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Overhead cost allocation options in

Product costing
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 reevaluate 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 Everyday activities


limitations and business
readiness

Costing sheet – Creation of costing sheet – Only input based – Overhead group to
(KZS2) rules are possible. be maintained in
material master
– Definition of calculation – No dependencies on (linked to costing
basis (percentage or quantity the confirmed actual sheet via overhead
based), time/quantity/yield. key).

– Definition of Credit object. – Addition step in


Period end closing –
costing sheet
allocation in actual
(CO43).

Activity type – No additional configuration – Separate overhead – Increase of


is needed. activity type is needed. production data
setup and
– Real-time overhead maintenance
posting during activity required in work
confirmation. centers and routings.

– Full cost absorption – Additional period


is possible with actual end closing steps
price recalculation required in case
actual activity price is
calculated (KSII,
CON1).

Template – Creation of template Input/output based. – Overhead group


allocation (CPT1). Full cost absorption is should be
possible maintained in
– Assigning template to material master
overhead key (KTPF). (linked to costing
sheet via overhead
– Assigning overhead key to key).
overhead group specified in
material master (OKZ2). – 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.