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Overhead Costs

Study Note - 11

Overhead Costs

This Study Note includes

●●●●● Introduction●●●●● Classification of Overheads●●●●● Codification of Overheads Cost●●●●● Collection of Overheads.●●●●● Production Overheads●●●●● Administration Overheads●●●●● Selling and Distribution Overheads●●●●● Treatment of Special Items

It can be observed that all indirect costs form overheads. Thus, overheads comprise of all coststhat cannot be directly linked to cost unit or cost object. CIMA London defines overheads as“expenditure on labour, materials or services which cannot be economically identified with a specificsaleable cost per unit.”

This means that although there is a remote theoretical possibility to find a linkage, the clericalefforts to indentify are so huge and costly that it is not feasible to do so. There are many syn-onyms used for the term overheads viz. ‘on cost’, ‘burden’, ‘loading’, ‘non-productive costs’,and ‘supplementary costs’. By whatever name they may be called the fact remains that theyconstitute the part of total cost and therefore need to be measured, analysed, controlled andsaved. With increased automation of processes, the proportion of costs even in manufacturingindustry attains the status of being ‘indirect’. In service industry, the proportion of overheadsin total cost is quite high. Around 1960s, a typical cost composition would show a break up as

11.0 Introduction

In preceding study notes we have discussed two specific elements of costs viz. material andlabour. We have also discussed the classification of costs into direct and indirect which is basedon traceability with respect to cost centre or cost unit or cost object in general. The total cost ofa product comprises of two basic components i.e. prime cost plus overheads. This is shown inthe following chart:

Prime Cost

Overneads

This comprises of costs directlylinked to job or process or a costcentre or a cost unit

These are common coststhat are not specifically relatedto cost unit

Material

Direct

Indirect

Labour

Direct

Indirect

Expenses

Direct

Indirect

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Material 60%, labour 25% and overheads 15%. Through the passage of time and advent oftechnology where multi-purpose and multi-utility machines have taken over reins from hu-man beings, this composition has changed to material 55%, labour 10% and overheads 35%.These numbers are not exact, but they reveal a trend.If this be so, what percentage of management time must be given for controlling this 35% of thecost? No doubt it has to be sizable. But usually the managements spend more time in managingpeople and material and overheads are assumed to be fixed and hence uncontrollable. Thosewho understand the importance of controlling overheads, improve their profits surely.Can we know production manager’s salary per unit of product? Is it possible to identify eachrupee spent on rent to a cost unit? Is it economical to identify the quantity of thread used pershirt? These questions form the very basis for identifying costs of such nature as indirect. The‘indirect’ relationship with product may be seen in two ways. One – the costs may be incurredin production departments but not directly linked to final unit of product or service. Two –costs are incurred in non-production centers i.e. support departments which do not take part inactual production, but provide all allied services.As a keen learner of the subject of costing, one must grasp the concept of overheads thor-oughly. It must be remembered that the line of distinction between ‘direct’ and ‘indirect’ isvery thin and subjective as well. The cost control and analysis mechanism depends on whetherthe costs are direct or indirect. While direct cost are controlled more by physical measures suchas reduction in weight, lowering the number of hours to produce, using alternative materialetc., the overheads are controlled by setting up budgets and ensuring that the actual costs arewithin that limits.The understanding of overheads will be easier if the concept is studied in the following se-quence:

- Classification and coding of overheads- Collection of overheads i.e. pooling costs together for various cost centers- Identification of overheads to cost centers- Allocation of common overheads to the cost centers on a suitable basis- Apportioning the service departments’ overheads to production departments- Absorbing the overheads in the unit cost of products produced in production depart-

ment

11.1 Classification of Overheads

The overheads are grouped in different ways to be able to understand them, their behaviour soas to control them properly. This classification is basically done on similar lines in which gen-eral costs are classified as seen in Chapter 8. It may be done in following ways:

a) Based on nature of expense i.e. elemental grouping into indirect material, indirect wagesand indirect expenses. This classification helps the understanding of the basic nature ofoverhead costs. The controls for material, labour and other expenses are different. Hencethis classification answers ‘on what’ the overheads are incurred. Examples of this clas-sification are shown in the table below.

b) Based on functions i.e. manufacturing or production overheads, Administrationoverheads and Selling and distribution overheads. The functional classification helpsto understand where in the organisation the costs are incurred. This helps to fix respon-sibility on persons responsible for those functions and control expenses through them.

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Overhead Costs

Examples are shown in the table below.c) Based on Behaviour i.e. fixed or variable overheads. This classification tries to answer

the question “how do the overheads behave” or “what is the rate of change in overheadswith respect to change in output level’. This classification helps in analyzing overheadsfor the purpose of decision making.

The different ways of classification and their meanings are similar to that explained in section8.4 of the chapter 8, with the only exception that here the reference is always made to ‘indirectcosts’. Hence to avoid duplication, the concepts are not elaborated again. But for the sake ofunderstanding of the student, examples of each grouping are given below.

Please remember that the classification used for cost collection is mostly combination of el-emental and functional. The behavioral classification cannot be used for booking of costs; it isused only for analysis and decision making. No cost can be permanently stamped as eitherfixed or variable.

Indirect costs (overheads) Elements > Functions

Material Labour Expenses

Factory or production or manufacturing or works overheads

Nuts & bolts, consumables, lubricants, welding electrodes, cleaning materials, nails, threads, ropes etc.

Salaries & wages to foremen, supervisors, inspectors, maintenance labour, idle time

Factory lighting & heating, factory rent, power & electricity, factory insurance, depreciation on machinery, repairs,

Administration overheads

Printing & stationery, office supplies

Salary of office staff, managers, directors, and other administrative departments as IT, audit, credit, taxation etc

General office rent, insurance, telephones, fax, travel, legal fees, depreciation on office assets

Selling overheads Price lists, catalogues, mailings, advertising material such as leaflets, danglers, samples, free gifts, exhibition material

Salaries of sales staff & managers, commission on sales, bonus on schemes

Sales office expenses, travelling, subscription to sales magazines, bad debts, rent & insurance of showrooms, cash discount, brokerage, market research

Distribution overheads

Secondary packing, material items used in delivery vans

Salaries of delivery staff such as drivers, dispatch clerk, logistic manager

Carriage outwards, forwarding expenses, rent & insurance of warehouses & depots, insurance, running expenses & depreciation of delivery vans,

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When we consider the classification of the overhead costs on the basis of behaviour, we try andlink them to the change in the activity level or the volume of output. The rate of change in overheadscaused due to rate of change in the volume or output levels, will determine the degree of variability of theoverhead costs. Different types of expenses show different characteristics with respect to thedegree of variability. There are two extremes within which costs may change.

- Whatever may be the changes in the level of output, some costs do not change at all.These are called as fixed overheads

- Some costs change in direct proportion to the changes in the output. These are called asvariable overheads

- Some costs change with the level of output, but not in the same proportion. These arecalled as semi-fixed or semi-variable overheads

Fixed Overheads:

There are those overhead costs that have no relationship with the level of activity at which aproduction department operates. These costs remain perfectly constant throughout the differ-ent volumes of output. These costs are many times referred to as Period costs or policy costs.They are called as period costs because they are related to the period of time and not with thevolume of activity. They are called as policy costs because they are incurred based on the deci-sions by the management. Take for example a case of McDonald’s outlet which serves burgersand other fast food items. The rent payable per month for the outlet is Rs 10000/- Firstly, canwe relate each rupee of the rent to the every burger made and sold? No. Hence it’s an indirectexpense i.e. overhead cost. Secondly, once the rent agreement is in force, rent has to be paidirrespective of any number of burgers made & sold. The amount is fixed at Rs 10000/- permonth. So even if no burgers are made in month, rent will be Rs 10000, and if 2000 burgers aremade Rent will be same.

Fixed overheads and relevant range

A very important point has to be noted here. When we say these costs do not change, do wemean that they do not change permanently? That’s not the case. For example, landlord ofMcDonald’s outlet may increase the rent after the agreement period is over. Similarly, salariesmay go up. But this does not happen in the short run i.e. in a period of say a year. Within theshort run, these costs remain fixed.

So we need to modify the definition of fixed overheads as “overheads that do not change with change inactivity level within the relevant range’.

The ‘relevant range’ here could be the time for which the costs are committed (e.g. rent asdiscussed above) or it could be the production capacity installed e.g. if the current machine isable to produce 100000 units per annum, the fixed costs related to the machine will remainsame till the capacity operated is within 100000 units. If the management decides to change theinstalled capacity by adding another machine due to increased demand, the fixed overheadswill change. Within the given range, however, the fixed costs will remain the same.

