UNDER- AND OVER-RECOVERY OF OVERHEADS

When a company uses standard costing, it derives a standard amount of

overhead cost that should be incurred in an accounting period, and applies it to
cost objects (usually produced goods. The effect of calculating overhead rates based
on budgeted annual overhead expenditure and activity is that it will be most unlikely
that the overhead allocated to products manufactured during the period will be the
same as the actual overhead incurred. If the actual amount of overhead turns out to
be different from the standard amount of overhead, then the overhead is said to be
either under absorbed or over absorbed. If overhead is under absorbed, this means
that more actual overhead costs were incurred than expected, with the difference
being charged to expense as incurred. This usually means that the recognition of
expense is accelerated into the current period, so that the amount of profit
recognized declines. If overhead is over recovery, this means that fewer actual
overhead costs were incurred than expected, so that more cost is applied to cost
objects than were actually incurred.

For example, if the overhead rate is predetermined to be $20 per direct

labor hour consumed, but the actual amount should have been $18 per hour, then
the $2 difference is considered to be over absorbed overhead
Consider a situation where the estimated annual fixed overheads are
£2,000,000 and the estimated annual activity is 1,000,000 direct labour hours. The
estimated fixed overhead rate will be £2 per hour. Assume that actual overheads are
£2,000,000 and are therefore identical with the estimate, but that actual activity is
900,000 direct labour hours instead of the estimated 1,000,000 hours. In this situation,
only £1,800,000 will be charged to production. This calculation is based on 900,000
direct labour hours at £2 per hour, giving an under-recovery of overheads of
£200,000.
Consider an alternative situation where the actual overheads are £1,950,000
instead of the estimated £2,000,000, and actual activity is 1,000,000 direct labour
hours, which is identical to the original estimate. In this situation, 1,000,000 direct
labour hours at £2 per hour will be charged to production giving an over-recovery of
£50,000. This example illustrates that there will be an under- or over-recovery of
overheads whenever actual activity or overhead expenditure is different from the
budgeted overheads and activity used to estimate the budgeted overhead rate. This
under- or over-recovery of fixed overheads arising from actual activity differing from
budgeted activity is also called a volume variance and any under- or over-recovery
arising from actual fixed overhead expenditure differing from budget is also called a
fixed overhead expenditure variance.

NON-MANUFACTURING OVERHEAD
Non-manufacturing overhead costs, also known as administrative or operating
expenses, refer to the costs that are not directly tied to the manufacturing or
production process in a business. Unlike manufacturing overheads, which include
costs like raw materials, direct labor, and factory overheads, non-manufacturing
overhead costs are not associated with the creation or production of goods or services.
For external reporting, it is therefore unnecessary to allocate non-manufacturing
overheads to products. However, for decision-making, it may be necessary to assign
non-manufacturing costs to products.
For example, in many organizations, it is not uncommon for selling prices to
be based on estimates of total cost or even actual cost. Housing contractors and
garages often charge for their services by adding a percentage profit margin to actual
cost. Some non-manufacturing costs may be a direct cost of the product. Delivery
costs, sales people’s salaries, commission and travelling expenses may be directly
identifiable with the product, but it is likely that many non-manufacturing overheads
cannot be allocated directly to specific products

Example of Non-Manufacturing Overhead Costs

TechX produces and sells a variety of technological devices. Aside from the
costs associated directly with producing these devices (like the cost of materials, labor
costs for assembly, costs to run the factory, etc.), they also have a number of non-
manufacturing overhead costs.
 Marketing and Sales Expenses: TechX spends $500,000 on a marketing
campaign for their new smartphone. This includes TV commercials, online ads,
and hiring a marketing agency to run the campaign. They also pay their sales
team a total of $200,000 in salaries.
 General and Administrative Expenses (G&A): TechX’s headquarters in a
city office costs $300,000 in annual rent. They pay $100,000 for utilities for
this office building. They also have an administrative staff that manages the
office, human resources, legal, and finance, costing $400,000 in salaries.
 Research and Development (R&D): TechX is also developing a new AI
technology that they plan to implement into their future devices. They have a
team of engineers and AI specialists working on this project, with salaries
totaling $600,000. They also spend $200,000 on testing and other research
materials.

