Certified

Management
Accountant

Part 1 : Financial Planning,

Performance and Control

Section C : Cost Management

Topic 3 : Overhead Costs

Overhead Costs
Overhead Costs :

Manufacturing overhead costs can be very significant for a business because they include all
manufacturing costs except direct materials and direct labor.
Overhead costs are product costs, which flow through inventory accounts such as raw materials
inventory, work-in-process inventory, and finished goods inventory.
Product costs flow to the income statement once the product has been sold.

Fixed Overhead Costing

Include depreciation on assets, rentals,

leasing costs, and indirect labor incurred in
manufacturing.
Most fixed costs are set for a certain
performance period, so, by definition, the
day-to-day operations of a business have
little effect on fixed costs
The time frame for planning fixed
overhead costs has two phases:
Setting priorities .
Being efficient.

Variable Overhead Costing

include power, water, sewage,

engineering support, machine
maintenance, and indirect materials.
It is affected by day-to-day operations
process costing uses a production cost
report to track all department costs

The time frame for planning fixed

overhead costs has two phases:
Setting priorities
Being efficient
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Overhead Costs
Budgeted Fixed Overhead Cost Allocation Rates

Fixed overhead costs are a lump-sum amount that will not change over the course of a
period even if wide variations occur in activity.
The four steps in determining the budgeted fixed allocation rate are:

Determine the proper accounting period.

Determine the allocation base (cost driver) to use when allocating fixed overhead.
Determine the fixed overhead costs associated with each cost driver.
Calculate the rate per unit of each allocation base used when allocating fixed overhead costs
to cost objects

Fixed Overhead Application Rate =

Total Cost in Fixed Overhead Cost Pool

Total Quantity of Allocation Base

For example:
A tennis ball manufacturer uses machine hours as its fixed cost driver.
The company budgets 40,000 machine hours annually to produce 200,000 cans of tennis
balls.
All fixed manufacturing overhead costs relate to the machine hours allocation base.
The budgeted fixed overhead costs total $1,000,000 for the year.
The rate per unit is calculated as:

Fixed Overhead Application Rate =

1,000,000
= $25/Machine hour
40,000

Overhead Costs
Job Costing Using the High-Low Method :
The high-low method is a cost accounting technique that separates the fixed and
variable cost components of a mixed cost.
It uses, within a relevant range of activity, the highest and lowest amounts of the cost
driver and the highest and lowest respective cost amounts in order to estimate a slope
coefficient (e.g., the variable cost component) and the constant (or fixed
amount/component) of the cost function.

Highest Cost Lowest Cost 31000 28000 3000

Slope coefficient = Highest Level Lowest Le = 2100 1800 = 300 = $10

Overhead Costs
Regression Equation :
Y = a + bX

31000 = a + 2100 X 10
31000 = a + 21000
A = 31000 21000 = 10000
New Regression Equation :
Y = 10000 + 10 b

Overhead Costs
Overhead Rate
Firms with two or more production departments can assign factory overhead costs to
jobs or products in these ways:

Plant-wide overhead rate.

Departmental overhead rate.
Activity-based overhead costing.

Plant-Wide Overhead Rate:

A plant-wide overhead rate is a single rate used for all overhead costs incurred at a production
facility.
it can be used only by facilities that have a strong single cost driver that relates to all types of
production.

Total Plant Overhead

Fixed Overhead Application Rate = Total units of cost driver common to all jobs

Departmental Overhead Rate

A departmental overhead rate is a single overhead rate calculated for a particular department.
Departmental overhead rates are more accurate than plant-wide rates.
Each department could have its own rate calculated based on its own cost drivers.

Overhead Costs
Activity-Based Overhead Costing

When plant-wide and departmental overhead allocation methods are not

accurate enough, an activity-based costing (ABC) method can be used.
ABC assigns factory overhead costs to products or services using multiple cost pools

and multiple cost drivers.

The cost drivers are selected based on a cause-and-effect relationship and can be both
activity based and volume based.
Activity-based overhead allocation may help management identify inefficient products,
departments, and activities when it attempts to eliminate activities that do not provide
value to products and services.
Activity-based overhead allocation may encourage focusing resources on profitable
products, departments and activities, and controlling costs.

Assume that the facility described has two jobs for the current period.
Job 1 uses 4,000 machine hours and 30,000 pounds in direct materials weight and has 100
setups.
Job 2 uses 6,000 machine hours and 10,000 pounds in direct materials weight and has 200
setups.
Assume that Plant wide rate is machine hours.

Mr. Tamer Bedir

Overhead Costs
Allocation of Service Department Costs :

There are two basic types of departments in a company : production departments and service
departments.
Service departments do not directly perform operating activities. Instead, they assist production
departments, customers, and employees.
Allocation of service department costs has three phases:

Phase 1: Trace all direct costs and allocate overhead costs to all departments
(production departments and other service departments). Using either Single Rate
Cost Allocation or Contribution Margin Cost Allocation (Dual Rate method)
Phase 2: Allocate service department costs to production departments or other
service departments.
Phase 3: Allocate production department costs to products.

Service department costs are allocated because most service departments do not generate any
revenue (i.e., they are cost centers).
When a service department does generate revenue, such as the cafeteria or a repairs department,
these revenues offset the costs, and any net cost is transferred to the production departments.

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Overhead Costs
Phase 2: Allocate service department costs:
Three methods can be used to allocate costs of service Departments :
1. Direct Method: Service to Production Directly, The direct method ignores the cost drivers
that are related to the service departments and concentrates only on the cost drivers
attributable to the production departments.
2. Step Down Method: Sequentially allocates service department costs, starting with the
department that provides the most services to other service departments and finishing with
the department that provides the least services to other service departments.
3. Reciprocal Method : The reciprocal method fully recognizes all interdepartmental service costs using
simultaneous equations.

Example :

The human resources (HR) departments costs use the production departments labor hours,.
The janitorial department uses the production departments space measurements.

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Direct Method :
HR
Dept. Costs before allocation

200,000

Allocation of Janitorial Dep.

Allocation of HR Dep.

Janitorial

Metal

Chrome

80000

400000

100000

(80000)

=80000 * (60000/80000) =
60000

=80000 * (20000/80000) =
20000

=200000*(20000/25000) =
160000

=200000*(5000/25000) =
40000

620000

160000

(200000)

Zero

Zero

Step Down Method :

HR

Janitorial

Metal

Chrome

Dept. Costs before allocation

200,000

80000

400000

100000

Allocation of HR Dep.

(200000)

33333

133334

33333

Zero

113333

533337

133333

(113333)

85000

28333

Zero

618337

161666

Allocation of Janitorial Dep.

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3 - Reciprocal Method
HR = 200000 + 15000/95000 J
= 200000 + .158 J
J = 80000 + 5000 / 30000 HR
= 80000 + .167 HR
HR = 200000 + .158 (80000 + .167 HR) =
HR = 200000 + 12640 + .026 HR
.974HR = 212640
HR = 212640 / .974= 218316

J = 80000 + .1667 x 218316 = 80000 + 36393 = 116393

Reciprocal Method :
HR

Janitorial

Metal

Chrome

Dept. Costs before allocation

200,000

80000

400000

100000

Allocation of HR Dep.

(218316)

36386

145544

36386

18376

(116386)

73506

25402

619050

163788

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End of Topic
Mr. Tamer Bedir
tamerbedir_81@yahoo.com
00966541553318

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