Overhead Analysis

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FACTORY OVERHEADS COSTS COMPUTATIONS

Overheads stand for the indirect costs of a product of service. In addition to direct materials,
direct labour and direct expenses, there are indirect materials, labour and expenses. These cannot
be traced directly to specific units. Hence, they have to be distributed on some equitable basis.
These overheads represent costs which are „over-the-head” of direct materials incurred in the
manufacturing process. The chartered institute of management accountants, London, defines
overheads as expenditure on materials, labour and services which cannot be economically
identified with a specific saleable cost. These costs are incurred for the activities as a whole in a
case of any organization or departments.

Accounting and control of overheads


Accounting means accumulating and reporting of costs. Two major objectives of accounting for
overheads are: (1) product costing – determining full cost of jobs and processes and (2)
managerial planning and control.
Accounting and control of overheads involve the following four steps:
1. Classification
2. Collection and accumulation
3. Analysis of overheads
4. Absorbing or charge to production units

Classification of overheads
Overheads are costs, but of an indirect nature. As such, like costs, they have been classified
according to their behavioral patterns or managerial function

Behavior classification
In terms of behavior, they could be fixed, variable and semi-variable.

Fixed overheads; these overheads remains the same at various levels of output. These are
incurred on time basis e.g. monthly or yearly overhead cost. While fixed overheads remain fixed
in aggregate, they vary per unit as the level of activity increases or decreases managing director‟s
salary, factory rent, audit fees etc are examples of fixed overheads.

Variable overheads; these overheads fluctuate in direct proportion to the units of production.
They increase or decrease exactly according to the changes in the volume of activity. While
variable overheads per unit remains the same, variable overheads in total increase or decrease as
the output increases or decreases. Examples of variable overheads are:
 fuel
 indirect materials
 indirect labour
 store handling expenses

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 stores losses
 salesmen‟s commission etc

Semi-variable overheads; also known as semi-fixed overheads, these are expenses which neither
remain fixed nor vary directly with the output. A part of the cost remains unchanged up to a
particular level and the other part varies with change in activity. Power charges, telephone
expenses, repairs and maintenance, electrical costs and depreciation are examples of semi-
variable overheads

Functional classification
Functionally, overheads are classified into factory overheads, office and administration
overheads and selling and distribution overheads

Factory overheads; Factory/manufacturing/production include all indirect materials, indirect


labour and indirect expenses incurred in the factory till that stage when goods are ready for
dispatch.

Office and administration overheads; these include all expenses incurred in the performance of
managerial function of planning, implementation, decision-making and control. These include
office salaries, office rent, depreciation of office equipment and other office expenses.

Selling and distribution overheads; these are generally referred to as market overheads. These
indirect costs generate sales, and distribute goods up to the customers. These include
advertisement, salaries of salesman, rent of sales warehouse, delivery van expenses, depreciation
of delivery vans and other sundry selling and distribution expenses.

Collection and accumulation


To collect the overheads items, it is necessary to allocate suitable account heading for each type
of expenses. Such account heading may be either standing order numbers concerning
manufacturing overheads or cost account numbers concerning administration, selling and
distribution overheads items. Overheads are collected from the following main sources:
1. Invoices – for collection of indirect expenses like rent, insurance ets.
2. stores issue requisitions –for collection of indirect materials cost
3. wage analysis book-for collection of indirect wages
4. journal entries-for collection of these overheads items which do not requires current cash
expenditure and need some adjustment e.g. depreciation charge, outstanding rents etc.
5. cash book
6. Other registry and report.

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Analysis of overheads
An overhead analysis is an analysis that charges overheads to cost centre or cost units. A cost
centre is defined as “A location, person, or item of equipment (or group of these) in respect of
which costs may be ascertained and related to cost unit”. It is a particular part of enterprise. For
example, production department “A” is a cost centre and all overheads incurred in respect of this
department should be ascertained.
There are two ways of charging overheads to cost centres. These are:
a) allocation of overheads
b) apportionment of overheads

Allocation of overheads
This is the process of charging a cost centre with those overheads which can easily be identified.
Allocation of overheads means to charge those overheads to a cost centre which result solely
from the existence of that cost centre. For example, all indirect materials used in department „A‟
must be charged to this department only similarly the salaries of supervisor s of department A are
expenses of this department and these must be allocated to this cost centre only. It means the
overheads which are incurred for one cost centre only, the charging of these overheads to that
cost centre is known as allocation of overheads.
The overheads are allocated when the following two conditions are fulfilled:
1. the cost centre must have caused the overhead to be incurred
2. the exact amount of the overhead must be known

Apportionment of overheads
Apportionment of overheads means to charge a cost centre a fair share of overheads. If overhead
cannot be allocated it is then apportioned.
The overheads which are incurred for the organization as a whole must be charged to various
cost centres of that organization. We assume there are four departments of an enterprise. The rent
is paid monthly for the whole enterprise. This rent must be shared among four departments of
this enterprise. This process of sharing of rent among four departments is known as
apportionment of overheads.

