Overheads
1
Overheads
Overhead includes a large number of types
of indirect costs
 Direct cost are identifiable to cost units, but
overhead which are often considerable,
cannot be related directly to cost units

2
Two-stage method to allocate
overhead to products
Overheads are assigned to the cost centres
such as department
 An allocation base is selected for allocating
production centre expenses to products

3
Procedures of overhead
allocation to product
Assign all factory overheads to cost centres
 Reallocate service-centre overheads to
production cost centres
 Calculate separate overhead absorption rate
for each cost centre
 Assign cost-centre overhead to products

4
Assign all factory overheads to
cost center
5
Assign all factory overhead to
cost centres
Cost allocation
 Cost apportionment

6
Cost allocation

Where a cost can be clearly identified with
a cost center or cost unit, then it can be
allocated to that cost center or cost unit
7
Cost apportionment

It is not possible to identify a discrete item
of cost with a cost center and it is necessary
to split a cost over several cost centers on
some agreed basis
8
Bases of apportionment
Apportionment of indirect expenses to cost
centers must be made on fair and reasonable
bases
 Different types of expense require different
bases according to their individual
characteristics

9
Base of apportionment
Costs
Area
Rent and rates, heat and
lighting, insurance of
lighting
Depreciation, machine
insurance
Machine value
No. of employees
Wages of supervisors,
canteen cost
Example textbook P.183
10
Reallocate service-center
overheads to production center
11
Reallocate service-centre
overheads to production cost
centres

Service departments are not directly involved in
production
They only support service to other production
departments in order to facilitate the production
process
Therefore, it is necessary to reallocate the servicecentre overheads to production departments so that
all production costs can be absorbed into
production.
Typical bases are listed as follows:

12



Typical
bases are listed as follows:
Service departments
Possible bases of
apportionment
Maintenance
Maintenance labour hours,
machine value
Stores
Value or weight of materials
issued, number of
requisitions
No. of employees, no. of jobs
inspection
Example textbook P.183
13
Calculate separate overhead
absorption rate for each cost
center
14
Calculate separate overhead
absorption rate for each cost centre

To determine the overheads to be absorbed
by a cost centre, it is necessary to establish
an overhead absorption rate (OAR)
OAR =
Total overhead of cost centre
Total number of units of absorption base applicable
to cost centre
15
An appropriate OAR should reflect the
effort or time taken to produce the products
 Some commonly used absorption bases are
listed as follows:

Direct labour hours
Machine hours
It is frequently used in the labour
intensive department because
overheads assigned to this department
are closely related to the direct labour
hours worked
It is most appropriate for the
appropriate for the machining
department since most of the
overheads are closely related to
16
machine hours
Direct wages
Direct materials
Units of output
It is only suitable in the department
where the uniform wage rate is
applied
This method is not recommended
unless the majority of overheads
incurred in a department are related
to materials instead of time
This method is suitable only where
all units produced in a period are
identical in the production process
and time. Therefore, this application
is very rare
Example textbook P.183
17
Example 1
Refer to textbook P.183 and P.184
18
O/H Apportionment Total
item
Basis
$000
Indirect Actual
material
Indirect Actual
wages
Rent& Area
Rates
Machine Machine
Insurance Value
Dep.
Machine
Value
Heat & Area
Light
Production No. of
Supervisor Employees
Production dept.
Service dept.
Maching Assembly Finishing Stores Maintenance
$000
$000
$000
$000 $000
727
200
199
185
20
123
510
200
200
80
10
20
200
40
20
60
60
20
30
16
10
2
1
1
300
160
100
20
10
10
100
20
10
30
30
10
160
48
32
48
16
16
2027
684
571
425
147
200
19
O/H Apportionment Total
item
Basis
$000
2027
Production dept.
Service dept.
Maching Assembly Finishing Stores Maintenance
$000
$000
$000
$000 $000
684
571
100
100
40
60
884
671
425
147
200
Reallocation
of service-centre
overheads
Stores
Materials issued
Maintenance Maintenance
Work
2027
7
40
472
(147)
(200)
-
-
20