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Overhead Costs

If you notice the above chart carefully, you will notice that a line parallel to x axis representsthe total fixed overhead costs and the curve showing descend along the x axis represents perunit fixed overhead costs. Can you now look at the table of costs shown above and find outcosts that are fixed overheads?

Variable Overheads:

There overhead costs show a linear relationship with the change in the volume of activity. Thismeans the expenses will go hand in hand with the change level of output. Take for examplepower costs. If the machine is not turned (i.e. no production) there won’t be any power con-sumption, but more the production, more will be power consumption. Similarly, consider achemical that is added as a catalyst for producing a drug, where the consumption will increasewith level of activity. A salesmen’s commission also will vary as sales increase. Hence as againstthe fixed overheads, the variable overheads increase as production increases and decrease asthe production decreases.

Variable Overheads – Total and per Unit

It is interesting to note that while variable costs in totality will increase, the variable overheadper unit will be constant. Consider that a salesman is paid commission of Rs 50 for one unitsold. If he sales 10 units he will get Rs 500, if he sales 100 units, he will get Rs 5000. So the totalcommission has gone up by 10 times as the volume also has gone up by 10 times. But what hashappened to the commission per unit? It is same at Rs 50. The conclusion therefore is that whilevariable overheads in totality change with the change in volume, but variable overheads perunit remain constant.

Fixed Overheads – Total and per Unit

Another important feature of fixed costs is their behaviour at the total expenses level and theper unit level. We know fixed overheads in totality will be constant. But as production vol-umes increase, these costs will get spread over more number of units produced. Hence, thefixed overhead per unit will reduce as production rises. Similarly, fixed overheads per unit willincrease on reduction in the production level. Can we say that fixed overheads per unit arevariable? Yes we can!

T o ta l fixe d O v e rh e a d s

P er u n it f ixe d o v e rh e a d

O u tp u t o r v o lu m e in u n its

Cos

t (R

s)

0 o

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The above chart has shown the behaviour of the variable overheads in totality and per unitbasis. If you notice the above chart carefully, you will notice that the straight line showingascend along the x axis represents total variable overheads and a line parallel to x axis repre-sents per unit variable overhead costs. Can you now look at the table of costs shown above andfind out costs that are variable overheads?

The relationship of fixed and variable overheads with the volume of output is exhibited in thefollowing table. The range of output is considered as 5000-10000 units. Variable overheads aretaken at Rs 2 per unit and fixed overheads are assumed to be at the level of Rs 25000. Can youcheck for yourself how the graph will look like for the following figures?

Overheads per unit Output units

Fixed Overheads

Variable Overheads

Total Overheads Fixed Variable Total

5000 25000 10000 35000 5.00 2.00 7.00 6000 25000 12000 37000 4.17 2.00 6.17 7500 25000 15000 40000 3.33 2.00 5.33 8000 25000 16000 41000 3.13 2.00 5.13 9000 25000 18000 43000 2.78 2.00 4.78 10000 25000 20000 45000 2.50 2.00 4.50

Observe that the fixed overheads per unit decreases as the output goes up. This would meanincreased profits. This relationship helps management in cost estimations and decision mak-ing. We will discuss this in depth in the topic on marginal costing.

Semi-fixed or Semi-variable Overheads:

There are certain items of overhead costs that do change with change in volumes, but not in thesame proportion. These overheads are partly fixed and partly variable. A simple example willclear this concept. Consider a telephone expenses. It has a fixed monthly rental and the per callcharges. Now if the total phone bill is Rs 1200 for a month, it has two elements – a fixed portionof rental (say Rs 225) and call charges (Rs 975). The bill will increase based on number of calls

Total variable overhead

Output or volume in units

per unit variable overhead

Cos

t (R

s)

0

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Overhead Costs

made, but rental will remain the same. Hence it is partly fixed and partly variable. In a factory,if the maintenance workers are paid wages as Rs 2500 fixed plus Rs 75 per breakdown call, thenthe total wages will be recognised as semi-fixed or semi-variable costs. There are certain typesof overheads that are initially constant, but jump due to increase in volume and then againremain constant at the revised level. The best example is the supervision costs. A supervisorlooks after 20 workers. Due to additional business needs, 10 more workers are added. Here ifone additional supervisor is taken, then the salary cost of supervision will go up and thenremain constant till the time there are 2 supervisors only. Such, step-up behaviour of someoverhead items is shown in the chart below.

Such type of overheads always poses problems for the cost accountant. Whether they are to betreated as fixed or variable is difficult to determine. For the purpose of accurate cost analysis,these overheads are segregated into fixed and variable. The separation of fixed and variableelements of these costs can be done by using certain statistical and other methods such as:

a) Graphical method – expenses are plotted on a graph paper and a line that passes throughmaximum points is drawn and extended to meet y axis. The point at which it intersectsy axis represents fixed portion of the cost and remaining is variable.

b) Simultaneous equations – This uses the straight line equation of y = m x + c where yrepresents total cost, m is variable cost per unit, x is the level of output and c is fixedcosts. The total costs at two different volumes are put into these equations which aresolved for the values of m and c.

c) High and low method – The highest and lowest levels of output and costs are takenand the differential is found. This difference arises only due to variable costs. The re-maining portion will be fixed costs.

d) Least square method – This statistical tool uses straight line equation and finds the lineof best fit to solve the equations.

Semi-variable overheads

Output or volume in units

Cos

t (R

s)

0

11.2 Codification of Overhead costs

As we have discussed in the section on basic financial accounting, there is a chart of accountswhich is used to capture the business transactions. The expenses or costs are grouped underproper heads so that they can be easily understood and analysed. These days as most of thebusiness organisations use computers, numerical codes are used.

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The logic for codification may be decided based on the need for detail and nature of expenses,size of business organisation etc.

You may observe the logic in giving the codes. All codes starting with 1 are production depart-ments, all codes starting with 2 are factory related services and all codes starting with 3 aregeneral services. This coding helps collection of costs on functional basis and also to identify anitem of expense directly to a department or cost centre.

The actual account code for booking an item of expenses is different. Mostly, it is a numericalcode with logic. For example, numbers starting with 1 may be used for indirect materials, 2may be for indirect labour and 3 for indirect expenses. It could be seen in following table.

Nature-wise expenses or costs are given codes under which the concerned costs are booked.For functions cost centre concept is used. Cost Centers are also given codes. When an expenseis to be booked, it is simultaneously recorded for an account code under a cost centre.

An example of these codes is given below:

Cost Centre codes Department name 1100 Turning department 1200 Grinding Department 1300 Components manufacturing 1400 Assembly 2100 Maintenance 2200 Quality control 2300 Stores 3100 HR & Administration 3200 Accounts

Ledger account code Name 100000 Indirect material 100100 Indirect steel items 100200 Indirect packing material 200000 Indirect wages 200100 Indirect wages – statutory

benefits 300000 Indirect expenses 300100 Rent 300200 Insurance 300300 Advertising

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Overhead Costs

Document Overhead costs Nature Stores Issue note, purchase voucher

Indirect material Consumables, lubricants etc.

Payroll sheets, time sheets

Indirect labour Wages, salaries, contribution to statutory benefits, bonus, incentives, idle time

Cash books Indirect material, Indirect labour & indirect expenses

All type of costs

Subsidiary records – journal

Indirect material, Indirect labour & indirect expenses

For provisions of costs that are not actually paid for

Other reports Indirect expenses Depreciation, scrap, wastage etc

Remember these costs can be collected based on above documents for every function whethermanufacturing, administration, selling and distribution. Collection of overheads is the processof actually identifying an item of expense or cost to a cost centre directly. Whatever cannot bedirectly identified needs to be allocated or apportioned on the most logical basis of distribu-tion.

Depending upon the nature of business, the proportion of overheads related to a particularfunction will change. In a manufacturing company, production departments will constitute amajor proportion in comparison to administration, selling & distribution. For a trading com-pany, selling & distribution will play a major role. A service organisation will have maximumnumber of common items which will have to be apportioned. We will discuss the general pro-cess of linking each item of overhead to the cost unit taking all functional overheads.

11.4 Production Overheads

As we know production overheads (also called as manufacturing overheads, works overheadsor works on-cost), include all factory indirect costs that cannot be directly linked to productionunits. Even if a supervisor in working in a production department that produces say 1000 unitsin a month, each rupee of his salary of say Rs 2500 cannot be identified with every unit pro-duced, as his salary is time based and not piece rate based. The question arises for all such

11.3 Collection of overheads

As we know expenses or costs are booked in costs accounts based on the source documents.These source documents are generated in departments where the transactions are generated.In the total cost determination, collection of costs is an important step. The source documentsfrom which costs are collected are as follows:

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P-1

P-2

P-2

S-1

S-2

At the next stage, we take S-1 and S-2 total costs and load it on to P-1, P-2 and P-3 on somesuitable basis. This is shown below.

