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Unit 6

THE ANALYSIS OF OVERHEAD

INTRODUCTION
In this unit we will learn about the analysis of indirect costs or overheads. We
will be looking at the three-stage process of attributing overheads to individual
cost units: Allocation, Apportionment and Absorption.

What is an overhead cost?

An overhead cost is defined in the CIMA Terminology as ‘ expenditure on labour,

materials or services that cannot be economically identified with a specific
saleable cost unit .

Overhead costs are also referred to as indirect costs. Therefore, overhead cost
comprises indirect material, indirect labour and indirect expenses. The indirect
nature of overheads means that they need to be ‘ shared out ’ among the cost
units as fairly and as accurately as possible. In this unit we will be learning how
this ‘ sharing out ‘, or attribution, is accomplished for production overheads, using
a costing method known as absorption costing. One of the main reasons for
absorbing overheads into the cost of units is for inventory valuation purposes.
Accounting standards recommend that inventory valuations should include an
element of fixed production overheads incurred in the normal course of business.
We therefore have to find a fair way of sharing out the fixed production overhead
costs among the units produced.

Functional analysis of overhead costs.

Overhead costs may be classified according to the function of the organization
responsible for incurring the cost. Examples of overhead cost classifications
include production overhead, selling and distribution overhead, and
administration overhead. It is usually possible to classify the majority of
overhead cost in this way, but some overhead costs relate to the organization
generally and may be referred to as general overhead. In this unit we shall focus
mainly on production overhead. Production is that function of the business,
which converts raw materials into the organization’s finished product. The
production department is usually divided into a number of departments or cost
centers. Some of these cost centers are directly involved with the production
process. These are called production cost centers and might include, for
example, the cutting department and the finishing department. Other cost
centers in the production department are not directly involved with the production
process but provide support services for the production cost centres. These are
called service cost centers , and examples include the maintenance
department and the stores.
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Overhead allocation and apportionment

The first stage in the analysis of production overheads is the selection of
appropriate cost Centers. The selection will depend on a number of factors,
including the level of control. Required and the availability of information.
Having selected suitable cost centers, the next stage in the analysis is to
determine the overhead cost for each cost center. This is achieved through
the process of allocation and apportionment.

Cost allocation is possible when we can identify a cost as specifically

attributable to a particular cost center. For example, the salary of the manager of
the packing department can be allocated to the packing department cost center.
It is not necessary to share the salary cost over several different cost centers.

Cost apportionment is necessary when it is not possible to allocate a cost to a

specific cost center. In this case, the cost is shared out over two or more cost
centers according to the estimated benefit received by each cost center. As far
as possible the basis of apportionment is selected to reflect this benefit received.
For example, the cost of rent and rates might be apportioned according to the
floor space occupied by each cost center.

Bases of apportionment

Overhead apportionment basis:-

Basis of apportionment of service cost centres

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There are four Step in primary distribution required as follows:

1. Assigning all manufacturing overheads to production and service cost
centers.
2. Reallocating the costs assigned to service cost centers to production cost
centres;
3. Computing separate overhead rates for each production cost center;
4. Assigning cost centre overheads to products or other chosen cost objects.

Example 1
SBL Ltd has three production centres (two machine centres and one assembly
centre) and two service centres (material procurement and general factory
support). Annual overhead costs for the company are as follows:

$ $
Indirect wages and supervision
Machine centres: X 1,000,000
Y 1,000,000
Assembly 1,500,000
Materials procurement 1,100,000
General factory support 1,480,000 6,080,000
Indirect materials
Machine centres: X 500,000
Y 805,000
Assembly 105,000
Materials procurement 0
General factory support 10,000 1,420,000

Lighting and heating 500,000

Property taxes 1,000,000
Insurance of machinery 150,000
Depreciation of machinery 1,500,000
Insurance of buildings 250,000
Salaries of works management 800,000 4,200,000
11,700,000

The following information is also available:

Book Area Number of Direct Machine
Value of Occupied Employees Labour Hours
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Machinery (sq. Hours

($) metres)
Machine shop:
X 8,000,000 10,000 300 1,000,000 2,000,000
Y 5,000,000 5,000 200 1,000,000 1,000,000
Assembly 1,000,000 15,000 300 2,000,000
Stores 500,000 15,000 100
Maintenance 500,000 5,000 100
15,000,000 50,000 1,000

Details of total materials issued (i.e. direct and indirect materials) to the
production centres are as follows:
$
Machine shop X 4,000,000
Machine shop Y 3,000,000
Assembly 1,000,000
8,000,000

Required:
a) Prepare an overheard analysis sheet for the period, using suitable bases of
apportion.
b) Calculate the absorption rates for each department.
c) Allocate the overheads to products passing through the production centers.
Using the following information.

