OVERHEAD COSTING

An overhead is the cost incurred in the making of a product, providing a service or running a
department, but which cannot be traced directly and in full to the product, service or
department.
An overhead is actually the total of the following:
 Indirect material
 Indirect labour
 Indirect expenses

Indirect costs are usually classified by function as shown below:

 Production overhead
 Administration overheads
 Selling and distribution overheads
Sources of overheads are Material requisitions,Wages analysis book,Vouchers and Invoices
PRODUCTION OVERHEADS
Production overheads represent indirect materials, indirect wages and indirect
expenses attributable to production and also the service activities associated with
production.
Indirect production costs are incurred in three main ways:
Activity Overheads

Production e.g Fuel, protective clothing depreciation super vision

Service The costs of operating non production departments within the
factory such as materials handling, production control and
canteen
Establishment General overheads such as factory rent/rates, heating and
lighting and production management salaries.
 OVERHEAD COSTING PROCEDURES

2.Collecting overheads
1.Establishing cost centers

3.Allocation • Specific to cost centre

 Service cost centers
(No cost units)
• Common to cost centres

5.Re.Apportionment

6.Calculate OAR = Budgeted Overheads Costs

Budgeted Level of Activity

 Production cost centers

(Produce cost units) 7.Overheads Absorption
COST UNITS

8.Compare overheads absorbed with actual overhead incured

OVERHEAD COSTING PROCEDURES
To attribute production overheads to cost units, a sequence of procedures is under taken:
 Establishing cost centers
 Collecting overheads by item from different sources
 Allocation of overheads
 Apportionment of overheads
 Reapportionment of service center costs
 Computation of overhead absorption rates
 Absorbing of production overheads into cost units
 Computation of over/under absorption
OVERHEAD ALLOCATION
Allocation is the process by which whole cost items are charged direct to a cost unit or
cost center.
OVERHEAD APPORTIONMENT
This is a stage which follows overhead allocation. It is a process of sharing out general
overhead costs to beneficiary cost centres on fair basis such as these shown below:

Example of overhead Basis of apportionment

Rent, rates, heating and lighting and Floor area occupied by each cost centre
depreciation of buildings
Depreciation, insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, wages and Number of employees, or labour hours worked in
cost offices, first aid each cost centre
Heating, lighting Volume of space occupied by each cost centre

Overhead allocation and apportionment is done using Overhead Analysis Sheet.

EXAMPLE

Encryption Inc. sells and maintains fax encryption hardware and Software.The Company
has 3 manufacturing departments, Federal Systems, International, and Private. All the
manufacturing departments are profit Centres.The Company has also an Engineering
department and Stores Department .Federal systems contracts with government
agencies. The international deals with foreign buyers and the private deals with private
buyers.
The company, for the past one month, had the following overheads:
K K
Indirect wages and salaries
Federal 4,000
International 3,000
Private 3,500
Engineering 2,500
Stores 1,500
NAPSA 780
Rent and Rates 600
Repairs to plant and machinery 600
Depreciation of Plant and Machinery 450
Heating and lighting 300
Power 560
Insurance of Stocks 350
Medical costs 20
The following information is also available.

Federal International Private Engineering Stores

Area in M2 10,000 8,000 7,000 3,000 2,000

No.of Employees 20 12 15 7 6

BV Plant & machinery K10,000 K12,000 K5,000 K2,000 K1,000

Average Stock K2,000 K1,500 K1,500 - -

Horse Power of Machines 120 95 55 10 -

Budgeted Labour Hours 16,000 3000 600

Budgeted Machine Hours 500 2000 2000

Actual Machine Hours 100 300 2229

Actual Labour Hours 14300 2,850 300

Budgeted Overheads K8000 K6,000 K4,500

The following data summarizes the utilization of each of the service departments.

