UNIVERSITY OF EDUCATION WINNEBA

SCHOOL OF BUSINESS
DEPARTMENT OF ACCOUNTING
Course Title: Cost Accounting
Course Code: BBAd 246
Level 200
Semester Two
Topic: Accounting for Overheads
Course instructor: I.A Ahmed
Introduction
• This session discusses the various methods for accounting for
overheads
• A distinction between direct and indirect expenses is presented
• An explanation for overheads and its classification is also discussed
What are Expenses
• Expenses may be defined as notional cost for the use of owned
assets.
• Thus, it is how much an entity pays for using its assets.
• Note that expenses are at best classified as assets
• They are assess which have either been consumed or yet to be
consumed.
• It could also be defined as the costs of services provided to a
business.
Direct Expenses
• Direct expenses are those expenses which are directly chargeable to a
job account.
• They are those expenses which are easily identifiable and attributable
to the individual units or jobs.
• All expenses other than the direct material or direct labor which are
incurred for a particular product or process are termed as direct
expenses.
• It includes all direct cost except direct material and direct labor as
Treatment of Direct Expenses
• In the financial accounting, they are debited to the direct expenses
account.
• However, in cost accounting records, the direct expenses account is
credited and the concerned account is debited.
• The cost department should therefore verify from the accounts
department that the expenses are properly booked.
• These expenses should not be mixed up with overheads.
Indirect Expenses
• Indirect expenses are expenses other than direct expenses.
• These refer to those expenses which cannot be directly, conveniently
and wholly allocated to cost centers or cost units.
• Examples are factory rent & insurance, power, general repairs etc.
Notional Expenses
• Expenses that are usually incurred should be included in costs even if
a particular firm is not required to pay for such expenses.
• Rent for own premises is an example.
• For instance, if a firm occupies its own buildings, it does not pay any
rent for this, but for costing purposes, an appropriate amount of rent
should be included in costs.
• Notional expenses are therefore expenses incurred for the use of
owned assets or properties
Accounting Treatment for Indirect Expenses
• Indirect expenses may or may not be allocated.
• Indirect expenses that are in the form of factory overhead will be
allocated to those units produced in the factory.
• This will be done during the same period that the indirect expenses
were incurred
• Administrative expenses are rarely allocated unless they are corporate
in nature
• In such cases, they may be allocated to subsidiaries
What are overheads?
• Simply put, overheads are the inverse of direct materials, wages and
expenses.
• They are defined to encompass the cost of indirect material, indirect
labor and such other expenses.
• Other expenses will include services, as they cannot be conveniently
charged directly to specific cost centers or cost units.
• Note that overheads could be Production or Non-production
overheads.
Classification of Overheads
• Generally overheads are classified on the following basis:
1. Functional analysis
2. Behavioral analysis
3. Ease of Traceability
4. Ease of Control
Functional classification
• This includes:
a. Manufacturing or production
b. Administrative
c. Selling and Distribution
d. Research and Development
Behavioral classification
• Fixed overhead
• Variable overheads
• Semi-variable overheads
Ease of Controllability
• Controllable
• Non- controllable

• Ease of Traceability: Direct and Indirect overheads

• Other classification: production and non-production

Accounting for overheads
• There are two approaches to accounting for overheads

1. The traditional (volume) approach

2. The activity based approach. Also known as Activity-Based Costing

(ABC).
Traditional (volume) Approach
• In this approach, overheads (production) are charged to cost units by

a. Tracing overheads to cost centers- that is, accumulation and

charging of overheads to cost centers. This is done by allotment,
allocation and apportionment of overheads.
b. Absorption of overheads by cost units- that is computation and
charging of overheads to cost units (Products and Services). This
involves computation of suitable overhead absorption rates (O.A.R)
and charging them to products or services.
Allocation of Overheads
• After overheads have been collected under proper standing order
numbers the next step is to arrive at the amount for each department
or cost center.
• This may be through allocation or absorption.
• According to the CIMA terminology, cost allocation is “that part of
cost attribution which charges a specific cost to a cost center or cost
unit”.
Apportionment of Overheads
• Apportionment refers to the distribution of overheads among
departments or cost centers on an equitable basis.

• In other words, apportionment involves charging a share of the

overheads to a cost center or cost unit.

