OVERHEADSDefinitionsTypes ClassificationsDistribution of Overheads Cost to Various Cost CenterOverhead Analysis Sheet

Definition - OverheadsCosts that cannot be traced and

attributed to the physical units of a product.

A combination of all indirect costs which consist of indirect materials, indirect labour and indirect expenses.

Definition - OverheadsIndirect Materials

◦Materials cost other than direct materials

◦Materials which are not traceable to the product being made

◦Ex. Oil and grease used in operating and maintaining of machines in the factory, glue in shoe making and nails used in furniture trade.

Definition - OverheadsIndirect Labour

◦Labour cost other than direct labour◦Cost incurred to pay for the factory

employees who are not directly involved in production.

◦Ex. Supervisor’s salary, salary paid to cleaners and security guards

Definition - OverheadsIndirect Expenses

◦Expenses other than direct expenses◦Expenses incurred for the business

as a whole◦Ex. Electricity expenses, depreciation

of assets, rent and telephone expenses

Types of Overheads

1. Manufacturing/Production Overhead

- Indirect cost incurred in production process such as indirect material, indirect labour, insurance on plant and machinery, and rent of factory.

Types of Overheads

2. Non Manufacturing Overhead- Costs that is not related directly with

the production of the products such as administrative overhead, selling and distribution overhead

Production Overhead

• Indirect materials, indirect factory wages, insurance on plant and machinery, factory of rent

Administrative Overhead

• Officers salaries, audit fees, stationeries and office rent

Selling Overhead

• Advertising cost, salesman commission

Distribution Overhead

• Transportation charges and packing costs

Types of Overheads

Methods of Classifying OverheadsBehaviourNature of expenditureTraceabilityFunction

Overhead ClassificationBehaviour:

◦Fixed overheads◦Variable overheads◦Semi-variable overheads

Overhead ClassificationNature of expenditure:

◦Indirect materials cost◦Indirect labour cost◦Indirect expenses

Overhead ClassificationTraceability to Department:

◦Direct departmental overheads◦Indirect departmental overheads

Overhead ClassificationFunction:

◦Factory overheads◦Administrative overheads◦Selling overheads◦Distribution overheads

Distribution of Overhead Cost to Various Cost CenterOverheads are apportioned to the cost

center/department to facilitate absorption of overheads into cost units.

2 broad categories of cost center:◦Production Cost Center – department

where the production is carried on. Ex. Machining, Assembly and Finishing Department

◦Service Cost Center – department that provide service to production department. Ex. Canteen, Stores, Maintenance and Inspection Department.

Distribution of Overhead Cost to Various Cost CenterSteps to assign overheads cost to

product:1. Assign all factory overheads to

production and service cost centers.i. Cost allocationii. Cost apportionment

2. Reallocation of service center overheads to production cost centers

3. Calculation of Overhead Absorption Rates (OAR) of production cost centers.

4. Charging overheads to product.

i. Cost AllocationIs part of cost attribution which charge a

specific cost to a cost centre or cost unit. To allocate the cost, two conditions must be met:i. Specific cost or exact amount is known.ii. Cost centre must have caused the overhead to

be incurred (can be clearly identified with a cost centre)

Cost allocation is used when overhead can be directly traced to a cost centre.

If cost cannot be allocated, they have to be split over several cost centers on some agreed basis known as apportionment.

Example: Cost AllocationOverhead

sProduction Cost

CenterService Cost Center

Machining (RM)

Assembly (RM)

Maintenance (RM)

Store (RM)

Indirect Materials

7,000 5,000 3,000 2,000

Indirect Expenses

3,300 1,500 500 300

ii. Cost Apportionment Is part of cost attribution which shares costs

among two or more cost centers or cost units in proportion to the estimated benefit received that is known as ‘fair basis’.

“Fair basis” should produce fair and equitable share of the common cost for each of the receiving cost centers – cost apportionment reflect the benefits received.

