Overhead Costing - Notes

Ahmadhiyya International School
Subject: ACCOUNTING-Gr-11-Unit: Overhead costing-Ref.Material

Syllabus
 The characteristics of overhead expenses, fixed, semi-fixed, semi-variable and variable.
 Allocation, apportionment and absorption of overheads
 Apportionment and continuous allotment of service departments
 Machine hour and labour hour rates per hour
 Over absorption and under absorption of overheads
Overhead costs
The total of all indirect costs is known as overhead costs. This is the third and last
element of cost incurred for the production of an item. These are common expenses
incurred relating to the production, office and administration, selling and distribution and
other financial expenses. Example: rent and rates, supervision charges, insurance etc.
These overhead costs are apportioned among different sections
Characteristic features of Overhead costs
 These are costs, which cannot be directly linked to an individual unit.

 These are expenses incurred in common
 The overhead expenses may be fixed, variable or semi-variable
 These costs change as the volume of production changes.
Classification of Costs:
Based on the level of activity, costs may be classified into:
a) Fixed costs
b) Semi-fixed costs
c) Variable costs and
d) Semi-variable costs
FIXED COSTS
Costs which do not change with level of activity are collectively known as fixed costs.
Examples: Rent and rates, Management salaries, interest on loan etc
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SEMI FIXED COSTS
Semi-fixed costs are constant over a range of activity. When that range of activity is
reached the costs will increase and then remain constant over the next stage of output.
These are also known as “stepped costs”.
For example: one supervisor is needed up to a particular level of output. it may require
to appoint another supervisor if production moves to the next level.
VARIABLE COSTS
Variable costs change in direct proportion to the level of business activity/production.

These costs include direct material and direct labour
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SEMI –VARIABLE COSTS
These costs include an element of fixed cost and an element of variable cost. There will
be a fixed cost element regardless of the level of activity. As activity increases, the
variable element will increase in proportion to the increase in activity.
Example: electricity charges remain up to a level but increase after that, based on the
usage.
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ALLOCATION, APPORTIONMENT AND ABSORPTION OF OVERHEADS
The allocation , apportionment and absorption of overheads, often referred to as

“absorption costing” is the process of ensuring that all factory overheads are absorbed
into the total production cost for each cost unit made in the factory. The process
consists of three distinct stages:
Alloction Apportionment Absorption
a) Allocation of overheads:
It is the process of charging costs to a cost centre, where costs are completely
associtated with that cost centre.(The person, section or department to whom the cost
can be allocated is called the cost centre). Allocation occurs where a cost is wholly
identifiable with one cost centre
Example: The salary of a machine supervisor, working only in the Machine department
shall be allocated to that department. OR the rent of a factory space used entirely by
one cost centre, to be allocated to the same.(here the overhead is not shared with other
departments)
b) Apportionment of overheads
Apportionment of overheads is the sharing of overheads between all cost centres that
benefit from the overhead expense, on an appropriate basis.The reasons for sharing
overheads depend on the nature of the expense. Apportionment occurs where costs are
shared and must be apportioned across the cost centres on some equitable basis
c) Absorption of overheads
Once all the costs have been allocated and apportioned to a cost centre, the total
overhead cost must then be charged to an individual cost unit. This is known as
absorption.
Overhead Absorption Rate (OAR)
it is the rate at which common overheads are absorbed by different cost centres
involved in a production process.It will be a bugeted overhead rate rather than the
actual.This allows the business to calculate total costs for products and prepare
customer quotations.
($)
OAR =

The most common methods of of budgeted work in cost centre are Labour hours
worked and Machine hours
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OVER ABSORPTION AND UNDER ABSORPTION OF OVERHEADS
The overhead absorption rates (recovery rates) are based on budgeted figures, the
actual will be either hight or lower than planned. It such variation happens, the OAR will
be inaccurate.
Over or under absorption is the difference between the total amount of overheads
recovered and the total amount spent on overheads in the year.
 If the overheads absorbed are greater than the actual overheads, it is over
absorption.
 If the overheads absorbed are less than the actual overheads, it is under
absorption.
Cause of over absortpion:
1. The activity level was higher than planned

2. The actual level of the overhead expense is lower than planned.
3. The orginal rate of absorption calculated may be inaccurate.
Cause of under absortpion:
1. The activity level is lower than the budgeted plan

2. The actual level of overhead expense is higher than planned.
3. The orginal rate of absorption calculated may be inaccurate
Accounting entries:
For over absorption:

Production overheads (Dr)
Statement of profit or loss and other comprehensive income (Cr)
For under absorption:
Statement of profit or loss and other comprehensive income (Dr)
Production overheads(Cr)
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Apportionment and continous allotment of service departments

When the costs are identifiable to a specific department, the allocation process is not
complicated. However, when the overhead costs are consumed by more than one
department, they are to be shared in fair basis.
it is quite common for manufacturing companies to have both production

departments as well as service departments. Service departments do not make
products but support the production departments
The operating costs of such service departments must be apportioned to the

production departments so that all costs are absorbed.
There are three situations to consider for the apportionment of overhead costs of a
service department:
 When the service department serves only production departments

 When the service department serves other service departments and production
departments
 When the service department serves other service departments and gets back
service from other service departments
There are 3 methods to re-apportion service department costs to production

departments, considering the above situations:
1. Direct apportionment
Under this method the costs of a service department is directly allocated to the
production departments, since it serves only the later.
2. The Step-down method
This approach is used when one service department uses the services of a second
service department, but the second service department does not use the services of the
first department
3. The continuous allotment method
This method is used when a service department provides a service to another service
department, and the latter receive a service back from that department. This method is
also known as “reciprocal method”
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Ahmadhiyya International School

Subject: ACCOUNTING-Gr-11-Unit: Overhead costing-Ref.Material

Characteristic features of Overhead costs

 These are costs, which cannot be directly linked to an individual unit.

Variable costs change in direct proportion to the level of business activity/production.

The allocation , apportionment and absorption of overheads, often referred to as

Alloction Apportionment Absorption

Overhead Absorption Rate (OAR)

OVER ABSORPTION AND UNDER ABSORPTION OF OVERHEADS

Cause of over absortpion:

1. The activity level was higher than planned

Cause of under absortpion:

1. The activity level is lower than the budgeted plan

For over absorption:

Apportionment and continous allotment of service departments

it is quite common for manufacturing companies to have both production

The operating costs of such service departments must be apportioned to the

 When the service department serves only production departments

There are 3 methods to re-apportion service department costs to production

2. The Step-down method

3. The continuous allotment method

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