M4_A1 ABC or Activity Based Costing

CHAPTER 9 Accounting and Information Systems

This chapter considers the use of accounting information systems. We look at different methods of data collection and different types of information systems, with a particular focus on enterprise resource planning systems. The chapter also reviews the importance of a horizontal business process perspective on organizational functioning, rather than a vertical, hierarchical, or functional business unit perspective. The chapter concludes with an overview of the importance of systems design and internal controls for information systems.

Introduction to accounting and information systems

An information system is a system that collects information and presents it, usually in summarized form, for management. Data is a set of raw facts. Information is different from data because it has been made usable by some form of summarization and/or analysis. For example, daily sales data can be summarized and analysed as trends by customer and/or product/service in a monthly sales analysis report and thereby become meaningful management information which can be used for decision making.

Organizations will typically have an information systems (IS) strategy which follows the organizational business strategy and determines the long-term information requirements of the business. The IS strategy provides an ‘umbrella’ for different information technologies to help ensure that appropriate information is acquired, retained, shared, and available for use in strategy implementation. The IS strategy can be distinguished from the information technology (IT) strategy which defines the specific systems that are required to satisfy the information needs of the organization, including the hardware, software, and operating systems. The third element is the information management (IM) strategy which is concerned with ensuring that the necessary information is being provided to users. This includes the type of database that is used, data warehousing, and reporting systems.

Information is an essential tool of management, but it needs to be relevant, timely, accurate, complete, concise, and understandable. The benefits of quality information that meets these criteria may include improved decision making, better customer service, improved product/service quality, enhanced productivity, and reduced staffing and waste. However, the collection, processing, analysis, and reporting of information is an expensive process (e.g. the cost of hardware, software development, staff time), and organizations need to ensure that the value of the information obtained is greater than the cost of providing that information.

An accounting information system is one that uses technology to capture, store, process, and report accounting information. However, in this chapter we consider accounting to be only one component, albeit an important one, of management information systems.

Methods of data collection

Most data collection in organizations takes place as a by-product of transaction recording through computer systems, which have automated tasks that were carried out before computers by manual processing of documents and entries into journals and ledgers (Chapter 3 described the recording of financial transactions).

Computer systems have substantially automated routine tasks with multiple aspects of a transaction being carried out simultaneously. For example, credit sales typically incorporate the whole process of delivering goods (or services) by producing a delivery docket that accompanies goods, reducing inventory, producing an invoice, updating the receivables (debtor) records to show the amount owed by customers, producing a sales analysis by customer/product, and calculating the gross profit margin on the sale by deducting the cost of sales. This information is transferred into the general ledger, where along with all other similar transactions it is summarized and reported as sales and gross profit.

Retailers make extensive use of electronic point of sale (EPOS) technology which uses bar code scanning to reduce inventory, price goods and calculate margins, and print a cash register listing for the customer. Over a time period (day, week, or month) the outputs from such a system include a detailed analysis of business volume (e.g. number of customers, number of items sold, scanning time at the checkout), sales analysis by product, product profitability, and inventory reorder requirements. Additional benefits of EPOS include information about peak sales times during each day, products that may need to be discounted, and sales locations that may need to be expanded. More recently, supermarkets have introduced self-scan units where customers scan, pack, and pay for their own purchases without the need for a checkout operator. In many stores, a single member of staff can supervise up to a dozen self-scan terminals, a significant labour cost saving for supermarkets. Even small businesses like restaurants can take advantage of modern point of sale terminals that are relatively inexpensive and can enable business owners to monitor customer seating, generate orders for the kitchen, price goods and calculate bills, and provide detailed management reporting on inventory, sales trends, etc.

The use of electronic funds transfer at point of sale (EFTPOS – whether debit or credit cards) means that customers do not have to pay cash (which is expensive for retailers to deal with due to security requirements) but can automatically transfer funds from their bank account (or credit card) to the retailer’s bank account, thereby eliminating further transactions. ‘Pay pass’ or ‘pay wave’ technology allows customers to merely pass their card over a terminal to pay for smaller value purchases without the need to enter account and PIN details, saving time for staff taking customer money. Some banks now provide their merchant customers with demographic data on customer spending using debit/credit cards, including number of transactions and average spend by customer age, gender, place of residence, etc.

