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Overheads
Overheads
Overheads
OVERHEADS
Cost is simply the aggregate of all the expenses incurred in bringing a product to its present
condition and location, it will be discovered that while some expenses are directly traceable to
the cost object, some are not. The problem remains that production overhead, which is not
directly traceable, should form part of the production cost of a product.
IAS No. 2 requires that historical cost of manufactured stocks (inventories) should
include production overhead costs that relate to putting the stocks in their present
location and condition.
Overheads: These refer to indirect materials, indirect labour and indirect expenses. That is,
there could be production overheads, administrative overheads, selling overheads, etc.
Whereas, all these would eventually form part of the total cost of production (rates can also
be set for each of these types of overheads), it is important to understand the distinction
between these overheads. This is because, most organisations are more concerned with
absorbing production overheads for purposes of stock valuation, and when doing so, it is only
production overheads that should be covered.
IMPORTANT CONCEPTS
Overheads: By overheads, is meant, the aggregate of indirect materials, indirect labour and
indirect expenses.
Production
Overheads:
Indirect
costs
associated
with
manufacturing
activities.
Manufacturing activities are the sequence of operations, which begin with supplying
materials to work stations and end with the primary packing of the product. Examples of
these would include depreciation of plant and machinery, and production salaries.
Administrative Overheads: It encompass the costs of formulating policy, directing the
organisation, and controlling the operations of an undertaking which is not related to
production, selling, distribution, research or development activity or function. Examples of
these include office rent, office electricity, office salaries, printing and stationery, audit and
professional fees, etc.
Selling Overheads: Indirect costs, which are associated with marketing and selling (excluding
distribution) activities. Examples of these will include salaries of sales staff, advertisement,
sales commissions, etc.
Distribution Overheads: Indirect costs associated with the distribution of finished products.
Examples of these would include haulage costs to customers, warehouse rents, etc.
STEPS IN OVERHEAD ACCOUNTING
Overhead cannot be charged directly to cost units or jobs like direct expenses (direct material,
direct labour and direct wages among others). True cost of production can be ascertained only
when factory(production) overhead has been added to the prime cost. The following processes
are needed before adding the indirect expenses to the prime cost, Allocation, apportionment and
absorption.
Allocation
Allocation of overhead: Allotment of whole items of cost to cost centres or cost units.
Overhead costs arising solely from the existence of a particular dep. (production or service
dept) can be charged or allocated to that dept., e.g. salary of a departmental head.
Apportionment of overhead: Means the allotment but of a portion of cost to costs centers
or cost units. Apportionment of overhead is the process of distributing those items of
overhead which cannot be allocated to a cast centers or dept between cost centers or depts.on
an equitable basis. Overhead such as factory rent, factory insurance, factory lighting, power,
salary of factory manager incurred for the entire factory require apportionment to different
production and service depts on some equitable or reasonable basis.
BASIS OF APPORTIONMENT OF OVERHEAD
There is no hard and fast rule with regard to apportionment of overhead. However, the basis to be
used shall be determined with reference to the nature of the particular item of overhead. Some
common bases are;
1. Floor area/floor space e.g. rent rates, insurance of building, lighting e.t.c.
2. Direct wages this base is use for those items which are related to direct wages, e.g. pension
fund, contribution to employees insurance scheme.
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Service department
A
B
2000
1000
Service Dept
ZN
AN BN
400 3000 800
900 200
1300
2000 1875 625
1200 800
400
600 450
300
400 300
200
750 1000 500
6250 9425 4125
Workings
Total hrs consumed for the company: X, +Y, +Z+A+B = 2200+2000+800+750+250 = 6000 Hrs.
N
For department X, 2000 x 15000 = 5000
6000
Y,
Z,
A,
B,
6000
RE-APPORTIONMENT OF SERVICE DEPARTMENT EXPENSES TO PRODUCTION
DEPARTMENT
After the apportionment of the overhead cost to production and service dept., the nest step is to
apportion the expenses of various service department to production. This is so because the
service department are not engaged in actual output, it becomes necessary to apportion the cost
of the production process of doing so is called secondary distribution,
Base on re-apportionment (secondary distribution)
Generally it is done on the basis of the benefits derived by the production department from the
service department, the more conventional way is on the following;
1. Time keep dpt. Wages or pay roll
department
a. No. of workers
b. Labour hrs. worked
c. Machines hrs worked
No. of employees in each dept.
a. No. of purchase order placed
b. Cost of material purchased
a. No. of material requisition
b. Value of material used
a. No. of labour hrs. worked
b. Machines hrs. worked
Floor space occupied
ILLUSTRATION TWO
AA has three production departments and two service department. The summary of the primary
distribution for the month of May 2012 is as follows
Production department
X
14700
Production department Y
17300
Production department
Z
6250
Maintenance
A
9425
Stores
B
4125
Additional Information
Direct lab hrs.