Please carefully note the arrowsbetween S-1 and S-2. This indicatesone service department givingservice to other service depart-ment! Maintenance departmentmay give services to stores. Suchservices must be re-apportioned

factory on-costs as to how exactly should we associate the same to the cost unit. As there is nodirect link, it will have to be in the form of an equitable charge per unit of production. In abovecase simply put, we can say the cost of supervisor’s salary per unit is Rs 2.50 (i.e. 2500/1000).But what if there are two different types of products made – both requiring different supervi-sion time? In such case, we cannot average out the salary!

The process of accounting and linking of production overheads is as follows:

a) Departmentalisationb) Classification and collection of overheadsc) Allocation and apportionment of costsd) Distribution of service centre costs to production departmentse) Absorption of production department costs to cost units

It is a rather lengthy process and understood so as it’s an indirect way of allocating. In practicehowever, it is not so lengthy due to use of computerised systems. Carefully, see the chart be-low.

0-1

0-2

P-1

P-2

P-3

S-1

S-2

Here O-1 & O-2 are two items of ex-penses, P-1, P-2, & P-3 are productiondepartments and S-1 and S-2 are pro-duction related services departments.This is the process of identification ofcosts to departments

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Overhead Costs

P-1

P-2

P-3

Units produced

Once this is done, the last step is to absorb the totals of each production department on to theunits produced by them. See the following chart.

11.4.1 Allocation of production overheads:

While identifying the overheads to various departments, it must be made sure that

- the cost is incurred due to action executed by that department and- Exact amount of overhead is known. This may be found from the source documents

listed in 11.3 above.For example if a stores requisition is raised by maintenance department for repair of a ma-chine, it could be directly identified with maintenance department. If canteen employees tem-porary contractor for cleaning, it could be directly identified with canteen based on the billreceived from such contractor.

11.4.2 Apportionment of production overheads:

Some overheads are not caused by the departments neither the exact cost for that departmentis known, such expenses need to be pro-rated or apportioned to various departments on asuitable basis. The basis for apportionment is normally predetermined and is decided after acareful study of relationships between the base and the other variables within the organisation.The cost accountant must ensure that the selected basis is the most logical. A lot of quantitativeinformation has to be collected and constantly updated for the purpose of apportionment. Thebasis selected should be applied consistently to avoid vitiations. However, there should be aperiodical review of the same to revise the basis if needed. A general example of various basesthat may be used for the purpose of apportionment is shown below:

Overhead item Basis Rent of building Floor space occupied by each department General Lighting No of light points in each department Telephones No of extensions in a department Depreciation of factory building Floor space Material handling No of trips made

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Allocate or apportion the overheads among the various departments on suitable basis.Answer:

This list is not exhaustive and depending upon peculiarities of the organisation, it could beextended. This allocation and/or apportionment is called as primary distribution of overheads.

Example: A factory has 3 production departments (P1, P2, P3) and 2 service departments (S1 &S2). The following overheads & other information are extracted from the books for the monthof January 2007.

Expense Amount Rs Rent 6000 Repair 3600 Depreciation 2700 Lighting 600 Supervision 9000 Fire Insurance for stock 3000 ESI contribution 900 Power 5400

Particulars P1 P2 P3 S1 S2 Area sq ft 400 300 270 150 80 No of workers 54 48 36 24 18 Wages 18000 15000 12000 9000 6000 Value of plant 72000 54000 48000 6000 Stock value 45000 27000 18000 Horse power of plant 600 400 300 150 50

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Overhead Costs

11.4.3 Secondary Distribution of Production Overheads:

After the primary distribution as shown above is over, the next step is to re-distribute theservice department costs over the production departments. This also needs to be done on somesuitable basis, as there may not be a direct linkage between services and production activity.The products actually do not pass through the service departments. So does it mean that theservice cost is not a part of cost of production? It very much is the part of production cost!Hence the loading of service costs onto the production departments is necessary. This process iscalled secondary distribution of overheads.

The basis for secondary distribution is dependent on- The nature of service given e.g. it may be maintenance department or stores- Measurement of service based on surveys or analysis- General use indices

In the above example, the costs of S1 (Rs 2910) and that of S2 (Rs 1610) will have to be loaded onto the totals of P1, P2 and P3.

Here are some examples of the bases that can be used to distribute cost of different servicedepartments:

Expense Total Basis P1 P2 P3 S1 S2 Rent

6,000 Area sq ft

2,000

1,500

1,350

750

400 Repair

3,600 Plant value

1,440

1,080

960

120

-

Depreciation 2,700

Plant value

1,080

810

720

90

-

Lighting 600 Area sq ft

200

150

135

75

40

Supervision 9,000

No of workers

2,700

2,400

1,800

1,200

900

Fire Insurance for stock

3,000

Stock value

1,500

900

600

-

-

ESI contribution 900 Wages

270

225

180

135

90

Power 5,400

Horse power

2,160

1,440

1,080

540

180

Total

31,200

11,350

8,505

6,825

2,910

1,610

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Again this is not an exhaustive list and could differ from company to company. Many timespercentage estimation is also done for such distribution if the service cannot be measured onthe basis of any of the above bases. It may be decided that the cost of S1 is to be distributed asP1-40%, P2-25% and P3-35%. Such arbitrary method should be avoided as far as possible.

Methods of secondary distribution

a) Direct distribution method: This method is based on the assumption that one servicedepartment does not give service to other service department/s. Thus between servicedepartments there is no reciprocal service exchange. Hence under this method, servicecosts are directly loaded on to the production departments. This is simple. But the as-sumption may not be correct. Can we say that the canteen service is not available toother service departments like labour office or stores or maintenance department? Thisis incorrect and thus the method should not be used as far as possible.

In the above example consider that if the S1 and S2 costs are to be distributed on as-sumption of services rendered as S1 to P1- 40%, P2-30% and P2-10% and the S2 costs areon the basis of 5:3:2, then the table for redistribution of S1 and S2 costs over the produc-tion departments P1, P2 and P3 will be as given below.

Department Total Basis P1 P2 P3 Overheads as per primary distribution

26,680

11,350

8,505

6,825

Distribution of S1 2,910 40%:30%:30%

1,164

873

873

Distribution of S2 1,610 5:3:2

805

483

322

Total 31,200

13,319

9,861

8020

Service department Basis Quality control No of inspections done Maintenance No of maintenance calls or

Material usage for maintenance or Time spent on maintenance

Stores Indirect material cost or No of issue slips or Quantity of material issued or Value of stock handled

Canteen, welfare No of workers Internal transport No of trucks or trolleys used or

Tonne-miles consumed Payroll office No of labour hours Purchase office No of purchase orders or

Value of material purchased

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Overhead Costs

b) Step distribution method: This method does away with the assumption made underabove method, but only partly. It recognises that a service department may render ser-vice to the other service department, but does not receive service from it. In above ex-ample, S1 may render services to S2 but not vice versa, i.e. S2 may not render service toS1. In such situation, cost of that service department will be distributed first whichrender services to maximum number of other service departments. After this, the costof service department serving the next large number of departments is distributed. Thisprocess is continued till all service departments are over. Because it is done in steps, it iscalled as Step method of distribution.

A manufacturing company has two production departments Fabrication and Assemblyand 3 service departments as Stores, time office and maintenance. The departmentaloverheads summary for the month of March 2007 is given below:

Fabrication Rs 24000Assembly Rs 16000Stores Rs 5000Time office Rs 4000Maintenance Rs 3000

Other information relating to these departments was:

Apportion the costs of service departments to the production departments.

Answer:

In this example, we will have to determine the sequence in which the service depart-ments should be selected for distribution and the bases on which each of them will bedistributed. The following logical bases are decided based on the additional informa-tion given:

Production departments Service departments

Particulars Fabrication Assembly Stores Time office Maintenance

No of employees 40 30 20 16 10 No of stores requisition slips 24 20 6 Machine Hours 2400 1600

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Time office No of employeesStores No of stores requisitionsMaintenance Machine hours

Also, it can be easily noticed that the time office serves maximum departments (i.e.both production departments, stores & maintenance departments). Stores serve the nextlarger number of departments (i.e. both production departments and maintenance de-partment). Maintenance department serves only production departments. Hence thesequence for distribution will be time office, stores and maintenance. This is shown inthe following table:

Please notice when we distribute the time office costs first, the charge to stores depart-ment is Rs 800. This makes the total cost of stores to be distributed as Rs 5800 (5000+800).Same is the logic for Rs 4096 of Maintenance department.

