SESSION 05 – OVERHEADS

OVERVIEW
Objective

¾ To describe the principles and processes of overhead cost analysis.

¾ Terminology
OVERHEADS ¾ Allocation, apportionment and
absorption
¾ Absorption bases

SERVICE ACCOUNTING
ABSORPTION
DEPARTMENTS FOR OVERHEADS

¾ Overview ¾ Departmental rates ¾ Steps in accounting for

¾ Explanation
¾ Direct method
¾ Step (down) method
¾ Reciprocal methods
¾ Blanket rate production overheads
¾ Under/over-absorption of
manufacturing overheads
¾ Non-manufacturing overhead
¾ Concluding remarks

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SESSION 05 – OVERHEADS

1 OVERHEADS
1.1 Terminology

¾ Overheads are costs that cannot be charged directly to cost units.

¾ Therefore must be shared on an equitable basis.

1.2 Allocation, apportionment and absorption

Most businesses assign overheads to products by

¾ allocation and apportioning overheads to cost centres, and

¾ absorbing costs accumulated in cost centres into cost units.

1.2.1 Allocation

¾ Charging to a cost centre those overheads that result solely from its existence, e.g.

Cost centre Allocated cost

Canteen Tea bags, spaghetti, chef’s wages

Packing department Cardboard, string

1.2.2 Apportionment

¾ When an overhead is common to more than one cost centre it must be shared out or
split on an equitable basis, e.g.

Cost Possible bases of apportionment

Rent & rates Square metres occupied by departments

Light & heat Cubic capacity or metered usage
Insurance of inventories Value of inventory holding at each location

1.2.3 Absorption

¾ Attributing the overheads accumulated by a cost centre to the cost units passing
through it, e.g.

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 SESSION 05 – OVERHEADS

Illustration 1

Pocket calculators manufactured in a single production dept with $15,000

overheads. Planned production is 5,000 units
$15 ,000
∴ overhead absorption rate per unit = = $3/unit
5,000

1.3 Absorption bases

1.3.1 Absorption per unit

¾ As illustrated above – is appropriate if only one type of unit is produced by a cost

centre.

1.3.2 Absorption per labour hour

¾ Appropriate where more than one type of unit is produced each taking a different
amount of time.

Illustration 2

Sam produces calculators and computers in one production department, with

$15,000 overheads. He has planned production of 3,000 calculators each taking
1 hour, and 2,000 computers each taking 6 hours.

Solution

Total overheads
Overhead absorption rate per hour =
Total planned hours worked

$15,000
= = $1/hour
( 3 ,000 × 1) + ( 2 ,000 × 6 )

Overhead per calculator = 1 hr @ $1/hr = $1

Overhead per computer = 6 hrs @ $1/hr = $6

¾ This is a fairer method of absorbing the overhead as it recognises the greater time taken
to produce a computer rather than a calculator.

1.3.3 Alternative bases

¾ Per kg of material used.

¾ Per machine hour.
¾ Percentage of material cost (also labour cost or prime cost).

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SESSION 05 – OVERHEADS

Example 1

Budget for May $

Canteen costs 4,100
Machine depreciation 1,700
Machine repairs 500
Factory rent & rates 6,300
Production manager’s salary 7,200
Heat & light 3,200
Materials storage 2,000
______
25,000
______
Production data

Sofas Chairs
Volume (units) 100 400
$ $
Direct costs per unit:
Materials ($10.00 per kg) 80.00 30.00
Labour ($2.50 per hr) 105.00 42.50

Other information

Sofas and chairs pass through two production cost centres; the Assembly
department and the Trimming department. A sofa takes 24 hrs in the
Assembly department and 18 hrs in the Trimming department. A chair takes 9
hrs in the Assembly department and 8 hrs in the Trimming department.

Labour wage rates in both departments are the same.

The Assembly department occupies approximately three quarters of the area of

the factory.

The production manager, on average, spends twice as long supervising the 30

workers in the Assembly department as he does supervising the 70 workers in
the Trimming department.

The written down value of the equipment in the Assembly department and the
Trimming department is $104,500 and $115,500 respectively.

Materials storage costs should be apportioned two fifths to Assembly and three
fifths to Trimming.

0504
 SESSION 05 – OVERHEADS

Required:

(a) Using appropriate bases apportion total overheads between the two cost
centres. Calculate an absorption rate per hour for each cost centre.

(b) Calculate the overhead cost per unit for each product.

