Topic: Overhead Costing
Definition: Overheads are the aggregate of indirect materials, indirect labour and indirect expenses. it is made up of a
number of cost elements; materials; labour and expenses therefore, its determination and control is complex and
more challenging.
Examples include:
a. Cost of cleaning materials
b. Cost of stationery
c. Cost of consumable materials
d. Supervision cost
e. Bonus payable to employees
f. Salaries of indirect workers
g. Lighting and heating
h. Rent and rates
i. Insurance premium
j. Depreciation of fixed assets.
TYPES AND CLASSIFICATION OFOVERHEADS
Overheads can be classified variously as follows:
a. production overheads
b. administrative overheads
c. marketing, selling and distribution overheads
d. research and development overheads
The objective of overhead cost determination is to:
a. enable overhead cost to be absorbed by products and
b. provide useful information for management decision making and cost control decisions
Overheads can be analysed as consisting of:
i. Indirect materials cost
ii. Indirect labour cost and
iii. Indirect expenses.
Overheads can also be analysed either as
- Fixed overheads or
- Variable overheads
Overhead Allocation and Apportionment Methods
a. Overhead Allocation
This is the assignment of overheads to cost centres directly without sharing. Overhead cost that is specifically
incurred in respect of a particular cost centre is wholly assigned to that cost centre; this is referred to as overheads
allocation.
b. Overhead Apportionment
This is the sharing of overhead cost incurred in respect of a number of cost centres to the centres involved using a fair
and equitable basis of apportionment. There are some overhead costs that are incurred for a number of cost centres
and at times even for the whole organization. Such overheads cannot be allocated but must be apportioned. The
basis of apportionment should be fair and equitable. Examples of bases of apportionment commonly used are:
i. Space occupied by cost centre
ii. Number of employee
iii. Value of plant
iv. Number of material requisitioned
v. Kilowatt hours of energy used
vi. Horse power energy used, etc.
Where the cost centres involved are production and service cost centres, then the overheads relating to the service
cost centres must be re-apportioned to the production cost centre.
One of the following methods can be used for the re-apportionment of service cost centre overheads to production
cost centres where service cost centres serve one another. That is where there is reciprocal service
The Concept of Overhead Absorption
This is the process of assigning overhead costs to products or services produced. Overheads are absorbed into
products by first calculating the overhead absorption rate and then applying the calculated overhead absorption rate
to determine the overhead absorbed by each cost unit
Methods of overheads analysis
To determine the overhead cost per unit of any product or service therefore, the following process is followed:
a. The organization is divided into cost centres which represent areas of the business, items of equipment or persons
with respect to which cost can be gathered and related to cost unit.
There are two types of such cost centres
i. production cost centres
i. service cost centres
b. Allocate to the various cost centres, the cost incurred for each of them that can be wholly assigned to the cost
centre without sharing or apportionment.
c. Those overhead costs that are incurred for more than one cost centre, should be apportioned among the
beneficiary cost centres. The apportionment should be done using a fair, equitable and reasonable basis of
apportionment. Some bases that can be used include:
i.
Basis
Floor space or area occupied
ii.
Kilowatt hours
iii.
Value of Plant and Machinery
iv.
Number of employees
v.
Number of requisitions
Type of overhead
Rent
Rates
Heating and lighting
Insurance of buildings, etc.
Electricity
Power, etc.
Depreciation of Plant &
Machinery
Insurance of plant
Plant maintenance, etc.
Canteen expenses
Supervisors' wages
Personnel dept expenses
Stores expenses
Indirect material expenses, etc
d. Re-apportion the overhead cost of the service cost centres to the production cost centres.The reason for this reapportionment is that cost units are not produced in the service cost centres and so it will not be possible for the cost
units to absorb the overhead costs of the service cost centres unless and until such have been reapportioned to the
production cost Centres.
When re-apportioning service cost centre overheads it is important to observe whether or not the service cost
centres serve each other. That is, whether or not they provide reciprocal services. If they don't provide reciprocal
services, then the following procedure should be followed:
i. First re-apportion the service cost centre that serves other service cost centres beginning with the service cost
centre that serves the largest number of cost centres.
ii. Repeat the first process until all service cost centres overheads have been reapportioned to production cost
centres. Note that under these circumstances once a service cost centre's overheads have been re-apportioned, that
centre does not receive any re-apportioned overheads.
