Accounting for Overheads and Marginal costing

By Gayithri Kuruppu Dept. of Management of Technology University of Moratuwa

Overheads
Overhead is the cost incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and fully to the product, service or department. Overheads is actually the total of the following: Indirect materials Indirect labour Indirect expenses In cost accounting there are two school of thoughts as to the correct method of dealing with overheads: Absorption costing Marginal costing

Overheads
There are four categories of overheads.
Production/ manufacturing overheads Marketing/ selling and distribution overheads Research and development overheads Administration overheads

Allocating Overheads to Products

In general overheads are charged to products through two stages.
1. Overheads are assigned to cost centres 2. Accumulated costs at cost centres allocated to the products

Overhead Cost Allocation & Apportionment

1. Costs are specifically allocated, where they can be ascertained specifically and charged to a particular cost centre. e.g. The depreciation of machines in production division. In here, the depreciation of machines in production division, which is considered as a cost centre, can be charged (allocated) to that cost centre. apportioned to the cost centres that benefit from the cost on an appropriate basis (e.g. machine hours, number of employees etc.).

2. When overhead item is a common cost, the cost item is

3. The overheads are to be allocated to service department as well as to production departments. 4. Service department overheads are to be absorbed through jobs or products passing through production department. So service department costs are reapportioned to production departments.

Absorption costing stages

The three stages of absorption costing are: Allocation Apportionment Absorption

Overhead allocation
Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre For example, the following cost will be charged to the following cost centres via the process of allocation: Direct labour will be charged to the production cost centre The cost of warehouse security will be charged to the warehouse cost centre Costs such as canteen are charged direct to the various overhead cost centres.

Apportionment of overhead
Apportionment of overhead is distribution of overheads to more than one cost centre on some equitable basis. When the indirect costs are common to different cost centres, these are to be apportioned to the cost centres on an equitable basis. For example, the expenditure on general repair and maintenance pertaining to a department can be allocated to that department but has to be apportioned to various machines (Cost Centres) in the department. If the department is involved in the production of a single product, the whole repair & maintenance of the department may be allocated to the product.

Bases of apportionment
Overhead apportionment basis Overhead to which basis apply Basis of apportionment

Rent, rates, heating and light, repairs and depreciation of building

Floor area occupied by each cost centre

Deprecation and insurance of equipment

Cost or book value of equipment

Personnel, office, canteen, welfare, wages and costs of offices, first aid

Number of employees, or labour hours worked in each cost centre

Basis of apportionment of service cost centers

Service cost centre Possible basis of apportionment

Stores

Number of cost value of material requisitions

Maintenance

Hours of maintenance work done for each cost centre

Production planning

Direct labour hours worked in each production cost centre

Overhead Cost Absorption

1. Determine an absorption rate at which the cost of each cost centre is charged to jobs / products passing through the cost centre. Absorption Rate= Total cost at the centre Appropriate basis 2. Overhead costs absorbed by individual products at an absorption rate based on the total expected output or volume of input. Eg. total labour hours

Eg. Total Overhead of dept = Rs. 10,000, Tota labour hrs = 250 Absorption rate = 10,000/250 = Rs. 40 per labour hr

Example
The Assembly cost center has estimated overheads for period 1 of Rs. 225,000/=. Labour hours are considered the most appropriate basis and it is expected that 9,000 hours will be worked in total during the period. What is the overhead absorption rate for Assembly? = 225,000 9,000 = Rs 25 per lobour hour

Example
Job 232 is one of many jobs that pass through the assembly cost center during a period. The only work done on job 232 is assembly work and its direct costs are, Direct materials 65 Direct labour ( 5 hours @ Rs 18) 90 Total direct cost 155 What is the total production cost of job 232 assuming that the Assembly OAR is Rs 25 per hour as previously calculated? = DM+DL+OH= total production cost =65+90+(25*5)=Rs 280

Re apportionment of service department costs

Once the overhead have been allocated and apportioned to production and service departments and totaled, the next step is to reapportion the service department costs to production departments.

