Accounting for Overheads

Overview

1) Absorption costing
2) Allocation and apportionment of overheads
3) Absorption of overheads
4) Over and under absorption of overheads
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
 The total of these indirect costs is usually split into the following categories.
 Production Selling and distribution
 Administration
 In cost accounting there are two schools of thought as to the correct method of
dealing with overheads.
 Absorption costing Marginal costing
Absorption costing

This is a method of costing whereby all production costs

both variable and fixed are considered as part of cost of
production. It is a method of sharing overheads between
different products on a fair basis. Under absorption costing,
the value of closing stock comprises an element of fixed
production overhead whereas the closing stock under
marginal costing does not.
 Overheads are made up of indirect materials, indirect
labour and indirect expenses
 Absorption costing is a costing method where direct costs
are assigned to cost units along with production overheads
using an overhead absorption rate.
 Under absorption costing principles, the production
overheads of a business are absorbed into the cost of each
of the products.
The overheads of the business, under absorption costing are
required to be included in the cost of the products of the
business. For inventory valuation requirements only
production overheads are included in the valuation of the
product. For product costing and profitability purposes all
overheads need to be considered. In this chapter we will
mainly consider the process whereby the production
overheads are absorbed into the cost of the production
units.
In overview, the process is to share out all of the production
overheads amongst the cost centres that incur them and
then to share their overheads amongst the products made in
the cost centre. However we have to recognise that not all
of these cost centres are production cost centres, ie cost
centres that actually produce goods. Some of the cost
centres which incur overheads are service cost centres.
These are areas of the business that provide necessary
services to the production cost centres such as stores,
maintenance or a canteen.
The overheads incurred by the service cost centres must in
turn be shared amongst the production cost centres until all
of the overheads are within the production cost centres.
Then finally the total overhead can be shared amongst the
units which are made in each of the production cost centres.
Collection of overheads

Overheads are collected from a various sources:

 From the suppliers’ invoices-stationery, cleaning, materials etc
 From plant register-method and rate of depreciation.
 From wages analysis sheet- indirect wages
 From lease agreement-rent
 From the meter record- power and light
Allocation and apportionment of
overheads
 The first stage in the process is to allocate any specific production
overheads to individual cost centres that have incurred them. These
will often be items such as indirect materials and indirect labour.
 However there will be many expenses of the business such as rent and
rates which are shared by a number of different cost centres. These
joint expenses must be apportioned between the cost centres on
some suitable basis. For example, rent and rates are often
apportioned or shared out between cost centres on the basis of the
amount of floor area that each cost centre occupies. The machinery
insurance costs might be apportioned on the basis of the value of the
machinery in each cost centre.
Overheads should be apportioned between the departments on a fair basis.
Common examples include:
 Floor area
 Value of machinery
 Hours spent working for a particular department
 Number of requests
 Machine time.
Bases of apportionment
Illustration
Overhead Analysis Sheet
Illustration

Required: allocate and apportion the production

overheads to the four cost centres
 The overheads of the service cost centres must then be
reapportioned to the production cost centres on an
appropriate basis.
 The reason for this is that each production centre is likely
to make different use of the service cost centres, and this
should be reflected in the costs they are deemed to have
incurred. In order to do this there needs to be an
appropriate basis of apportionment, usually an
approximation of the use that each production cost centre
makes of the service cost centres.
Reapportion service department costs

 Only production departments produce goods that will ultimately be sold. In

order to calculate a correct price for these goods, we must determine the
total cost of producing each unit – that is, not just the cost of the labour and
materials that are directly used in production, but also the indirect costs of
services provided by such departments as maintenance, stores and canteen.
 The direct method, where the service centre costs are apportioned to
production departments only.
 The step-down method, where each service centre's costs are not only
apportioned to production departments but also to some (but not all) of the
other service centres that make use of the services provided.
 The repeated distribution (or reciprocal) method, where service centre
costs are apportioned to both the production departments and service
departments that use the services.
Direct method of reapportionment

 The direct method of reapportionment involves

apportioning the costs of each service cost centre to
production cost centres only.
Illustration
Illustration
Step down method of reapportionment

 Reapportion one of the service cost centre's overheads to all the other
centres which make use of its services (production and service).
 Reapportion the overheads of the remaining service cost centre to the
production departments only. The other service cost centre is ignored.
The reciprocal (repeated distribution)
method of apportionment
The repeated distribution (or reciprocal) method, where
service centre costs are apportioned to both the production
departments and service departments that use the services.
The service centre costs are then gradually apportioned to
the production departments. This method is used only when
service departments work for each other – that is, service
departments use each other's services (for example, the
maintenance department will use the canteen, while the
canteen may rely on the maintenance department to ensure
its equipment is functioning properly or to replace bulbs,
plugs, and so on).
The reciprocal (algebraic) method of
apportionment
 The results of the reciprocal method of apportionment may also be obtained
using algebra and simultaneous equations
Absorption of overheads

 Once all of the production overheads have been

apportioned to the production cost centres an overhead
absorption rate is determined normally based upon direct
labour hours or machine hours.
 Overhead absorption rate is 'a means of attributing
overhead to a product or service, based for example on
direct labour hours, direct labour cost or machine hours'.
CIMA Official Terminology (Eaton, 2005)
 The final stage of the process now that all of the
production overheads have been allocated and
apportioned to the production cost centres is to find an
absorption rate with which to absorb or include the
overhead into the cost of each unit of production. This is
done by finding a basis for absorption which will generally
tend to be based upon the activity of the department.
Overhead Absorption

It is the process whereby overhead costs allocated and

apportioned to production cost centres are added to unit job
or batch cost. It involves calculation of an overhead
absorption rate given by:
Total overhead to be absorbed
Total unit of base to be used.
When we are absorbing overheads we are aiming to do two
things:
 Collectenough money from our customers to pay the
overheads bills.
 Do so in a fair way so that products are not over /
under priced.
Reasons for absorption of overhead

 For stock valuation.

