhead Expense?

In traditional cost accounting, the term overhead refers to expenses that are not associated easily with production of specific product units, specific service engagements, or specific sales. "Overhead" refers instead to the costs of supporting product production, service delivery, or sales activities.

Business firms plan, measure, and analyze overhead costs as transactions in certain expense accounts. As a result, overhead expenses—like all other expenses—ultimately impact Income statement profits. As expenses increase, profits decrease. Note esepecially that overhead can impact Gross, Operating Profit, and bottom line Net Profit.

Overhead Appears At All Levels of the Income Statement

Expenses that qualify as overhead can appear under all major expense categories on the Income statement. And, not all overhead expenses on the statement carry the name "Overhead." Some businesspeople, for instance, regard all entries under "Selling, General, and Administrative Expenses" as overhead, even though the statement does not label them as such.

The Overhead Role in Costing, Pricing, Budgeting, and Product Management

Companies that sell products or services must know their per-unit product costs. This information is important when setting prices and it is crucial for managing the product portfolio effectively. The firm has a vital interest in knowing which products sell with acceptable Gross Margin and which sell at a loss. In product costing, however, overhead "muddies the waters" and makes it difficult to measure per-unit costs accurately.

In most cases analysts estimate rather than measure per-unit overhead costs. Sections below show how cost accountants use cost allocation to assign per-unit overhead costs indirectly.

The discussion below also presents an alternative approach to overhead costing, Activity Based Costing (ABC). This approach, arguably, does measure per-unit overhead costs directly.

Overhead Plays an Important Role in Competitive Strategy

Business firms set overhead objectives when planning their own cost structures. This is because overhead targets are in fact a key component of the firm's high level business strategy .

In competitive industries, business firms rightly call the top-level business strategy a competitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins.

  • Some companies plan to operate with very low overhead. These firms expect to earn higher margins than their competitors, while charging the same prices as the competition.
  • Low overhead strategies can, alternatively, enable the firm to differentiate itself in the market by charging lower prices. This is possible because low-price sellers can still earn the same margins as their high-price competitors if they operate with lower overhead.

Explaining Overhead in Context

Sections below further define and explains overhead as an Income Statement term, as a costing concept, and as an important factor in competitive strategy. Examples illustrate overhead concepts in context with related terms including the following:

Activity Based Costing
Administrative Overhead
Fixed Overhead Cost
General Overhead
Gross Profit
Income Statement
Indirect Labor
Manufacturing Overhead
Operating Overhead
Retail Overhead
Selling Overhead
Variable Overhead Cost
Production Cost Structure
Variable Overhead Cost
Variable Overhead Cost

 

Contents

Related Topics


 

Overhead in Retail Business

In retail business, merchants normally distinguish between the costs of acquiring merchandise inventory from their suppliers, on the one hand, and their own overhead expenses on the other hand.

Retail Business Cost Structure, Business Model, and Margins

Retail businesses use the term overhead when describing their own cost structure and business model and margins.

When a retail business refers to its margin, it has in view the difference between what it pays to acquire goods for sale and the selling price of these goods to customers. Merchandise acquisition cost, however, is not overhead. Acquisition cost and selling price alone determine the firm's margin on sales. A retail merchant may, for instance, acquire goods to sell at a cost of $6 per unit. The same items may sell to customers for $8 each. To the merchant, therefore, each sale earns a 25% margin on sales. The $2 earnings are 25% of the $8 selling price.

Out of the same margin, however, the merchant pays overhead expenses. Many business people in fact classify all merchant expenses, outside of product acquisition costs, as overhead, and these expenses do impact another margin, the firm's overall Net Profit margin.

In this context overhead can include the seller's payments for such things as:

Floor Space Rent or Lease
Sales Commissions
Employee Salaries, Wages
Insurance Premiums
Advertising
Accountant's Fees
Shop Maintenance
Security Services
Taxes
Shipping & Delivery costs
Legal Fees
Inventory Handling
Electricity
Heating & Cooling
Losses to Theft, Shoplifting

Low Overhead! Low Overhead!

It is not unusual for a retail business to claim or advertise that it can offer lower prices than its competitors because it has lower "overhead" costs. This can mean, for instance, that the firm pays less than its competitors for retail selling space, or it pays less for warehouse inventory storage. And, it could also mean the firm simply pays less to its own sales people.

In any case, such messages are meant to enhance the buyer's sense of value by explaining how the firm can offer lower prices without sacrificing product quality.

Overhead in Financial Accounting and Reporting

Business overhead is viewed essentially as a business support cost. Businesspeople often begin explaining the concept by stating what overhead expenses do and do not do:

  • In manufacturing, overhead refers to expenses not easily associated with specific product units. On the automobile assembly line, the employee installing windshields is not overhead because the firm can measure the labor cost for each installation, directly. However, the mechanic repairing assembly line machinery, is overhead expense.
  • For companies that sell services, overhead refers to expenses not clearly tied to specific service delivery engagements. The costs of acquiring and maintaining customer service call center phones, for example, are overhead.

