Overheads

Direct Expenses
are expenses that can be directly identified with a specific cost unit or cost centre e.g. the hire of
tools and equipment used directly in producing a particular product.
Direct expenses are part of the prime cost of a product.

Indirect Expenses
a) Production O/H
- indirect materials + indirect labour + indirect expenses are indirect expenses which cannot be
directly identified with a specific cost unit or cost centre
- are incurred inside the factory, during the production process
e.g. factory rent, factory light and heat.

b) Non-Production O/H
are indirect expenses that are incurred after a product leaves the factory (are incurred outside the
factory)
for example, administration overhead, selling and distribution overhead

Absorption costing
is a method used to recover production overheads by absorbing them into the cost of a product.
Absorption costing involves 3 stages:
1. allocation and apportionment of overheads [Allocation means charging overheads
directly to specific departments, If the overheads relate to more than one department, then
they must be apportioned / shared between these departments using a fair basis i.e. floor
area – for rent, rates, heat and light overheads. cost or net book value of non-current assets
– for depreciation and insurance of machinery. number of employees or labour hours
worked in each cost centre – for canteen costs; personnel office, welfare, wages, first aid].
2. reapportionment of service (non-production) cost center overheads to production
cost centers
3. absorption of overheads

Suitable Bases for Absorption

• A rate per machine hour (for machine intensive departments)

• A rate per direct labour hour (for labour intensive departments)
• A rate per unit (when production includes identical units)

OAR = Budgeted Prod. O/H / Budgeted Level of Activity

This OAR is calculated for each department

Illustration

Budgeted fixed production overhead = $120,000

Budgeted machine hours 30,000
What is the O.A.R?

Solution
$120,000/30,000 hours = $4 / machine hour

Reapportion service cost centre costs to production cost centres

overheads in a service department must be apportioned to the production departments so that all of
the overheads can finally be absorbed into the cost unit.
1. One service department doing work for another service department, and production
departments (Step down method) Here, the service department which does most work for
other departments is reapportioned first.
2. Two service departments doing work for each other.Full recognition is given for all work
done by service departments for each other. It may be solved algebraically by simultaneous
equation or through repeated distribution.
Tip - the algebraic method is quicker and simpler, so use it!

Illustration

L Ltd. consists of 2 production centres (A and B) and 2 service centres (C and D)

Overheads incurred for each centre:
A $99,000
B $85,000
C $60,000
D $36,000
Work done by the service centres:

A B C D

% of C 45 65

% of D 30 60 10

What is the total overhead of production centre A?

Illustration

A company has 2 production departments (A and B) and 2 service departments (C and D)

Overheads incurred for each centre:

A $70,000
B $30,000
C $20,000
D $15,000
What will be the total overheads finally charged to the production departments A and B?

Allocated and apportioned overheads A B C D

Work done by C (%) 50 30 20
Work done by D 45 40 15

Solution:

C=20000+.15D ------ (i)

D=15000+.2C ---------(ii)

Note – For linear equation

Put each equation into each other to solve it.

Then Apportion C & D to only A&B not to each other

Under / Over Absorption of OverHeads

Overheads absorbed = OAR x actual level of activity

1. Over-absorption (over-recovery) = Overheads absorbed is MORE than Actually Incurred

2. Under-absorption (under-recovery) = Overheads absorbed is LESS than Actually incurred

Illustration

Budgeted fixed overheads $120,000

Budgeted machine hours 30,000

Actual machine hours worked 31,000

Actual fixed overhead incurred $125,000

Solution : OAR = 4/Hr
124000 Absorbed
1000 Under Absorbed