OVERHEADS

Any cost which is not directly identifiable to any product, job, operation or process is referred
as overhead. As such it is sum total of indirect material cost, indirect labour cost and indirect
expenses.

Indirect costs are costs which are not traceable to a cost center or and cost unit and therefore
have to be apportioned to the cost centre or cost unit. Also known as on cost or supplementary
cost or non-productive cost. Overheads are sometimes called as burden.

Examples of overhead costs include rent, utilities, insurance, legal fees, office supplies,
advertising, payroll, and accounting fees.

Overhead Accounting

The ultimate aim of overhead accounting is to absorb them in the units produced by the firm.

As overheads are indirect costs, it becomes difficult to charge them to the units produced. So,
it becomes necessary to charge them to the units produced on some equitable basis which is
called as ‘Absorption’ of overheads.

The important steps involved in overhead accounting are as follows:

1. Classification of overheads

2. Codification and collection of overheads

3. Allocation and apportionment of overheads (Departmentalization of overheads)

4. Re-apportionment of overheads

5. Absorption of overheads

Classification of overheads

Classification is the process of arranging items into groups according to their degree of
similarity. Classified as:

a) according to elements

b) according to function
c) according to behaviour

d) according to controllability

Codification and Collection of overheads

Codification of overhead is the process of allotting number or symbol to each sub group of
overhead for easy identification. Codes are helpful and useful in classification, accounting and
control.

Collection of overheads means the collection of various items of overheads under suitable
account heading. Overheads are collected from various documents like invoices, cash book,
subsidiary records like – records of depreciation, scrap, waste, idle time, etc.

Allocation and Apportionment of overheads

Allocation of overheads

Allocation of overhead means charging of overhead to a particular cost centre (department)

when such overhead has been incurred directly for that cost centre. If the overhead is directly
related to a particular cost centre or department, it is charged to that. Allocation involves
identifying overheads to particular cost centre. Allocation is allotment of whole items of
indirect costs to cost centre without any division.

Apportion of overheads

Apportionment of overhead means those overheads which are not directly identifiable with any
particular production or cost centre, are distributed over the departments / cost centres on some
equitable basis. These are joint costs whose benefits are commonly shared.

Distribution of various items of overheads in proportions to the departments or products on

logical or equitable basis is called apportionment.

Stages of Apportionment (or Distribution) of overheads

1.) Primary Distribution – When overheads are apportioned to all departments (i.e., both
production and service departments), it is called primary distribution.
2) Secondary Distribution – When the total of overheads allocated and apportioned to service
departments (as per primary distribution) are apportioned again to production departments, it
is called secondary distribution.

 Primary Distribution

Overhead Item Basis of apportionment

Rent, rates and taxes Floor area occupied

Repairs and maintenance to building Value of building/ floor area

Lighting No. of light points/ no. of employees/ floor

area

Power Horse power of machines

Telephones No. of extensions

Supervision No. of employees

Depreciation Asset value

Repairs and maintenance of plant &

Asset value
machinery

Canteen expenses No. of employees

Welfare expenses No. of employees

ESI, PF Direct wages

General Overheads Direct wages

Overtime cost Direct labour hours

Stores overhead Value of direct materials

No. of material requisitions or value of direct

Material handling
materials

Audit fees Sales

  Secondary Distribution/ Redistribution/ Reapportionment

After the primary distribution the next step is to reapportion the service department costs over
the production departments. The products actually do not pass through the service departments
but the cost-of-service departments have to be recovered from the sales of the finished products.
Hence, the overheads of the service departments have to be apportioned to production
department. This process is called secondary distribution of overhead.

Methods of Re-apportionment of overheads

Direct redistribution method Apportionment to

(apportionment to production departments and
production departments) service departments

Non reciprocal basis (step ladder method) Reciprocal basis

Repeated Distribution method Simultaneous equation Trial and error method

method

Direct Distribution Method

This method is based on the assumption that one service dept does not give service to another
service departments. Thus, between service depts there is no reciprocal service exchange.
Hence under this method, service costs are directly loaded on to the production departments.

Non reciprocal basis (step ladder method)

This method is based on the assumption that one service department gives service to other
service depts but does not receive Service from other service dept.

In this case the cost of most serviceable department is first apportioned to other production as
well as service departments. After this the cost of next serviceable department is apportioned
to other departments excluding the first one. The cost includes the own cost of the second
service department plus the apportioned cost of first service department.
It should be noted that the department to which the apportioning has already been done is not
charged again. This process is continued until the expenses of all service departments have
been apportioned to the production departments.

