Overhead And Absorption Notes
1. Cost allocation :
When items of cost are identifiable directly with some products or departments such costs are charged to such cost centres. This process is known as cost allocation. Wages paid to workers of service department can be allocated to the particular department. Indirect materials used by a particular department can also be allocated to the department. Cost allocation calls for two basic factors-(i) concerned department/product should have caused the cost to be incurred, and (ii) exact amount of cost should be computable.
2. Cost Apportionment :
When items of cost are not directly chargeable to or accurately identifiable with any cost centres, they are pro-rated or distributed amongst the cost centres on some predetermined basis. This method is known as cost apportionment. Thus, we see that items of indirect costs residual to the process of cost allocation are covered by cost apportionment. The determination of suitable basis of apportionment is very important and usually following principles are adopted for such process-(i) service or use, (ii) survey method, (iii) ability to bear. The basis ultimately adopted should ensure an equitable share of common expenses for the cost centres and a basis once adopted should be reviewed at periodic intervals to improve upon the accuracy of apportionment.
3. Cost Absorption :
Ultimately the indirect costs or overhead as they are commonly known, will have to be distributed over the final products so that the charge is complete. This process is known as cost absorption, meaning thereby that the costs are absorbed by the production during the period. Usually any of the following methods are adopted for cost absorption (I) Direct material cost percentage (ii) Direct labour cost percentage cost (iii) Prime cost percentage (iv) Direct labour hour rate (v) Machine hour rate etc. The basis should be selected after careful consideration of all relevant factors and should ensure maximum accuracy of cost-distribution to various production units. The basis should be reviewed periodically and corrective action whatever needed should be taken for improving upon the accuracy of the absorption.
4. Discuss in brief three main methods of allocating support departments costs to operating departments. Out of these three, which method is conceptually preferable ?
Ans: The three main methods of allocating support departments costs to operating departments are :
i. Direct re-distribution method : Under this method, support department costs are directly apportioned to various production departments only. This method does not consider the
service provided by one support department to another support department.
ii. Step method :Under this method the cost of the support departments that serves the maximum numbers of departments is first apportioned to other support departments and production departments. After this the cost of support department serving the next largest number of departments is apportioned. In this manner we finally arrive on the cost of production departments only.
iii. Reciprocal service method : This method recognises the fact that where three are two or more support departments they may render services to each other and, therefore, these inter-departmental services are to be given due weight while re-distributing the expenses of the support departments. The methods available for dealing with reciprocal services are :
a. Simultaneous equation method.
b. Repeated distribution method.
c. Trial and error method.
The reciprocal service method is conceptually preferable. This method is widely used even if the number of service departments are more than two because due to the availability of computer software it is not difficult to solve sets of simultaneous equations.
5. What is blanket overhead rate ? In which situations, blanket rate is to be used and why ?
Ans. Blank overhead rate is one single overhead absorption rate for the whole factory. It may be computed by using the following formulae :
Blanket overhead rate = Overhead costs for the whole factory
* Total units of the selected base
The selected base can be the total output; total labour hours; total machine hours etc.
Situations for using blanket rate :
The use of blanket rate may be considered appropriate for factories which produce only one major product on a continuous basis. It may also be used in those units in which all products utilise same amount of time in each department. If such conditions do not exist, the use of blanket rate will give misleading results in the determination of the production cost, specially when such a cost ascertainment is carried out for giving quotations and tenders.
6. Write a note on ‘classification’, ‘allocation’ and ‘absorption’ of overheads. How does it help in controlling overheads ?
Ans: Classification of overheads :
It means determination of categories, classes or groups in which overhead costs may be sub-divided.
Usually, overhead costs are classified under three broad categories viz., Factory Overheads; Office and administrative Overheads and Selling and distribution Overheads.
Factory overheads represent all those indirect costs that are incurred in the manufacturing process. For example, consumable stores, factory rent, depreciation of plant. Factory building, repairs and maintenance.
Office and administrative overheads represent costs which are associated with the administration and maintenance of the office.
Selling and distribution overheads are the expenses incurred for selling and distribution of products. It includes salaries of sales staff and commission; sales promotion expenses; advertising expenses, warehousing costs etc.
