Overheads

Overheads Overhead includes a large number of types of indirect costs Direct cost are identifiable to cost units, but overhead which are often considerable, cannot be related directly to cost units

Two-stage method to allocate overhead to products Overheads are assigned to the cost centres such as department An allocation base is selected for allocating production centre expenses to products

Procedures of overhead allocation to product Assign all factory overheads to cost centres Reallocate service-centre overheads to production cost centres Calculate separate overhead absorption rate for each cost centre Assign cost-centre overhead to products

Assign all factory overheads to cost center

Assign all factory overhead to cost centres Cost allocation Cost apportionment

Cost allocation Where a cost can be clearly identified with a cost center or cost unit, then it can be allocated to that cost center or cost unit

Cost apportionment It is not possible to identify a discrete item of cost with a cost center and it is necessary to split a cost over several cost centers on some agreed basis

Bases of apportionment Apportionment of indirect expenses to cost centers must be made on fair and reasonable bases Different types of expense require different bases according to their individual characteristics

Rent and rates, heat and lighting, insurance of lighting Base of apportionment Costs Area Rent and rates, heat and lighting, insurance of lighting Machine value Depreciation, machine insurance No. of employees Wages of supervisors, canteen cost Example textbook P.183

Reallocate service-center overheads to production center

Reallocate service-centre overheads to production cost centres Service departments are not directly involved in production They only support service to other production departments in order to facilitate the production process Therefore, it is necessary to reallocate the service-centre overheads to production departments so that all production costs can be absorbed into production. Typical bases are listed as follows:

Typical bases are listed as follows: Service departments Possible bases of apportionment Maintenance Maintenance labour hours, machine value Stores Value or weight of materials issued, number of requisitions inspection No. of employees, no. of jobs Example textbook P.183

Calculate separate overhead absorption rate for each cost center

Calculate separate overhead absorption rate for each cost centre To determine the overheads to be absorbed by a cost centre, it is necessary to establish an overhead absorption rate (OAR) Total overhead of cost centre OAR = Total number of units of absorption base applicable to cost centre

Some commonly used absorption bases are listed as follows: An appropriate OAR should reflect the effort or time taken to produce the products Some commonly used absorption bases are listed as follows: Direct labour hours It is frequently used in the labour intensive department because overheads assigned to this department are closely related to the direct labour hours worked Machine hours It is most appropriate for the appropriate for the machining department since most of the overheads are closely related to machine hours

Direct wages It is only suitable in the department where the uniform wage rate is applied Direct materials This method is not recommended unless the majority of overheads incurred in a department are related to materials instead of time Units of output This method is suitable only where all units produced in a period are identical in the production process and time. Therefore, this application is very rare Example textbook P.183

Refer to textbook P.183 and P.184 Example 1 Refer to textbook P.183 and P.184

O/H Apportionment Total Production dept. Service dept. item Basis Maching Assembly Finishing Stores Maintenance $000 $000 $000 $000 $000 $000 Indirect Actual 727 200 199 185 20 123 material Indirect Actual 510 200 200 80 10 20 wages Rent& Area 200 40 20 60 60 20 Rates Machine Machine 30 16 10 2 1 1 Insurance Value Dep. Machine 300 160 100 20 10 10 Value Heat & Area 100 20 10 30 30 10 Light Production No. of 160 48 32 48 16 16 Supervisor Employees 2027 684 571 425 147 200

O/H Apportionment Total Production dept. Service dept. item Basis Maching Assembly Finishing Stores Maintenance $000 $000 $000 $000 $000 $000 2027 684 571 425 147 200 Reallocation of service-centre overheads Stores Materials issued 100 40 7 (147) Maintenance Maintenance 100 60 40 (200) Work 2027 884 671 472 - -

Calculation of overhead absorption rates: Maching Assembly Finishing Overhead absorption basis Machine hours Labour hours Overhead absorption rates $884000/200000 hrs = $4.42/hr $671000/100000 hrs = $6.71 /hr $472000/40000 hrs = $11.8/hr