 For pricing decisions.
 Establishing the profitability of different products
Methods of calculating overhead
absorption rates
There are six usual methods of calculating overhead absorption rates.
Each will give a different overhead cost per unit. The six methods are:
 Direct materials cost percentage
 Direct wages cost percentage rate
 Prime cost percentage rate
 Machine hour rate
 Direct labour hour rate
 Cost unit rate.

The overhead absorption rate is then used to cost each

product depending upon how many relevant
hours each product takes in each production cost centre.
Direct Materials cost percentage rate

Overhead usually accrues on a time basis and there is little

relationship between overhead and direct material cost.
Products with a high material content will absorb more
overhead than others which might totally be unrealistic.
Direct wages cost percentage

This method is suitable where there is uniformity of wage

rates and working conditions. It is effective in a cost centre
where there is only one type of labour and one rate of pay.
Prime cost percentage rate

A combination of the previous two and it is not a good basis

for absorption in normal circumstances.
Machine hour Rate

It is a suitable method where production is carried out on

machines but all products must use machine time otherwise
some products will not absorb overheads. It is possible to
treat individual machines as cost centres and include the
operators’ wages in total machine cost to arrive at an hourly
cost of operating the machine.
Direct labour hour rate

It is suitable in departments where production is carried out

mainly by manual methods. As a time based rate it is
generally preferred to the direct wages cost but it requires
regular revision in times of inflation to keep pace with
increase in overhead. It is unaffected by differences in wage
rates and skill but will require the keeping of additional
labour time records unless they are already being
maintained for some purpose.
Cost Unit rate

It is a simple and practical method provided that all units

passing through a cost centre are identical ie one product
line. If more than one product is being made then a
weighting could be applied but this is very cumbersome.

NB to overcome the difficulty of fluctuations in production

or delays in coming up with the absorption rate, the use of
budgeted data becomes necessary.
Illustration 4
Departmental Absorption

 Normally there is more than one department or cost.

 It is usual to calculate the overheads for each cost centre
separately on the cost card.
 It is not necessary to use the same absorption basis for
each department. For example, a machining department
will probably use a machine hour overhead absorption
rate, whereas a labour intensive department will use a
labour hour rate.
Illustration
Blanket Overhead Absorption
Rate/plant wide rate
An alternative to the above is what is termed a blanket rate for
absorption. This means that one absorption rate is calculated for the
entire factory regardless of departments.
It is one which is applied to the whole factory or a group of departments.
As individual cost centres incur overheads in different proportions this
rate will not distinguish between products which incur high overheads in
mechanized processes and those which incur low overheads in manual
processes.
Blanket rates are usually unreliable and shouldn’t be used unless
circumstances are exceptional. Consequently separate overhead
absorption rates are calculated for each cost centre. Charging of
overheads will be fair and the full cost of items of production will
represent the amount of effort and resources put into making them.
Illustration
Predetermined Overhead absorption
rates
Production overheads are usually calculated at the start of a
period to enable a cost for the product to be calculated
before it is sold to the customer. This means that budgeted
figures must be used.
Overhead absorption rates are therefore predetermined as follows.
 The overhead likely to be incurred during the coming period is
estimated.
 The total hours, units, or direct costs on which the overhead
absorption rates are to be based (activity level) are estimated.
 The estimated overhead is divided by the budgeted activity level to
arrive at an absorption rate for the forthcoming period.
Illustration
Over- and Under-absorption

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. Actual overheads incurred will probably be
either greater than or less than overheads absorbed into the
cost of production.
Over absorption means that the overheads charged to the
cost of production are greater than the overheads actually
incurred.
Under absorption means that insufficient overheads have
been included in the cost of production.
Illustration
Illustration

Calculate the over/under absorption of overhead

The reasons for under/over absorbed
overhead
The overhead absorption rate is predetermined from budget estimates
of overhead cost and the expected volume of activity. Under or over
recovery of overhead will occur in the following circumstances.
 Actual overhead costs are different from budgeted overheads.
 The actual activity level is different from the budgeted activity level.
 Both actual overhead costs and actual activity level are different from
budget.
Illustration
Illustration
Accounting for under or over absorption

 The under-absorbed overhead is written off to the statement of profit

and loss as a cost to compensate for the undercharging of overheads
to that point.
 DEBIT Statement of profit and loss
 CREDIT Production overhead control
 To account for an over-absorption of production overheads, the
double entry would be as follows
 DEBIT Production overhead control
 CREDIT Statement of profit and loss
 When production costs are incurred.
Dr Production overhead account.
Cr Cash/bank
 Absorption of production overheads
Dr Work in progress control account
Cr Production overhead control account