Accounting for Overheads
To find the full cost of a product or service, overheads have to be shared out to the cost units. This chapter builds the method up in stages: absorbing overheads with an overhead absorption rate; choosing a basis when several products share a factory; allocating and apportioning overheads between departments; and reapportioning the costs of service cost centres to the production cost centres – including the two reciprocal methods the syllabus requires, repeated distribution and simultaneous equations (algebraic).
Under- and over-absorbed overheads, which arise because absorption rates are set in advance from estimates, are dealt with in chapter 5.
1 Introduction
A business needs to know the cost per unit of goods or services that they produce for many reasons.
to value inventory
to fix a selling price
to analyse profitability
In principle, the unit cost of materials and of labour should not be a problem, because they can be measured. It is the overheads that present the real difficulty – in particular the fixed overheads.
E.g. if the factory costs $100,000 p.a. to rent, then how much should be included in the cost of each unit?
The product or service whose cost we want is the cost object (chapter 2). In this chapter it is usually a cost unit such as a desk, but exactly the same approach gives the full cost of a service, an activity or a customer.
2 Absorption of overheads
To show our approach to solving the problem referred to above, consider the following example:
X plc produces desks.
Each desk uses 3 kg of wood at a cost of $4 per kg, and takes 4 hours to produce.
Labour is paid at the rate of $2 per hour.
Fixed costs of production are estimated to be $700,000 p.a.
The company expects to produce 50,000 desks p.a.
Calculate the cost per desk.
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This method of arriving at an overhead cost p.u. (dividing total overheads by total production) is known as the absorbing of overheads.
The figure used – here $14 per desk – is called the overhead absorption rate (OAR):
Overhead absorption rate = budgeted overheads ÷ budgeted level of activity
(Note that because we need the cost p.u. for things like fixing a selling price, we will usually absorb the overheads based on estimated total cost and estimated production. This can lead to problems later because obviously our estimates may not be correct. We will deal with this problem in the next chapter.)
The same method gives the full cost of a service. A clinic in Malaysia expects its overheads (rent, reception, equipment, cleaning) to be $360,000 a year, and its doctors to work 24,000 consultation hours. Doctors are paid $40 an hour, and each consultation uses $5 of medical supplies and lasts 30 minutes.
Overhead absorption rate = $360,000 ÷ 24,000 hours = $15 per consultation hour.
$ per consultation | |
Medical supplies | 5.00 |
Doctor’s time (½ hr × $40) | 20.00 |
Overheads (½ hr × $15) | 7.50 |
Full cost | 32.50 |
Although the basic approach to absorbing overheads is not difficult, there are two extra problems that can occur and that you can be asked to deal with.
We will consider each of these problems in turn, and then look at a full example.
3 First problem – more than one product produced in the same factory
In this situation we have to decide on a basis for absorption first.
There are many bases for absorption that could be used (e.g. per unit, per labour hour, per machine hour etc.)
Absorbing per unit would be unfair when the products are different: a desk that takes four hours to make uses far more of the factory’s resources than a chair that takes one hour. A time-based basis – labour hours in a labour-intensive factory, machine hours in a machine-intensive one – usually reflects better how overheads are incurred.
X plc produces desks and chairs in the same factory.
Each desk uses 3 kg of wood at a cost of $4 per kg, and takes 4 hours to produce.
Each chair uses 2 kg of wood at a cost of $4 per kg, and takes 1 hour to produce.
Labour is paid at the rate of $2 per hour.
Fixed costs of production are estimated to be $700,000 p.a.
The company expects to produce 30,000 desks and 20,000 chairs p.a.
(Overheads are to be absorbed on a labour hour basis)
Calculate the cost per unit for desks and chairs
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In practice it would be up to the Management Accountant to decide on the most appropriate basis.
In examinations it will be made obvious to you which basis to use, but read the question carefully.
4 Second problem – more than one department in the factory
In this situation we need first to allocate and apportion the overheads between each department. We can then absorb the overheads in each department separately in the same way as before.
