OVERHEAD RECOVERY/ OVERHEAD ABSORPTION.

Introduction.
Direct materials, direct labour and direct expenses consumed by each product can be
measured accurately from the costing records. However, production overheads, e.g.,
indirect materials, indirect labour and indirect expenses cannot be directly assigned to
products manufactured, services provided or departments. Overheads are charged to
products through a process called overhead absorption/ overhead recovery. The main
objective of overhead recovery is to calculate the total production cost of each product
produced. The calculation of the total production cost/unit is useful for management
decision making.
TPC/ unit = DM + DL + DE + FACTORY OVERHEADS.
Overhead recovery/overhead absorption.
-It is a process in which overheads are included in the total cost of the product. The process
involves the following procedures:
1. Allocation and apportionment of all factory overheads to production and service cost
centres.
2. Re-allocation of service centre costs to production departments.
3. Calculation of separate Overhead Absorption Rates (OARs) for each production cost
centre.
4. Assigning cost centre overheads to products.

1. Allocation and apportionment of overheads to all cost centres

-costs are assigned to cost centres to control them and to evaluate the performance
of each cost centre.

(a) Overhead allocation

-is the charging of a specific overhead cost to the appropriate cost centre or cost
unit. In this case the costs incurred in each cost centre, or a cost unit is known. E.g.,
indirect material cost, or power if metered.
(b) Overhead apportionment
- it is the sharing of a cost among two or more cost centres using a reasonable
method/basis. E.g., factory rent, heating and lighting.
Assigning overheads to production cost centres and service departments
Some overheads can be directly assigned to production cost centres e.g., machine
depreciation, indirect materials. However, there are certain items of overhead expenditure
that cannot be directly attributed to specific departments because they are incurred for the
benefit of many departments.
In respect of these items, it is necessary to establish a logical basis for apportioning the
overheads to cost centres.
The following tabulation summarizes some commonly used apportionment bases for all the
cost centres.
Cost Basis of apportionment
1. Buildings:
-Rent
-rates
-maintenance Area
-insurance
-depreciation

1. Lighting and heating Area

2. Plant and machinery

-Depreciation cost or net book value of plant and
machinery in each cost centre/machine
hours.

-Insurance cost or replacement value of plant and

machinery in each cost centre.

-Maintenance number of machines in each cost

Centre/machine hours.

3. Power kilowatts

4. Employee related expenditure

e.g. canteen costs -Number of employees in each cost centre
6. Costs of stores keeping -number or value of stores requisition
raised by each department.
5. Supervision costs -number of employees in cost centre
Problems with cost apportionment
-It is not possible to allocate costs in a universally acceptable manner.
-Several alternative methods of apportioning costs may be acceptable in different
circumstances and often the allocation of overheads is (discretional) arbitrary.

NB: The result of this stage is that all manufacturing overheads will be allocated and
apportioned to factory production and service departments.
2. Re-allocation of service cost centre overheads to production cost centres.
-service departments provide essential support services to other units of the organization
e.g., stores, canteen, and maintenance departments. They are also called support
departments.
-they do not deal directly with the products being produced and therefore it is not possible
to allocate service department costs directly to products.
-Consequently, their costs must be re-apportioned to production departments that work on
the manufactured product on a suitable basis.
-The method chosen to apportion service department costs to production departments
should be related to the benefits that the production departments derive from these service
departments.

Service department costs and basis of apportionment

Cost Basis of Apportionment
1. Stores costs Number of stores requisitions raised or value of
Materials.
2. Canteen costs Number of employees in each production cost centre.
3. Maintenance costs
• buildings Area occupied by each production cost centre.
• plant and machinery number or value of machines in each production cost
centre.

4. Alternatively records of maintenance costs can be kept for each production cost centre
and these costs are allocated accordingly.

NB: The easiest and quickest way of apportioning service cost centre overheads to
production departments is the use of the elimination method.
-Once the service department costs have been re-apportioned to production departments,
all overhead expenditure will be assigned to production departments.
This enables an Overhead Absorption Rate for each production department to be
established.
3. Calculation of Overhead Absorption Rates (OAR)
OARs are used to calculate overheads to be absorbed/charged to each cost unit. The
OARs are usually calculated for future periods to enable the selling to be fixed before
the actual production takes place.

POAR = Budgeted cost centre overheads

Budgeted no. of units of the appropriate base in that cost centre.

-The amount of overheads absorbed by each cost unit is usually calculated by referring
to the time the product spends in a production department –also called volume-related.

The following are time related absorption bases.

