Chapter 4 - Overheads And Expenses Flashcards
Overheads
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.
Collecting overheads in responsibility centres
Depending on the type of cost, overheads are either allocated to responsibility centres or apportioned to centres.
Allocation of overheads
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.
Apportionment of overheads
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.
Apportionment and ratios
Apportionment of overheads can use ratios. E.g overheads relating to buildings are shared in a ratio of floor space.
Service departments
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.
Re apportionment of service department overheads
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
Direct apportionment
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.
Step down method
This is used when one service department provides services to another. Under the step down method we re apportion the different overheads.
Overhead absorption (Recovery)
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.
Calculating overhead absorption rate
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
Direct labour hour method
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
Machine hour method
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
Service sector - Hourly rate
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
Service sector - miles travelled
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
Using a pre - determined rate
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.
Over or under absorption of overheads
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.
Over absorption of overheads
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.
Under absorption of overheads
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.
Bookkeeping entries for overheads
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