Solution

(a) Overhead
Basis Ratio Assembly Trimming
$ $
Canteen
Machine depn &
machine repairs
Rent and rates
Prod man’s salary
Heat and light
Materials storage
______ ______

______ ______
WORKINGS

(1) Assembly – overhead absorption rate

Total direct labour hours:

WORKING Hours
Sofas
Chairs
_____

_____
Absorption rate =

(2) Trimming – overhead absorption rate

Total direct labour hours:

WORKING Hours
Sofas
Chairs
_____

_____
Absorption rate = (b) Overhead cost per unit

0505
SESSION 05 – OVERHEADS

WORKINGS $
Sofas: Assembly
Trimming
_____

_____
Chair: Assembly
Trimming
_____

_____

2 SERVICE DEPARTMENTS
2.1 Overview

Steps
Indirect Indirect Establish cost centres
Rent Electricity materials labour and
1 Allocate and
2(a) apportion
overheads to cost centres

Production Production Service

2(b) Reapportion service
cost centre 1 cost centre 2 cost centre dept costs to prod n
eg assembly eg packing eg canteen cost centres

Product X 3 Absorb prod ncost

centre overheads into
Product Y cost units via
absorption rates
Product Z

Direct Direct
materials labour

2.2 Explanation

¾ Absorption is the process of charging overhead into a cost unit. The overhead is
absorbed while a product passes through a cost centre.

¾ Products do not pass through service cost centres and therefore an absorption rate will
not be calculated for the service cost centre. Absorption rates are only calculated for
production departments.

¾ This is why overhead in service cost centres must be reapportioned to production cost
centres.

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 SESSION 05 – OVERHEADS

¾ This secondary apportionment should be done on a fair basis to reflect the benefit derived
from the service centre.

Example 2

A firm has two production departments and two service departments. It

makes two products and its total overhead bill for the year is as follows.

$
Rent 20,000
Depreciation – machinery 10,000
– buildings 8,000
Electricity 5,000
Indirect materials 15,000
______
58,000
______
The following statistics are available.

Production Production Service Service

Dept 1 Dept 2 Dept 1 Dept 2
Pressing Assembly Canteen Maintenance
Area (M2) 2,500 5,000 1,000 1,500
Machine value ($) 1,000 5,000 1,000 3,000
KW hour rating of machinery 10,000 10,000 2,500 2,500
Indirect materials consumed ($) 5,000 5,000 3,700 1,300

Required:

STEPS 1 and 2(a) – Allocate (1) and primarily apportion (2(a)) overheads to cost centres.

Overhead Total Basis Pressing Assembly Canteen Maintenance

$ $ $ $ $
Rent 20,000
Machine Dep’n 10,000
Buildings 8,000
Electricity 5,000
Indirect 15,000
materials
______ ______ ______ _____ _____
58,000
______ ______ ______ _____ _____

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SESSION 05 – OVERHEADS

STEP 2(b) – Reapportion service department costs to production cost centres (secondary
apportionment)

Usage of service department costs is estimated as

Pressing Assembly Canteen Maintenance

Use of canteen 50% 30% 20%
Use of maintenance 55% 40% 5%

A situation of reciprocal services is apparent i.e. the canteen does 20% of its work
for the maintenance department and the maintenance department does 5% of
its work for the canteen.

3 treatments are possible:

¾ Direct method
¾ Step-down method
¾ Reciprocal method – 2 methods

Continuous reapportionemnt Algebraic (simultaneous equations)

2.3 Direct method

¾ Reciprocal services (if any) are ignored. The service department costs are reapportioned
to production departments only.

Pressing Assembly Canteen Maintenance

$ $ $ $
15,000 26,000 8,000 9,000
Canteen (50:30) (8,000)
Maintenance (55:40) (9,000)
______ ______ ______ ______
– –
______ ______ ______ ______

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 SESSION 05 – OVERHEADS

2.4 Step (down) method

¾ Services that do most work for other service departments are allocated first. Reciprocal
services (if any) are then ignored.

Pressing Assembly Canteen Maintenance

$ $ $ $
15,000 26,000 8,000 9,000
Canteen (50:30:20)
______ ______ ______ ______

Maintenance (55:40)
______ ______ ______ ______
– –
______ ______ ______ ______

2.5 Reciprocal methods

¾ Reciprocal services are fully recognised. May be solved by continuous re-apportionment

or algebraically.