The increase in e-commerce for business-to-consumer (B2C) sales means that for many products and services, purchasing over the internet enables customers to carry out the data processing previously carried out by a retailer’s own employees. Companies such as Amazon and iTunes save costs by not needing expensive retail premises or staff taking customer orders. Customers order and pay online. All the retailer has to do is ship the goods (and for iTunes, Apple doesn’t even have to do that as the customer downloads the purchased product). For business-to-business (B2B), electronic data interchange (EDI) enables supplier and customer systems to be linked by a common data format so that purchase orders raised by the customer are automatically converted into sales orders on the supplier. For example, in the automotive industry, orders from the major vehicle assemblers are placed on suppliers using EDI. EDI transactions enable the supplier to confirm their ability to meet the order by online means. The use of EDI enables automatic generation of invoicing by the supplier, tracing of deliveries by the logistics supplier, and receipt of goods by the vehicle assembler, ultimately leading to payment to the supplier (for a case study, see Berry and Collier, 2007).

An important part of data collection is collecting the financial details of a transaction. Also important is capturing as much information as possible about the transaction from a non-financial perspective. An example of this is the information collected from customers through retail credit cards, store loyalty cards, frequent flyer, and similar programmes. These enable retailers to maintain a detailed knowledge of their customers’ purchasing habits to enable targeted promotional campaigns aimed at specific customers.

Another source of data is that which is available from and about suppliers. For example, in the automotive industry, the large vehicle assemblers collect vast quantities of information about their suppliers’ costs: their cost of labour; the cost of manufacturing equipment and its capacity; the cost of raw materials such as steel. Much of this information is publically available but retaining it in an organization’s information system supports subsequent negotiations between the automotive assembler’s purchasing department and its suppliers. By using this information, buyers can check the reasonableness of supplier prices for component parts, as buyers can perform their own checks on what it should cost to produce the same components. This more strategic use of accounting information is described further in Chapter 18.

Of course, the more that is expected of an information system, the more data has to be collected, stored, and reported. Accounting is one type rather than the only type of information that is collected. In Chapter 4, we saw that Balanced Scorecard-type performance measurement systems collate and report information about customers, business processes, and innovation to supplement financial performance measures. Therefore, organizations need to capture information from their marketing, purchasing, production, distribution, and human resource activities. Information about key factors such as customer satisfaction, cycle times (from order to delivery), quality, waste, and on-time delivery need to be part of an information system and integrated with and reported together with financial information for management purposes.

Big data

Large volumes of information are now available from public sources. The term ‘big data’ refers to very large and complex data sets, which can be seen in the massive data resources of the internet and the results provided by search engines such as Google, or data held on Facebook. Organizations are able to access this information (for a fee) to enable targeted marketing. According to IBM (2012), 90% of the data in the world today has been created in the last two years. This data comes from, for example, sensors used to gather climate information, posts to social media sites, digital pictures and videos, purchase transaction records, and mobile phone signals.

Strategic intelligence and learning are more feasible with the advent of technologies to access ‘big data’. It is now possible to collect extensive data about potential customers through their interaction with a business’s website and through interaction with social media such as Facebook and Twitter. This data can be mined to learn about customers, competitors, and products/services. Parise, Iyer, and Vesset (2012) distinguish social analytics (non-transactional, social data) from performance management (business intelligence using transactional data). In non-transactional data, Parise, Iyer, and Vesset describe the use of social metrics to help inform managers about the success of their external and internal social marketing campaigns and the ability to calculate a ‘digital footprint’.

However, big data faces the problem of how to analyse multiple pictures to devise the optimum strategy. Buytendijk (2010) has emphasized the limitations of analytics in performance measurement because, as he explains, strategy is concerned with satisfying the often differing expectations of different stakeholders. Developing strategy is full of dilemmas and analytical thinking is only partly helpful in dealing with these dilemmas. Rather than analysis, Buytendijk emphasizes the importance of synthesis, the process of taking multiple, sometimes contradictory, ideas and bringing them together to create a single picture.

