Management Accounting F2

Overheads
Direct expenses- are those expenses which are directly incurred and can be specifically identified with a
product ,process or job. e.g. royalty, cost of drawings etc also known as chargeable expenses.
Overheads consist of indirect material, indirect labour and indirect expenses.
Indirect expenses – are those which cannot be conveniently identified to a job, product, or process e.g.
Maintenance, supervision, rent, rates and taxes.
Since indirect production expenses (production overheads) cannot be identified to a job, it has to be distributed
to cost units in an equitable manner. This distribution is a 3-stage process:
(1) Allocation of overheads-the charging of discreet , identifiable items of cost to cost centres or units. E.g.
wages of storekeeper to stores dept
(2) Apportionment of overheads-The allotment of 2 or more cost centres of proportions of common items
of cost on the basis of benefits received
(3) Reapportionment of service cost centre overheads to production depts.
Bases of reapportionment
(i)Direct redistribution method
(ii)Step distribution method
(iii)Reciprocal method
 Simultaneous equation
 Repeated distribution
Simultaneous equation method
Example: Production dept Service
dept
A B C 1 2
$800 $700 $500 $234 $300
Overhead distribution table
1 20% 40% 30% 10%
2 40% 20% 20% 20%
Let X represent the total amount of overheads of service department 1
Let Y represent the total amount of overheads of service department 2
Then: X = 234 + 20% Y And Y = 300 + 10% X
Solving the equations we get X = 300 and Y = 330
Production
departments
A B C
$800 $700 $500
Reapp 1 60 120 90
2 132 66 66
992 886 656
Repeated distribution method – Easier where there are more than 2 service departments.
Production dept Service dept
A B C 1 2
$800 $700 $500 $234 $300
1 46 92 72 (234) 24
2 129 64 64 67 (324)
1 13 27 20 (67) 7
2 4 1 1 1 (7)
1 1 (1)
992 885 657
1 Overheads
 Management Accounting F2

Absorption of overheads
o Blanket rate-It is a single OAR used throughout a factory to absorb overheads into units produced.
Is applied where (i)All products spend nearly the same time in each cost centre
(ii)The factory produces only one product or all products are similar.
The drawbacks of using a blanket rate are that:
(i)Distorts the value of WIP-costs not yet used are charged
(ii)Impossible to evaluate the performance of each dept
o Departmental rates- or Multiple OAR –where each dept or centre has its own rate for absorbing
overheads.
These are more accurate because:
(i)Some products pass only through a few centres
(ii)Each cont centre has different features(packing and stitching not same)
(iii)Time span is different in each centre.
o Actual OAR

Actual OAR is calculated as follows:

Actual overheads
Actual activity
This can only be calculated at the end of a period when actual figures become available. However it causes a
delay in ascertaining cost figures.

o Predetermined OAR is calculated as follows:

Budgeted overheads
Budgeted activity
With the use of a predetermined OAR:
(i)Product costs can be calculated on a timely basis
(ii)Product prices can be fixed in advance
(iii)Target will be set and worked upon.

Common absorption rates:

(i)Direct labour hour-applicable to labour intensive cost centres
(ii)% of direct labour costs –It is simpler than DLH since no time records will have to be kept but will be
relevant only if wages rate within a dept are uniform.
(iii)%of direct material cost –Simple but not logical –Does not take into account time spent on each job.
(iv)%Prime cost-Simple but not recommended .same disadvantage as (ii)and (iii)
(v)Rate per machine hour –Good method if work is of a capital intensive nature
(vi)Rate per unit of output- Simple but is suitable only if cost centre performs one standard task on all
units e.g. Painting of cars

2 Overheads