2.5.1 Continuous re-apportionment

Pressing Assembly Canteen Maintenance

$ $ $ $
15,000 26,000 8,000 9,000
Canteen (50:30:20)
______ ______

Maintenance (55:40:5)
______ ______

Canteen (50:30:20)
______ ______

Maintenance (55:40:5)
______ ______

Canteen (50:30)
______ ______ ______

______ ______

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SESSION 05 – OVERHEADS

2.5.2 Algebraic (simultaneous equations)

Let c be

Let m be
c =
m =

There are numerous ways in which these equations can be solved either simultaneously
and/or by substitution – the suggested solution is only one way.

c = 8,535
m = 10,707

Pressing Assembly Canteen Maintenance

$ $ $ $
15,000 26,000 8,000 9,000
Canteen (50:30:20)
Maintenance (55:40:5)
______ ______ ______ ______
– –
______ ______ ______ ______

STEP 3

The firm’s two products have the following direct costs per unit.

Product A B
$ $
Direct Materials 7.00 5.00
Direct Labour
Pressing A: 3 hrs/unit 15.00
B: 2 hrs/unit 10.00
Assembly A: 2 hrs/unit 8.00
B: 1 hr/unit 4.00
______ ______
Prime cost 30.00 19.00

Production volume is 1,000 units of A and 2,000 units of B.

It has been decided to absorb overheads into products on the basis of labour
hours.

Required:

Calculate the overhead costs of the two products.

0510
 SESSION 05 – OVERHEADS

Commentary

A reciprocal method must be used for reciprocal services unless told otherwise.

Units Pressing Assembly

Overhead $25,156 $32,844
Direct labour hours A

B
______ ______

______ ______

Rate per hour

Overhead cost per unit Hours A B

Pressing

Assembly
_____ _____
Overhead cost per unit
_____ _____

3 ABSORPTION
3.1 Departmental rates

¾ Are calculated, as above, by the “two-stage” process of

‰ allocating and apportioning overheads to cost centres

‰ absorbing costs into cost centres.

¾ Non-machine departments – direct labour hours.

¾ Machine departments – machine hour rate.

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SESSION 05 – OVERHEADS

3.2 Blanket rate

¾ A single overhead rate computed for the entire factory by omitting the first of these two
stages.

¾ Not a satisfactory method where a factory consists of a number of different production

centres and products consume cost centre overheads in different proportions.

‰ Cost units passing through centres with high overhead costs (e.g. machine shops)
will be under-costed

‰ Those passing through low overhead centres (e.g. an assembly department) will be
over-costed.

¾ May be used where they are an approximation to departmental rates as they simplify
product cost calculations.

4 ACCOUNTING FOR OVERHEADS

4.1 Steps in accounting for production overheads

¾ As management needs to know overhead costs per unit in advance e.g. to ensure sales
price covers all costs, they calculate predetermined overhead absorption rates, i.e.

Budgeted (forecast) overheads for the next year

Budgeted (forecast) activity (e.g. direct labour hours)

¾ This standard absorption rate is then used during each period (e.g. month) to charge
production overheads through the management accounting Income Statement.

¾ For example every time labour works one hour a standard amount of overhead is
charged into cost of sales.

¾ Total overhead absorbed = standard rate x actual activity during the period .

¾ At the end of each period the cost accountant must check that the correct amount of
overhead has been charged through the income statement.

¾ If overhead absorbed > actual overhead incurred then this is described as over-absorption
and the difference is written off as a credit to cost of sales or to the profit figure (there is
no one rule about exactly where the adjustment is made).

¾ If overhead absorbed < actual overhead incurred then this is described as under-
absorption and the difference is written off as a debit to cost of sales or to the profit
figure.

¾ Under/over-absorption is particularly likely to occur with fixed production overheads.

Remember that the pre-determined/standard absorption rate is often calculated using
budgeted data for the next year and is then used to charge overheads in specific month.

¾ Activity in a specific month may be higher or lower than the long-run average level
used to calculate the standard rate.

0512
 SESSION 05 – OVERHEADS

¾ If activity in a particular period is higher than normal levels then too much fixed cost
will be charged into cost of sales i.e. over-absorption. If activity is below normal levels
then under-absorption will occur.

¾ You may feel that the above system for accounting for overheads is rather complex –
rather than simply showing the actual overhead for a period (as in financial accounting)
we go through three steps when showing cost accounting i.e.

(1) in advance calculate standard absorption rate

(2) during the period use the standard rate to charge overhead through the cost
accounts (standard rate x actual activity)

(3) at the end of the period reconcile overhead absorbed to actual overhead incurred by
making an adjustment for under/over-absorption.

¾ The next section works through the calculation of under/over-absorption and should
help to clarify the system. Furthermore you will see under/over-absorption again in
session 6 on absorption costing.

