COST ACCOUNTING

OVERHEADS

Introduction
One of the classifications of costs is on the basis of Nature/Element in which costs are
classified as Direct and Indirect.
 Direct costs are those which are properly identified with a cost centre.
 Indirect costs are not traceable to cost centre.
If a firm manufactures only one product, all cost are direct but if more than one product
offered by the firm, the indirect costs incurred are not traceable with a particular
product.
Direct costs are allocable to a job, process, service, cost unit or a cost centre, indirect
costs cannot be so allocated. These indirect costs are called as overhead costs.
Meaning
Overhead is the aggregate of indirect material cost, indirect labour cost and indirect
expenses which cannot be identified with and directly allocated to a particular cost
centre.
Indirect cost or overhead = Indirect material + Indirect labour + Indirect expenses.
Classification of overheads
Classification of overheads is the process of grouping of indirect cost on the basis of
common characteristics and clear objectives. Overhead cost may be classified as
follows.
a) Functional wise Classification
Overheads can also be classified according to their functions. This classification is done
as given below.
i. Manufacturing Overheads:
Indirect expenses incurred for manufacturing are called as manufacturing overheads.
Factory overheads are also termed as production overheads or works overheads or
manufacturing overheads etc. For example, factory power, works manager’s salary,
factory insurance, depreciation of factory machinery and other fixed assets, indirect

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materials used in production etc. It should be noted that such expenditure is incurred
for manufacturing but cannot be identified with the product units.
ii. Administrative Overheads:
Indirect expenses incurred for running the administration are known as administrative
overheads. Administration overheads are also termed as office overheads or
management overheads or establishment overheads etc. Examples of such overheads
are, office salaries, printing and stationary, office telephone, office rent, electricity used
in the office, managers salary, audit fees, legal charges etc.
iii. Selling Overheads:
Overheads incurred for getting orders from consumers are called as selling overheads.
It is the cost incurred for transferring the ownership of goods to the buyer. Examples of
selling overheads are sales promotion expenses, marketing expenses, salesmen’s
salaries and commission, advertisement expenses, showroom expenses, travelling
expenses, bad debts etc.
iv. Distribution Overheads:
Overheads incurred for execution of order are called as distribution overhead. Examples
of distribution overheads are, warehouse charges, delivery van cost, carriage outward,
packing charges etc.
b) Element wise Classification
According to this classification overheads are divided according to their elements. The
classification is done as per the following details.
i. Indirect Materials
Materials which cannot be identified with the given product unit of cost centre is called
as indirect material. Indirect materials cost is the cost which cannot be allocated, but
which can be apportioned to or absorbed by cost centres or cost units.
ii. Indirect Labour
Wages and salaries paid to indirect workers, i.e. workers who are not directly engaged
on the production are examples of indirect labours.
iii. Indirect Expenses:

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Indirect expenses are all expenses of the factory such as rent and taxes, insurance of
factory, repairs of factory machinery, electricity etc. It is also includes indirect expenses
incurred for office and selling and distribution.
iv. Behaviour wise Classification
According to this classification, overheads are classified as fixed, variable and semi
variable. These concepts are discussed below.
i. Fixed Overheads
Fixed overheads are commonly described as those that do not vary in total amount with
increase or decrease in production volume for a given period of time. Salaries,
depreciation of fixed assets, property taxes are some of the examples of fixed costs.
Fixed overheads do not increase or decrease when the volume of the production or
output changes. For example rent and taxes, depreciation, salary etc.
ii. Variable Overheads:
Variable overheads are those which go on increasing if production volume increases and
go on decreasing if the volume decreases. Such increase or decrease may or may not
be in the same proportion. Variable overheads are generally considered to be
controllable as they are directly connected with the production. For example indirect
material, salesmen’s commission, power, fuel etc.
iii. Semi Variable Overheads:
Semi variable overheads mean partly variable overheads and partly fixed overheads
with the output in any organization. This cost is also known as mixed cost. For example
monthly telephone charges, repairs, indirect labour, fuel and power, service charge +
extra charge etc.
Overhead Allocation and Apportionment

Overhead are distributed to the department through allocation(we exactly see it is from
specific department) or apportionment(distribution to various department through
sharing).

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Overhead Allocation
This is the assignment of overheads to cost centres directly without sharing. Overhead
cost that is specifically incurred in respect of a particular cost centre is wholly assigned
to that cost centre; this is referred to as overheads allocation.

Overhead Apportionment
This is the sharing of overhead cost incurred in respect of a number of cost centres to
the centres involved using a fair and equitable basis of apportionment. There are some
overhead costs that are incurred for a number of cost centres and sometimes even for
the whole organization. Such overheads cannot be allocated but must be apportioned.

