(a) A Brief introduction of Overhead cost analysis and the importance of overhead costs

in Bright Light Trading LLC.

An overhead cost is defined as ‘expenditure on labour, materials or services that cannot be economically
identified with a specific saleable cost unit’. Overhead costs are also referred to as indirect costs.
Therefore, overhead cost comprises indirect material, indirect labour and indirect expenses. The indirect
nature of overheads means that they need to be ‘shared out’ among the cost units as fairly and as
accurately as possible. Overhead costs may be classified according to the function of the organization
responsible for incurring the cost. Examples of overhead cost classifications include production
overhead, selling and distribution overhead, and administration overhead. It is usually possible to
classify the majority of overhead cost in this way, but some overhead costs relate to the organization
generally and may be referred to as general overhead.

We shall focus mainly on production overhead. Production is that function of the business, which
converts raw materials into the organization has finished product. The production department is usually
divided into a number of departments or cost centers. Some of these cost centers are directly involved
with the production process. These are called production cost centers and might include, for example,
the cutting department and the finishing department. Other cost centers in the production
department are not directly involved with the production process but provide support services for the
production cost centers. These called service cost centers, and examples include the maintenance
department and the stores. Bright company five department including the three-production department
and two-service department, on which overheads are allocated on the different basis. There are
unallocated overhead amounting to 11,440 which allocated and absorbed into the different departments
Components department allocated more overheads than the assembly and finishing department.

(b) Discuss steps involved in Overhead cost accounting and the impact of overhead cost
apportionment on selling price determination of Bright Light Trading LLC.
The following points highlight the five main steps in overhead accounting. The steps are 1.
Classifications of Overheads Costs 2. Codification of Overheads 3. Collection of Overheads 4.
Departmentalization of Overheads 5. Absorption of Overheads.

1. Classifications of Overheads Costs:

Overheads can be classified on the basis of number of characteristics.
The following are the important basis of overhead classification:
1. Function wise Classification.
2. Element wise Classification.
3. Behavior wise Classification.
4. Based on Normality.
5. Controllability Basis.

2. Codification of Overheads:
Codifications of overheads are useful in accumulating and control of overheads. After classification of
overheads, the next step involved in overhead accounting is to codify them. This is so because there are
number of overheads which are incurred in factories and unless proper attention is given, the chances of
accounting of all overheads may not be possible. Thus, all overheads falling under the category of
depreciation relating to plant and machinery, factory building, factory furniture may be given a separate
number.
 3. Collection of Overheads:
The process of ascertaining the amount of overheads incurred for a period is called collection of
overhead. The classified and coded overheads are collected and recorded under the standing over
number and cost accounting number.

4. Departmentalization of Overheads:
Departmentalization of overhead is the process of allocation and apportionment of overhead to different
departments or cost centers. For smooth and efficient working a factory is sub-divided into a number of
departments, each of which denotes a particular activity of the factory e.g. purchase department, stores
department, time keeping department, personnel department, crushing department, melting shop, etc.

5. Absorption of Overheads:
This is the last step in the accounting procedure of overheads. After all the overheads are apportioned
from the service departments to production departments, it involves charging of production department
overheads to the number of units produced in those departments. The process of charging the overheads
from cost centre to cost unit is known as absorption of overheads.

Overhead apportionment has impact on the sale price of the product, there are different basis to calculate
the overheads under the different accounting methods. Under the traditional method, overhead cost are
absorbed on the basis of the labour hours or machine hours or product units. Whereas under the ABC
method overheads are absorbed on the basis of the activity performed by the different departments and
provide the most accurate and reliable overhead cost allocation. Cost under the traditional method
increased due to inaccurate basis and therefore, result in the higher sale price and impact on the business
profitability.

(c) Evaluate overhead cost analysis, showing the bases of apportionment of overhead to
Production departments and Service departments. Work out overhead cost for each
of the production and service departments.

Apportionment of Unallocated Overheads Production Departments

Item Basis of Apportionment Components Assembly Finishing Total

Depreciation Value of machinery (Omani Rials) 1,066.67 1,333.33 1,600.00 4,000.00
Lighting Light Points 90.00 60.00 90.00 240.00
Indirect wages Direct wages (Omani Rials) 133.33 200.00 266.67 600.00
Power HP of machines 346.15 138.46 115.38 600.00
Rent Floor Area (Square feet) 500.00 666.67 833.33 2,000.00
Others Floor Area (Square feet) 1,739.11 1,125.14 1,135.75 4,000.00
Total Overheads 11,440.00

Overhead cost information

Unallocated Overhead Omani Rials
Depreciation 4,000
Lighting 240
Indirect wages 600
Power 600
Rent 2,000
 Others 4,000
Total Overheads 11,440

Overhead absorption Rate 1.60

Components 4,974
Assembly 3,218
Finishing 3,248
Total Overhead Cost 11,440

Overhead cost of the service department (unallocated overheads) are apportioned to the production department. It
is observed that components department incur the higher amount of the overheads than the assembly and finishing
departments. OAR is calculate based on the working hours of labour, rate is used to absorbed the overhead into
the departments and thus to the products.

(d) Demonstrate how the service department costs re-distribute over the production
departments and explain the reapportionment method used in Bright Light Trading
LLC.
There are three methods commonly used to allocate support costs: (1) the direct method; (2) the
sequential (or step) method; and (3) the reciprocal method. Many instructors choose to defer coverage of
the reciprocal method to cost accounting. It is important for students to realize that no matter which
method of support department cost allocation is used; total factory overhead costs remain unchanged.
That is, the different allocation methods simply split up the costs differently among the producing
departments.
Three methods used to allocate support-department costs to producing departments are:
1. Direct method
2. Sequential method, and
3. Reciprocal method.

Bright light trading LLC used the direct method for the distribution of overhead from the services department to
the production department.

Services department overhead such as depreciation on the basis of the value of machinery, light based on the
lighting points, indirect wages based on the total direct wages, power based on the HP of the power and rent on
the based of floor area.

(e) Assess the final total overhead cost of production departments after
reapportionment ignoring the apportionment of service department costs among
service departments.

(f) Analyze the factors influencing the selection of Overhead Recovery Rate and compute the
absorption rate per hour of each Production department of Bright Light Trading LLC.
(g) Appropriate conclusion