Cost AllocationCost Allocation

What is overhead? What is overhead? Basis of classifying overheads Basis of classifying overheads Various types of overheads Various types of overheads Steps in overhead accounting Steps in overhead accounting Basis of Apportionment of Overheads Basis of Apportionment of Overheads Principles of Apportionment Principles of Apportionment Methods of Reapportionment Methods of Reapportionment Absorption of overheads Absorption of overheads Methods of absorption Methods of absorption Under absorption Under absorption Over absorption Over absorption

Definition of OverheadsDefinition of Overheads

The CIMA defines overhead cost as “the The CIMA defines overhead cost as “the total cost of indirect materials, indirect total cost of indirect materials, indirect labor and indirect expenses. In short, it is labor and indirect expenses. In short, it is the cost of materials, labor and expenses the cost of materials, labor and expenses that cannot be economically identified with that cannot be economically identified with specific saleable cost unit. specific saleable cost unit.

Classification of Overhead CostsClassification of Overhead Costs

Element wise Classification Element wise Classification

Steps on Overhead AccountingSteps on Overhead Accounting

The various steps in an overhead The various steps in an overhead accounting are:accounting are:

Collection of overhead details Collection of overhead details Distribution of overhead to cost centers Distribution of overhead to cost centers Reapportionment of service department Reapportionment of service department

costs to production departments costs to production departments

Primary Distribution of Overheads and Primary Distribution of Overheads and

Reapportionment of OverheadsReapportionment of Overheads

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Basis of apportionment of Basis of apportionment of overheadsoverheads

Direct Allocation Direct Allocation

Direct Labor Hours Direct Labor Hours

Direct Wages Direct Wages

Number of workers Number of workers

Methods of ReapportionmentMethods of Reapportionment

Direct Redistribution Direct Redistribution • Chances of overcharge or under charge Chances of overcharge or under charge • Non accuracy in department overhead rates Non accuracy in department overhead rates

Step Method Step Method • Apportioning service department costs Apportioning service department costs

Reciprocal Service Method Reciprocal Service Method •   Simultaneous equation method Simultaneous equation method • Repeated distribution method Repeated distribution method • Trial and error method Trial and error method

Illustrations…Illustrations…

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Absorption of OverheadsAbsorption of Overheads

““Process of allocating the overhead Process of allocating the overhead expenses to the cost centers/cost units is expenses to the cost centers/cost units is known as overhead absorption” known as overhead absorption”

Absorption ratesAbsorption rates

Actual rate Actual rate

Predetermined rate Predetermined rate

Moving average rate Moving average rate

Blanket and multiple rates Blanket and multiple rates

Rate per unit of productionRate per unit of production

OH rate = OH rate = Budgeted overhead expensesBudgeted overhead expenses Budgeted productionBudgeted production

Features: Features: • Simple /easy to use Simple /easy to use • Suitable for extractive industries Suitable for extractive industries

Direct Wages MethodDirect Wages Method OH rate = OH rate = Budgeted overhead expensesBudgeted overhead expenses

                               Direct wages                                Direct wages Advantages:Advantages:

• Consideration of time factor Consideration of time factor • Stability of labor rates Stability of labor rates • Proportional charge to production Proportional charge to production • Easy availability of data Easy availability of data • Most appropriate in certain  situations Most appropriate in certain  situations

Limitations:Limitations: • Not related to efficiency of workers Not related to efficiency of workers • Consideration of time factor (piece rate basis) Consideration of time factor (piece rate basis) • Ignores contribution by other factors of production Ignores contribution by other factors of production • No distinction between fixed and variable expensesNo distinction between fixed and variable expenses

Production hour method Production hour method

OH rate = OH rate = Budgeted overhead expensesBudgeted overhead expenses                Total productive hours of direct labor                 Total productive hours of direct labor

    Advantages:Advantages: • When job is labor-oriented When job is labor-oriented • Uniform time for various jobs Uniform time for various jobs • No impact on rate by the method of wage No impact on rate by the method of wage

payment/grade/rate of workers payment/grade/rate of workers

Limitations:Limitations: • Faulty distribution of overhead Faulty distribution of overhead • Not suitable where piece rate system is used Not suitable where piece rate system is used • Expenses not related to labor hours are ignored Expenses not related to labor hours are ignored • No clear distinction between types of labor/costs/workers No clear distinction between types of labor/costs/workers

Machine hour rate method Machine hour rate method

OH rate = OH rate = Total running expensesTotal running expenses                 Number of working hours for the machine                  Number of working hours for the machine

Advantages:Advantages: • Scientific/practical/accurate Scientific/practical/accurate • Comparison of relative efficiencies Comparison of relative efficiencies • Decision making by the management Decision making by the management • Detection of idle time Detection of idle time

