14-09-2012

OVERHEADS

OVERHEAD ANALYSIS
Objectives of Cost Accounting:

To estimate the cost of each product

To calculate the cost of any work-in-progress

To attempt to control costs by comparing actual with

estimated

1
 14-09-2012

Three elements of Cost

Direct Materials – raw materials

materials, stationery
stationery, stores from
all departments.

Direct Labour – wages, salaries, commission paid to

employees.

O h expenses
Other – admin,
d i selling,
lli di
distribution
ib i andd
financial expenses.

‘Other Expenses'
These ‘Other Expenses’ can be DIRECT or INDIRECT:

DIRECT – traceable to a particular product or job.

They vary in proportion to production.

Direct Materials + Direct Labour + Direct Expenses

p =
PRIME COST

2
 14-09-2012

Indirect Expenses
INDIRECT – these are expenses which cannot be
traceable to a p
particular job
j or product.
p

Normally known as They are essential to the running

Overheads of the business.

They fall into 3 groups – Manufacturing

g

Selling and Distribution

Administration and Financial

Examples…
y Storage charges y Professional fees
y Salaries of support
pp staff y Staff trainingg
y Electricity y Foreign travel
y Water y Depreciation
y Rent y Staff incentives
y Tools and consumables y Legal expenses
y Telephone and connectivity y Subscriptions
y Staff welfare y Insurance
y Rates and local taxes y Interest
y Maintenance expenses y Bank charges

3
 14-09-2012

Prime Cost +
Manufacturing PRODUCTION
Overheads = COSTS

Production Costs
+ Selling and
Distribution + TOTAL COST
Administration
and Financial =

Overheads are…
y Generallyy fixed costs

y Difficult to identify with a product or service

delivery

y Can be a significant portion of a business’s costs

y Example: a hotel will have high gross margins but also high
overheads which need to be ‘covered’ with each sale they make

4
 14-09-2012

Managing Overheads
y “what gets measured, gets managed”

y Objective evaluation of costs: often businesses

find ways of ‘cutting costs’.Æ meaning cutting
overheads

y If not monitored well, this can ‘balloon’ to very

large amounts that will eventually affect a
company’s competitiveness..

Steps in Managing Overheads

y Step 1 – Identify Direct/Indirect costs

y Step 2 – Organize “Cost Collection” by creating “Cost Centers” and

record expenses in that manner

y Step 3 – Identify costs that can be ‘allocated’ and those that need to be
‘apportioned’

y Step 4 – find suitable bases to relate the overheads collected to the

product/service delivery

y Step 5 – Calculate overhead absorption based on the rates and

measure product / service costs accordingly

5
 14-09-2012

Cost Pool : Includes Direct & Indirect Cost

Direct Costs Indirect Costs

Allocate Apportion

Cost Cost Cost Cost

Center Center Center Center

Absorption Absorption Absorption Absorption

Rate Rate Rate Rate
Product
Cost

COST CENTRES
y In order to control costs it is necessary to trace them to
the area responsible for the costs.

These areas are known as COST CENTRES

A Cost Centre can be a location, person or equipment

The Cost Centre acts as a collecting place for costs eg a

manufacturing department, a machine, an operating
theatre in a hospital.

6
 14-09-2012

Two Types of Cost Centres

Production / – these are involved in the

O
Operation
ti manufacturing
f t i / servicei delivery
d li
Cost process such as machining and
Centres assembly Cost Centres.

Service Cost – these are not involved in the actual

Centres manufacturing
f t i process but b t provide
id
services to the production Cost
Centres such as the maintenance and
stores departments.

Class Exercise:
y From the list of cost centers below, identify which cost centers are
pproduction cost centers and which are service cost centers:
Raw Material Mixing Production Planning
Packing Material Stores Factory HR Dept
Production – Filling Machine Room
Finished Goods Assembly Plant Administration Dept
Finished Goods Packing Staff Canteen Dept
E i
Engineering
i I fi
Infirmary andd First
Fi aidid
Quality Assurance Waste water and Sludge Dept
Raw Material Stores
Finished Good Stores

7
 14-09-2012

Cost Units

A Cost Unit is the final product or service being costed

y Examples of Cost Units might be:

a television set manufactured

a ball-bearing made on a machine

a bus journey in terms of operating cost per passenger

mile travelled
a heart transplant operation

HOW TO TRACE COSTS TO COST

CENTRES

Direct Costs Power, Lighting and Heating

(when separately metered),
Repairs and Maintenance to
a machine

– are ALLOCATED to a Cost Centre.

8
 14-09-2012

Allocation of Costs to Cost Centres

Cost Allocation
C All i refers
f to theh allotment
ll off
whole items of overhead costs to cost centres;
that is, overhead costs can be allocated
directly to a Cost Centre.

For example, if the canteen is treated as a

separate cost centre, then the wages of the
canteen manager are allocated to that cost
centre.

