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Accounting For Overheads

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191 views13 pages

Accounting For Overheads

Class notes

Uploaded by

ludorabil
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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ACCOUNTING FOR 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 in full to the product, service or department.
Overhead is actually the total of the following.
• Indirect materials
• Indirect expenses
• Indirect labour
In cost accounting there are two schools of thought as to the correct method of dealing with
overheads.
• Absorption costing
• Marginal costing

ABSORPTION COSTING: AN INTRODUCTION


The objective of absorption costing is to include in the total cost of a product an appropriate
share of the organization’s total overhead.
An organisation with one production department that produces identical units will divide the
total overheads among the total units produced.
Absorption costing is a method for sharing overheads between different products on a fair basis.

ABSORPTION COSTING STAGES


The three stages of absorption costing are:
1 Allocation
2 Apportionment
3 Absorption
Overhead allocation
Allocation is the process by which whole cost items are charged direct to a cost unit or cost
centre.
Example
Consider the following costs of a company.
Wages of the foreman of department A $200
Wages of the foreman of department B $150
Indirect materials consumed in department A $50
Rent of the premises shared by departments A and B $300
The cost accounting system might include three overhead cost centres.
Cost centre: 101 Department A
102 Department B
201 Rent
Overhead costs would be allocated directly to each cost centre, ie $200 + $50 to cost centre 101,
$150 to cost centre 102 and $300 to cost centre 201. The rent of the factory will subsequently
be
shared between the two production departments but, for the purpose of day to day cost recording,
the
rent will first of all be charged in full to a separate cost centre.
OVERHEAD APPORTIONMENT
Apportionment is a procedure whereby indirect costs are spread fairly between cost centers.
Service cost center costs may be apportioned to production cost centers by using the reciprocal
method.
Bases of apportionment
It is considered important that overhead costs should be shared out on a fair basis. The bases of
apportionment for the most usual cases are given below.

A different apportionment basis may be applied for each service cost centre.
DIRECT METHOD OF APPORTIONMENT
The direct method of reapportionment involves apportioning the costs of each service cost centre
to production cost centers only.
Illustration

Secondary apportionment
The canteen is a production-related cost because it is used to provide meals to the workforce. It is
known as a service department. However, units being produced spend time only in the
preparation and assembly departments. Therefore, to account for canteen costs they must be re-
apportioned into the preparation and assembly departments (secondary apportionment).
MORE ON SERVICE DEPARTMENT COSTS: RECIPROCAL SERVICES
Direct apportionment:
this approach completely ignores inter-service department costs transfers. Because inter-service
relationships are usually relatively minor and there are some arbitrary choices to make on initial
apportionment (heating could be apportioned on floor area, volume of buildings or the number of
radiators), this rough and ready approach is almost certainly good enough.
Step down method:
this approach starts with one service department and apportions its costs to production
departments and other service departments. Another service department is then reapportioned to
production departments and remaining service departments: no costs will ever be apportioned
back into a service centre once it has been cleared out of costs.
Illustration

Solution
Direct method

Step down method

Practice Question
Sandstorm is a jobbing engineering concern which has three production departments (forming,
machines and assembly) and two service departments (maintenance and general).
The following analysis of overhead costs has been made for the year just ended.
Solution
OVERHEAD ABSORPTION
Overhead absorption is the process whereby overhead costs allocated and apportioned to
production cost centres are added to unit, job or batch costs.
Overhead absorption is sometimes called overhead recovery.
Having allocated and/or apportioned all overheads, the next stage in the costing treatment of
overheads is to add them to, or absorb them into, cost units.

Calculation of overhead absorption rates

Choosing the appropriate absorption base


The choice of an absorption basis is a matter of judgement and common sense; what is required
is an absorption basis which realistically reflects the characteristics of a given cost centre and
which avoids undue anomalies.
The different bases of absorption (or 'overhead recovery rates') are as follows.
A percentage of direct materials cost
A percentage of direct labour cost
A percentage of prime cost
A rate per machine hour
A rate per direct labour hour
A rate per unit
A percentage of factory cost (for administration overhead)
A percentage of sales or factory cost (for selling and distribution overhead)
Many factories use a direct labour hour rate or machine hour rate in preference to a rate based on
a percentage of direct materials cost, wages or prime cost.
(a) A direct labour hour basis is most appropriate in a labour intensive environment.
(b) A machine hour rate would be used in departments where production is controlled or
dictated by machines.
(c) A rate per unit would be effective only if all units were identical.

Illustration 1
ILLUSTRATION
Using example 1 above:
Assume the following;

Solution

Practice question
Over and under absorption of overheads
Over and under absorption of overheads occurs because the predetermined overhead absorption
rates are based on estimates.
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 not agree with what actually occurs.
(a) Over absorption means that the overheads charged to the cost of sales are greater then the
overheads actually incurred.
(b) Under absorption means that insufficient overheads have been included in the cost of sales.
It is almost inevitable that at the end of the accounting year there will have been an over
absorption or under absorption of the overhead actually incurred
Illustration

Practice Question
Practice Question
Ledger entries relating to overheads

To record OVER-absorption

DR Production Overheads control account

CR Statement of profit or loss

With the over-absorbed amount.

To record UNDER-absorption

DR Statement of profit or loss

DR Production Overheads control account

With the UNDER-absorbed amount.

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