Federal International Private Engineering Stores

Cost of

Material

Requisitions K30, 000 K30, 000 K20, 000 K20,000 -

Engineering

Hours needed 5,000 3,000 1,000 - 1,000

(A)Carry out the allocation and apportionment of overheads to the five departments
(Prepare Overhead Analysis Sheet)
 SOLUTION

(A) OVERHEAD ANALYSIS SHEET

Basis Federal International Private Engineering Stores Total

Indirect labour Allocation 4,000 3,000 3,500 2,500 1,500 14,500

NAPSA No.workers 260 156 195 91 78 780

Rent&Rates Area 200 160 140 60 40 600

Repairs Bookvalue 200 240 100 40 20 600

Depreciation Bookvalue 150 180 75 30 15 450

Heat&Light Area 100 80 70 30 20 300

Power Horsepower 240 190 110 20 - 560

Insurance Average stock 140 105 105 - - 350

Medical No.Workers 7 4 5 2 2 20

Total 5,297 4,115 4,300 2,773 1,675 18,160

RE-APPORTIONMENT OF SERVICE CENTRE COSTS
A factory is divided into several production cost centres and also many service cost
centres such as stores maintenance and canteen. The third stage in overhead costing
concerns the treatment of overheads in service centres. This is also secondary or
second stage apportionment. This is where service cost centre overheads are fairly
charged to production cost centres. Fairness is achieved by using benefit that each
production cost centre received from service cost centre as a basis for overheads
apportionment.
Because no production cost units pass through the service cost centres, it is necessary
to apportion the service department costs to the production cost centres so that all
production costs (including those of the service departments) are accounted for.
Typical bases for re-apportionments are shown below.
Service Department Basis of apportionment

Stores Number of requisitions

Value of materials issued

Maintenance Maintenance Hours

Personnel office Number of employees

Production planning Direct labour hours per each department

There are three ways of re-apportionment of service centre costs:
 Direct method:This method ignores interservice cost centre dealings in full.
 Elimination method:This method recognises interservice cost centre dealings only
once.Overheads allocated to each cost centre depends on which service cost centre is
removed first.This method is also called step down method.
 Continuous allotment:Under this method interservice cost centre dealings are recognised in
full.This is the same as using simultaneous equations.
(B)Re apportion service department overheads to Manufacturing
departments using:
(i) Direct method
(ii)Step down method
(iii)Repetitive Method
(iv)Simultaneous equations
 (i) DIRECT METHOD.

Federal International Private Engineering Stores

Overheads 5,297 4,115 4,300 2,773 1,675

Stores(3:3:2) 628 629 418 - (1,675)

Engineering(5:3:1) 1,541 924 308 (2,773) -

7,466 5,668 5,026 0 0

(ii)STEP DOWN METHOD

Basis Federal International Private Engineering Stores Total

Overheads 5,297 4,115 4,300 2,773 1,675 18,160

Stores (3:3:2:2) 502.5 502.5 335 335 (1,675)

5,799.5 4,617.5 4,635 3,108 0 18,160

Engineering(5:3:1) 1,726.7 1,036 345.3 (3,108)

Total 7,526.2 5,653.5 4,980.3 0 0 18,160

The weakness with this method is that the overheads charged to each cost centre depends on which service cost centre
is removed first.In this example we started with stores and followed by Engineering. If we started with engineering and
then stores,overheads allocated to each cost centre will change as below:
(ii)STEP DOWN METHOD

Basis Federal International Private Engineering Stores Total

Overheads 5,297 4,115 4,300 2,773 1,675 18,160

Engineering(5:3:1:1) 1,386.5 831.9 277.3 (2,773) 277.3

6,683.5 4,946.9 4,577.3 0 1952.3 18,160

Stores (3:3:2) 732.1 732.1 488.1 - (1,952.3)