4.2 Under/over-absorption of manufacturing overheads

Illustration 3

Continuing with Example 2, the following figures applied to the assembly

department.

Budgeted Actual
Overhead $32,844 $35,742
Direct labour hours 4,000 hrs 4,200 hrs

Solution

$32 ,844
Predetermined absorption rate = = $8.211 per direct labour hour
4 ,000

$
Actual overhead incurred 35,742
Overhead absorbed (recovered)
Actual hours × Predetermined absorption rate
(4,200 × $8.211) 34,486
_____
Under-absorption
1,256
_____
¾ Under/ (over) absorption is simply written off in total through the income statement i.e.
is not split between the income statement and balance sheet. .

0513
SESSION 05 – OVERHEADS

4.3 Non-manufacturing overhead

4.3.1 Selling overheads

¾ Benefit received by a cost unit is usually in proportion to its value ∴

Total selling overheads

¾ Selling overhead rate = × 100%
Total factory cost of all sales

4.3.2 Distribution overheads

¾ A distribution department is very similar to a production department in that there is

‰ direct materials – e.g. packing cases, air products

‰ direct labour – e.g. packers and van drivers
‰ direct expenses – e.g. freight
‰ departmental overhead – e.g. supervision, light & heat
‰ machinery – fork lift trucks, vehicles, etc.

¾ Therefore can be treated similarly.

4.3.3 Administration overheads

¾ So unrelated to production and selling that any basis of apportionment is very

subjective but possible methods are to.

‰ apportion between production, distribution and selling departments

‰ further apportionment within departments based on number of employees.

4.4 Concluding remarks

¾ This session is perhaps the most complex of the three concerning resource inputs.
However for decision making, overhead apportionment and absorption may be
considered as irrelevant due to the subjective nature of sharing overheads between
products.

¾ That does not mean that the analysis of overheads becomes redundant as for many
organisations they constitute a large proportion of totals costs.

¾ Overheads may therefore need to be analysed more accurately and ways of absorbing
overheads looked at more closely, to ensure appropriate costs per unit are calculated.

¾ The following section on Activity Based Costing (ABC) suggests a method of analysing
overheads more accurately. This is provided for background purposes; ABC is not
likely to be examined in paper F3 but is important for later ACCA papers.

0514
 SESSION 05 – OVERHEADS

Key points

³ Overheads are indirect costs which cannot be traced directly to a

particular unit of output. However, for costing purposes, we may wish to
include an appropriate amount of overhead cost in each unit produced.

³ As overhead costs are incurred, they are allocated or apportioned to the

appropriate cost centre.

³ The costs in service cost centres must then be apportioned to the

production cost centres.

³ Having allocated and apportioned all overhead costs to production cost

centres, an overhead absorption rate must be calculated as a method of
calculating the cost per unit. Overhead absorption rates are typically based
on per unit basis, per labour hour basis or per machine hour basis. Other
methods are also used.

³ The calculations above may often be prepared in advance, based on the

budgeted quantities. As units are produced, overheads will be absorbed
based on budgeted absorption rates. At the end of the year, the difference
between actual overheads, and overheads absorbed will be written off
directly to the income statement.

FOCUS
You should now be able to:

¾ explain the different treatment of direct and indirect expenses;

¾ describe the procedures involved in determining production overhead absorption rates;

¾ allocate and apportion production overheads to cost centres using an appropriate basis;

¾ reapportion service cost centre costs to production cost centres (using the reciprocal
method where service cost centres work for each other);

¾ select, apply and discuss appropriate bases for absorption rates;

¾ calculate and explain the under and over absorption of overheads;

¾ apply methods of relating non-production overheads to cost units.

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SESSION 05 – OVERHEADS

EXAMPLE SOLUTION
Solution 1 — Allocation, apportionment, absorption of overheads

(a) Overhead
Basis Ratio Assembly Trimming
$ $
Canteen No of employees 30:70 1,230 2,870
Machine depn &
machine repairs WDV 104.5:115.5 1,045 1,155
Rent and rates Area 3:1 4,725 1,575
Prod man’s salary Time spent 2:1 4,800 2,400
Heat and light Area 3:1 2,400 800
Materials storage Allocation 2:3 800 1,200
______ ______
15,000 10,000
______ ______
WORKINGS

(1) Assembly – overhead absorption rate

Total direct labour hours:

Hours
Sofas 100 × 24 = 2,400
Chairs 400 × 9 = 3,600
_____
6,000
_____
15,000
Absorption rate = = $2.50 per direct labour hour.
6 ,000

