Chapter 3 Overheads Final

7/29/2019 Chapter 3 Overheads Final

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CHAPTER 3

OVERHEADS

Overheads are costs, which are not traced directly to cost units. In other words, overhead

is the total of indirect material costs, indirect labour costs, and indirect expenses. The

terms burden, supplementary costs, on costs and indirect expenses are used

interchangeably for overhead. Overheads are aggregated under some account head (e.g.

supervisors salary, office lighting, depreciation, and building up keep) and then assigned

to cost units on some equitable basis.

Overheads are usually classified in terms of functions: factory overhead, administration

overhead, selling overhead, and distribution overhead. The terms factory overhead,

manufacturing overhead and production overhead are used interchangeably.

Manufacturing overheads

Manufacturing overheads are indirect costs associated with the manufacturing process. In

a product manufacturing set up manufacturing process is the sequence of operations that

begin with supplying materials to work stations and end with the primary packing of the

product. In the context of producing services, the manufacturing process is the process of

performing activities, concurrently or in sequence, which are directly related to creating

the service. For example, in the context of an organisation providing road transportservices, manufacturing overheads are overheads associated with the operation of the

vehicles. Indirect costs incurred in stores department and in departments providing

support services are also included in manufacturing overhead.

Administration overheads

Administration overheads are costs of formulating the policy, directing the organization

and controlling the operations which are not directly related to production, selling,

distribution and research or development or any other function.

Cost of factory administration is a part of manufacturing overhead. Similarly, the cost of

administration of marketing offices is a part of selling overhead.

Selling overheads

Selling overheads are costs associated with marketing and selling (excluding distribution)

activities.


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Distribution overheads

Distribution overheads are costs associated with the distribution of finished products.

Distribution includes such activities as moving finished goods to central or local storage,

moving finished goods to and from prospective customers as in case of goods on sale or

return basis. In gas, electricity and water industries, distribution means pipes, mains and

services which may be regarded as equivalent to packing and transportation.

3.1 ACCOUNTING FOR MANUFACTURING OVERHEADS

Manufacturing overheads form part of the product cost. Accounting for manufacturing

overheads aims to equitably assign overheads to units produced during a period.

Overheads for a period are aggregated and then assigned to units produced using a

method that reasonably captures the demand of the units on resources represented by

overheads. Usually, an average rate per unit is calculated and the same is applied to

assign overheads to units produced. Overheads are aggregated at the cost centre level and

average rate is calculated for each cost centre because the incidence of cost is different at

different cost centres and different products consume varying amount of resources at each

cost centre.

Conventional method for assigning overheads to units produced during the period

involves the following four steps:

Allocation

Apportionment

Reapportionment

Absorption


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Total overheads for a particular period are collected under production cost centres and

separate overhead absorption rates are used for different production cost centres. This is a

refinement over the earlier practice of using a single absorption rate for the

factory/facility. In past, most firms used to produce a single product or similar products,

and the demand used to be created by each unit of such products on resources represented

by fixed factory overheads did not vary significantly. Consequently, use of the blanket

rate did not impair the product cost. Firms felt the need for refinement when they added

different types of products which either do not use the resources of all the cost centres or

the time spent by them in a particular cost centre is not uniform.

The conventional method required further refinement because it fails to produce result

with desired accuracy for firms that produce variety of products using the same facility in

situations where the amount of resources consumed by a unit in a particular cost centre

does not depend on the time spent by it in the cost centre.. Activity based costing (ABC)

method, which is a refinement over the conventional method, provides result with much

higher accuracy than that obtained by using the conventional method.

We shall discuss the ABC method in chapter 14.

3.1.1 Allocation

Overheads that can be identified to a cost centre are assigned to the cost centre. For

correct allocation of factory overheads, source document which is used for collection of

overheads must clearly indicate the cost centre which has received the benefit from the

expenses covered under the document. Notification of account-headings (standing order

number) and cost centres is essential for allocating factory overheads to various cost

centres. Examples of overheads that can be identified with cost centres are: depreciation,

insurance, and repair and maintenance of equipment located in different cost centres,

remuneration to supervisors and indirect workers dedicated to different cost centres, and

power (if separate meters are installed in different cost centres).

3.1.2 Apportionment

Apportionment refers to proportionate allotment of overheads common to various cost

centres to those cost centres on some equitable basis. Examples of common overheads

are: rent, rates, depreciation, repairs and maintenance of the building in which cost-


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centres are located, lighting of the premises, works-managers salary, medical directors

salary in a hospital, and managing partners salary in an accounting firm.

Allocation of directly identifiable items and apportionment of common items of factory

overheads result in collection of total factory overheads under various cost centres,

including support-service cost centres.

The following are some of the common bases used for measurement of benefits:

Basis Cost item

Floor area Rent, rates, depreciation, maintenance of building and other

expenses connected with the premises; lighting and heating (if a

better basis is not available); fire protection service, etc.

Number of employees Any expense associated with employees, such as canteen

expenses, recreation expenses, timekeeping, supervision, etc.

Value of materials

passing through

cost centres

Expenses associated with material such as material

handling expenses

Capital values Depreciation, insurance and maintenance of production

facilities

Direct labour hours

and/or machine hours

Majority of general overhead items

Technical estimates (a)Lighting: capacity of lighting or number of lights

(b)Electric power: horse power of machines coupled with

operating time

(c)Steam

(d)Water.