Where the service cost centres provide reciprocal services, it means one service cost centre serves another and
receives services from that other. In such a situation the following methods can be used for the re-apportionment:
i. elimination method
ii. Continuous allotment method
iii. Simultaneous equation method
Overheads Absorption Methods
a. The Concept of Overhead Absorption
This is the process of assigning overhead costs to products or services produced. Overheads are absorbed into
products by following the process below:
i. Calculate the overhead absorption rates
ii. Apply the calculated overhead absorption rate to determine the overhead absorbed
Methods of Overhead Absorption.
Generally, overhead absorption rate (OAR) is computed as
OAR
=
Budgeted overheads
Budgeted activity level
There are different factors that could possibly be used as activity level. These include the
following:
i. Direct labour hours
ii. Machine hours
iii. Units of production
iv. Direct material cost
v. direct labour cost
vi. Prime cost, etc.
Why Predetermined Rates Are Used
a. Actual overheads are not known until after the end of a given period.
b. Actual overheads are substantially influenced by the general price level and actual activity
levels are subject to wide fluctuations
Blanket Overhead Absorption Rates Versus Cost Centre Overhead Absorption Rates.
Where an overhead recovery rate is in respect of the whole factory it is termed a blanket overhead recovery rate or
factory wide overhead recovery rate. Blanket overhead recovery rates are not very appropriate because of the
following reasons
a. The factory consists of different production cost centres and products may consume cost centre overheads in
different proportions.
b. Different activity bases drive cost for different products in different proportions.
Determination and Treatment of Over or Under Absorption of overhead
Overhead absorbed = Overhead absorption rate X actual quantity of activity base.
It is unlikely for the actual overhead incurred to be the same as the overheads absorbed. This thus creates a situation
of over absorbed overheads or under absorbed overheads.
Treatment of under or over absorption of overheads
a. Adjust the under or over recovery to cost units produced during the period.
- This may not be worthwhile and such historical information is of no use to management
b. Carry the under or over recovery to future accounting periods
- This results in a distortion of performance figures.
c. Treat the under or over recovery as a period cost by writing it off in the Profit and Loss account.
- This is the most preferred treatment.
The treatment of overheads could be done using
a. Absorption costing system where both fixed and variable overheads are considered and charged to products.
b. Marginal costing system where only variable overheads is considered and absorbed into products and fixed
overheads treated as a period cost and charged to Profit & Loss account.
Activity-Based Costing
Activity-Based Costing is a costing approach that focuses on how costs of resources utilised are traced to activities
that causes them to incur and then to absorb overhead to products or services based on the activities utilisation.
Thus, ABC identifies factors that cause or drive costs and termed those factors as cost driver.
Cost Driver is defines as “any factor that causes a change in the cost of an activity (CIMA).
Examples of Cost Drivers are:
• Number of materials handling or issued
• Number of machine set-up
• Number of machine hours
• Number of inspector orders
Stages in ABC
Two stages are involved in how overheads are absorbed into products through ABC. They include:
1. Stage One: Grouping of overheads into pool in accordance with identifying activities that drive them
2. Stage Two: Determination of how much overhead should be charged
The first stage involves identification of cost driver that allows cost to be incurred.
The steps required in this first stage include:
Step 1: Identify and classify activities;
Step 2: Selection of cost driver bases such as number of machine set-up etc;
Step 3: Assigning of cost to each activity or cost pools; and
Step 4: Ascertainment of activity cost per cost driver base. The formula is:
Cost Driver Rate
=
Activity cost for each cost pool
Quantity of cost driver available
Stage Two: This stage computes amount of overheads to be recovered i.e assuming 100 units of product Lare to be
manufactured. If total overhead is determined as:
Machine set up: 20 set up x N40 =
Materials handling: 10 issues- 10 x N20 =
800
200
Total 1,000
Overhead rate per unit of output of product =
N1,000
100
= N100
MULTIPLE-CHOICE QUESTIONS
1. Overheads are the aggregates of
A. Indirect materials, indirect labour and indirect expenses B. Expenses incurred over the normal expense heads C.
Expenses incurred by the owners of the business D. All uncontrollable expenses E. All unauthorized expenses
2. Distinguish between overhead allocation and overhead apportionment
A. Allocation is used in government whilst apportionment is used in the private sector
B. Allocation is assigned direct to cost centres whilst apportionment is shared to a number of cost centres
C. Allocation is made scientifically whilst apportionment is done arbitrarily
D. Allocation benefits only managers whilst apportionment benefits junior staff
E. Both terms mean the same thing
3. What is the usual basis of apportioning factory rent?
A. Number of employees B. Number of machines C. Floor space occupied D. Kilowatt of energy used
E. Number of pillars
4. What distinguishes a profit centre from a cost centre?
A. Direct Cost B. Indirect Cost C. Profit D. Loss E. Revenue
5. What does OAR stand for in overheads accounting?
A. Organisational Accounting Returns B. Overheads Accounting Rate C. Overheads Accounting Returns
D. Overheads Absorption Rate E. Organisational Absorption Rate
6. Over – absorption of factory overhead due to inefficiency of management should be disposed of by
A. Transfer to costing profit and loss account B. Carry forward to next year C. Supplementary rate
D. Comprehensive rate E. Allocation
7. How do you treat a cost that is impossible to identify with a particular cost centre?
A. Allocate it B. Distribute it C. Apportion it D. Recover it E. Amortise it
8. Which of the following basis is suitable for apportioning Building Depreciation Overhead?
A. Number of Employees B. Book Value of Equipment C. Space Occupied D. Number of Unit/Department
E. Weight of Materials
9. Which of the following is NOT a functional classification of overhead?
A. Variable overhead B. Production overhead C. Administration overhead D. Distribution overhead
E. Selling overhead
10. In overhead costing OAR stands for:
A. Overheads Accounting Rate B. Overheads Accounting Returns C. Overheads Absorption Rate
D. Organisational Accounting Re-absorption E. Overheads Absorption Returns
11. A location, person or item of equipment for which costs may be ascertained and used for the purpose of cost
control is _______ A. Revenue Centre B. Profit Centre C. Investment Centre D. Cost Centre E. Contribution Centre
SHORTANSWER QUESTIONS
1. Where the actual overhead for a period exceeds the predetermined overheads, we have a case of ……
2. A system of continuously reallocating each service cost centre overhead until the amounts become insignificant is
known as ……………….
3. Overheads covering cost of securing orders, publicizing and presenting to customers the products of a company in
proper forms at acceptable prices and delivery of the goods to customers are generally known as …………………
4. Where the production process is highly mechanized making the use of labour hours inappropriate for overhead
absorption, what alternative basis may be used?
5. Which is the best way to treat over- and under-absorbed overheads for a period?
6. When the amount of overhead absorbed is more than the amount of actual overheads incurred, it is known
as………………….
7. The difference between overhead incurred and overhead absorbed is known as……………….
8. When apportioning canteen service overhead cost among departments in an organisation, what basis of
apportionment would be most appropriate?
9. Allocation of support department costs to other support departments and to the operating departments in a
sequential manner that partially recognizes the mutual services provided among all support departments is referred
to as……………………
Question 1
Apple Ltd. makes wooden crates which are sold to brewers and soft drinks bottling companies. The production work
involves three production departments, Sawing, Assembling and Finishing. There are also two service departments,
Maintenance and Materials Handling.
During the year ended 31st December 1991, 40,000 crates were made:
Costs incurred:
Materials issued
Direct Wages
Overheads
Sawing (N)
Assembly (N)
Finishing (N)
800,000
300,000
120,000
600,000
150,000
80,000
100,000
250,000
30,000
Materials handling wages totalled N21,000
Maintenance wages totalled
N45,000
Consumable stores totaled
N15,000 (maintenance)
The departments' benefits from the service departments are as follows:
Sawing Assembly
Finishing
Materials Handling
%
%
%
%
Maintenance
30
40
20
10
Materials Handling
50
20
30
Required:
(a) Prepare a Statement showing the overheads allotted to each production department
(b) Calculate the unit cost of a wooden crate.
Question 2
Lamina Manufacturing Company has four production departments and three service departments.
