Introduction:
Overhead refers to the total cost of indirect materials, indirect labour and indirect expenses. Indirect costs are those which cannot be identified with the production of some specific goods or services. These costs are incurred for the organization as a whole.
Allocation of overhead cost
Overhead allocation occurs when an overhead can be identified as belonging to a specific cost centre and is charged to that centre. Therefore there is no need for apportionment of such overheads.
Appointment of overhead cost
Overhead apportionment occurs when overheads cannot be identified as belonging to a specific cost centre and are therefore shared out on an equitable basis. Overheads though not directly related to the items being manufactured, should finally form part of the total cost of the products being manufactured. If an organization has two or more departments each carrying out a separate activity, then the overheads of the organization should be divided among these departments equitably.
The process of sharing the overhead costs between products or departments or divisions in an organization is referred to as appointment of overheads. The initial distribution of overheads that is done to all departments, whether production or service departments, is called primary distribution of overheads.
Bases of overhead appointment
This refers to the logic for sharing a common overhead cost between various departments or products within the organization. The most common bases of overhead apportionment include:
Illustration 1
The following information relates to a factory which has four departments:
Illustration 2
A modern company (X ltd) has 4departments A, B, C and D. The actual cost for a given period was extracted from their books as follows:
Required:
Apportion the above costs to the various departments on the basis of the most equitable basis.
Solution:
Overhead analysis statement
The following data is also available in respect of the 4 departments:
Required:
Apportion the above costs to the various departments on the basis of the most equitable basis.
Solution:
Overhead analysis statement
Overheads of service departments
Service departments are those which are not engaged in production of any specific items but provide support to production department e.g. stores department, repairs and maintenance department, personnel department etc
The overheads charged to service department must further be reappointed to the production departments. This is called, secondary distribution of overhead or reappointment of service department overheads.
Methods of reappointment of service department overheads
There are main methods include
i. Repeated distribution method (continuous allocation method)
ii. Algebraic method (simultaneous equation method)
iii. Direct allocation method
iv. Sequential allocation method
Repeated distribution method
Under this method the overheads of the service department are transferred to the production department on the basis of the benefit that the production department enjoys from these service departments.
The process of transferring the overheads can begin by allocating the overheads of one service department to other production departments before proceeding to the next service department and so on.
If the service departments are engaged in reciprocal relationships i.e. service departments provides services to one another, then in the process of reallocating the overheads of any given service department, some overhead cost is transferred to a previously closed service department and the process has to begin all over again.
Algebraic/simultaneous method
This method transfers the overheads of service departments by modeling the problem into a system of simultaneous equations and solving it using any of the conventional methods.
Illustration
The departmental distribution summary for XY Ltd has been extracted as follows
It has been estimated that the cost of running service departments can be charged to the various departments according to the following percentages:
Required:
Determine the total overheads apportioned to production department 1- 4 using;
i) Repeated distribution method/ continuous allocation method
ii) Algebraic method
Solution
Using algebraic method
Let the total overheads in department A be x Let the total overheads in department B be y
Direct allocation method
Under this method overheads of the service departments are transferred to the production department on the basis of the benefit that the production departments enjoy from a particular service department. In this method, no overhead is allocated to another service department even if it enjoys the services of any given service department. Therefore the basis of transferring the overheads is the ratio formed in the production department only with respect to benefits enjoyed.
Sequential allocation/ step down method
Under this method, the service departments are ranked in a descending order on the basis of the total amount of the benefits they offer to other departments. The overhead cost of the service departments that give the highest amounts of services is allocated first to the other (departments including other service department).
The service department that gives the second highest amount of service then reallocated to the other departments but nothing is reallocated back to the first service department even if it enjoys the benefits. The process continues until all the overheads of the service department have been reallocated.
Illustration
MMC Limited operates two production department and two service department. The budgeted cost and normal activity levels for each of the four departments are given below:
Additional information
The cost of maintenance department is allocated on the basis of number of employees while those of power department on the basis maintenance hours
Required
Allocate the service department overheads using:
i) Direct allocation method
ii) Sequential allocation method
Solution
Direct allocation method:
OVERHEAD ABSORPTION / RECOVERY/APPLICATION/CHARGING
Once overheads have been allocated or apportioned to the various production departments, the total overhead cost of production departments are ultimately charged or absorbed in the cost of products passing through these departments. Absorption of overheads is therefore the last step in the distribution plan of overheads.
There are two steps in the absorption of overheads:
a) Computation of overhead absorption rates (OARs)
b) Application of these rates to the cost units
Computation of overhead absorption rates
There are various methods of determining overhead absorption rates
1. Rate per unit of output
Illustration
A company estimated its overhead cost in a given period to be Ksh. 3,000,000 and for an estimated output of 150,000 units.
Required:
Determine;
i) The OAR
ii) If the actual output turned out to be 175,000 units for which the actual overhead cost of Ksh. 3,200,000 was incurred, compute the over/under absorbed overhead.
Solution
Illustration II
A company budgeted to incur an overhead cost amounting to Ksh 6 million for a budget activity level of 50,000 units. During the year, the company produced 47,500 units for which they actually incurred a total overhead cost of Ksh 5 million.