Two secondary criteria, other than the proportionate benefit, which are sometimes used

for apportionment of factory overheads, are as follows:

(a) Ability to pay. One of the accepted principles of taxation is what the traffic will

bear. This principle is sometimes applied in cost accounting for cost apportionment. For

example, sales office expenses may be apportioned to various product groups on the basis

of sale value. The assumption is that a product with a higher sale value can bear a higher


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burden of sales expenses, although actual efforts involved in selling an easy selling line

but having higher sales must be lower as compared to the effort involved in other product

lines having a lower sales value.

(b) Efficiency or incentives. In some organizations, overheads are apportioned on the

basis of a predetermined activity level (often budgeted production or sales level). If actual

performance exceeds the predetermined level, average per unit overhead cost would be

lower as compared to predetermined rate while failure to achieve the predetermined

activity level would result in a higher average per unit overhead cost. This provides an

incentive for better performance.

3.1.3 Re-apportionment

Overheads of service cost centres are reapportioned to other cost centres based on the

proportionate benefit derived by those cost centres. The following are some of the most

apparent bases for reapportionment:

Basis Cost centres

Number of employee Canteen, welfare and recreation centres, timeoffice

Value of material used or

requisitioned

Stores and internal transport

Capital value (This basis is likely to

give inaccurate results. A moreappropriate basis would be the

actual maintenance hours and the

actual issue of spares.)

Maintenance

Technical estimates Tool roomFloor area Building service

Energy/power consumed Boiler house and power house

Usually technical estimates are used to reapportion overheads assigned to support-service

cost centres to production cost centres, because, often it is difficult to identify appropriate

criteria for reapportioning service cost centre overheads.

One of the following methods is used to reapportion overheads of service cost centres to

production cost centres:

(a) Direct redistribution method

(b) Step distribution method


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(c) Reciprocal services method.

Direct redistribution method

A service cost centre renders services to production cost centres as well as to other

service cost centres. This method ignores the services rendered by one service cost centre

to other service cost centres. Service cost centre overheads are apportioned to production

cost centres in the ratio of benefits received by them. This is a simple, but an inaccurate

method.

Illustration 3.1

Maria Limited (ML) has three production centres, A, B and C and two service cost

centres, X and Y. Costs allocated to service centres are required to be apportioned to the

production centres to find out cost of production of different products. It is found that

benefit of service cost centres is also received by each other along with the production

cost centres.

Overheads as allocated to the five cost centres and estimates of benefit of service cost

centres received by each of them are as under:

Cost

centres

Overheads as allocated

(CU)

Estimates of benefits received by other cost

centres (%)

X Y

A 80,000 20 20

B 40,000 30 25

C 20,000 40 50

X 20,000 5

Y 10,000 10

Required: Work out final overhead of each of the production departments including

reapportioned overheads of service centres using direct redistribution method.(Adapted, ICWA, Inter)

Solution

Total overhead accumulated under the cost centre X is to be distributed to A, B and C in

the ratio of 2:3:4. Similarly, total overhead accumulated under the cost centre Y is to be

distributed to A, B and C in the ratio of 2:2.5:5. Calculations are shown below:


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Cost

centres

Overheads

allocated and

apportioned(CU)

Reapportionment

of Xs overhead (CU)

Reapportionment of Ys

overhead (CU)

A 80,000 20,000 (2/9) = 4,444 10,000 (2/9.5) = 2,105

B 40,000 20,000 (3/9) = 6,667 10,000 (2.5/9.5) = 2,632

C 20,000 20,000 (4/9) = 8,889 10,000 (5/9.5) = 5,263

The final overhead of production cost centres are as follows:

A: CU 80,000 + 4,444 + 2,105 = CU 86,549

B: CU 40,000 +6,667 + 2,632 = CU 49,299

A: CU 20,000 + 8,889 + 5,263 = CU 34,152

Step distribution method

Under this method service cost centres are ranked in order of the magnitude of overhead

to be reapportioned. Sometimes, support-service cost centres are ranked on the basis of

the number of service cost centres to whom services have been rendered by the particular

service cost centre.

Overhead of the support-service cost centre, which is ranked first, is reapportioned to all

other cost centres including service cost centres. The overhead of the service cost centre

ranked second would then be reapportioned to all other cost centres except to the service

cost centre ranked first. In this manner, overhead of a service cost centre would bereapportioned to all cost centres including service cost centres ranked lower to that

service cost centre. This method provides more accurate results as compared to the direct

redistribution method. However, it often fails to provide the desired result, because in

reapportioning the overhead of a particular support-service cost centre, support-service

cost centres ranked higher are ignored.

Illustration 3.2

Based on the information provided in illustration 3.1, work out final overhead of each of

the production departments, including reapportioned overheads of service centres using

step redistribution method.

Solution




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Cost

centres


(CU)

Estimates pf benefits received by other cost

centres (%)

X Y

A 80,000 20 20

B 40,000 30 25

C 20,000 40 50

X 20,000 5

Y 10,000 10

Based on the magnitude of overhead, service centre X is ranked I and Y is ranked II.

