Overheads

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Overheads

 Overhead includes a large number of types

of indirect costs
 Direct cost are identifiable to cost units, but
overhead which are often considerable,
cannot be related directly to cost units

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Two-stage method to allocate
overhead to products
 Overheads are assigned to the cost centres
such as department
 An allocation base is selected for allocating
production centre expenses to products

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Procedures of overhead
allocation to product
 Assign all factory overheads to cost centres
 Reallocate service-centre overheads to
production cost centres
 Calculate separate overhead absorption rate
for each cost centre
 Assign cost-centre overhead to products

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Assign all factory overheads to
cost center

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Assign all factory overhead to
cost centres
 Cost allocation
 Cost apportionment

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Cost allocation

 Where a cost can be clearly identified with

a cost center or cost unit, then it can be
allocated to that cost center or cost unit

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Cost apportionment

 It is not possible to identify a discrete item

of cost with a cost center and it is necessary
to split a cost over several cost centers on
some agreed basis

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Bases of apportionment

 Apportionment of indirect expenses to cost

centers must be made on fair and reasonable
bases
 Different types of expense require different
bases according to their individual
characteristics

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Base of apportionment Costs

Area Rent and rates, heat and

lighting, insurance of
lighting
Machine value Depreciation, machine
insurance
No. of employees Wages of supervisors,
canteen cost

Example textbook P.183

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Reallocate service-center
overheads to production center

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Reallocate service-centre
overheads to production cost
centres
 Service departments are not directly involved in
production
 They only support service to other production
departments in order to facilitate the production
process
 Therefore, it is necessary to reallocate the service-
centre overheads to production departments so that
all production costs can be absorbed into production.
 Typical bases are listed as follows:


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Typical bases are listed as follows:
Service departments Possible bases of
apportionment
Maintenance Maintenance labour hours,
machine value
Stores Value or weight of materials
issued, number of
requisitions
inspection No. of employees, no. of jobs

Example textbook P.183

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Calculate separate overhead
absorption rate for each cost
center

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Calculate separate overhead
absorption rate for each cost centre
 To determine the overheads to be absorbed
by a cost centre, it is necessary to establish
an overhead absorption rate (OAR)

Total overhead of cost centre

OAR =
Total number of units of absorption base applicable
to cost centre

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 An appropriate OAR should reflect the
effort or time taken to produce the products
 Some commonly used absorption bases are
listed as follows:
Direct labour hours It is frequently used in the labour
intensive department because
overheads assigned to this
department are closely related to the
direct labour hours worked
Machine hours It is most appropriate for the
appropriate for the machining
department since most of the
overheads are closely related to
machine hours 16
Direct wages It is only suitable in the department
where the uniform wage rate is
applied
Direct materials This method is not recommended
unless the majority of overheads
incurred in a department are related
to materials instead of time
Units of output This method is suitable only where
all units produced in a period are
identical in the production process
and time. Therefore, this application
is very rare

Example textbook P.183

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 Class Exercise

• The modern company has three

production departments viz. A,
B and C and two service
departments (D and E).
• From the given figures apportion
the costs to various departments
on the most equitable basis.
• Assume the cost driver to be
direct wages for the service
department. 18
 Rs.

Indirect Materials 15,000

Indirect Wages 12,000
Depreciation on Machinery 20,000
Depreciation on Buildings 10,000
Rent, Rates and Taxes 10,000
Electric Power for Machinery 15,000
Electric Power for Lighting 300
General Expenses        21,000
Total 1,03,300

Items Total A B C D E

Direct Materials (Rs.) 60,000 20,000 10,000 19,000 6,000 5,000

Direct Wages (Rs.) 40,000 15,000 15,000 4,000 2,000 4,000
Value of Machinery (Rs.) 2,50,000 60,000 1,00,000 40,000 25,000 25,000
Floor Area (sq. ft.) 50,000 15,000 10,000 10,000 5,000 10,000
No. of Light Points 50 15 10 10 5 10
Horse Power of Machines 150 50 60 30 5 5
Labor Hours 15,000 5,000 5,000 2,000 1,000 2,000