In business generally, overhead refers to costs not easily associated with specific customer sales, product units, or service delivery engagements. As a result …

  • Salaries for executives, managers and administrative assistants are overhead.
  • IT support costs usually qualify as overhead because firms charge them to internal organizations or groups—not to individuals and not for specific product units.

Overhead Impacts Profits

Overhead expenses—along with all other expenses—impact the firm's reported profits each accounting period. As expenses increase, profits decrease. The Income Statement for the period shows the magnitude of this impact, exactly. Note first that this statement is simply a detailed instance of the Income Statement Equation:

Profit = Revenues – Expenses

In brief, profits are what remains after subtracting the period's expenses from the period's incoming revenues. A complete Income Statement example appears below as Exhibit 11.

Where is Overhead on the Income Statement?

Note in Exhibit 11 and in sections below that overhead expenses can appear under any of the major Income Statement headings. Moreover, some Income statement overhead expense categories carry a name that includes Overhead, such as "Manufacturing Overhead." At the same time, many other overhead items are not so-named.

One obvious conclusion from these practices is that the distinction between "Overhead" and "Non Overhead" expenses plays a very minor role, if any, in structuring the Income statement. Nevertheless, cost accountants, analysts, and strategists must know where to find overhead expenses on the statement. That is because Income statement overhead figures serve as input data for certain exercises in product costing and strategy building.

  • Firstly, product production overhead expenses appear above the Gross Profit line, where they impact all profit measures below: Gross, Operating, and Net Profits.
  • Secondly, all other overhead expenses from the firm's core business appear below the Gross profit line, under Operating Expenses. These expenses impact Operating Profit and Net Profit.
  • Thirdly, it is possible, for activities outside the core line of business to incur overhead expenses. Companies report this kind of overhead under major headings below the Operating Profit line. These could include, for instance, "Extraordinary Items," or "Financial Revenues and Expenses."

Fixed vs. Variable Overhead Costs
What Are the Differences?

In cost accounting, budgetary planning, and variance analysis, it is useful to distinguish between fixed overhead costs and variable overhead costs.

  • Fixed overhead costs do not change as the number of units produced or units sold changes.  Manufacturing floor space rental costs, or retail sales floor space leasing costs for instance, normally qualify as fixed overhead costs.
  • Variable overhead costs do increase or decrease with changes in the numbers of units sold or the number of units manufactured. Manufacturing machinery electricity costs, for instance, usually qualify as variable overhead cost.

Fixed and Variable Overhead in Break Even Analysis

When launching a new product, management takes a keen interest in knowing exactly how many product units they must sell for the product to break even. For this, the analyst calculates a break even point—the unit volume for which total production costs equal total incoming sales revenues.

In simple break even analysis, the break even point calculates from just three input variables: Selling price, total fixed cost, and variable cost per unit. Fixed overhead costs and variable overhead costs are of course part of these costs.

See Break Even Analysis for example for more explanation and example calculations.

Overhead Above Gross Profit
Product Production and Service Delivery

Some expenses from the firm's core line of business appear on the Income statement above the Gross Profit line. These are expenses specifically for producing (manufacturing) products the firm will sell. Or, they may represent expenses specifically for preparing and delivering services. As a result, the expense total above Gross Profit may appear under several different names:

Cost of Goods Sold (CGS or COGS)

CGS covers the costs of producing goods for sale.

Cost of Services

Firms that sell services sometimes list the costs of service delivery under Cost of Services. services, These costs may include, for instance, labor, delivery vehicles, other service delivery equipment such as phones. Cost of Service may also include the costs of floor space used exclusively for service delivery activities.

Cost of Sales

Companies that sell both goods and services typically identify as Cost of Sales, all expenses above the Gross Profit line.

Note that "Cost of Sales" expenses, when they above Gross Profit, are the costs these expenses are costs for producing goods or delivering services--not the cost of selling. (Selling expenses appear below Gross Profit as Operating Expenses).

Example Overhead Above Gross Profit

Exhibit 1, below, is an extract from the Exhibit 11 Income Statement. This Exhibit shows just the statement lines above Gross Profit:

Grande Corporation                                   Figures in $1,000's
Income Statement for Year Ended 31 December 20YY   
Revenues
Gross sales revenues
   Less returns & allowances
      Net sales revenues
Cost of goods sold
   Dirct materials
   Direct labor
   Manufacturing Overhead
      Indirect labor
      Depreciation, mfr equipment
      Other mfr overhead
      Net mfr overhead
         Net cost of goods sold
Gross Profit








5,263
360
  4,000


33,329
    346


6,320
  6,100




 9,623



32,983








 22,043
 10,940
 • • • • •
 

Exhibit 1. The Income statement above Gross Profit shows items in Manufacturing overhead as part of Cost of Goods Sold. The complete statement appears below as Exhibit 11.

Note in Exhibit 1 that the Income statements for manufacturing firms usually include a Cost of Goods Sold category called Manufacturing Overhead. This overhead may include such expenses as floor space rent, insurance, as well as indirect materials costs and certain indirect labor costs.

