Overheads 1 Overheads Overhead includes a large number

Overheads 1

Overheads Overhead includes a large number of types of indirect costs n Direct cost are identifiable to cost units, but overhead which are often considerable, cannot be related directly to cost units n 2

Two-stage method to allocate overhead to products Overheads are assigned to the cost centres such as department n An allocation base is selected for allocating production centre expenses to products n 3

Procedures of overhead allocation to product Assign all factory overheads to cost centres n Reallocate service-centre overheads to production cost centres n Calculate separate overhead absorption rate for each cost centre n Assign cost-centre overhead to products n 4

Assign all factory overheads to cost center 5

Assign all factory overhead to cost centres Cost allocation n Cost apportionment n 6

Cost allocation n Where a cost can be clearly identified with a cost center or cost unit, then it can be allocated to that cost center or cost unit 7

Cost apportionment n It is not possible to identify a discrete item of cost with a cost center and it is necessary to split a cost over several cost centers on some agreed basis 8

Bases of apportionment Apportionment of indirect expenses to cost centers must be made on fair and reasonable bases n Different types of expense require different bases according to their individual characteristics n 9

Base of apportionment Costs Area Rent and rates, heat and lighting, insurance of lighting Depreciation, machine insurance Machine value No. of employees Wages of supervisors, canteen cost Example textbook P. 183 10

Reallocate service-center overheads to production center 11

Reallocate service-centre overheads to production cost centres n Service departments are not directly involved in production They only support service to other production departments in order to facilitate the production process Therefore, it is necessary to reallocate the servicecentre overheads to production departments so that all production costs can be absorbed into production. Typical bases are listed as follows: n 12 n n n

n. Typical bases are listed as follows: Service departments Possible bases of apportionment Maintenance labour hours, machine value Stores Value or weight of materials issued, number of requisitions inspection No. of employees, no. of jobs Example textbook P. 183 13

Calculate separate overhead absorption rate for each cost center 14

Calculate separate overhead absorption rate for each cost centre n To determine the overheads to be absorbed by a cost centre, it is necessary to establish an overhead absorption rate (OAR) OAR = Total overhead of cost centre Total number of units of absorption base applicable to cost centre 15

An appropriate OAR should reflect the effort or time taken to produce the products n Some commonly used absorption bases are listed as follows: n Direct labour hours It is frequently used in the labour intensive department because overheads assigned to this department are closely related to the direct labour hours worked Machine hours It is most appropriate for the machining department since most of the overheads are closely related to machine hours 16

Direct wages Direct materials Units of output It is only suitable in the department where the uniform wage rate is applied This method is not recommended unless the majority of overheads incurred in a department are related to materials instead of time This method is suitable only where all units produced in a period are identical in the production process and time. Therefore, this application is very rare Example textbook P. 183 17

Example 1 Refer to textbook P. 183 and P. 184 18

O/H Apportionment item Basis Indirect Actual material Indirect Actual wages Rent& Area Rates Machine Insurance Value Dep. Machine Value Heat & Area Light Production No. of Supervisor Employees Total $000 Production dept. Service dept. Maching Assembly Finishing Stores Maintenance $000 $000 727 200 199 185 20 123 510 200 80 10 20 200 40 20 60 60 20 30 16 10 2 1 1 300 160 100 20 10 10 100 20 10 30 30 10 160 48 32 48 16 16 2027 684 571 425 147 200 19

O/H Apportionment item Basis Total $000 Production dept. Service dept. Maching Assembly Finishing Stores Maintenance $000 $000 2027 684 571 100 40 60 884 671 425 147 200 Reallocation of service-centre overheads Stores Materials issued Maintenance Work 2027 7 40 472 (147) (200) - - 20

n Calculation of overhead absorption rates: Overhead absorption basis Maching Assembly Finishing Machine hours Labour hours Overhead $884000/200 absorption rates 000 hrs = $4. 42/hr $671000/100000 $472000/40000 hrs = $6. 71 /hr = $11. 8/hr 21

Assign cost-center overhead to products 22

Assign cost-centre overheads to products n The final step is to charge the overheads to the products passing through the production departments 23

Example 24

n The facts are the same as those in Example on slide no. 18. The number of hours needed to finish the products are listed as follows: Departments Product A Product B Machining 4 hours 5 hours Assembly 2 hours 1 hour Finishing 1/10 hour 25

Departments Product A $ Machining 4 hours at $4. 42 per mach. hr. Assembly 2 hours at $6. 71 per mach. hr. Finishing 1/10 hour at $11. 88 per labour hr. Total overhead charged per unit 17. 68 13. 42 1. 19 32. 29 Departments Product A $ Machining 5 hours at $4. 42 per mach. hr. Assembly 1 hours at $6. 71 per mach. hr. Finishing 1/10 hour at $11. 88 per labour hr. Total overhead charged per unit 22. 10 6. 71 1. 19 30. 00 26

Predetermined overhead absorption rates (POAR) 27

Predetermined overhead absorption rates (POAR) n n The overhead absorption rates are usually computed in advance of operations In practice, most absorption rates are only predetermined because the actual overheads are not known until the end of the period If the actual overheads are used to compute the OAR, the product cost can only be obtained at the end of the accounting period A delay in product cost calculation will also affect the pricing setting, the profit calculation and stock valuation 28

The formula of POAR The formula are as follows: Budgeted total overheads POAR = Budgeted total number of units of absorption base 29

Under-absorption and overabsorption base n n n Since the POAR are based on the estimated production and estimated overheads, the overheads absorbed seldom agree with the actual overheads incurred for the period Under-absorption occur when overhead absorbed are small than the actual overheads Over-absorption occurs when the overhead absorbed are greater than actual overheads 30

n n n For financial accounting, under- or overabsorption of overheads should be treated as period cost and written off against the profit and loss account in the current accounting period The under- or over-absorption of overheads should be debited or credited to the profit and loss account The under-absorbed overheads should be deducted from profit and vice versa 31

Example 32

Example n Estimated annual overheads $400 Estimated machine hours 200 machine hour n POAR = n $400 200 hrs = $2 per machine hour 33

Product 1 Product 2 Product 3 Product 4 Actual overheads incurred $400 $300 $500 Actual machine hours 250 hrs 160 hrs 200 hrs Overhead absorbed $2 * 250 hrs = $500 $2 * 160 hrs $2 * 200 hrs = $400 = $320 Under- or over Over-absorbed Under. Over. Under-absorption absorbed $100 $80 $100 s 34

Blanket Overhead Rate 35

Blanket overhead rate n n According to the overhead allocation procedure, the overheads are allocated to departments and each department calculate its own OAR and allocate the overheads to products passing through that department Alternatively, some firms do not assign overheads to departments. Rather, they adopted a single overhead rate, i. e. a blanket overhead rate, that is assigned to all products produced within the whole factory 36

n The use of the blanket overhead rate is not recommended as many products are produced in different production centres, and products consume cost-centre overheads in different proportions 37

Example 38

The annual overhead costs of a factory with three production departments are shown as follows: Overheads Direct machine hours Dept. A $20000 Dept. B Dept. C $400000 $180000 Total $600000 100000 300000 $4 $1. 8 Departmental $0. 2 overhead rate per direct machine hour Blanket overhead rate pre machine hour $2 39

If the production of product X only requires 10 direct machine hours in department A, the overheads absorbed will be computed as follows: Using departmental overhead rate Overhead absorbed $0. 2 *10 = $2 Using blanket overhead rate $2 *10 = $20 In this example, the production of product X does not consume Large amounts of overheads in department B and C. Therefore, there will be over-absorption of overheads if the blanket overhead 40 rate is used