Therefore, we allocate the overhead of the service centre X to A, B, C and Y as per

calculations below:

A: CU 20,000 (2/10) = CU 4,000

B: CU 20,000 (3/10) = CU 6,000

C: CU 20,000 (4/10) = CU 8,000

Y: CU 20,000 (1/10) = CU 2,000

The total overhead of Y, including reapportioned overhead of X is CU 12,000. In

reapportioning overhead of Y, we shall ignore the service received by X from Y, because,

X is ranked higher than Y. The following are the calculations:

A: CU 12,000 (2/9.5) = CU 2,526

B: CU 12,000 (2.5/9.5) = CU 3,158

C: CU 12,000 (5/9.5) = CU 6,316

The final overhead of production cost centres are as follows:

A: CU 80,000 + 4,000 + 2,526 = CU 86,526

B: CU 40,000 +6,000 + 3,158 = CU 49,158

A: CU 20,000 + 8,000 + 6,316 = CU 34,316

Reciprocal service method

This is the most accurate method because it recognises and gives due weightage to inter

service transfers. The following methods deal with reciprocal services:

(i) Simultaneous equation method

(ii) Repeated distribution method

(iii) Trial and error method


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Simultaneous equation method

There are two steps in this method. First, overheads of service cost centres are ascertained

using simultaneous equation method; and second, overheads collected under service cost

centres are reapportioned to production cost centres on the basis of certain predetermined

percentages.

Repeated distribution method

Simultaneous equation method can get quite complicated if there are several service cost

centres. Repeated distribution method is the easiest to follow. Under this method,

overheads of service cost centres are reapportioned to other service and production cost

centres on the basis of predetermined percentages. The process continues until the figures

under service cost centres either get exhausted or become too small to be of any

consequence.

Trial and error method

Under this method, the first step is to ascertain overheads of service cost centres by

repeated distribution method. The second step is to reapportion the total overheads of

service cost centres to the production cost centres on the basis of predetermined

percentages.

Illustration 3.3

Based on the information provided in illustration 3.1, work out final overhead costs of

each of the production departments including reapportioned cost of service centres using

(a) continuous distribution method and

(b) simultaneous equation method.

Solution



Cost

centres


(CU)

Estimates pf benefits received by other cost

centres (%)

X Y

A 80,000 20 20

B 40,000 30 25

C 20,000 40 50


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X 20,000 5

Y 10,000 10

(a) Continuous distribution method

A (CU) B (CU) C (CU) X (CU) Y (CU)

80,000 40,000 20,000 20,000 10,000

4,000 6,000 8,000 (20,000) 2,000

84,000 46,000 28,000 12,000

2,400 3,000 6,000 600 (12,000)

86,400 49,000 34,000 600

120 180 240 (600) 60

86,520 49,180 34,240 60

12 15 30 3 (60)

86,532 49,195 34,270 3

1 1 1 (3)*

86,533 49,196 34,271

*The amount being insignificant, it is equally distributed to production departments.

(b) Simultaneous equation method

Equations will be:

X = 20,000 + 5% of Y (1)

Y = 10,000 + 10% of X (2)

Solving equations (1) and (2) we get

X = CU 20,063; and Y = CU 12,060

Overheads of A, B and C will be as follows:

Particulars A (CU) B (CU) C (CU)

Allocated and apportioned 80,000 40,000 20,000

Share of X (Ratio 20:30:40) 4,120 6,180 8,240

Share of Y (Ratio 20:25:50) 2,412 3,015 6,030

Ad hoc of residual amount (CU 3) 1 1 1

Total 86,533 49,196 34,271

Management perspective


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We may compare the results obtained under different methods.

Cost centre Direct

redistribution

method

Step

redistribution

method

Continuous

distribution

method

Simultaneous

equation

method

A CU 86,549 CU 86,526 CU 86,533 CU 86,533

B 49,299 49,158 49,196 49,196

C 34,152 34,316 34,271 34,271

Considering that in our example only two service cost centres are considered and the

quantum of reciprocal services are not significant (10 % of X to Y and 5% of Y to X), the

variation in results obtained by using different methods is significant. Continuous

distribution method and simultaneous equation method give the same result. The

accuracy of those two methods is much higher than the other methods. Firms use

continuous distribution method because with the present computing power, the method is

easy to use, while the simultaneous equation method becomes complex with more than

two service centres.

3.1.4 Absorption

Commonly used methods for assigning overheads to units produced in a particular period

assume that volume is the only cost driver. In other words, they assume that the amount

of resources (represented by overheads) consumed by units produced vary in proportion

to the quantity produced during the period. Therefore, the absorption rate per unit is

calculated by dividing total overhead for the period by number of units produced.

However, in most situations, units of different products produced are not uniform. For

example, a firm producing pumps of different types and different sizes cannot use a rate

per unit for overhead absorption. It has to establish rate per equivalent unit, taking a

particular type of pump as the measurement unit, provided it can convert one unit of each

variety of pumps into equivalent units. Usually firms use machine hour rate for machine-

intensive cost centres and direct-labour hour rate for labour-intensive cost centres. Use of

an hourly rate provides accurate result in situations where the amount of resources, in a

particular production cost centre, consumed by different units routed through that cost

centre varies in direction proportion to the time spent by those units in that cost centre.


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Moreover, use of an hourly rate avoids the complexity of converting one unit of each

variety of products in to equivalent units.

Pre-determined overhead rates

Firms use predetermined overhead absorption rate computed for a normal period (usually,

one year) of business activity. Usually budgeted figures are used to calculate the

overhead absorption rate. Therefore, the method does not involve additional clerical

work. The following are the advantages in using predetermined overhead absorption

rate:

(i) Product costs can be worked out promptly.

(ii) Product costs can be estimated correctly even before production activity commences

and this helps the management in deciding the prices to be quoted to prospective

customers. However, this may not be counted as a true advantage for two reasons. First,

price of a product is determined by factors operating at the market place; and second,

product cost determined for use in valuing stock cannot be used for decision making

except in rare circumstances.