Allocation of overheads :
It refers to the allotment of whole items of overhead cost to cost centres or cost units. In other words, allocation of overhead means the allotment of the whole, undivided item of expense to a particular department or cost centre. For example, department salaries directly related to various departments are allocated to them.
Absorption of overheads :
It is defined as the process of absorbing all overhead costs allocated or apportioned over particular cost centre or production department by the units produced.
Absorption of overheads takes place only after the allocation and apportionment of overhead expenses. In other words, the overhead costs are either allocated over different cost centres or cost units and afterwards they are absorbed on equitable basis by the output of the same cost centres.
Help rendered in controlling overheads :
The classification, allocation and absorption of overhead costs over different cost centres helps in two ways. Firstly, the overheads costs assigned to cost centres are used for cost control and performance evaluation purposes. These assigned costs are periodically totaled and listed on performance report which also has the figures of budgeted costs. Differences between budgeted and actual costs for each item of expenditure are highlighted in the performance reports and provide feedback information for performance evaluation and cost control purposes. Secondly, the accumulated production cost centre overhead costs are assigned in the second stage of the procedure to products to satisfy financial accounting requirement for inventory valuation.
7. What is notional rent of a factory building ? Give one reason why it may be included in cost accounts.
Ans: Notional Rent: It is a reasonable charge raised in the cost accounts for the use of owned premises. One reason for the use of such a nominal charge is to enable comparison between the cost of items made in factories which are owned and in rented factories. However, it may be noted that in the case of owned factory cost for the same is accounted for by means of depreciation.
8. Why is the use of an overhead absorption rate based on direct labour hours generally preferable to a direct wages percentage rate for a labour intensive operation ?
Ans: A method of overhead absorption is considered appropriate if the total amount of overhead absorbed in a period does not fluctuate materially from the actual expenses incurred in the period. Direct wages percentage rate method do not possess the aforesaid feature. In other words, the overhead charged varies from period due to changes in direct wages.
In fact, overhead expenses are generally a function of time. Therefore, a time based overhead absorption rate method is always preferred over any other method. In the case of labour intensive operations, it is advisable to use labour hour method for overhead absorption.
(a) Problem of controlling the selling & distribution overheads are :
i. The incidence of selling & distribution overheads depends on external factors such as distance of market, nature of competition etc. which are beyond the control of management.
(ii) They are dependent upon customers’ behaviour, liking etc.
(iii) These expenses are of the nature of policy costs and hence not amenable to control.
The above problems of controlling selling & distribution overheads can be tackled by adopting the following steps :
(a) Comparing the figure of selling & distribution overhead with the figure of previous period.
(b) Selling & distribution overhead budgets may be used to control such overhead expenses by making a comparison of budgetary figures with actual figures of overhead expenses, ascertaining variance and finally taking suitable actions.
(c) Standards of selling & distribution expenses may be set up for salesmen, territories, products etc. The laid down standard on comparison with actual overhead expenses will reveal variances, which can be controlled by suitable action.
9. Short note on Selling & Distribution Expenses.
Ans : Selling expenses: Expenses incurred for the purpose of promoting, marketing and sales of different products.
Distribution expenses: Expenses relating to delivery and dispatch of goods/products to customers.
Accounting treatment for selling and distribution expenses
Selling and distribution expenses are usually collected under separate cost account numbers.
These expenses may be recovered by using any one of following method of recovery.
1. Percentage on cost of production/cost of goods sold.
2. Percentage on selling price.
3. Rate per unit sold.
10. Explain, how under-absorption and over-absorption of overheads are treated in Cost Accounts.
Ans:. Production overheads are generally recovered or charged on the goods on some predetermined basis. Irrespective of the method used for the recovery of overheads, it has been observed that a difference arise between the amount of overheads absorbed and the amount of overheads actually incurred. If the absorbed amount is more than the overheads actually incurred then such a difference is termed as an over absorption of overheads. If the recovery is less than the actual overheads incurred then the difference is termed as under absorption of overheads. The over-absorbed and under-absorbed amount of overhead can be treated in Cost Accounts by following any one of the methods explained below :
Cost Accounts treatment of under-absorption and over-absorption of overheads :
The under-absorption and over-absorption of overheads can be disposed off in cost accounting by using any one of the following methods.