No. of required.
X
1800
90
Y
1600
60
5
Z
1100
50
Production Dept
XN
YN
ZN
14,700 17,300 6250
3,770 3,351 2,304
1,856 1,238 1,031
20,326 21889 9,585
Service Dept.
AN
BN
9425
4125
(-)9,425
(-)4,125
-
There are two steps needed to be taken in the apportionment of overheads. These are as follows;
i) Computation of overhead: this is made by diving the total overhead costs of a department by
the number of units in the BASE. The base could be direct materials costs, direct labor costs
direct labor hour among others. Thus, the general formula is
Overhead rate = Total overhead of the department
Total unit base used
ii) Application of the overhead rate to cost units: in order to ascertain the cost of each unit, the
overhead rate calculated above, is multiply to the unit of base direct materials costs, direct labor
costs direct labor hour) in the particular cost unit.
Overhead chargeable to a cost unit = unit of base in cost unit X overhead rate
The activity level or production volume is estimated based on what is believed largely influences
overhead costs. Traditionally, the following measures are used:
(i) Machine Hours;
(ii) Labour Hours;
(iii) Amount of Material Cost;
(iv) Amount of Labour; and
(v) Amount of Prime Cost.
The following Overhead absorption/recovery rates are in use:
(a) Machine Hour Rate = Estimated Amount of Overhead
Estimated Machine Hours
(b) Labour Hour Rate = Estimated Amount of Overhead
Estimated Labour Hours
(c) Percentage of Material Cost = Estimated Amount of Overhead x 100%
Estimated Amount of Materials
(d) Percentage of Labour Cost =Estimated Amount of Overhead x 100%
Estimated Labour Cost
N160,000
10,000hrs
Unit produced
4,000 units
Calculate the following rates: (i) direct labour hours, (ii) direct wages, (iii) direct materials, (iv)
machine hour (v) Prime cost, (vi) unit cost
SOLUTION TO ILLUSTRATION THREE
DLH OAR = Total OH/ Total No of Units = 600, 000/5,000 = N120 overheads per labour hour
DW OAR = 600,000/160,000 = N3.75 overheads per N of wages
DM OAR = 600,000/350,000 = N1.71 overheads per N of materials
MH OAR = 600,000/10,000 = N60 overheads per machine hour
PC OAR = 600,000/510, 000 = N1.18 overheads per N of Prime cost
Cost Unit OAR = 600,000/4000 = N150 overheads per unit produced
FORMAT OF A COST STATEMENT
Direct materials
Direct labour
Direct expenses
Prime cost
Production Overhead
Factory or Production Cost
Add: other Overheads
Selling and Distribution X
Administrative
X
Total Cost
N
X
X
X
X
X
X
X
XX
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ILLUSTRATION FOUR
KT manufacturer ltd had the following information for the year ended December 2000. Materials
used N60,000; Direct labour hour (wages)N30,000; overheadN18, 000;direct labour hour 12,000;
machine hours 10,000.the below info relates to a job No. 106: materials usedN1200; Direct labor
(wages) N650;Direct labor hour 265; machine hours 255. Prepare a statement showing the toatal
cost of the job using; a)% of DM b) % of DL cost c)DLH method d) MH method
SOLUTION TO ILLUSTRATION FOUR: WORKINGS IN THE CLASS
ILLUSTRATION FIVE
Tutors Nig Ltd manufactures two products COS and COR. The following details relate to the
product.
DM
Product Cos
Product Cor
N50
N45
DL Cost:
Machine at N10 per hr
60hrs
80hrs
Assembly at N5 per hr
20hrs
40hrs
The company plans to produce 6,000 units of product Cos and 3,300 units of product Cor during
the forthcoming month and estimates it overhead for that month at 700,000
You are required to calculate overhead absorption rate using: i) percentage of prime cost, ii)
direct labour hour, iii) machine hr. work to the nearest decimal places.
SOLUTION TO ILLUSTRATION FIVE: WORKINGS IN THE CLASS
ACTUAL AND PREDETERMINED OVERHEAD RATE
Actual overhead rate is that rate which is based on the actual amount of overhead to be absorbed
and the actual value of the based selected, i.e. its relied on actual overhead and base value (DM,
MH etc). actual overhead rate enables the absorption(recovery) of actual amount of overhead.
