CHAPTER – 5

ACCOUNTING FOR OVERHEAD

1 Direct and indirect expenses

Direct expenses are expenses that can be directly identified with a specific cost unit
or cost centre.
• There are not many examples of direct expenses but royalties paid to a
designer or fees paid to a subcontractor for a specific job could be classed as
direct expenses.
• Direct expenses, direct materials and direct labour are the prime cost of a
product.
Indirect expenses are expenses that cannot be directly identified with a specific cost
unit or cost centre.
• The cost of renting a factory is classified as an indirect cost as the rent could be
covering the manufacturing location of all products and also possibly other areas of
the business such as the accounting department, a non-production location. It is not
possible to relate the rent to a single products or location.
• Indirect expenses, indirect materials and indirect labour are the overheads of a
business.
2 Production (manufacturing) overheads
Overheads can be grouped based on where in the business they are incurred:
• Production/manufacturing
• Administration
• Sales and distribution.
This chapter focuses on how production overheads are absorbed into the products
being manufactured.
Production overheads of a factory can include the following costs:
• heating the factory
• lighting the factory
• renting the factory.
Production may take place over a number of different production cost centres and
each cost centre should be assigned with its fair share of overhead cost. Examples of
production cost centres include:
 • Assembly
• Machining
• Finishing.
There may also be a number of production service cost centres that provide support
to the production cost centres. Examples of production service cost centres include:
• Maintenance
• Canteen
• Stores.

Absorption costing
Production overheads are recovered by absorbing them into the cost of a product
and this process is called absorption costing.
• The main aim of absorption costing is to recover overheads in a way that fairly
reflects the amount of time and effort that has gone into making a product or
service.
• Absorption costing involves the following stages:
– allocation and apportionment of overheads to the different production
cost centres
– reapportionment of production service cost centre overheads to the
production cost centres
– absorption of overheads into the products.
• Absorption costing allows businesses to make decisions about pricing policies
and value its inventory in accordance with IAS 2.
IAS 2
IAS 2 Inventories defines cost as comprising: ‘all costs of purchase, costs of
conversion and other costs incurred in bringing the inventories to their present
location and condition’. Specifically excluded are:
a) abnormal amounts of wasted materials, labour and other production costs
b) storage costs, unless necessary in the production process before a further
production stage
c) administrative overheads that do not contribute to bringing inventories to
their present location and condition
d) selling costs.
3 Allocation and apportionment
Allocation and apportionment of overheads
The first stage of the absorption costing process involves the allocation and
apportionment of overheads.
• Allocation involves charging overheads directly to specific cost centres
(production and/or service).
• If overheads relate to more than one production or service cost centre, then
they must be shared between these cost centres using a method known as
apportionment.
• Overheads must be apportioned between different production and service
cost centres on a fair basis.
Bases of apportionment
There are no hard and fast rules for which basis of apportionment to use except that
whichever method is used to apportion overheads, it must be fair. Possible bases of
apportionment include the following:
• floor area – for rent and rates overheads
• carrying amount of non-current assets – for depreciation and insurance of
machinery
• number of employees – for canteen costs.
Illustration 1 – Allocation and apportionment
LS Ltd has two production cost centres (Assembly and Finishing) and two
production service cost centres (Maintenance and Canteen). The following are
budgeted costs for the next period:
– Indirect materials – $20,000
– Rent – $15,000
– Electricity – $10,000
– Machine depreciation – $5,000
– Indirect labour – $16,520
The following information is available:
Assembly Finishing Maintenance Canteen Total
Area (sq mtrs) 1,000 2,000 500 500 4,000
KW hrs 2,750 4,500 1,975 775 10,000
Consumed
Machine Value 45,000 35,000 11,000 9,000 100,000
($)
Staff 18 30 12 2 62
Direct Labour 3,175 3,800 - - 6,975
hrs
 Indirect 7,000 8,000 3,000 2,000 20,000
Material Budget
($)
Indirect Labour 1,600 2,220 11,200 1,500 16,520
Budet ($)

Required: Complete the extract from the overhead analysis sheet shown below.