Example
ABC Co. Ltd has four production departments P1, P2, P3 and P4 and three service departments S1, S2 and S3. S1 stores S2 production control section S3 maintenance department Calculate for each production department an appropriate overhead absorption rate per machine hour. Calculate the total cost of each department.
The annual overheads are as follows:

Information

Cost
Indirect labour Supervision Power Rent

Total (Rs.000)
2,000 200 600 80

Insurance -Building
Insurance -Plant Depreciation -Building Depreciation -Plant

160
100 240 120

Information

Indirect Labour Costs Cost centres P1 P2 P3 P4 S1 S2 S3 Actual costs Rs.000 300 200 500 100 200 300 400

Information

P1 400 3,000 7,000 4,000 600

P2 400 9,000 5,000 5,000 300

P3 500 8,000 3,000 5,000 250

P4 600 8,000 2,000 3,000 150

S1 30 1,000 1,500 -

S2 20 1,000 500 400

S3 50 2,000 1,000 1,000 300

Total 2,000 32,000 20,000 18,000 2,000

No. of employee Floor Area (Sq.M) Power (KWHrs) Pro.Cntrl Hours Stores Requisitions

Maint. Dept Hours

Plant Hrs (000) Book value of plant (Rs.000)

6,000
120 300

8,000
80 200

5,000
200 100

6,000
100 80

120

50

150

25,000
500 1,000

Allocation of costs to Production and Service Departments

Item
Ind. Labour Supervision Power Rent & Rates Insurance Building Insurance Plant Depreciation Building Depreciation Plant Total

Basis
Actual No. of employee KWHr Floor area Floor area Book value Floor area Book value

Total
2000 200 600 80 160 100 240 120 3500

P1
300 40 210

P2
200 40 150

P3
500 50 90 20 40 10 60 12 782

P4
100 60 60 20 40 8 60 9.6 357. 6

S1
200 3 45 2.5 5 12 7.5 14.4 289.4

S2

S3

300 400 2 15 2.5 5 2 7.5 6 5 30 5 10 15 15 18

7.5 22.5 15 30 45 20

22.5 67.5 36 661 24 569

343 498

Calculation
Item
Ind. Labour
Supervision Power Rent & rates Insurance -B Insurance-P Depreciation-B Depreciation-P

Basis
Actual
No. of Employee KWHr Floor area Floor area Book value Floor area Book value

Total P1
2000
200 (200/2,000)*400 600 (600/20,000)*7000 80 (80/32,000)*3000 160 (160/32,000)*3000 100 (100/1,000)*300 240 (240/32,000)*3000 120 (120/1,000)*300

300.0
= 40.0 = 210.0 = 7.5

= 15.0 = 30.0 = 22.5 = 36.0

Total

3500

661.0

Reallocation of Service Department Overheads to Production Departments

Item Total costs S1stores Store req Basis

Total P1
3500 661.0 86.8

P2
569.0 43.4

P3
782.0 36.2

P4
357.6

S1
289.4

S2
343.0 57.9

S3
498.0 43.4

21.7 -289.4

S2-Pro Prodn Control control

S3Maint Total Main Hrs

3500

748.8 89.1
837.9 135.3 973.2

612.4 111.35
723.75 180.4 904.15

818.2 111.35
929.55 112.7 1042.25

379.3 66.8
446.1 135.3 581.4

400.9 -400.9

541.4 22.3

3500 3500

- 563.7 - -563.7 -

S1stores

Store req

87.8

43.4

36.2

21.7

(289.4)

57.9

43.4

S1

P1 P2 P3 P4 S2 S3

(289.4/2000)*600 = 86.82 86.8 (289.4/2000)*300 = 43.41 43.4 (289.4/2000)*250 = 36.18 36.2 (289.4/2000)*150 = 21.71 21.7 (289.4/2000)*400 = 57.88 57.9 (289.4/2000)*300 = 43.41 43.4 Total 289.4

S2-Pro Prodn Control control

3500

748.8 89.1

612.4 111.35

818.2 111.35

379.3 66.8

400.9 - (400.9)

541.4 22.3

S2

P1 (400.9/18,000)* 4000= 89.08 89.1 P2 (400.9/18,000)* 5000=111.35 P3 (400.9/18,000)* 5000=111.35 P4 (400.9/18,000)* 3000=66.81 66.8 S3 (400.9/18,000)* 1000=22.27 22.3

S3Maint

Plant Hrs

3500

837.9 135.3

723.75 929.55 446.1 180.4 112.7 135.3

563.7 (563.7)

S3

P1 (563.7/25,000)*6000 P2(563.7/25,000)*8000 P3(563.7/25,000)*5000 P4 (563.7/25,000)*6000 Total