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 Production Dept. Service Dept.
Expenses Basis Total
A B C D E
Direct Materials Given 60,000 20,000 10,000 19,000 6,000 5,000
Direct Wages given 40,000 15,000 15,000 4,000 2,000 4,000
Indirect Material Direct Material 15,000 5,000 2,500 4,750 1,500 1,250
Indirect Wages Direct Wages 12,000 4,500 4,500 1,200 600 1,200
Dep. of Machinery Machine Value 20,000 4,800 8,000 3,200 2,000 2,000
Dep. of Building Floor Area 10,000 3,000 2,000 2,000 1,000 2,000
Rent, Rates, etc. Floor Area 10,000 3,000 2,000 2,000 1,000 2,000
Electric Power              
For Machinery H.P. 15,000 5,000 6,000 3,000 500 500
For Lighting Light Points 300 90 60 60 30 60
General Expenses Labor Hours. 21,000 7,000 7,000 2,800 1,400 2,800
   
   
2,03,300 67,390 57,060 42,010 16,030 20,810
Expenses of Dep. D In ratio to
between A,B,C Direct Wages ------- 7,072 7,072 1,886 (16030)

Expenses of Dep. E In ratio to

Direct Wages ------- 9,180 9,180 2,450 (20810)
between A,B,C

2,03,300 83,635 73,305 46,360 0000 0000

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Assign cost-centre overheads to
products
 The final step is to charge the overheads to
the products passing through the production
departments

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Example

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Predetermined overhead
absorption rates (POAR)
 The overhead absorption rates are usually computed
in advance of operations
 In practice, most absorption rates are only
predetermined because the actual overheads are not
known until the end of the period
 If the actual overheads are used to compute the
OAR, the product cost can only be obtained at the
end of the accounting period
 A delay in product cost calculation will also affect
the pricing setting, the profit calculation and stock
valuation
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The formula of POAR
The formula are as follows:
Budgeted total overheads
POAR =
Budgeted total number of units of absorption base

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Under-absorption and over-
absorption base
 Since the POAR are based on the estimated
production and estimated overheads, the
overheads absorbed seldom agree with the actual
overheads incurred for the period
 Under-absorption occur when overhead absorbed
are small than the actual overheads
 Over-absorption occurs when the overhead
absorbed are greater than actual overheads

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 For financial accounting, under- or over-
absorption of overheads should be treated as
period cost and written off against the profit and
loss account in the current accounting period
 The under- or over-absorption of overheads
should be debited or credited to the profit and loss
account
 The under-absorbed overheads should be deducted
from profit and vice versa
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Example

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Example
 Estimated annual overheads $400
 Estimated machine hours 200 machine hour

 POAR = $400
200 hrs
= $2 per machine hour

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 Product 1 Product 2 Product 3 Product 4
Actual $400 $400 $300 $500
overheads
incurred
Actual 250 hrs 160 hrs 200 hrs 200 hrs
machine hours
Overhead $2 * 250 hrs $2 * 160 hrs $2 * 200 hrs $2 * 200 hrs
absorbed = $400 = $400
= $500 = $320
Under- or Over-absorbed Under- Over- Under-
over-
$100 absorbed absorbed absorbed
absorption
$80 $100 $100s

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Blanket Overhead Rate

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Blanket overhead rate
 According to the overhead allocation procedure,
the overheads are allocated to departments and
each department calculate its own OAR and
allocate the overheads to products passing through
that department
 Alternatively, some firms do not assign overheads
to departments. Rather, they adopted a single
overhead rate, i.e. a blanket overhead rate, that is
assigned to all products produced within the whole
factory
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 The use of the blanket overhead rate is not
recommended as many products are
produced in different production centres,
and products consume cost-centre
overheads in different proportions

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Example

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The annual overhead costs of a factory with three
production departments are shown as follows:

Dept. A Dept.B Dept. C Total

Overheads $20000 $400000 $180000 $600000

Direct machine 100000 100000 100000 300000

hours
Departmental $0.2 $4 $1.8
overhead rate per
direct machine
hour
Blanket overhead $2
rate pre machine
hour 34
If the production of product X only requires 10 direct machine
hours in department A, the overheads absorbed will be computed as
follows:
Using Using blanket
departmental overhead rate
overhead rate
Overhead absorbed $0.2 *10 $2 *10
= $2 = $20
In this example, the production of product X does not consume
Large amounts of overheads in department B and C. Therefore,
there will be over-absorption of overheads if the blanket overhead
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rate is used