For more on reporting manufacturing labor expenses, see Direct and Indirect Labor.

Overhead Below Gross Profit
Selling, General, and Administrative Expenses

On the Income Statement, expenses from the firm's core line of business appearing below Gross Profit carry the name Operating Expenses. These expenses may in fact appear as items in a single section with that name, "Operating Expenses." Note that this section sometimes has a more descriptive name, such as Selling, General, and Administrative Expenses (SG&A).

Also note that some firms report core business operating expenses under two sub-headings, in this manner:

Operating Expenses
Selling Expenses
General and Administrative Expenses

Exhibit 2 below is an extract from the Exhibit 11 statement, showing how Operating Expenses might appear on the Income Statement for a manufacturing company:

Grande Corporation                                   Figures in $1,000's
Income Statement for Year Ended 31 December 20YY   
 • • • • •
Operating Expenses
Selling expenses

   Sales salaries
   Warranty expenses
   Depreciation, Store equip
   Other selling expenses
          Total selling expenses
General & Admin expenses
   Administrative salaries
   Rent expenses
   Depreciation, computers
   Other general & admin expenses
      Total general & admin exp
           Total operating expenses
Operating Income Before Taxes
  

  4,200
  730
  120
   972


1,229
180
179
   200






6,022





  1,788













  7,810
  3,130
 • • • • •
 

Exhibit 2. Income statement extract with Operating expenses appearing in two sections, (1) Selling expenses and (2) General & administrative expenses. The complete Income statement appears below as Exhibit 11.

Where is the Overhead in Operating Expenses?

The term Overhead does not appear in the Exhibit 2 Income statement extract. Some business people nevertheless describe all such Operating Expenses (all SG&A Expenses) as "Overhead." That position is arguably defensible—at least for manufacturing firms and service providers. Not all businesspeople share that opinion, however.

The position that all operating expenses are "overhead" is less appropriate in retail business. Retail firms—retail merchants—do not manufacture goods for sale. Instead they purchase merchandise inventory ready for sale. For this reason, retail business inventory purchase is an operating expense.

In any case, accountants generally prefer not to debate over which operating expenses are and which are not "overhead." For financial reporting, the classification of expenses as either "Overhead" or "Non Overhead" is a non-issue. Financial accountants prefer instead simply to describe expense items under SG&A more precisely with designations such as the following:

Administrative Expenses

The category Administrative expenses covers office rental, secretarial salaries, utilities, and office supplies, for example. Income statement Administrative expenses also include the salaries of senior executives and managers.

Retail Expenses

Operating expenses that appear as Retail expenses may including such things as store space rental, and the costs of store managers, accountants, secretaries, and other administrative employees who do not have a direct role in selling.

Selling Expenses

For companies that employ sales people in direct selling. "Selling expense" refers to the costs of supporting sales people and selling but which cannot be assigned to specific customer sales. These can include expenses, such as the costs of providing office space and mobile phones for sales people, or sales training.

Research and Development (R&D) Expenses

Research and Development expenses do not support or cover current product or service delivery sales. R&D instead refers to development of new products and services.

Costing Overhead
The Management Accounting Challenge

Firms that produce products for sale must understand their own per-unit product costs accurately. However, production costs typically include substantial overhead. To find the full per-unit product cost, therefore, they must find per-unit overhead costs.

Why Try to Measure Per-Unit Overhead Costs?

On first hearing, the statement above may seem to be an oxymoron—a contradiction in terms and an impossible task for the analyst. Overhead, after all, is defined here and elsewhere as follows:

Overhead:
An expense that cannot be assigned directly or easily to individual product units.

The key words in this statement are directly and easily. Cost accountants and business analysts do in fact try to estimate per-unit overhead costs for products and service delivery engagements—routinely. They may have to use indirect measures and seldom do they find the task "easy." Nevertheless, they must produce per unit product costs—including overhead—because the following activities require them.

Setting Prices

Sellers have available quite a few different pricing models to guide them in setting prices. However, several popular pricing models require that sellers know their own per-unit costs for producing goods or for delivering services. Implementing Cost-plus pricing, for instance, obviously requires full per-unit cost knowledge.

Sellers also need to know their own per-unit costs accurately even when using other pricing models, such as Market-based pricing. In that case, the market—not the seller—determines prices. The seller still must decide whether or not to even bring a proposed product to market when it has to sell at market prices. That decision turns on the gross margin the seller projects for the product. And, gross margins are known only when full per-unit production costs are known.

Product Portfolio Management

Companies that sell from a large product portfolio must know, for themselves, which products earn good margins and which sell at a loss. It is difficult or impossible to manage a large product portfolio effectively without this knowledge. As a result, product managers and marketing analysts take a keen interest knowing the full per-unit margins for individual products. This information is crucial for deciding which products to retire and which to update and re-launch.

