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Accounting for Overheads and Marginal costing

Overheads

Overhead is the cost incurred in the course of making a product, providing a service or running a

department, but which cannot be traced directly and fully to the product, service or department.

Overhead is actually the total of the following:-

Indirect materials

Indirect labor

Indirect expenses

In cost accounting, there are two schools of thoughts as to the correct method of dealing with

overheads:-

Absorption costing

Marginal costing

There are four categories of overheads.

1. Production/ manufacturing overheads

2. Marketing/ selling and distribution overheads

3. Research and development overheads

4. Administration overheads

Allocating Overheads to Products

In general, overheads are charged to products through two stages.

1. Overheads are assigned to cost centers

2. Accumulated costs at cost centers allocated to the products

Overhead Cost Allocation & Apportionment

1. Costs are specifically allocated, where they can be ascertained specifically and charged to a

particular cost centre.

Example: The depreciation of machines in production division.

In here, the depreciation of machines in production division, which is considered as a cost centre, can

be charged (allocated) to that cost centre.

2. When overhead item is a common cost, the cost item is apportioned to the cost centers that

benefit from the cost on an appropriate basis (e.g. machine hours, number of employees etc.).

3. The overheads are to be allocated to service department as well as to production

departments.

4. Service department overheads are to be absorbed through jobs or products passing through

production department. So service department costs are re-apportioned to production

departments.

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Absorption costing stages

Overhead allocation

Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre

For example, the following cost will be charged to the following cost centers via the process of

allocation:-

Direct labor will be charged to the production cost centre

The cost of warehouse security will be charged to the warehouse cost centre

Costs such as canteen are charged direct to the various overhead cost centers.

Overhead Apportionment

Apportionment of overhead is distribution of overheads to more than one cost centre on some

equitable basis.

When the indirect costs are common to different cost centers, these are to be apportioned to the

cost centers on an equitable basis. For example, the expenditure on general repair and

maintenance, If the department is involved in the production of a single product, the whole repair

& maintenance of the department may be allocated to the product. If not it will be apportioned

according to their use of the above-mentioned cost. We can use several ways as basis of

apportionment, when dividing the cost between different cost centers. Examples,

Overhead to which basis apply Basis of apportionment

Rent, rates, heating and light, repairs and

depreciation of building

Floor area occupied by each cost centre

Deprecation and insurance of equipment Cost or book value of equipment

Personnel, office, canteen, welfare, wages and

costs of offices, first aid

Number of employees, or labor hours worked in

each cost centre

Allocation Apportionment Absorption

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For services…

Service cost centre Possible basis of apportionment

Stores Number of cost value of material requisitions (requisitions - An official

order laying claim to the use of property or materials)

Maintenance Hours of maintenance work done for each cost centre

Production planning Direct labor hours worked in each production cost centre

Overhead Absorption

Determine an absorption rate at which the cost of each cost centre is charged to jobs / products

passing through the cost centre.

𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 =𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑐𝑒𝑛𝑡𝑟𝑒

𝐴𝑝𝑝𝑟𝑜𝑝𝑟𝑖𝑎𝑡𝑒 𝑏𝑎𝑠𝑖𝑠

Overhead costs absorbed by individual products at an absorption rate based on the total expected

output or volume of input. Example,

Total Overhead of dept = Rs. 10,000

Total labor hrs = 250

Absorption rate = 10,000/250 = Rs. 40 per labor hr

Example:

Job 232 is one of many jobs that pass through the assembly cost center during a period. The

only work done on job 232 is assembly work and its direct costs are,

Direct materials 65

Direct labor ( 5 hours @ Rs 18) 90

Total Overhead on Assembly cost center 225000

Expected that 9,000 hours will be worked in total during the period, what is the total

production cost of job 232?

Overhead absorption rate = 225000/90000 = 25

Total Direct Cost = 155

Total production cost = Total Direct Cost + OAR = 155 + 25 = 180

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Re – apportionment of service department costs

Once the overhead have been allocated and apportioned to production and service

departments and totaled, the next step is to reapportion the service department costs to

production departments.

Here is an Example that talks about full cycle of allocation, apportion, absorption, and re-

apportion. Here we talk about three basic methods of allocating service department costs.

1. Continuous Allotment

2. Simultaneous Equation method

3. Specified order of Re-Allocation

Choice of Overhead Rates

• The overhead rate is calculated based on several alternative bases. The basis chosen should be

suitable for the cost centre activities.

𝐷𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟 𝑟𝑎𝑡𝑒 =𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑

𝐷𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠

𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟 𝑟𝑎𝑡𝑒 =𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑

𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠

𝐷𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑒 =𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟 ℎ𝑒𝑎𝑑

𝐷𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡

In above example we used the second way, 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟 𝑟𝑎𝑡𝑒 = (𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑)/(𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠)

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Absorption and marginal costing

Absorption - Before we allocate all manufacturing costs to products regardless of whether they are

fixed or variable. This approach is known as absorption costing/full costing. It is costing system, which

treats all manufacturing costs including both the fixed and variable costs as product costs

Marginal - However, only variable costs are relevant to decision-making. This is known as marginal

costing/variable costing. It is a costing system, which treats only the variable manufacturing costs as

product costs. The fixed manufacturing overheads are regarded as period cost

Practical reasons for using absorption costing

Inventory in hand must be valued for two reasons, In absorption costing, closing inventory is valued at

fully absorbed factory costs :-

For the closing inventory figure in the statement of financial position

For the cost of sales figure in the statement of comprehensive income

Many companies attempt to fix selling prices by calculating the full cost of production or sales of each

product, and then adding a margin for profit. Without using absorption costing, a full cost is difficult to

ascertain.

If a company sells more than one product, it will be difficult to judge how profitable each individual

product is, unless overhead costs are shared on a fair basis and charged to the cost of sales of each

product

Here is a example for absorption and marginal costing

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Difference between absorption and marginal costing

Absorption costing Marginal costing

Treatment for

fixed

manufacturing

overheads

Fixed manufacturing overheads are

treated as product costing. It is believed

that products cannot be produced

without the resources provided by fixed

manufacturing overheads

Fixed manufacturing overhead is treated

as period costs. It is believed that only

the variable costs are relevant to

decision-making.

Fixed manufacturing overheads will be

incurred regardless there is production or

not.

Value of closing

stock

High value of closing stock will be

obtained as some factory overheads are

included as product costs and carried

forward as closing stock

Lower value of closing stock that

included the variable cost only

Argument for absorption costing

Compliance with the generally accepted accounting principles

Importance of fixed overheads for production

Avoidance of fictitious profit or loss

o During the period of high sales, the production is small than the sales, a smaller

number of fixed manufacturing overheads are charged and a higher net profit will be

obtained under marginal costing

o Absorption costing is better in avoiding the fluctuation of profit being reported in

marginal costing

Arguments for marginal costing

More relevance to decision-making

Avoidance of profit manipulation

o Marginal costing can avoid profit manipulation by adjusting the stock level

Consideration given to fixed cost

o In fact, marginal costing does not ignore fixed costs in setting the selling price. On the

contrary, it provides useful information for break-even analysis that indicates whether

fixed costs can be converted with the change in sales volume