(iii) Product costs are not unnecessarily affected by seasonal fluctuations in costs and

activity levels.

Some cost accountants suggest use of moving average rate for overhead absorption.

Under this method, moving average is calculated with reference to figures for the twelve

months immediately preceding the month for which the rate has to be determined. For

example, if rate is to be determined for the month of August 2008, figures for twelve

months ended July 2008 will be considered in calculating the absorption rate. This

method uses figures pertaining to some of the months falling in the previous accounting

year and to that extent the rate gets distorted because past figures fail to incorporate

changes planned in the budget for the current year. Although under this method, delay is

less as compared to delay in calculating the actual rate; it fails to provide data well in

advance for the purpose of cost estimation. Therefore, it is preferable to use

predetermined overhead absorption rate.

Length of the period

The general principle governing the selection of the period is that the period should be

long enough to normalize the rate. In industries which are subject to cyclical fluctuations


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in business, perhaps the best alternative is to select a period which covers all the phases

of a cycle. The period in such a case may be longer than one year. Selection of period is

also influenced by seasonality of costs. Many overhead items such as repairs and

maintenance, rates and taxes, heating and insurance are not incurred evenly throughout

the year. If there is a predominance of such items, the period selected should longer as

compared to that in industries in which costs accrue evenly. Similarly, in industries in

which production is seasonal, the period selected should be longer as compared to that in

which production volume does not fluctuate from period to period. The objective is to

determine the normal rate.

Usually, predetermined overhead absorption rates are calculated at the beginning of each

accounting year.

What activity level should be used?

Overhead rate per unit or per hour is influenced by the activity level used as denominator

in calculating the rate.

The estimated activity level can be based on:

1. Average output of past years;

2. Estimated output of the current year;

3. Normal production capacity.

The average output of past few years does not represent the normal capacity. Therefore,

the rate calculated by using the average output as denominator is not the normal rate. This

method is suitable for small firms because of its simplicity. In large firms conditions are

rarely static and, therefore, average output of past years should not be used for

computation of predetermined overhead rates.

Estimated output of the current year (the period in which the rate will be used) may or

may not represent the normal capacity. In the year of depression, estimated production

level is likely to be lower as compared to the normal production level. Similarly, in boom

period estimated production level is likely to be higher as compared to the normal

production level.

Overhead absorption rate determined based on estimated output would be comparatively

higher during recession and lower during boom. In other words, during the period of

reduced activity and falling prices, the cost of production would be higher as compared to


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the cost during the period of normal business. Similarly during the period of increased

activity and rising prices the cost of production would be lower. This is highly illogical.

Moreover, it is against the basic cost-accounting principle that products should neither be

loaded with abnormal costs nor benefit from abnormal gains. According to this principle,

abnormal costs should be directly charged to the costing profit and loss account and

abnormal gains should be directly credited to the costing profit and loss account. In

accordance with this principle, the predetermined overhead absorption rate should be a

normal rate and should be such that the total overhead is absorbed if normal production is

achieved. If the actual production is below the normal production, the unabsorbed

overheads arising due to idle capacity should be transferred to the costing profit and loss

account. Similarly, if the actual production exceeds the normal production, over-absorbed

overheads should be credited to the costing profit and loss account.

Normal capacity refers to the expected average production over a sufficiently long period

covering a business cycle. Expected average production is determined taking into account

the practical capacity and the average market demand. Normal capacity should be used as

denominator for calculating predetermined overhead absorption rates and temporary

fluctuation in output level should be disregarded. The following are the advantages in

using normal production capacity in calculating the predetermined overhead absorption

rates:

(a) It helps calculate and recover the true cost of production. If a factory or a cost centre

is operating below normal capacity, it cannot be said that the whole of the fixed cost has

been incurred in achieving the actual output.

(b) It helps calculate and highlight losses due to idle time.

The twin objectives of cost accounting, namely, determination of normal product cost and

cost control are best achieved by using normal recovery rate. Therefore, normal capacity

should be used for calculating the predetermined overhead absorption rate.

Illustration 3.4 (Machine hour rate)

Three machines P, Q and R, which are of different nature, are used in a department of a

factory. From the following information, compute machine-hour rate of machine R:


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(i) Total cost of machine P, Q and R is CU 50,000, out of which cost of machine R is CU

10,000. Its estimated scrap value and working life are CU 1,000 and 18,000 hours,

respectively;

(ii) Rent (total area 1,000 sq. ft and machine R occupies 250 sq. ft): CU 780 per annum;

(iii) Lighting (total light points 12, out of which 2 points are used for machine R): CU

288 per annum;

(iv) Insurance premium for all machines: CU 45 per quarter;

(v) Consumable stores for machine R: CU 60 per month;

(vi) Salary for supervisor (supervisor denotes 1/4th of his time for machine R): CU 6,000

per annum;

(vii) Repair and maintenance for the entire life of machine R: CU 1,800;

(viii) Machine R consumes 5 units of power per hour at a cost of CU 16 per 100 units;

(ix) Machine R will work 2,000 hours per annum out of which normal idle time

estimated at 8% of total working hours and time for routine maintenance estimated at 40

hours per annum.