Cost Control, Budgeting, and Planning

Every fiscal year, firms that manufacture products for sale and those that sell services develop an Operating Budget for the forthcoming year. For this, they must project incoming revenues as well as production costs. Production costs include the so-called direct costs to cover as well as quite a few indirect costs (production overhead costs), which they will eventually report under Cost of Goods Sold. These forecasts, in turn, depend largely on projected production needs and projected sales volume.

From this it follows that forecasting product production costs accurately requires precise knowledge of per-unit overhead costs.

Keep it Private! Per-Unit Overhead as Proprietary Information

For public companies, overall gross profits and gross margins are public knowledge. These are readily apparent on the firm's published Income statement. What the public does not see, however, are the firm's gross margins for individual product or service offerings.

Companies in competitive industries normally treat their product gross margins as sensitive proprietary information, which they hide from the public.

  • Outside consultants find they must sign a non-disclosure agreement covering this information before they can work with the firm.
  • New employees find, upon hiring, they must sign a similar agreement promising not to disclose this information should they leave the firm.

Product-specific gross margins and per-unit overhead costs are especially sensitive issues when an employee with this knowledge leaves the firm to work for a competitor.

Example: Traditional Costing vs. Activity Based Costing

Without doubt, cost accountants can measure some of the costs that go into product production or service delivery easily and directly on a per-unit basis. These are called—not surprisingly—direct costs when they appear under Cost of Goods Sold. On an automobile assembly line, for instance, the employee labor time required to install the windshield each car is known. To find the per-unit cost per unit, the analyst simply multiplies labor cost per minute by the number of minutes in each installation.

Producing a cost figure for the so-called indirect costs (production overhead costs) is not so straightforward. To produce a per-unit overhead cost total, the analyst has available two different approaches:

  1. Estimating and assigning per-unit overhead costs with allocation.
  2. Measuring per-unit overhead costs directly with activity based costing.

The costing example in this section and following sections shows firstly that each approach has its own rationale, and secondly, that different costing methods can reach different conclusions about per-unit overhead costs and product gross margins.

Two Products With Different Production Needs

For this example, consider a costing challenge facing Autofirma Company. Autofirma manufactures and sells two product models, Model A and Model B. Exhibit 3 below shows how the two product models compare with respect to certain sales and production factors:

Comparing Products Model A Model B
   1. Selling Price Higher price Lower price
   2. Materials
    Purchased
More materials purchase orders, smaller orders Fewer materials purchase orders, larger orders
   3. Production
    Runs
More production runs, smaller runs Fewer production runs, larger runs
  4. Machine
    Set Ups
More machine set ups Fewer machine set ups
  5. Packaging 1 Unit per package 4 Units per package
  6. Direct Labor More direct labor required Less direct labor required
  7. Direct 
    Materials
Higher direct materials cost Lower direct materials cost
 Exhibit 3. Comparing product Models A and B production. The comparison suggests that the two models have different production processes.

Two Products With Different Product Cost Structures

The comparisons in lines 2 - 6 of Exhibit 3 do suggest strongly that the two product models have different product cost structures. This means that total per-unit production cost is no doubt distributed differently among cost categories for each product. And, if these differences prove real, the two products very likely earn different margins.

When a firm produces different products, each with its own product cost structure, managers normally take a keen interest in uncovering the actual profitability of each product. This information supports pricing activities, budgeting, planning, and effective product portfolio management in general.

While finding the per-unit direct costs is usually straightforward and easy, finding the per-unit indirect (overhead) costs is a different matter. For these, the firm must choose and apply a costing methodology. In most cases, this means choosing between traditional cost allocation and activity based costing. 

The example below shows some of the input data and typical results for both costing methods. For more in-depth coverage of the same example, see Activity Based Costing ABC. That article provides more detail on the input data, assumptions, intermediate calculations, and costing results for product models A and B

Input Data for Both Costing Methods

During one fiscal year, Autofirma produces and sells:

  • 900,000 units of product Model A at $3.00 per unit
  • 2,100,000 units of Model B at $2.00 per unit.

Direct Costs Are the Same Under Both Costing Methods

Direct costs for each product calculate in the same way under both costing methods. Exhibit 4 below shows the resulting revenues and direct costs for these sales.

Exhibit 4 shows that the analyst has produced product-specific direct costs on a per-unit basis. Line 9 of Exhibit 4 shows that Model A has a per-unit direct cost of $1.25 while Model B has a per-unit direct cost of $1.00. The per-unit direct costs will contribute later to product-specific gross margin calculations.

Note especially that per-unit direct costs will be the same under both costing methods.

