OVERHEADS

1 OVERHEADS

1.1 Terminology

• Overheads are costs that cannot be charged directly to cost units, and must be therefore shared on an equitable basis

1.2 Allocation, apportionment and absorption

Most businesses assign overheads to products by

• allocation and apportioning overheads to cost centres, and

• absorbing costs accumulated in cost centres into cost units

1.2.1 Allocation

• Charging to a cost centre those overheads that result solely from its existence, eg

Cost centre	Allocated cost
Canteen Packing department	Coffee, sugar, wages of catering staff Packing materials and labour

1.2.3 Apportionment

• When an overhead is common to more than one cost centre it must be shared out or split on an equitable basis, eg

Cost	Possible bases of apportionment
Rent & rates Light & heat Insurance of stocks	Square metres occupied by departments Cubic capacity or metered usage Value of stock holding at each location

1.2.4 Absorption

• Attributing the overheads accumulated by a cost centre to the cost units passing through it, eg

Illustration 1

Pocket calculators manufactured in a single production dep^t with £15,000 overheads. Planned production is 5,000 units
overhead absorption rate per unit = = £3/unit

1.3 Absorption bases

1.3.1 Absorption per unit

• As illustrated above – is appropriate if only one type of unit is produced by a cost centre.

1.3.2 Absorption per labour hour

• Appropriate where more than one type of unit is produced each taking a different amount of time.

Illustration 2

Sam produces calculators and computers in one production department, with £15,000 overheads. He has planned production of 3,000 calculators each taking 1 hour, and 2,000 computers each taking 6 hours.

Solution

• This is a fairer method of absorbing the overhead as it recognises the greater time taken to produce a computer rather than a calculator.

1.3.3 Alternative bases

• Per kg of material used.
• Per machine hour.
• Percentage of material cost (also labour cost or prime cost).

Example 1

Production data

Other information

Sofas and chairs pass through two production cost centres; the Assembly department and the Trimming department. A sofa takes 24 hrs in the Assembly department and 18 hrs in the Trimming department. A chair takes 9 hrs in the Assembly department and 8 hrs in the Trimming department.

Labour rates in both departments are the same.

The Assembly department occupies approximately three quarters of the area of the factory.

The production manager, on average, spends twice as long supervising the 30 workers in the Assembly department as he does supervising the 70 workers in the Trimming department.

The written down value of the equipment in the Assembly department and the Trimming department is £104,500 and £115,500 respectively.

Materials storage costs should be allocated two fifths to Assembly and three fifths to Trimming.

Required

(a) Using appropriate bases, allocate and apportion total overheads between the
two cost centres.

(b) Calculate the overhead absorption rate per unit (based on direct labour
hours).

2 SERVICE DEPARTMENTS

2.1 Overview

2.2 Apportionment (secondary)

• Some cost centres do not have production units passing through them. They exist simply to service other cost centres (eg quality control department).
• Before absorption into cost units can be carried out, the total costs of the service cost centres must be reapportioned to production cost centres.
• This secondary apportionment should be done on a fair basis to reflect the benefit derived from the service centre.

Example 2

A firm has two production departments and two service departments. It makes two products and its total overhead bill for the year is as follows.

The following statistics are available.

Required-carry out the allocation and apportionment procedure

STEP 2(b) – Reapportion service department costs to production cost centres (secondary apportionment)

Usage of service department costs is estimated as

A situation of reciprocal services is apparent.

3 treatments are possible:

• Direct method
• Step-down method
• Reciprocal method– 2 methods

2.3 Direct method

• Reciprocal services (if any) are ignored. The service department costs are reapportioned to production departments only.

	Pressing	Assembly	Canteen	Maintenance
	£	£	£	£
	15,000	26,000	8,000	9,000
Canteen (50:30)			(8,000)
Maintenance (55:40)				(9,000)
	———	———	———	———
			–	–
	———	———	———	———

2.4 Step (down) method

• Services that do most work for other service departments are allocated first. Reciprocal services (if any) are then ignored.

	Pressing	Assembly	Canteen	Maintenance
	£	£	£	£
	15,000	26,000	8,000	9,000
Canteen (50:30:20)
	———	———	———	———
Maintenance (55:40)
	———	———	———	———
			–	–
	———	———	———	———

2.5 Reciprocal methods

• Reciprocal services are fully recognised. May be solved by continuous re-apportionment or algebraically.

2.5.1 Continuous re-apportionment

	Pressing	Assembly	Canteen	Maintenance
	£	£	£	£
	15,000	26,000	8,000
Canteen (50:30:20)
			———	———
Maintenance (55:40:5)
			———	———
Canteen (50:30:20)
			———	———
Maintenance (55:40:5)
			———	———
Canteen (50:30:20)
	———	———	———
	———	———

STEP 3

The firm’s two products have the following direct costs per unit.