From an accounting perspective, while these sources of data can provide valuable information, it can come at a significant cost to the business. A cost-benefit analysis needs to be conducted to ensure that the value to the business of this information exceeds its cost of acquisition, storage, and analysis.

Types of information system

There are various types of information system.

Transaction processing systems collect source data about each business transaction, for example customer orders, sales, purchases, inventory movements, payments, and receipts. Transaction processing reports are important for control and audit purposes but provide little usable management information. Data from transaction processing systems is predominantly financial in nature. The most common form of delivering management information to users has been the ‘hard copy’ report, a computer-generated report that may list transactions (a transaction report or audit trail), exceptions (an exception report, such as product sales below a predetermined price level), or a summarized report (e.g. a sales analysis) for a period.

Management information systems (MIS) may extend from financial to non-financial information and typically are more oriented to support management decisions. For example, displays of key performance data with graphical representation are becoming increasingly common. Traffic lights (red/amber/green) draw attention to those aspects of performance that are meeting target (green), those that are in need of urgent attention (red), and those that need to be considered as they are borderline (amber). However, these systems do not integrate accounting, manufacturing, and distribution systems. Market research carried out by Oracle (2011) identified criticisms by respondents including an over-reliance on spreadsheets, working with out-of-date data from multiple ‘silos’ of information, and a lack of data sharing between departments.

An enterprise resource planning (ERP) system helps to integrate data flow and access to information over the whole range of a company’s activities. ERP systems typically capture transaction data for accounting purposes, together with operational, customer, and supplier data which are then made available through data warehouses against which custom-designed reports can be produced. ERP systems take a whole-of-business approach. ERP system data can be used to update performance measures in a Balanced Scorecard system (Chapter 4) and can be used for activity-based costing (Chapter 13), shareholder value analysis (Chapter 2), strategic planning, customer relationship management, and supply chain management (Chapter 18). ERP systems are a development of earlier material requirements planning (MRP), distribution requirements planning (DRP), and manufacturing resource planning (MRP2) systems.

Strategic enterprise management systems (SEM) are a type of ERP system that provide support for the strategic management process. They are based on data stored in a data warehouse which is then used by a range of analytical tools. An SEM can be an important driver of organizational performance as it enables faster and better decision making at all organizational levels.

Decision support systems (DSS) go a step further and contain data analysis models that provide the ability for managers to simulate scenarios or ask ‘What if?’ questions so that different options can be considered to aid in decision making. DSS may be contained in a spreadsheet or in a complex software package.

Executive information systems (EIS) are systems used for decision support which incorporate access to summarized data, often in graphical form, to enable senior managers to evaluate information about the organization and its environment. An EIS utilizes a ‘drill-down’ facility to move from aggregated data down to a more specific and detailed level (e.g. customer, product, business unit). Information is typically also available from external sources, for example public databases. Ease of use is an important feature so that enquiries can be made without a detailed knowledge of the underlying data structures.

Expert systems store data relevant to a specialist area and are populated with knowledge gained from experts which is retained in a structured format or knowledge base. Expert systems provide solutions to problems that require discretionary judgement. Users access data through a graphical user interface (GUI) to ask questions of the system, which prompts the user for more information. Various rules are then applied by the expert system to make decisions. The best example of an expert system is that used for credit approval. Information is entered to the system in response to prompts, such as postcode, telephone number, age, employment history, which is compared with confidential data held by credit reference agencies on a large number of similar applicants to make an automated judgement about an applicant’s creditworthiness and the allocation of a credit limit.

In this chapter, we will use the term ‘enterprise resource planning’ (ERP) systems to refer to information systems that are not limited to accounting but integrate different functional areas of the business and take a business process perspective. The best-known examples of these systems include SAP and Oracle. These systems can be extended with tools such as Business Intelligence (or BI) or tools that enable SEM, DSS, EIS, or expert applications. ERP systems avoid ‘information silos’ that provide limited and specialist information to narrow groups of managers. Often these silos (typical of older transaction processing or MIS systems) are based on different software packages, use different databases, and do not always report timely, accurate, or consistent data to users. Although different modules exist in an ERP (e.g. customer order entry, inventory, invoicing, accounts receivable, management reporting), these are all integrated so that each module provides consistent information to users.