The Concept of Overhead Absorption

This is the process of assigning overhead costs to products or services produced.
Overheads are absorbed into products by first calculating the overhead absorption rate
and then applying the calculated overhead absorption rate to determine the overhead
absorbed by each cost unit.

Generally, overhead absorption rate (OAR) is computed as

OAR = Budgeted overheads / Budgeted activity level
There are different factors that could possibly be used as activity level. These include
the following:
i. Direct labour hours

This method assumes that direct labour hours are the most significant factor that
influences the amount of overhead incurred in the production of products and services.
Direct labour hours are therefore used as basis for the absorption.

OAR = budgeted overhead /Budgeted direct labour hours

= OAR per direct labour hour

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This method is suitable where the production technology is labour intensive and wage
rates are stable.

ii. Machine hours

Where the production process is highly mechanized and is not labour intensive, the use
of labour hours may be inappropriate. Under such circumstances, machine hours may
be preferred as activity base for overhead absorption.
OAR = Budgeted overheads/ Budgeted machine hours
= OAR per machine hour.

iii. Units of production

Where the production process turns out uniform products in mass quantities, units of
production could be used as basis for overheads absorption. Where the units are not
uniform however, it will be inappropriate to use units of production as a basis for
overhead absorption.
OAR = Budgeted overheads /Budgeted production units
= OAR per unit of output

iv. Direct material cost percentage

Overheads are absorbed as a percentage of direct materials cost. This method is used
when there are stable and uniform materials prices. Where materials price are not
uniform, this method will not yield good results
OAR = (Budgeted overhead /Budgeted direct materials costs) x 100
= OAR as a percentage of direct material cost
v. Direct labour cost percentage
Overheads are absorbed as a percentage of direct labour cost. Where intensive labour
technology is used and wage rates are stable and uniform, this method may be used
OAR = (Budgeted overheads / Budgeted direct labour cost) x 100
= OAR as a percentage of direct labour cost

vi. Prime cost percentage

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Prime cost as we have already explained is the aggregate of direct materials cost, direct
labour cost and direct expenses. Overheads can therefore be absorbed as a percentage
of prime cost. Where there is relative stability of rates and prices, this method could be
used.
OAR = (Budgeted overheads /Budgeted price cost) x 100
= OAR as a percentage of prime cost

Example 1

The following information is available from a manufacturing company:-

Total overhead = Tzs.600, 000

Total direct wages = Tzs.480, 000
Total direct material cost = Tzs.500, 000
Direct labour = Hours 75,000
Direct machine = Hours 50,000
Units of output = Unit 750, 000
Required

Calculate six overhead absorption rates.

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 Review question

Question 1

a) Distinguish between Overhead Absorption and Overhead Apportionment

b) Sanawari Manufacturing Company Ltd. produces three products - X, Y and Z. The
cost estimates of each of the products are given below:

X Y Z
Direct Materials Tzs.7,200 Tzs.12,800 Tzs.18,000
Direct Labour:
Production Dept. at Tzs.600/hr. 2 hrs. 1.5 hrs. 2 hrs.
Finishing Dept. at Tzs.400/hr. 2 hrs. 2.5 hrs. 1 hrs.
Variable Overheads Tzs.800 Tzs.300 Tzs.400
Fixed overhead cost for the following year is estimated at Tzs.60 million and
planned production is:

X 10,000 units
Y 20,000 units
Z 40,000 units
The directors are considering alternative methods of absorbing fixed overheads into
product costs and you have been asked, as the Cost Accountant, to calculate
a) Total product Cost
b) Rates to be applied for the following alternatives:

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 i. Percentage of direct Labour Costs
ii. Percentage of Total product Cost
Question 2

a) Explain the meaning of the following terms:

i. Overhead Allocation
ii. Overhead Apportionment
b) Equator garments Ltd manufactures custom-made suits tailored to the
requirements of each customer. They use predetermined overhead absorption
rates in allocating overheads to each job.
In the cutting department the rate is based on direct labour hours and in the
stitching department the rate is based on machine hours.
The management of equator garments ltd wants to set overhead absorption rates
to help in determining prices in the next financial year. The cost accountant has
provided the following budgeted data for the financial year:-
Cutting Stitching
Direct labour cost Tzs.1, 200,000 Tzs.750, 000
Factory overhead Tzs.1,500,000 Tzs.1,620,000
Direct labour hours 60, 000 Hours 30, 000 Hours
Machine hours - 40, 000 Hours

The following data relates to Job No. A4.

Cutting Stitching
Direct labour cost Tzs.500 Tzs.750
Direct labour hours 60 Hours 10 Hours
Machine hours - 20 Hours

Administration overheads are absorbed at 25% on factory costs. Profits mark –

up is 33 1/3 % on costs.
Required:

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 i. Calculate the overhead absorption rates for each department
ii. Prepare a cost statement for Job A4 showing the price that will be charged to the
customer.