Reciprocal service methods

Here service departments give as well as receive services from and to the other service
departments.

E.g.: Power department Repairs department

There are three methods in reciprocal service methods.

1) Repeated Distribution methods (Continued distribution method)

The Costs of service departments are apportioned to all production departments and other
service departments according to the agreed percentages. This process is repeated till the total
costs of service departments become "nil" or "negligible".

2) Simultaneous equation method (Metrix method or Algebraic method)

In case of reciprocal services, the problem is that total overheads of one service department,
say X, includes a share from the total overheads of other department, say, Y. Therefore, to
ascertain total overheads of X we should know total overheads of Y and to ascertain total
overheads of Y, we should know the total overheads of X. This problem is solved with the help
of simultaneous equations. Thus, under simultaneous equation method the total amount of
overhead attributable to each service department is worked out by solving simultaneous
equations.

3) Trial and error method

This method is more useful when there are two or more service departments. Under this method
the cost of first service department is apportioned to other service department(s) only, at a given
percentage. Then the cost of second service department (plus cost from the first service
department) is apportioned back to the first service department. This process is repeated till the
amount for apportionment becomes nil or negligible.

Absorption of Overheads Absorption of overheads simply, means charging overheads of a

cost Centre (productive department) to different Cost units (products, jobs, etc).
It is the charging of overheads to the individual products or Units. Overhead absorption means
charging of overheads of a particular cost centre to its different cost units by means of overhead
absorption rates.

In short, absorption of overheads refers to the process of apportionment of overheads of a cost

cente, to its Cost units.

Also known as recovery of overheads or application of overheads.

𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
Overhead absorption rate = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒

Methods for determining overhead absorption rates:

 Actual overhead rate

Actual overhead during the month
Overhead Rate =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑚𝑜𝑛𝑡ℎ

 Pre-determined overhead rate

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

Overhead Rate =
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐵𝑎𝑠𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

 Blanket (single) overhead rate

𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐶𝑜𝑠𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑓𝑎𝑐𝑡𝑜𝑟𝑦

Blanket Rate =
𝑇𝑜𝑡𝑎𝑙 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒

 Multiple Rates or Separate rates

Overhead cost allocated and apportioned to each product,department
Overhead Rate =
𝐶𝑜𝑟𝑟𝑒𝑠𝑝𝑜𝑛𝑑𝑖𝑛𝑔 𝐵𝑎𝑠𝑒

Methods of Overhead Absorption

Production unit method - Under this method overheads are absorbed on the basis of number
of units produced.

𝑇𝑜𝑡𝑎𝑙 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
Overhead absorption rate = 𝑁𝑜.𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑
Percentage on direct material cost method - Here the absorption rate is expressed as a
percentage of direct material cost. This method is useful when the portion of material cost is
very high and that of labour cost is comparatively negligible.

𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
Overhead absorption rate = ×100
𝐷𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡

Percentage of direct wages method - Under this method, overhead for a job is recovered on
the basis of a pre-determined percentage of direct wages. This method is used when the
component of direct wages is higher.

𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
Overhead absorption rate = ×100
𝐷𝑖𝑟𝑒𝑐𝑡 𝑤𝑎𝑔𝑒𝑠

Percentage of Prime Cost - This method could be used when prime cost constitutes a major
proportion of the cost and the rates of material and labour are stable. It is needed that the
product made is standard product.

𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
Overhead absorption rate = ×100
𝑃𝑟𝑖𝑚𝑒 𝐶𝑜𝑠𝑡

Direct Labour Hour Rate Method - Under this method, the absorption rate is calculated by
dividing the overhead amount by the actual or predetermined direct labour hours. This is
extremely useful when the production is labour intensive.

𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
Overhead absorption rate = 𝐷𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠

Machine Hour Rate Method - The overheads in a highly mechanized factory are mostly
related to the number of hours a machine runs. Hence, this is supposed to be the best method
for absorbing overhead costs into the cost unit.

𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
Overhead absorption rate = 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠

A machine hour rate may be calculated using only those overheads which are directly related
to the machine e.g., power fuel, repairs, maintenance, depreciation etc. Sum total of these
expenses is calculated and then divided by the hours to compute the rate. This is called ordinary
machine hour rate. Whereas, if costs not related to machine are also included (e.g., supervision,
rent, lighting, heating etc.) for the rate calculation, such rate is called as composite machine
hour rate.
Machine Hour Rate

Machine hour rate is an important method of absorption of factory overhead. It is used in those
factories where machines are predominant. Machine hour rate refers to the cost of running and
operating a machine per hour. In simple words, it is obtained by dividing the amount of
overhead related to a machine by the number of machine hours (or working hours of the
machine). A separate machine hour rate is calculated for each machine.