Production volume is 1,000 units of A and 2,000 units of B.

It has been decided to absorb overheads into products on the basis of labour hours.

Required

Calculate the overhead costs of the two products.

Note: A reciprocal method must be used for reciprocal services unless told otherwise.

3 ABSORPTION

3.1 Departmental rates

• Are calculated, as above, by the "two-stage" process of
• allocating and apportioning overheads to cost centres
• absorbing costs into cost centres.
• Non-machine departments – direct labour hours.
• Machine departments – machine hour rate.

3.2 Blanket rate

• A single overhead rate computed for the entire factory by omitting the first of these two stages.
• Not a satisfactory method where a factory consists of a number of different production centres and products consume cost centre overheads in different proportions.
• Cost units passing through centres with high overhead costs (eg machine shops) will be undercosted
• Those passing through low overhead centres (eg an assembly department) will be overcosted.
• May be used where they are an approximation to departmental rates as they simplify product cost calculations

4 ACTIVITY-BASED COSTING

4.1 Attributes

• A more refined approach to assigning overheads to products and calculating product costs.
• Provides product cost information more relevant to decision-making purposes than absorption costing.
• Recognises that in the long run most manufacturing costs are not fixed.
• Assumes that activities cause costs and that products (and customers) create demand for activities.

4.2 Overview of system

Illustration 3

Required

Calculate the production overhead to be absorbed by one unit of A and B using

(i) a traditional costing approach using labour hour rates to absorb overheads
(ii) an ABC approach, using suitable cost drivers to trace overheads to products.

Solution

(i) Traditional approach

Direct labour hour rate = = £15 per hour

ie	A	£15 1 = £15 per unit
	B	£15 2 = £30 per unit

WORKING

Total labour hours: A (5,000 1) + B (7,000 2) = 19,000

(ii) ABC approach

• Driver costs

Machine-hour driver costs	£220,000/22,000 (W) = £10/machine hour
Set-up driver costs	£20,000/50 set-ups = £400/set up
Order driver costs	£45,000/75 orders = £600/order

WORKING

Total machine hours

A (5,000 3)

+

B (7,000 1) = 22,000 hrs

• Overhead absorbed

			A			B
Machine driver costs	(15,000 £10)		150,000	(7,000 £10)		70,000
Set-up costs	(10 £400)		4,000	(40 £400)		16,000
Order driver costs	(15 £600)		9,000	(60 £600)		36,000
			_______			_______
			163,000			122,000
			_______			_______
Overhead cost per unit		= = £32.60			= = £17.43

• Comparison

	A	B
(i) TAC	£15	£30
(ii) ABC	£32.60	£17.43
Change	117%	41.9%

5 ACCOUNTING FOR OVERHEADS

5.1 Predetermined

• As firms often need to know overhead costs per unit in advance they employ predetermined overhead absorption rates, ie

• This can lead to discrepancies between the amount absorbed and the amount spent (called over/(under) absorption – see below).

5.2 Under/over-absorption of manufacturing overheads

Illustration 4

Continuing with Example 2, the following figures applied to the assembly department.

Solution

Predetermined absorption rate = = £8.211 per direct labour hour

	£
Actual overhead incurred Overhead absorbed (recovered) Actual hours Predetermined absorption rate (4,200 £8.211) Under-absorption	35,742 34,486 _____ 1,256 _____

• Under/(over) absorbed overhead is debited/(credited) to the P&L a/c.
• If too little overhead has been absorbed, the under-absorption is deducted from profit.
• If too much overhead has been absorbed into production, the over-absorption must be added back to profit.
• In no circumstances should any under/(over) absorption be included in the overheads of following periods.

5.3 Non-manufacturing

5.3.1 Selling overheads

• Benefit received by a cost unit is usually in proportion to its value
• Selling overhead rate =

  100%

5.3.2 Distribution overheads

• A distribution department is very similar to a production department in that there is
• direct materials – eg packing cases, air products
• direct labour – eg packers and van drivers
• direct expenses – eg freight
• departmental overhead – eg supervision, light & heat
• machinery – fork lift trucks, vehicles, etc.
• Therefore can be treated similarly.

5.3.3 Administration overheads

• So unrelated to production and selling that any basis of apportionment is very artificial, eg
• apportion between production, distribution and selling departments
• further apportion within departmental analyses based on number of employees.

