Topic 5

Overhead

© 2000 Colin Drury

Part Two:
Cost accumulation for inventory
valuation and profit measurement

Chapter Three:
Cost assignment

© 2000 Colin Drury

Overhead absorption costing

A method for sharing overheads

between a number of different
products or services on a fair basis.
Indirect costs = Overheads
 Costs that are assigned to cost objects can be
divided into two categories – direct costs and
indirect costs.

 The term, overheads is sometimes used for

indirect costs.
Cost Tracing/Cost Allocation
 Cost tracing - where a cost can be directly
assigned to a cost object

 Indirect costs cannot be traced directly to a

cost object-usually common to several cost
objects. Therefore assigned to cost objects
using cost allocations.
3.1a

Assignment of direct and indirect costs

• Direct costs can be specifically and exclusively identified with a

given cost object – hence they can be accurately traced to cost
objects.

• Indirect costs cannot be directly traced to a cost object – therefore

assigned to cost objects using cost allocations.

• Cost allocations = process of assigning costs to cost

objects that involve the use of surrogate rather than direct
measures.
• Surrogates known as allocation bases or cost drivers.
• For accurate cost assignment,allocation bases should be
significant determinants of the costs (i.e.cause-and-effect
allocations).
© 2000 Colin Drury
Overhead Absorption
 Two types of systems can be used to assign
indirect costs to cost objects

(1) Traditional costing system and

(2) Activity Based Costing (ABC)

systems (to be covered later).
3.3a

© 2000 Colin Drury

3.3b

© 2000 Colin Drury

The Allocation Process
 Overheads are assigned to production and
service cost centers.
 Reallocate the costs assigned to service cost
centers to production cost centers;
 Compute the separate overhead rates for each
production cost centre
 Assign the cost centre overheads to products
or other chosen cost objects.
Service cost centers
 Exist to provide services of various kinds to
other units within the organization.
 Sometimes called support departments. Render
essential services that support the production
process.
 The method that is chosen to allocate service
centre costs to production centre should be
related to the benefits that the production
centers derive from the service rendered.
Example 1
 The following relevant costs data for production departments A and B and
service department S have been budgeted:
Production Dept. Service Dept. Total
A B S
Indirect wages 5,000 3,000 10,000 18,000
Depreciation 6,000
Personnel 4,000
Rental charges 8,500
Machine hours 800 100 40
Direct labor hours 250 500
Floor area (sq. ft) 5,500 3,600 1,500
Fixed Assets value ($) 12,000 7,000 2,000
Employees (No.) 45 25 12

Prepare an overhead analysis sheet which demonstrates the cost of the

production departments. Service department costs to be allocated in the ratio
of 3:5
Answer 1
 Overheads Basis Total A B S
 Indirect Wages Given 18,000 5,000 3,000 10,000
 Depreciation Asset 6,000 3,428 2,000 572
 Personnel Emp. 4,000 2,196 1,219 585
 Rental charges Floor 8,500 4,410 2,887 1,203
 Total 36,500 15,034 9,106 12,360
 Service alloc. 3:5 4,635 7,725 0
 Total 36,500 19,669 16,831
3.6b
Figure 3.3 (a) An illustration of the two-stage allocation process for traditional
costing systems

© 2000 Colin Drury

3.8a
The annual overhead costs for a company which has three production centres
and two service centres (Materials procurement and General factory support)
are as follows:

© 2000 Colin Drury

3.8b
The following information is also available

© 2000 Colin Drury

3.9a

© 2000 Colin Drury

3.9b

© 2000 Colin Drury

3.10

© 2000 Colin Drury

Allocation bases/cost drivers
 Direct Machine hours
 Direct Labor hours

 Direct Wages percentage

 Units of Output

 Direct Materials percentage

 Prime Cost percentage

Example 3
 The budgeted overheads for a department for the next
accounting period are $200,000. The following information
is available for the period:
 Estimated direct wages $250,000
 Estimated direct material $100,000
 Estimated output 10,000 units
 Machine hours 4,000
Labor hours 3,000
 Calculate the overhead absorption rates above using
machine hours, labor hours, direct wages percentage
method, units of output method, direct materials
percentage method and prime cost percentage method.
Answer 3
 Machine hours: 200,000/4,000 = $50 p hr.
 Labor hours: 200,000/3000 = $66.67 p. hr.

 D W percentage: 200,000/250,000 = 80%

 Units of Output: 200,000/10,000 = $20 p.u.

 D Materials %: 200,000/100,000 = 200%

 Prime Cost %: 200,000/350,000 = 57.14%

3.4a

Assigning indirect costs using blanket overhead rates

• Some firms use a single overhead rate (i.e.blanket or plant-wide) for

the organization as a whole.

Example
Total overheads = £900 000
Direct labour (or machine hours) = 60 000
Overhead rate = £15 per hour

© 2000 Colin Drury

3.4b
• Assume that the company has 3 separate departments and costs and hours are
analysed as follows:

• Product Z requires 20 hours (all in department C)

Separate departmental rates should be used since product Z only consumes

overheads in department C.

© 2000 Colin Drury

3.4c

• A blanket overhead rate can only be justified if all products consume

departmental overheads in approximately the same proportions:

Product X spends 1 hour in each department and product Y spends 5

hours in each department (Both blanket and departmental rates would
allocate £45 to X and £225 to Y).

• If a diverse range of products are produced consuming departmental

resources in different proportions separate departmental (or cost
centre)rates should be established.

