Topic 3

Accounting for
Factory
Overhead
 Learning Objectives

• Define the term “Overheads”

• Assignment of costs as direct and indirect.
• Classification of Overheads
• Identify cost behaviour patterns
• Understand the principles of overheads apportionment
and absorption.
Learning Objectives

• Distinguish between Allocation and

Apportionment of Overheads.
• Know how to deal with the overheads of
service departments.
• Apply factory overhead using predetermined
rates.
 Definition

• Overheads is an aggregate of indirect materials, indirect

wages and indirect expenses. Thus, the total of indirect
expenditure/ costs is called Overheads.

• An overhead cost is defined in the CIMA Terminology as ‘

expenditure on labour, materials or services that cannot be
economically identified with a specific saleable cost unit ’

• It is therefore “Any expenditure over and above the Prime

Cost [Direct materials, Direct labour and Direct expenses].”
Assignment of direct
and indirect costs

• Direct costs can be specifically and

exclusively identified with a given cost
object –hence they can be accurately
traced to cost objects.

• Indirect costs cannot be directly

traced to a cost object – therefore
they are assigned to cost objects
using cost allocations.
 Classification of
Overheads
 Cost classification is the process of grouping costs according to their
common characteristics and establishment of a series of special
groups according to cost class
 Classification of overheads
Overheads

Function Elements Behaviour

1. Production 1. Indirect Material 1. Fixed overheads

overheads
2. Administration 2. Indirect Labour 2. Variable overheads
overheads
3. Selling and 3. Indirect expenses 3. Semi-variable
packaging or Overheads overheads
4. Distribution
overheads
Factory Overhead Analysis
Sheets

• These sheets may be used to keep a

subsidiary record of factory overhead
expenses.

– Expense-type analysis spreadsheet

– Department-type analysis spreadsheet

 General Factory
Overhead Expenses

• When factory overhead expenses are not

identified with a specific department, they
are charged to departments by a process of
allocation.

• Allocation may be made for each item of

expense as incurred, or expenses may be
accumulated, and the allocation made at the
end of the accounting period.
 Summary of Factory
Overhead
Summary of Factory Overhead
Dept. A Dept. B Dept. C Total

Expenses
Indirect $500 $200 $80 $780
materials

Indirect labor 150 60 50 260

Power 100 40 100 240
Depreciation 200 100 70 370

General factory 150 140 100 390

expenses

Total $1100 $540 $400 $2040

Steps in Overheads
Accounting
•Administrative
1.Collection of Overheads
2.Classification and codification of
overheads
•Accounting
1.Direct/ specific allocation
2. Apportionment of overheads
3. Re-apportionment of service departments
costs to production departments.
4. Absorption of overheads
• Codification- Coding is technique of intelligent
description of numerous cost accounting heads for
recording and controlling. It helps to group items of
overheads of similar nature.

• Allocation- it is process of identification of overheads

with a specific production or service department . E.g.
Overtime wages paid to department A.

• Apportionment- It is the allotment of proportions of

items to departments or units. E.g: rent, depreciation,
repairs charges
 Distributing Service
Department Expenses
• Service departments are an essential part of
the organization, but they do not work
directly on the product.
• Production departments perform the actual
manufacturing operations that physically
change the units being processed.
• An analysis of the service department’s
relationship to other departments must be
done
• The costs of the service departments must
be apportioned to the production
departments.
Assign all factory overheads to
cost centers
• Cost Allocation

• Cost apportionment

• Remember cost centers are…

 Cost allocation
 Where a cost can be clearly identified with a cost
center or a cost unit, then it can be allocated to that
cost center or cost unit.
or
 Allocation is the process by which cost items are
charged directly to cost unit or cost centre

 E.g. electricity charges can be allocated to various

departments if separate meters are installed &
 Salary of stores clerk can be allocated to stores
department
 Cost apportionment

 Whenever possible, the overheads are to be allocated.

