Cost Assignments

Learning Objectives
•Explain the different treatment of direct and indirect
expenses
•Describe the procedures involved in determining
production absorption rates
•Allocate and absorption production overheads to
cost centers using an appropriate basis
•Reapportion service cost center costs to production
cost centers
•Select, apply and discuss appropriate bases for
absorption rates
•Calculate and explain the under- and over-
absorption of overheads
 Assignment of Direct and Indirect Costs

• Direct costs can be specifically and exclusively identified

with a given cost object – hhence they can be accurately
traced to cost objects.
• Indirect costs cannot be directly traced to a cost object –
therefore assigned to cost objects using cost allocations.
• Cost allocations = process of assigning costs to cost objects
that involve the use of surrogate rather than direct measures.
• Surrogates known as allocation bases or cost drivers.
• For accurate cost assignment, allocation bases should be
significant determinants of the costs (i.e. cause-and-effect
allocations).
 Cost Assignment Process

Direct Cost Tracing

costs
Cost
Cost Allocation Object
Indirect
costs
 Overhead Distribution process
1. Accumulation of overheads
2. Allocation and apportionment of overheads
• Allocation of Overheads
• Apportionment of overheads
• Reapportionment of overheads
3. Absorption of overheads
• Determination of absorption rate
• Determination the cost of unit with the absorption
rate
 1. Accumulation of overheads( Collection of
overheads costs)

• Initial step of overhead allocation is to collect

overheads under each category from different
sources.

Overheads cost sources

Factory rent Lease agreement
Electricity Electricity bills
2. Allocation and apportionment of overheads
Allocation of overheads

• Provision of overheads is where the directly

attributable overheads for a specific
production or service center are reserved for
that production or service centers.

• Ex: Indirect wages in the packing section of

garment factory is reserved as a cost item in
that division
 Apportionment of overheads costs
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 respects of
these items, it is necessary to establish a logical basis for
allocating the overheads to cost centers/departments.
Cost  Basis of allocation 
Property taxes, lighting and heating Area
 
Employee-related expenditure No of employees
Depreciation & Insurance of plant & Value of items of plant & machinery
machinery
 
Stock keeping, material handling No of material requisitions
cost
Electricity , heating Technical estimate
 
Fuel Machine hours.
Example 01
• You are provided with the following information extracted from the books of shehan Company

Production Department Service Department

A B X Y
Dimension (square 300 420 70 10
meters)
Issue of indirect materials 310 630 160 440
(Rs.000)
Indirect labour (Rs.000) 1,170 1,790 626 1,840
No of employees 200 300 16 30
Cost of machines (Rs.000) 2000 1200 800 -
Estimated Kw hours 320 210 20 -
the following are budgeted costs for the next period.

Factory administration 2,184

Rent 1,600
Electricity 1,100
Machine depreciation 800
Machines insurance 1,000
Power 1,100

Prepare overhead analysis sheet

 Reapportionment of service cost center costs
to production cost centers
• Service cost centers (department) are not directly involved in
making products and therefore fixed production overheads of
service cost centers must be shared out between the production
cost centers ( departments) using suitable basis.

•Practically the following methods are used to apportion the

overheads of service cost centers to the production cost centers.
• Basic reapportionment
•Reciprocal reapportionment
• Basic Reapportionment
Overheads attributable for the service cost centers are apportioned only among the
production cost centers, if the service cost centers are provided to the production cost
centers only.

Example 02
• The overheads of each service cost centers of the above ex: 01 apportion to the
production cost centers as follows

Prepare overhead analysis sheet for Reapportionment

Production department
A B
X- Overheads 50% 50%
Y- Overheads 40% 60%
Reciprocal reapportionment

• The overheads of service cost centers should also be

apportioned to the service cost centers as well as to
the production cost centers. Three methods can be
used for the reciprocal reapportionment.

1.Continuous allotment method

2.Equation method
3.Elimination method
• Example 03
• The overheads in the ex :01 apportion among each
cost centers as follows
Production Service
department Department
A B X Y
X- Overheads 20% 30% - 50%

Y- Overheads 40% 50% 10% -

Prepare overhead analysis sheet for reapportionment

3. Absorption of overheads
Bases of absorption
• Once the overheads are allocated , apportioned and
reapportioned in to the production departments the
overheads need to be related to or absorbed in to the
units of product.
• Overheads can absorbed into cost unit absorption bases
» Direct labor hours
» Machine hours
» Direct Material cost.
» Direct labor cost.
» Units of Production.
• The overhead absorption rate (OAR) is
calculated as follows

