OVERHEADS

Areas to be covered:
• Revenue And Capital Expenditure

• Production And Non-Production Overheads

• Allocation And Apportionment

• Reapportionment Methods

• Overheads Absorption Rate

• Blanket And Departmental Rate

• Under And Over-Absorption of Overheads

• Non-Manufacturing Overheads
REVENUE EXPENDITURE AND CAPITAL EXPENDITURE

Revenue expenditure is expense incurred during the course of business or incurred to

maintain existing fixed assets. It is charged to the profit and loss account as an expense.

Capital expenditure is expense incurred in the acquisition of fixed assets. It is not charged to

the profit and loss account as an expense. The expenditure is capitalised as a fixed asset and

a depreciation amount is charged to the profit and loss account to write off the capital

expenditure over a period of time.

PRODUCTION AND NON PRODUCTION OVERHEADS
Production / Manufacturing overheads are indirect costs that are related to the production.

They become part of the production cost. For example, Production supervisor’s salary, Nails

use in making table, etc.

Non-production / Non-manufacturing overheads are expenses that are not directly or

indirectly, related to the production. They cover Selling, Distribution, Administration and

Finance overheads, etc.

PRODUCTION AND NON PRODUCTION OVERHEADS
Treatment:

Overheads are not charged directly into cost units. However, they charged to the cost units

to avoid under-estimation of product costs which may end up with under-setting the product

selling price. They charge to cost centers, where they converted to unit rate and than

become part of total cost

 Cost Center

Production Cost Centers Service Cost Centers

Centres that actually produce Centres that provide necessary

goods. Directly involve in services to the production cost

production like assembly centres. Indirectly involve in

department, finishing production like stores,

department, etc maintenance, etc.

The process of charging production overheads is to share out all of overheads among the

cost centre (production cost centre and service cost centres) then share overheads of

service cost centres to production cost centres and charge them to cost units.

In absorption costing system there are four steps of charging overhead costs to cost centres

and cost units.

1. Allocation.

2. Apportionment.

3. Re-apportionment.

4. Absorption.
Designing
(200 Sq.m)
Stitching
(500 Sq.m)
Cutting
(300 Sq.m)
1. Allocation

Costs that relate to a single cost centre are allocated to that cost centre. Mostly

indirect materials and indirect labour costs are allocated.

It relates to costs that can be identified with a specific cost centre, which is why it is directly

charged to the cost centres or cost units.

2. Apportionment

Apportionment where an overhead is common or combined to more than one cost

centres and therefore needs to be shared out amongst the relevant cost centres on the

basis of benefit received by each cost centre.

Formula of overheads apportionment:

For example,
Costs Related Basis

Rent and rates Floor area / space occupied

Light and heat Floor area / space occupied

Power Power usage/ Kilowatt hour / capacity of machines

Employee related costs Number of employees / wages cost / Labour hours

Depreciation of plant & machinery Value of machinery / Machine hours

Insurance of plant & machinery Value of machinery / Machine hours

Canteen cost Number of employees

Depreciation of building Floor Area / Space occupied

Insurance of building Floor Area / Space Occupied

Example 1
The total rental cost of an organization is $20,000. The total floor area of the building is 100,000

square feet. The assembly department takes up 6,000 square feet and the stores department

10,000 square feet.

How much of the total rent should be apportioned to the assembly department and the stores

department?
3. Reapportionment
Service departments are cost centres, which exist to provide services to other departments. The
canteen is a common example. Having allocated and apportioned the costs to the production
and service departments, the totals of service cost centres, then latter need to be
reapportioned to the production cost centres.

Formula:

BASIS OF REAPPORTIONMENT

Service cost centres: Bases of reapportionment

Stores Number of material requisitions
Maintenance Number of maintenance hours or number of maintenance calls
Canteen Number of employees
Reapportionment Methods

Direct Method Indirect Methods

Ignores work between Step down Method (1 way method): One service department
provides services to other service departments but others do not.
service departments.
Service department which does most work for other departments is
reapportioned first. Other reciprocal services are ignored.

