THE INSTITUTE OF CHARTERED ACCOUNTANTS OF SRI LANKA

Thilanka WarnakulasooriyaB.Com Special (Col), ACA

POSTGRADUATE DIPLOMA IN BUSINESS AND FINANCE - 2013/2014

Principles of Financial and Cost Accounting

Accounting for Overhead

Overhead is the Expenditure incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and fully to the product, service or department

Classification of Overhead Overhead can be classified under 3 basis

Overhead

Element Base

Indirect Material

Indirect Labor

Indirect Expense

Behavior based

Fixed Overhead

Variable OH

Semi-VariableOH

Function Based

Production OH

Administration OH

Selling & Distribution OH

General OH

Overhead Allocation, apportionment & absorption Steps.

1. Identify OH cost & Accumulate the costi.e. Rent , Electricity,

2. Identify the Cost Center of the OrganizationIdentify the activity or item or equipment where the cost are accumulated.

Cost centers can be either production cost center or service cost center

i.e Garment Factory

Production cost centers

Service cost centers

Cutting, Sawing, washing, Packaging

Maintenance , HRM, Planning

3. Allocation of OH cost to cost centers

Some OH can be directly identify to a particular cost centers. Accordingly that OH cost can be allocated to that cost center called “allocation”

i.e. Cutting supervisor salary directly identified to the cutting cost center

4. Apportioning overhead cost to cost centersSome OH can not be directly identified to particular cost center. Accordingly such cost should be shared among the cost centers. These cost should be divided among cost centers based on most reasonable basis.

(Apportionment of overhead is distribution of overheads to more than one cost centre on some equitable basis)

i.e. Garment factory monthly electricity bill was Rs. 200,000. Factory consist of 4 cost centers . The floor area occupied by each cost center are as follows.

Apportion the electricity between cost centers.

OH Basis for Apportionment

Rent, rates, heating and light, repairs and depreciation of building

Floor area occupied by each cost centre

Deprecation and insurance of equipment

Cost or book value of equipment

Personnel, office, canteen, welfare, wages and costs of offices

Number of employees, or labor hours worked in each cost centre

Cost Center Floor area (Sq. Feet)Cutting 3,000Sawing 5,000HR 500Warehouse 1,500

5. Reapportioning the service cost centre cost to production cost centers.

Service cost centers cost should charged to production cost centers since salable units does not pass through service departments. The reasonable apportionment basis should be used

Service cost centre Possible basis of apportionment

Stores Number of cost value of material requisitions

Maintenance Hours of maintenance work done for each cost centre

Production planning Direct labor hours worked in each production cost centre

Reapportioning the service cost centre cost to production cost centers

Secondary Distribution with reciprocal Servicing overhead absorption rates

Direct Method

Only to Production

Department

To production & service department

Simultaneous Equation Method

Repeated Distribution Method

Step Down Method

6. Calculate the overhead absorption rate & absorb the cost

Overhead absorption is the process whereby overhead costs allocated and apportioned to production cost centers are added to unit, job or Cost object.

Overhead absorption is sometimes known as overhead recovery

Overheads are usually added to costs units using a predetermined overhead absorption rate, which is calculated using figures from the budget.

Overhead absorption rate (OAR)

“Attributing OH to particular product or service based on particular basis”

Generally OAR calculated by dividing the OH cost of the cost center by number of units/ Volume of absorption base which is appropriate for the cost center

Calculation of overhead absorption rateOAR = Budgeted Overhead cost

Budgeted volume

Estimate the overhead likely to be incurred during the period Estimate the activity level for the period Divide the estimated overhead by the budgeted activity

level Absorb the overhead into the cost unit by applying the

calculated absorption rate

Ex 06.

There is no ideal OAR, depending on the company some use machine hours or labor hours. The most appropriate OAR depends on factors such as cost, information availability, nature of the product, technology used etc.

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Choosing the appropriate absorption baseA percentage of direct materials costA percentage of direct labor cost A percentage of prime costA rate per machine hourA rate per direct labor hourA rate per unitA percentage of factory cost (for admin

overhead)A percentage of sales or factory cost

( for selling and distribution overhead)

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Over and under absorption of overheads

The rate of overhead absorption is based on estimates ( of both numerator and denominator) and it is quite likely that either one or both of the estimates will nit agree with what actually occurs

◦ Over absorption means that the overheads charged to the cost of sales is more than the overheads actually incurred

◦ Under absorption means that insufficient overheads have been included in the cost of sales

Actual Overhead incurred xxxxOverhead absorbed xxxx(budgeted OAR * actual activity level)

Under/ Over absorption xxx

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The reasons for over/under absorbed overheads The overhead absorption rate is predetermined from budget

estimates of overhead cost and the expected volume of activity.

Over or under recovery of overhead will occur in the following circumstances:-◦ Actual overhead costs are different from budgeted overhead◦ The actual activity level is different from the budgeted

activity level◦ Actual overhead costs and actual activity level differ from

the budgeted costs and levels

◦i.e . Following information with regard to “ A” Company

◦Budgeted overhead cost per month 80,000◦Actual Overhead cost per month 70,000◦Budgeted units plan to produce 10,000◦Actual units Produced 8,000

◦Calculate over or under absorption of overhead per month