Overheads constitute a growing portion of product cost in many industries today. As a general rule, overhead costs are not easily traceable to units of product, so spreading them over product cost is an inherently arbitrary process. Access to the true make-up of product cost can help operations executives and plant controllers make better decisions about controlling costs, evaluating manufacturing in alternate facilities, and making or buying a product.

I'll provide insight into the method of quantity-based overhead application in SAP R/3 and Enterprise in the module Controlling — Product Cost Controlling, in which you charge overheads to product cost. The method first became available with Release 3.0 and is a mid-way offering between the percentage-based overhead method (which is easy to set up but arbitrary) and the accurate but highly complicated method of template assignments. The functionality and configuration applies to ECC 5.0 as well.

It is appropriate to use the mid-way method when overhead needs to be applied per a given quantity of an input factor of production (such as number of hours worked or quantity of raw material used). I'll use an example to walk you through the origin of costs in a cost center and their disposition to the product. Along the way, configuration is explained for the quantity-based option. Finally, I compare the various methods available to apply overhead in R/3, so users can make informed choices appropriate to their business circumstances.

In my example of the quantity-based overhead option in R/3, overhead is applied based on a rate per hour of activity consumed. Direct costs are charged from cost center to product per actual activity consumption on the routing/recipe at the standard rate for the activity. Overheads are charged at the standard rate times the standard activity consumption on the routing/recipe. In other words, overhead does not fluctuate or vary in relation to input factors (activity quantities), based on the rate for a given level of a production plan.

Quantity-Based Overhead Example

I'll start with the origination and disposition of cost at the cost-center level. The portion of cost that is credited to a cost center appears as a debit in the standard cost estimate or a product, as well as the production/process order for the product.

The credits are of three types — via overhead application, assessments to other cost centers or cost objects, and activity allocations from the routings/recipes. My focus is on the overhead type. The overhead cost elements are 847500, 847505, and so on. The cost center is 100111.

The overhead costs credited to the cost center in plan (and eventually in actual) are then applied to the standard cost estimate and the production/process order of all affected materials.

The activity allocation cost elements are entered later as base cost elements for the overhead calculation. (See "Calculation base cost elements").

The originating cost center (100111) is retained to show the source of the overhead. In addition, costs from the activity types are also charged to the order. Line item 1 shows Mfg. Direct Labor cost against activity CLBL2L. This is based on a planned activity price for the standard quantity consumed. Related to it is activity OCLBLL in line item 3 with a virtual zero price and 288 hours of standard quantity. In fact, all the activities starting with O are dummy overhead activities with zero prices. They are overhead drivers that exist on the routing only to induce the application of standard overhead based on the standard hours in the dummy overhead activity. For example, for line item 3, the corresponding overhead is in line item 18 — Indirect Labor Overhead — and is calculated for the same 288 hours at the overhead rates set up in the costing sheet.

All overheads are categorized under G and activities are charged under E. You can see that the overhead can be traced to the cost center, resource (i.e., work center), and the activity.

In this example, line item 1, the intent is to absorb only a fixed, standard amount of overhead, based on the standard activity quantities on the routing at the fixed overhead rate. The costing sheet applies the overhead rate to the overhead activity quantities and posts the overhead amount as a line item on the cost element. For example, the direct activity CLBL2L on cost center 100314 with cost element 845600 has its corresponding overhead activity in line item 3, OCLBLL with cost element 847055 (All overhead activities start with O).

The cost element 847055 exists only on the routing, to facilitate charging of overhead of 288 hours at the standard overhead rate. It carried on cost element 847500 for cost center 100314 for $5,411.52 in line item 14. This workaround was devised to charge only a fixed amount of overhead (fixed rate multiplied by fixed overhead activity quantities), rather than to have overhead scale according to the actual quantity consumed. Of course, if the intent is to scale overhead in relation to activity input, then one would apply overhead based on the activity CLBL2L and not have the dummy overhead activity OCLBLL at all.

The overhead items along with other product costs represented by cost elements, both primary and secondary, can be categorized into so-called cost components. Except for things like Raw Material and Semi-Finished goods, the cost components are designated as Fixed. This means that the overheads do not swing in relation to the overhead driver by which overhead is applied. You can do this via a configuration setting.

R/3 uses the concept of rolled-up costs, meaning that product cost is built incrementally, based on a multilevel bill of materials (BOM), starting with the lowest level first. Each of the cost components then should be rolled up into the next level assembly of the product. Material and manufacturing overhead cost components are generally rolled up into the cost of goods manufactured, whereas sales and administration overheads are not. The implication is that the former are part of work in process (WIP) and inventory valuation, whereas the latter are not. In my example, these overheads are considered part of the cost of goods manufactured.

Overhead Application Methods in SAP R/3

Overheads can be input based or output based, meaning that the application is dependent upon the source quantities of the overhead driver/material or the output quantity of the driver or the material manufactured. R/3 provides four methods by which overhead can be charged to product cost:

• Overhead via activity types. Activity types are used to represent one or more overhead categories. Each category may have a group of cost elements, the planned and actual costs of which provide an activity rate. The activity is entered on the product's routing or recipe along with a default quantity. During standard cost estimation, the standard (default) quantity multiplied by the planned activity rate is used to assign value to the overhead. For actual production/process order costing, during confirmation, the activity quantity confirmed, whether standard or actual, is multiplied by the activity rate to arrive at the overhead amount on the order. The standard rate is determined in real time, whereas the actual rate is determined after calculation at period close.

• Overhead via templates in business processes. Costs arising in a cost center are ascribed to business processes, which are incorporated into a template. The template is a flexible tool used to charge overheads to the cost estimate. This is an output-based method, whereby overhead can be applied based on the planned order quantity or the actual quantity delivered to stock.