© 2000 Colin Drury

3.5

Cost centre overhead rates

• Where a department contains a number of different centres (each

with significant overhead costs)and products consume overhead
costs for each centre in different proportions,separate overhead rates
should also be
established for each centre within a department.

• See example on page 63 of text for an illustration.

• The terms cost centres or cost pools are used to describe allocation
to which overhead costs are initially assigned.

• Frequently cost centres/cost pools will consist of departments but

they can also consist of smaller segments within departments.

© 2000 Colin Drury

Budgeted overhead rates
 The calculation of overhead rates based on the
actual overheads is not feasible - delay the
calculation of product costs until the end of the
accounting period.
 However, information on product costs is
required quickly - for monthly profit calculations
and inventory valuations or as a basis for setting
selling prices.
 Therefore, it is preferable to establish a budgeted
overhead rate based on annual estimated
overhead expenditure and activity.
Overhead Absorption Rate
Calculation is based on:

Budgeted overheads divided by

Budgeted hours

OAR = (Budgeted overheads/Budgeted

hours)
3.13

Budgeted overhead rates

• Actual overhead rates are not used because of:

1.Delay in product costs if actual annual rates are used.
2.Fluctuating overhead rates that will occur if actual monthly rates are
used.

© 2000 Colin Drury

(Under)/Over-Recovery Overheads
 The effect of calculating overhead rates based on
budgeted annual overhead expenditure and
activity is that it will be most unlikely that the
overhead allocated to products manufactured
during the period will be the same as the actual
overhead incurred.
 The under or over-absorption is calculated by
comparing the actual overhead incurred and the
overhead absorbed.
Example 4
 Estimated annual fixed overheads $2,000,000
 Actual overheads incurred is also $1,850,000
 Estimated annual activity 800,000 direct labor hours.
 Actual direct labor hours 900,000

 Calculate the under or over recovery of overhead above.

Answer 4
 OAR = 2,000,000/800,000 = $2.50
 Actual charged to production = (900,000
x2.50) = $2,250,000
 Actual OH incurred = $1,850,000
 Therefore, (2,250,000 – 1,850,000) = $400,000
is the over recovery or over absorption of OH.

 Note: Under/Over recovery of OH is treated as

a period cost and w/off to P/L account
3.14

Under-and over recovery of overheads

•If actual activity or overhead spending is different from that used to

compute the estimated overhead rates there will be an under or over
recovery of fixed overheads.

Example

Estimated fixed overheads = £2 million

Estimated activity = 1 million direct labour hours
Overhead rate = £2 per DLH

© 2000 Colin Drury

3.14

• Assume actual activity is 900 000 DLH ’s and actual overheads are
£2 million:

Overhead allocated to products = £1.8 million

(900 000 × £2)
Under-recovery = £200 000

• Assume actual overheads are £1 950 000 and actual activity is 1

million DLH ’s:

Overhead allocated to products = £2 million

(1 million ×£2)
Over-recovery = £50 000

• External financial accounting principles (GAAP) require that

under/over recoveries are treated as period costs.

© 2000 Colin Drury

Example 4
 Estimated annual fixed overheads $2,000,000
 Actual overheads incurred is also $1,850,000
 Estimated annual activity 800,000 direct labor hours.
 Actual direct labor hours 900,000

 Calculate the under or over recovery of overhead above.

Answer 4
 OAR = 2,000,000/800,000 = $2.50
 Actual charged to production = (900,000
x2.50) = $2,250,000
 Actual OH incurred = $1,850,000
 Therefore, (2,250,000 – 1,850,000) = $400,000
is the over recovery or over absorption of OH.

 Note: Under/Over recovery of OH is treated as

a period cost and w/off to P/L account
Example 5
 A company uses a a predetermined overhead recovery
rate based on machine hours. Budgeted factory
overhead for a year amounted to $720,000, but actual
factory overhead incurred was $738,000. During the
year, the company absorbed $714,000 of factory
overhead on 119,000 actual machine hours.

 What was the company’s budgeted level of machine

hours for the year?
Answer 5
 OH absorbed = Act. Hrs. x OAR
 OAR = OH absorbed / Act. Hrs
 = 714,000 / 119,000 = $6.00

 Bud. OH = Bud m/c hrs x OAR

 Bud m/c hrs = Bud OH / OAR
 = 720,000 / 6
 = 120,000 hrs
Example 6
 A company absorbs overheads on machine
hours which were budgeted at 11,250 with
overheads of $258,750. Actual results were
10,980 hours with overheads of $254,692.

 How much are overheads under or over-

absorbed?
Answer 6
 OAR = Bud OH / Bud hrs
 = 258,750 / 11,250 = $23
 OH absorbed = Act Hrs X OAR

 = 10,980 x 23 = 252,540
 OH incurred = 254,692

 Therefore, under/over recovery = OH absorbed

– OH incurred = 254,692 -252,540 = 2,152
under recovery
Calculation of product cost
and profit
Example 1
 A company makes and sells 100 units of a
product . The prime cost per unit is $6 and the
unit sales price is $10. Production overhead
costs $200 and Administration costs is $150.

 The Profit and Loss can be calculate in 2 ways.

Answer 1(a)

 Sales (100 x 10) 1,000

 Prime costs (100 x 6) 600
 Production overheads 200
 Administration costs 150
950
 Profit 50
Answer 1(b)
 Prime cost per unit 6
 Production overhead 2
 Full factory cost 8

 Sales 1,000
 Less factory cost of sales 800
 Gross profit 200
 Less administration costs 150
 Net profit 50