Comparing Products Model A Model B Total
1. Units Produced & Sold 900,000 2,100,000 3,000,000
2. Selling Price / Unit $3.00 $2.00  
3. Direct labor Cost / Unit $0.50 $0.50
4. Direct Materials Cost / Unit $0.75 $0.50
5. Sales Revenues [ = 1 * 2 ] $2,700,000 $4,200,000 $6,900,000
Direct Costs
6. Direct Labor Costs [ = 1 * 3 ] $450,000 $1,050,000 $1,500,000
7. Direct Materials Costs [ = 1 * 4 ] $675,000 $1,050,000 $1,725,000
8. Total Direct Costs [ = 6 + 7 ] $1,125,000 $2,100,000 $3,225,000
9. Direct Costs / Unit [ = 8 / 1 ] $1.25 $1.00  
Exhibit 4. Sales revenues and direct costs for product models A and B. Direct costs appear in lines 6 - 9. Direct cost figures are the same under both costing methods.

Per Unit Overhead With Traditional Costing

Note that Exhibit 4 says nothing about overhead cost items such as indirect labor. These are absent from the table because the firm has not yet costed overhead for individual products. Certainly, Model A has a greater per-unit direct labor cost than Model B. However, the total per-unit product costs are still unknown.

In order to find total product costs for each product, Autofirma must now find product-specific indirect (or overhead) costs. The indirect cost results in Exhibit 5, below result from a simple method called production volume based (PVB) cost allocation. Note incidentally that some analysts will refer to this approach simply as traditional cost accounting.

Major Steps in Cost Allocation

The major steps in PVB are the following:

  • The PVB process starts with the firm's overall total cost for each indirect cost item. The process purpose is to allocate these totals to different products. Here, for instance, the overall total for indirect labor was $1,422,500.
  • The firm allocates total indirect labor cost to product models A and B based on proportional usage of production factors which are known directly, on a per-unit basis. In this case, Autofirma allocates indirect labor costs referring to each product's consumption of direct labor resources.
  • Total direct labor costs for this accounting period were in this case were $1,500,000 (Exhibit 5, line 6).
  • From these figures, Autofirma finds that total indirect labor costs were 94.8 % of total direct labor costs. That is, $1,422,500 / $1,500,000 = 94.8%.
  • For product Model A, direct labor costs are $450,00. The indirect cost allocation for A is 94.8% of this, or $426,750.
  • For product B, direct labor costs are $1,050,000. The indirect cost allocation for model B is 94.8% of this, or $995,750.

Example Cost Allocation Results

These allocated cost estimates for each product Model appear in line 11 of Exhibit 6. Note especially the per-unit gross profit and gross margins for each product model in Exhibit 6 lines 15 and 16.

     Comparing Products

Model A Model B Total
9. Units Produced and Sold
[Exhibit 5, line 1]
900,000 2,100,000 3,000,000
10. Total Direct Costs
[Exhibit 5, line 8]
$1,125,000 $2,100,000 $3,225,000
11. Total Indirect Costs
[Allocation shown above]
$426,750 $995,750 $1,422,500
12. Revenues Per Unit
[Table 5, line 2 ]
$3.00 $2.00  
13. Direct Costs / Unit
[ = 10 / 9 ]
$1.25 $1.00
14. Indirect Costs / Unit
[ = 11 / 9 ]
$0.47 $0.47
15. Gross Profit / Unit
[ = 12 − 13 − 14 ]
$1.28 $0.53
16. Gross Profit Margin
[ = 15 / 12 ]
42.5% 26.3%
 Exhibit 6. Gross profit and gross margin calculation for each product, using
 traditional cost allocation for indirect costs.

Models A and B Bottom Line Under Traditional Cost Allocation:

  • Per-unit indirect costs for Models and B are both $0.47 (Exhibit 6, line 14).
  • Equality between product models must result because indirect costs for both products use the same allocation rate ( 94.8%) applied to the same direct labor rate ($0.50 / unit (Exhibit 5, line 3)
  • Each Model A unit sold earns a gross margin of 42.5%. Model B's per-unit gross margin is 26.3%.
  • Conclusion: Model A is more profitable than B.

Per-unit Overhead With Activity Based Costing

Cost analysts do not always trust traditional cost allocation methods to distribute indirect costs fairly among products. The PVB allocation example above, for instance, assigns indirect labor costs to products by referring to their use of another resource, direct labor. In most such cases, however, the connection between usage of an overhead resource and a directly measured resource (direct labor) is less than certain.

The product comparisons in Exhibit 4 above, for instance, would lead many to expect Models A and B to have quite different resource usage profiles. However, absent more data on product resource usage, there is simply no way to know whether or not per-unit direct labor is a suitable stand-in for indirect labor. In such cases, analysts sometimes turn to another costing methodology, Activity Based Costing (ABC).

ABC is based on the premise that analysts can in fact measure the so-called indirect costs directly, given more data on the production activities required by each product. The example immediately below describes in principle how this is done, as well the results of an ABC costing analysis of Autofirma product Models A and B.

The example below shows some of the input data and typical results for both products under ABC. For more in depth coverage of the same example, see Activity Based Costing ABC. That article covers in detail the input data, assumptions, intermediate calculations, and costing results for Models A and B

Direct Costs Are the Same Under Both ABC and PVB Allocation Costing Methods

Direct costs for both product models are the same under both traditional PVB allocation costing and ABC. For direct costs, accountants calculate per-unit direct costs from (1) product-specific use of the direct cost item, and (2) the number of product units produced.