C) Reciprocal service method: This method takes cognizance of the fact that service de-partments may actually give as well as receive services from and to the other servicedepartments on reciprocal basis. Such inter-departmental exchange of service is givendue weight in the distribution of the overheads. There are two methods used for distribu-tion under this logic. One is called Repeated Distribution method and the other SimultaneousEquation Method.

i). Repeated Distribution Method: This is a continuous distribution of overheadcosts over all departments. The decided ratios are used to distribute the costs ofservice departments to the production and other service departments. This iscontinued till the figures of service departments become ‘nil’ or ‘negligible’.Consider the following example:

Particulars Total Basis Fabrication Assembly Time office Stores Maintenance

As per primary distribution

52,000 as given 24,000

16,000

4,000

5,000 3,000

Time office

4,000 no of employees 1,600

1,200

(4,000)

800 400

Stores

5,800 no of req. slips 2,784

2,320

(5,800) 696

Maintenance

4,096 Machine hours 2,458

1,638 (4,096)

Total 30,842

21,158

-

- -

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Overhead Costs

The summary as per primary distribution is as follows:

Production departments A- Rs 2400, B- Rs 2100 & C- Rs 1500Service departments X – Rs 700, Y- Rs 900

Expenses of service departments are distributed in the ratios of:

X dept. A- 20%, B- 40%, C- 30% and Y- 10%Y dept A- 40%, B- 20%, C- 20% and X- 20%

Show the distribution of service costs among A, B and C under repeated distri-bution method.

It can be noticed that the undistributed balance in service department is verynegligible and thus can be ignored for further distribution.

ii). Simultaneous Equations Method: Under this method, simultaneous equationsare formed using the service departments’ share with each other. Solving thetwo equations will give the total cost of service departments after loading theinter-departmental exchange of services. These costs are then distributed amongproduction departments in the given ratios. In the above example, service deptX gives 10% of its service to Y and receives 20% of Y’s service.

Let ‘x’ be the total expenses of dept X (its own + share of Y) and‘y’ be the total expenses of dept Y (its own + share of X)

This can be expressed as:

‘x’ = 700 + 20% of ‘y’ and‘y’ = 900 + 10% of ‘x’

i.e. x = 700 + 0.2y andy = 900 + 0.1x

Production departments Service departments

Particulars A B C X Y As per primary distribution 2400 2100 1500 700 900 Service dept X 140 280 210 -700 70 Service dept Y 388 194 194 194 -970 Service dept X 38.8 77.6 58.2 -194 19.4 Service dept Y 7.76 3.88 3.88 3.88 -19.4 Service dept X 0.776 1.552 1.164 -3.88 0.388 Total 2975.336 2657.032 1967.244 0 0.388

��������� B 131

Multiplying both equations by 10, we get

10x = 7000 + 2y i.e. 10x –2y = 7000 and10y = 9000 + x i.e. -x+10y = 9000

Now multiplying 2nd equation by 10, and then adding the two equations we get,

98y = 97000

Thus y = 990 and x = 898

Based on this we distribute the service department costs as below

Production Departments Particulars Total A B C As per primary distribution

6,000

2,400

2,100

1,500

Service dept X (90% of 898)

808

180

359

269

Service dept Y (80% of 990)

792

396

198

198

Total 7,600

2,976

2,657

1,967

You can notice that the final answers under both methods are same. The simul-taneous equation method is quick to apply and hence more in use.

Limitations of apportionment:

Whichever method we may use, it still depends on a suitable basis used. The basis will alwayslead to approximations. If an approximate data is used for analysis, control and decision-mak-ing, it may cause erroneous results. Thus one has to be careful in relating the cost data to costcentre or cost unit. The natural relation of most of the indirect costs i.e. overheads is to a timeperiod. In other words, almost all overheads are period costs and hence an attempt to link it tocost unit will always be arbitrary. As such, the traditional methods of allocation and appor-tionment are often challenged by many in the industry. The techniques like marginal costingowe their origin to such limitations of traditional costing.

11.4.4 Absorption of Production Overheads:

Once the steps of primary and secondary distribution are carried out, what we get is totalindirect costs of production departments. The next step is to assign these totals to the indi-vidual product units. A job or a product passes through all or many production departmentsbefore it is formed into a finished saleable product. It is necessary to know the cost of each

���������B 132

Overhead Costs

department it passes through per unit. The absorption of overhead enables a cost accountant torecover the overhead cost spent on each product department through each unit produced.Overhead absorption is also known as levy or recovery of overheads. How is this done? Sup-pose in turning department a total of 1200 tubes are turned and the cost of turning departmentoverheads (after secondary distribution) are Rs 72000, then can we say the cost of turning pertube is Rs 6/-? Most probably yes. This Rs 6 per unit is called as overhead absorption rate.

In general, the formula for overhead absorption rate is give as:

Overhead rate =

The moot question here is – do we use actual or estimated rates? By the time the actual cost datais known, it will take a lot of time and the data may not be useful for decision making. Henceit’s a common practice to determine the rate in advance. Such rates are known as predeterminedrates. The predetermined rates are calculated using the budgeted or standard overhead costsfor the production departments as divided by the budgeted or standard number of units of thebase. Actual costs as well as output may fluctuate from one period to other, and hence therecovery rates also will fluctuate. In order to even out the rates throughout the year and to usedata for decision making, pre-determined rates are used quite commonly.

In the above formula, the numerator is an absolute amount calculated (or budgeted). Whatshould be used in the denominator? What exactly do we mean by the number of units of the base? Thereare different ways of absorbing overheads using different types of denominators. These arediscussed below:

a) Production unit method: Simply put the concept here is to average out the totaloverheads on total units produced. As seen above the total overheads are Rs 72000 andtotal tubes processed are 12000. The overhead absorption rate is: 72000/12000 i.e. Rs 6per tube. If this rate is based on the budgeted costs and number of units, and if thefactory now gets an order for 2500 tube processing, the amount of production overheadsto be charged to that order will be (2500 * 6) i.e. Rs 15000/-

b) Percentage of Direct Wages: Under this method, overhead for a job is recovered on thebasis of a predetermined percentage of direct wages. This method is used when thecomponent of direct wages is higher. If the overhead to be absorbed is Rs 120000 andthe direct wages are estimated at Rs 800000, the predetermined rate will be calculatedas (120000/800000) i.e. 15%. If a job is received where direct wages are estimated atRs 9000/- then the production overheads to be absorbed will be 15% of Rs 9000 i.e. Rs1350/- This method is useful if the direct labour hours can be standardised and thelabour rates do not fluctuate too much. However, this method ignores the contributionmade by other resources like machinery. The method also ignores the fact that theremay be different types or grades of workers and each may cost differently. It also sidelinesthe fact that most of the production overheads are time-related.

c) Percentage of Direct Material Cost: Here the absorption rate is expressed as a percentageof direct material cost. This method is useful when the proportion of material cost isvery high and that of labour cost is comparatively negligible. It is useful if material

��������� B 133

grades and rates do not fluctuate too much. If production overhead to be absorbed is Rs2000 and the material cost is expected to be Rs 4000, then the absorption rate will be(2000/4000) i.e. 50% of direct material cost. This for a job requiring direct material of Rs200, the production overheads to be absorbed will be Rs 100/- i.e. 50% of Rs 200/-.However, many overhead items bear no relationship with material cost, and also thefact of time dimension of overheads is not taken into account by this method.

d) Percentage of Prime Cost: This method combines the benefits of direct wages and directmaterial cost methods as we know prime cost means direct material plus direct wagesplus direct expenses. This method could be used when prime cost constitutes a majorproportion of the cost and the rates of material & labour are stable. It is needed that theproduct made is standard product. If the prime cost is expected to be Rs 50000 and theproduction over heads are estimated at Rs 2500, then the absorption rate will be 5% ofprime cost. If a job has a prime cost of Rs 800, then overhead absorbed on that job willbe Rs 40/-

e) Direct labour hour rate: Under this method, the absorption rate is calculated by dividingthe overhead amount by the actual or predetermined direct labour hours. This isextremely useful when the production is labour intensive. This method is superior tothe earlier ones, because it takes cognizance of the time factor. If the direct labour hoursfor a month amount to 10000 and the overheads to be absorbed are Rs 5000, then theabsorption rate is Rs 0.50 per hour (i.e. 5000/10000). If a job is going to require a labourtime of 250 hours, the production overheads to be loaded on the job will be Rs 125 (i.e.250 * 0.50). the data related to labour hours has to be properly collected or estimated.The labour hour rate may be calculated as a single rate or different for different groupsof workers.

f) Machine Hour Rate: In the days of mechanised production processes, the most relevantrate to be applied is the machine hour rate. This is the rate calculated by dividing theactual or budgeted overhead cost related to a machine or a group of machines by theappropriate number of machine hours. These hours could be actual hours or budgetedhours. When budgeted hours are used they are taken at average capacity at which afactory normally operates. You cannot take full capacity hours as the factory may notoperate at that level and then the absorption rate may be unnecessarily fixed at a lowerlevel. The overheads in a highly mechanised factory are mostly related to the numberof hours a machine runs. Hence this is supposed to be the best method for absorbingoverhead costs into the cost unit. If a machine normally runs for 2000 hours in a monthand monthly overheads to be absorbed are Rs 15000, then the machine hour rate will becalculated as (15000/2000) i.e. Rs 7.50 per machine hour. If a job take 75 hours on thatmachine, then Rs 562.50 (75 * 7.5) will have to be loaded as cost of using the machine forthat job.