Assign cost-center overhead to products

Assign cost-centre overheads to products The final step is to charge the overheads to the products passing through the production departments

Example

The facts are the same as those in Example on slide no. 18 The facts are the same as those in Example on slide no. 18. The number of hours needed to finish the products are listed as follows: Departments Product A Product B Machining 4 hours 5 hours Assembly 2 hours 1 hour Finishing 1/10 hour

Departments Product A $ Machining 4 hours at $4.42 per mach. hr. 17.68 Assembly 2 hours at $6.71 per mach. hr. 13.42 Finishing 1/10 hour at $11.88 per labour hr. 1.19 Total overhead charged per unit 32.29 Departments Product A $ Machining 5 hours at $4.42 per mach. hr. 22.10 Assembly 1 hours at $6.71 per mach. hr. 6.71 Finishing 1/10 hour at $11.88 per labour hr. 1.19 Total overhead charged per unit 30.00

Predetermined overhead absorption rates (POAR)

Predetermined overhead absorption rates (POAR) The overhead absorption rates are usually computed in advance of operations In practice, most absorption rates are only predetermined because the actual overheads are not known until the end of the period If the actual overheads are used to compute the OAR, the product cost can only be obtained at the end of the accounting period A delay in product cost calculation will also affect the pricing setting, the profit calculation and stock valuation

The formula of POAR The formula are as follows: Budgeted total overheads POAR = Budgeted total number of units of absorption base

Under-absorption and over-absorption base Since the POAR are based on the estimated production and estimated overheads, the overheads absorbed seldom agree with the actual overheads incurred for the period Under-absorption occur when overhead absorbed are small than the actual overheads Over-absorption occurs when the overhead absorbed are greater than actual overheads

For financial accounting, under- or over-absorption of overheads should be treated as period cost and written off against the profit and loss account in the current accounting period The under- or over-absorption of overheads should be debited or credited to the profit and loss account The under-absorbed overheads should be deducted from profit and vice versa

Example

Example Estimated annual overheads $400 Estimated machine hours 200 machine hour POAR = $400 200 hrs = $2 per machine hour

Product 1 Product 2 Product 3 Product 4 $400 $300 $500 250 hrs 160 hrs Actual overheads incurred $400 $300 $500 Actual machine hours 250 hrs 160 hrs 200 hrs Overhead absorbed Under- or over-absorption $2 * 250 hrs = $500 $2 * 160 hrs = $320 $2 * 200 hrs = $400 $2 * 200 hrs = $400 Over-absorbed $100 Under- absorbed $80 Over- absorbed $100 Under- absorbed $100s

Blanket Overhead Rate

Blanket overhead rate According to the overhead allocation procedure, the overheads are allocated to departments and each department calculate its own OAR and allocate the overheads to products passing through that department Alternatively, some firms do not assign overheads to departments. Rather, they adopted a single overhead rate, i.e. a blanket overhead rate, that is assigned to all products produced within the whole factory

The use of the blanket overhead rate is not recommended as many products are produced in different production centres, and products consume cost-centre overheads in different proportions

Example

The annual overhead costs of a factory with three production departments are shown as follows: Dept. A Dept.B Dept. C Total Overheads $20000 $400000 $180000 $600000 Direct machine hours 100000 300000 Departmental overhead rate per direct machine hour $0.2 $4 $1.8 Blanket overhead rate pre machine hour $2

If the production of product X only requires 10 direct machine hours in department A, the overheads absorbed will be computed as follows: Using departmental overhead rate Using blanket overhead rate Overhead absorbed $0.2 *10 = $2 $2 *10 = $20 In this example, the production of product X does not consume Large amounts of overheads in department B and C. Therefore, there will be over-absorption of overheads if the blanket overhead rate is used