Chapter 4 - Overheads And Expenses

Question 1

Overheads

Answer 1

Businesses usually plan or budget their overheads in advance, often on an annual basis. By doing this they can work out how to recover the overheads through their output using an overhead absorption rate.

Question 2

Collecting overheads in responsibility centres

Answer 2

Depending on the type of cost, overheads are either allocated to responsibility centres or apportioned to centres.

Question 3

Allocation of overheads

Answer 3

Some overheads belong to one centre. E.g the wages of a supervisor who works in only one centre, the rent of a separate building in which there is only one centre.

Overheads like these can therefore be allocated to the centre to which they belong.

Question 4

Apportionment of overheads

Answer 4

Overheads that can’t be allocated to a particular centre have to be shared. E.g a department which is a cost centre within a factory will be charged a proportion of the factory rent and rates.

Overheads can be apportioned on a basis of floor space for rents, heating costs and cost of machinery for insurance and depreciation costs between two different centres.

Question 5

Apportionment and ratios

Answer 5

Apportionment of overheads can use ratios. E.g overheads relating to buildings are shared in a ratio of floor space.

Question 6

Service departments

Answer 6

Departments which provide services. E.g maintenance, transport, stores and stationery. Each service department is a cost centre to which a proportion of overheads is charged. They do not have any cost units to which their overheads may be charged, the cost of each service department must be re apportioned to the production departments which do have cost units.

Question 7

Re apportionment of service department overheads

Answer 7

The overheads of service cost centres are charged to production cost centres using:

Direct apportionment - Service departments provide services to production departments only

Step down method - Service departments provide services to production departments and to other service departments

Question 8

Direct apportionment

Answer 8

We will assume that the service departments do not provide services to one other. Their costs are directly apportioned to production departments using a suitable basis.

Question 9

Step down method

Answer 9

This is used when one service department provides services to another. Under the step down method we re apportion the different overheads.

Question 10

Overhead absorption (Recovery)

Answer 10

Once overheads have been allocated or apportioned to production cost centres the final step is to ensure that the overheads are charged to cost units. This is known as absorption or recovery.

Question 11

Calculating overhead absorption rate

Answer 11

In order to recover the overheads of a department there are two steps to be followed:

Calculation of the overhead absorption rate

Application of the rate to actual work done

OAR = Total budget cost centre overheads / total planned work in the cost centre

The amount of work must be measured in a suitable way which is usually: Direct labour hours or machine hours

Question 12

Direct labour hour method

Answer 12

With this method production overhead is absorbed on the basis of the number of direct labour hours worked. Commonly used in labour intensive production.

1 Formula for oar:

Total budgeted cost centre overheads/ total direct labour hours in cost centre

2 Application of the rate: Direct labour hours worked x oar = overhead absorbed

Question 13

Machine hour method

Answer 13

Production overhead is absorbed on the basis of machine hours. It is most commonly used where production is machine intensive.

1 Formula of oar:

Total cost centre overheads/ total machine hours

2 machine hours worked x overhead absorption rate = overhead absorbed

Question 14

Service sector - Hourly rate

Answer 14

This method is often used by businesses such as accountants, solicitors or dentists where the overhead is absorbed on the basis of chargeable time or sales price or units sold.

1 Forumal of oar:

Total cost centre overheads/ total chargeable hours = cost per hour of chargeable time

2 Application of the rate:

Chargeable hours x overhead absorption rate = overhead absorbed

Question 15

Service sector - miles travelled

Answer 15

The overhead is absorbed on the basis of miles travelled

1 Formula of oar:

Total cost centre overheads/ total miles travelled = cost per mile travelled

2 Miles travelled x oar = overhead absorbed

Question 16

Using a pre - determined rate

Answer 16

Most businesses calculate a pre-determined overhead absorption rate for each department.

The OAR is calculated in advance using estimates which means this avoids having to calculate the rate regularly.

Question 17

Over or under absorption of overheads

Answer 17

Most businesses will find that the amount of overheads absorbed into the cost of their actual work is not the same amount that has been spent. If the amount absorbed is greater this called over absorption/recovery, if the amount is less the difference is called under absorption/recovery.

Question 18

Over absorption of overheads

Answer 18

It is worked out by multiplying the oar by the actual labour/machine hours and comparing this figure with actual overheads.

At first over absorption seems to be a bonus as the actual overheads are losing the absorbed amount. This will mean profits will be higher, however sales might have been lost as the selling price has been too high due to basing the selling price off of the absorbed cost.

Question 19

Under absorption of overheads

Answer 19

The actual overhead absorbed is less than the actual overheads. Under absorption is a cost to the business as the actual overheads are higher so reducing profits. It may have been that selling price has been to low as it may have been calculated from the lower overhead asborbed.

Question 20

Bookkeeping entries for overheads

Answer 20

A production overhead account is uses to:

Transfer production overheads to production

Credit the amount of over absorbed to the statement of profit or loss

Debit the amount of under absorbed overheads to the statement of profit or loss