Total 7,415.6 5,679.0 5065.4 0 0 18,160

REPETITIVE METHOD
Basis Federal International Private Engineering Stores Total
Overheads 5,297 4,115 4,300 2,773 1,675 18,160
Stores (3:3:2:2) 502.5 502.5 335 335 (1,675)
5,799.5 4,617.5 4,635 3,108 0 18,160
Engineering(5:3:1:1) 1,554 932.4 310.8 (3,108) 310.8
Total 7,353.5 5,549.9 4,945.8 0 310.8 18,160
Stores (3:3:2:2) 93.24 93.24 62.16 62.16 (310.8)
7,446.74 5,643.14 5,007.96 62.16 0 18,160
Engineering(5:3:1:1) 31.08 18.648 6.216 (62.16) 6.216
Total 7,477.82 5,661.788 5,014.176 0 6.216 18,160
Stores (3:3:2:2) 1.8648 1.8648 1.2432 1.2432 (6.216)
Total 7,479.6848 5,663.6528 5015.4192 1.2432 0 18,160
Engineering(5:3:1:1) 0.6216 0.6216 0 (1.2432) 0
Total 7,480.3064 5,664.2744 5015.4192 0 0 18,160
SIMULTANEOUS EQUATIONS
Let X = stores after receiving 10% from Engineering.
Let Y = Engineering after receiving 20% from stores.
X = 1675 + 0.1y
Y=2773 + 0.2 x
x- 0.1y = 1675 solving the equations
-x +5y = 13865
4.9 y = 15,540
Y= 3171. X= 1992.
Federal International Private
Overheads 5297 4115 4,300
Stores(30%:30%:20%) 597.6 597.6 398.4
Engineering (50%:30%:30%) 1,585.5 951.8 317.1
7,480.1 5664.4 5,015.5
OVERHEAD ABSORPTION
The final stage in the process in overhead costing is to reflect the cost of overheads in individual cost
units. This is known as overhead absorption. To determine the overhead to be absorbed by a cost unit, it is
necessary to establish an overhead absorption rate which is calculated as
Total Budgeted Overhead
Overhead Absorption Rate =
Total Budgeted Level of Activity

Level of activity might mean units budgeted ,labour hours, machine hours or any other activity which is
perceived to be of high volume and there fore a major causer of the overheads
ABSORPTION BASES (Levels of activity)
Overheads can be absorbed into cost units by means of:
•Units produced
•Total prime cost
•Total Material cost
•Total direct wages
•Direct labour hours
•Machine hours
Example
Budgeted overhead Costs are K250,000
a) Budgeted Units to be produced 25,000
b) Total prime cost K500,000
c) Total Material cost K300,000
d) Total direct wages K200,000
e) Direct labour hours 12,500
f) Machine hours 10,000

Calculate Overhead Absorption Rate (OAR) using

I. Units produced
II. Total prime cost
III. Total Material cost
IV. Total direct wages
V. Direct labour hours
VI. Machine hours
Calculate Overhead Absorption Rate (OAR) using
I. Units produced= K250,000/25,000 units = K10 per unit
II. Total prime cost= K250,000/K500,000 x 100 = 50%
III. Total Material cost = K250,000/300,000 x 100 = 83.3%
IV. Total direct wages = K250,000/K200,000 x 100 = 125%
V. Direct labour hours =K250,000/12,500 LH = K20 per Labour Hour
VI. Machine hours = K250,000/10,000 MH = K25 per Machine Hour.

NOTE THAT ONLY ONE OAR IS USED.THE ACTIVITY WHICH IS OF HIGH VOLUME IS USED
AS LEVEL OF ACTIVITY
PRE-DETERMINED OVERHEAD ABSORPTION RATE (OAR)

The overhead absorption rates used for absorption are calculated prior to the accounting
period using budgeted overheads and budgeted activity.

The main reason for this is that the actual overhead and actual activity is not known until
the end of the period and the actual overhead absorption rate would not be calculated
until then. This would mean that product cost can not be calculated until the end of the
period and this would create unacceptable delays for such activities as invoicing and
cost estimation.
The only solution is to use predetermined rates.

From our example above OARs will be calculated as below:

 Production Department
Federal International Private
Budgeted Overheads (K) 8,000 6,000 4,500
Budgeted Labour Hours 16,000 3000
Budgeted Machine Hours 2,000
OAR/Labour Hour K0.5 K2.0
OAR/Machine Hour K2.25
UNDER OR OVER ABSORPTION
Overhead absorption rates are based on budgeted overhead costs and the budgeted
volume or activity. In practice we should expect that:
Actual overhead expenditure will differ from budgeted overhead expenditure; and
The actual volume activity will differ from the budgeted volume of activity

As a consequence the amount of overheads charged to product costs will differ from the
actual overhead expenditure.

We might charge more overhead costs to production than the amount of overheads
expenditure actually incurred. If so there is over absorption or over recovery of
overheads.

Alternatively, we might charge less overhead costs to production than the amount of
overheads expenditure actually incurred. If so there is under absorption or under
recovery of overheads.