(Adapted, B.Com, CU)

Solution

Computation of Machine Hour Rate

Particulars Per

annum

(CU)

Per

hour

(CU)

Standing charges:

Rent CU 780 (250/1000) 195

Insurance CU 45 4 (10,000/50,000) 36

Salary of supervisor CU 6,000 (1/4) 1,500

2,731 1.517

Running charges:

Depreciation (CU 10,000 Rs. 1,000)/18,000

0.500

Repairs and maintenance CU 1,800/18,000 0.100

Lighting CU 288 (2/12) (1/1,800) 0.027


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Consumable stores (CU 60 12)/1,800 0.400

Power (CU 16/100) 5 0.800

Machine-hour rate 3.344

Note: Effective working hours = (20,000 0.08 2,000 40) = 1,800 hours.

Under- or over-absorption of overheads

When a firm use pre-determined rate to absorb overhead, factory overhead incurred

during a period may exceed the factory overhead applied to units produced during that

period. The excess is under-absorbed overhead. For example, if overhead incurred was

CU 100,000 and overhead applied to production units was CU 90,000, there was under-

absorption of CU 10,000. If applied overheads exceed overheads incurred, the difference

is over-absorbed overhead. For example, if actual overhead was CU 100,000 and

overhead applied to production was CU 120,000, there was over-absorption of CU

20,000. In either case, the difference must be analyzed to determine the causes of the

variance. Under or over absorption may arise either due to the difference between actual

expenditure and budgeted expenditure or due to difference in budgeted production

volume and actual production.

Over or under absorption of overheads should be calculated at the end of each accounting

period. More frequent calculations may give rise to seasonal variations which offset each

other over the full accounting period.

Under-absorbed overheads are written-off to the profit and loss account and over-

absorbed overheads are credited to the profit and loss account if the following conditions

are fulfilled:

(i) Over- or under-absorption has arisen due to the difference between the output

achieved and the normal output level; or

(ii) The amount is not significant in relation to the total factory overhead incurred.

In both the above situations, production costs are normal and require no correction.

Under-absorption arising due to idle capacity should always be charged to the profit and

loss account. Similarly, over-absorption arising due to higher (as compared to normal)

capacity utilization should always be credited to the profit and loss account.

If the variance is significant and has arisen from an error in the fixation of rates,

production costs should be adjusted. The total variance is apportioned between


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inventories (finished goods and work-in-progress) and cost of goods sold by using

supplementary rates.

Some firm use Suspense Account and transfer the amount of under- or over- recovery to

the suspense account. The suspense account is carried over to subsequent accounting

years for writing off as deferred charge or for crediting as deferred credit. This method is

justified only under the following circumstances:

(i) Variances have arisen due to seasonal fluctuations and business cycle which cover

more than one period.

(ii) Variances have arisen in initial periods of a new project which is yet to achieve 100%

utilization of the normal capacity.

This method is not in common use.

Illustration 3.5

In a manufacturing unit overhead was recovered at a pre-determined rate of CU 25 per

man-day. The total factory overhead incurred and the man-days actually worked were CU

4,150,000 and 150,000, respectively. Out of the 40,000 units produced in a period,

30,000 units were sold. There were also 30,000 incomplete units which may be reckoned

at 66.67 per cent complete. On analyzing the reasons, it was found that 40% of the

unabsorbed overheads were due to defective planning and the rest were attributable to

increase in overhead costs. How would an absorbed overhead be treated in cost accounts?

(Adapted, ICWA, Inter)

Solution

(A) Computation of under- or over-absorbed overheads

Overhead actually incurred CU 4,150,000

Overhead absorbed: CU 25 150,000 man-days = CU 3,750,000

Overhead under-absorbed CU 400,000

(B) Reasons for under-absorption

Due to defective planning 40% of CU 400,000 CU 160,000

Due to increase in overhead cost (Balancing figure) CU. 240,000

Under absorbed amount of CU 160,000, attributable to defective planning is to be treated

period cost and is to be directly charged to profit and loss account. Product cost needs

to be adjusted for Rs. 240,000, being the amount of under-absorbed overheads arisen due


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to error in estimating overhead costs. It is assumed that the difference in expenditure has

not arisen from an abnormal transaction or event.

(C) Apportionment of CU 240,000 between cost of sales, finished good and incomplete

units:

(i) Total production during the period in terms completed unit

(a)Number of units completed: 30,000 + 10,000 = 40,000 units

(b) Incomplete units in terms of completed unit: 66 .67% of 30,000units = 20,000 units

Total production in terms of completed unit: 60,000 units

(ii) Apportionment in the ratio of completed units

(a) To cost of sales: CU 240,000 (30,000/60,000) = CU 120,000

(b) To finished goods: CU 240,000 (10,000/60,000) = CU 40,000

(c)To incomplete units: CU 240,000 (20,000/60,000) = CU 80,000

(D) Treatment of under-absorbed overheads in cost accounts

To be written off to costing profit and loss account: CU 160,000

To be absorbed in cost of sales: 120,000

To be absorbed in stock of finished goods 40,000

To be absorbed in Stock of work-in-progress 80,000

CU 400,000

3.1.5 Capacity Levels

Capacitygenerally implies the maximum that can be achieved by the best possible use of

the available facilities and other resources (e.g. human resources, basic organization

structures, funds, etc.). Capacity depends upon the fixed amount of resources with which

the management expects to run the business. The concept is applicable to plant and

equipment and other resources such as human resources and material. Usually capacities

of different operations in the production process are not balanced. Therefore, the

bottleneck operation, which has the minimum capacity among all operations,

determines the capacity of the complete production process. Let us take an example,

assume that there are five operations A, B, C, D and E in the production process.

Capacities of A, B, C, and D are 1,000 units. The capacity of E is 900 units. The capacity

of the production process is 900 units.