• Both Allocation and Apportionment are done using the Overhead

Analysis Sheet (OAS).
Methods of Apportioning Overheads
• Primary Method: using the basis of Apportionment

• Secondary Method: Re-apportionment of service department

overheads
Methods of Re-apportionment
1. Direct distribution method: Under this method, the cost of service
department are directly apportioned to production departments,
without taking into consideration any service from one service
departments to another service department.
2. Step method: In this method the cost of the most serviceable
department is first, apportioned to other service departments and
production departments. The next service department is taken up
and its cost is apportioned and this process continues until the cost
of last service department is apportioned. The cost of last service
department is apportioned among production departments only.
Methods of Re-apportionment
• Reciprocal service method: This method gives cognizance to the fact
that where there are two or more service departments, they may
render service to each other and therefore these interdepartmental
services are to be given due weight in distributing the expenses of
service departments.
Variants of Reciprocal Services Method
1. Simultaneous Equation Method
2. Repeated Distribution Method
3. Trial and Error

See Illustration 5.1 for worked example.

Absorption of Overheads
• Overheads are absorbed by computing an Overhead Absorption Rate
(OAR).
• This could be done using:
1. Historical figures
2. Estimates
3. Production volume or capacity
Actual and Pre-determined Rates
• This is also known as historical overhead rate.
• This rate is obtained by dividing the overhead expenses incurred
during the accounting period by the actual quantum (quantity/value)
of the base selected.
• This rate is determined as follows:
Actual overhead rate = Actual Overhead for the period
Actual quantity or value of base for the period
Pre-determined Overhead Rate
• Pre-determined overhead rate is determined in advance of the actual
production
• It is computed by dividing the budgeted overhead expenses for the
accounting period by the budgeted base for the period.
• This is indicated as below:
Pre-determined overhead rate = Budgeted overhead for the period
Budgeted base for the period
Why use Pre-determined Rates?
1. Pre-determined overhead rate facilitates product cost
determination immediately after production is completed
2. In those concerns where the budgetary control system is in
operation, all the data for the purpose of calculation of pre-
determined overhead rate is available without any extra clerical
cost.
3. It is useful when cost plus contracts are undertaken.
4. Cost estimation and competitive pricing offer ideal situations for use
of pre-determined overhead rates.
Blanket Overhead Rate (BOR)
• This refers to the use of one single or general overhead rate for the
whole factory.
• The blanket rate is used in those factories:
a. Where only one major product in continuous process is being
produced.
b. Where several products are produced it can be applied only if:
all products pass through all departments; and
all products are processed for the same length of time in each
department.
BOR
• This rate is calculated as follows:

Blanket overhead rate = Overhead cost for the entire factory

Base for the period
Multiple Overhead Rate (MOR)
• This is used when different rates are computed for each
1. production department
2. service department
3. cost center
4. each product or product line
5. each production factor and
6. for fixed overhead and variable overhead
7. It is calculated as below:
Overhead rate = overhead cost apportioned and allocated to each cost center
Corresponding base
Methods of Absorbing Production Overheads
• There are three (3) main methods each with its variations.
• These are
1. Percentage of cost
2. Hourly rate
3. Units of production
• However, the following seven (7) O.A.Rs are the most common methods applicable:
1. Percentage of direct materials cost.
2. Percentage of prime cost.
3. Percentage of direct labor cost.
4. Direct labor hour rate.
5. Machine hour rate.
6. *Combined machine hour and labor hour rate.*(not normally used)
7. Rate per unit of production.
Over and Under Absorption of Overheads
• Overhead expenses are usually applied to production on the basis of
predetermined rates.
• The predetermined rates may represent estimated, actual or normal
costs.
• In either case, the amount of expenses actually incurred and the
amount of overheads applied to production will seldom be the same.
• Some difference is inevitable.
Over and Under Absorption of Overheads
(cont)
• If the actual expenses fall short of the amount applied, there is said
to be an over-absorption of overheads
• if the actual expenses exceed the amount applied to production, it is
a case of under-absorption.
• Such over or under-absorption may also be termed as overhead
variance
• The amount of over-absorption is represented by the credit balance
on the overhead absorption (variance) account
• The amount of under- absorption is represented by a debit balance.
Accounting for Non-production Overheads
• Non-production overheads will include: S&D, R&D, G&A
• They are accounted for or absorbed in the following ways:

1. Apportioning between production and sales departments

2. Transfer to profit and loss account
3. Treating them as a separate addition to the cost of jobs or products

See illustration 5.8 to 5.10 for worked example

THE END

Do well to read the main text and solve questions to better your
understanding