EXAMPLE SOLUTIONS

Solution 1 – Allocation, apportionment, absorption of overheads

(a) Overhead

	Basis	Ratio	Assembly	Trimming
			£	£
Canteen	No of employees	30:70	1,230	2,870
Machine dep^n &
machine repairs	WDV	104.5:115.5	1,045	1,155
Rent and rates	Area	3:1	4,725	1,575
Prod man’s salary	Time spent	2:1	4,800	2,400
Heat and light	Area	3:1	2,400	800
Materials storage	Allocation	2:3	800	1,200
			______	______
			15,000	10,000
			______	______

WORKINGS

(1) Assembly – overhead absorption rate

Total direct labour hours:

		Hours
Sofas	100 × 24 =	2,400
Chairs	400 × 9 =	3,600
		_____
		6,000
		_____

Absorption rate = = £2.50 per direct labour hour.

(2) Trimming – overhead absorption rate

Total direct labour hours:

		Hours
Sofas	100 × 18 =	1,800
Chairs	400 × 8 =	3,200
		_____
		5,000
		_____

Absorption rate = = £2.00 per direct labour hour.

(b) Overhead rate per unit

		£
Sofas:	Assembly 24 × 2.50 (W1) =	60.00
	Trimming 18 × 2.00 (W2) =	36.00
		_____
		96.00
		_____
Chair:	Assembly 9 × 2.50 =	22.50
	Trimming 8 × 2.00 =	16.00
		_____
		38.50
		_____

Solution 2 – Service departments

"Step 2(a)" – Primary apportionment

Overhead	Total	Basis	Pressing	Assembly	Canteen	Maintenance
	£		£	£	£	£
Rent	20,000	Area	5,000	10,000	2,000	3,000
Machine Dep’n	10,000	Value	1,000	5,000	1,000	3,000
Buildings	8,000	Area	2,000	4,000	800	1,200
Electricity	5,000	KW hrs	2,000	2,000	500	500
Indirect materials	15,000	Allocation	5,000	5,000	3,700	1,300
			______	______	_____	_____
			15,000	26,000	8,000	9,000
			______	______	_____	_____

"Step 2(b)" – Secondary apportionment

Direct method

	Pressing	Assembly	Canteen	Maintenance
	£	£	£	£
	15,000	26,000	8,000	9,000
Canteen (50:30)	5,000	3,000	(8,000)
Maintenance (55:40)	5,211	3,789		(9,000)
	———	———	———	———
	25,211	32,789	–	–
	———	———	———	———

Step (down) method

	Pressing	Assembly	Canteen	Maintenance
	£	£	£	£
	15,000	26,000	8,000	9,000
Canteen (50:30:20)	4,000	2,400	(8,000)	1,600
	———	———	———	———
	19,000	25,400	–	10,600
Maintenance (55:40)	6,137	4,463		(10,600)
	———	———	———	———
	25,137	32,863	–	–
	———	———	———	———

Reciprocal methods

Continuous re-apportionment

	Pressing	Assembly	Canteen	Maintenance
	£	£	£	£
	15,000	26,000	8,000	9,000
Canteen (50:30:20)	4,000	2,400	(8,000)	1,600
			———	———
			–	10,600
Maintenance (55:40:5)	5,830	4,240	530	(10,600)
			———	———
			530	–
Canteen (50:30:20)	265	159	(530)	106
			———	———
			–	106
Maintenance (55:40:5)	58	42	6	(106)
			———	———
			6
Canteen (50:30:20)	3	3 (say)	(6)
	———	———	———
	25,156	32,844
etc	———	———

Algebraic (simultaneous equations)

Let x be the total cost of canteen service department

Let y be the total cost of maintenance service department

x = 8,000 + 0.05y

y = 9,000 + 0.20x

—————————

Rearranging

x – 0.05y = 8,000 (1)

– 0.20x + y = 9,000 (2)

Multiply (1) by 0.2

0.20x – 0.01y = 1,600 (3)

– 0.20x + y = 9,000 (2)

——————————

Add: 0.99y = 10,600

y =

y = £10,707

———

Substitute into (1)

x – 535 = 8,000

x = £8,535

————————

	Pressing	Assembly	Canteen	Maintenance
	£	£	£	£
	15,000	26,000	8,000	9,000
Canteen (50:30:20)	4,267	2,561	(8,535)	1,707
Maintenance (55:40:5)	5,889	4,283	535	(10,707)
	———	———	———	———
	25,156	32,844	–	–
	———	———	———	———

"Step 3" – Absorption

				Pressing	Assembly
Overhead				£25,156	£32,844
Direct Labour hours	A	1,000 units 3 hrs		3,000
		1,000 units 2 hrs			2,000
	B	2,000 units 2 hrs		4,000
		2,000 units 1 hr			2,000
				———	———
				7,000	4,000
				———	———
Rate per hour			= £3.59		= £8.21

Overhead cost per unit		A	B
Pressing	3 hrs £3.59	10.77
	2 hrs £3.59		7.18
Assembly	2 hrs £8.21	16.42
	1 hr £8.21		8.21
		_____	_____
Overhead cost per unit		27.19	15.39
		_____	_____