While an ERP system makes reporting easy in terms of the hierarchical or vertical structure of organizations, as reflected in the traditional organization chart, increasingly businesses are looking at the horizontal business processes that cut across departmental structures.

Business processes

We typically think of an organization in terms of its hierarchical structure: a head office with departments responsible for marketing, production, and administration; or a business unit structure with autonomous units responsible for particular products/services or geographic territories. Financial information about the hierarchical structure is important for internal financial reporting, comparing actual with budget performance and holding managers accountable for the performance of their departments or business units.

However, an organization can also be thought of as a collection of processes or activities that when combined form part of the value chain (see Chapter 11 ) delivering value to customers. The hierarchical perspective is based on functions carried out such as selling or accounting, with different specialists responsible for each. The business process perspective is a horizontal rather than a vertical perspective on the organization, where the focus is on how things are done to satisfy customer demand, with more emphasis on generalists rather than specialists. One example of a business process starts with accepting a customer’s order and ends with delivering it to the customer, including the accounting transaction of invoicing the customer. Another business process is that of placing an order with a supplier through to receiving the goods or services and making payment to the supplier.

Flowcharting and process mapping are commonly used methods for representing business processes. Process maps are graphical representations of business processes showing the activities and flows of data between activities and the areas responsible for carrying out those activities. These can be simple or complex.

Figure 9.1 shows a simplified example of a process map for processing a customer order and its computer entry through the physical picking of goods from a warehouse to dispatch and invoicing. To satisfy the customer, this needs to be an effective, seamless, and error-free process. However, in this example five separate departments are involved (Sales, Order Processing, Warehouse, Transport, and Accounting). As we will see in Chapter 13 , accounting systems generally capture costs for departments (i.e. at the vertical or hierarchical level), but what is more important in terms of cost, efficiency, and quality is the cost of the business process itself, and the need to streamline that business process as much as possible.

Figure 9.1 Customer order processing.

Business process re-engineering (or BPR) is defined as ‘the fundamental rethinking and radical design of business processes to achieve dramatic improvements in critical contemporary measures of performance, such as cost, quality, service, and speed’ (Hammer and Champy, 1993).This approach can lead to improvements that eliminate duplication and waste and identify gaps where failures in quality, delivery, or service can occur. A continual re-evaluation of business processes can lead to continuous improvement, increased competitiveness, and profitability. ERP systems take a business process perspective and can help to re-engineer those processes to be more efficient and effective.

A business process perspective enables a different view of cost than the traditional approach to departments or product/services. Activity-based costing systems (see Chapter 13 ) provide a means by which costs can be accumulated both for hierarchical reporting purposes and on a horizontal or business process basis in relation to business activities. This means that, using Figure 9.1 as an example, in addition to accumulating costs for each of the five departments, we could produce total costs for customer order processing, and in an ERP system, link this to non-financial data such as the number of customer orders, number of picking slips, number of inventory items, and number of deliveries to produce useful analytical data about the cost of these activities.

Information systems design and controls

The sheer volume of data now available to organizations and the variety of types of information systems that can be utilized make the design of information systems to meet the needs of the business particularly important. This is particularly so when the complexity of accounting for both the hierarchical organizational structure and the business processes is required. Organizations will frequently need to improve or change their ERP systems to meet changing customer demand or environmental constraints. However, there is a significant risk in the development of these systems that the system does not meet user needs, is late, or costs more than was estimated. Therefore, it is important to have strong controls over information systems design. This is necessary even where proven ERP systems such as SAP and Oracle are introduced as these systems will usually require customization to meet an organization’s specific needs.

The key elements of project management for information systems are:

· specification of requirements and obtaining top management support;

· project organization: defining the roles and responsibilities of the steering committee and project manager;

· resource planning – both staff and money;

· quality control and progress monitoring;

· user participation and involvement.