Indirect Costs
Depreciation, Rent, Rates, – are APPORTIONED to
Heating and Lighting (not Cost Centres on a suitable
separately metered), Canteen basis.
costs, Supervision etc

Cost overhead costs are shared out among various

Apportionment Cost Centres on some fair and equitable basis
since the overhead cannot be directly
allocated
ll t d tot any one particular
ti l costt centre.
t

A suitable basis could be:

Floor space for Heating Number of Employees for

and Lighting Canteen Costs.

9
 14-09-2012

Apportionment of Costs
“Apportion” means to distribute the overheads among two or more cost
centers based on an identified criteria which best reflects the way the
costs were incurred
Overhead Cost Basis of Apportionment

Rent, rates, heating and floor area, size of department

lighting

Depreciation and insurance book value of the fixed

of plant and machinery assets

Canteen, factory number of employees

administration costs

Power horse power of machines

However, all
H ll businesses
b i Maintenance
M i or Personnel
P l
will incur Service Costs eg Departments.

These departments exist for the whole business not just one
department and therefore these Service Costs must be
APPORTIONED among the other Production Departments,
Departments
again using a suitable basis.

10
 14-09-2012

Basis of Apportionment
Service Overhead Cost Basis of Apportionment

Canteen, personnel and number of employees

security guards' wages

cost of materials used or

Cleaning
material requisitions

Maintenance maintenance man hours or

value of the capital equipment

ABSORPTION OF COSTS
Now that Overhead Costs have been Apportioned to Cost
Centres, they must now be Absorbed into the Total Cost.

Overhead Absorption refers

to the method of charging a
the number of labour
proportion of the final
hours or machine hours
production cost centres'
taken to complete the job.
overheads onto a particular
job on the basis of for
example,

This is often also referred to as Overhead Recovery.

11
 14-09-2012

Bases for Absorbing Overhead Costs:

Rate per Direct Labour when Labour Hours in the
Hour relevant factor

Total Predetermined Overheads / Total Labour Hours

Machine Hour Rate: Area occupied by machine –

either rates, rent etc

Cost off operating

C i –
depreciation, power etc

Total Predetermined Overheads / Total Machine Hours

Class Exercise 01

Calculate:
a. Production Overhead Absorption Rates using the bases given
b. Production Overhead Cost for Job X14

12
 14-09-2012

Alternative Overhead Absorption Rates

Overheads as a ppercentage
g of Direct Wages
g

Overheads as a percentage of Direct Materials

Overheads as a percentage of Prime Costs

Rate per Unit Produced

Service Cost Centers

y Practically,
y, Service Cost Centers provide
p services to other
Service Cost Centers.
y Eg- Factory Canteen will allow HR Dept staff to use their
services and Vice versa

y In accounting for these ‘reciprocal costs’ there are two

methods
th d we can use:
y Simultaneous Equation
y Repeated Distribution Method

13
 14-09-2012

Class Exercise 02
A company has two service and two producing departments.

The two service departments serve not only to producing departments but
also to each other.
other The departmental estimates for the next year are as
follows

Producing departments:
A 50,000
B 40,000

Service departments:
X 10,000
Y 8 800
8,800
The service departments costs are to be distributed as under:
Cost of X : 50% to A, 40% to B, and 10% to Y

Cost of Y : 40% to A, 40% to B, and 20% to X

a. Calculate the cost of X and Y Departments using the Continuous Distribution Method
b. Calculate the cost of X and Y Departments using the Simultaneous Equation Method

Class Exercise 03

a. Calculate the cost of X and Y Departments using the Continuous

Distribution Method
b. Calculate the cost of X and Y Departments using the Simultaneous
Equation Method

14
 14-09-2012

Classs Exercise 04

SUITABILITY OF DIFFERENT OVERHEAD ABSORPTION OR

RECOVERY RATES

One of the most important facts about Overheads is that

they are incurred OVER TIME.

This means that the 2 most accurate methods of

recovering overheads will be:

Direct Labour Hour Rate most suitable for labour

intensive jobs

Direct Machine Hour Rate most suitable for

machine intensive jobs

15
 14-09-2012

All the other Overhead Absorption bases generally do not

allow for the time element but nonetheless are often used:

Where there is only slight variation in the

Percentage of rates of pay for different grades of labour
Direct Wages this method will produce similar results to
the direct labour rate.

There is obviouslyy no relationshipp between

Percentage
P t off the cost of raw materials and overheads.
Direct Materials For example, rent and rates and electricity
do not change simply because the cost of
raw materials have changed.

Same reasons as for the

Percentage of percentage of direct wages and
Prime Cost percentage of direct material
p
overhead absorption rates.

Since the Cost units are likely to have

Rate per Unit different production processes and
Produced different lengths of time in the
production
d ti processes it would ld nott be
b
suitable to apply the same cost unit
absorption rate to all the different
products produced.

16
 14-09-2012

ACTUAL OVERHEADS AND PREDETERMINED/BUDGETED

OVERHEADS

A difficultyy in usingg overhead absorption

p or recoveryy rates in
practice is that you will not know what the actual overheads are
until after the accounting period is finished – for example, a
month or year.