The following points should be borne in mind while calculating machine hour rate:

1. Divide overheads relating to the machine into two-standing charges (fixed) and machine
expenses (variable)

2. Rent, rates, lighting, insurance, supervision, wages of operators, lubricating oil and
consumable stores etc. may be treated as standing charges.

3. Depreciation, power, repairs, steam, water etc. may be treated as machine expenses.

4. Depreciation can be treated as standing charges also depending upon the convenience.

5. Estimate the total standing charges for the machine (one machine) for a period (day, or week
or month or year) and divide this total by the working hours of the machine (effective working
hours) for that period. This gives the standing charges per machine hour.

6. The machine expenses are to be estimated separately. These are divided by the normal
working hours (effective working hours). It gives hourly rates for each item.

7. The total of standing charges per hour (as per 5) and the machine expenses per hour
(separately calculated as under 6) will give the M.H.R.

8. If ordinary MHR is to be computed, direct wages (of operators, machine men, machine
attendant etc.) should be excluded.

9. If comprehensive MHR is to be ascertained the direct wages should be included.

10. While calculating normal working hours idle time, maintenance time and setting up time
should be deducted. This gives the effective working hours.

11. Sometimes working hours may not be given in the question. It can be ascertained from
power cost.
12. Standing charges are usually given for the department. Then they are to be apportioned to
the machine (whose rate is to be determined) on an equitable basis.

13. Always remember that MHR is the cost of operating and running a machine (one machine)
per hour.

Under-absorption and Over-absorption of Overhead

The actual overhead costs and activity levels are not known until the end of the period. Thus it
would not be desirable for managers to have to wait until after the end of the period before they
had a rate of overhead that they could use on a day-to-day basis, but this gives rise to the
problem of under/over absorption as the actual figures for overhead and for the absorption base
are likely to be different from the estimates used in calculating the absorption rate.

When this happens, the overhead will be either under absorbed or over absorbed. If the actual
overhead incurred is higher than the overhead absorbed, then overhead is ‘under absorbed’ and
if the actual overhead incurred is lower than the overhead absorbed then the overhead is ‘over
absorbed’.

How does one deal with the situation of over or under absorption?

There are three ways to handle over or under absorption:

1. Write off (in case of under-absorption) or write back (in case of over-absorption) to the
Profit and Loss Account. This treatment is valid if most of the overhead items are related to
time.

2. Carry forward to the next period through a reserve account – this method is not
recommended on the logic that it is inconsistent with Accounting Standard.

3. Use of supplementary rates - to adjust the effect to the cost of sales, finished stocks and
work in progress stocks. This sound logical as it does not carry forward the unabsorbed or over-
absorbed overheads to the next accounting period entirely.
Treatment of Under Absorption and Over Absorption

UNDER ABSORPTION OVER ABSORPTION

It means absorbed overhead are less than the actual It means absorbed overhead are
overhead more than the actual overhead

It may be due to: It may due to

a) Normal reasons a) Error in estimation

b) Abnormal reasons b) Seasonal fluctuations
c) Unanticipated changes in
methods of production
Accounting treatment Accounting treatment

In case of Normal reason In case of Abnormal If amount is If amount is

reason relatively relatively large
small

The amount of normal increase Transfer to Costing Write off to Use of

in cost is apportioned to P&L a/c costing P&L supplementary
account recovery rate.
a) Units sold
b) Closing Stock of FG
c) Closing Stock of WIP

Use of Supplementary Rate

𝑈𝑛𝑑𝑒𝑟 𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛
= 𝐴𝑐𝑡𝑢𝑎𝑙 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑜𝑢𝑡𝑝𝑢𝑡

E.g. Genuine error in planning, E.g. Defective

change in planning premises, planning, Strike
inefficiency of worker, etc. period wages, write
off of obsolete
stocks, etc.

Journal Entry: Journal Entry:

Cost of sales a/c………...Dr

Closing stock of FG Costing P/L

a/c………...Dr a/c..........Dr

Closing stock of WIP a/c…...Dr To Factory overheads

a/c
To Factory overheads a/c