A steering committee should monitor the system implementation and have overall responsibility to ensure that the system meets requirements in terms of quality, time, and cost. Systems development projects should comprise four distinct stages:

· Feasibility study stage: there should be a clear understanding about the objectives of the new system, the deliverables, its cost, and time to completion.

· System design stage: data security and levels of authorization need to be built into the system design. During this stage, the internal auditor should review system documentation, interfaces with other systems, and acceptance of design by all in the project team, especially users.

· Testing stage: comprehensive testing by systems development staff, programmers, users, and internal auditors.

· Implementation stage: a review of training and documentation, file conversion, and operational issues, e.g. staffing and supervision.

An implementation plan will cover parallel running, where the new system is operated in conjunction with the existing system until such time as the new system is proven to work by reconciling outputs from both systems; and ensuring that users are satisfied with the new system and are confident about discontinuing the existing system. If there is a changeover without parallel running, then testing prior to implementation becomes more important and additional monitoring may be needed during the early stages of implementation. A post-implementation review of the new system should also be carried out to establish whether the system is operating as intended and to confirm that user needs are being satisfied.

As organizations increasingly rely on their ERP systems, information system controls are essential to ensure the security of data and the reliability of information once an information system is operational. There are four main types of controls in relation to information systems:

1. Security controls: the prevention of unauthorized access, modification, or destruction of stored data. Recruitment, training, and supervision need to be in place to ensure the competency of those responsible for programming and data entry. Access controls, e.g. through passwords, provide security over unauthorized access to data.

2. Application controls are designed for each individual application, such as payroll, accounting, and inventory control. The aim of application controls is to prevent, detect, and correct transaction processing errors.

3. Network controls have arisen in response to the growth of distributed processing and e-commerce and the need for protection against hacking and viruses. A firewall comprises a combination of hardware and software located between the company’s private network (intranet) and the public network.

4. Contingency controls are relied upon if other controls fail; there must be a back-up facility and a contingency plan to restore business operations as quickly as possible (e.g. a business continuity or disaster recovery plan).

Conclusion

This chapter has shown the important role that information systems play in planning, decision making, and control. We have not limited ourselves to purely accounting systems here but have focused on the role of enterprise resource planning systems (ERP, such as Oracle and SAP) which increasingly play a key role in providing financial and non-financial information for managers. In using ERP systems, organizations are able to refocus on business processes rather than the hierarchical organizational structures that are more allied with externally oriented financial reporting. We have also looked at the importance of the design of information systems to ensure they can meet organizational needs.

References

Berry, A. J. and Collier, P. M. (2007). Risk management in supply chains: processes, organisation for uncertainty and culture. International Journal of Risk Assessment and Management, 7(8), 1005–26.

Buytendijk, F. (2010). Dealing with Dilemmas: Where Business Analytics Fall Short. New Jersey: John Wiley & Sons. Hammer, M. and Champy, J. (1993). Reengineering the Corporation: A Manifesto for Business Revolution. London: Nicholas Brealey.

IBM (2012). What is big data? http://www-01.ibm.com/software/data/bigdata/what-is-big-data.html (accessed August 2014).

Oracle (2011). Performance management: An incomplete picture. The Oracle Report. http://www.oracle.com/webapps/dialogue/ns/dlgwelcome.jsp?p_ext=Y&p_dlg_id=10077790&src=7038701&Act=29 (accessed August 2014, sign up to Oracle is required which is free of charge).

Parise, S., Iyer, B., and Vesset, D. (2012). Four strategies to capture and create value from big data. Ivey Business Journal, July/August http://www.iveybusinessjournal.com/topics/strategy/four-strategies-to-capture-and-create-value-from-big-data (accessed August 2014).

CHAPTER 13 Overhead Allocation Decisions

This chapter explains how accountants determine the costs of products/services through differentiating product and period costs, and direct and indirect costs. The chapter emphasizes the overhead allocation problem: how indirect costs are allocated to determine product/service profitability and assist in pricing decisions. In doing so, it contrasts variable costing, absorption costing, and activity-based costing. The chapter includes an overview of contingency theory, a comparison between Western and international approaches to management accounting, and a consideration of the behavioural consequences of accounting choices.

