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Tutorial.png Unit 4 

Introduction | Traditional Approach to Assigning Overheads | Critique of Traditional Methods of Cost Accounting | Activity-Based Costing | Steps in Activity-Based Costing | Critique of Activity-Based Costing


In Unit 1 we defined indirect costs or overheads as any expenditure that CANNOT be directly related to a particular product or service. Expenditure on the salaries of senior managers, on units that provide shared services (such as financial administration or human resources) and general supports for the institution as a whole (such as insurance or grounds maintenance) are normally classified as overheads.

Overheads are sometimes treated as a separate category of expenditure in the budgets and accounts of government departments and ODL institutions, but this has a number of disadvantages. In the first instance, there is the danger that these indirect costs will be overlooked when determining the fees paid for courses or other services. By way of contrast, a commercial concern must (at a minimum) cover all of its overheads in setting the prices of the products it sells. Second, because administrative units that provide shared services do not produce measurable products, their activities may be seen as unnecessary or ‘wasteful’. As a result, there is a widespread tendency to reduce overheads before seeking cuts in direct expenditure whenever financial constraints are encountered. For these reasons, it is undesirable for ODL institutions to classify all indirect costs as overheads.

This unit explores the problem of overheads and examines the advantages and disadvantages of two common approaches to analysing such costs.

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By the end of this unit, you will be able to:

  • explain why it is important for ODL institutions to analyse and attach indirect costs to particular courses or programmes;
  • list two different approaches to attaching indirect costs;
  • explain how overheads are apportioned and absorbed in traditional approaches to management accounting;
  • discuss at least one situation where these traditional approaches present a distorted picture;
  • outline two differences between the traditional approach and Activity-Based Costing (ABC);
  • suggest three reasons why an ABC approach can produce a more accurate picture of indirect costs;
  • list at least one drawback of the ABC approach;
  • define the term business-sustaining costs.