Chapter 8 Accounting for overhead

Explain the different treatment of direct and indirect expenses. [k] Describe the procedures involved in determining production overhead absorption rates. [k] Allocate and apportion production overheads to cost centres using an appropriate basis. [s] Reapportion service cost centre cost s to production cost centres (using the reciprocal method where service cost centres work for each other). [s]

Select, apply and discuss appropriate bases for absorption rates. [s] Prepare journal and ledger entries for manufacturing overheads incurred and absorbed. [s] Calculate and explain the under and over absorption of overheads. [s]

How overhead is shared? A cost card of an individual unit: Cost/unit 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 in full to the product, service or department. A cost card of an individual unit: Cost/unit Direct materials 4kg @ $2/kg $8 Direct labour 3 hours @ $7/hr $21 Direct expenses $4 Prime cost $33 Indirect costs (overheads) $10 Total cost $43 Indirect materials Indirect labour Indirect expense Production Administration Selling and distribution How overhead is shared? Indirect costs (overheads)

1 Absorption costing：an introduction 1.1 Absorption costing, AC, 吸收成本法 Absorption costing is a method for sharing overheads between different products on a fair basis.

In absorption costing, overhead costs will be added to each unit of product manufactured and sold.

Sometimes, but not always, the overhead costs of administration, selling and distribution are also added to unit costs, to obtain a full cost of sales.

1.2 Absorption costing steps Total production cost Direct costs Indirect costs More difficult to link to unit so we need a methodology Be easily to linke directly to unit and put in cost card Absorption costing Step 1 Step 2 Step 3 Cost Centres 产品 A 产品B 服务 产品 A 产品B Cost unit

2 Step 1- allocation and apportionment of production overheads to cost centres Allocation 分配 is the process by which whole cost items are charged direct to a cost unit or cost centre. Direct costs are allocated directly to cost units If indirect costs are clearly identifiable with cost centres, they are allocated to those cost centres If indirect costs are not clearly identifiable with particular cost centres, they are allocated to general overhead cost centres Apportionment 分摊 is a procedure whereby indirect costs are spread fairly between cost centres

Production department Production area service department Types of cost centre: Production department Production area service department Administration department Selling or a distribute department Overhead cost centre (common expense) Factory cost centres

Mixing stirring Stores Maintenance Finished goods store Service cost centres Production cost centres Finished goods store

Solution Base of apportionment: it is considered important that overhead costs should be shared out on a fair basis. The bases of apportionment for the most usual cases are given below： Overhead to which the basis applies Basis Rent, rates, heating and light, repairs and depreciation of buildings Floor area occupied by each cost centre Depreciation, insurance of equipment Cost or book value of equipment Personnel office, Canteen, Welfare, Wages and cost offices, First aid Number of employees, or labour hours worked in each cost centre

3. Step 2- Reapportionment of service cost centre overhead Service cost centre costs may be apportioned to production cost centres. All service department costs must be allocated. Direct method (直接分配法） Step-down method （阶梯分配法） Reciprocal method （交互分配法）

3.2 Reciprocal method - Repeated distribution Reciprocal method is used only when service departments work for each other-that is, service departments use each other's services.

3.3 Reciprocal method – algebraic method

4. Step 3 – Absorption of overheads into production (cost units) All of the production overhead costs have now been apportioned to the production cost centres. We now need to charge these to the cost units. This is termed overhead absorption (Overhead recovery). i.e., add overhead to , or absorb them into, cost unit.

4.1 Calculation of overhead absorption rates (OAR) Production overhead OAR = Activity level

4.2 Choosing the activity (a) Per unit (b) Per labour hour (c) Per machine hour (d) % of direct labour cost (e) % of direct materials cost (f) % of prime cost Main methods used in exam

4.3 Process of absorption into cost units Calculate the overhead absorption rate using an appropriate activity level Find the activity level per unit (e.g. machine hours per unit) and then apply the OAR calculated to the specific unit. OAR per unit = OAR per machine hour x machine hours per unit Repeat for all production cost centres.

The most appropriate activity for mixing department is labour hours as it is labour intensive department. The most appropriate activity for mixing department is machine hours as it is machine intensive department.

1.2 Absorption costing steps Total production cost Direct costs Indirect costs More difficult to link to unit so we need a methodology Be easily to linke directly to unit and put in cost card Absorption costing Step 1 Step 2 Step 3 Cost Centres 产品 A 产品B 服务 产品 A 产品B Cost unit

5. Is absorption costing necessary? In absorption costing, overhead costs will be added to each unit of product manufactured and sold. The theoretical justification for using absorption costing is that all production overheads are incurred in the production of the organisation's output and so each unit of the product receives some benefit from these costs. Each unit of output should therefore be charged with some of the overhead costs.

The main practical reasons for using absorption costing are for inventory valuations, pricing decisions, and establishing the profitability of different products. Absorption costing is recommended in financial accounting by IAS 2 （International Accounting Standard 2） Inventories. IAS 2 deals with financial accounting systems. IAS 2 states that costs of all inventories should comprise those costs which have been incurred in the normal course of business in bringing the inventories to their 'present location and condition'. In other words, in financial accounting, closing inventories should be valued at full factory cost, and it may therefore be convenient and appropriate to value inventories by the same method in the cost accounting system.

6. Predetermined overhead absorption rates Overheads are usually added to cost units using a predetermined overhead absorption rate, which is calculated using figures from the budget. Businesses need to cost their production throughout the year, not at the end of an accounting period. Therefore they predetermine or estimate their absorption rates for the year.

Budgeted overhead Pre-determined OAR = Budgeted activity level Overhead absorbed Predetermined OAR = Actual activity x

Overheads absorbed may differ from actual overhead costs incurred for either or both of the following two reasons: Actual expenditure was more or less than budget (expenditure variance). Actual units produced (i.e. volume) were more or less than budget (volume variance). Over absorption Under absorption

IAS 2 Inventories states that the activity level used for absorption of overheads should always be the budgeted (normal) activity, i.e. the expected long term average. This is to stop fluctuations in OAR’s due to fluctuations in activity. It is almost inevitable that at the end of the accounting year there will have been an over absorption or under absorption of the overhead actually incurred. The difference between the overhead absorbed and the actual overhead is shown in the I/S （Income Statement ，损益表） so that in total the actual overhead is charged. The actual overhead is equal to the amount absorbed plus an under absorption or minus an over absorption.

7. Blanket absorption rates and departmental absorption rates Used throughout the factory and for all jobs and units of output Separate absorption rates Used for each department

Chapter roundup 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 in full to the product, service or department. The objective of absorption costing is to include in the total cost of a product an appropriate share of the organisation's total overhead. An appropriate share is generally taken to mean an amount which reflects the amount of time arid effort that has gone into producing a unit or completing a job. The main reasons for using absorption costing are for stock valuations, pricing decisions and establishing the profitability of different products,

The three stages of absorption costing are: - Allocation - Apportionment - Absorption Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre. Apportionment is a procedure whereby indirect costs are spread fairly between cost centres. Service cost centre costs may be apportioned to production cost centres by using the reciprocal method. 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 called overhead recovery.

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 were produced. Over and under absorption of overheads occurs because the predetermined overhead absorption rates are based on estimates.