OVERHEAD COSTING

DR. HELENA THOMAS HAULE​

 LEARNIG OBJECTIVES
In this topic the following key issues will be covered:

1. Introduction to Overhead Costs

2. Types of Overhead Costs

3. Treatment of Overhead Costs in Cost Accounting

4. Practical Examples and Case Studies

 INTRODUCTION TO OVERHEAD COSTS 3

 Overhead cost is a third important type of costs also known as indirect

costs – theses are expenses that are not directly tied to a specific product or
service. Unlike direct costs, which can be traced directly to a particular
cost object (like a product or service), overhead costs are incurred for the
overall operation of the business.
 Can be manufacturing or non-manufacturing e.g., rent, utilities, insurance,
and salaries. Generally, overhead costs are the sum of all indirect expenses
i.e. Indirect materials + Indirect labour + Indirect expenses.
 Understanding how OH are costed is critically important as it assist in
accurate costing of products and services thus supporting well decision-
making such as pricing, budgeting, and financial analysis as well as
identifying areas of inefficiencies and potential for cost savings.
 TYPES OF OVERHEAD COSTS
There are three different types in which OH costs can be classified, as presented below:

Element –Wise
 Indirect Materials
 Indirect Labour
 Indirect Expenses
Function – Wise [Manufacturing vs. Non-
Manufacturing OH]
OH  Factory Overhead
 Office Admn. OH
 Selling and Distribution OH
Behaviour – Wise
 Fixed OH
 Variable OH
 Semi- Variable OH
CLASSIFICATION OF OH BY ELEMENTS OF COSTS 5

 Classification of OH by elements of costs means grouping the indirect

costs according to their nature or type.
 INDIRECT MATERIALS: Materials that are used in the
production process but do not form part of the finished product
e.g., lubricants, cotton waste, and stationery.
 INDIRECT LABOUR: Wages paid to the workers who are not
directly involved in the production process but perform
supporting or auxiliary functions e.g., salaries of supervisors,
managers and accountants.
 INDIRECT EXPENSES: Other expenses incurred for the general
operation of the business but are not directly related to the
production process e.g., rent, utilities, insurance and
depreciation.
 FUNCTIONAL & BEHAVIOURAL CLASSIFICATION 6

 Factory Overhead is actually a manufacturing overhead while other

two (Office administrative OH and Selling and Distribution OH) are
non-manufacturing overhead. For examples, factory rent and taxes,
indirect wages, are examples of factory overhead while, salary of office
staff is an example of office and administrative overhead, and
commission of salesman is an example of selling and distribution
overhead.
 VOH: vary in direct proportion with the level of activity e.g., indirect
wages and salesman’s commission. FOH are those that remain fixed
irrespective of the level of activity within a relevant range e.g., factory
rent. SEMI-VARIABLE OH are those, which vary with the level of
activity but not in direct proportion e.g., repair and maintenance, and
electricity charges.
 TREATMENT OF OH, AND PRACTICAL EXAMPLES 7

 There are three key concepts that also informs the basic techniques
and tools for treatment of OH in managerial accounting namely
allocation/apportionment of overhead costs, assignment of overhead
costs, and absorption of overhead costs.
 In the process we also consider other terms and concepts such as
Predetermined Overhead Rate, and Under/ Over-applied Overhead.
 OVERHEAD ALLOCATION: the process of spreading overhead
costs to cost objects – the goal is to distribute overheads in a manner
that accurately reflects the consumption of overhead resources by
different cost objects. For example, RTC has a total OH of $10,000,
and has two departments (R and T) that respectively incur 60% and
40% of the overhead costs. What would be the overhead costs
allocated to the two departments?
 TREATMENT OF OH, AND PRACTICAL EXAMPLES 8

 Solution:
 Department R: $10,000 * 60% = $6,000
 Department T: $10,000 * 40% = $4,000
 OVERHEAD ASSIGNMENT: the process of assigning or passing on
OH to a specific department, project, or activity using an allocation
base, which is a measure of activity that is used to assign costs to cost
objects. Common allocation bases; direct labour hours, machine
hours, or direct labor costs. For example, if Department R has 1000
labour hours and Department T has 500 labour hours. What would be
the OH assignment per labour hour for the two departments?
 Department R: $6,000 / 1000 hours = $6 per hour
 Department T: $4,000 / 500 hours = $8 per hour
 TREATMENT OF OH, AND PRACTICAL EXAMPLES 9

 OVERHEAD ABSORPTION is also known as absorption costing - a

method of spreading overhead costs over the units produced. It
involves dividing total OH by the number of units produced to find
the overhead cost per unit. This OH cost per unit is then added to the
direct costs (DM and DL) to find the total cost per unit.
 For example, if Department R produces 200 units and Department T
produces 100 units, what would be the OH absorption per unit?

 SOLUTION
 Department R: $6,000 / 200 units = $30 per unit
 Department T: $4,000 / 100 units = $40 per unit
 TREATMENT OF OH, AND PRACTICAL EXAMPLES 10

 Predetermined Overhead Rate: In many cases, OH are applied

(charged/distributed/added) to products or services using a
predetermined overhead rate. This rate is calculated at the beginning
of the accounting period based on estimated overhead costs and
estimated activity levels. The predetermined overhead rate is then
used throughout the accounting period to apply overhead costs to
products or services.
 For example, assume that RTC has an estimated overhead costs for
the next period, $12,000 and the estimated total labour hours are 1800,
what would be the predetermined overhead rate?
 Solution: Predetermined OH Rate = Total Estimated OH ÷ Total
Activity Level
 $12,000 / 1800 hours = $6.67 per hour
 TREATMENT OF OH, AND PRACTICAL EXAMPLES 11

 Under/Over-applied OH: At the end of the accounting period, the

actual OH are usually compared to the applied OH, then, if actual
OH costs are higher (or greater than applied OH costs), the OH is said
to have been under-applied. Contrary, if actual OH costs are lower or
less than applied OH, then OH Costs are said to have been over-
applied. These differences are typically adjusted at the end of the
accounting period.
 For example, assume that RTC’s actual OH at the end of the period
are $11,500 and the applied OH (using the predetermined rate) are
$12,000. Would there be an under/over-applied OH?
 Solution: Under/Over- Applied OH = Applied OH – Actual OH
 Therefore: $12,000 - $11,500 = $500
 Since Applied OH > Actual OH, OH is over-applied by $500
TREATMENT OF OH, AND PRACTICAL EXAMPLES 12

 CLASS ACTIVITY 1
 ABC Pty manufactures two types of products: Product X and
Product Y. The company’s total OH costs are $20,000.
Product X uses 70% of the overhead resources, and Product
Y uses 30%. The company uses labour hours as the allocation
base. Product X requires 1400 labor hours to manufacture,
and Product Y requires 600 labor hours. The company
produces 200 units of Product X and 150 units of Product Y.
Requirements: Calculate the following (1) Overhead
allocation, (2) Assignment, (3) Absorption, (4) Predetermined
OH rate, and (5) Is the OH Costs under/over-applied at the
end of the period?
TREATMENT OF OH, AND PRACTICAL EXAMPLES 13

 CLASS ACTIVITY 2
 For the following overheads show the logical allocation bases
that will be used to apportion the OH Costs:
1) Rent, rates and taxes (10) Repair & maintenance of assets
2) Insurance of Stock (11) Supervisor’s salary
3) Insurance of other fixed assets
4) Depreciation of fixed assets
5) Stores overhead
6) Indirect wages
7) Indirect materials
8) Lighting/Electricity expenses
9) Canteen expenses
THANK YOU
Dr. Helena Thomas Haule