Product A
Units 100
Direct Cost 100
Machine Hours:
Machine X 5
Machine Y 10
Labour Hours:
Assembly 10
20

Absorption of overheads into saleable cost units

General principles
The last stage in the analysis of overheads is their absorption into the cost units
produced in the production cost centers. This is sometimes referred to as
overhead recovery. Overhead Absorption refers to the method of charging a
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proportion of the final production cost centers’ overheads onto a particular job on
the basis of for example: the number of labour hours or machine hours taken to
complete the job.

 Direct material cost;

 Direct labour cost;
 Prime cost.

It is quite likely that different production departments will measure their

production in different ways. The objective is to use a measure, which reflects
the nature of the work involved. The physical unit measure is in theory the
simplest but it is only valid if all of the items produced require the same amount
of resources. The overhead costs of each production cost center are then divided
by the quantity of production achieved to calculate the amount of overhead cost
to be attributed to each unit

Applying the overhead absorption rate

When using an absorption method based either on direct labour hours or on
machine hours the cost attributed to each unit is obtained by multiplying the time
taken per unit by the absorption rate per hour.

Bases for Absorbing Overhead Costs: Rate per Direct Labour ;when Labour
Hours in the relevant factor

Total Predetermined Overheads / Total Labour Hours

Machine Hour Rate: Area occupied by machine – rates, rent etc

Cost of operating – depreciation, power etc

Total Predetermined Overheads / Total Machine Hours

Alternative Overhead Absorption Rates

 Overheads as a percentage of Direct Wages
 Overheads as a percentage of Direct Materials
 Overheads as a percentage of Prime Costs
 Rate per Unit Produced

Suitability of different overhead absorption or recovery rates One of the most

important facts about Overheads is that they are incurred OVER TIME.

This means that the 2 most accurate methods of recovering overheads will be:

 Direct Labour Hour Rate: Most suitable for labour intensive jobs
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 Direct Machine Hour Rate: Most suitable for machine intensive jobs

All the other Overhead Absorption bases generally do not allow for the time
element but nonetheless are often used:

Percentage of Direct Wages: Where there is only slight variation in the rates of
pay for different grades of labour this method will produce similar results to the
direct labour rate.

Percentage of Direct Material: There is obviously no relationship between the

cost of raw materials and overheads. For example, rent and rates and electricity
do not change simply because the cost of raw materials have changed.

Percentage of Prime Cost: Same reasons as for the percentage of direct wages
and percentage of direct material overhead absorption rates.

Rate per Unit Produced: Since the Cost units are likely to have different
production processes and different lengths of time in the production processes it
would not be suitable to apply the same cost unit absorption rate to all the
different products produced.

ACTUAL OVERHEADS AND PREDETERMINED/BUDGETED OVERHEADS

A difficulty in using overhead absorption or recovery rates in practice is that you

will not know what the actual overheads are until after the accounting period is
finished – for example, a month or year. But since you have to charge overheads
onto the job when it is done or indeed even before it is done, particularly if the
customer wants an estimate of how much the job will cost, then you will have to
use some method of "guessing" what the overheads will be.

The way round this problem is to use PREDETERMINED or BUDGETED

Overhead Costs.

This is simply an estimate of what overhead costs will be in the next financial
year based on an extension of what they were in the past year after allowing for:

 Any anticipated increases or decreases in production, and

 Any anticipated price increases.

What this means is that when we come to the end of the accounting period the
actual overhead costs incurred will in all probability differ from the overheads
absorbed into the cost units.
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If the actual overheads for the accounting period are greater than the overheads
absorbed then we will have under absorbed costs and so we will have to make
an additional charge for the difference to the Costing Profit and Loss Account.

On the other hand, if the actual overheads for the accounting period are less than
the overheads absorbed then we will have over-absorbed costs and so we will
have to make an adjustment by crediting the gain to the Costing Profit and Loss
Account.

EXAMPLE – OVERHEAD UNDERABSORBED

Cost Center A Budgeted Actual Data

Overheard $50 000 $52 000
Direct Labour Hours 5000Hours 5050 hours

Calculate the Under-absorption of overheard

Overheard Absorbed = Actual Direct Hour x Budgeted overheard rate

Overhead Over/ Under Absorbed = Actual Overheards Incurred – Overheard
Absorbed

Step 1

Calculate the Budgeted Overhead Rate based on Direct Labour Hours.