(a) Direct labour hours.

-is normally used in a labour-intensive department. This base is used when a process
requires the use of manual labour rather than machines and the labour cost will be
greater than the cost of using machines.

(b) Machine hours.

-is normally used in a mechanised cost centre, that is when most of the work is done by
machines. This base is used when the machine running cost is greater than the labour
cost.
NB: Overheads like machine depreciation are closely related to machine running time.

Other absorption bases

(c) Direct material cost.

-the overheads absorbed by each cost unit depends on the quality of raw materials
used to manufacture that product. A product which uses expensive raw materials
will be charged with greater share of overheads than the one with uses cheap
materials.
-this method can give inaccurate results if used to charge overheads to products.

(d) Direct labour cost/direct wages.

-a product which is manufactured by highly skilled labour will have a greater share of
overheads as compared to the one manufactured by less skilled workers. This method
can also give inaccurate results if used.

(e) Prime cost.

-the method combines the weaknesses of the direct material cost and the direct
labour cost. It gives absurd results if used.
 (f) Cost unit.
It can give accurate results provided it is used when one type of product is produced
using the same machines with identical processes.

Factory Wide rate/single overhead absorption rate.

-a factory wide rate is an absorption rate used throughout the factory and for all jobs and
units produced irrespective of the cost centre in which they are produced.

Advantages of using a factory wide rate.

1. It is cheaper to calculate OAR using a factory wide rate.
2. It is a less time-consuming way of costing products.
3. Procedures to calculate Overhead Absorption Rates (OAR) and products costs are not
complex.

Disadvantages of using a Factory wide rate.

1. It does not differentiate capital intensive production from labour intensive production.
2. It does not reflect accurate departmental usage especially when jobs spend different
amounts of time in each department.
3. It produces less accurate Overhead Absorption Rates and therefore, some products are
overcharged, and others are undercharged with overheads.
4. It produces less accurate Total production cost for products and therefore it leads to
setting of inaccurate selling prices.

Over-/under absorption of overheads.

Introduction
-over/under absorption occurs because OARs are calculated using budgeted overheads and
budgeted number of units appropriate to that cost centre. At the end of the accounting
period, it is most likely that the budgeted overheads are different from the actual overheads
or the budgeted number of units of the absorption base differs from the actual.

(a) Over-absorption of overheads

It occurs when:

• budgeted overheads greater than actual overheads. This can result from the use of
better machines than planned or use of less skilled workers than planned or when,
• Actual production is more than budgeted.
 -over-absorption means too many overheads have been charged in the statement of
profit or loss and hence there is need to increase net profit with the over-absorbed
figure.
-over-absorption is favourable.

Accounting entries:

Dr- factory overheads account

Cr- cost of sales/ income statement.

-alternatively add over-absorption to gross profit.

(b) Under-absorption of overheads

Occurs when:

• Budgeted overheads are less than actual overheads. This can result from increase
in overheads because of inflation or the use of more skilled workers than
planned or the continued use of old inefficient machinery or,
• Actual production is less than planned.

-under-absorption means not enough overheads have been charged in the statement of
profit or loss and therefore reduce the net profit with the under-absorbed figure
-under absorption is Unfavourable.

Accounting entries
Dr- cost of sales/Income statement
Cr- factory overheads.

Alternatively subtract under-absorption from gross profit.

Procedure of calculating under-/over-absorption.

1. Calculate the POAR.

2. Calculate the overheads absorbed as follows:

Overheads absorbed = POAR X Actual No. of units of the appropriate base.

3. Compare the overheads absorbed and the actual overheads.

4. Calculate the over-/under-absorption of overheads.

Illustration.

1. The following information is planned by a company

Actual direct labour hours 12 400

Actual overhead expenditure $198 400
Budgeted direct labour hours 11 000
Budgeted overhead expenditure $170 500

Required
Calculate the under-absorption or over-absorption.
Answer: POAR = Budgeted overheads
Budgeted no. of units appropriate to the cost centre

$170 500
11 000 labour hours
=$15,50 per labour.

Overheads absorbed = rate x actual labour hours

=$15,50x12400hrs
=$192 200

Actual overheads =$198 400

Under-absorption =$198 400 -$192 200
=$6 200.
2. The following information is given:

Budgeted Actual

Overheads $ 6 000 $6 312

Direct Labour hours 800 950

Required
Calculate the under-absorption or over-absorption.
POAR = $7,50
Overheads absorbed = $7,50x950hours
=$7 125
over-absorption = $7 125-$6312
=$813.