Factory Overhead : Distribution

Chapter 6

Prescribed Textbook: Lal, Srivastava and Singh

CLO 1: Students will be able to apply cost accumulation

and absorption techniques
 Cost Allocation
• Assigning indirect costs to cost objects

• These costs are not traced

• Indirect costs often comprise a large percentage of Total

Overall Costs

• Allocation is a direct process of identifying overheads to cost

units or cost centres. So the term allocation means allotment
of whole item of cost to a particular cost centre or cost object
without any division
 FACTORY OVERHEADS
• COST ALLOCATION

SPINNING WEAVING DYEING

• COST APPORTIONMENT

MAINTENANCE POWER
 SPINNING WEAVING DYEING

• COST ABSORPTION

OUTPUT/
PRODUCT
 Allocation of Overhead Costs – 4 Step Process
• Step 1: Determine the amount of costs in the “cost pool”

• Step 2: Choose an “allocation base”

• Step 3: Calculate the allocation rate :

• OH allocation rate = Overhead / Allocation base

• Step 4: Use allocation rate to allocate OH to cost object based on

object’s use of the base
Allocating Costs of a Supporting Department to
Operating Departments

• Supporting (Service) Department – provides the

services that assist other internal departments in
the company
• Operating (Production) Department – directly
adds value to a product or service
Methods of Allocating Support Costs to Production
Departments

1. Direct
2. Step-Down/Sequential
3. Reciprocal/ Matrix
 Direct Method

Support Departments Production Departments

• Allocates support costs only

to Operating Departments. Information Systems

Manufacturing

• No Interaction between
Support Departments prior to
allocation.
Packaging

Accounting
 Step-Down Method

• Allocates support costs to Support Departments Production Departments

other support departments

and to operating
departments that partially
recognizes the mutual Information Systems

services provided among Manufacturing

all support departments.

• One-Way Interaction
between Support
Departments prior to Packaging

allocation.
Accounting
 Reciprocal Method

• Allocates support Support Departments Production Departments

department costs to
operating departments by
fully recognizing the mutual Information Systems

services provided among all Manufacturing

support departments.

• Full Two-Way Interaction

between Support Packaging

Departments prior to
allocation. Accounting
• Determine the total cost of product X which is processed for
manufacture in department P1, P2 and P3 for 5 hours, 3 hours
and 4 hours respectively, given that its direct material cost is Rs.
625 and direct labour cost is Rs. 375.

Manufacturing Overhead Cost heads Rs.

Rent and rates 62,500
General lighting 7,500
Indirect Wages (based on direct wages) 18,750
Power 25,000
Depreciation on machinery 50,000
Insurance of machinery 20,000
 P1 P2 P3 S1 S2
Direct wages (Rs.)
37,500 25,000 37,500 18,750 6,250
Horse Power of Machines
60 30 50 10 −
used
Cost of machinery (Rs.)
3,00,000 4,00,000 5,00,000 25,000 25,000
Floor space (Sq. ft)
2,000 2,500 3,000 2,000 500
Number of light points
10 15 20 10 5
Production hours worked
6,225 4,050 4,100 − −
Ratio of Service departments’ services to
production departments:

P1 P2 P3 S1 S2

S1 20% 30% 40% − 10%

S2 40% 30% 25% 5% −

 Choosing Between Methods

• Reciprocal is the most precise

• Direct and Step-Down are simple to compute and
understand
• Direct Method is widely used
 Methods of Absorption
• The rate which is used to charge overhead cost to the products or jobs is
known as absorption rate.

Percentage on Direct Materials

• An absorption rate based on materials cost is obtained by dividing total
estimated factory overhead by total direct materials cost expected to be
used in the manufacturing process.

