Overheads and absorption costing

Overheads Overhead is the cost incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and fully to the product, service or department. Overheads is actually the total of the following:- Indirect materials Indirect labour Indirect expenses In cost accounting there are two school of thoughts as to the correct method of dealing with overheads:- Absorption costing Marginal costing

Introduction to absorption costing The objective of absorption costing is to include in the total cost of a product an appropriate share of the organization's total overheads. An appropriate share is generally taken to mean an amount which reflects the amount of time and effort which has gone into producing a unit or completing a job. The theoretical justification for using absorption costing is that all production overhead are incurred in production of output so each unit of the product receives some benefits from these cost. Therefore each unit of output should be charged with some of the overhead costs.

Practical reasons for using absorption costing- Inventory valuations Inventory in hand must be valued for two reasons:- For the closing inventory figure in the statement of financial position For the cost of sales figure in the statement of comprehensive income In absorption costing, closing inventory is valued at fully absorbed factory costs.

Practical reasons for using absorption costing- Pricing decisions Many companies attempt to fix selling prices by calculating the full cost of production or sales of each product, and then adding a margin for profit. Without using absorption costing, a full cost is difficult to ascertain.

Practical reasons for using absorption costing- Establishing profitability of different products If a company sells more than one product, it will be difficult to judge how profitable each individual product is, unless overhead costs are shared on a fair basis and charged to the cost of sales of each product

Absorption costing stages The three stages of absorption costing are:- Allocation Apportionment Absorption

Overhead allocation Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre For example, the following cost will be charged to the following cost centres via the process of allocation:- Direct labour will be charged to the production cost centre The cost of warehouse security will be charged to the warehouse cost centre Costs such as canteen are charged direct to the various overhead cost centres.

Example1-Overhead allocation Cost of company:- Wages of foreman of department A Rs 200 Wages of foreman of department B Rs 150 Indirect materials consumed in department A Rs 50 Rent of premises shared by department A and B Rs 300 The accounting system might include three cost centres:- Cost centre 1 Department A Cost centre 2 Department B Cost centre 3 Rent Calculate the overhead costs of cost centres 1, 2 and 3

Apportionment of overhead Apportionment of overhead is distribution of overheads to more than one cost centre on some equitable basis. When the indirect costs are common to different cost centres, these are to be apportioned to the cost centres on an equitable basis. For example, the expenditure on general repair and maintenance pertaining to a department can be allocated to that department but has to be apportioned to various machines (Cost Centres) in the department. If the department is involved in the production of a single product, the whole repair & maintenance of the department may be allocated to the product.

Bases of apportionment Overhead apportionment basis:- Overhead to which basis apply Basis of apportionment Rent, rates, heating and light, repairs and depreciation of building Floor area occupied by each cost centre Deprecation and insurance of equipment Cost or book value of equipment Personnel, office, canteen, welfare, wages and costs of offices, first aid Number of employees, or labour hours worked in each cost centre

Basis of apportionment of service cost centres Possible basis of apportionment Stores Number of cost value of material requisitions Maintenance Hours of maintenance work done for each cost centre Production planning Direct labour hours worked in each production cost centre

Primary and Secondary Distribution of Overheads In case of multi-product environment, there are common service cost centres which are providing services to the various production cost centres and other service cost centres. The costs of services are required to be apportioned to the relevant cost centres. First step to be followed is to apportion the overheads to different cost centres and then second step is to apportion the costs of service cost centres to production cost centres on an equitable basis. The first step is termed as primary distribution and the second step is termed as secondary distribution of overheads.

Absorption of overheads Absorption of overheads is charging of overheads from cost centres to products or services by means of absorption rates for each cost center which is calculated as follows : Overhead absorption Rate = The base ( denominator) is selected on the basis of type of the cost centre and its contribution to the products or services, for example, machine hours, labour hours, quantity produced etc. TOTAL OVERHEADS OF COST CENTRE TOTAL QUANTUM OF BASE

Example of overhead apportionment-Primary Distribution of overheads Jazz PLC Part 1

Apportionment of service departments costs The aim is to apportion all the service department costs to the production departments, in one of three ways:- The direct method, where the service centre costs are apportioned to production departments only The step down method, where each service cost centres’ are not only apportioned to production departments but to some (but not all) of the other service centres that make use of the services provided

Example 2- Simple distribution of overheads JAZZ PLC Part 2

Apportionment of service departments costs- the reciprocal method 3. The repeated distribution (or reciprocal) method, where service cost centres are apportioned to both the production departments and services department that use the services. The service centre costs are then gradually apportioned to the production departments. This method is used only when service departments use each other’s services

The reciprocal method of distribution Steps to be followed under this method are : The proportion at which the costs of a service cost centres are to be distributed to production cost centres and other service cost centres are determined. Costs of first service cost centres are to be apportioned to production cost centres and service cost centres in the proportion as determined in step (i). Similarly, the cost of other service cost centres are to be apportioned. This process as stated in (ii) and (iii) are to be continued till the figures remaining undistributed in the service cost centres are negligibly small. The negligible small amount left with service centre may be distributed to production cost centres.