Usually, capacity is expressed in terms of number of units or standard hours per annum.


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Theoretical capacity (Ideal capacity)

It refers to the output that can be achieved if production is carried out at a maximum

speed without interruption. With reference to plant and equipment, it indicates the rated

capacity, that is, the capacity specified by the manufacturer or erector of the plant. Thus,

theoretical capacity assumes no loss of time.

Practical capacity

This represents the production volume that can be achieved by efficient operation.

Practical capacity provides for unavoidable operating interruptions such as weekly off,

time lost for repair, unavoidable inefficiencies, normal down-time, normal breakdown,

set-ups, etc. Practical capacity should be determined taking into account the maximum

number of hours for which the facility can be used during the year.

Practical capacity is determined by deducting unavoidable operating interruptions from

theoretical capacity, and is usually expressed as a percentage of theoretical capacity. The

percentage varies from industry to industry. On an average, practical capacity is expected

to be between 7585 per cent of the theoretical capacity.

Normal capacity

The level of capacity utilization which satisfies the average customer demand is termed

as normal capacity. Average is calculated by taking expected sales over a reasonably long

period (35 years). Selection of a sufficiently long period levels out the peaks and

troughs which come with seasonal and cyclical variations. Normal capacity is also termed

as average capacityand is often less than 100 per cent of practical capacity.

Budgeted capacity

Budgeted capacity represents the expected (planned) level of activity for the budget

period. Usually budget period covers one year..

Capacity based on sales expectancy

Products are manufactured to be sold and, therefore, if a firm is unable to sell what it can

produce, it would restrict its output for a particular period to the quantity expected to be

sold during the period. Expected sales volume is determined after a careful analysis of the

competitive conditions, general demand of the product and the influence of price changes

on the sales volume. While capacity based on sales expectancy is a short-term concept,


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normal capacity is a long-term concept. Usually budgeted capacity represents capacity

based on sales expectancy.

Actual capacity

Output achieved during the year is often termed as actual capacity. Usually, actual

capacity fluctuates from year to year and may be more or less than the normal capacity. It

cannot be more than the practical capacity.

Idle capacity

Idle capacityrepresents the temporary idleness of production or distribution facilities due

to slow down in the inflow of orders. Idle capacity is the difference between the normal

capacity and the actual capacity. Idle capacity may be divided into normal idle capacity

and abnormal idle capacity. The difference between the normal capacity and the budgeted

capacity may be viewed as normal idle capacity. The difference between the budgeted

capacity and actual capacity may be viewed as abnormal idle capacity.

Excess capacity

Excess capacity represents the capacity which the firm does not expect to utilise in the

near future (35 years). Firms create excess capacity because either the investment is

indivisible or it expects increase in demand in the long term. Excess capacity is the

difference between the practical capacity and the normal capacity.

Excess capacity in a workstation might arise due to imbalance in practical capacities

among different workstations. This excess capacity can be reduced by attempting

synchronization of capacities of different workstations.

3.1.6 Accounting for Some Specific Cost Items

Estimating and drawing office expenses

Estimating and drawing office should be treated as a service cost centre. The overheads

are usually reapportioned to production cost centres for final recovery. However, a

portion of overheads collected under this cost centre is often treated as selling overhead

and the balance is reapportioned to production cost centre. For example, expenses

associated with preparation of tender estimates are treated as selling overhead.

In a heavy engineering factory manufacturing specific on-off jobs, drawing hours for

each job are recorded, and drawing office expenses are directly apportioned to jobs by

using an hourly rate.


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Canteen expenses

If the canteen runs on no profit, no loss basis, cost to the firm is zero. If the canteen is

subsidized, the amount of subsidy is treated as factory overhead. The canteen is treated as

a separate service cost centre and the net subsidy is reapportioned to production cost

centres. If there is more than one canteen (e.g. workers canteen, supervisors canteen,

officers canteen), each canteen should be treated as a separate cost centre. Similarly,

subsidy to canteens supporting sales or administration offices should be treated as

sales/administration overhead.

Costs auxiliary to salaries and wages

Costs auxiliary to salaries and wages include contribution to P.F., E.S.I., gratuity funds,

pension funds and costs for providing fringe benefits to employees. If possible, auxiliary

costs related to direct workmen should be charged to units produced by inflating the wage

rates to be applied for the recovery of direct wages. Alternatively, those should be treated

as overhead of the respective cost centres. Auxiliary costs related to indirect workers and

other employees should be treated as overhead.

Maintenance and repair of plant and buildings

Maintenance and repair cost should be analyzed separately under the following

categories:

(a) Costs of preventive maintenance

(b) Costs of major overhaul

(c) Costs of repairing breakdowns

Maintenance and repair costs include costs of maintenance spares and other materials,

employee costs, and expenses of the maintenance department. The method of issuing

service order authorizing each maintenance and repair work helps accumulate costs.

Usually, repair hours are booked against each service order along with costs of spares and

other materials. Maintenance department expenses are apportioned to each service order

on the basis of maintenance hours. Costs accumulated against service orders are

allocated to respective production cost centres. Cost for maintenance hours, not

accounted for by service order, is reapportioned to production cost centres on some

equitable basis.


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True costs of maintenance and repair can be worked out only if costs of other services

received by the maintenance cost centre and administration costs are added to

maintenance cost centre expenses. However, as the total expenditure on maintenance and

repairs is in itself an overhead cost, such precision is usually considered wasteful.

