4. overheads
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Overheads
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Overheads
Aggregate of indirect materials, indirect labour and
indirect expenses.
Classification of Overheads :
Functional Classification : Manufacturing / factory / works / production
Administration / general / office
Selling and Distribution
Element-wise Classification : Indirect materials
Indirect Labour
Indirect Expenses
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Classification of Overheads - continued
Behavioral Classification : Fixed rent , insurance, salary
Variable consumable stores, nuts/bolts
Semi Fixed or Semi variable maintenance, power,electricity
Incidence-wise Classification : Direct / relatable / allocable
Indirect / general / common Controllability :
Normal / Controllable
Abnormal / non-controllable
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Procedure for charging the overheads
Primary Allocation
Expenses incurred forthe comany as a whole
Allocation:
Identify expensesallocable to individual
department eg. Wages paid tomaintenance workersfrom wage sheet toallocate tomaintenance dept.Primary
Apportionment : Common expenses to
apportion on suitablebasis.
Item of Expenditure Base
Canteen Exps / Staff
Supervision
Number of workers
Rent / Taxes Area
Power HP/Kwh
General Lighting Number of light points
Depreciation Value of assets
Supervision Number of employees /
wages paid
Telephone Exps No. of telephones /
calls made
Repairs Wages paid
Fire Insurance Value of stock / asset
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Procedure for charging the overheads
Secondary Apportionment
Transfer of theoverheads of non-productiondepartments toproduction department.
If non-productiondepartment renderservices either
Ignore the services butthe defects are obvious
Or allocate based onthe % in whichservices given by
Simultaneous Equation
Repeated distributionmethod
Non-production
Departments
Base
Maintenance Dept. No. of hours worked
Stores Dept. No. of requisitions
Purchase Dept. Number of Purchaseorders
Building service dept. Area
Welfare, Canteen and
other facilities
No. of employees
Personnel or Timekeeping Dept.
No. of employees
Internal transport Weight / value of goods
moved
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Procedure for charging the overheads -
Absorption
Charging expenses of production departments to each job orproduct. Various methods of absorption are:
Direct Materials cost % rate i.e.
Amount of overheads to be absorbed
Direct Materials cost This method may not be effective if
- Material prices vary without much variation in overheads
- job using expensive material may get high loading of overhead ascompared to job using cheap material, which may not be fair
Direct Wages % Rate i.e
Amount of overheads to be absorbedDirect Wages Cost
The problem is there is a very little relationship betwn. Direct wages andoverheads.
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Procedure for charging the overheads
Absorption - continued
Prime Cost % Rate It considers both material as well as labour
cost
Amount of overheads to be absorbed
Prime Cost
Labour Hour Rate Useful only if labour is the most importantelement of job
Amount of overheads to be absorbed
Labour hours required for production
Machine Hour Rate Useful only if machine use account for a large
element of cost in overall production cost.Amount of overheads to be absorbed
Number of Machine Hours
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Overhead Absorption Rates
Overhead absorption rates can be
Actual based on actual data of previous period but the problem is actual data will be available only after end of
the previous period or
if the products are of seasonal in nature comparison is difficult
Predetermined estimated rates
In case of predetermined absorption there can be Under absorption actual overheads being more than the
estimated or actual output or hours worked being less thanestimated
Over absorption actual overheads being less than theestimated or actual output or hours worked being more thanthose estimated
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Treatment of Under or over Absorbed
Overheads
Use of supplementary rate If the difference is
considerably significant, cost of the cost centres is
adjusted by supplementary absorption rate
Carrying over to remaining period carried over to theremaining part of the a/cing period
Writing Off to costing P&L a/c In case of under-
absorption out of abnormal circumstances, they are
written off to a costing P&L
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Control Over Overheads
Correct classification If correct classification is done,
Variable and factory overheads are controlled by lower
and middle level management and Fixed and
administrative overheads are controlled by topmanagement.
Either budgetary or standard costing method is used for
proper control
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ABC Activity based Costing
Discuss case
ABC - Rather than using single departmental
overhead rate for the entire department,
separate cost allocation rates for each activity isused eg. Number ofPos for purchase dept cost, No. of
inspection for QA dept. etc.
Therefore least cost distortion among products
because indirect costs are allocated to theproducts based on the
Type of activities used by the product and
The extent to which the activity is used.
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ABC System
1. Identify activities
2. Estimate the total indirect costs associated with
each activity
3. Identify the allocation base for each activitys
indirect costs primary cost driver
4. Estimate the total quantity of each allocation
base5. Compute the cost allocation rate for each
activity i.e.
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ABC System
Estimated total indirect cost of activity
Rate = --------------------------------------------------------------------
Estimated total quantity of cost allocation base
6. Obtain the actual quantity of each allocationbase used by the cost object
7. Allocate the costs to each costAllocated activity cost = Activity cost allocation rate x Actual quantity of
cost allocation base used by the cost object
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Example
Chemtech is a chemical development and manufacturing firm. Most
of the chemicals the company develops are licensed and sold to
other manufacturers. However Chemtechs chemical manufacturing
dept continues to produce two types of chemicals : Common
chemical (Aldehyde) used for producing plastics and a specialtychemical (Phenylephrine Hydrochloride) used in a blood-pressure
medication. Chemtech produces mass quantities of the common
chemical for large customers. It produces small batches of the
specialty chemical for only one customer (a pharmaceutical
company).Last updated several years ago, the Chemical Manufacturing depts
cost system uses a single plantwide overhead rate that allocates
manufacturing overhead (5 mio for a year) at 200% of direct labour
cost.
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Because of the profitability of specialty chemical, the CEO wonders
whether Chemtech should switch its focus to specialty chemical.
However the production supervisor says that it takes no more time
to mix a large batch of common chemical than it does to mix a small
batch of the specialty chemical.
The CEO is also puzzled because Chemtechs competitors seems
to be earning good profits. He want to better understand
manufacturing overhead what drives it and how it should be
allocated.
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Chemtech
Traditional Costing system
Common Chemical Specialty Chemical
Sales per unit 10.00 70.00
Less : Manufacturing
cost per unit:
Direct MaterialsDirect labour
Manufacturing overhead
(at 20% of direct labour
cost)
5.001.00
2.00
20.0010.00
20.00
Total manufacturing cost
per unit
8.00 50.00
Gross profit per unit 2.00 20.00
Number of units
produced and sold
2,000,000 50,000
Total Manufacturing
overheads = 50,00,000
2 x 20,00,000 20 x 50,000
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ABC Example
Step 1 Identify activities The team identifies three primary
activities in the Chemical
Manufacturing Dept.
Step 2 Estimate total indirect costs
to each activity
Mixing 8,25,000
Processing - 38,00,000
Testing - 3,75,000
Total - 50,00,000
Step 3 Identify allocation base for
each activity
Mixing Number of batches
Processing Machine hours
Testing Number of samples