Overheads

Lecture IV
By S Mwanza
MACC; BACC; AIBZ; SAAA; PGDE
 Overheads
Overheads absorption
 The charging of overheads to cost centres by means
of rates, separately calculated for each cost centre.
 The process of by which overheads are absorbed in
the total cost of a product. The rates used are
predetermined.
Calculation of overhead
absorption rates (OAR)

Formula: = Overheads
Activity base

Examples of activity bases includes the following:

 Direct material costs
 Direct labour costs or wages
 Direct labour hours
 Machine hours
 Production (output or units)
 Prime costs (all direct expenses)
Example 1
Budgeted overheads $10 000
Machine hours 1 500
Labour hours 1 000
Direct wages $15 000
Direct material costs $10 000
Production (units) 500
Required:
Calculate the applicable overheads absorption rates
Solution to example 1

i. Machine hours OAR = $10 000/1 500hours =

$6.67/mhr
ii. Direct labour hour = $10 000/1 000hours =
$10/Dlhr
iii. Direct labour costs = [$10 000/15 000] x 100% =
67%
iv. Direct material costs =[$10 000/10 000] x 100%
= 100%
v. Prime costs = [$10 000/(15 000 + 10
000)]x100% = 40%
vi. Production(units) = $10 000/500 = $20/unit
Application of overheads

NB: Overhead applied = overhead absorption rate (OAR) x

Actual units of the activity base
Example 2: The following details apply to job no.100
Actual Results
Direct material consumed $400
Direct labour hours 50
Direct labour costs $500
Units produced 100
Machine hours 20
Required: Calculate the overheads applied to job 100 and
the total production cost of the job using the rates
calculated in example 1 above.
Solution to example 2

Production cost of job no.100

Machine hour OAR: $
Direct material cost 400
Direct labour cost 500
Prime cost 900
Add: Overheads (20 machine hrs x $6.67) 133
Total costs 1033
Direct labour cost (OAR)

Direct material cost 400

Direct labour cost 500
Prime cost 900
Add: Overheads ($500 x 67%) 335

Total costs 1235

NB: complete the calculation of the remaining OARs.

Use the same concepts. Please note that prime cost
is the same throughout and it is only the overheads
which differs
Why budgeted rates?

a. Actual overheads and actual units of the activity

base are not known in total until the end of the
accounting period, i.e. the actual OAR can only be
calculated at this point. This would mean that
production costs could not be calculated until the
end of the accounting period, thus causing delays
in decision making and setting prices.
b. Overheads rates cannot be calculated at more
frequent intervals, e.g. monthly, quarterly, etc.
because of a large amount of overhead
expenditure is fixed while activity levels vary from
one month to another and this would lead to
multiple rates.
Blanket rate vs Depart
rate
A blanket or plant-wide or factory-wide rate refers to
a situation where a single OAR is established for the
factory as a whole and is used to charge overheads
to all jobs irrespective of the departments in which
they were produced.
Example: Budgeted factory overheads $120 000
Direct labour hours 60 000
Required: Calculate the BOAR
Solution:
$120 000/60 000 hours = $2 per Direct Labour
hour
Cont’d

The plant-wide rate may not be a satisfactory method of

applying overheads in a situation where factory consists
of a number of departments and all jobs do not spend an
equal amount of time in each of these departments.
Example. The total overheads for the three departments;
A, B and C is $120 000, while total direct labour hours is
60 000 hours.
Additional information:
A B C
Budgeted overheads $12 000 $100 000 $8 000
Budgeted labour hours 20 000 20 000 20 000
Required: Calculate the departmental OARs
Solution

Departmental rates
A $12 000/20 000 hours = $0.60/hour
B $100 000/20 000hrs = $5.00/hour
C $8 000/20 000hrs =$0.40/hour

Plant-wide rate
$120 000/60 000 hours = $2.00/hour
Cont’d

Assume that job Z requires 20 direct labour hours in

department C, but does not pass through
departments A & B. What will be the overheads
applied to job Z using:
a. Plant-wide rate
b. Departmental rate
Solution:
c. Plant-wide rate = 20 hours x $2.00/hour = $40.00
d. Departmental = 20 hours x $0.40/hour = $8.00
Conclusion

 Using the plantwide rate job Z is overcharged with

$32.00.
 It’s more meaningful to use separate dept. rates
than overall blanket rates in a situation where the
job do not spend equal amount of time in each
and every department.
Over or under recovery of
overheads
 It is unlikely that overheads charged to production
using BOAR will be equal to the actual overheads
incurred at the end of the accounting period.
 Overheads is said to be
over-applied/charged/recovered or absorbed if the
overheads applied using the BOAR is greater than
the actual overheads incurred.
 Budgeted overheads > actual overheads incurred
 It is said to be under applied if the overheads
applied to production using the BOAR is less than
the actual overheads incurred.
 Budgeted overheads < actual overheads incurred
Accounting treatment for
under/over absorption of
overheads
Over application/absorption of overheads
 Deduct from production expenses
Under recovery of overheads
 Add to production costs
Reciprocal Services
 Refers to a situation where two or more services
departments provide services for each other as
well as for production departments
 For product costing purposes, services
departments costs must be allocated to
production departments
 Calculated using the following methods:
A. Continuous allotment (repeated distribution
method)
B. Direct allocation method
C. The step down allocation (Specific order of closing
or elimination method)
D. Simultaneous (reciprocal/matrix/double
distribution) method
 Example
A company has three production departments and two services
departments. The overhead distribution sheet showed the following totals:
Production departments Total overheads
A $2 500
B $3 100
C $2 800
Service Departments
S $800
T $1 390
The costs of service departments are to be distributed using the following
bases of apportionment.
Department: S T
A 30% 40%
B 20% 15%
C 40% 25%
S - 20%
T 10% -
100% 100%
Required: Apportion the service departments using the following methods:
I. Continuous allotment
II. Specific order of closing
III. Simultaneous equation
 Continuous allotment
Production Departmen Service Department
ts s

A B C S T

$ $ $ $ $

As per 2500 3100 2800 800 1390

distribution Sheet

Allotment of S 240 160 320 (800) 80

Allotment of T 588 221 367 294 (1470)

Allotment of S 88 59 118 (294) 29

Allotment of T 12 4 7 6 (29)

Allotment of S 2 1 2 (6) 1/0.6

3430 3545 3612 - -

 Specific order of closing
Production Departmen Service Departments
ts
A B C S T

$ $ $ $ $

As per distribution sheet 2500 3100 2800 800 1390

Allotment of S 240 160 320 (800) 80

Allotment of T 735 276 459 - (1470)

3475 3536 3579 - -

Eg. A 40/80 = 50% of 1470 = 735 units

Simultaneous equation

Let the total overheads allocated to S after receiving 20% of T be S and

that of service department 10% of S be T.
S = 800 + 0.20T
T = 1390 + 0.10S
S – 0.20T = 800 equation (1)
T – 0.10S = 1390 equation (2)
5(S = 800 + 0.2T)
5S = 4000 + T
5S – T = 4000
(-0.10S + T = 1390)
4.9S = 5390
S = 1100
T = 1100 = 800 + 0.2T = (1100 -800) = 300
300 = 0.2T = 300/0.2 = 1500
 Cont’d

Producti Departmen Servic Department

on ts e

A B C S T

$ $ $ $ $

As per distribution 2500 3100 2800 1100 1500

sheet

Allotment of S 330 220 440

Allotment of T 600 225 375

3430 3545 3612