Limitations:Limitations: • Higher cost Higher cost • Not useful when blanket rate is used Not useful when blanket rate is used • Inaccurate results if use of labor is equally important Inaccurate results if use of labor is equally important • Doesn’t consider expenses that are not proportionate to working Doesn’t consider expenses that are not proportionate to working

hourshours

Direct material cost methodDirect material cost method OH rate = OH rate = Budgeted overhead expenseBudgeted overhead expense

                     Expected direct material cost                      Expected direct material cost   Advantages:Advantages:

• Simple /easy to use Simple /easy to use • Suitable when Suitable when

Output is uniform Output is uniform Stable material cost Stable material cost Proportion of OH to total cost is significant Proportion of OH to total cost is significant

Limitations:Limitations: • Unstable and inaccurate Unstable and inaccurate • No consideration for time factor No consideration for time factor • No distinction between fixed and variable costs No distinction between fixed and variable costs • No distinction between production of workers and machines No distinction between production of workers and machines

Prime cost method Prime cost method

OH rate = OH rate = Budgeted overhead expenseBudgeted overhead expense                      Prime cost                       Prime cost

Advantages:Advantages: Simple /easy to use Simple /easy to use   Suitable when there is no wide fluctuations in Suitable when there is no wide fluctuations in

processing processing Limitations:Limitations:   No consideration for time factor No consideration for time factor No distinction between fixed and variable costs No distinction between fixed and variable costs

Sale price method Sale price method

OH rate = OH rate = Budgeted overhead expensesBudgeted overhead expenses                 Sale price of units of production                  Sale price of units of production

Suitable for the absorption of : Suitable for the absorption of : • Administration Administration • Selling and distribution Selling and distribution • Research and development Research and development • Design costs Design costs

Factors to be considered for determining Factors to be considered for determining

the basis of apportionmentthe basis of apportionment AdequacyAdequacy: The OH rate should be in such a way that : The OH rate should be in such a way that

equitable apportionment can be made to the cost centers equitable apportionment can be made to the cost centers or cost units.or cost units.

Convenience: Convenience: The OH rate should be simple and easy The OH rate should be simple and easy to understand and also convenient in application.to understand and also convenient in application.

Time factor:Time factor: The OH rate should have some relation to The OH rate should have some relation to the time taken by various jobs for completion.the time taken by various jobs for completion.

Manual or machine work:Manual or machine work: There can be different OH There can be different OH rates for manual and machine work.rates for manual and machine work.

Differential OH rates:Differential OH rates: If the nature of work done by the If the nature of work done by the various departments is not same, different OH rates can various departments is not same, different OH rates can be ascertained. be ascertained.

InformationInformation: The availability of information affects the : The availability of information affects the selection of the OH rates. selection of the OH rates.

Under absorption/Over absorptionUnder absorption/Over absorption

The OH costs are fully recovered from The OH costs are fully recovered from production, if actual rate method of production, if actual rate method of absorption is adopted. If the OH rate absorption is adopted. If the OH rate absorbed is less than the overheads absorbed is less than the overheads incurred, it is called as under absorption of incurred, it is called as under absorption of overheads. overheads.

If the OH rate absorbed is more than the If the OH rate absorbed is more than the actual overheads incurred, it is known as actual overheads incurred, it is known as over absorption of overheads. over absorption of overheads.

Accounting of Under absorption Accounting of Under absorption and Over absorptionand Over absorption

Use of supplementary rates Use of supplementary rates To carry out adjustment for the difference To carry out adjustment for the difference

between between overhead absorbed and overhead incurred overhead absorbed and overhead incurred Under or over absorbed overheads/actual base Under or over absorbed overheads/actual base

Writing off to costing P/L accountWriting off to costing P/L accountUnder/Over absorption due to abnormal situations Under/Over absorption due to abnormal situations Distortion in the value of stockDistortion in the value of stock Absorption in the accounts of subsequent years Absorption in the accounts of subsequent years

Deferred charge Deferred charge Suitable when the business period is more than Suitable when the business period is more than

one one year year

SummarySummary How we can define overhead? How we can define overhead? Classification and types of overheads Classification and types of overheads Major steps involved in overhead accounting Major steps involved in overhead accounting What are the basis for apportioning the What are the basis for apportioning the

overheads? overheads? What are the principles of apportionment? What are the principles of apportionment? Trace the common methods of reapportionment. Trace the common methods of reapportionment. What do you mean by absorption of overheads? What do you mean by absorption of overheads? Methods of absorption Methods of absorption Under absorption and over absorption. Under absorption and over absorption.