The choice of fair basis is subjective and the apportionment of overhead cost is arbitrary, depend on the information given.

ii. Cost Apportionment – cont’dSuggested apportionment basis are

given below:Overhead Costs Common Basis of Apportionment

Rent, Rates, Depreciation on Building, Insurance on Building, Fire Insurance on office, Heating, Lighting, Utilities, Air Conditioning

AreaSpace OccupiedFloor Area

Supervision, Welfare, Wages, Canteen expenses, Pension Funds, Administration

Number of employees

Material handling, Material Storage Number of material requisitions Material Handling

Power Expenses (electricity consumed) Kilowatt hoursHorse Power

Depreciation on assets (Machinery), Insurance on Plant & Machinery

Asset ValueBook Value of Assets

Fire Insurance on stock / storeroom Value of stock

Maintenance Maintenance hoursCost of Maintenance

Inspection Number of inspectionNumber of Production Employees

Example: Cost ApportionmentOther Cost RM

Rent on Building 36,000

Depreciation of Machinery 10,000

Electricity (Power) 3,920

Production Cost Center

Service Cost Center Total

Machining

Assembly Maintenance

Store

Kilowatt hours

150 100 100 50 400

Machinery Value

RM50,000

RM30,000 RM10,000 RM10,000 RM100,000

Floor Area (sq m)

2,500 2,500 2,000 500 7,500

iii. Reapportionment of Service Cost Center Costs After the overheads cost have been analysed

an totaled, service cost centers cost has to be charged to production cost centers. The method used is repeated or continuous allotment.

Under this method, the first service cost center is allotted in the normal way, and then the appropriate proportion of the second department is allotted back to the first department. This process will be repeated until the amount of overheads involve become insignificant or zero for the service department.

iii. Reapportionment of Service Cost Center CostsSuggested possible basis for

reapportionment are given below:Service Department Possible Basis

Maintenance Maintenance HoursMaintenance cost/wages

Stores Number of requisitionMaterial HandlingWeight of Materials Issued

Inspection Number of InspectionNumber of ProductionNumber of Prod. Employees

Personnel Department Number of Employees

Canteen Number of Employees

Power Technical EstimatesMetered Usage

iv. Overhead AbsorptionOnce the overhead have been

analysed to production cost centers, they can be charged to the cost unit. This will be done by using overhead absorption rate (OAR)

*There are six bases that can be used to calculate OAR

OAR = Budgeted Production Overheads

Budgeted Units of Basis* Used

Bases of Calculating OAR:1. Units Basis (OAR=RM/u)2. Direct Labour Hr Basis (OAR=

RM/DLH)3. Machine Hour Basis (OAR= RM/MH)4. Direct Labour Cost Basis (OAR= ?%

of DLC)5. Direct Material Cost Basis (OAR= ?%

of DMC)6. Prime Cost Basis (OAR= ?% of PC)

Format of Overhead Analysis Sheet (Example)OVERHEAD ANALYSIS SHEET.docx

Departmental OAR and Blanket OARDepartmental OAR◦ Used in a situation where a number of products are

produced in a number of departments and the products do not receive an equal amount of time in each of these departments.

◦ Different department will have its own OAR regarding to the basis used for the department.

Blanket OAR◦ Where a single OAR established for the factory as a

whole and is charged to all jobs irrespective to the departments in which they were produced.

◦ This OAR may be used under one of these situations: Only one type of product is produced Each job receives equal amount of benefits from the

production departments.

Blanket OAR = Budgeted Prod. Overheads of ALL Prod Dept

Budgeted Units of Basis Used of ALL Prod. Dept

Example: Blanket OARDept A Dept B Dept C Total

Overheads (RM)

12,000 100,000 8,000 120,000

Direct Labour Hour (DLH)

20,000 20,000 20,000 60,000

OAR per DLH RM0.60 RM5.00 RM0.40 RM2.00

Departmental OAR Blanket OAR

Actual OAR Vs Predetermined OAR Actual OAR – based on the actual production

overheads and actual units of base. Predetermined OAR

◦ established based on budgeted annual overhead expenditure and budgeted activity.

◦ Calculated prior to the accounting period◦ Predetermined OAR has to be used because of the

following reasons: Actual costs are not known until the end of a costing period –

to wait for the actual cost will not only be inconvenient but will also be too late to determine the total cost and the selling price of a product.

Using actual costs will produce fluctuating unit cost when the activity is seasonal .

The use of predetermined rates enables product costs to be calculated as soon as production is completed.

Predetermined OAR = Budgeted Prod Overheads Budgeted Units of Base

Over/Under AbsorptionOver or under absorption of

overheads occurs when:◦The amount of overhead expenditure

incurred differs from the amount budgeted

◦The actual production units (volume) differs from budgeted production

Overhead Absorbed = OAR x Actual Units of Base

Treatment of Over/Under Absorption

Under Absorbed = Overheads Absorbed < Actual Overheads Incurred

Dr Profit & LossCr Production Overheads

Over Absorbed = Overheads Absorbed > Actual Overheads Incurred

Dr Production OverheadsCr Profit and Loss Account