Example 3- Reciprocal method Jazz Plc Part 3

The reciprocal (Algebraic) method of apportionment Jazz Plc

Overhead absorption Overhead absorption is the process whereby overhead costs allocated and apportioned to production cost centres are added to unit, job or batch costs. Overhead absorption is sometimes known as overhead recovery Therefore having allocated and/or apportioned all overheads, the next stage is to add them to, or absorb them into, cost units Overheads are usually added to costs units using a predetermined overhead absorption rate, which is calculated using figures from the budget.

Calculation of overhead absorption rate Estimate the overhead likely to be incurred during the period Estimate the activity level for the period Divide the estimated overhead by the budgeted activity level Absorb the overhead into the cost unit by applying the calculated absorption rate

Example- Calculation of overhead absorption rate Gamma makes two products, crushers and cements. Crushers take 2 labour hours each to make and cement takes 5 labour hours. Gamma estimates that total overheads will be Rs 50,000 and that a total of 100,000 direct labour hours will be worked. What is the overhead cost per unit for Crushers and cements respectively if overheads are absorbed on the basis of labour hours.

Choosing the appropriate absorption base A percentage of direct materials cost A percentage of direct labour cost A percentage of prime cost A rate per machine hour A rate per direct labour hour A rate per unit A percentage of factory cost (for admin overhead) A percentage of sales or factory cost ( for selling and distribution overhead)

Activity The budgeted production overheads and other budgeted data of Nick are as below. Calculate the absorption rate using the various bases of apportionment Production Budget department A department B Overhead cost Direct materials cost Direct labour cost Machine hours Direct labour hours Unit of production Rs 36,000 Rs 32,000 Rs 40,000 10,000 18,000 Rs 5,000 1,000

Blanket absorption rate and departmental absorption rate A blanket overhead absorption rate is an absorption rate used throughout a factory and for all jobs and units of output irrespective of the department in which they are produced If a separate absorption rate is used for each department, charging of overheads will be fair and the full cost of production of items will represent the amount of effort and resources put in making them Blanket overhead rates are not appropriate in the following circumstances:- There is more than one department Jobs do not spend an equal amount of time in each department

Activity- Blanket and separate absorption rate A company has two production departments, for which the following budgeted information is available:- Calculate the rate of overhead recovery if a single factory overhead absorption rate is applied Calculate the rate of overhead recovery if a separate departmental rate is applied Dept A Dept B Total Budgeted overheads Rs 360,000 Rs 200,000 Rs 560,000 Budgeted direct labour hours 200,000 hours 40,000 hours 240,000

Activity (Cont…)- Blanket and separate absorption rate If the company undertakes two jobs, X and Y, where Job X has a prime cost of Rs 100 and takes 30 hours in dept B and does not involve any work in dept A and job Y has a prime cost of Rs 100, takes 28 hours in dept A and 2 hours in dept B, What would be the factory cost of each job, using the following rates of overhead recovery:- A single factory rate of overhead c\recovery Separate departmental rates of overhead recovery

Activity-Machine hour absorption rate The following data relate to one year in a department:- Budgeted machine hours 25,000 Actual machine hours 21,875 Budgeted overheads Rs 350,000 Actual overheads Rs 350,000 Based on the above data, what is the machine hour absorption rate?

Over and under absorption of overheads The rate of overhead absorption is based on estimates ( of both numerator and denominator) and it is quite likely that either one or both of the estimates will nit agree with what actually occurs Over absorption means that the overheads charged to the cost of sales is more than the overheads actually incurred Under absorption means that insufficient overheads have been included in the cost of sales

The reasons for over/under absorbed overheads The overhead absorption rate is predetermined from budget estimates of overhead cost and the expected volume of activity. Over or under recovery of overhead will occur in the following circumstances:- Actual overhead costs are different from budgeted overhead The actual activity level is different from the budgeted activity level Actual overhead costs and actual activity level differ from the budgeted costs and levels

Example-over and under absorption The following data is given for a production department:- Budgeted overhead Rs 80,000 Budgeted direct labour hours 40,000 Actual overhead Rs 84,000 Actual direct labour hours 45,000 Calculate the under/over absorbed overheads

Activity Ref co has a budgeted production overhead of Rs 50,000 and a budgeted activity of 25,000 direct labour hours. Calculate the under/over absorbed overheads and give reasons for the under/over absorption in the following circumstances:- Actual overheads cost Rs 47,000 and 25,000 direct labour hours are worked Actual overheads cost Rs 50,000 and 21,5000 direct labour hours are worked Actual overheads cost Rs 47,000 and 21,500 direct labour hours are worked