i. Use of supplementary rates
ii. Writing off to Costing Profit & Loss Account
iii. Carrying over to the next year’s account.
i. Use of supplementary rates : This method is used to adjust the difference between overheads actually incurred by computing supplementary overhead rates. Such rates may be either positive or negative. A positive rate is intended to add the unabsorbed overheads to the cost of production. The negative rate, however corrects the cost of production by deducting the amount of over-absorbed overheads. The effect of applying such a rate is to make the actual overheads get completely absorbed.
ii. Writing off to Costing Profit & Loss Account : When under or over-absorbed amount is quite negligible and it is not felt worthwhile to absorb it by using supplementary rates, then the said amount may be transferred to Costing Profit & Loss A/c.. In case under-absorption of overheads arises due to factors like idle capacity, defective planning etc., it may also be transferred to Costing Profit & Loss A/c.
iii. Carrying over to the next year’s account : Under this method the amount of under/over- absorbed overhead may be carried over to the next year’s accounts. This method is not considered appropriate as it allows costs of one period to affects costs of another period. Further, comparison between one period and another is rendered difficult. Therefore, this method is not proper and has only a limited application. However, this method may be used when the normal business cycle extends over more than one year, or in the case of a new project where the output is low in the initial years.
Technique of Absorption Costing
Absorption Costing is a technique of pricing the products or services. It consisting of certain rules & procedure with the help of which overhead recovery rates are ascertained for determination of product price for the purpose of profit planning.
Steps to be followed
1. Prepare the production value chain.
2. Identify the cost centres- production & service cost centres.
3. Calculate the normal capacity or activity levels of each cost centres. Activity level implies the operating level of the cost centers. It is generally expressed in terms of units, capacity % or hours work. So always consider the normal or actual activity which is ever is higher.
4. Estimate the cost of each cost centers by applying the behaviour of costs . These costs are Direct Costs to each cost centers.
5. Estimate the Indirect cost of the products .
6. Identify the Prime Cost of the product.
7. Prepare the Production Overhead analysis sheet & show
- Absorption/recovery/application/charging rates.
8. Compute the Production overhead of the product.
- Add Administration overhead of production nature.
- Compute the Cost of Production.
- Adjust W.I.P. & Finished Stock.
- Add Administration , Selling & Distribution Overhead
There are six main steps in dealing with factory overheads in cost account :
A. COLLECTION : There are seven main sources of cost data relating to factory overheads.
1. Purchase day book ;
2. Overheads invoices ;
3. Stores requisitions. These three meant for collection of indirect materials cost.
4. Wages analysis book for indirect wages.
5. Cash book and petty cash book.
6. Journal proper.
7. Other registers like plant and machinery.
B. CLASSIFICATION : There may be three broad categories of factory overheads.
1. Plant overheads .
2. Overheads relating to production cost centres ; and
3. Overheads relating to service cost centres.
All the factory overheads are to be classified to suit the purpose of cost accounting, whether item wise i.e. rent, insurance, depreciation etc., or function-wise. Standing order numbers are used for collecting the factory overheads. Cost Account numbers are used for collecting the Administration, Selling and Distribution overheads.
C. ALLOCATION : Allocation is the allotment of whole items of cost centres, whether they may be production cost centres or service cost centres . For example, indirect wages of production. department A is to be allocated to Department ‘A’ only. Similarly, wages of services department ‘S’ is to be allocated to Department ‘S’ only.
D. APPORTIONMENT (or Primary Distribution) : Apportionment is the distributions of items of cost to other cost centres on suitable basis after they are collected under separate standing order numbers.. Overheads which are not directly identifiable with any Particular Production or service cost centre are distributed over the department/cost centres on the basis of Labour hours
The following tables indicates the various bases of apportionment for the usual items of factory overhead :