• OAR= Budgeted production overheads

Budgeted total of absorption basis
 Budgeted Overhead Rates
• Actual overhead rates are not used because of:
1. Delay in product costs if actual annual rates are used.
2. Fluctuating overhead rates that will occur if actual monthly
rates are used.
Example 04
With reference to the Example 01 , assume that the company is producing two types of product namely, Product P
and Product Q .
Following information is relevant to calculating cost of products

Product P Product Q
Direct Material cost per unit Rs 150 Rs. 110

Direct Labour cost per unit

Department A 20 Hours 15hours
Department B 10 hours 12 hours

i. Calculate the Overhead absorption rates based on labour hoursA

Department Department B
ii.Calculate the total cost per each products
Budgeted Labour hours 300,000 500,000
Labour Rate per hour Rs.50 Rs.30
 Example 04
The annual overhead costs for the Vonara company which has three production
centers(two machine centers and one assembly center) and two service centers
(materials procurement and general factory support) are as follows.
  Indirect wages and supervision
Machine centers X 1000,000
Y 1000,000
Assembly 1500,000
Materials Procurement 1100,000
General factory support 1480,000 6080,000

Indirect Materials
  Machine centers X 500,000
Y 805,000
Assembly 105,000
Materials Procurement 0
General factory support 10,000 1420,000
 
Lighting and heading 500,000
Property taxes 1000,000
Insurance of machinery 150,000
Depreciation of machinery 1500,000
Insurance of building 250,000
Salaries of works management 800,000 4 200,000
11,700,000
•The following information is also available.
  Book value of Area occupied Number of Direct labor Machine
machinery (sq.metres) employees hours hours

Machine 8,000,000 10,000 300 1,000,000 2,000,000

shop X
5,000,000 5,000 200 1,000,000 1,000,000
Y
Assembly 1,000,000 15,000 300 2,000,000  
Stores 500,000 15,000 100    
Maintenance 500,000 5,000 100    
Total 15,000,000 50,000 1000    
The following information is also available.
Details of total materials issues (i.e. direct and indirect materials) to the production cente
are as follows.
Machine shop X 4,000,000
Machine shop Y 3,000,000
Assembly 1,000,000
8,000,000
 Details of total materials issues (i.e. direct and indirect materials) to the
production centers are as follows.
Machine shop X 4,000,000
Machine shop Y 3,000,000
Assembly 1,000,000
8,000,000
  (i) Prepare an overhead analysis sheet to allocate the overheads listed above to
the production and service centers.
 
(ii)
Assume product A is a low sales volume product with direct costs of $. 100. It is
manufactured in batches of 100 units and each unit requires 5 hours in machine
centre X, 10 hours in machine centre Y and 10 hours in the assembly centre.

Product B is a high sales volume product thus enabling it to be manufactured in

larger batches. It is manufactured in batches of 200 units and each unit requires
10 hours in machine centre X, 20 hours in machine centre Y and 20 hours in the
assembly centre. Direct costs of $. 200 have been assigned to product B.

Compute the manufacturing costs of two products

 Under-and Over Recovery of Overheads

• If actual activity or overhead spending is different from

that used to compute the estimated overhead rates there
will be an under or over recovery of fixed overheads.
Example
Estimated fixed overheads = Rs2 million
Estimated activity = 1 million direct
labour hours
Overhead rate = Rs.2 per DLH
• Assume actual activity is 900 000 DLH ’s
and actual overheads are Rs 2 million:
Overhead allocated to products = Rs. 1.8 million
(900 000 × Rs.2)
Under-recovery = Rs.200 000
• Assume actual overheads are Rs 1800 000 and actual
activity is 1 million DLHLs:
Overhead allocated to products = Rs.2 million
(1 million × Rs.2)
Over-recovery = Rs.200 000
• External financial accounting principles (GAAP) require
that under/over recoveries are treated as period costs.
Illustration – under- and over-absorption of overheads

A business absorbs its fixed production overhead on the

basis of direct labour hours. The budgeted direct labour
hours for week 24 were 4,200. during the week 4,050 direct
labour hours were worked and the production overhead
incurred was Rs. 16,700. the overhead was under-absorbed
by Rs. 1,310.
Required:
calculate the budgeted fixed overhead for the week.
 Non-manufacturing Overheads
• Financial accounting regulations specify that only manufacturing
overheads should be allocated to products.
• Non-manufacturing costs should be assigned to products for
decision-making (particularly cost-plus pricing).
• Simplistic methods such as using direct labour hours, or a
percentage of total manufacturing cost, are frequently used as
allocation bases with traditional systems.
Example
Manufacturing cost = £1 million
Non-manufacturing overheads = £500 000
Overhead rate = 50%of manufacturing cost
• Simplistic methods do not provide a reliable measure of the non-
manufacturing overheads consumed by products.
• ABC is advocated for providing a more accurate measure of
resources consumed by products.