A machine hour rate may be calculated using only those overheads which are directlyrelated to the machine e.g. power, fuel, repairs, maintenance, depreciation etc. Theseexpenses are totaled and then divided by the hours to compute the rate. This is called asordinary machine hour rate. Whereas, if costs not related to machine are also included(e.g. supervision, rent, lighting, heating etc.) for the rate calculation, such rate is calledas Composite machine hour rate.

���������B 134

Overhead Costs

While calculating machine hour rate, the wages paid to machine operators may be addedto the total costs. This is because these operators directly wok on the machines & thusrelated to machine operation. At times a factory may have more than one similarmachines simultaneously working. In such case, a group machine hour rate may becalculated.

Choice of method of Absorption Rate calculation

Which of the above methods should be used for calculating the overhead absorptionrates? The choice may be difficult, but could be based on the following:

1) The method should bear a logical relationship with items of overhead and the baseused.

2) It should suit the type of industry and conditions prevailing therein. One cannotuse a direct labour hour rate in a fully automated factory.

3) It should take into account the nature of overheads. If more proportion of overheadsis time related, the method focusing on hours should be used. In case of morepercentage of indirect material, a material cost based system has to be used.

4) The data needed by a method should be available on a regular basis.

11.4.5 Over or Under Absorption of production overheads:

If overhead rates are based on the actual data i.e. actual costs and actual base, then the sum oftotal overheads absorbed in all units produced will match with the total overheads incurred.But if the absorption rate is a pre-determined rate based on budgets or estimates which couldbe different from the actual, then it may result into either over-absorption or under-absorptionof overheads. Consider, a factory uses predetermined machine hour rate based on the machinecosts of Rs 220000 per annum and normal machine hours of 55000 hours. This would give apre-determined rate of Rs 4 per machine hour (i.e. 220000/55000). Now if during the year, theactual machine costs happen to be Rs 235000 and the actual machine hours worked are 53000,then based on the pre-determined rate of Rs 4 per hour, the factory would have absorbed atotal of Rs 212000 (53000 * 4) through the cost of production as against the actual overheads ofRs 235000. Here, this is the case of under-absorption by Rs 23000.

How does one deal with the situation of over or under absorption. There are three ways tohandle it:

a) Write-off (in case of under absorption) or write back (in case of over-absorption) to theP & L account. This treatment is valid if most of the overhead items are related to time.

b) Carry forward to the next period through a reserve account. This method is notrecommended on the logic that it is inconsistent with accounting standards.

c) Use of supplementary rates to adjust the effect to the cost of sales, finished stocks andWork in Process stocks. This sounds logical as it does not carry forward the unabsorbedor over absorbed overheads to the next accounting period entirely. It aims at splitting

��������� B 135

the total effect between the cost of sale (which is charge to current year’s profits) andstocks (which get carried forward to the next year). This is illustrated below:

Overhead incurred Rs 150000Overhead recovered Rs 100000Cost of sales Rs 1000000Finished goods Rs 800000Work in process Rs 700000

Here, the overheads under-absorbed are (150000-100000) Rs 50000.Total of Cost of sales, FG stock & WIP is Rs 2500000

The supplementary rate will be 50000/2500000 i.e. Rs 0.020

This will be distributed as:

Rs 20000 to cost of sales (i.e. 1000000 * 0.020)Rs 16000 to FG stock (i.e. 800000 * 0.020) andRs 14000 to WIP (i.e. 700000 * 0.020)

This will certainly help show a correct picture.

11.4.6 Reporting and control of production overheads

Overheads being indirect costs need a different approach for control. The pre-requirements forcontrolling production overheads are:

a) Correct departmentalisation of the factoryb) Correct classification according to variability, and functionsc) Proper quantitative data maintenance such as hours, number of requisitions, repair

calls, idle time etc.d) Proper selection of overhead distribution method and absorption rate method.e) A comprehensive reporting of actual costs and comparison with budgets or standards

11.5 Administration Overheads

As per the functional classification, administration overheads comprise of those indirect costswhich are related to the general administrative function in the company. Such functions arerelated to policy formulation, directing the organisation and controlling the operations of thecompany. In section 11.1 we have seen the examples of administration overheads furtherclassified into indirect material, indirect labour and indirect expenses. Please refer to thoseexamples.

Administration overheads are incurred for the benefit of organisation as a whole. Controllingthem is difficult for they do not vary with most of the variables viz. production or sales.

���������B 136

Overhead Costs

Photocopying of documents is a major cost which is not related to either production or sales –it’s just the habit of people. The size as well as control over these overheads depends largely ondecisions of management. Organisations growing very fast face the problem of controllingadministrative overheads. Multi-location set up leads to duplication of many administrativecosts.

11.5.1 Collection and absorption of administration overheads

The collection of overheads is done firstly by nature of the expenses through the chart of accountsprocess as explained earlier in this chapter. These expenses are booked under respectivedepartments. The administrative departments in an organisation could be:

Corporate officeFinance and AccountsCompany SecretaryHuman resourcesLegalGeneral Administration

The overheads that are common to all these departments are apportioned on some suitablebasis e.g. in the following manner:

Office rent, rates & taxes floor spaceDepreciation on office building floor spaceLegal fees No of cases handledSalaries of common staff ratio of salaries of departmentsTypist pool No of documents typed

Absorption of the administrative overheads into cost units is very difficult. Many times it isadvised that these overheads may not be absorbed into product units because of the difficultyand non-relevance of them with production activity. Normally, the administrative overheadsare totaled together and then using a suitable basis, a rate of recovery is arrived at to absorb thesame. It could be mostly a percentage of Works cost or factory cost. Based on the principle of‘charging what the traffic can bear’, the absorption could be on the basis of a percentage of grossprofit. Whatever method selected, it wil be arbitrary and could lead to erroneous conclusions.A cost accountant has to use all the experience and history of the organisation before he selectsa particular method to adopt.

11.5.2 Treatment of Administration overheads:

There are three different ways of treating the administration overheads:

1) Apportion between Production and Selling & Distribution functions: This treatmentis based on the logic that the administrative functions are for the entire company andthese functions facilitate both production as well as selling. In other words, the absorption

��������� B 137

of administration overheads would happen through production and selling overheads.This means these overheads lose their identity. The problem is of course, selection ofbasis to divide these overheads over the two principal functions of production andselling.

2) Transfer to P & L account: This method agrees that administrative costs are all timebased costs and as such bear no relation what is produced or what is sold. These aremainly of fixed nature. Hence there is no point in dividing them further to be includedin the cost of production or cost of selling. They should be simply charged to the P & Laccount. However, this may lead to undervaluation of stocks.

3) Treating as a separate addition to cost of production & sales: In this method,administration is treated as a separate function and is added as a separate line in thecost computation sheet for a job or an order. Here again, the basis for inclusion as a partof cost of a job is a difficult choice. Generally, a percentage of factory cost is taken as abasis. A care needs to be taken to ensure that the administration overheads are chargedequitably to cost of sales, FG stock and WIP as well.

11.5.3 Controlling Administration Overheads

Given the nature of these expenses, they cannot be controlled at the lower level of management.They can be better controlled by top management as they pertain to formulating policy anddirecting the organisation. The first step in the control mechanism is proper classification ofexpenses & departmentalisation. The actual expenses are collected for each department andthen compared with a bench mark. Deviation are analysed and causes for increase are mitigatedby fixing responsibility on the departmental head.

The control benchmarking can be done with respect to:

- Figures of the previous year. Expenses could be compared with the figures of previousyear and increase or decrease are analysed. However, comparison with previous yearmay not help as the condition may have totally changed from one year to the other.

- Use of budgets. Budgets are estimates for the current year, and they take into accountthe changed conditions. They also built in the year’s complete plan which would factorall changes in the cost structure. It is advisable to compare budgeted overheads withactual for control purpose.

