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Introduction to Cost & Management Accounting –ACCT 1003 (MS15B)
OVERHEADS
Overheads are those costs that cannot be traced directly to a cost object e.g. supervisor’s salary,
rent and rates, electricity expense, indirect material, and indirect labour costs. Overheads fall into
two broad categories:
a)
b)
Production overhead costs
Non-production overhead costs
Production overhead costs include indirect material costs e.g. lubricants for machinery, indirect
labour such as wages and salaries of foremen, timekeepers and inspectors, and indirect expenses
such as factory light and power and depreciation of plant and machinery.
Non-production overhead costs consist of selling and distribution expenses relating to the
activities of the sales department and administrative expenses relating to management and
clerical staff.
Production overheads are allocated for:
i)
Determining cost of production. IAS 2 recommends that production overhead costs be
included with prime cost when preparing published accounts.)
ii)
Making pricing decisions e.g. quotation on jobs.
iii)
Determining profitability of different products. To determine profits costs must first
be determined.
Cost Allocation v Cost Apportionment.
Overhead allocation refers to the process of assigning a specific overhead cost to a cost centre
e.g. maintenance cost to the maintenance department. A cost centre is a responsibility centre,
where managers are accountable for expenses that are under their control. A department for
example is deemed to be a cost centre. Cost centres are usually either production or service
departments e.g. assembly department, maintenance department, canteen and legal department.
Cost centres usually incur expenses but do not generate revenues.
Overhead apportionment refers to the process of sharing among two or more cost centres
overhead costs that cannot be allotted to a particular cost center e.g. rent and rates which cannot
be allocated in full to any one cost center and so must be apportioned on some equitable basis.
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Unlike DM, DL and DE that apply to specific jobs, manufacturing overhead relates to the
production operation as a whole. These overhead costs therefore cannot be assigned to a specific
product or job on the basis of actual costs incurred. Most companies allocate overheads to
products using a two-staged procedure. In the first stage overheads are assigned to the cost
centers; while in stage two, these assigned overhead costs are passed on to products using
overhead absorption rates (OARs). Overheads are passed on to products using some allocation
base or cost driver. The most popular bases are direct labour hours, direct labour cost and
machine hours. These bases are also referred to as traditional cost drivers. OARs are calculated
by dividing the total budgeted overheads in each cost center by the total budgeted units of the
cost driver. Overhead expenses are then passed on to the products by multiplying the OAR by
the allocation base consumed by the product.
Calculating Overhead Absorption Rates (Summary)
1.
Assign factory overheads to production
assigned using some equitable bases.
Example:
COST
Rent and rates
Supervisory salaries
Canteen costs
Depreciation and insurance of machinery
Material handling
and service cost centres. Overheads are
BASIS
Floor space
Number of employees
Number of employees
Machinery value
Weight of material
2.
Re-allocate service cost centre costs to the production cost centres.
3.
Identify the cost driver for each production cost centre.
4.
Calculate overhead rates for each cost centre by dividing the total budgeted overheads
by the units of the cost driver.
5.
Assign cost centre overheads to products using the rates calculated.
Overhead Costs
Summary Diagram
A
A
B
B
C
C
Allocation &
Apportionment
Product
Calculate OARs
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Example
i)
Total overheads allocated to cost centre
$100,000
ii)
Allocation base/Cost Driver 20,000 direct labour hours
(After steps 1 & 2)
(Step 3)
iii)
OAR = $100,000/20,000 direct labour hours
=$5.00/direct labour hour
(Step 4)
iv)
If a product consumed 30 direct labour hours, the overhead expense applied or passed on
to that product would be $150 i.e. 30 @ $5.00.
(Step 5)
Some organizations do not assign manufacturing overheads to cost centers, but instead use what
is called a blanket overhead rate or a plant-wide rate i.e. a rate that is established for the plant as
a whole. Hence the total overheads for the plant would be divided by the total budgeted units of
the cost driver, for the plant.
Where a factory consists of a number of production cost centers, the plant-wide rate is not an
acceptable basis of allocation, as products consume cost center overheads in varying proportions
i.e. the product does not spend the same amount of time in each cost center. Department
overhead rates therefore produce a more accurate overhead cost allocation, since they recognize
the variation in intensity of the resources in the different cost centers.
Recall
Service departments, also referred to as support departments, render essential services that
support the production process e.g. maintenance costs incurred in the maintenance department.
Pre-determined Overhead Rates
The calculation of OARs based on actual overheads incurred in the accounting period causes a
number of problems
1.
Production cost calculation would have to be delayed until the end of the accounting
period. However, this may be necessary before the end of the accounting period,
especially where selling prices has to be estimated.
2.
OARs may have to be calculated on a monthly basis. This would lead to fluctuation in
these rates, making it volatile. Also some costs such as repair and maintenance are
incurred evenly throughout the year.
As a result of these, overhead rates should be based on standard rather than actual data.
Where pre-determined rates are used, very often these rates will be different from the actual
rates. In this case, there will be variance i.e. either an over- or under-recovery/absorption of
overheads. Any under- or over-recovery of overheads (variance) should be treated as a period
cost adjustment i.e. it should be written off against profits in the current accounting period.
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