• Percentage-based overhead via overhead costing sheet (OHCS). Traditional concepts of overhead application use the percentage method—i.e., the application of overhead as a percentage of direct costs. This percentage is usually a round number after calculating the total overhead costs as a percentage of direct costs based on a certain production plan. While this approach is simple, it does not allow for interrogation of the source of these costs and what drives their application. More importantly, the overhead is scaled in relation to the input costs, although there may not be a causal relation between the two.

• Quantity-based overhead via overhead costing sheet (OHCS). In the quantity-based application, overhead rates can be as granular as your business requirements need them to be to charge product cost per input quantity used in the value-added process of manufacturing the product. For example, if a material needs to get overhead based on its consumption quantity, you can specify a rate per the material's unit of measure and have the system apply this rate to the quantities consumed in the manufacturing process. If a product needs to get overhead based on an input quantity of activities such as direct labor hours, you can specify a rate per hour for the activity's secondary cost element and apply it to the product.

The OHCS-based application is an input-based rather than an output-based functionality. Overhead can be applied based on costs resulting from input factors of production rather than on the output quantity of the product delivered to finished inventory. Lump-sum or flat-charge lobbing of overheads to product is not possible via the OHCS. Overhead via the OHCS can be made dependent on one or more parameters, e.g., company code, plant, or order type. Overheads defined via the OHCS are always time-dependent.

In product cost by period or in order-based costing, you can apply overhead as soon as the dependency is at least partially complete. If it is a percentage-based overhead, direct cost must be charged to the order. If it is a quantity-based overhead, the activity from which the quantity originates must be at least partially confirmed. Generally, overhead is applied at month-end; however, for accurate costing purposes where orders can be delivered to finished goods inventory, overhead can be applied via a daily batch job.

Requirements for Quantity-Based Overhead

Next, I'll discuss the configuration and master data settings for the application of quantity-based overhead. The first step is to create secondary cost elements of type 41. This cost element type allows for overhead to be applied via the OHCS and to provide credit to the cost originator. The cost element is also assigned to a cost component within the structure.

Checking the Record qty indicator in cost element master data is necessary for overhead application based on quantities consumed and is useful in reporting.

The next step is to configure the costing sheet, which is a collection of parameters assembled in one place that tell the system to apply a certain overhead on defined criteria and credit the source cost originator. The debit for the cost is assumed to be a cost object, such as the product for standard cost estimation or production or process order for plan and actual. You reach the costing sheet configuration via the IMG menu path Accounting>Controlling>Product Cost Controlling>Product Cost Planning> Basic Settings for Material Costing> Overhead>Define Costing Sheets or Costing Sheet: Components.

The elements of a costing sheet, which need to be defined in order, are:

1. Calculation base cost elements. The base cost element is one or a group of primary or secondary cost elements to which overhead should be applied. There are two types of overheads:

• Material overhead. Raw material consumed is a primary cost element for charging material overheads.

• Production or sales/administration overhead. Production-related costs charged through an activity is a secondary cost element. Here, the link between the overhead and the activity is via the secondary cost element of the activity's master data.

Since these overheads are activity-dependent, it is possible to distinguish between the fixed and variable overhead by selecting the appropriate button in the Cost portion of the base cost element definition.

In a quantity-based overhead application, the quantity of units of measure consumed (such as hours) on the base cost element is multiplied by an overhead rate to arrive at the overhead amount.

2. Overhead conditions and rates. Overhead is dependent upon conditions, which, if met, invoke the application of a rate. R/3 provides a number of these conditions as standard. The conditions are built using the concepts similar to SD pricing conditions. Standard conditions include controlling area, company code, plant, profit center, order type, and overhead key.

The overhead key requires special mention. If you want overhead to be material-dependent, create a freely definable overhead key, assign the key to an overhead group, and enter the overhead group in the Costing 1 view of the material master record. To enter the rate for each overhead in Change View "Quantity-based overhead":Overview, select a line and double-click to go to the rate screen, shown in Change View "Details": Overview.

The overhead type reflects whether overhead is to be applied to a production/process order in actual costs determination (Overhd type 1) or in standard cost estimate or production/ process order planned cost (Overhd type 2). Normally, planned and actual rates are the same.

Since rates are subject to change, the option of entering rates is also available under the application menu Accounting>Controlling>Product Cost Controlling>Cost Object Controlling>Period-End Closing> Current Settings>S_ALR_87008272 - Define Quantity-Based Overhead Rate.

The question now is where and how the rates are calculated. R/3 does not independently calculate overhead rates (it does calculate activity rates). Therefore, this calculation has to be performed offline and the rates entered in the above IMG step. The basis is the identified cost center costs divided by the total units of the drivers. For instance, the cost of a technical services pooled cost center could be divided by the total production capacity or activity quantity to arrive at a rate. Care should be taken to ensure that the rate could be applied by the system using an input and not an output driver. Otherwise, it is not possible to apply overhead in planned or actual costs of the production or process order.

3. Credits. Specify the cost originator that needs to be credited upon application of overhead to the cost object (production or process order). It is typically a cost center, though it could be an internal order or a business process. The edit screen showsyou see each type of overhead and the associated cost center that is to be credited. To view details of each credit, select the credit line (C01) to get to the next screen.

This piece of configuration results in credit to the cost center for both plan and actual under the secondary cost element, and a debit to the standard cost and the process order. The percentage of cost recovery to be treated as fixed is to be entered under Fxd %. The default entry is *, which means the credit is to be apportioned between fixed and variable in the same way as it is in the debit in the calculation base.