Accounting for overheads
Fixed production overheads
Fixed production overheads
=
indirect materials
+
indirect labour
+
indirect expenses
Fixed production overheads
The total cost of a product also includes a share
of the fixed production overheads.
 This is because organisations must recover
their fixed production overheads and they do
this by absorbing a fixed amount into each
product that they make and sell.
 One way of recovering fixed production
overheads is on a cost per unit basis.
Illustration
RS Ltd is a manufacturing company producing Product
P, which has the following cost card.
Direct labour
Direct materials
Direct expenses
Prime cost
2 hrs
1 kg
@ $5 per hour
@ $5 per kg
$
10
5
1
16
Illustration
RS Ltd produces and sells 1,000 units in a month.
Based on past experience, RS Ltd estimates its monthly
overheads will be as follows.
Heating
$
3000
Power
2000
Maintenance
Total
500
5,500
Solution
The overhead cost allocated to each unit of
Product P is $
Answer:
$5,500/1,000 = $5.5
The cost per unit of Product P is $
Answer:
$5.5+$16= 21.5
Illustration
In addition to producing Product P, RS Ltd now starts to produce
another product, Product Q. RS Ltd plans to make and sell 1,000
units of Product Q in a month, as well as producing 1,000 units of
Product P. Due to the increase in production levels, the
overheads are likely to increase as follows.
Heating
4 200
Power
2,900
Maintenance 700
Total
7,800
Solution
 Calculate the overhead cost allocated to each
unit of Product P.
Answer:
$7800/2000= $3.9
 Calculate the new cost per unit of Product P.
Answer:
$3.9+16=19.9
Absorption costing
 Production overheads are recovered by
absorbing them into the cost of a product and
this process is therefore called absorption
costing.
 The main aim of absorption costing is to
recover overheads in a way that fairly reflects
the amount of time and effort that has gone
into making a product or service.
Allocation and apportionment of
overheads
Allocation involves charging overheads directly to
specific departments (production and service).
 If overheads relate to more than one specific
department, then they must be apportioned
(shared) between these departments using a
method known as apportionment.
 Overheads must be apportioned between
different production and service departments on
a fair basis.
Bases of apportionment
 floor area – for rent and rates overheads
 net book value (NBV) of fixed assets – for
depreciation and insurance of machinery
 number of employees – for canteen costs.
Problem
LS Ltd has two production departments (Assembly and
Finishing) and two service departments (Maintenance and
Canteen).
The following are budgeted costs for the next period:
Indrect materials $ 20,000
Rent
$ 15,000
Electricity
$ 10,000
Machine depreciation $ 5,000
Indirect labour $ 16,520
Direct labour
$ 125,000
Problem
Assembly
Area (sq
metres)
kW hours
consumed
Machine value
($)
Staff
Direct labour
hours
Indirect
materials
budget ($)
Indirect labour
budget ($)
Finishing
Maintenance Canteen
1000
2000
500
500
2750
4500
1975
775
45000
20
35000
30
11000
10
9000
2
3175
3800
7000
8000
3000
2000
1600
2220
11200
1500
Solution
Overhead
Rent
Basis of
apportionm
Mainte
ent
Assembly Finishing nance Canteen Total
3 750
7 500 1 875
1 875 15 000
Indirect materials Directly
7 000
8 000 3 000
2 000 20 000
Indirect labour
Directly
1 600
2 220 11 200
1 500 16 520
Electricy
kW hours
Machine
value
2 750
4 500 1 975
775 10 000
2 250
1 750
450 5 000
Machine Depr
Area
550
Reapportionment
 Service cost centres (departments) are not
directly involved in making products and
 therefore the fixed production overheads of
service cost centres must be shared out
between the production cost centres
(departments) using a suitable basis.
3 methods
• Direct method– the cost of each service cost centre is reapportioned to the production cost centres only
• Step down method – used when one service department
works or provides a service for other service departments as
well as the production departments.
• Reciprocal reapportionment (or the repeated distribution
method) – used where service cost centres do work for each
other as well as provide a service for the production cost
centres. It involves carrying out many reapportionments until
all of the service departments’ overheads have been
reapportioned to the production departments.
Bases of absorption
Overheads can also be absorbed into cost units
using the following absorption bases:
– machinehour rate (when production is
machine intensive)
– labourhour rate (when production is labour
intensive)
– percentage of prime cost
– percentage of direct wages.
Overhead absorption rate
The overhead absorption rate (OAR) may be
calculated as follows:
The absorption basis is most commonly units of
a product, labour hours, or machine hours.
Predetermined OARs
 Production overheads are usually calculated at
the beginning of an accounting period in order
to determine an OAR for products before they
are sold to customers.
 This means that budgeted (or expected)
figures must be used for production
overheads and activity levels (machine hours,
labour hours).
Predetermined OARs
The predetermined OAR is calculated as follows.