Sales data and direct costs for Autofirma product Models A and B appear above as Exhibit 5.

Assigning Costs to Activity Pools

Turning to overhead cost items (the so-called indirect items), note that each overhead cost contributor in ABC is called an activity pool. Specifically, an activity pool is the full set of all activities needed to finish a task. The set of activities needed to perform production machine set up, for instance, is the machine set up activity pool.

Total activity pool cost, for each product, requires finding cost drivers (CDs) for each pool. In the case of machine set up, the single CD is the labor cost per set up, which in this example is $1,500.

With activity pool cost drivers known, the analyst can then begin to differentiate Models A and B from each other by counting machine set ups for each product model number. And, from that , it is easy to calculate product-specific activity pool costs. In this case:

  • Product model A required 150 machine set ups at $1,500 each. Total overhead cost for Product A machine set up was therefore 150 x $1,500 = $225,000.
  • Product model B needed 100 machine set ups at $1,500 each. Total overhead cost for Product B machine setup was therefore 100 x $1,500 = $150,000.

Finding Total Overhead Costs for Each Product.

In this example, machine set up is just one of five overhead cost items. The full analysis includes activity pools for (1) machine set ups, (2) purchase order processing, (3) product packaging, (4) Machine testing and calibration, and (5) maintenance and cleaning. The analyst finds costs for activity pools 2-5, for each product, in the same way machine set up costs were found.

For the the cost sums for all 5 overhead activity pools are as follows:

  • Product Model A, total overhead activity pool cost: $870,000.
  • Product Model B, total overhead activity pool cost: $552,000

Finding Per-Unit Overhead Costs for Each Product

Autofirma now finds per-unit overhead costs by dividing the total overhead activity pool cost, for each product by the numbers of product units produced and sold (Exhibit 5, line 1).

  • For product model A, total overhead activity pool cost of $870,000 divided by 900,000 units gives a per-unit overhead cost of $0.97.
  • For product model B, total overhead activity pool cost of $552,000 divided by 2,100,000 units gives a per-unit overhead cost of $0.26

Exhibit 7 below shows how these costs contribute to the Activity Based Costing based profitability calculations for each product.

     Comparing Products

Model A Model B Total
22. Units Produced and Sold 
[Table 2, line 1]
900,000 2,100,000 3,000,000
23. Total Direct Costs
[Table 2, line 8]
$1,125,000 $2,100,000 $3,225,000
24. Total Overhead Costs
[Table 5C, line 21 ]
$870,000 $552,500 $1,422,500
25. Revenues Per Unit
[ Table 2, line 2 ]
$3.00 $2.00  
26. Direct Costs / unit
[ = 23 / 22 ]
$1.25 $1.00
27. Overhead Costs / Unit
[ = 24 / 22 ]
$0.97 $0.26
28. Gross Profit / Unit
[ = 25 −26 − 27 ]
$0.78 $0.26
29. Gross Profit Margin
[ = 28 / 25 ]
26.1% 36.8%
Exhibit 7. Calculating product model-specific gross profit and gross margins. through activity based costing.

Conclusions: Activity Based Costing Example.

  • ABC finds different per-unit overhead costs for each product. By contrast, traditional cost allocation showed the same per-unit indirect (overhead) cost for Models A and B.
  • In other words, ABC reports here that Model A uses more activity pool resources than Model B.
  • Product-specific gross profits and gross margins result from adding the following figures:
    • Per-unit direct costs (Exhibit 6, line 13).
    • Per-unit indirect costs (Exhibit 7, line 27).
  • ABC thus finds product B more profitable than product A. Model B's gross margin of 36.8% for B compares with Model A's gross margin of 26.1% (Exhibit 7, line 29).

Comparing OH Costing Methods:
Results, Advantages, Disadvantages

Exhibit 8 below has per-unit profitability estimates for Autofirma's Model A and Model B.

     Product Gross Margin

Model A Model B
Margins Under Traditional Cost Allocation
42.5% 26.3%
Margins Under Activity Based Costing 26.1% 36.8%
Exhibit 8. Different costing methods lead to different product gross margins. Traditional allocation approach finds product Model A more profitable than Model B. Activity based costing finds Model B more profitable than Model A. The differences between methods are due entirely to differences in overhead (indirect) costs.

Key Differences Between Costing Methods

The Autofirma example illustrates some of the key differences between cost allocation and activity based costing.

Amount of Data and Analysis Work

  • For ABC, the analyst must understand in detail the activities that constitute overhead support. The analyst must also know the resources they consume, and their cost drivers.
  • The analyst can apply traditional cost allocation knowing only total overhead cost and a simple allocation rule.

Activity based costing, in other words, is more data intensive and more labor intensive than cost allocation.