Calculation of overhead absorption rates:
Maching
Assembly
Finishing
Overhead
absorption
basis
Machine
hours
Machine hours
Labour hours
Overhead
absorption
rates
$884000/200
000 hrs
= $4.42/hr
$671000/100000 $472000/40000
hrs
hrs
= $6.71 /hr
= $11.8/hr
21
Assign cost-center overhead to
products
22
Assign cost-centre overheads to
products

The final step is to charge the overheads to
the products passing through the production
departments
23
Example
24

The facts are the same as those in Example
on slide no. 18. The number of hours
needed to finish the products are listed as
follows:
Departments
Product A
Product B
Machining
4 hours
5 hours
Assembly
2 hours
1 hour
Finishing
1/10 hour
1/10 hour
25
Departments Product A
$
Machining
4 hours at $4.42 per mach. hr.
Assembly
2 hours at $6.71 per mach. hr.
Finishing
1/10 hour at $11.88 per labour hr.
Total overhead charged per unit
17.68
13.42
1.19
32.29
Departments Product A
$
Machining
5 hours at $4.42 per mach. hr.
Assembly
1 hours at $6.71 per mach. hr.
Finishing
1/10 hour at $11.88 per labour hr.
Total overhead charged per unit
22.10
6.71
1.19
30.00
26
Predetermined overhead
absorption rates (POAR)
27
Predetermined overhead
absorption rates (POAR)




The overhead absorption rates are usually
computed in advance of operations
In practice, most absorption rates are only
predetermined because the actual overheads are not
known until the end of the period
If the actual overheads are used to compute the
OAR, the product cost can only be obtained at the
end of the accounting period
A delay in product cost calculation will also affect
the pricing setting, the profit calculation and stock
valuation
28
The formula of POAR
The formula are as follows:
Budgeted total overheads
POAR =
Budgeted total number of units of absorption base
29
Under-absorption and overabsorption base



Since the POAR are based on the estimated
production and estimated overheads, the
overheads absorbed seldom agree with the actual
overheads incurred for the period
Under-absorption occur when overhead absorbed
are small than the actual overheads
Over-absorption occurs when the overhead
absorbed are greater than actual overheads
30



For financial accounting, under- or overabsorption of overheads should be treated as
period cost and written off against the profit and
loss account in the current accounting period
The under- or over-absorption of overheads should
be debited or credited to the profit and loss
account
The under-absorbed overheads should be deducted
from profit and vice versa
31
Example
32
Example

Estimated annual overheads $400
Estimated machine hours
200 machine hour

POAR =

$400
200 hrs
= $2 per machine hour
33
Actual
overheads
incurred
Product 1
Product 2
Product 3
Product 4
$400
$400
$300
$500
160 hrs
200 hrs
200 hrs
Actual
250 hrs
machine hours
Overhead
absorbed
Under- or
overabsorption
$2 * 160 hrs $2 * 200 hrs $2 * 200 hrs
= $400
= $400
= $320
OverUnderOver-absorbed Underabsorbed
absorbed
absorbed
$100
$80
$100
$100s
$2 * 250 hrs
= $500
34
Blanket Overhead Rate
35
Blanket overhead rate


According to the overhead allocation procedure,
the overheads are allocated to departments and
each department calculate its own OAR and
allocate the overheads to products passing through
that department
Alternatively, some firms do not assign overheads
to departments. Rather, they adopted a single
overhead rate, i.e. a blanket overhead rate, that is
assigned to all products produced within the whole
factory
36

The use of the blanket overhead rate is not
recommended as many products are
produced in different production centres,
and products consume cost-centre
overheads in different proportions
37
Example
38
The annual overhead costs of a factory with three
production departments are shown as follows:
Overheads
Direct machine
hours
Dept. A
$20000
Dept.B Dept. C Total
$400000 $180000 $600000
100000
100000
100000
$4
$1.8
Departmental
$0.2
overhead rate per
direct machine
hour
Blanket overhead
rate pre machine
hour
300000
$2
39
If the production of product X only requires 10 direct machine
hours in department A, the overheads absorbed will be computed as
follows:
Using
departmental
overhead rate
Overhead absorbed $0.2 *10
= $2
Using blanket
overhead rate
$2 *10
= $20
In this example, the production of product X does not consume
Large amounts of overheads in department B and C. Therefore,
there will be over-absorption of overheads if the blanket overhead
40
rate is used