- Use of standards. Although very scientific, this method is difficult to operate.Administrative activities (being very subjective) cannot be standardised. O a certainlevel it can be applied e.g. the time taken to process a voucher by accountant can bestandardised, or time taken for processing a payment could be standardised.

11.6 Selling and Distribution Overheads (S & D)

As the name suggests these are overheads incurred for handling post-production activity. Thepurpose of these activities is to make sure that the products are sold & distributed to thecustomers to realize profit thereon. Although they are usually put together, selling anddistribution are two different activities. While selling involves efforts to create demand for the

���������B 138

Overhead Costs

product and secure orders from customers; distribution refers to the physical movement ofproducts through various channels of distribution so that the products reach ultimate customers.Many organisations club these functions as one function called as ‘marketing’ and as such theS & D overheads can be called as ‘indirect marketing costs’.

The magnitude of S & D overheads in the total cost would depend on many factors such asnature of the product, type of customers, spread of market, statutory restrictions etc. A con-sumer product needs heavy expense on advertising. A sale to institutions rather than indi-vidual customers needs a different selling effort. Distribution costs will increase if the spreadof the market is large. Some activities cannot be advertised at all such as a doctor, a cost ac-countant. The total magnitude of S & D costs and the proportion of selling and distributionefforts will decide the treatment thereof and control mechanisms to be used.

For some of selling expenses there may not be a direct relationship with the product. If a com-pany incurs expense on advertising, it may be difficult to relate to a specific product unless it’sa product advertisement. But further, there may be a substantial time lag between the expenseand the benefit arising out of that. In case of distribution costs many of them may be possiblylinked to the product.

11.6.1 Collection and Absorption of S & D overheads

While classifying the S & D costs are properly bifurcated and coded accordingly. This could bedone by having separate account codes for:

Selling overheads

- Advertising- Sales commission- Travelling expenses- Communication- Exhibition- Market survey- Selling material such as leaflets, pamphlets, posters, danglers, price lists, catalogues

etc.- Free samples- Credit & collection costs- Bad debts

Delivery expenses

- Transportation vehicle related expenses- Warehousing and storage at different places- Depreciation and maintenance

Depending upon the size of the organisation, there may be a proper departmentalisation of theS & D activities. The departments could be:

��������� B 139

- Sales head office- Sales regional offices- Depots- Direct selling department- Dealers management- Credit and collection (commercial)

The costs are collected through various source documents under the above heads and for theabove departments. For absorption, the basis to be used will have practical difficulties, as onewill have to look for a relationship between the expenses and the cost unit. Some expenses likesales commission, shipping costs, and direct selling expenses can be absorbed directly. Theother expenses can be absorbed on the basis of either sales value, cost of goods sold, grossprofit or number of units sold. Out of these the sales value method is the most commonly used.

11.6.2 Control over S & D expenses

The S & D expenses are related to sales and distribution activity which is externally focused.The extent of these expenses depend mainly on external factors like consumer profile, chang-ing habits, technology improvements etc. Controlling these expenses does not mean cappingthem. It aims at increasing the effectiveness of these expenses e.g. getting maximum sales perrupee of S & D expenses. For control purpose, a great care should be taken to ensure correctclassification and collection of S & D overheads. The collected expenses must be analysed toassess the effect of them on sales. Such analysis could be done as follows:

1) Analysis of sales and S & D expenses by geographical locations – This could be regions,zones, domestic and international etc.

2) Analysis by type of customers - This could be done as institutional, government, retailetc.

3) Analysis by products or services – This may be done as range of products, the applica-tion of products, brands etc.

4) Analysis by salesmen5) Analysis by channel of distribution – This analysis pertains to wholesalers, retailers,

commission agents etc.

The analysis of sales, profits and S & D expenses on the basis of above factors will give a goodinsight into the performance as well as control over expenses. All these three parameters maybe compared with

- Previous year- Budget for the current year or- Standards for the current year

���������B 140

Overhead Costs

11.7 Treatment of special items

After sales service: This relates to services rendered after a product is sold. If the service isrendered during the warranty period, it is normally free of cost. The cost of in-warranty serviceis treated as S & D overhead and accounted for accordingly. The services provided after expiryof warranty period, are normally charged to the customer. In such cases, the actual cost in-curred on such service is collected as per element in the routine way and treated as cost ofproduction of the service. Let us take sale of a car as an example. Usually, there’s one yearwarranty for manufacturing defects and many companies also provide 3 year or 40000 kmservicing free. The cost of this service being free will be treated as S & D overhead. The servicesafter that period will be billed to the customer. A job card is issued for each car when it comesfor servicing and the costs of parts, consumables and labour time are booked against that jobnumber. This cost will be charged off against the billing done for service.

Packing Costs: Packing may refer to primary packing and secondary packing. Primary pack-ing is the minimum necessary without which a product cannot be handled. Liquid productsmust either have bottles or sachets. This packing is considered as direct material cost. Thesebottles may be further kept in bigger boxes or cartons for ease of transportation. This packingcost is treated as S & D overhead.

Advertising expenses: The advertising could be done for different purposes. There could be arecruitment ad, which is booked under personnel department and treated as administrationoverhead. At times there could be a corporate advertisement to be booked under the corporateoffice and treated as administration overhead. If a product specific advertisement is done, it istreated as selling cost. If there is a big advertisement campaign the benefits of which are ex-pected to accrue over a longer term, it may be treated as deferred revenue expenditure.

Market research: Many times organisations appoint professional bodies or conduct by them-selves a study of potential market for their products. This study is aimed at finding the cus-tomer needs, their habits, changing market for the products, technological changes in the prod-uct, competition etc. This is treated as S & D cost.

Bad debts: We know bad debts refer to customers who do not pay money after having pur-chased the product. This situation arises after the sale is done. Many experts say that bad debtis not an item of expense but it’s a financial loss and thus should be excluded for the purpose ofcosting. However, normal bad debts may be considered as selling expense and included in thecost. An exceptional case like bankruptcy of a big institution may be excluded from cost.

Tool set up costs: if the set up is related to specific product or a job, such cost may be treated asa direct cost of the job. But if the set is related to different products, it may be charged as a partof factory overheads.

Carriage and Freight: These are paid for transporting of material. If these are incurred forincoming material, it is included in the cost of material and treated as material cost – eitherdirect or indirect. If it is paid for transportation of finished goods, it is treated as a distributioncost.

��������� B 141

Miscellaneous examples

Q 1

Calculate a comprehensive machine hour rate from the following information:

Cost of machine is Rs 25 Lacs, having a scrap value of Rs 1 lac after 10 years. The machine isoperated for three shifts of 7 hours each for 300 working days in a year of which 300 hours willbe used for normal repairs. The wages payable include Rs 8000 pm for operator, Rs 3000 pm fora helper for every shift. Rs 16000 pm are paid to a supervisor per shift for the department whichhave 4 machines (including this machine).

The power consumption is 25 units (KWH) @ Rs 4.80 per unit. Repairs and maintenance are Rs30000 per annum. General lighting for the department is RS 4000 pm. Insurance is Rs 18000 permachine per year. Rent, rates & taxes Rs 3000 for the department and factory overheads are Rs36000 for the department.

Answer 1

As a comprehensive rate is to be calculated, we need to take in to account fixed expenses aswell as running expenses of the machine. Secondly we also need to determine the hours work-able for the year.

Computation of machine hours No of days operated in the year

300

Shifts per day

3

No of hours per shift

7

Total available hours

6,300 Less normal repair hours

(300)

Net hours for calculation

6,000

���������B 142

Overhead Costs

Computation of Costs Amount

Rs Amount

Rs Fixed expenses

Depreciation (25-1)/10 (2500000 - 100000) / 10 240000

Rent, rates & taxes 1/4th share (3000*12) / 4 9000 Supervisor salary 1/4th share

(16000 * 12 *3) / 4 144000

Insurance Actual 18000 Factory Overheads (36000/4) 9000

General Lighting (4000*12)/4 12000

432,000 Running expenses Operators wages (8000*3*12) 288000 Helpers wages (3000*12*3) 108000 Power (25*4.80*6000) 720000 Repairs & maintenance 30000

1,146,000

Total expenses for the year

1,578,000

No of hours calculated as above

6,000

Comprehensive Machine Hour Rate

263

��������� B 143

Q 2A company has three production departments (A, B and C) and two service departments (D &E).The following figures are extracted from its books. Calculate the overhead rate per labourhour.