Item of factory Overhead Basis of apportionment
1. Rent………………………………………… Area or volume of building
2. Depreciation of Machinery………………. % of original cost of machinery or machine hour rate
3. Power………………………………………. HP rating ,Horse power multiplied by machine hours or KWH or value of machine.
4. Electric lighting……………………………. Number of light points or area.
5. Canteen expenses……………………….. Number of employees
6. Store-keeping and materials handling….. Number of stores requisition or material consumed
7. Indirect wages of maintenance department .. Estimated of actual time spent. or direct wages
8. Delivery expenses……………………….. Weight, volume or ton-kilometre
9. Repairs of plant………………………….. Value of plant.
10. Supervision………………………………. no. of machine/employee or Direct wages
11. Fire Insurance……………………………. Value of Asset or area occupied.
12. Machine shop exp……………………… Machine hours or Labours hours.
13. General Exp……………………………… Direct Wages or No. of Employees
14. Audit Fees ……………………………….. Sales or total cost
15. Maintenance of building………………… Area or labour hours.
16. Repair and Maintenance Cost…………. Value of assets or hours worked for each department.
17. Stores Department……………………… No. of stores requisitions.
18. Canteen Exp……………………………. No. of meal served or no. of employees.
19. Transport Dept………………………….. Weight or volume or ton-km.
20. Civil Service Dept………………………. Area.
21. Purchase Department………………….. No. of purchase orders placed or value of materials
purchased for each department.
22. Crane service……………………………. Crane hours or weight of materials handled.
23. Time-keeping……………………………. No. of employees
24. Power house……………………………. Heat area of cubic contents or KWH.
25. Tool Room……………………………….. Direct Labour hours.
26. Inspection………………………………… Number of units
27. Hospital and Dispensary………………. Number of units
Secondary Distribution of Factory Overheads.
Apportionment of overheads of service Apportionment of overheads of service dept., to
department directly to production departments. other service depts., and production depts.
Reciprocal basis Non-reciprocal basis | | Step ladder method
Repeated Distribution method Simultaneous Equation method.
F. Absorption is amount of overhead absorbed / charged / recovered / applied to product .
Recovery Rate = Budgeted overhead ¸ base
Bases are of four types
1. Unit Basis 3. Machine Hour
2. Labour Costs 4. Labour Hour
OVERHEAD Charged or Recovered or Applied or Absorbed = Recovery Rate x ACTUAL BASE
Accounting Treatment for Under or Over Recovery of Overhead:
1. Supplementary overhead rate : If the under-absorption is significant, supplementary overhead rate is computed and applied to the jobs or number of units as follows :
Supplementary overhead rate = Under-absorption of factory overhead ¸ Actual base
2. Transfer to current year’s costing P and L a/c :- If the under-absorption is minor and insignificant, it may be transferred to the current year’s costing P and L a/c., without re-opening the various job accounts involved.
3. Transfer to next year : Alternatively, the under-absorption can be transferred to the next year’s Factory overhead control account with the hope that the same can be adjusted in the next year. But this method is not recommended as most of the overhead are period costs and related to time.
Note : Adjustment and accounting treatment of over-absorption of factory overheads can be done in the reversal way.
Treatment of Administration Overhead
Administrative overheads included the following items of cost :
Printing and stationery, other office supplies
Employees cost – salaries of administrative staff
Establishment expenses – Office rent & rates, insurance, depreciation of office building and other assets, legal expenses, audit fees, bank charges, etc.
Administrative overheads are to be further analysed into two
1. For production activities and
2. Other for sales and distribution activities.
Administrative overheads relating to production activities are to be apportioned to different production cost centres on the basis conversion costs of production cost centres. The apportioned overheads are absorbed to products on the basis of the normal capacity.
In case of under-absorption or over absorption of administrative overhead relating to production, tile same shall also be adjusted with Costing Profit & Loss Account.
Recovery of S & D expenses : on the basis of Sales Or Units Sold Or Cost Of Sales.
Selling & Distribution Overhead is apportioned to the products on the following basis
Commission and Remuneration of salesmen Sales value
Advertisement Sales Value of physical units.
Warehousing expenses Sales Volume of each product
Rent Floor Space
Insurance Value of Finished Stock of each product line.
Depreciation Percentage of capital value of Assets
Transport Weight or Volume Distance travelled.
Credit and collection Number of sale orders
Financial Sale value of each product line
General Admn. No. of sales-men
Misc., Sales value or volume
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