Session 3

Question 1

What are Direct costs and indirect costs

Answer 1

1) Direct costs (also known as prime costs)
These are costs that can be accurately assigned to a particular batch, product or service
e.g. raw materials, production wages etc

2) Indirect costs
These are costs that cannot be traced directly to an individual product. They are usually common to several products.
e.g. Factory rent, inspection costs, production supervisors salary

Question 2

How do you deal with indirect costs/overheads

Answer 2

The four steps are
1) Allocate/apportion overheads to appropriate cost centers production and service. (e.g. the rent needs to be split between production, H.R., canteen etc)

2) Reapportion “service” cost center overheads to the “production” cost centers. This can be done in three ways
i) Direct Method
ii) Specified order of closing
iii) Repeated distribution

3) Select an appropriate overhead absorption base for each production department and use this base to calculate an overhead absorption rate (OAR).
4) Absorb overheads into cost units (products) using predetermined overhead absorption rate (OAR)

Question 3

What is cost allocation

Answer 3

Cost allocation is where you assign a whole item of cost to a single cost center

Question 4

What is cost apportionment

Answer 4

Cost apportionment is where you splkit costs over a number of cost centers by means of some apportionment bases.
e.g. Rent although paid in full is shared between cost centers on the basis of floor area

Question 5

Formula for OAR

Answer 5

OAR= Total budgeted overheads/ budgeted volume of absorbtion base

Question 6

Why do we use a blanket overhead rate compared to a departmental overhead rate?

Answer 6

1) Blanket overhead rate
- This is where one overhead rate is calculated for an organisation as a whole. This only really works however is a very simplistic business because otherwise overheads would be absorbed in many different ways.

NEGATIVES

• It does not consider how products consume overheads in the various departments of an organisation
• It generally results in reporting inaccurate product costs
• It is only suitable when all product consume overheads in the same proportions.

2) Departmental overhead rates
- Recognise that some departments are more overhead intensive than others and that different products spend different amounts of time in various departments
- It is more accurate in allocating costs to products
- It is more appropriate in a modern business environement.

Question 7

Why do we use predetermined rates for OAR?

Answer 7

Note: The OAR is calculated at the start of the accounting period using estimated or budgeted figures for overheads and base units.

1) Actual overheads and actual number of base units are not known until the end of the period. So the actual OAR could not be calculated till the end of the period.
2) This would lead to product costs not being calculated until the end of the period which could result in unacceptable delays in pricing and invoicing.

Question 8

What is over absorbtion

Answer 8

Over absorption occurs when the overheads absorbed are more than actual overheads. Therefore we charged too much.

Question 9

What is under absorbtion

Answer 9

Under absorption occurs when the overheads absorbed are less than actual overheads. Therefore we charged too little.

Question 10

What are the steps in dealing with over/under absorption

Answer 10

1) Calculate the overhead and the under/over absorption
2) Do journals for under/over absorption
3) Prepare the Ledger accounts for under/over absorption

Question 11

Explain why under/over absorption occurs

Answer 11

It arises because we got either the cost or the activity levels wrong or both.

Question 12

Reasons for under/over absorption

Answer 12

1) Actual overheads differ from budgeted figures
2) Actual activity levels differ from budgeted levels
3) Change in labour/machine efficiency

Question 13

Why do we allocate overheads to individual products

Answer 13

1) Meets the requirement of IAS2 INVENTORIES, where inventory must be valued at full manufacturing cost. i.e. comprise all direct and indirect production costs
2) Aids cost control by providing managers with a better understandingof the effect of overheads on overall costs
3) Helps managers make pricing decisions
4) Helps managers distinguish between profitable and unprofitable products

Question 14

What are the criticism of absorbtion costing

Answer 14

overheads contain:

1) FC which do not change when the level of activity changes and which would still have to be paid for if there was no activity e.g. rent
2) VC which vary directly with activity e.g. direct materials

Question 15

Journal entry for underabsorbtion of overheads

Answer 15

Dr P and L

Cr Production overheads

Question 16

Journal entry for overabsorbtion of overheads

Answer 16

Cr P and L

Dr Production overheads

Question 17

When service departments within an organisation perform services for another service center, it may be necessary to perform secondary distribution of overheads. Explain, making specific reference to 3 methods that could be used, how secondary distribution may be performed in such cases.

