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Accounting for Overheads and Marginal costing

Overheads

Overhead is the cost incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and fully to the product, service or department.

Overhead is actually the total of the following:-

Indirect materials

Indirect labor

Indirect expenses

In cost accounting, there are two schools of thoughts as to the correct method of dealing with

overheads:-

Absorption costing

Marginal costing

There are four categories of overheads.

1. Production/ manufacturing overheads

2. Marketing/ selling and distribution overheads

3. Research and development overheads

4. Administration overheads

Allocating Overheads to Products

In general, overheads are charged to products through two stages.

1. Overheads are assigned to cost centers

2. Accumulated costs at cost centers allocated to the products

Overhead Cost Allocation & Apportionment

1. Costs are specifically allocated, where they can be ascertained specifically and charged to a particular cost centre.

Example: The depreciation of machines in production division.

In here, the depreciation of machines in production division, which is considered as a cost centre, can be charged (allocated) to that cost centre.

2. When overhead item is a common cost, the cost item is apportioned to the cost centers that benefit from the cost on an appropriate basis (e.g. machine hours, number of employees etc.).

3. The overheads are to be allocated to service department as well as to production departments.

4. Service department overheads are to be absorbed through jobs or products passing through production department. So service department costs are re-apportioned to production departments.

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Absorption costing stages

Allocation Apportionment Absorption
Allocation
Apportionment
Absorption

Overhead allocation

Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre

For example, the following cost will be charged to the following cost centers via the process of

allocation:-

Direct labor will be charged to the production cost centre

The cost of warehouse security will be charged to the warehouse cost centre

Costs such as canteen are charged direct to the various overhead cost centers.

Overhead Apportionment

Apportionment of overhead is distribution of overheads to more than one cost centre on some equitable basis.

When the indirect costs are common to different cost centers, these are to be apportioned to the cost centers on an equitable basis. For example, the expenditure on general repair and maintenance, If the department is involved in the production of a single product, the whole repair & maintenance of the department may be allocated to the product. If not it will be apportioned according to their use of the above-mentioned cost. We can use several ways as basis of apportionment, when dividing the cost between different cost centers. Examples,

Overhead to which basis apply

Basis of apportionment

Rent, rates, heating and light, repairs and depreciation of building

Floor area occupied by each cost centre

Deprecation and insurance of equipment

Cost or book value of equipment

Personnel, office, canteen, welfare, wages and costs of offices, first aid

Number of employees, or labor hours worked in each cost centre

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For services…

Service cost centre

Possible basis of apportionment

Stores

Number of cost value of material requisitions (requisitions - An official order laying claim to the use of property or materials)

Maintenance

Hours of maintenance work done for each cost centre

Production planning

Direct labor hours worked in each production cost centre

Overhead Absorption

Determine an absorption rate at which the cost of each cost centre is charged to jobs / products passing through the cost centre.

=

Overhead costs absorbed by individual products at an absorption rate based on the total expected output or volume of input. Example,

Total Overhead of dept = Rs. 10,000

Total labor hrs = 250

Absorption rate = 10,000/250 = Rs. 40 per labor hr

Example:

Job 232 is one of many jobs that pass through the assembly cost center during a period. The only work done on job 232 is assembly work and its direct costs are,

Direct materials 65

Direct labor ( 5 hours @ Rs 18) 90

Total Overhead on Assembly cost center 225000

Expected that 9,000 hours will be worked in total during the period, what is the total production cost of job 232?

Overhead absorption rate = 225000/90000 = 25

Total Direct Cost = 155

Total production cost = Total Direct Cost + OAR = 155 + 25 = 180

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Re apportionment of service department costs

Once the overhead have been allocated and apportioned to production and service departments and totaled, the next step is to reapportion the service department costs to production departments.

Here is an Example that talks about full cycle of allocation, apportion, absorption, and re- apportion. Here we talk about three basic methods of allocating service department costs.

1. Continuous Allotment

2. Simultaneous Equation method

3. Specified order of Re-Allocation

Choice of Overhead Rates

The overhead rate is calculated based on several alternative bases. The basis chosen should be suitable for the cost centre activities.

=

ℎℎ =

ℎℎ

=

In above example we used the second way, ℎ ℎ = ()/(ℎ ℎ)

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Absorption and marginal costing

Absorption - Before we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing. It is costing system, which treats all manufacturing costs including both the fixed and variable costs as product costs

Marginal - However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing. It is a costing system, which treats only the variable manufacturing costs as product costs. The fixed manufacturing overheads are regarded as period cost

Practical reasons for using absorption costing

Inventory in hand must be valued for two reasons, In absorption costing, closing inventory is valued at fully absorbed factory costs :-

For the closing inventory figure in the statement of financial position

For the cost of sales figure in the statement of comprehensive income

Many companies attempt to fix selling prices by calculating the full cost of production or sales of each product, and then adding a margin for profit. Without using absorption costing, a full cost is difficult to ascertain.

If a company sells more than one product, it will be difficult to judge how profitable each individual product is, unless overhead costs are shared on a fair basis and charged to the cost of sales of each product

fair basis and charged to the cost of sales of each product Here is a example

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Difference between absorption and marginal costing

Absorption costing

Marginal costing

Treatment for

Fixed manufacturing overheads are treated as product costing. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads

Fixed manufacturing overhead is treated as period costs. It is believed that only the variable costs are relevant to decision-making. Fixed manufacturing overheads will be incurred regardless there is production or not.

fixed

manufacturing

overheads

Value of closing stock

Lower value of closing stock that included the variable cost only

High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock

Argument for absorption costing

Compliance with the generally accepted accounting principles

Importance of fixed overheads for production

Avoidance of fictitious profit or loss

o

During the period of high sales, the production is small than the sales, a smaller number of fixed manufacturing overheads are charged and a higher net profit will be obtained under marginal costing

o

Absorption costing is better in avoiding the fluctuation of profit being reported in marginal costing

Arguments for marginal costing

More relevance to decision-making

Avoidance of profit manipulation

o Marginal costing can avoid profit manipulation by adjusting the stock level

Consideration given to fixed cost

o In fact, marginal costing does not ignore fixed costs in setting the selling price. On the contrary, it provides useful information for break-even analysis that indicates whether fixed costs can be converted with the change in sales volume

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my- business-economics-and-financial.html