Cost classification

In this chapter we are concerned with developing what we have simply referred to in earlier chapters as ‘overhead’ (or what in North American companies is commonly referred to as ‘burden’). Overhead is defined in the CIMA official terminology as ‘Expenditure on labour, materials or services that cannot be economically identified with a specific saleable cost unit’ (CIMA, 2005, p. 15). Overheads are also called indirect costs. We first consider the classification of product and period costs, and then direct and indirect costs.

Product and period costs

The first categorization of costs made by accountants is between period and product. Period costs relate to the accounting period (year, month). Product costs relate to the cost of goods (or services) produced. This distinction is particularly important to the link between management accounting and financial accounting, because the calculation of profit is based on the separation of product and period costs. However, the value given to inventory is based only on product costs, a requirement of accounting standards. The IFRS accounting standard on Inventories (see Chapter 6), IAS2, requires that the cost of stock should:

comprise that expenditure which has been incurred in the normal course of business in bringing the product or service to its present location and condition. Such costs will include all related production overheads.

Although Chapters 10, 11, and 12 introduced the concept of the contribution (sales less variable costs), as we saw in Chapter 6 there are two types of profit: gross profit and net profit:

gross profit=sales−cost of salesgross profit=sales−cost of sales

The cost of sales is the product (or service) cost. It is either:

· the cost of providing a service; or

· the cost of buying goods sold by a retailer; or

· the cost of raw materials and production costs for a product manufacturer.

net(or operating)profit=gross profit−expensesnet(or operating)profit=gross profit−expenses

Expenses are the period costs, as they relate more to a period of time than to the production of products/services. These will include all the other (marketing, selling, administration, IT, human resources, finance, etc.) costs of the business, i.e. those not directly concerned with buying, making, or providing goods or services, but supporting that activity.

To calculate the cost of sales, we need to take into account the change in inventory, to ensure that we match the income from the sale of goods with the cost of the goods sold. As we saw in Chapter 6, inventory (or stock) is the value of goods purchased or manufactured that have not yet been sold.

net(or operating)profit=gross profit−expensescosnet(or operating)profit=gross profit−expensescos

for a retailer, or:

cost of sales=opening stock+cost of production−closing stockcost of sales=opening stock+cost of production−closing stock

for a manufacturer. For a service provider, there can be no inventory of services provided but not sold, as the production and consumption of services take place simultaneously, so:

cost of sales=cost of providing the services that are soldcost of sales=cost of providing the services that are sold

As we know, sales, cost of sales, gross profit, expenses, and operating profit are all shown in the Income Statement. Product costs are those that appear under cost of sales, while period costs are those that are deducted from gross profit to arrive at net or operating profit. While the valuation of inventory is prescribed by accounting standards, there are no such rules as to how gross profit is calculated and the distinction between product and period costs varies across different businesses. For example, in most large retail chains, the cost of sales reported in Income Statements includes not only the cost of the goods sold but also all the costs of the supermarkets (store rental, staff costs, etc.) in which we shop. Period costs include the distribution centres that hold the bulk of inventory and the head office functions. One reason for this is to avoid competitors knowing what the mark-up or margin (see Chapter 10) is on the company’s sales. In service businesses, there is no requirement to show gross profit and there is considerable variation in how service businesses report.

Therefore, when we speak of ‘overheads’ we are not always sure what costs are included for any particular company. Perhaps a more meaningful distinction is that between direct and indirect costs.

Direct and indirect costs

Accounting systems typically record costs in terms of line items. As we saw in Chapter 3, line items reflect the structure of an accounting system around accounts for each type of expense, such as raw materials, salaries, rent, and advertising. Production costs (the cost of producing goods or services) may be classed as direct or indirect. Direct costs are readily traceable to particular products/services. Indirect costs are necessary to produce a product/service, but are not able to be readily traced to particular products/services. Any cost may be either direct or indirect, depending on its traceability to particular products/services. Because of their traceability, direct costs are nearly always variable costs because these costs increase or decrease with the volume of production. However, as we saw in Chapter 12, direct labour is sometimes treated as a fixed cost. Indirect costs may be variable (e.g. electricity) or fixed (e.g. rent). Indirect costs are often referred to as overheads.