Solution (W1) Indirect materials are allocated directly to the relevant cost centres.
(W2) Rent is apportioned to all cost centres based on the area occupied.
Total rent cost = $15,000
Total area occupied = 4,000 sq metres
Apportioned to Assembly cost centre = area of assembly/total area × cost
= 1,000/4,000 × $15,000 = $3,750
(W3) Electricity is apportioned to all cost centres on the basis of kW hours.
Total electricity costs = $10,000
Total kW hours consumed = 10,000 kW hours
Apportioned to Finishing cost centre = 4,500/10,000 × $10,000 = $4,500
(W4) Machine depreciation is apportioned to all cost centres on the basis of
machine value.
Total machine depreciation costs = $5,000
Total machine value = $100,000
Apportioned to Maintenance cost centre = 11,000/100,000 × $5,000 = $550
(W5) Indirect labour costs are allocated directly to all cost centres based on the
indirect labour budget for each cost centre.
Overhead analysis sheet
Overhead Basis of Assembl Finishin Maintenan Cantee Total
apportionme y g ce n
nt $ $ $ $
Indirect Allocated 7,000 8,000 3,000 2,000 20,00
materials (W1) 0
Rent Area (W2) 3,750 7,500 1,875 1,875 15,00
0
Electricity KW Hrs (W3) 2,750 4,500 1,975 775 10,00
0
Machine Machine 2,250 1,750 550 450 5,000
Depreciatio Value (W4)
n
Indirect Allocated 1,600 2,220 11,200 1,500 16,52
Labour (W5) 0
4 Reapportionment of production service cost centre costs to production cost
centres
Production service cost centres are not directly involved in making products and
therefore the production overheads of service cost centres must be shared out
between the production cost centres using a suitable basis. This is known as
reapportionment or secondary apportionment.
There are 3 methods that can be used:
• Direct method – the cost of each production service cost centre is reapportioned to
the production cost centres only.
Direct Reapportionment
The total overheads allocated and apportioned to the production and service cost
centres of LS Ltd are as follows:
– Assembly = $17,350
– Finishing = $23,970
– Maintenance = $18,600
– Canteen = $6,600
The canteen feeds the staff that work for the company in Assembly and Finishing.
The number of employees in each cost centre:
Assembly Finishing Maintenance Canteen
Number of 18 30 12 2
Employees

The amount of time spent by the maintenance cost centre servicing equipment in
the Assembly and Finishing cost centres has been analysed as follows:
Assembly 60%
Finishing 40%
Required:
Complete the overhead analysis sheet.

Solution
(W1) Canteen overheads are reapportioned on the basis of number of employees
that work in the cost centres it services. Total employees that eat in the canteen =
18 + 30 = 48 Reapportioned to Assembly cost centre = 18/48 × $6,600 = $2,475
Reapportioned to Finishing cost centre = 30/48 × $6,600 = $4,125
(W2) Assembly = 60% × $18,600 = $11,160
Finishing = 40% × $18,600 = $7,440
 Overhead Basis of Assembl Finishin Maintenan Cantee Total
Apportionme y g ce n $
nt $ $ $ $
Total from 17,350 23,970 18,600 6,600 66,52
above 0
Reapportio Employees 2,475 4,125 - (6,600) -
n canteen (W1)
Reapportio % time (W2) 11,160 7,440 (18,600) - -
n
maintenan
ce
Total 30,985 35,535 0 0 66,52
0

Practice Question
Solution
Illustration 3 – Step down reapportionment
The total overheads allocated and apportioned to the production and service cost centres
of LS Ltd are as follows:
– Assembly = $17,350
– Finishing = $23,970
– Maintenance = $18,600
– Canteen = $6,600
The canteen feeds all the staff that work for the company in maintenance, finishing and
assembly but the maintenance staff do not provide support for the canteen equipment.
The amount of time spent by the maintenance cost centre servicing equipment in the
Assembly and Finishing cost centres has been analysed as follows: Assembly 60% Finishing
40% The number of employees in each cost centre:
Assembly Finishing Maintenance Canteen

Number of 18 30 12 2
Employees

Required: Complete the overhead analysis sheet.