X plc produces desks and chairs in the same factory. The factory has two departments, assembly and finishing.
Each desk uses 3 kg of wood at a cost of $4 per kg, and takes 4 hours to produce – 3 hours in assembly and 1 hour in finishing.
Each chair uses 2 kg of wood at a cost of $4 per kg, and takes 1 hour to produce – ½ hour in assembly and ½ hour in finishing.
All labour is paid at the rate of $2 per hour.
Fixed costs of production are estimated to be $700,000 p.a. Of this total, $100,000 is the salary of the supervisors – $60,000 to Assembly supervisor, and $40,000 to Finishing supervisor.
The remaining overheads are to be split 40% to Assembly and 60% to Finishing.
The company expects to produce 30,000 desks and 20,000 chairs.
(Overheads to be absorbed on a labour hour basis)
Calculate the cost per unit for desks and for chairs
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The charging of supervisors’ salaries to the relevant department is known as allocation of overheads.
The splitting or sharing of overheads between departments (as in the remaining $600,000 in our example) is known as the apportionment of overheads.
Apportionment uses a basis that reflects how each department benefits from the cost – for example rent and heating by floor area or cubic space, depreciation and insurance of equipment by the value of the equipment, and canteen and welfare costs by the number of employees.
A fuller example of allocating and apportioning overheads:
Production overhead costs for the period
$ | |
Factory rent | 20,000 |
Factory heat | 5,000 |
Processing Dept – supervisor | 15,000 |
Packing Dept – supervisor | 10,000 |
Depreciation of equipment | 7,000 |
Factory canteen expenses | 18,000 |
Welfare costs of factory employees | 5,000 |
80,000 |
Processing | Packing | Canteen | |
Cubic space | 50,000 m3 | 25,000 m3 | 5,000 m3 |
Carrying amount (NBV) of equipment | $300,000 | $300,000 | $100,000 |
No. of employees | 50 | 40 | 10 |
Allocate and apportion production overhead costs amongst the three departments using a suitable basis.
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5 Reapportionment of service cost centre overheads
Factory cost centres can be broken down into two types:
Production cost centres – these make the cost units.
Service cost centres – these do work for the production cost centres and one another (for example a canteen, stores or maintenance department).
We therefore need to transfer all service cost centre overheads to the production centres so that all production overheads for the period are shared between the production cost centres alone - as it is through these cost centres that cost units flow.
No inter-service work done
If there is just one service department, or if there is more than one service department but there is no work done by one service department for another, then reapportionment is done using a suitable basis (e.g. canteen costs by the number of employees).
Reapportion the canteen costs in Example 4 to the production cost centres.
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Inter-service work done
The problem is a little more complicated if there is more than one service cost centre and they do work for one another (reciprocal servicing). The way to deal with this is the reciprocal method.
The reciprocal method can be carried out in one of two ways:
either the continuous or repeated distribution (tabular) method; or
the algebraic (simultaneous equations) method.
Both methods give the same answer. The syllabus requires you to be able to use both.
Production | Service | ||||
X | Y | Stores | Maintenance | ||
$ | $ | $ | $ | ||
Allocated and apportioned overheads | 70,000 | 30,000 | 20,000 | 15,000 | |
Estimated work done by the service centres for other departments: | |||||
Stores | 50% | 30% | - | 20% | |
Maintenance | 45% | 40% | 15% | - | |
Reapportion service department costs to departments using:
(a) repeated distribution method; and
(b) algebraic method.
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Summary: the stages of accounting for production overheads
Allocate costs that belong wholly to one cost centre (for example a department’s supervisor).
Apportion shared costs between cost centres on a fair basis (floor area, value of equipment, number of employees).
Reapportion the service cost centres’ totals to the production cost centres (using the reciprocal method if they serve each other).
Absorb each production cost centre’s overheads into the cost units, using an overhead absorption rate.
6 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Accounting for Overheads
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