Direct materials are traceable to particular products through material issue documents. For a manufacturer, direct material costs will include the materials bought and used in the manufacture of each unit of product. They will clearly be identifiable from a bill of materials: a detailed list of all the components used in production (see Chapter 11). There may be other materials of little value that are used in production, such as screws, adhesives, and cleaning materials, which do not appear on the bill of materials because they have little value and the cost of recording their use would be higher than the value achieved. These are still costs of production, but because they are not traced to particular products they are indirect material costs.

While the cost of materials will usually only apply to a retail or manufacturing business, the cost of labour will apply across all business sectors. Direct labour is traceable to particular products or services via a time-recording system. It is the labour directly involved in the conversion process of raw materials to finished goods or the cost of providing a service (the cost of labour was introduced in Chapter 12). Direct labour will be clearly identifiable from an instruction list or routing, a detailed list of all the steps required to produce a good or service. In a service business, direct labour will comprise those employees providing the service that is sold, such as the recording of chargeable hours in professional service firms like accountants, lawyers, architects, and consultants. In a call centre, for example, the cost of those employees making and receiving calls is a direct cost. Other labour costs will be incurred that do not appear on the routing, such as supervision, quality control, health and safety, cleaning, and maintenance. These are still costs of production, but because they are not traced to particular products, they are indirect labour costs.

Other costs are incurred that may be direct or indirect. For example, in a manufacturing business, the depreciation of machines (a fixed cost) used to make products may be a direct cost if each machine is used for a single product (because the cost will be traceable) or an indirect cost if the machine is used to make many products (because it may be more difficult to trace the depreciation cost applicable to different products). The electricity used in production (a variable cost) may be a direct cost if it is metered to particular products or indirect if it applies to a range of products. A royalty paid per unit of a product/ service produced or sold will be a direct cost. The cost of rental of premises, typically relating to the whole business, will be an indirect cost.

Prime cost is an umbrella term used to refer to the total of all direct costs. Overhead is divided into those overheads that are involved in production (i.e. indirect product costs) and those that are associated more with marketing and sales, finance, and administration (which are period rather than product costs). Production overhead is the total of all indirect material and labour costs and other indirect costs,

i.e. all production costs other than direct costs. This distinction applies equally to the production of goods and services.

Non-production overheads (such as marketing, sales, distribution, finance, IT, administration) are period costs and are not included in production overhead. They are typically deducted from gross profit in the calculation of net profit. A simple way to think about the distinction is to imagine a factory and office complex. These are generally separated by a large wall. The office on one side has nicely dressed people working at desks. On the other side of the wall, people work with machines and wear overalls. This is a bit simplistic, but it does help to understand the distinction. Production overheads relate to the factory side of the wall, and non-production overheads to the office side. Hence, a factory manager and his production clerks who sit in the factory will be classed as production overhead. This distinction is not so straightforward where there is no factory, in which case each business will make its own distinction between product (or service) and period costs.

Distinguishing between production and non-production costs and between materials, labour, and overhead costs as direct or indirect is contingent on the type of product/service and the particular production process used in the organization. Contingency theory is described later in this chapter. There are no strict rules, as the classification of costs depends on the circumstances of each business and the decisions made by the accountants in that business. Consequently, unlike financial accounting, there is far greater variety between businesses – even in the same industry – in how costs are treated for management accounting purposes.

We do need to be careful when using the term ‘overhead’ to ensure that people we are talking to use the term in the same way, as its use may change from business to business and even from situation to situation. When we use the term, it may be limited to production overheads, or may comprise all the overheads of a business, both production and non-production. In this chapter, we will define overheads as comprising indirect product costs, i.e. those costs of production not readily traceable to products/services.