But since you have to charge overheads onto the job when it is
d
done or iindeed
d d even before
b f it is
i done,
d particularly
ti l l if the
th
customer wants an estimate of how much the job will cost,
then you will have to use some method of "guessing" what the
overheads will be.

The way round this problem is to use PREDETERMINED or

BUDGETED Overhead Costs.

This is simply an estimate of what overhead costs will be in the

next financial year based on an extension of what they were in
the past year after allowing for:

• any anticipated
i i d increases
i or • any anticipated
i i d price
i
decreases in production, and increases.

17
 14-09-2012

What this means is that when we come to the end of the

accounting period the actual overhead costs incurred will
in all probability differ from the overheads absorbed into
the cost units.

If the actual overheads for On the other hand, if the

the accounting period are actual overheads for the
greater than the overheads accounting period are
absorbed then we will have less than the overheads
absorbed then we will
underabsorbed costs and so have overabsorbed
we will have to make an costs
t andd so we will
ill
additional charge for the have to make an
difference to the Costing adjustment by crediting
Profit and Loss Account. the gain to the Costing
Profit and Loss Account.

EXAMPLE – OVERHEAD UNDERABSORBED

Cost Centre A Budgeted Data Actual Data
Overheads Rs. 50,000 Rs. 52,000
Direct Labour Hours 5,000 hours 5,050 hours

Calculate the underabsorption of overheads

Overhead absorbed =
actuall direct
di labour
l b hours
h x budgeted
b d d overhead
h d rate

Overhead over / under absorbed =

actual overheads incurred – overheads absorbed

18
 14-09-2012

Step 1

Calculate the Budgeted Overhead Rate based on Direct

Labour Hours.

B d
Budgeted
dOOverheads
h d / Direct
Di L b
Labour Hours
H

Rs. 50,000 / 5,000 hours = Rs. 10 per Labour Hour

Step 2
Calculate the Overhead Absorbed using the rate from Step 1
and the Actual Hours worked:

Overhead Absorbed = 5,050 hours x Rs.10 per hour = Rs.50,500

Step 3
Compare this Budgeted Cost with the Actual Cost

Overhead Underabsorbed = Rs. 52,000 – Rs. 50,500 = Rs. 1,500

As a result the Profit and Loss Account would be charged

with an expense of Overhead Underabsorbed of Rs.1,500.

19
 14-09-2012

EXAMPLE – OVERHEAD OVERABSORBED

Cost Centre A Budgeted Data Actual Data

Overheads Rs.50,000 Rs.49,400

Direct Labour Hours 5,000 hours 4,950 hours

Calculate the overabsorption of overheads.

Overhead absorbed =
actual direct labour hours x budgeted overhead rate

Overhead over / under absorbed =

actual overheads incurred – overheads absorbed

Step 1

Calculate the Budgeted Overhead Rate based on Direct

Labour Hours.

B d
Budgeted
dOOverheads
h d / Direct
Di L b
Labour Hours
H
Rs.50,000 / 5,000 hours = Rs.10 per Labour Hour

Step 2
Calculate the Overhead Absorbed using the rate from Step 1
and the Actual Hours worked:

Overhead Absorbed = 4,950 hours x Rs.10 per hour = Rs.49,500

20
 14-09-2012

Step 3
Compare this Budgeted Cost with the Actual Cost

Overhead Overabsorbed = Rs.49,400 - Rs.49,500 = Rs.100

As a result the Profit and Loss Account would be charged

with an expense of Overhead Overabsorbed of Rs.100.

Class Exercise 05

21
 Classs Exercise 0
07
Classs Exercise 06

22
14-09-2012
 14-09-2012

A company has three production cost centres (P1, P2 and P3) and two service cost centres (S1 and
S2) in its factory. The actual production overhead costs for a period, totaling $487,430, have been
allocated and apportioned to cost centres as follows:
Production Cost Centers Service Cost Centers
P1 P2 P3 S1 S2
Rs. 176,860 Rs. 96,250 Rs. 134,770 Rs. 42,150 Rs. 37,400
The overheads of service cost centre S1 are reapportioned on the basis of the number of materials
requisition notes (MRNs) raised in the period.
period The overheads of service cost centre S2 are
reapportioned on the basis of the number of employees in the other cost centres. The following
Cllass Exercise 08

additional information is available for the period:

Cost Center Number of No. of Required:
Employees MRNs •Reapportion the service cost centre overheads.
P1 20 4,970 •The predetermined production overhead rates
P2 25 3,550 for the period, used to absorb overheads, are:
P3 50 5,680 P1 Rs. 24.60 per machine hour
S1 08 P2 Rs. 13.40 per direct labour hour
S2 05 P3 Rs 10 80 per direct labour hour.
Rs.10.80 hour
Machine hours and direct labour hours in each production cost centre are:
Cost Machine hours Direct labour hours Required:
centre Calculate for the period for each production cost
Budget Actual Budget Actual centre:
1. The amount of overheads absorbed
P1 8,100 8,250 3,650 3,680
2. The amount of any over or under absorption
P2 1,960 1,880 8,650 8,440 of overheads
P3 3,610 3,720 15,600 15,990

23