Required:
i) Compute the OAR
ii) Determine the over/under absorbed overhead
2. Direct material cost percentage method
Under this method, the amount of overhead cost to be absorbed by a cost unit is determined by the cost of direct materials consumed in producing it.
Illustration
X Ltd estimated that its overhead cost in a given period to be ksh. 1.2 million during which period the direct material cost was also estimated at ksh. 1.8 million. At the end of the period, the actual overhead cost incurred was ksh. 1 million and the expenditure on direct material amounted to ksh. 1.4million.
Required;
i) Calculate the OAR
ii) Compute the overhead over/under absorbed overheads
3. Direct labour cost percentage method
Under this method, the amount of overhead cost to be absorbed by a cost unit is determined by the cost of direct labour consumed in producing it.
Illustration
The following information was obtained from the books of ABC Ltd
Required:
i) Calculate the OAR
ii) Calculate the over/under absorbed overhead
iii) Determine the selling price of job number Y200 given that the company has a policy of 20% mark-up. (the company absorbs overheads on the basis of direct labour cost)
Prime cost percentage method
Prime cost refers to the total direct cost i.e. direct material cost plus direct labour cost plus direct expense
Illustration
The following information was obtained from the books of KCA Ltd
Required;
- Compute the OAR
- Compute the SP for job 120 given that the company adds a margin of 20% (use prime cost percentage method)
1. Labour Hour Method
Under this method, the amount of overhead cost to be absorbed by a cost unit is determined by the direct labour hours consumed in producing it.
Illustration
KCA Ltd budgeted to incur an overhead cost amounting to ksh. 3.5 million and to work ksh. 175,000 direct labour hours. During the period the actual results was recorded as follows:
Actual overhead ksh. 4.3 million
Actual direct labour hours 210,000
The cost accountant has extracted the following details with respect to job K002.
- Direct material 450
- Direct labour 300
- Direct expense 150
- Machine hours 15
- Labour hours 12
It‟s the policy of the company to charge a profit margin of 25%. The company absorbes overheads on the basis of direct labour hours
Required;
- Calculate the over/under absorbed overhead
- Determine the selling price of job number K002
Machine hour method
Under this method, the amount of overhead cost to be absorbed by a cost unit is determined by the machine hours consumed in producing it.
Illustration
JK Ltd presented the following information regarding their cost for the year 2010
During the same period, the company‟s cost accountant extracted the full information with respect to job No. JK010 as follows:
- Labour hours 25
- Machine hours 18
- Direct labour cost 420
- Direct expenses 180
- Direct material 600
Required;
- Compute the over/under absorbed overhead
- The selling price of Job No JK010, given that the company has a policy of 15% mark up
Solution
Activity 1
BCD ltd manufactures office and household furniture to customers‟ specifications. Because of the specialized nature of the manufacturing process, each job is treated separately for costing purposes. There are two stages in the manufacture of each item namely, Assembly and Finishing. In the assembly department, overheads are absorbed on the basis of prime cost incurred in that department. In the finishing department, overheads are applied on the basis of total accumulated cost on the job in both the two stages inclusive of overhead absorbed in assembly. The selling price of the item is then determined by applying the usual 40% profit margin.
The following information is provided about budgeted data for the next financial period:
Required:
Calculate the overhead absorption rates for each production
Job no. 148 shows the following data concerning its production
Required:
Prepare the cost statement for this job and indicate the proposed final selling price.
The following data relates to the actual manufacturing operations as accumulated for the whole financial period:
Required:
Calculate the amount of overhead over applied or under applied for the company as a whole.
Comment on the overhead absorption rates used by the company in light of the results obtained in (c)
Activity 2
Mwangaza Metals Ltd. Fabricates steel products for export to the COMESA region. The products go through three processing departments: forming, machining and finishing.
The following information relates to operations for the year ended 31 October 2010.
Budget manufacturing costs for the year ended 31 October 2010 were as follows
While there were no finished goods or work-in-progress inventories at the beginning of the year, stocks on 31 October 2010 were made up as follows:
The above balances include actual direct materials, direct labour and absorbed overhead costs.
Manufacturing overhead costs are absorbed into products on the basis of direct labour costs, at rates pre-determined at beginning of the year, using the annual budgeted
Two alternatives of absorbing overheads could be employed: Use a single factory wide manufacturing overhead rate. Use separate departmental manufacturing overhead rates.
The policy of the company is to dispose of over (under) absorbed overheads at the year-end by allocating the amount between ending inventories and cost of goods sold in proportion to their unadjusted cost
Required:
- Using the separate departmental manufacturing overhead rates:
- Determine the total under/over absorbed overheads for the
- Allocate the over/under absorbed overheads to the relevant accounts.
- Prepare a journal entry to record the disposal of the over/under absorbed
- A particular order code named E20, from a customer was worked on and completed during the year. The following costs were incurred in relation to the
Required:
Using the factory wide absorption rate, determine total overhead applied to the order (E20).
Recommended texts for further reading
Costing T. Lucey
Costing, An Introduction, Colin Drury Wheldon‟s, “Costing Simplified”
Colin Drury, “Management and Cost Accounting”
Bhabatosh Banerjee, “Cost Accounting Theory and Practice”