Cost for packing

Packing may be of the following three types:

(i) Primary packing: Packing that is essential for protection and convenient handling of

the product;

(ii) Secondary packing: Packing that is essential for safe transportation of the product;

(iii) Fancy packing: Packing which aims to attract customers attention.

Primary packing is treated as factory overhead, secondary packing is treated as

distribution cost and fancy packing is treated as advertisement cost.

Packing department is a separate cost centre and the total expenses are apportioned

between primary packing, secondary packing and fancy packing on the basis of some

technical estimate. Costs apportioned to primary packing are then reapportioned to

production cost centres on some equitable basis.

Royalties and patent fees

Royalty based on units produced is treated as factory overhead. Royalty based on units

sold is treated as selling expenses. If royalty is a fixed charge like rent, it is treated as

factory overhead. The expenditure incurred for registration and renewal of patent is

treated as administration overhead.

3.2 ADMINISTRATION OVERHEADS

Administration overheads are expenses associated with the administration of an

undertaking. Costs of formulating the policy, directing the organization and controlling

the operations of an undertaking which are not directly related to production, selling,

distribution, research or development activity or function are administration overheads.

Thus, administration overheads do not include costs of administering manufacturing

activities. Those costs are treated as manufacturing overhead. For example, costs of

operating a time office are manufacturing overheads and not administration overheads.

Examples of administration overheads are: office rents and rates; expenses of office

lighting, heating and cleaning; depreciation, and costs of maintenance, repair and


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insurance of office building, office furniture and office equipment; salaries to office staff;

directors remuneration; office supplies and other expenses; expenses on postage,

telephone and courier services; printing and stationery; audit fees; legal expenses; and

bank charges.

Administration is an independent function and is as important as the other major

functions. Since no direct relationship can be established between administration

overhead and products or jobs manufactured and sold, and because these costs are largely

fixed in nature, they are treated as period costs and charged directly to costing profit and

loss account.

3.3 SELLING AND DISTRIBUTION OVERHEADS

Selling overheads are costs of creating and stimulating demand and securing and

executing orders. Costs of manufacturing and distributing finished products are excluded

from selling overheads.

Distribution overheads are costs of moving finished products to central and local storage,

moving finished products to the customers, moving finished products to and from the

prospective customers as in the case of goods on sale or return basis and making empty

packages reusable.

In short, when a product is placed in a saleable condition, production function ends and

distribution function begins. Overheads related to distribution function are termed as

distribution overhead. Many accountants prefer to deal with selling and distribution

overheads together. Examples of selling overheads are: salaries, commissions, travelling

expenses of salesmen and technical representatives; sales office expenses; bad debts;

brokerage or third-party commissions; cost of operating the marketing information

system including market research; expenses on advertisement and publicity; cost of

catalogues and price lists; and costs of maintenance of showrooms.

Examples of distribution overheads are: carriage and freight outwards; depreciation, cost

of repair and maintenance, insurance charges and operating costs of distribution vehicles;

costs of secondary packing; warehousing expenses; expenses on insurance of finished

goods; and wastage of finished goods.

Selling and distribution overheads are treated as period costs and charged directly to

costing profit and loss account.


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3.4 RESEARCH AND DEVELOPMENT COSTS

Research is original and planned investigation undertaken with the prospect of gaining

new scientific or technical knowledge and understanding. Development is the application

of research findings or other knowledge into a plan or design for the production of new or

substantially improved materials, devices, products, processes, systems or services prior

to the commencement of commercial production or use.

An enterprise undertakes research to increase the stock of its scientific knowledge and

devices new applications which is expected to create competitive advantage for its

business.

Research activities aim at the discovery of new knowledge which can be used in

developing new products, services, processes, techniques or in improving existing

products or processes. Development starts where research ends. The results of a research

cannot be put directly to commercial use. It requires feasibility study and identifying

practical difficulties which may arise in its applications. Development activities include

conceptual formulation, design and listing of product/process alternatives, development

of prototypes, etc.

Research and development costs are likely to benefit future products and, therefore, an

elaborate system of absorbing these costs to products, orders or process is hardly

justified. Where research has been undertaken at the request of a client, it should

obviously be charged to the customer. If research is specifically related to an existing

product, it should be directly assigned to the product and considered in analyzing the

profitability of the product. Research undertaken for the general interest of the firm

should be treated as period cost.

3.5 ACCOUNTING FOR CERTAIN KEY ITEMS

Bad debt

There are two approaches for treating bad debt in cost accounts. One view is that bad

debt is a financial loss only and should be excluded from cost accounts. The other view is

that bad debt is similar to other expenses and should not be excluded from cost accounts.

Accordingly, bad debt is considered an item of selling overhead. Abnormally high bad

debts and bad debts of exceptional nature should be excluded from cost accounts. They

should be charged to the profit and loss account.


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Advertisement costs

Advertisement costs should be allocated and apportioned to various functions. For

example, cost of advertisement for recruitment should be allocated to the personnel

function. Costs of advertisements to create and retain demand for products and services

should be allocated to selling function. Advertisement cost is an overhead but its

accounting depends on its exact nature.

Advertisement cost which is likely to result in a long-term benefit should be treated as

fixed asset and depreciation on the same should be treated as selling overhead, e.g. the

cost of neon signs.

Market research costs

Market research addresses itself to specific marketing problems. This includes the study

of potential markets, customers behaviour, competitors strategy, etc. It is like a policy

cost because it does not depend on the activity level, but varies with management policy

on market research.

