Overhead cost allocation options in Product costing

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A well organized cost accounting system can provide valuable inside into product pricing, cost trends, performance of departments (cost centers, profit centers), production and personnel capacity requirements. However, it is very rarely that controllers properly consider the extent to which cost accounting can be beneficial. If direct cost allocation does not cause much problems due to its nature and clear connection to the product (e.g. via BOM/Routing), indirect costs are not directly accountable to the cost object. Sometimes it is getting tricky to find the right allocation factor - the basis for posting expenses to the final product.

The similar conclusion can be done when analyzing overhead allocation rules and methods that are applied by different companies using SAP ERP system. Surprisingly, even manufacturing companies where cost saving becomes a buzzword, for cost allocation  often adopted very primitive rules defined long time ago, mainly during initial SAP implementation. Moreover, even after introduction of new data collection system these rules are rarely updated for exploding full advantage of the SAP system’s functionality features.

In this article the main standard overhead cost allocation methods that are being used in product costing process are analyzed – costing sheet, template allocation and overhead allocation via activity type. The pros and cons of every option is summarized. It should help to identify the most suitable cost allocation option for the particular organization and understand what needs to be done in order to implement and successfully use it in a product costing process.

The first and most popular method for calculating indirect costs is by using costing sheet. Costing sheet combine quantity-based and percentage based allocation methods or can use only one of these. E.g. allocating 5% based on amount confirmed (debited) on specific cost element, in addition adding 1 EUR for each confirmed labor hour. The big disadvantage with costing sheet is that it can’t be used to calculate actual overheads with full absorption of indirect costs (since the cost calculation is only input based). However, a cost center specified under credit key will always have some balance at the period end.

This method can be suitable for the companies with relatively small amount of overheads comparing to the direct costs or for the companies that prefer the simplicity of cost allocation comparing to the additional complexity and accuracy.

The second indirect costs calculation option – template allocation. It is the most flexible alternative of overhead allocation, thus it is the most complex setting it up.  The standard costing and planned/actual cost on manufacturing orders are managed by the template. The template defines a cost object, a triggering event (e.g. once order was released or delivered)  and calculation rules separating standard cost planning and cost object controlling as templates are created per environment. The main advantage of this method - overhead calculations with full cost absorption are possible. Moreover, templates can be very important and useful tracking variable part of overhead costs (e.g. allocating quality control cost based on delivered quantity). This method can be recommended for the companies that have complex and well defined cost accounting and costing systems and do not want to lose it with the implementation of SAP ERP system. It also can be suggested for the companies that would like to enhance internal overhead allocations taking a full advantage of the SAP functional flexibility.

To enable template allocation functionality, “Parallel and integrated calculation” needs to be activated for the controlling area (TCODE OKKP). In case the decision is taken to use template allocations with business processes - standard hierarchy for business processes needs be created and assigned to controlling area (TCODE OKW1).

The third option – allocation of indirect costs in the same way as direct labor/machine costs - using activity types and routings/master recipes. It affects production master data set up as new activities should be added just for costing purpose, taking into consideration that maximum six standard values in the routing/master recipe are allowed. In addition, actual production time needs to be filled in for the overhead activities in the routing. The main advantages for this option is that actual overheads could be calculated at the same time as direct costs (additional step is not required at the month end just for overhead allocation). Though this method can be proposed when the main part of overhead cost can be linked with expenses/time of direct activities (e.g. machine amortization or energy cost based on the number of hours when it is turned on). In addition, tight connection between direct labor/machine hours and overhead time can be defined if the rule is not lot size dependent.

The balance of cost center (under/over absorption) can be allocated to the product using SAP functionality of revaluation at actual price. This allows to recalculate activity rate in order to achieve zero cost center balance.

For this purpose it is necessary to perform appropriate settings of the following parameters:

• The “Own business transaction” parameter of general controlling version maintenance must be set at “Actual (OKEQ)”.


• “Actual price, automatically based on activity” (5) indicator of activity type master data must be set-up. “Plan price, automatically based on activity” (1) -  in case activity price is calculated automatically also in planning.

At the end of each period additional steps should be performed - actual price calculation (KSII) posting all cost center variances (leftovers) to manufacturing orders one step after (CON1). If Material Ledger is used to calculate actual costs of materials, this step is not required. Setting ‘Activity Update Indicator 2” under actual costing configuration, the balance will be capitalized/expensed directly on material/product level eliminating the need to revaluate in addition related cost object.

Another alternative for overhead costs allocation – to increase planned activity rate including overhead cost and allocate it during confirmation of direct labor/machine cost. However, in this case overhead cost is shown under the same cost component as direct activities so overhead analysis is limited.

Finally, if it is not possible to define any rule for overhead cost calculations in planning process, overhead cost can be loaded using additive cost functionality on the random basis.

Table 1. Overhead allocation methods in SAP ERP system

Method	Required configuration	Features and limitations	Everyday activities and business readiness
Costing sheet	- Creation of costing sheet (KZS2) - Definition of calculation basis (percentage or quantity based), - Definition of Credit object.	- Only input based rules are possible. - No dependencies on the confirmed actual time/quantity/yield.	-  Overhead group to be maintained in material master (linked to costing sheet via overhead key). -  Addition step in Period end closing – costing sheet allocation in actual (CO43).
Activity type	- No additional configuration is needed .	- Separate overhead activity type is needed. - Real-time overhead posting during activity confirmation. - Full cost absorption is possible with actual price recalculation	-  Increase of production data setup and maintenance required in work centers and routings. -  Additional period end closing steps required in case actual activity price is calculated (KSII, CON1).
Template allocation	- Creation of template (CPT1). - Assigning template to overhead key (KTPF). - Assigning overhead key to overhead group specified in material master (OKZ2).	Input/output based. Full cost absorption is possible	- Overhead group should be maintained in material master (linked to costing sheet via overhead key). - Addition period end closing step – template allocation in actuals (CPTA).

 

Conclusions

SAP ERP system provides the best practice business processes for most industries. However, due to the nature of overhead costs, allocation rules cannot be standardized and require special attention of consultants and business controllers during SAP implementation and ongoing support. SAP presents a few options how technically overhead cost can be allocated to manufacturing orders. Each option has its benefits and limitations. However, every organization should  individually assess existing controlling system, considering required level of accuracy. Moreover, required level of accuracy should match with the companies’ possibilities to gather planned and actual data on which basis overhead can be allocated.

This article is based on my personal opinion and does not necessarily represent the views of companies I am affiliate with.