The Analysis of Overheads

Learning Objectives
Identify cost centres and cost units Allocation and Apportionment of overhead costs Re-apportionment of service department overhead costs Absorption of overheads Calculation of overhead absorption rate (OAR)

Overhead Cost definition:

Expenditure on labour, materials or services, which can not be economically identified with a specific saleable cost unit

Classification of overhead costs

Overhead Costs Classified according to

Functions

Elements

Behaviour

1. Production O/H 2. Administration O/H 3. Selling O/H 4. Distribution O/H

1. Indirect Materials 2. Indirect Labour 3. Indirect Expenses

1. Fixed O/H 2. Variable O/H 3. Semi -Variable O/H 4. Semi -Fixed O/H

Allocation and Apportionment of Overhead Costs (Primary Distribution)

The overheads accumulated in a cost centre can be in two ways:

1. Allocation of Overhead Costs

Allotment of overhead costs, which can be directly identified with a particular department or cost centre is known as cost allocation. e.g. the salaries of the staff in the planning department.

2. Apportionment of Overhead Costs

The overheads, which are shared between all cost centres e.g. rent for the factory premises, which are shared between all cost centres. The process by which common costs are shared out between cost centres is known as cost apportionment

Apportionment Basis The basis on which the apportionment is carried out varies from cost to cost but some typical bases are shown below:
Basis Costs, which may be apportioned on this basis

Floor Area
Volume or Space Occupied Number of Employees in each cost centre Book (Replacement) Value of Plants, Equipments, Premises etc. Stores Requisitions Weight of Materials

Rent, Heating, Cleaning, Lighting, Building Depreciation

AC, Heating, Lighting, Building Depreciation Canteen, Welfare, Personnel, General Administration, Industrial Relations, Safety Insurance, Depreciation

Store Keeping Store Keeping, Materials Handling

Absorption of Overheads
Estimated overheads for cost centre

Predetermined OAR for cost centre

Estimated units of absorption base

Necessity of Predetermined Overhead Absorption Rate

There are three serious limitations of using actual overhead rate: 1. Delay in the ascertainment of production cost:

If actual overheads are used, product cost could only be determined after the end of the accounting period when the actual overhead expenses could be ascertained.
2. Effects of seasonal changes: If the product is of seasonal nature, the actual overhead rate will result in fluctuating unit costs. 3. Fluctuations in overhead costs: The actual overhead rate per hour or per unit will be subject to wide fluctuations. If the actual rate was used in product costing, then product costs would also fluctuate widely. To overcome these problems overhead absorption rates are usually calculate in advance in other words overhead absorption rates are predetermined

Re- apportionment of service department costs (Secondary distribution)

Once the overheads have been allocated and apportioned to production and service departments and totaled, the next step is to reapportion the service department costs to production departments.
This is necessary as our ultimate objective is to charge overheads to cost units, and no cost units pass through service departments. Therefore, the costs of service departments must be charged to production departments, which directly come in contact with cost units. This is called Secondary Distribution.

Apportionment of Service Department Overheads Apportionment to Production Departments Only Apportionment to Production and other Service Departments

Simultaneous equations method

Repeated distribution method

Trial and error method

Apportionment of Service Department Overheads to Production and other Service Departments

1. Simultaneous Equation Method In this method the following algebraic equations help in finding out cost of service departments

X = a + bY Y=a+bX
This method of simultaneous equations gives accurate results. However, when the number of service departments exceeds two, calculations become difficult.

2. Repeated Distribution Method

3. Trial and Error Method