Indirect labour and other indirect costs for a typical month have been allocated as shown below:
Lamina Manufacturing Company
Production Department
Maintenance
Indirect labour
Other Indirect Costs
Grinding
Blending
¢000
4,600
1,400
¢000
3,300
1,200
Firing
Polishing
¢000
5,400
2,800
¢000
2,900
1,600
Service Department
Adminis
Personnel
Maintenance
tration
¢000
¢000
¢000
700
1,800
800
500
300
1,200
The service departments' costs are allocated as follows:
Grinding
Personnel (%)
Administration (%)
Maintenance (%)
15
10
15
Blending
25
30
30
Firing
30
40
40
Polishing
20
15
5
Adminis
tration
5
10
Maintenance
5
5
In the Grinding and Firing Departments, an overhead rate per machine hour is used; whereas in the Blending and
Polishing Departments, an overhead rate per direct labour hour is used.
Machine hours are budgeted as 620 in the Grinding Department and 520 in the Firing Department. Direct labour
hours are budgeted as 1,050 in the Blending Department and 450 in the Polishing Department.
Required:
(a) Determine the total overheads for each of the production cost centres.
(b) Calculate the overhead recovery rates for each of the production department
Question 3
Enyo Manufacturing Company Ltd. produces three products - Frytol, Brilliant and Pepsodent. The cost estimates of
each of the products are given below:
Frytol
Brilliant
Pepsodent
Direct Materials
N720
N1,280
N1,800
Direct Labour:
Production Dept. at ¢60/hr.
2 hrs.
1.5 hrs.
2 hrs.
Finishing Dept. at ¢40/hr.
2 hrs.
2.5 hrs.
1 hr.
Variable Overheads
N80
N30
N40
Fixed overhead cost for the following year is estimated at ¢6 million and planned production is:
Frytol
10,000 units
Brilliant
20,000 units
Pepsodent
40,000 units
The directors are considering alternative methods of absorbing fixed overheads into product costs and you have been
asked, as the Cost Accountant, to calculate the rates to be applied for the following alternatives:
i, Direct Labour Costs
ii, Percentage of Total Variable Cost
Question 4
Agape Co. Ltd. operates two production departments (machining and assembling) and one service department
(which is responsible for maintenance). The data below was extracted from the books of the company on 31st July,
1998.
Hours Spent
Machining Assembling Maintenance
Direct labour hours
600
Machine hours
300
Expenses
Indirect labour
Indirect materials
Machine handling
Housekeeping
Air Conditioning
Rent and rates
Supervision
N’ 000
200
420
N’ 000
250
450
50
30
160
240
70
30
120
180
N’ 000
120
500
80
100
50
150
200
Expenses of the maintenance centre are subsequently re-apportioned to the two production centres in proportion to
the total expenses incurred by those departments during the month. Predetermined overhead rates were established
as follows:
Budgeted Monthly overhead
Planned machine hours
Planned direct labour hours
Machining
N’ 000
2,000
500
Assembling
N’ 000
1,200
400
You are required to :
a. calculate the overhead absorption rates which were in operation during July;
b. prepare a statement showing the actual overhead borne by the production department for July;
c. state the extent to which overhead was under- absorbed or over-absorbed by the production departments during
the month of July.
Question 5
MMT manufactures two products. The company provides you with the following details relating to 2015 financial
year
1. Units Produced:
Product AB - 150,000 units
Product CD - 200,000 units
2. Cost drivers identified
Activity
Activity
Cost Pool ( N )
Machine set up
300,000
60 set up
Materials issued
200,000
90 requisition
Quality control
100,000
40 inspection
3. Cost drivers identified
Activity
Machine set up
Materials issued
Quality control
PRODUCT
AB
CD
10
10
20
10
10
5
You are required to determine overhead absorption rate through activity based costing
Question 6
Monami Limited has three production departments namely MIXING, FILLING and SEALING and two service
departments: ADMIN and ENGINEERING. The overhead departmental distribution summary shows the following.
MIXING
N600,000
FILLING
N500,000
SEALING
N400,000
ADMIN
N150,000
ENGINEERING N120,000
The service department expenses are allotted on a percentage basis as follows:
ADMIN
ENGINEERING
MIXING FILLING SEALING
40%
30%
20%
30%
40%
15%
ADMIN
ENGINEERING
10%
15%
You are required to apportion the expenses of ADMIN and ENGINEERING departments to the production
departments using continuous allotment method. Round up to the nearest whole number