Accounting for other expenses
1 Introduction
This chapter looks at how fixed overheads are accounted for.
2 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 (production overheads, both fixed and variable) 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 is 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.
A factory has two production departments: preparation and assembly, and one canteen for the labour force.
Statistics about the departments are:
Preparation | Assembly | Canteen | |
Floor area | 400 m2 | 500 m2 | 100m2 |
Machine value | $94,000 | $80,000 | $6,000 |
Employees | 8 | 6 | 2 |
Power consumption | 75% | 20% | 5% |
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.
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Once the amounts are apportioned the cost in each department will be:
Cost | Basis of apportionment | Total | Preparation | Assembly | Canteen |
Rent | Floor area 4:5:1 | 45,000 | 18,000 | 22,500 | 4,500 |
Insurance | Machine value 94:80:6 | 5,400 | 2,820 | 2,400 | 180 |
Canteen | Employees 8:6:2 | 12,000 | 6,000 | 4,500 | 1,500 |
Power consumption | 75%,20%,5% | 40,000 | 30,000 | 8,000 | 2,000 |
Total | 102,400 | 56,820 | 37,400 | 8,180 |
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
Cost | Basis of apportionment | Total | Preparation | Assembly | Canteen |
Rent | Floor area 4:5:1 | 45,000 | 18,000 | 22,500 | 4,500 |
Insurance | Machine value 94:80:6 | 5,400 | 2,820 | 2,400 | 180 |
Canteen | Employees 8:6:2 | 12,000 | 6,000 | 4,500 | 1,500 |
Power consumption | 75%,20%,5% | 40,000 | 30,000 | 8,000 | 2,000 |
Total | 102,400 | 56,820 | 37,400 | 8,180 | |
Reapportionment of service department costs | 8:6 | 4,674 | 3,506 | (8,180) | |
Final apportionment | 102,400 | 61,494 | 40,906 | – |
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.
Allocate an overhead when it belongs wholly to one cost centre. Apportion it when several centres share the benefit. Absorb the resulting production-centre total into cost units using the stated activity base. These verbs describe different stages, not interchangeable methods.
When a service department is shared in a stated ratio, distribute its cost by the ratio’s total parts, add the recipient share to that production department’s overhead, and only then divide by its own activity level. Common errors are ignoring the service cost, using half by default, or reversing the ratio.
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;
Preparation department | Assembly department | ||||
Product | Budgeted volume | Machine hours per unit | Labour hours unit | Machine hours per unit | Labour hours unit |
Product A | 10,000 units | 2 | 2.5 | 1 | 3 |
Product B | 6,000 units | 3 | 1 | 1 | 4 |
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
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
Preparation department | Assembly department | ||||
Product | Budgeted volume | Machine hours per unit | Labour hours unit | Machine hours per unit | Labour hours unit |
Product A | 10,000 units | 2 | 2.5 | 1 | 3 |
Product B | 6,000 units | 3 | 1 | 1 | 4 |
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3 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 rates 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.
Budgeted fixed costs = $100,000
Budgeted output = 50,000 units
Therefore, fixed overhead absorption rate per unit = $2
Actual fixed costs = $120,000
Actual production = 53,000 units.
Here, the 53,000 units produced will each absorb (account for) $2, so, $2 x 53,000 = $106,000 fixed costs will be accounted for in the cost of production. However, actual fixed costs are $120,000, so the costs have been under-absorbed by $14,000 and a deduction of this amount has to be made from profits.
If results had been:
Actual fixed costs = $95,000
Actual production = 49,000 units.
Here, the 49,000 units produced will each absorb (account for) $2, so, $2 x 49,000 = $98,000 fixed costs will be accounted for in the cost of production. However, actual fixed costs are $95,000, so the costs have been over-absorbed by $3,000 and $3,000 has to be added back to profits
Accounting for Other Expenses
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