Reciprocal Method (2 way method): Service departments provide

services to 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.
Example 2 (for direct method)
Particulars Prod. Dept A Prod. Dept B Stores Maintenance

Total after apportionment 10,000 20,000 500 200

Stores 45% 55% - -

Maintenance 60% 40% - -

Reapportion service center’s overheads to production centers by direct method.
Example 3 (for step down method)
Particulars Prod. Dept A Prod. Dept B Stores Maintenance

Total after apportionment 10,000 20,000 500 200

Stores 40% 50% - 10%

Maintenance 60% 40% - -

Reapportion service center’s overheads to production centers by step down method?
Example 4 (for reciprocal method)

Particulars Prod. Dept A Prod. Dept B Stores Maintenance

Total after apportionment 10,000 20,000 500 200

Stores 40% 50% - 10%

Maintenance 60% 20% 20% -

Reapportion service center’s overheads to production centers by Reciprocal

method.
Solution:
Example 3: Home Assignment
4. Absorption
It is a method of including a fair proportion of the total overheads costs as part of the cost

of each cost unit. The amount of overhead that is to be treated as a cost of each cost unit

(or product) is calculated using overhead absorption rate:

ℎ
ℎ

The total of the overheads in each production department must now be absorbed into the

units of production on the following basis:

4. Absorption
Activity level Absorption rate

Direct labour hours $5 per direct labour hour

Machine hours $7 per machine hour

Units of production $10 per unit

Direct wages cost 30% of direct wages cost

Direct materials cost 40% of direct materials cost

Prime cost 50% of prime cost

Full production cost 20% of full production cost

Example 11:
The following data was collected for a water supply factory:

Production overheads $20,000

Direct labour cost $16,000

Direct materials $10,000

Direct labour hours 2,000 hours

Machine hours 4,000 hours

Production 2,500 units

Example 11:
Calculate the OAR using each of the below bases.

a. Direct labour hour

b. Machine hour

c. Direct labour cost

d. Direct material cost

e. Prime cost

f. Production cost

g. Unit production basis

Blanket and Departmental Rate System

Blanket rate: It is when single OAR is used for the whole factory or organisation. It is

appropriate if;

• company has few departments

• Few but similar products

• Similar processing

With this use, some products will receive a higher overhead proportion and some will be

under charged.
Blanket and Departmental Rate System

Departmental rate: It uses a separate rate for each department or cost centre. It is suitable

when:

Company has many department

Produce diverse range of products, etc.

Comparison between blanket rate and departmental rate

The use of blanket rate saves time and thus cost, but less accurate then departmental rates.

Therefore a careful selection of which type of rate to use is essential, taking into account the

cost-benefit analysis.
Over / Under Absorption of Overheads
Overhead absorption rate (OAR) is based on budgeted overheads and budgeted activity

levels, so absorbed overheads may be different from actual overheads incurred.

Absorbed overheads = Absorption rate x actual activity level

Absorbed overheads are compared with actual overheads incurred in a period; the

difference (if any) is either under absorption or over absorption.

Over / Under Absorption of Overheads
Under/Over Absorption:

Absorbed overheads: Actual activity level x OAR = X

Actual overheads =X

Under/Over-Absorbed =X

• Absorbed OH > Actual OH = OVER absorption (deduct from Cost of goods sold or add in profit)

• Absorbed OH < Actual OH = UNDER absorption(add to Cost of goods sold or deduct from profit)

If actual overheads incurred are not given then an assumption can be taken that

Budgeted overheads = Actual overheads .

Over or Under Absorption of Overheads will occur if:
• Actual overheads are different from the budgeted overheads

• Actual activity level different from the budgeted activity level

• Or both situations arise

Example 14:

Budgeted units 100 units

Budgeted production overheads $200

Actual units’ 120 units

Actual production overheads $230

Calculate under or over absorption of overheads?

Non-Manufacturing Overheads
Non-manufacturing overheads may be allocated by choosing a basis for overhead

absorption rate which fairly reflects the non-production overheads.

Basis for apportionment of non-manufacturing overheads

There are two options available for apportioning non-manufacturing costs to cost units:

• Method-1

Choose a basis for apportioning non-manufacturing overheads which fairly reflects non-

manufacturing overhead such as direct labour hour, machine hour etc.

Non-Manufacturing Overheads
• Method-2

Allocate non-manufacturing overheads to product on the basis of products ability to bear

such cost. For example manufacturing cost may be used to apportion non-manufacturing

cost to product

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