However, it is main drawback is that It is based on historical cost in nature which can be
ascertained after the overhead have been incurred. For this reason, the actual overhead rate is
useless.
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Predetermined rate, this rate is based on the anticipated amount of overhead and the anticipated
value of the base selected. It is worked out by dividing the estimated amount of overhead by the
estimated value of the base before the actual production commences. It is then applied for the
absorption of the overhead during the period which it has been computed for.
For the purpose of evaluation, the actual sand the predetermined rate are compared. The
comparison will give one of the three outcomes equal, under or over absorption. This will now
take us to the next sub heading.
absorbed areN10, 800 and the actual incurred are N10,000. There is over-absorption of N800. In
this case of over absorption, the cost of production is inflated to the extent of the amount being
over absorbed.
CAUSES OF UNDER AND OVER ABSORPTION OF OVERHEAD
*Under utilization of the production capacity
*Seasonal fluctuations in the production in the case of seasonal factories
*errors in the anticipating the overhead cost or value of the base
*major change in the method of production
*change in the working capacity
TREATMENT OF UNDER AND OVER ABSORPTION OF OVERHEAD
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(a) Supplementary rate, under or over absorption is apportioned to work in progress, finished
goods, and cost of sales by means of supplementary rate. The amount of under absorbed is
adjusted by adding (+) it back to cost of production. While, over absorption is deducted through
a negative (-) supplementary rate. Supplementary rate is calculated as :
Supplementary rate = overhead incurred overhead absorbed
Value of the base
(b)Carry forward to next accounting period, the amount of over/under absorbed overhead is
transferred to an overhead reserve or a suspense account to be carried forward to the next period
account for absorption.
(c) Transfer to costing P and L account
The amount of over/under absorbed overhead is transferred to costing P and L account as
abnormal gain for under absorption and abnormal loss for over absorption of overheads.
CHOICE OF OVERHEAD ABSORPTION METHOD
At this stage we are fully aware that there exist a number of methods which can be used for
absorbing the factory overhead for e.g. DL, DM,MH etc. the method selected for absorbing the
overhead must be suitable and equitable, failing which the costing result may be misleading. The
below factors should be considered while selecting a method of factory overhead absorption;
1. Type of industry whether job order, continuous production
2. Nature of the manufacturing process whether manual or mechanical
3. The main constituents of overhead and their nature whether fixed or variable
4. The organization set up of the undertaking into departments, cost centers
5. The capacity at which the factory is working full capacity or under capacity
6. Policy of the management
CHARACTERISTICS OF A GOOD OVERHEAD ABSORPTION METHOD
1. it should be simple and convenient in its application and should not be require the
maintenance of unnecessary clerical records
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2. It should be adequate ensuring the recovery (absorption) of overhead is more or less equal to
the actual amount of overhead
3. it should give due consideration of the time factor involved in the production
4. It would make proper distinction between the work done by skilled and unskilled workers
5. it should make proper distinction between work done by manual labor and mechanics
6. Multiple rates should be preferred to blanket rate or overall overhead rate of the whole factory
BLANKET ABSORPTION RATE AND DEPARTMENTAL ABSORPTION RATE
These terms are used in relation to recovery or absorption of overhead. The common absorption
rate used throughout a factory and for all jobs and units of production irrespective of the
department they were produced is known as Blanket absorption rate. Whereas departmental
absorption rate, refers to overhead absorption rate calculated separately for each department of
the factory. It is advisably to establish separate overhead rates for each department in order to
ensure that all jobs and units of production are charged with fair share of overheads in cases
where these jobs and units do not spend approximately the same time in each department.
ILLUSTRATION SIX
KKY ltd provides the following budgeted information for the year 2010
Department Machine hrs Overhead Machine hrs required for Job Q
Fabrication 15,000
N150,000 40
Machining 12,000
N180,000 50
Assembly
5,000
N120,000 30
Finishing
8,000
N100,000 20
Required: Calculate the blanket and departmental overhead absorption rates and overhead to be
charged to Job Q.
SOLUTION TO ILLUSTRATION SIX
Calculation of departmental absorption rates
Department (a) Machine hrs (b) Overhead (c)
Fabrication
15,000
N150,000
Machining
12,000
N180,000
Assembly
5,000
N120,000
Finishing
8,000
N100,000
550,000
N40,000
Calculation of blanket overhead absorption rate:
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