Distinction between allocation and apportionment


Allocation and apportionment represent two successive stages in the process of
analysis/distribution of overheads. The objective of both is the same, namely, to identify or
allocate costs to cost centres or cost units. However, there is distinction between them.
Allocation deals with whole items of cost, whereas apportionment deals with proportions of
items of cost. For apportionment, suitable bases are to be selected. Whether an item of expenses
can be allocated or apportioned does not depend upon the nature of the expense but upon its
relation with the cost centre or cost unit to which it is charged. For example the expenditure on

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general repairs and maintenance relating to a department can be allocated to that department but
it can only be apportioned to be various machines running in that department.

Bases of apportionment
For the apportionment of overheads of cost centres, various bases are applied. The following are
the most common bases of apportionments:

Bases used in primary apportionment


S/N Basis of apportionment Overheads to which basis applied
1 Area or volume expressed in Rent, rates, heat and light, depreciation of
square metres or square feet buildings maintenance of buildings, insurance
of premises etc.
2 Book value Depreciation of plant and machinery, insurance
of plant, repairs and maintenance etc.
3 Number of employees Expenses of personnel office, canteen, welfare
of staff, safety measures, supervision etc
4 Weight of materials or cost of Material handling expenses, storekeeping
materials used packages cost etc.
5 Technical estimate Power consumption, water usage, steel
consumption etc
6 Sales revenue Advertisement, selling and distribution
expenses etc
7 Direct wages Staff training provident contributions etc.
8 Machine hours or labour hours General overhead items
9 Number of radiators Heating

The choice of an appropriate basis of apportionment is really a matter of judgment. A company


may decide any basis of apportioning overheads according to its own circumstances. The above
bases of apportionments are given in order to provide a guideline. Mostly, the bases of
apportioning overheads are indicted in the examination questions. In the absence of such
indications, the students can use that basis of apportionment which is most appropriate.
The basis of apportionment should be:
 equitable
 practical
 economical
 reasonable
 accurate

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OVERHEAD ANALYSIS SHEET
Overhead analysis sheet is prepared to show how the various overheads have been allocated and
apportioned among different centres or department. This sheet contains the following columns:
1. The first column shows the name of overheads to be allocated or apportioned
2. The second column shows the basis of apportionment. If an overhead is to be allocated
then the word „allocate‟ is written in this column
3. The third column shows the total amount of the overhead which is to be apportioned.
4. The fourth column shows the number of total units in respect of any specific overhead
e.g. area, book value etc.
5. The fifth column shows the rate of overhead per unit. It is obtained by dividing total
overhead amount by total number of units. It means columns number three is divided by
column number four in order to obtain column five.
6. In addition to the above five columns, some more columns are used according to number
of departments or cost centre. If there are four departments then four more columns are
used. Each column shows the share of overhead for a specific department.

Example
The following information relates to a factory which has four departments
a) Overheads Shs.
Rent 80,000
Repairs to plant 50,000
Depreciation of plant 40,000
Light and heat 20,000
Supervision 60,000
Repairs to buildings 30,000

b) Information in respect to four departments:

Dept: A Dept: B Dept: C Dept: D


Area sq: meters 1,500 1,200 800 500
Number of employees 35 25 25 15
Value of plant: shs 500,000 300,000 200,000 -

Prepare an overhead analysis/distribution sheet showing clearly the bases of apportionment

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Solution
Overhead Basis Amount Units Rate Dept: A Dept: B Dept: C Dept:
(shs) per (shs) (shs) (shs) D (shs)
unit
(shs)
Rent Area 80,000 4,000 20 30,000 24,000 16,000 10,000
Repairs to Value of 50,000 1,000,000 0.05 25,000 15,000 10,000 -
plant plant
Depreciation Value of 40,000 1,000,000 0.04 20,000 12,000 8,000 -
of plant plant
Light and Area 20,000 4,000 5 7,500 6,000 4,000 2,500
heat