Solution
Workings (W1) Canteen overheads are reapportioned on the basis of the number of
employees that work in the cost centres it serves
Total employees that eat in the canteen = 18 + 30 + 12 = 60
Reapportioned to Assembly department = 18/60 × $6,600 = $1,980
(W2) Assembly = 60% × $19,920 = $11,952
Finishing = 40% × $19,920 = $7,968
Overhead Basis of Assembly Finishing Maintenance Canteen Total
Apportionment $ $ $ $ $
Total from 17,350 23,970 18,600 6,600 66,520
above
Reapportion Employees 1,980 3,300 1,320 (6,600) -
canteen (W1)
Subtotal - 19,330 27,270 19,920 0 66,520
Reapportion % time (W2) 11,952 7,968 (19,920) - -
maintenance
Total - 31,282 35,238 - - 66,520

Practice Question
Solution
Simultaneous Equation Method

Practice Question
Solution
Trial & Error Method
Solution
Repeated Distribution Method

Practice Question

Solution
Types of Overhead Rates
Practice Question
Solution
Practice Question
Solution
5 Absorption of overheads
Bases of absorption
Once the overheads are allocated, apportioned and reapportioned into the
production cost centres the overheads need to be related to or absorbed into the
units of product.
• Overheads can also be absorbed into cost units using the following absorption
bases:
– units produced
– machine-hour rate (when production is machine intensive)
– labour-hour rate (when production is labour intensive)
– percentage of prime cost
– percentage of direct wages.
• Production overheads are usually calculated at the beginning of an accounting
period in order to determine how much cost to assign to a unit before
calculating a selling price.
• The overhead absorption rate (OAR) is calculated as follows:
OAR = Budgeted production overhead /Budgeted total of absorption basis
• The absorption basis is most commonly units of a product, labour hours, or
machine hours. It is usual for a product to pass through more than one cost
centre during the production process. Each cost centre will normally have a
separate OAR.
• For example, a machining cost centre will probably use a machine-hour OAR.
• Similarly, a labour-intensive cost centre will probably use a labour-hour OAR.
An alternative to individual cost centre OAR is a blanket OAR. With blanket OARs,
only one absorption rate is calculated for the entire factory regardless of the cost
centres involved in production. Blanket OARs are also known as single factory-wide
OARs.
6 Under- and over-absorption of overheads
If the estimates for the budgeted overheads and/or the budgeted level of activity
are different from the actual results for the year then this will lead to one of the
following:
• under-absorption (recovery) of overheads
• over-absorption (recovery) of overheads.
Calculating an under- or over-absorption
There is a three step procedure:
Step 1 – calculate the OAR (based on budget)
OAR = Budgeted overheads/ Budgeted level of activity
Step 2 – calculate the overhead absorbed by actual activity
Overheads absorbed = OAR × actual level of activity
Step 3 – Compare absorbed to actual
If at the end of this period, the overheads absorbed are greater than the actual
overheads, then there has been an over-absorption of overheads. If the overheads
absorbed are less than the actual overheads, then there has been an under-
absorption of overheads.

Working backwards
Sometimes you may be given information relating to the actual under- or
overabsorption in a period and be expected to calculate the budgeted overheads or
the actual number of hours worked.
Approach to working backwards
• As long as you remember the basic calculation involved in identifying an
under/over-absorption, you should not have any problems.
• The main thing to remember is that if actual overheads are greater than
absorbed overheads then we have under-absorption and any under-
absorption need to be deducted from actual overheads incurred in order to
calculate the overheads absorbed.
• Similarly, if over-absorption occurs, the over-absorption needs to be added
to actual overhead in order to calculate the overheads absorbed.
CHAPTER SUMMARY