Answer 17

1) Specified order of closing (Step reapportionment)

• Starts either with the support cost center having the highest departmental overhead total after primary distribution, or with that providing the highest level of service to other cost centers.
• • This centers costs are apportioned to all other cost centers, including support centers
• • This column is “closed off” in the analysis sheet.
• The next support center is then apportioned to all other centers excluding the center that has already been apportioned.
• The procedure is repeated until all columns have been apportioned and “closed off”.
• The percentages used to make the reapportionments should relate only to those cost centers receiving a share of the apportioned cost.
• For all service centres subsequent to the first, the amount of overhead being apportioned will consist of that centers total from the primary distribution and a share of any other centers overheads that have already been apportioned.
  2) Reappotionment by repeated distribution
• Gives full recognition to reciprocal services provided by one service dept to another.
• Support centers are reapportioned in sequence to all other depts, including service centers.
• The sequence is not important as long as its kept the same for each set of reapportionments
• Once the first set of reappportionments has been carried out, this provides smaller figures that will form the basis for the next set of reapportionments.
• The process continues in sequence until the figures become too small, and the remainder of overhead can be split.

3) Simultaneous equations
- This method uses algebra

• The reciprocal use of departments services by other depts in expressing in 2 algebraic equations-
• The equations are then solved simultaneously.
• Can be less cumbersome than the other methods
• Works best where there are only two recirocal service centers

Question 18

Explain briefly 2 possible reasons for any under/over absorption of overheads in a question

Answer 18

1) under absorption
Check the number of hours in your time period and compare that to the average. If you have less m/c hours you would expect under absorption.

Check the number of units produced during the year. If it is below the average again this would leave to a under aborption

Question 19

Describe the nature of manufacturing overheads and give two examples of cost items which would typically be classed as manufacturing overheads.

Answer 19

Manufacturing overheads comprise all manufacturing costs EXCEPT for direct materials, direct labour and direct expenses. They consist of all indirect manufacturing costs that cannot be directly traced to products. Manufacturing overheads are essential in the production process and in generating the finished product. These overheads are attributed to products using cost allocation.

Examples of manufacturing overheads include factory rent, factory insurance, depreciation of machinery, indirect materials etc

Question 20

Explain why accountants expend considerable time and effort allocating such overhead to individual units of products

Answer 20

There are a number of reasons why the allocation of manufacturing overheads to individual units or product is important:
- In order to meet financial accounting requirements under IAS2 inventory valuations must be at full manufacturing cost i.e. comprise all direct costs and all indirect or manufacturing overhead costs.

• Manufacturing overheads are allocated to aid cost control as this provides managers with a better understanding of the effect of overhead on overall costs.
• By allocation of manufacturing overheads to individual units of product, managers are facilitated in making decisions regarding suitable prices for those products.
• For decision-making purposes accurate, representative product costs are required so as to be able to distinguish between profitable and unprofitable products.

Question 21

Why use of predetermined overhead absorption rates are more appropriate than actual costs

Answer 21

• If monthly actual overhead costs were used in order to calculate an actual overhead rate this could lead to fluctuating overhead rates as although overhead expenditure may be fixed in the short term, activity may vary significantly from one month to another. E.G. seasonal industries may have significant monthly variations in activity with resulting disparities in product costs from one month to the next.
• Total actual overhead costs are generally not available until the end of the accounting period and this delays product cost calculations. Product cost calculations are required quickly in order to generate monthly profit calculations, stock valuations and a basis for setting prices. Predetermined rates are preferable as once calculated they are available for use throughout the accounting period.

Question 22

Why departmental overhead rates are considered more appropriate to a single blanket overhead rate

Answer 22

Blanket overhead rates are calculated for the organisation as a whole and generally result in reporting inaccurate product costs. This is because blanket overhead rates do not consider how products consume overheads in the various departments of an organisation. Blanket overhead rates are only suitable when all products consume overheads in the same proportions.

Departmental overhead rates recognise that different departments give rise to varying levels of overhead and that different products may spend diverse amounts of time in the various departments. Departmental overheads are thus more accurate in allocating costs to products.