The market research cost is treated as a selling overhead. However, if it is high in a

particular period, it should be treated as a deferred charge. Only a portion of it should be

included in the overhead for the current year and the balance should be carried forward to

future years for inclusion in overhead costs for those years.

Royalty and patent fees

Royalty and patent fees may either be based on the units sold or produced, or may take

the form of a periodical payment of a predetermined amount. If royalty and patent fees

are fixed charges in the nature of rent, or are based on the number of units produced, they

should be treated as manufacturing overheads. On the other hand, if they are based on the

number of units sold, they should be treated as selling overhead.

After-sales services

It is a common practice to offer continued free support/maintenance services during a

stipulated guarantee period.

Treatment of cost of after-sales services in cost accounts depends upon the cause which

has given rise to the after-sales services. If it is to rectify manufacturing defects, the cost

is treated as manufacturing overhead. If design department is responsible for the defect,

the cost is allocated to design department. If damage is caused in transit, the cost is


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treated as distribution overhead. The following after-sales service costs are usually

treated as selling overhead:

(a) Costs of routine services

(b)Costs of after-sales services rendered only to retain customers goodwill, even though

such services are not covered under any agreement.

Appropriate accounting of costs of after-sales services requires a careful analysis of the

total costs. Costs on after-sales services of an exceptional nature should be charged off to

profit and loss account. For example, if suddenly an electrical engineering company

incurs an abnormally heavy expenditure in rectifying a defect in a transformer supplied to

a customer, inclusion of the same in production or selling costs would distort costs of

production or sales. It is, therefore, logical to charge such a heavy expenditure to profit

and loss account.

ASSIGNMENT

3.1 (Re-apportionment)

The Space Production Company manufactures components for radio and television

satellites using two service departments and two production departments. The inter-

departmental relationship and estimated overhead costs are given below:

Percentage of Service Provided

Maintenance Scheduling Moulding Assembly

From: Maintenance 10% 40% 50%

Scheduling 20% 50% 30%

Total overhead cost CU 750,000 400,000 378,000 276,000

Required:

(i) Using the direct method, show the amount of scheduling department costs to be

allocated to assembly departments.

(ii) Repeat (i) using the step method and allocating maintenance first.

(iii) Repeat (ii) using the reciprocal method (method of simultaneous equations may be

used).

[Answer: (i) CU 120,000 (ii) Moulding CU 959,122; Assembly CU 844,878

(iii) Moulding CU 959,122; Assembly CU 844,878.]

3.2 (Overhead absorption)


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A manufacturing company has two departments X and Y and all products pass through

both the departments. The following figures relate to production cost for June, 2008:

X Y

Direct labour-hours 6,000 4,000

Machine-hours 4,500 2,000

Raw materials CU 100,000 CU 50,000

Direct wages CU 6,000 CU 8,000

Overheads CU 45,000 CU 10,000

Job card for job no. 1 shows:

Raw materials CU 3,000 CU 1,000

Direct wages CU 250 CU 380

Direct labour-hours 225 200

Machine-hours 200 600

What method would you recommend for absorbing overhead? Give reasons. Compute the

cost of job no. 1 under the method recommended by you and under another method of

overhead absorption.


[Answer: Using machine-hour rate CU 9,630.00; using labour-hour rate CU 6,817.50.]

3.3 (Overhead absorption)

The following particulars related to the production department of a factory for the month

of June, 2008.

Material used CU 80,000

Direct wages CU 72,000

Direct labour-hours worked 20,000

Hours of machine operation 25,000

Overhead charges allocated to the department CU 90,000

Cost data of a particular work order carried out in the above department during June,

2008 are given below:

Material used CU 8,000

Direct wages CU 6,250

Labour-hours booked 3,300


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Machine-hours booked 2,400

What would be the factory cost of the work order under the following methods of

charging overheads?

(i) Direct labour cost rate;

(ii) Machine-hour rate; and

(iii) Direct labour-hour rate


[Answer: (i) CU 22,062.50 (ii) CU 22,890.00 (iii) CU 29,100.00.]

3.4 (Comprehensive machine-hour rate)

A machine shop has 6 identical machines manned by 5 operators. The machine cannot be

worked without any operator wholly engaged on it. The original cost of all these 6

machines works out at CU 0.6 million. The following estimates are available for the year

2008:

(a) Normal working hours per month 220 hr

(b) Absenteeism (without pay) per month 20 hr

(c) Leave with pay per month 20 hr

(d) Normal idle time (unavoidable) 20 hr

(e) Average rate of wages per day of 8 hours CU 40

(f) Production bonus 15% of wages

(g) Cost of power for the period CU 20,700

(h) Supervision and indirect labour cost for the year CU 8,100

(i) Lighting and electricity per annum CU 3,070

(j) Repairs and maintenance of machines 20% of the value of machines p.a.

(k)Insurance charges CU. 30,000 p.a.

(l) General management expenses as allocated for the year CU 84,000

(m)Depreciation under straight line method 15% on original cost of machines

You are required to workout a comprehensive machine-hour rate for the machine shops.

(Adapted, B.Com, CU)

[Answer: Machine-hour rate CU 33.01.]

Hint: Working-hours per month: 220 (20 + 20 + 20) = 160 hr. per worker; for 6

machines 5 160 = 800 hr.


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3.5 (Administration overheads)

In a certain business, administration costs are absorbed as a percentage of production

costs. It is found that tenders for work made of expensive materials are regularly being

lost on account of price, whereas, tenders for work using cheap materials are accepted.

What explanations and/or recommendations would you make to the management

regarding the matter?


Chapter 3 Overheads Final

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