CHAPTER 5 ACCOUNTING FOR OVERHEADS Flashcards
what are direct expenses
Direct expenses are expenses that can be directly identified with a specific cost unit or cost centre.
There are not many examples of direct expenses but royalties paid to a designer or fees paid to a subcontractor for a specific job could be classed as direct expenses.
Direct expenses, direct materials and direct labour are the prime cost of a product.
what are indirect expenses
Indirect expenses are expenses that cannot be directly identified with a specific cost unit or cost centre.
The cost of renting a factory is classified as an indirect cost as the rent could be covering the manufacturing location of all products and also possibly other areas of the business such as the accounting department, a non-production location. It is not possible to relate the rent to a single products or location.
Indirect expenses, indirect materials and indirect labour are the overheads of a business.
how are overheads grouped
Overheads can be grouped based on where in the business they are incurred:
Production/manufacturing
Administration
Sales and distribution.
production overheads of a factory
Production overheads of a factory can include the following costs:
heating the factory
lighting the factory
renting the factory.
examples of production cost centres
Production may take place over a number of different production cost centres and each cost centre should be assigned with its fair share of overhead cost. Examples of production cost centres include:
Assembly
Machining
Finishing.
examples of production service cost centres
There may also be a number of production service cost centres that provide support to the production cost centres. Examples of production service cost centres include:
Maintenance
Canteen
Stores.
what is absorption costing and its purposes/aims
Production overheads are recovered by absorbing them into the cost of a product and this process is called absorption costing.
The main aim of absorption costing is to recover overheads in a way that fairly reflects the amount of time and effort that has gone into making a product or service.
Absorption costing involves the following stages:
allocation and apportionment of overheads to the different production cost centres
reapportionment of production service cost centre overheads to the production cost centres
absorption of overheads into the products.
Absorption costing allows businesses to make decisions about pricing policies and value its inventory in accordance with IAS 2.
what is the first stage of the absorption costing process - allocation and apportionment of overheads?
The first stage of the absorption costing process involves the allocation and apportionment of overheads.
Allocation involves charging overheads directly to specific cost centres (production and/or service).
If overheads relate to more than one production or service cost centre, then they must be shared between these cost centres using a method known as apportionment.
Overheads must be apportioned between different production and service cost centres on a fair basis.
what are the possible bases of apportionment for absorption costing
There are no hard and fast rules for which basis of apportionment to use except that whichever method is used to apportion overheads, it must be fair. Possible bases of apportionment include the following:
floor area – for rent and rates overheads
carrying amount of non-current assets – for depreciation and insurance of machinery
number of employees – for canteen costs.
what are the 3 methods that can be used to reapportion service cost centre costs to production cost centres?
Production service cost centres are not directly involved in making products and therefore the production overheads of service cost centres must be shared out between the production cost centres using a suitable basis. This is known as reapportionment or secondary apportionment.
There are 3 methods that can be used:
Direct method – the cost of each production service cost centre is reapportioned to the production cost centres only.
Step down method – used when one production service cost centre works or provides a service for other production service cost centres as well as the production cost centres.
Reciprocal reapportionment (or the repeated distribution method) – used where production service cost centres work for each other as well as provide a service for the production cost centres.
following allocation and apportionment how are overheads absorbed into cost units?
Once the overheads are allocated, apportioned and reapportioned into the production cost centres the overheads need to be related to or absorbed into the units of product.
Overheads can also be absorbed into cost units using the following absorption bases:
units produced
machine-hour rate (when production is machine intensive)
labour-hour rate (when production is labour intensive)
percentage of prime cost
percentage of direct wages.
what is the overhead absorption rate formula
Production overheads are usually calculated at the beginning of an accounting period in order to determine how much cost to assign a unit before calculating a selling price.
The overhead absorption rate (OAR) is calculated as follows:
OAR = budgeted production overhead/budgeted total of absorption basis
The absorption basis is most commonly units of a product, labour hours, or machine hours.
For example, a machining cost centre will probably use a machine-hour OAR.
Similarly, a labour-intensive cost centre will probably use a labour-hour OAR.
An alternative to individual cost centre OAR is a blanket OAR. With blanket OARs, only one absorption rate is calculated for the entire factory regardless of the cost centres involved in production. Blanket OARs are also known as single factory-wide OARs.
what is the under/over absorption of overheads?
If the estimates for the budgeted overheads and/or the budgeted level of activity are different from the actual results for the year then this will lead to one of the following:
under-absorption (recovery) of overheads
over-absorption (recovery) of overheads.
how are under/over absorptions calculated?
There is a three step procedure:
Step 1 – calculate the OAR (based on budget)
Step 2 – calculate the overhead absorbed by actual activity
Overheads absorbed = OAR × actual level of activity
Step 3 – Compare absorbed to actual
If at the end of this period, the overheads absorbed are greater than the actual overheads, then there has been an over-absorption of overheads.
If the overheads absorbed are less than the actual overheads, then there has been an under-absorption of overheads.
why might you often have to work backwards in calculating over/under absorption of overheads?
Sometimes you may be given information relating to the actual under- or over-absorption in a period and be expected to calculate the budgeted overheads or the actual number of hours worked.
As long as you remember the basic calculation involved in identifying an under/over-absorption, you should not have any problems.
The main thing to remember is that if actual overheads are greater than absorbed overheads then we have under-absorption and any under-absorption need to be deducted from actual overheads incurred in order to calculate the overheads absorbed.
Similarly, if over-absorption occurs, the over-absorption needs to be added to actual overhead in order to calculate the overheads absorbed.