(2) Trimming – overhead absorption rate

Total direct labour hours:

Hours
Sofas 100 × 18 = 1,800
Chairs 400 × 8 = 3,200
_____
5,000
_____
10 ,000
Absorption rate = = $2.00 per direct labour hour.
5 ,000

0516
 SESSION 05 – OVERHEADS

(b) Overhead cost per unit

$
Sofas: Assembly 24 × 2.50 (W1) = 60.00
Trimming 18 × 2.00 (W2) = 36.00
_____
96.00
_____
Chair: Assembly 9 × 2.50 = 22.50
Trimming 8 × 2.00 = 16.00
_____
38.50
_____
Solution 2 — Service departments

“Step 2(a)” – Primary apportionment

Overhead Total Basis Pressing Assembly Canteen Maintenance

$ $ $ $ $
Rent 20,000 Area 5,000 10,000 2,000 3,000
Machine Dep’n 10,000 Value 1,000 5,000 1,000 3,000
Buildings 8,000 Area 2,000 4,000 800 1,200
Electricity 5,000 KW hrs 2,000 2,000 500 500
Indirect 15,000 Allocation 5,000 5,000 3,700 1,300
materials
______ ______ _____ _____
15,000 26,000 8,000 9,000
______ ______ _____ _____

“Step 2(b)” – Secondary apportionment

Direct method
Pressing Assembly Canteen Maintenance
$ $ $ $
15,000 26,000 8,000 9,000
Canteen (50:30) 5,000 3,000 (8,000)
Maintenance (55:40) 5,211 3,789 (9,000)
______ ______ ______ ______
25,211 32,789 – –
______ ______ ______ ______

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SESSION 05 – OVERHEADS

Step (down) method

Pressing Assembly Canteen Maintenance
$ $ $ $
15,000 26,000 8,000 9,000
Canteen (50:30:20) 4,000 2,400 (8,000) 1,600
______ ______ ______ ______
19,000 25,400 – 10,600
Maintenance (55:40) 6,137 4,463 (10,600)
______ ______ ______ ______
25,137 32,863 – –
______ ______ ______ ______

Reciprocal methods

Continuous re-apportionment

Pressing Assembly Canteen Maintenance

$ $ $ $
15,000 26,000 8,000 9,000
Canteen (50:30:20) 4,000 2,400 (8,000) 1,600
______ ______
– 10,600
Maintenance (55:40:5) 5,830 4,240 530 (10,600)
______ ______
530 –
Canteen (50:30:20) 265 159 (530) 106
______ ______
– 106
Maintenance (55:40:5) 58 42 6 (106)
______ ______
6
Canteen (50:30:20) 3 3 (say) (6)
______ ______ ______
25,156 32,844
______ ______
etc

0518
 SESSION 05 – OVERHEADS

Algebraic (simultaneous equations)

Let c be the total cost of canteen service department

Let m be the total cost of maintenance service department

c = 8,000 + 0.05m
m = 9,000 + 0.20c
__________________
Rearranging
c – 0.05m = 8,000 (1)
– 0.20c + m = 9,000 (2)

Multiply (1) by 0.2

0.20c – 0.01m = 1,600 (3)
– 0.20c + m = 9,000 (2)
__________________
Add: 0.99m = 10,600
10 ,600
m =
0.99
m = $10,707
________
Substitute into (1)

c – 535 = 8,000
c = $8,535
__________________

Pressing Assembly Canteen Maintenance

$ $ $ $
15,000 26,000 8,000 9,000
Canteen (50:30:20) 4,267 2,561 (8,535) 1,707
Maintenance (55:40:5) 5,889 4,283 535 (10,707)
______ ______ ______ ______
25,156 32,844 – –
______ ______ ______ ______

“Step 3” – Absorption

Pressing Assembly
Overhead $25,156 $32,844
Direct Labour hours A 1,000 units × 3 hrs 3,000
1,000 units × 2 hrs 2,000
B 2,000 units × 2 hrs 4,000
2,000 units × 1 hr 2,000
______ ______
7,000 4,000
______ ______

0519
SESSION 05 – OVERHEADS

Rate per hour $25,156 $32 ,844

= $3.59 = $8.21
7 ,000 4 ,000

Overhead cost per unit A B

Pressing 3 hrs × $3.59 10.77
2 hrs × $3.59 7.18
Assembly 2 hrs × $8.21 16.42
1 hr × $8.21 8.21
_____ _____
Overhead cost per unit 27.19 15.39
_____ _____

0520