Why Keep the Old Terminology?

"Overhead" Is Overused In the Internal Accounting Structure

By Emanuel Schwarz

Nov. 16, 1998 (Pro2Net) Let us analyze the old terminology still used in our managerial accounting -- terminology that was fine when our famous professors first wrote their cost accounting books somewhere in Chicago.


Surely many readers will remember a foot-note written on a page of Professor Horngren's cost accounting book, where he questioned, "Why do we use the term of Overhead - and not the word Underfoot?"

That was a fitting observation -- I read it in his book around the year 1981. And I believed that from that point forward, our professors would stop using this pointless denomination known as Overhead. I was convinced that in the future, cost accounting books in the U.S. would start to use terms that would clearly point toward a positive identification of what we like to express with our word.

Unfortunately I was very wrong.

Our cost accounting books still use this old-fashioned term and the relevance in accounting is still lost. (As an example, review the cost accounting book written by Johnson and Kaplan).

It is interesting to investigate how the word Overhead entered into our accounting system. During a time when our accounting was only interested in financial information -- information that was necessary to show to people outside the company -- our good professors accepted this word Overhead, a term mentioned by an accountant, somewhere in the U.S.

Our teachers agreed on this term, because it did not point toward any specific identification of production cost: It could be used in any discussion of cost that had anything to do with internal accounting.

This term known as Overhead made it possible to avoid the structuring of the internal chart of accounts, since it lacked the identification of the different departments or cost centers that a company actually has to address.

By using Overhead, our teachers had an opportunity not to open accounts that would clearly relate to the internal structure of the company - accounts that were not associated with our General Accounting structure.

Professors never taught internal accounting that had a clear structure of the different departments that a company might have. When this general terminology became established in our universities, the larger CPA firms then indicated to American companies that they needed only one Overhead account (to be called Manufacturing Overhead): There would be no need to have any descriptions of the different administrative, production and service departments.

This Overhead account was a mix-up of different indirect costs.

The CPA companies then loaded this Manufacturing Overhead account with all different costs, related to different departments or cost centers. Just imagine what a crazy mix-up was created - and this was it.

University professors opted to say nothing with regard to this unacceptable procedure: We still see graphics showing only one Overhead account.

If we were to insist on a structure for the internal chart of accounts -- with clear identification of the different departments - CPA firms would likely fight the change violently, because it would cost them so much to train their people to understand a modern internal accounting structure.

Review Exhibit 1-10:
What an advanced presentation of the different departments a company could have. Instead of talking about Manufacturing Departments, we would instead use terms such as Administrative and Sales Departments.

We would also clearly identify Direct Production Departments from Indirect Production Departments. In addition, Service Departments would be distinguished from one another. This presentation would correspond perfectly to the Responsibility Accounting system.

With this presentation, we would be able to develop a clear movement of the so-called Re- allocation amounts. We have to re-allocate the departmental operating cost of the different Service Departments and also from some of the Indirect Production Departments.

We can also follow the lines in this graphic showing us how the operating cost of the Direct Production departments will transfer their cost to the different products - that is the Absorption Costing procedures.

Now that you have had opportunity to analyze in Exhibit 1-10, here are some additional details:

From the different cost elements accounts (on the left side of the Exhibit) we allocate all indirect cost to the different departments. This is the action that we have to realize to fulfill the purpose and ideas expressed in the Responsibility Accounting System.
It is important that we also identify all our administrative departments. Our chart of accounts for internal accounting will have specific codes for these departments. You will also see, that the sales departments are also located under this Group One structure.
Consider also the important Direct Production Departments. Today's cost accounting teaching does not show our students the important structure of our chart of accounts. The whole philosophy of departmental operating costs suggests that we summarize all indirect costs to these departments, before we charge them to the Production Cost accounts (today we recognize these as Work in Process accounts) or as we also say, "before the production will absorb these indirect costs."
Direct Production Departments will send operating costs to the different products of our company. From the right side of Exhibit 1-10 we apply the absorption cost system toward the production cost accounts.
Today teachings also ignore the so-called Indirect Production Departments. Under this denomination we would identify our Research department and naturally also all our maintenance and repair departments. The operating costs of these departments would have to be absorbed by these functional activities or reallocated to the departments that used the service given by these indirect production departments.
These reallocated amounts may be charged to the Administrative and Sales departments -- and naturally also to the Direct Production departments. These reallocation transactions should use standard rate methods.
Finally, all of the Service Departments should be established under one group code. These departmental operating costs must also be reallocated to the different departments from which they render their service.