THE INSTITUTE OF CHARTERED ACCOUNTANTS OF SRI LANKA

POSTGRADUATE DIPLOMA IN BUSINESS AND

FINANCE - 2013/2014
Principles of Financial and Cost Accounting

Thilanka Warnakulasooriya
B.Com Special (Col), ACA
Accounting for Overhead

Overhead is the Expenditure 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
 Classification of Overhead
 Overhead can be classified under 3 basis

Overhead

Element Base Behavior based Function Based

Indirect Material Fixed Overhead Production OH

Indirect Labor Variable OH Administration OH

Indirect Expense Semi-Variable Selling &

OH Distribution OH

General OH
Overhead Allocation, apportionment & absorption
 Steps.

1. Identify OH cost & Accumulate the cost

i.e. Rent , Electricity,
2. Identify the Cost Center of the Organization
Identify the activity or item or equipment where the cost are
accumulated.

Cost centers can be either production cost center or service

cost center
i.e Garment Factory

Production cost centers Service cost centers

Cutting, Sawing, washing, Maintenance , HRM,
Packaging Planning
 3. Allocation of OH cost to cost centers

 Some OH can be directly identify to a particular cost centers. Accordingly

that OH cost can be allocated to that cost center called “allocation”

i.e. Cutting supervisor salary directly identified to the cutting cost center

4. Apportioning overhead cost to cost centers

Some OH can not be directly identified to particular cost center.
Accordingly such cost should be shared among the cost centers. These cost
should be divided among cost centers based on most reasonable basis.

(Apportionment of overhead is distribution of overheads to more

than one cost centre on some equitable basis)
 OH Basis for Apportionment

Rent, rates, heating and light, Floor area occupied by each cost
repairs and depreciation of centre
building
Deprecation and insurance of Cost or book value of equipment
equipment

Personnel, office, canteen, Number of employees, or labor

welfare, wages and costs of offices hours worked in each cost centre

i.e. Garment factory monthly electricity bill was Rs. 200,000. Factory consist of 4 cost
centers . The floor area occupied by each cost center are as follows.

Cost Center Floor area (Sq. Feet)

Cutting 3,000
Sawing 5,000
HR 500
Warehouse 1,500
Apportion the electricity between cost centers.
5. Reapportioning the service cost centre cost to production cost
centers.

Service cost centers cost should charged to production cost

centers since salable units does not pass through service
departments. The reasonable apportionment basis should be used

Service cost centre Possible basis of

apportionment
Stores Number of cost value of
material requisitions

Maintenance Hours of maintenance work

done for each cost centre

Production planning Direct labor hours worked in

each production cost centre
 Reapportioning the service cost centre cost to production
cost centers

Secondary Distribution with reciprocal Servicing overhead absorption rates

To production & service

Direct Method
department

Simultaneous Equation
Method
Only to
Repeated Distribution Production
Method Department

Step Down Method

6. Calculate the overhead absorption rate & absorb the cost

 Overhead absorption is the process whereby overhead costs

allocated and apportioned to production cost centers are added to
unit, job or Cost object.

 Overhead absorption is sometimes known as overhead recovery

 Overheads are usually added to costs units using a predetermined

overhead absorption rate, which is calculated using figures from
the budget.

Overhead absorption rate (OAR)

“Attributing OH to particular product or service based on particular

basis”

Generally OAR calculated by dividing the OH cost of the cost center

by number of units/ Volume of absorption base which is appropriate
for the cost center
Calculation of overhead absorption rate
OAR = Budgeted Overhead cost
Budgeted volume

 Estimate the overhead likely to be incurred during the period

 Estimate the activity level for the period
 Divide the estimated overhead by the budgeted activity level
 Absorb the overhead into the cost unit by applying the calculated
absorption rate

Ex 06.

There is no ideal OAR, depending on the company some use machine

hours or labor hours. The most appropriate OAR depends on factors
such as cost, information availability, nature of the product,
technology used etc.
Choosing the appropriate
absorption base
A percentage of direct materials cost
 A percentage of direct labor cost
 A percentage of prime cost
 A rate per machine hour
 A rate per direct labor hour
 A rate per unit
 A percentage of factory cost (for admin
overhead)
 A percentage of sales or factory cost ( for selling
and distribution overhead)

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 Over and under absorption of
overheads
 The rate of overhead absorption is based on estimates ( of both
numerator and denominator) and it is quite likely that either one or
both of the estimates will nit agree with what actually occurs

◦ Over absorption means that the overheads charged to the cost of

sales is more than the overheads actually incurred

◦ Under absorption means that insufficient overheads have been

included in the cost of sales

Actual Overhead incurred xxxx

Overhead absorbed xxxx
(budgeted OAR * actual activity level)

Under/ Over absorption xxx

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The reasons for over/under absorbed overheads
 The overhead absorption rate is predetermined from budget
estimates of overhead cost and the expected volume of activity.
 Over or under recovery of overhead will occur in the following
circumstances:-
◦ Actual overhead costs are different from budgeted overhead
◦ The actual activity level is different from the budgeted activity
level
◦ Actual overhead costs and actual activity level differ from the
budgeted costs and levels

◦i.e . Following information with regard to “ A” Company

◦Budgeted overhead cost per month 80,000

◦Actual Overhead cost per month 70,000
◦Budgeted units plan to produce 10,000
◦Actual units Produced 8,000

◦Calculate over or under absorption of overhead per month

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