=135.288 =180.384 =112.74 =135.288

135.3 180.4 112.7 135.3 563.7

Calculation of appropriate departmental overhead rates

Based on machine hours
P1 P2 P3 P4 = 973.3/120 = 904.15/80 =1042.25/200 = 581.4/100 = 8.11 = 11.30 = 5.21 = 5.81 per M/C hour per M/C hour per M/C hour per M/C hour

Charging Overhead Rates to Products

Overhead costs in each cost centre should be absorbed by the products, at an absorption rate of each product.
Pro.Dep. P1 P2 P3 P4 Job1(hours) 3 2.5 0 5 Job2(hours) 12 0 5 0 Job3(hours) 1.5 4 10 3

 Then, based on the production hours the overhead costs chargeable are as follows: Job 1 = 3*8.11+2.5*11.3+5*5.81 = 81.63 Job 2 = 12*8.11+5*5.21 = 123.37 Job 3 = 1.5*8.11+4*11.3+10*5.21+3*5.81 =

Allocation service department costs

Example
A manufacturing firm has three production departments, P1, P2 and P3, and two service departments, S1and S2. the following costs are shown in the overhead distribution sheet. production dep. P1 = Rs. 5000 production dep. P2 = Rs. 8000 production dep. P3 = Rs. 6000 service dep. S1 = Rs. 1280 service dep. S2 = Rs. 3000 Total = Rs.23,280

 The costs of the two service departments S1 and S2 are to be re-apportioned to production departments using the following basis. S1 S2 P1 20% 30% P2 40% 30% P3 10% 20% S1 20% S2 30% Total 100% 100%

There are 3 basic methods of allocating service department costs.

1. Continuous Allotment 2. Simultaneous Equation method 3. Specified order of Re-Allocation

Continuous Allotment
Costs of service departments are re-allocated to other departments repeatedly until the amount remaining is too insignificant. s1 20% 40% 10% 30% 100% s2 30% 30% 20% 20% 100%

P1 P2 P3 S1 S2 Total

Total Cost before re-allocation Dept S1 Dept. S2 23280

P1 5000 256 1015 135 61 8 3.6 4 6479

P2

P3

S1 1280

S2 3000

8000 6000

Total

2380

512 128 (1280) 384 1015 677 677 (3384) 271 68 (677) 203 62 40 40 (203) 16 4 (40) 12 3.6 2.4 2.4 (12) 4 3 9880 6920

Simultaneous equation method

X=total cost of S1 after receiving 20% cost of S2 Y=total cost of S2 after receiving 30% cost of S1 X=1280+0.2Y Y=3000+0.3X By solving two equation above, X=2000 and Y=3600

As above

Total

P1

P2

P3

Cost before re-allocation Dept S1

Dept S2 Total
(2000/100)*70 =1400

19000
2000 3600 1400* 2880 23280
(1400/70)*20 =400

5000
400* 1080 6480

8000
800* 1080 9880

6000
200* 720 6920

(1400/70)*40 =800

(1400/70)*10 =200

Specified order of Re-allocation

Assume that service dept. costs are first allocated to S1 and then to S2.

P1 P2 P3 S1 S2 Total

S1 20% 40% 10% 30% 100%

S2 37.5% 37.5% 25.0% 100%

30*(100/80)

30*(100/80)
20*(100/80)

Total Cost before re-allocation 23280

P1 5000

P2 8000

P3 6000

S1 1280

S2 3000

Dept S1
Dept. S2 Total 2380

256
1269 6525

512
1269 9781

128 (1280)
846 6974

384

- (3384) -

(1280/100)*20 (1280/100)*40 =256 =512

(1280/100)*10 =128

(1280)

(1280/100)*30 =384

Choice of Overhead Rates

The overhead rate is calculated based on several alternative bases. The basis chosen should be suitable for the cost centre activities.