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑨𝒃𝒔𝒐𝒓𝒑𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 =
𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 𝐶𝑜𝑠𝑡
 Methods of Absorption
Percentage on Direct Wages – Disadvantages

• No logical relationship between material cost of a product and factory

overhead.
• Materials prices are subject to fluctuations.
• Overhead expenses vary with time.
• All processes vs partly
 Methods of Absorption
Percentage on Direct Wages
𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑨𝒃𝒔𝒐𝒓𝒑𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 =
𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐶𝑜𝑠𝑡

Disadvantages
• Ignores other costs like taxes, property insurance, depreciation.
• Different types of remuneration
 Methods of Absorption
Prime Cost Percentage
𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑨𝒃𝒔𝒐𝒓𝒑𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 =
𝑃𝑟𝑖𝑚𝑒 𝐶𝑜𝑠𝑡

Unit of Production Basis

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑨𝒃𝒔𝒐𝒓𝒑𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 =
𝑈𝑛𝑖𝑡 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
 Methods of Absorption
Labour Hour/Production Hour Rate
𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑨𝒃𝒔𝒐𝒓𝒑𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 =
𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟𝑠

Unit of Production Basis

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑨𝒃𝒔𝒐𝒓𝒑𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 =
𝑈𝑛𝑖𝑡 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
Problem

Calculate machine hour rate from the following details provided by a

production Department of ABC Ltd.
(i) Bought machinery of INR 4,50,000, (ii) Installation charges INR 50,000 (iii)
Life of machine 5 years, (iv) Working hours per year 2,500 (v) Repair
charges 75% of depreciation (vi) Electric power consumed: 10 units per hour
@ INR 3 (vii) Lubricating oil INR 40 per day of 8 hours (viii) Consumable
stores @ INR 80 per day of 8 hours (ix) Wages of machine operator @ INR
200 per day of 8 hours
Solution

Operating Expenses
i. Depreciation = 5,00,000/5
Hourly Rate = 100000/2500 = 40
ii. Repair Charges = 75000/2500 = 30
iii. Electric Power = 10*3 = 30
iv. Lubricating oil = 40/8 = 5
v. Consumable stores = 80/8 = 10
vi. Wages = 200/8 = 25
Machine hour rate = INR 140
Problem: The following data relate to a manufacturing department for a period:
Budgeted Data Actual Data
Direct Material 1,00,000 1,40,000
Direct Labour 2,00,000 2,50,000
Production Overhead 2,00,000 2,30,000
Direct Labour Hours 50,000 62,500
Machine Hours 40,000 50,000
Job ZX was one of the jobs worked on during the period. The actual data
relating to this job were direct material INR 6,000; direct labour INR
3,000; direct labour hours 750; and machine hours 750.
(i) Calculate the production overhead absorption rate pre-determined for
the period based on: (1) % direct material cost (2) Machine hours (ii)
Calculate the production overhead cost to be charged to job ZX based on
the rates calculated under (i) above. (iii) Assuming that a machine hour
rate of absorption is used, calculate the under/over absorption for the
period and state the appropriate treatment on the accounts.
Solution
(1) Production overhead Absorption
Direct material cost rate = (Production overhead/Direct material cost)*100
Machine hour rate = Production overhead/Machine hours
(2) Production overhead cost to be charged to job ZX
On the basis of direct material cost rate =
On the basis of machine hour rate =
(3) If machine hour rate of absorption is used, then:
Overhead absorbed = Machine hours × Rate =
Actual Overhead =
Solution
Over- and under-absorption may be adjusted by applying supplementary
rate. The rate may be calculated as
Supplementary rate = Amount of over or under absorbed overhead/Actual
base
Here supplementary rate = Over absorbed overhead/Machine hour
 Actual Vs Predetermined (Standard)
• When the absorption is based on actual overhead, it is known as
actual absorption rate. This can be calculated only after the end
of the accounting period when all cost and production figures
have been collected.
• Pre-determined or standard overhead rate is generally used by
companies. This is a rate calculated in advance of the period in
which it is to be used, by dividing the estimated period overhead
to be absorbed by the estimated period production.
• When the amount absorbed is less than the actual overhead,
there is under-absorption. Over-absorption arises when the
amount absorbed is more than the actual overhead.
Problem
• In a manufacturing unit, overhead was recovered at a pre-determined rate
of INR 20 per labour-hour. The total factory overhead incurred, and the
labour-hours actually worked were INR 45,00,000 and 2,00,000 labour-
hours respectively. During this period, 30,000 units were sold. At the end
of the period, 5,000 units were held in stock while there was no opening
stock of finished goods. Similarly, though there was no stock of
uncompleted units at the beginning of the period, at the end of the period
there were 10,000 uncompleted units which may be reckoned at 50%
complete. On analysing the reasons, it was found that 60% of the
unabsorbed overheads were due to defective planning and rest were
attributable to increase in overhead costs.
• How would unabsorbed overheads be treated in cost accounts?
Solution
• Computation of unabsorbed overheads
Labour hours actually worked
Overhead rate per hour
Overheads absorbed at INR 20 per labour hour (A)
Overheads actually incurred (B)
Unabsorbed overheads (B) – (A)
Unabsorbed overheads
(a) due to defective planning (that is, 60% of Unabsorbed
overheads)
(b) Balance of unabsorbed overheads due to increase in
overhead costs
Solution
• Disposition of unabsorbed overheads
• (i) The unabsorbed overheads of INR 3,00,000 due to defective planning
may be treated as abnormal and should therefore be charged to Costing
Profit and Loss Account.
• (ii) Balance of unabsorbed overheads of INR 2,00,000 may be treated as
normal and, therefore, should be charged by a supplementary overhead
absorption rate computed as under:
• Total production during the year:

• Supplementary overhead absorption rate comes to:

• Disposition of normal unabsorbed Overheads of INR 2,00,000

Charged to Costing Profit & Loss Account (as

part of cost of units sold 30,000 units × INR 5)
Charged to Closing Stock of Finished Goods:
5,000 finished goods in stock @ INR 5 per unit
Charged to Work-in-Progress: 10,000 units, 50%
complete, that is, 5,000 equivalent units @ INR 5
per unit
Total
Problem
In a factory, a machine is considered to work for 208 hours in a month. It
includes maintenance time of 8 hours and set-up time of 20 hours. The
expense data relating to the machine are as under: Cost of the machine is
INR 5,00,000. Life 10 years. Estimated scrap value at the end of life is INR
20,000. Repairs and maintenance per annum INR 60,480, Consumable stores
per annum INR 47,520, Rent of building per annum (The machine under
reference occupies 1/6 of the area) INR 72,000, Supervisor’s salary per
month (Common to three machines) INR 6,000, Wages of operator per
month per machine INR 2,500, General lighting charges per month allocated
to the machine 1,000, Power 25 units per hour at INR 2 per unit. Power is
required for productive purposes only. Set-up time, though productive,
does not require power. The Supervisor and Operator are permanent.
Repairs and maintenance and consumable stores vary with the running of
the machine. Calculate a two-tier machine hour rate for (a) set-up time; and
(b) running time.
Solution
• Machine Hour Rate
Effective hours for standing charges
Effective hours for variable costs
Standing Charges Per Hour

Per Month Per Hour

Supervisor’s salary
General lighting
Rent
Total standing charges
Standing charges per hour
Solution
• Machine Hour Rate
Machine Expenses Per Hour

Per Month Per Hour

Depreciation

Repairs and Maintenance

Consumable stores

Power

Wages

Total machine expenses

Solution • Computation of Two-tier machine hour rate
Set-up Time Rate Running Time Rate
Per Machine Hour Per Machine Hour
Standing Charges
Machine Expenses
Depreciation
Repairs and Maintenance -
Consumable stores -
Power -
Machine hour rate of overheads
Wages
Total machine expenses
Comprehensive machine hour rate
Problem
In a manufacturing company, factory overheads are charged as fixed
percentage basis on direct labour, and office overheads are charged on the
basis of percentage of factory cost. The following information are available
related to the year ending 31st March, 2020:
Product A (INR) Product B (INR)
Direct Materials 19,000 15,000
Direct Labour 15,000 25,000
Sales 60,000 80,000
Profit 25% on cost 25% on sales price
You are required to find out:
(i) The percentage of factory overheads on direct labour.
(ii) The percentage of office overheads on factory cost
Solution
Let, the percentage of factory overheads on direct labour is “x” and
percentage of office overheads on factory cost is “y” than the total cost of
product A and product B will be as follows:
Product A Product B
Direct Materials
Direct Labour
Prime Cost
Factory O/H
Factory Cost
Office O/H
Total Cost
Solution