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Accounting for other expenses – fixed overheads

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CAT MA1 Course Notes Contents Page

Introduction to Accounting for fixed overheads

This chapter looks at how fixed overheads are accounted for.

Charging indirect costs to cost centres and cost units

You should remember from an earlier chapter that there are two ways of calculating the cost of a product:

Marginal costing. Here, only direct material, labour and expenses are traced to units.

Total absorption costing. Here, in addition to marginal costs, indirect production costs (also known as fixed production overheads) are also included in the cost of units.

There is little problem in theory with arriving at the marginal costs because the material and labour inputs can be measured directly (eg kilograms and hours) and specific costs worked out.

Including fixed costs production overheads is more difficult because making one more unit does not cause any more of these costs. The approach used is to work out a fixed overhead absorption rate based on:

Budgeted fixed production costs/Budgeted production in units

The first challenge it to calculate the fixed production costs relating to each production department.

Cost allocation: where the whole of a cost can be traced to a single department.

Cost apportionment: where a cost has to be divided over several departments.

 

Apportionments are done on a common sense basis.

For example:

Heating costs apportioned on the basis of floor area

Insurance of machines apportioned on the basis of machine value

Rent apportioned on the basis of floor area

Canteen costs apportioned on the basis of the number of people employed.

Example 1

A factory has two production departments: preparation and assembly, and one canteen for the labour force.

Statistics about the departments are:

apportionment to each department

Fixed overhead costs are: rent $45,000, insurance $5,400, canteen costs $12,000, electricity $40,000

Show how the costs would be apportioned to each department.

 

Once the amounts are apportioned the cost in each department will be:

apportionment cost in each department

The canteen is a production-related cost because it is used to provide meals to the workforce. It is known as a service department. However, units being produced spend time only in the preparation and assembly departments. Therefore, to account for canteen costs they must be re-apportioned into the preparation and assembly departments (secondary apportionment).

This will be done on the basis of the number of employees in each of those departments ie 8:6

secondary apportionment

 

The costs now have to be traced into (or charged) to items being produced. If there is only one type of item being produced then the costs per item would simply be the total costs spread over the items. This would be known as a fixed overhead absorption rate per unit.

However, often a mix of items is produced, and the normal approach is to charge overheads on the basis of the amount of time that the items spend in each department. It is assumed that there is a correlation between spending time in a department and benefitting from what goes on there.

The time can be estimated using:

  • Labour hours: this will give a fixed overhead absorption rate per labour hour
  • Machine hours: this will give a fixed overhead absorption rate per machine hour

Assume the following:

Labour and machine hours example

 

Machine hours basis

Budgeted machine hours in the preparation department

10,000 x 2 + 6,000 x 3 = 38,000

Budgeted machine hours in the assembly department

10,000 x 1 + 6,000 x 1 = 16,000

Fixed overhead absorption rate per machine hour in the preparation department

= 61,494 [the apportioned costs]/38,000 = $1.62/hour

Fixed overhead absorption rate per machine hour in the assembly department

= 40,906 [the apportioned costs]/16,000 = $2.56/hour

Fixed overheads charged to Product A:

Preparation 2 x 1.62 + Assembly 1 x 2.56 = $5.80

Fixed overheads charged to Product B

Preparation 3 x 1.62 + Assembly 1 x 2.56 = $7.42

 

Example 2

Re-calculate the overhead absorption rates and amount to be charged to each product using a labour hour basis.

The required information is below;

Costs apportioned into preparation department = $61,494

Costs apportioned into assembly department = $40,906

overhead absorption rates example 2

Total budgeted labour hours in preparation department = 31,000

Overhead absorption rate/labour hour in preparation = 61,494/31,000 = $1.98

Total budgeted labour hours in assembly department = 54,000

Overhead absorption rate/labour hour in preparation = 40,906/54,000 = $0.76

Product A overheads: 2.5 x 1.98 + 3 x 0.76 = 7.23

Product B overheads: 1.0 x 1.98 + 4 x 0.76 = 5.02

More on the process of cost absorption for indirect costs

The illustrations above showed how:

  • Fixed overheads are allocated or apportioned into production departments
  • An overhead absorption rate is calculated (usually per labour hour or per machine hour)
  • Overheads will be charged back to production using the same basis as used to work out the absorption rate.

It is important to understand that overhead absorption rate are calculated in advance on the basis of budgeted costs and budgeted output because a rate is needed from the very start of the period and only budgeted amounts will be known then.

The predetermined absorption rate is then never adjusted retrospectively.

This will usually mean that the actual fixed costs are not properly accounted for and that a final adjustment is needed in respect of:

  • Under-absorption – where not enough fixed costs have been accounted for.
  • Over-absorption – where too many fixed costs have been accounted for.

cost absorption for indirect costs illustration

Reader Interactions

Comments

  1. matjeka says

    August 17, 2016 at 6:24 pm

    Hello,could you please help me with this question.

    The production overhead of department D is absorbed using machine hour rate.Budgeted production overheads for the department were $280 000 and the actual machine hours were 70 000.Production overheads were under absorbed by$9400.

    If actual production overheads were $295 000 what was the overhead absorption rate per machine hour(to the nearest cent)?
    A $4.00
    B $4.08
    C $4.21
    D $4.35

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  2. njivan28 says

    August 9, 2016 at 1:14 am

    Why is that we charged fixed overhead to products based on the number of hours rather than the budgected volume volume?

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