Indirect material Rs 15000Indirect Wages Rs 10000Depreciation on machinery Rs 25000Depreciation on building Rs 5000Rent, rates & taxes Rs 10000Power for machinery Rs 15000Power for lighting Rs 500General expenses Rs 15000

The additional information available is given below:

Items Total (Rs) A B C D E Direct material 60000 20000 10000 19000 6000 5000 Direct wages 40000 15000 15000 4000 2000 4000 Machinery value 250000 60000 100000 40000 25000 25000 Floor area sq ft 50000 15000 10000 10000 5000 10000 No of light points 50 15 10 10 5 10 Horse power 150 50 60 30 5 5 Labour hours 15000 5000 5000 2000 1000 2000

Expenses of D and E are apportioned as follows:

A B C D E

Dept D 40 20 30 - 10Dept E 30 30 30 10 -

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Overhead Costs

Answer 2

Computation of direct labour hour based overhead rate

Item Basis of apportionment

Total (Rs) A B C D E

Indirect material direct material

15,000

5,000

2,500

4,750

1,500

1,250

Indirect Wages direct wages

10,000

3,750

3,750

1,000

500

1,000 Depreciation on machinery machine value

25,000

6,000

10,000

4,000

2,500

2,500

Depreciation on building floor space

5,000

1,500

1,000

1,000

500

1,000

Rent, rates & taxes floor space

10,000

3,000

2,000

2,000

1,000

2,000 Power for machinery horse power

15,000

5,000

6,000

3,000

500

500

Power for lighting light points

500

150

100

100

50

100

General expenses labour hours

15,000

5,000

5,000

2,000

1,000

2,000

95,500

29,400

30,350

17,850

7,550

10,350 Re-apportionment of service departments

Dept D

3,020

1,510

2,265

(7,550)

755

Dept E

3,332

3,332

3,332

1,109

(11,105)

Dept D

444

222

333

(1,109)

110

Dept E

33

33

33

11

(110)

Dept D

4

2

3

(11) 2

36,233

35,449

23,816

Labour Hours

5,000

5,000

2,000

Labour Hour Rate 7.25

7.09

11.91

rate

��������� B 145

Q 3

A factory has 3 production departments viz. 2 machine shops and 1 assembly shop. It also has3 service departments’ viz. stores, engineering services & general services. The engineeringservices department serves the machine shops only. The annual budgeted overheads are asfollows:

Indirect wages (Rs) Consumables (Rs)

Machine shop A 23260 6300

Machine shop B 20670 9100

Assembly shop 8110 2110

Stores 4100 1400

Engg. Services 2670 2100

General services 3760 1600

The other costs are: Depreciation on machinery- Rs 22000, Insurance of machinery – Rs 4000,Insurance of building – Rs 1800, Power – Rs 3600, Lighting & heating – Rs 3000 and rent – Rs7050. Machine shop A is exposed to special fire risks and hence insurance of building is appor-tioned to machine shop A to the tune of 1/3rd of total. The general services department is situ-ated in the building owned by the company valued at Rs 600000. It is charged at a notional rentof 0.08% in addition to the rent figure given above. The value of issues of material to the pro-duction departments are in the same proportion as shown above for consumables. You arerequired to:

a) Prepare a summary of primary & secondary distribution of overheads, showing basesof apportionment

b) Calculate an appropriate overhead absorption rate for production departments.

c) Calculate the overheads to be absorbed on the two products X and Y whose cost sheetshows the following times spent in the different departments as:

Machine shop A - X – 5 hours and Y – 3 hours

Machine shop B - X – 2 hours and Y- 7 hours

Assembly shop - X – 7 direct labour hours & Y – 9 direct labour hours

Following addition data is also provided to you.

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Overhead Costs

Answer 3

Department Machine value Area sq ft

HP hours %

direct labour hours

machine hours

Machine shop A

60,000

5,000

50.00

200,000

40,000

Machine shop B

45,000

6,000

33.33

150,000

50,000

Assembly shop

15,000

8,000

4.17

300,000

Stores

6,000

2,000

Engg. Services

18,000

2,500

12.50

General service

6,000

1,500

Overhead Distribution Summary

Summary Production departments Service departments

Item of expenses

Basis of apportionmen

t

Total Amount

(Rs)

M shop

A

M Shop

B Assembl

y Stores

Engg. Serv

Gen. Serv

Indirect wages as given 62570 23260 20670 8110 4100 2670 3760 Consumables as given 22600 6300 9100 2100 1400 2100 1600 Depreciation on machinery

machine value 22000

8,800

6,600

2,200

880

2,640

880

Insurance - machinery

machine value 4000

1,600

1,200

400

160

480

160

Insurance – building

1/3rd M shop A & balance on area 1800 600

360

480

120

150

90

Power HP hours % 3600 1800 1200 150 450 Lighting & heating Area 3000 600 720 960 240 300 180 Rent Area 7050 1500 1800 2400 600 750 Notional rent Gen serv 480 480 127100 44460 41650 16800 7500 9540 7150

Basis ofapportionment Assembly Stores

Gen.Serv

MShop

A

MShop

B

��������� B 147

rates Particulars Production departments

M shop A

M Shop B Assembly

Costs as per secondary distribution 53600 52500 21000 Machine hours for machine shops 40000 50000 Labour hours for assembly only 300000 Hourly absorption rates 1.34 1.05 0.07

OVERHEAD ABSORPTION RATES

M ShopA

M ShopB

Secondary distribution Production departments

Department Basis of apportionment

Total Amount

(Rs) M shop A

M Shop B Assembly

As per primary distribution 102910 44460 41650 16800 Stores

consumables (63:91:21) 7500 2700 3900 900

Engg Serv

Machine hours of shops A & B only 9540 4240 5300

General services

Labour hours 20:15:30) 7150 2200 1650 3300

Total 127100 53600 52500 21000

M ShopB

M ShopA

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Overhead Costs

Statement showing overheads absorbed on X and Y

Product X Product Y Department Rate per hour Hours Amount Hours Amount

Machine shop A 1.34 5

6.70 3

4.02

Machine shop B 1.05 2

2.10 7

7.35

Assembly 0.07 7

0.49 9

0.63

9.29

12.00

Q 4

The following data relate to a manufacturing department for a period:

Budget Actual Direct Material (Rs) 100000 140000 Direct labour (Rs) 200000 250000 Production overheads (Rs) 200000 230000 Direct labour hours 50000 62500 Machine hours 40000 50000

A job ZX 012 was one of the jobs worked during the period. The actual data for this job were:direct material Rs 6000, direct labour Rs 3000, direct labour hours 750 and machine hours 750.

Required: (1) calculate pre-determined production overhead absorption rate based on % ofdirect material cost and machine hours, (2) calculate the overheads to be absorbed by Job ZX012 based on these and (3) Assuming that machine hour rate of absorption is used, calculate theover or under absorption of overheads for the period .

Also recommend the action to be taken for the under or over absorption of the overheads forthe period.

��������� B 149

Answer 4

For the purpose of calculating pre-determined rates, the budgeted data must be used.

Rate based on % of direct material cost

Overhead rate =

This absorption rate is Rs 200000 / 100000* 100 i.e. 200% of direct material cost.

Rate based on machine hours

Overhead rate =

B u d g ete d m a teria l c o st

B u d g ete d m a ch in e h o urs

This absorption rate is Rs 200000 / 40000 i.e. Rs 5 per hour.

The overheads to be absorbed on to the job ZX 012 based on the above 2 rates will be as under:

Description

Material cost

based rate

Machine hour rate

Job ZX 012 Direct material 6000 Machine hours 750 Overheads to be absorbed 12000 3750

Over or under absorption based on machine hour rate

Actual machine hours 50000

Machine hour rate Rs 5 per hour

Overheads absorbed Rs 250000

Actual overheads Rs 230000

There is over-absorption to the tune of Rs 20000 for the period.

The over-absorption could be treated in one of the following ways:

1) Take a credit in the P & L account2) Carry forward to the next accounting period

���������B 150

Overhead Costs

3) Use supplementary rate to adjust against cost of sales & inventories of FG and WIP. Athis is over-absorption, it will have a credit effect on cost of sales and the cost of inven-tories will reduce proportionately

Q 5In 365 days a company follows 3 diwali holidays, 2 days for holi, 2 days for Christmas and allSundays as weekly offs. It works for 8 hours a day for 5 days and 4 hours on Saturday. Themachine room works on a 90% capacity and the normal maintenance time is assumed to be10%. Calculate the machine hour rate.

The following are the estimated expenses for 40 machines the year:

Item Rs.

Power 3120000Lighting 640000Foremen’s salary 1200000Lubrication oil 66000Repairs 1446000Depreciation 785000Total 7257000

Answer 5

Working of hours worked

Total number of days in a year 365Less holidays (3+2+2) - 7Less Sundays -52Less Saturdays -52

Net days 254

Number of hours available full days 254 * 8 2032Add: 4 hours on Saturdays 52 * 4 208Total available hours 2240

Hours at operating capacity @ 90% 2016Less 10% break down time @ 10% - 202

Net hours available per machine 1814

Total cost for 40 machines Rs 7257000Cost per machine Rs 181425Hours per machine 1814Machine hour rate Rs 100 per hour.