ABC Differentiates, Allocation Aggregates

  • Activity based costing recognizes that different products may use overhead components differently. One product model may need more maintenance work and resources, for example, while a different product consume relatively more maintenance resources, for instance, while another model may require less maintenance but relatively more production set up resources.
  • Allocation methods often put indirect components into fewer categories, or even a single category. Traditional cost allocation often uses a single allocation rate for all products.

Activity based costing, in other words, makes finer distinctions between support activities and between individual products. 

Direct vs. Indirect Measurement

  • This is because ABC results reflect actual cost driver consumption for each product model. These costs, in turn, enable the analyst to find per-unit overhead costs for individual products.
  • Cost allocation begins with accurate knowledge of total overhead cost. However, allocation distributes that total to individual products based on indirect measures of that cost.

As a result, activity based costing usually succeeds in turning so-called indirect costs into direct costs.

Should the Firm Move From Traditional Costing to ABC?

For the profit and profitability figures in Exhibits 6, 7, and 8, most businesspeople will probably see the ABC results to more accurate results allocation-based results. Most will no doubt be confident that the ABC-based figures more closely reflect true production costs and true margins.

In such cases, management will no doubt ask: Does the improved costing accuracy justify the higher cost of applying activity based costing? That is a question that local management must investigate and answer to its own satisfaction before committing to a comprehensive move to activity based costing.

Overhead Targets in Business Strategy

Business firms in competitive industries rightly call the top-level business strategy a competitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins. As a result, when a firm chooses a competitive strategy, it is at the same time setting target levels for overhead in its business model.

During the strategy building process, company leaders will ask questions like these:

  • Is the proposed strategy viable?
    That is, "Can we earn acceptable margins with this strategy?
  • Is the proposed strategy realistic?
    That is, "What is the likelihood we actually reach target profits and target margins?

To address such questions, the firm builds a quantitative example of business model implied by the strategy. The overhead concept plays a central role in providing credible answers. Understanding this role begins by understanding first the overhead implications of the firm's possible strategic choices. Exhibit 9 below summarizes these choices.

Choosing a Competitive Strategy.

Text book presentations on business strategy usually refer to several ideas underlying Michael Porter's approach to describing business strategy. Their best-known presentation appears in Porter's books Competitive Strategy 1 (1980) and Competitive Advantage2 (1985). Exhibit 9, below, shows the four choices available to strategy builders under Porter's system.

    Source of Competitive Differentiation
  Cost Leadership Product Differentiation
Market
Scope
Broad Cost Leadership Strategy Broad Differentiation Strategy
Focused Cost Focus Strategy Differentiation Focus Strategy
Exhibit 9. Michael Porter's Four Generic Competitive Strategies

Regarding the horizontal axis in Exhibit 9, firms that choose a "Product Differentiation" strategy can look forward to a business model very different from the model that results from choosing "Cost Leadership.

Strategy 1. Product Differentiation

Firms that choose to differentiate via Product Differentiation try to bring uniquely desirable products and services to market. In other words, they attempt to…

  • Communicate desirability, exclusiveness, superior design, or high quality.
  • Create new products or services.
  • Add unique features or capabilities to existing products.
  • Sell at lower prices.

Implementing a "Product differentiation" strategy inevitably calls for relatively high overhead levels in the firm's business model.

Strategy 2. Cost Leadership

On the other hand, firms that differentiate via Cost Leadership try to minimize their own production and selling costs. As a result, the firm can charge industry average prices and still earn greater profits and margins than its competition because its own costs are lower.

However, firms using cost leadership may also add an element of product differentiation by selling at lower prices. They can do so and still realize good margins because their own costs are lower.

Implementing a "Cost leadership" strategy calls for relatively low overhead levels in the firm's business model.

Reality Check: Overhead in the Business Model

The strategy is ready for implementation only after it validates with a quantitative business model. The model is meant to show whether or not a proposed strategy can actually bring desirable sales revenues, margins, and profits.

Here, the challenge is to build the quantitative model implied by the strategy that is realistic and credible. For this, the strategy builder refers to the firm's strategic business objectives, knowledge of the operating environment, and knowledge of the market. The model derives from this knowledge, along with realistic sales and cost assumptions.

Two strategies, Two Different Business Models

In its simplest form, the business model representing a strategy looks like a simple version of the Income statement. The model builder forecasts sales revenues and then, from these, subtracts forecasted expenses. This produces figures for profits and margins—gross profit, gross margin, operating profit before taxes, and operating profits and margin after taxes. When the firm decides to implement the strategy, the model becomes the cornerstone of the firm's business plan.

Exhibit 10, below has the business models from two different firms, each testing the viability of its own competitive strategy.