60,000 100 600 21,000 15,000 15,000 9,000


Supervision No. Of
employees
Repairs to Area 30,000 4,000 7.5 11,250 9,000 6,000 3,750
building
Total 280,000 114,750 81,000 59,000 25,250

Workings
1. Total area = 1500 + 1200 + 800 + 500 = 4000 sq.m
2. Total number of employees = 35 + 25 + 25 +15 = 100
3. Total value of plant = sh. 500,000 + sh. 300,000 + 200,000 = sh 1,000,000

4. Rent per sq.m = sh 80,000 = shs. 20


4,000

5. Repairs to plant per sh. = sh. 50,00 = sh. 0.05


1,000,000

6. Depreciation of plant per sh = sh.40,000 = 0.04


1,000,000

7. Light and Heat per sq.m = sh.20,000 =sh. 5


4,000

8. Supervision per employees = sh. 60,00 = sh. 600


100

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9. Repairs to buildings per sq.m = sh. 30,00 = sh. 7.5
4,000

10. Apportionment of rent


Sh.
Dept: A = 1500 x sh 20 = 30,000
Dept: B = 1200 x sh. 20 = 24,000
Dept: C = 800 x sh. 20 = 16,000
Dept: D = 500 x sh. 20 = 10,000

11. Apportionment of repairs to plant


Sh.
Dept: A = 500,000 X SH. 0.05 = 25,000
Dept: B = 300,000 X SH. 0.05 = 15,000
Dept: C = 200,000 X SH. 0.05 = 10,000
TOTAL 50,000
000000
12. Apportionment of depreciation of plant
Sh.
Dept: A = 500,000 X SH. 0.04 = 20,000
Dept: B = 300,000 X SH. 0.04 = 12,000
Dept: C = 200,000 X SH. 0.04 = 8,000
TOTAL 40,000

13. Apportionment of light and heat


Sh.
Dept: A = 1,500 X SH. 5 = 7,500
Dept: B = 1,200 X SH. 5 = 6,000
Dept: C = 800 X SH. 5 = 4,000
Dept: D = 500 X SH. 5 = 2,500
TOTAL 20,000

14. Apportionment of supervision


Sh.
Dept: A = 35 X SH. 600 = 21,000
Dept: B = 25 X SH. 600 = 15,000
Dept: C = 25 X SH. 600 = 15,000
Dept: D = 15 X SH. 600 = 9,000
TOTAL 60,000

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15. Apportionment of repairs to buildings
Sh.
Dept: A = 1500 X SH. 7.5 = 11,250
Dept: B = 1200 X SH. 7.5 = 9,000
Dept: C = 800 X SH. 7.5 = 6,000
Dept: D = 500 X SH. 7.5 = 3,750
TOTAL 30,000

16. Total overheads = sh. 114 750 + sh. 81,000 + sh. 59,000 + 25,250 = sh. 280,000

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OVERHEADS OF SERVICE DEPARTMENT
Secondary apportionment- is the process of apportioning service cost centres overhead to
production cost centres
The overheads to service departments must be further charged to production departments.
Service departments are those departments who provide some services to the production
departments e.g. store department, repairs departments etc. in order to apportion the overheads of
service departments among the production departments, some information is provided. If service
departments provide service to production departments only then there is no difficult in
transferring service department overheads to production departments.

Inter-Service Department Reallocations


Service department provide services for other service departments as well as for production
departments. When such interactions occur, the allocation process can become complicated.
Difficulties arise because each service department begins to accumulate charges from other
service departments from which it receives service, and these must be reallocated back to the
user department. Once it has begun, this allocation and reallocation process can continue for a
long time before a solution is found.

There are four different methods of allocating the service department costs:
1. Repeated distribution method
2. Simultaneously equation method
3. Specified order of closing method
4. Direct allocation method

REPEATED DISTRIBUTION METHOD


Where this method is adopted, the service department costs are repeatedly allocated in the
specified percentages until the figures become too small to be significant.

Example
A company has three production departments and two service departments. The overhead
analysis sheet provides the following totals of the overheads analyzed to production and service
departments.