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Q 6

A company manufactures 3 products PRIMA, SUPREME and SUPERB. These products aremarketed in the North, South and West regions. The estimated sales for 2008 are as follows:

North South WestPrima 20000 8000 —-Supreme 12000 —— 32000Superb —- 28000 16000

Budgeted advertising outlay for 2008 is

North South West TotalLocal cost 1280 1800 1680 4760General 2320

Work out a statement to present the advertising cost percent of sales for each product and foreach region.

Answer 6

The general advertising costs should be apportioned among the regions on the basis ofbudgeted regional sales. This is done as follows:

Particulars Basis Total North South West Local costs As given 4760 1280 1800 1680 General

Regional sales ratio of 8:9:12 2320 640 720 960

7080 1920 2520 2640 Budgeted sales 116000 32000 36000 48000 regional cost as % of sales 6.0% 7.0% 5.5%

Region-wise distribution of advertising costs

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Overhead Costs

Q 7

A manufacturing company has three production departments A. B and C and one servicedepartment. A predetermined overhead absorption rate is established for each of the threeproduction departments on the basis of machine hours at normal capacity. The overheads ofproduction departments comprise of direct allocations plus a portion of service costs which areapportioned in the ratio of 3:2:5 to departments A, B and C respectively. All overheads areconsidered as fixed.

The following information is available concerning apportionment and absorption of productionoverheads for a period. You are required to calculate the missing figures in the following table:

Particulars A B C Budgeted allocated expenditure (Rs) 143220 125180 213700 Budgeted service costs apportioned (Rs)

(i) (ii) 66300

Normal machine hours 15000 (iii) (iv) Predetermined absorption rate (Rs) (v) 8.20 (vi) Actual machine hours (vii) 19050 19520 Over/ (under) absorbed overheads (Rs)

(3660) (viii) (6720)

Actual overheads in each department were as budgeted.

Product-wise apportionment of advertising costs

Region Basis Total Prima Supreme Superb

North 6% on product sales 1920 1200 720 0

South 7% on product sales 2520 560 1960

West 5.5% on product sales 2640 1760 880

7080 1760 2480 2840

��������� B 153

Answer 7

Students will have to be absolutely thorough with the concepts discussed above to solve prob-lems of this type. There are 8 missing figures in the given table. The calculation is shownbelow:

- (i) For calculating this apportioned overhead to dept A, we know the ratio of appor-tionment used is 3:2:5. We are given allocation to dept C as Rs 66300. So the total wouldbe (66300/5*10) i.e. Rs 132600 of which dept A will get 3/10th i.e. Rs 39780

- (ii) Based on the logic given above the apportionment to department B is 2/10th of Rs132600 i.e. Rs 26520

- (iii) The figure asked is machine hours. The machine hour rate is given as Rs 8.20. Thetotal cost for department B is Rs 151700 (i.e.125180 + 26520). Based on this the machinehours should be (151700 / 8.20) i.e. 18500 hours

- (iv) Total overheads for dept C are Rs 280000 (i.e. 213700 + 66300). The under absorp-tion is to the tune of Rs 6720 which means the overheads absorbed would be Rs 273280(i.e. 280000 – 6720). This means the absorption rate would be Rs 14 per hour (i.e. 273280/19520). Therefore the normal machine hours would be 20000 hours (i.e. 280000/14)

- (v) Total cost of dept A is Rs 183000 (i.e. 143220 + 39780). Normal machine hours are15000. Thus the absorption rate will be Rs 12.20 (i.e. 180000/15000)

- (vi) Based on explanation given for (iv) above, the predetermined absorption rate fordepartment C is Rs 14 per machine hour

- (vii) Total cost for dept A is Rs 183000. There is under absorption of Rs 3660. So theoverheads absorbed would be Rs 179340 (i.e. 183000 – 3660). The absorption rate fordept A is Rs 12.20. Thus the actual machine hours would be 14700. (i.e. 179340/12.20)

- (viii) Overheads absorbed for dept B would be Rs 156210 (i.e. 19050 * 8.20). The bud-geted overheads for dept B are Rs 151700 (i.e. 125780+26520). Thus there would be anover absorption of Rs 4510

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Overhead Costs

Q 8

The standard departmental overhead rate is fixed at Rs 15 per machine hour. Based on thefollowing information, work out the activity level at which this rate has been fixed.

Activity level Overhead costs

(hours)

6000 Rs 120000

8000 Rs144000

10000 Rs 168000

Answer 8

Please refer to the section 11.1 where a high and low method of segregating fixed and variableportion of overheads is explained. Let us take the highest and lowest set of figures from givendata as follows:

Activity (hours) Overheads (Rs)

6000 120000

10000 168000

Difference in levels 4000 48000

This means for 4000 additional hours Rs 48000 is the incremental overhead cost. This must bethe variable portion @ Rs 12 per hour. If we take the base of 6000 hours, the fixed element iscalculated as:

Total overheads at 6000 level 120000

Less: variable (6000*12) -72000

Fixed overheads 48000

Now, the overhead rate is fixed at Rs 15, out if which Rs 12 is variable. So Rs 3 must be the fixedelement. Total fixed overheads are Rs 48000.

Hence this level must be fixed at 16000 hours (48000/3)

��������� B 155

Q 9

A large manufacturing company having national base operates through four zonal offices viz.West, East, North and South. The budgeted expenditure for a period is given below:

Sales manager’s salary Rs 120000

Expenses related to sales manager’s office Rs 80000

Travelling salesmen’s salaries Rs 320000

Travelling expenses Rs 36000

Advertisements Rs 30000

Godown rent West Rs 15000

East Rs 25200

North Rs 9800

South Rs 18000

Insurance on inventories Rs 20000

Commission on sales @ 5% on sales Rs 600000

Following particulars are also available:

Compute zone-wise break up of selling overheads as a percentage of sales.

Zone Sale in Rs Lacs

No of salesmen

Mileage covered

Allocation of Advt

Average stock Rs lacs

West 36 5 6000 30% 6 East 48 6 14000 30% 8 North 16 2 4500 20% 4 South 20 3 5500 20% 2

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Overhead Costs

Q 10

A manufacturing company generates its own power using generators. It has two productiondepartments A and B and two service departments X and Y. The data for the month of May2007 are as follows:

Horse power hours A B X Y Needed capacity production 10000 20000 12000 8000 Used for May 2007 8000 13000 7000 6000

Computation of selling overheads as a percentage of sales

Item Basis of

apportionment Total (Rs) West East North South

Sales manager's salary Sales

120,000

36,000

48,000

16,000

20,000 Expenses of sales manager's office Sales

80,000

24,000

32,000

10,667

13,333

Travelling salesmen's salary No of salesmen

320,000

100,000

120,000

40,000

60,000

Travelling expenses Mileage covered

36,000

7,200

16,800

5,400

6,600

Advertising Given ratio

30,000

9,000

9,000

6,000

6,000

Godown rent Actuals

68,000

15,000

25,200

9,800

18,000

Insurance Average stocks

20,000

6,000

8,000

4,000

2,000

Sales commission 5% on sales

600,000

180,000

240,000

80,000

100,000

1,274,000

377,200

499,000

171,867

225,933

Zonal sales

12,000,000

3,600,000

4,800,000

1,600,000

2,000,000 Selling overheads as % of sales 10.62% 10.48% 10.40% 10.74% 11.30%

��������� B 157

During May 2007, the cost of generating power amounted to Rs 9300 out of which Rs 2500 wasconsidered as fixed. Dept X renders service to A, B and Y in the ratio of 13:6:1 and dept Yrenders service to A and B in the ratio of 31:3. Given that direct labour hours in Dept A and Bare 1650hours and 2175 hours respectively, find the power cost per labour hour for each of thedepartments.

Answer 10:

Please note that the fixed portion should be apportioned on the basis of needed HP hours andthe variable portion should be divided in the ratio of used HP hours.

Based on this the primary and secondary distribution of the power costs are worked out asfollows:

Computation of overhead distribution

Item Basis of apportionment

Total (Rs) A B X Y

Power cost

Fixed HP hours needed 2500 500 1000 600 400

(10:20:12:8) Variable HP hours used 6800 1600 2600 1400 1200 (8:13:7:6) Total 9300 2100 3600 2000 1600 Redistribution of costs to production departments Total costs as above 9300 2100 3600 2000 1600 Dept X apportioned (13:6:1) 1300 600 -2000 100 Dept Y apportioned (31:3) 1550 150 -1700 Total 4950 4350