Alpha Corporation                             Business Model
Product Revenues
Cost of Goods Sold
      Gross Profit on Products

Services Revenues
Cost of Services
      Gross Profit on Services

Gross Profit Total

Operating Expenses
      General & Admin Expenses
      Sellling Expenses
         Total Operating Expenses

Net Profit Before Taxes
Tax on Operating Proft @30%

Net Profit After Taxes
100,100
 62,827


50,000
 35,000





28,700   12,811


37,273



  15,000

  52,273




 41,511

10,722
  3,217

7,505


← 37.2% Margin


← 30.0% Margin










← 5.0% Margin
Beta Corporation                               Business Model
Product Revenues
Cost of Goods Sold
      Gross Profit on Products

Services Revenues
Cost of Services
      Gross Profit on Services

Gross Profit Total

Operating Expenses
      General & Admin Expenses
      Sellling Expenses
         Total Operating Expenses

Net Profit Before Taxes
Tax on Operating Proft @30%

Net Profit After Taxes
150,100
 118,011


20,000
 18,000





16,825
  5,020


31,989



  2,000

  33,989




 21,845

12,144
  3,643

8,501


← 21.3% Margin


← 10.0% Margin










← 5.0% Margin
 

Exhibit 10. The quantitative business models for two strategies, from two different firms. Alpha corporation has a "Product differentiation" strategy that results in relatively higher overhead costs. Beta Corporation has a "Cost leadership" strategy that relies on lower overhead costs. In this case, both strategies forecast a bottom line net profit margin of 5%

Is the Alpha Strategy Viable? Will Alpha Corporation Succeed?

Alpha Corporation chose a "Broad Differentiation" strategy. The firm intends to differentiate itself as follows:

  • Strong branding emphasizing product quality, "cutting-edge" design, and desirability. Branding efforts will communicate qualities central to the firm's value proposition.
  • Unique product features and capabilities. For these, Alpha to intends achieve market penetration and market leadership by being "first to market"
  • With successful branding, moreover, Alpha believes it can charge premium prices and still sell successfully in a very broad market.

Alpha's model in Exhibit 10 shows the likely results of applying this strategy: Gross margins for products and services are relatively high (37% and 30%, respectively). However, Alpha's overhead for selling, administration, and overhead are also relatively high. Therefore, despite the high gross margins, the overall after tax net (operating) profit margin is only 5.0%.

Alpha leadership will now ask whether or not Net profits of $7,505,000 and a 5% Net Profit Margin are acceptable.

  • If such results are acceptable, Alpha can now build a business plan based on its model.
  • If, however, the Alpha leadership finds these results unacceptable, the firm will look for ways to apply still more overhead to improve differentiation, and at the same time improve sales revenues forecasts.

Is the Beta's Strategy Viable? Will the Beta Strategy Succeed?

Beta corporation has chosen a "Cost Leadership" strategy, targeting a broad market. For this, Beta will differentiate itself from competitors by selling at prices below industry averages. Success with the strategy depends on keeping overhead expenses low.

With this strategy, Beta expects lower gross margins than Alpha for products and services (21% and 10%, respectively). Nevertheless, Beta's model still forecasts $8,505,000 and an an after tax Net profit margin of margin of 5.0%.

Beta leadership will now ask whether or not Net profits of $8,501,000 and a 5% Net Profit Margin are acceptable.

  • If such results are acceptable, Beta can now build a business plan based on its model.
  • If, however, Beta leaders are not be satisfied with such results, the firm will look for ways to reduce overhead costs still further, so as to improve forecasted profits and margins.

Example Income Statement
With Overhead Items

Exhibit 11, below, is an example Income statement with typical level of detail for the Annual Report. Overhea

Grande Corporation                                   Figures in $1,000's
Income Statement for Year Ended 31 December 20YY   
Revenues
Gross sales revenues
   Less returns & allowances
      Net sales revenues
Cost of goods sold
   Dirct materials
   Direct labor
   Manufacturing Overhead
      Indirect labor
      Depreciation, mfr equipment
      Other mfr overhead
      Net mfr overhead
         Net cost of goods sold
Gross Profit








5,263
360
  4,000


33,329
    346


6,320
  6,100




 9,623



32,983








 22,043
 10,940
Operating Expenses
Selling expenses

   Sales salaries
   Warranty expenses
   Depreciation, Store equip
   Other selling expenses
          Total selling expenses
General & Admin expenses
   Administrative salaries
   Rent expenses
   Depreciation, computers
   Other general & admin expenses
      Total general & admin exp
           Total operating expenses
Operating Income Before Taxes
  

  4,200
  730
  120
   972


1,229
180
179
   200






6,022





  1,788













  7,810
  3,130
Financial revenue & Expenses
  Revenue from investments
      Less interest expense
      Net financial gain (expense)
Income before tax & ext items
  Less income tax on operations
    Income before extraordinary items
 



118
  511



  (393)
 2,737
  958
1,779
Extraordinary Items
   Sale of land
   Less initial cost
      Net gain on sale of land
      Less income tax on gain
         Extraord items after tax
 
610
  145



465
  118





  347
Net Income (Profit)       2,126
 

Exhibit 11. Example Income statement with individual Manufacturing Overhead items. Below the Gross Profit line, other overhead expenses are part of the listing "Other General & Administration Expenses."

1. Porter, M.E. Competitive Strategy, Free Press, New York, 1980.
2. Porter, M.E. Competitive Advantage, Free Press, New York, 1985.

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