Production department: X 48,000


Y 42,000
Z 30,000

Service department: 1 14,040


2 18,000
152,040

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The expenses of the service departments are apportioned as follows:
Production departments Service departments
X Y Z 1 2
Service department 1 20% 40% 30% - 10%
Service department 2 40% 20% 20% 20% -

Solution
Production departments Service
departments
X Y Z 1 2 Total
Allocation as per overhead analysis 48,000 42,000 30,000 14,040 18,000 152,040
Allocation of service department 1 2,808 5,616 4,212 (14,040) 1,404
(20%) (40%) (30%) (10%)
Allocation of service department 2 7,762 3,881 3,881 3,881 (19,404)
(40%) (20%) (20%) (20%)
Allocation of service department 1 776 1,552 1,165 (3,881) 388
(20%) (40%) (30%) (10%)
Allocation of service department 2 154 78 78 78 (388)
(40%) (20%) (20%) (20%)
Allocation of service department 1 16 31 23 (78) 8
(20%) (40%) (30%) (10%)
Allocation of service department 2 4 2 2 - (8)
(40%) (20) (20%)
Total overheads 59,520 53,160 39,360 - - 152,040

SIMULTANEOUS EQUATION METHOD (ALGEBRAIC APPROACH)


When this method is used simultaneous equations are initially established as follows: Let
X = total overhead of service department 1
Y = total overhead of service department 2
The total overhead transferred into service departments 1 and 2 can be expressed as:
x = 14,040 + 0.2y
y = 18,000 + 0.1x
Rearranging the above equations:
x – 0.2y = 14,040
-0.1x + y = 18,000
We can now multiply equation (1) by 5 and equation (2) by 1, giving:
5x – y = 70,200
-0.1x + y = 18,000
Adding the above equations together we have:
4.9x = 88,200

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Therefore: x = 18,000 (88,200/4.9)
Substituting this value for x in equation (1), we have:
18,000 – 0.2y = 14,040
Therefore: -0.2y =-3,960
Therefore: y = 19,800
We can now apportion the values for x and y to the production departments in the agreed
percentages:
X Y Z Total
Allocation as per 48,000 42,000 30,000 120,000
overhead
analysis
Allocation of 3,600 (20%) 7,200 (40%) 5,400 (30%) 16,200
service
department 1
Allocation of 7,920 (40%) 3,960 (20%) 3,960 (20%) 15,840
service
department 2
Total 59,520 53,160 39,360 152,040

You will see that the value for X (service department 1) of shs 18,000 is allocated in the
specified percentages. Similarly the value for Y (service department 2) of shs 19,800 is
apportioned in the specified percentages.

SPECIFIED ORDER OF CLOSING (STEP DOWN METHOD)


If this method is used the service departments‟ overheads are allocated to the production
departments in a certain order. The service department that does the largest proportion of work
for other service departments is closed first; the service department that does the second largest
proportion of work for other service departments is closed second; and so on. Return charges are
not made to service departments whose costs have previously been allocated.
Using the example above:

Production departments Service departments


X Y Z 1 2 Total
Allocation as per overhead 48,000 42,000 30,000 14,040 18,000 152,040
analysis
Allocate service department 2 7,200 3,600 3,600 3,600 (18,000)
(40%) (20%) (20%) (20%)
Allocate service department 1 3,920 7,840 5,880 (17,640) -
(2/9) (4/9) (3/9)
Total 59,120 53,440 39,480 - - 152,040

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The costs of service department 2 are allocated first because 20% of its work is related to service
department 1, whereas only 10% of the work of service department 1 is related to service
department 2. We allocate the costs of service department 1, but the return charges are not made
to department 2. This means that the proportions allocated have changed as 10% of the costs of
service department 1 have not been allocated to service department 2. Therefore 20% out of a
90% total 2/9 of costs of service department 1 are allocated to department X.
The totals allocated in this method do not agree with the totals allocated under the repeated
distribution or simultaneous equation methods. This is because the specified order of closing
method sacrifices accuracy for clerical convenience. However, if this method provides a close
approximation to an alternative accurate calculation then there are strong arguments for its use.

DIRECT ALLOCATION METHOD


This method it ignores inter-service department service reallocations, therefore service
department costs are reallocated only to production departments. Refer the previous example:

Production departments Service departments


X Y Z 1 2 Total
Allocation as per overhead 48,000 42,000 30,000 14,040 18,000 152,040
analysis
Allocate service department 1 3,120 6,240 4,680 (14,040)
(2/9) (4/9) (3/9)
Allocate service department 2 9,000 4,500 4,500 - (18,000)
(4/8) (2/8) (2/8)
Total 60,120 52,740 39,180 - - 152,040

This means that the proportions allocated have changed as 10% of the costs of service
department 1 have not been allocated to service department 2. And 20% of the costs of service
department 2 have not been allocated to service department 1.
The only justification for using the direct allocation method is its simplicity. The method is
recommended when inter-service reallocations are relatively insignificant

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