Budgeted Overheads / Direct Labour Hours

$50,000 / 5,000 hours = $10 per Labour Hour

Step 2
Calculate the Overhead Absorbed using the rate from Step 1 and the Actual
Hours worked: Overhead Absorbed = 5050 hours x $10 per hour = $50500

Step 3
Compare this Budgeted Cost with the Actual Cost Overhead Under absorbed =
$52,000 - $50,500 = $1,500

As a result the Profit and Loss Account would be charged with an expense of
Overhead Under absorbed of $1,500.
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EXAMPLE – OVERHEAD OVERABSORBED

Cost Center A Budgeted Actual Data

Overheard $50 000 $49 400
Direct Labour Hours 5000Hours 4950 hours

Calculate the over-absorption of overheard

Overheard Absorbed = Actual Direct Hour x Budgeted overheard rate

Overhead Over/ Under Absorbed = Actual Overheard Incurred – Overheard
Absorbed

Step 1

Calculate the Budgeted Overhead Rate based on Direct Labour Hours.

Budgeted Overheads / Direct Labour Hours $50,000 / 5,000 hours = $10 per
Labour Hour

Step 2
Calculate the Overhead Absorbed using the rate from Step 1 and the Actual
Hours worked: Overhead Absorbed = 4950 hours x $10 per hour = $49 500

Step 3
Compare this Budgeted Cost with the Actual Cost Overhead over absorbed =
$49400- $49500 = $100

As a result the Profit and Loss Account would be charged with an expense of
Overhead over absorbed of $1,00.

INTER-SERVICE DEPARTMENT REALLOCATIONS

Service departments may provide services for other service departments as well
as for production departments. For example, a personnel department provides
services for other service departments such as the power generating plant,
maintenance department and stores. The power-generating department also
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provides heat and light for other service departments, including the personnel
department and so on. When such interactions occur, the allocation process can
become complicated. Difficulties arise because each service department begins
to accumulate charges from other service departments from which it receives
services and these must be reallocated back to the user department. Once it has
begun, this allocation and reallocation process can continue for a long time
before a solution is found.

There are four methods of re-allocating the costs of service cost centres to
production cost centers. These are:
1. Repeated distribution method (Reciprocal)
2. Simultaneous equations method
3. Specific order of closing method (Step Down)
4. Direct allocation method

Re-allocating the Costs of Service Cost Centres to Production Cost Centres

by using the Repeated Distribution Method
Using this method, the service department costs are repeatedly allocated in the
specified percentages until the figures become too small to be significant. Some
of the overheads of this Service department will be re-allocated to the production
departments as well as to the other Service departments. The cost of the other
service departments are likewise re- allocated until the costs have become so
small that any further detailed apportionments are unnecessary. As a result, the
total overheads of the Service departments are allocated to production
departments only

Re-allocating the Costs of Service Cost Centres to Production Cost Centres

by using Simultaneous Equations Method

Using this method, various equations are developed, basing on the information
given on the question. The percentages of re-allocation are used to derive the
equations. This method normally gives a more precise answer.

Re-allocating the Costs of Service Cost Centres to Production Cost Centres

by using Specific Order of Closing Method
When using this method, service department’s overhead are allocated to the
production departments using a certain order. The service department that does
the largest proportion of work for other service departments will be re-allocated
first, followed by the second which does the next largest proportion of work and
so on. The totals of overheads allocated to the production departments will
slightly differ from those allocated by Repeated distribution or Simultaneous
method. This is because the specified order of closing method sacrifices
accuracy for clerical convenience. Besides, this method should be used if it
strongly provides a close approximation to other alternatives.
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Re-allocating the Costs of Service Cost Centres to Production Cost Centres

by using Direct Allocation Method
Direct allocation method ignores inter-service department service reallocations.
Service department costs are reallocated only to production departments. The
only advantage for using the direct allocation method is its simplicity. It is
preferred when there are less service departments and the re-allocations are
relatively insignificant .

Example 2
ABC Ltd has three production departments namely department X, department Y
and department Z and two service departments namely department A and
department B. Overhead costs for the company for the previous quarter were as
follows:

$
Production departments: X 48,000
Y 42,000
Z 30,000
Service departments: A 14,040
B 18,000
152,040

The expenses of the service departments are apportioned as follows:

Production Service
departments departments
X Y Z A B
Service department 20% 40% 30% - 10%
A
Service department 40% 20% 20% 20% -
B

Required:
Allocate the cost of the service departments to production departments by using:
(a) Repeated distribution method
(b) Simultaneous equations method
(c) Specific order of closing method; and
(d) Direct allocation method