 If it is not possible to charge the overheads to a particular

cost centre or cost unit, they are to be apportioned to
various departments on some suitable basis
How the overheads costs are distributed

1. Direct/specific Allocation

2. Primary allocation (Apportionment)

3. Secondary allocation (Re- apportionment)

How the overheads costs are
distributed...expained

1. Direct allocation- It is the allotment of total item cost (e.g.

rent) to a particular department.
2. Primary allocation (apportionment)- It refers to
spreading the overheads costs to all production and services
department on the common basis of distributing.
3. Secondary allocation (Re- apportionment)-
It refers to apportioning of all service dept. costs to
production dept . There are four methods for re-apportionment.
 Example of direct
allocation:
Overhead analysis
sheet centre centre
Producti Servic
on e

Items of Total Machine Machin Assem Repair

expenditu (P) X eY bly and
re mainten
ance
Indirect 7 000 1300 3200 1000 1500
material
Indirect 6 000 2000 1800 1600 600
wage and
supervisio
 Basis 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
 Common Bases for Primary
Allocation/apportionment
COST Basis for Distribution
Building Floor space occupied by departments
Maintenance,Rent
Depreciation of Book value of machinery
machinery
Insurance of building Area occupied
Salary of works Number of employees in department.
manager
Purchasing Number of purchase orders
Property taxes Area occupied
Stores Units of materials requisitioned
Tool Room Total direct labor hours in departments
served
 Methods of Re-apportionment
(Secondary allocation) :
1.Direct distribution method

2. Step-down or sequential distribution method

3.Repeated distribution method

4. Simultaneous or Algebraic method

Methods of re-apportionment
continued…

 Direct Distribution Method

 The costs of Service department are directly
apportioned to production department only.
 Sequential Distribution or Step-
Down Method
 Distributes service department costs
regressively to other service departments and
then to production departments.
 Algebraic Distribution Method
 Distributes costs by simultaneous equations
recognizing the relationship of services
rendered by departments to each other.
 Methods continued…

 Repeated distribution method:

Under this, the service department costs are repeatedly allocated
among the production and service department in the specified
percentages until the figures become too small to be significant

(NB: Our focus will be on Direct,

Repeated and Algebraic distribution
methods)
 Absorption means charging equitable share of overhead expenses
to the products.
 The absorption is to be made on some suitable basis.
 To determine overheads to be absorbed by a cost center, it is
necessary to establish overhead absorption rate (OAR).
 The basis is the absorption rate (OAR) which is calculated by
dividing the overhead expenses by the base selected.
Overhead Absorption Rates
(OAR)

OAR= Total Overhead expenses

Quantity or value of basis

The basic procedure for calculation of OH rate is to

divide the total overhead of a cost center by
total number of units of absorption applicable
to a cost center.
Main Overheads rates

The following are the main overhead absorption rates

usually referred in cost accounting

 Predetermined overhead rate

 Blanket(Plant wide) OH rate
 Multiple overhead rate
 Predetermined Factory
Overhead Rates
Predetermined overheads means that the
overhead absorption rate is calculated prior to
the accounting period, using estimated or
budgeted figures for overheads and units of the
absorption base chosen

= Budgeted Total Overhead for cost Center

Budgeted total number of units of absorption base
 Predetermined continued…
• An appropriate OAR should reflect the effort taken to produce the
products

• Some commonly used predetermined absorption bases are as follows:

– Basis of production units
– Basis of direct labour hour
– Basis of percentage of direct labour cost
– Basis of machine hour
 Continuation…

 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 machining

department since most of the overheads are closely related to
machine hours
Machine Hour Method

• This method best serves highly

automated departments where the
amount of factory overhead cost incurred
on a job is primarily a function of the
machine time that a job requires.
Cutting Dept
Direct materials $5,000
Direct labor (1000 hours) 6,000
Factory overhead (6000 machine hours @ 156000
$26)

Total cost of completed job $167000

Blanket overhead rate or Plant-wide
rate

 The most simplistic traditional costing system

assigns indirect costs (overheads) to cost objects
using a single rate for the factory or organization as
a whole.
 It is computed as:
= Total overheads
Total Direct labour hours/Total Machine hours
Blanket overhead rate or
Plant-wide rate cont…

 Advantages of Using Single / Plant-wide over

rate.
 1. Simple to calculate
 2. Can be applied easily in product costing as it
applies to all departments

 Disadvantage
 1. It assumes that all departments are the same.
Plant-wide rate

 Plant-wide Absorption Overhead Rates

 A plantwide overhead rate is a single overhead rate that a

company uses to allocate all of its manufacturing overhead costs
to products. Therefore, rather than calculating three different /
departmental overhead absorption rates as we did for

 overhead cost absorption, only one overhead rate will be used.

 Formula:

Overhead Absorption rate for Organization = Total Overhead costs for Organization
Total Allocation base for Dept