COST ASSIGNMENT IN NON-MANUFACTURING ORGANIZATIONS

For profit reporting, The primarily focused on cost assignment for allocating
65 costs between inventory costs and cost of goods sold. A job-order costing system
is also used by many service organizations. Accounting, legal, printing, automotive,
and appliance repair businesses, for instance, provide distinct services to customers,
necessitating cost tracking for each customer.
The prices of the services that have been provided are frequently determined
using the costs that have been assigned to each customer. At the conclusion of
the accounting period, these businesses may also have inventories that consist
of work that has only been partially completed (WIP).For profit reporting, we have
primarily focused on cost assignment for allocating 65 costs between inventory costs
and cost of goods sold.
A job-order costing system is also used by many service organizations.
Accounting, legal, printing, automotive, and appliance repair businesses, for instance,
providedistinct services to customers, necessitating cost tracking for each customer.
The prices of the services that have been provided are frequently determined using the
costs that have been assigned to each customer. At the conclusion of the accounting
period, these businesses may also have inventories that consist of work that has only
been partially completed (WIP).

However, a job-order costing system as described above is inappropriate for many

non-manufacturing
organizations for the following reasons:
1. They do not provide unique services for specific customers. Instead, they provide
similar
services for a large number of customers. Consider a bank whose principal activities
include mortgage lending, personal lending, variable interest and fixed interest
savings accounts, insurance, foreign currency, etc. It is not feasible or useful to track
the costs of undertaking these activities to individual customers. Instead, costs are
assigned to each activity so that the total costs incurred can be deducted from sales
revenue to periodically determine the profits/losses of each activity.
2. They do not need to assign costs to individual customers to determine prices of
the services provided because prices are determined by market forces rather than
cost.
3. They do not convert purchased materials into finished products or have work in
progress. Therefore, there is no legal requirement to assign indirect costs to cost
objects for inventory valuation

THE INDIRECT COST ASSIGNMENT PROCESS

This directive establishes the proper methods of assigning indirect
costs. Uniform Guidance 2 CFR 200 defines indirect costs as those that are incurred
for common or joint objectives and therefore cannot be identified readily and
specifically with a particular sponsored project, and instructional activity or any other
institutional activity. These costs are usually classified and accumulated in the
following indirect cost categories:

 depreciation/use allowances
 operations and maintenance
 general administration/general expenses
 department administration
 sponsored projects administration, library, and student administration/services
The following is a summary of the process of assigning indirect costs to cost objects
for a job-order
traditional costing system:
1. Identify the production departments (or their equivalent in service organizations)
that are responsible for creating the products of services that are sold.
2. Identify the support departments that provide essential support services for the
production departments.
3. Assign all indirect (overhead) costs in the firm to a producing (or customer-
facing) or support department.
4. Reallocate the support department costs to the production departments.
5. Calculate predetermined overhead rates for each producing department.
6. Allocate the departmental overhead costs to the units of the individual products
or services using the predetermined overhead rates

Where a job-order costing system is not used the process may end at stage 4.
For example, in the preceding section, the costs of the merchandising departmental
store were assigned to departments and not to the individual products sold within the
departments.
Therefore, the costs assigned to the departments are equivalent to the costs of
undertaking the activities. Thus for profitability analysis purposes the assignment of
costs can end at the fourth stage since the costs assigned to the departments also
represents the costs of undertaking the principal activities. We can conclude that the
nature of the business, the organization structure, its strategy, etc.
References
Understanding SAP Modules: SAP FI, SAP CO, SAP SD, SAP
HCM and more. Available at www.simplilearn.com/
sap-modules-sap-fi-sap-co-sap-sd-sap-hcm-and-more
rar111-article (accessed 28 April 2020)