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OVERHEADS & absorption COSTINGPUTERILIYANAZAIDIHAIZZATCHAPTER 8:

OVERHEADS

OverheadsIndirect cost or overhead is the total of the indirect costs incurred in the course of making a product , providing a service or running a department , but which cannot be traced directly and in full to the product or service.

INDIRECT MATERIALSINDIRECT LABOURINDIRECT EXPENCESOVERHEAD

DISTRIBUTION OVERHEADADMINISTRATION OVERHEADSELLING OVERHEADPRODUCTION OVERHEADCATOGERIES OF OVERHEAD

ABSORBTION COSTINGABSORBTION COSTINGAbsorption costing is a method of sharing overheads betweennumber of different products or services on a fair basis. It involves allocation , apportionment and absorption.

OBJECTIVE :To include in the total cost of a product or service an appropriate share of the organisations total overhead.

Practical REASONS for using absorption costingInventory valuations . Production overheads are added to the cost of production to give the factory cost or full cost of productionEstablishing the profitability of different products of services.

ABSORBTION COSTING PROCEDUREALLOCATIONAPPORTIONMENTRE-APPORTIONMENTABSORBTION

ALLOCATIONAllocation is the process of assigning whole items of cost to cost centres

Some cost are shared by all departments within organisation , so that they cannot be allocated in full to production , administration or sales and distribution overheads

Some cost can be directly allocated to cost centres for production, administration and sales and distribution overheads

Some cost can be allocated directly to specific production cost or service cost centres

APPORTIONMENTA procedure whereby indirect cost (Overhead) are spread/share between cost center based on a fair basis.

Examples of Apportionment Basis:Shared Overhead Cost ItemBasis of ApportionmentRent, rates, heating and light, repairs and depreciationFloor area accupied by each cost centreInsurance of equipment, where the same policy covers equipment in different cost centreCost or book value of equipment

Taken from BPP text book page: 140

RE-APPORTIONMENTRe-apportion service cost centre to the production cost centre.Alike apportionment , the basis used must be fair.

For Example:Service Cost CentrePosible Basis Of ApportionmentStores

Number of cost value of material requisitions.Maintenance Hours of maintenance work done for each cost centre.Production PlanningDirect labour hours worked in each production cost centre.

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DIRECTApportioning the cost of each Service Centre to the Production Cost Centre ONLY!

STEP DOWNIn this method, the Service Cost Centre will not apportion only to the Production Cost Centre but also to some Service Centre.

Taken from BPP text book page: 143

Taken from BPP text book page: 145 & 146IMPORTANT!

ABSORBTIONOverhead is absorbed into cost unitsDetermined an OAR based on appropriate basisPercentage of direct labour costRate per machine hourRate per labour hourRate per unitPercentage of prime costExamples*It depends on the concern of an organisation or department

INSENTIVE BASIS USEDLabourLabour hour rateProduction Department (Machinery)Direct Machine HourArbitrary nature of Absorption Costing: - less likely to be accurate

- methods or absorption used must be reviewed regularly

PREDETERMINED OAR

Total budgeted OH Total budgeted Activity= An expected costPredetermined VS ActualPREDETERMINEDACTUALPredetermined OAR is used but over or under absorption of OH will occur due to factors that vary throughout the period.It is not practical for management planning and control purposes to wait until the end of accounting period to calculate the actual OHOVER & UNDER ABSORBUnder Absorb = Actual > AbsorbedOver Absorb = Absorbed > ActualImportant Formula!

Actual OH Absorb OH = Value ( + / - )

-ve (n) = Over absorption (o)+ve (p) = Under absorption (u) NOPU !!Why under/ over absorption is very important in absorptioncosting using predetermined absorption rates?The rate is predetermined from estimates of OH cost n the expected volume of activity

NON-PRODUCTION OVERHEADThe indirect cost of an org. that are not classified as manufacturing OH

e.g: Administration OH, Selling OH, Distribution OH n Research n Development (R&D) costs.

Internal Reporting -Estimation of total cost/actual cost requires a total cost per unit of output. -For product pricing purposes n for internal management reports => Appropriate to allocate non-production OH to units of output.

b) External Reporting-Not necessary to allocate non-production OH to products.

Bases Of ApportioningThe methods of allocating :Choose a basis for the OAR.Use the prod cost as the basis for allocating non-prod costs to products. OAR = Estimated non-prod OH Estimated prod costs

Types Of OHPossible Absorption BaseSelling n MarketingSales ValueResearchConsumer cost = prod cost cost of direct materialAdded value = Sales value of product cost of bought in materials n servicesDistribution Sales valueAdministrationFull prod cost*Absorption rates are usually stated as %

Administration OH Consists:Executive salaries n wages/salaries of all staff in administration dept.Office rent n ratesLightingHeating n cleaning the office *Absorption rates for administration OH => % of full prod cost.

Selling n distribution OHSelling costs => incurred to obtain salesDistribution costs => Begin as soon as the finished goods are put into warehouse despatched to the customer. *Selling OH is absorbed on the basis on the basis of sales value. * Distribution OH more closely linked to prod > sales- Extra cost of prod - Absorbed on a % of prod cost but special situation (size n weight of products affecting the delivery charges) may cause a different basis to be used.

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