Choice of Overhead Rates

Direct labour hour rate = (Total overhead)/(Direct labour hours) Machine hour rate =(Total overhead)/(Machine hours)

Direct material cost rate =(Total over head/Direct material cost)

Absorption and marginal costing

Before we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing

Practical reasons for using absorption costing

Inventory in hand must be valued for two reasons: For the closing inventory figure in the statement of financial position For the cost of sales figure in the statement of comprehensive income In absorption costing, closing inventory is valued at fully absorbed factory costs. Many companies attempt to fix selling prices by calculating the full cost of production or sales of each product, and then adding a margin for profit. Without using absorption costing, a full cost is difficult to ascertain. If a company sells more than one product, it will be difficult to judge how profitable each individual product is, unless overhead costs are shared on a fair basis and charged to the cost of sales of each product

Definition
Absorption costing
It is costing system which treats all manufacturing costs including both the fixed and variable costs as product costs

Marginal costing
It is a costing system which treats only the variable manufacturing costs as product costs. The fixed manufacturing overheads are regarded as period cost

Trading and profit and loss account

Absorption costing Sales Less: Cost of goods sold Gross profit Less: Expenses Selling expenses X Admin. expenses X Other expenses X $ X X X

Marginal costing $ Sales Less: Variable cost of Goods sold Product contribution margin Less: variable non- manufacturing expenses Variable selling expenses Variable admin. expenses Other variable expenses Total contribution expenses Less: Expenses Fixed selling expenses Fixed admin. expenses Other fixed expenses Net Profit X X X

X X X X X X X X

Net Profit

A company started its business in 2005. The following information Was available for January to March 2005 for the company that produced A single product:
RS

Selling price pre unit Direct materials per unit Direct Labour per unit Fixed factory overhead per month Variable factory overhead per unit Fixed selling overheads Variable selling overheads per unit Budgeted activity was expected to be 1000 units each month Production and sales for each month were as follows: Jan Feb Unit sold 1000 800 Unit produced 1000 1300

100 20 10 30000 5 1000 4

March 1100 900

Required: Prepare absorption and marginal costing statements for the three months

Absorption costing
January February March

$ Sales 100000 Less: cost of good sold (Rs65)65000

Adjustment for Over-/(under) Absorption of factory overhead Gross profit 35000 Less: Expenses Fixed selling overheads 1000 Variable selling overheads 4000 Net profit 30000

$ 80000 52000 28000

9000 37000 1000 3200 32800

$ 110000 71500 38500

(3000) 35500 1000 4400 30100

Marginal costing
Sales Less: Variable cost of good sold ($35) 35000 Product contribution margin 65000 Less: Variable selling overhead4000 Total contribution margin 61000 Less: Fixed Expenses Fixed factory overhead 30000 Fixed selling overheads 1000 Net profit 30000
January $ 100000 February March $ $ 80000 110000 28000 52000 3200 48800 30000 1000 32800 38500 71500 4400 67100 30000 1000 30100

Wk1: Standard fixed overhead rate = Budgeted total fixed factory overheads Budgeted number of units produced = $30000 1000 units = $30 units

Wk 2: Production cost per unit under absorption costing: Direct materials Direct labour Fixed factory overhead absorbed Variable factory overheads

20 10 30 5 65

Wk 3: (Under-)/Over-absorption of fixed factory overheads: January February March $ $ $ Fixed overhead 30000 39000 27000 Fixed overheads incurred 30000 30000 30000 0 9000 (3000)
1000*$30 1300*$30 900*$30

Wk 4: Variable production cost per unit under marginal costing: $ Direct materials Direct labour Variable factory overhead No fixed factory overhead 20 10 5

35

Difference between absorption and marginal costing

Absorption costing Marginal costing

Treatment for fixed Fixed manufacturing overheads are manufacturing overheads treated as product costing. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads

Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decisionmaking. Fixed manufacturing overheads will be incurred regardless there is production or not.

Value of closing stock

High value of closing stock will be Lower value of closing stock that obtained as some factory overheads included the variable cost only are included as product costs and carried forward as closing stock

Argument for absorption costing

Compliance with the generally accepted accounting principles Importance of fixed overheads for production Avoidance of untrue profit or loss
During the period of high sales, the production is small than the sales, a smaller number of fixed manufacturing overheads are charged and a higher net profit will be obtained under marginal costing Absorption costing is better in avoiding the fluctuation of profit being reported in marginal costing

Arguments for marginal costing

More relevance to decision-making Avoidance of profit manipulation
Marginal costing can avoid profit manipulation by adjusting the stock level

Consideration given to fixed cost

In fact, marginal costing does not ignore fixed costs in setting the selling price. On the contrary, it provides useful information for break-even analysis that indicates whether fixed costs can be converted with the change in sales volume