ACCOUNTING FOR OVERHEADS

Overheads = Indirect material + Indirect labour + Indirect expenses These costs are not directly attributable to cost units yet the cost has to be recovered from the customer or the company will go out of business

What we are looking at in this session is how we charge the overhead costs into the individual product units, i.e. how much overhead cost does it take to make one unit of output?

Exercise 1
2Tone Ltd is a manufacturing company producing product P, which has the following cost card: $ 10 5 1 16

Direct labour 2 hrs @ $5 per hour Direct materials 1 kg @ $5 per kg Direct expenses Prime cost 2Tone Ltd produces and sells 1,000 units in a month Required: What price should be charged? $16 is the direct cost but doesnt include indirect expenses.

In addition, assume that based on past experience 2Tone Ltd estimates its monthly overheads as follows: $ Heating 3,000 Power 2,000 Maintenance 500 Total 5,500 Now what price should be charged?

To work out overhead price per unit by working out Total Overhead / Activity Level (or units produced) So 5500 (total cost of overhead) / 1000 (units produced) = $5.50 $5.50 + $16 = $21.50

Exercise 2
Imagine 2Tone Ltd in addition to producing product P now starts to produce another product, Product Q, which has the following cost card: $ 3.00 0.50 Nil 3.50

Direct labour 0.5 hrs @ $6 per hour Direct materials 0.1 kg @ $5 per kg Direct expenses Prime cost

2Tone Ltd plans to make and sell 1,000 units of Product Q in a month, as well as producing 1,000 units of product P. Due to additional production the overheads are likely to increase to: $ Heating Power Maintenance Total Required: What is the cost per unit for P and Q? Is it a fair split of overheads between the products? If you split the overheads 50 /50 then P would cost P= (7800/2000) + 16 = $19.90 Q = (7800/2000) + 3.50 = $7.40 However we can see that P uses a lot more labour so would presumably use a lot more energy, power etc. Methods of allocation of overheads Note that we can alter the monetary allocation of overheads to products by the changing the method of allocation. There are a number of methods of allocation, the most common being direct labour hours and machine hours. There is no single correct method it simply depends upon the circumstances given in the question. 4,200 2,900 700 7,800

In an exam, if you are not told which method to use, then use whichever is the greater out of labour hours or machine hours.
Exercise 2a. Now we will use labour hours to calculate the overhead split between the products in the exercise above. We will have to calculate something called an OAR i.e. Overhead Absorption Rate. This is calculated as follows: OAR = Total budgeted overhead Budgeted level of activity The OAR is the budgeted rate at which we charge overheads into our Profit and Loss account (Income Statement). 7800 / 2500 (Total amount of hours) = $3.12 P= 3.12 x 2 (Actual Hours Per Unit) = $6.24 Q= 3.12 x 0.5 (Actual Hours Per Unit) = $1.56 You can check this is correct by multiplying each by 1000. It should match the total overheads. Departmental and Blanket OARS An OAR can be calculated using a departmental approach or using a blanket approach.

Exercise 3
Selecta Ltd makes three products A, B and C. Each passes through two departments, Machining and Assembly. Labour hours used in each department by each product Machining Assembly Product A 1 hr 1 hr Product B 2 hrs hr Product C None 4 hrs Production is expected to be as follows: Product A 1,000 units Product B 2,000 units Product C 500 units Overheads are budgeted as follows: Direct material costs are as follows: Product A $20.00 Product B $30.00 Product C $40.00 Direct labour is charged at $7.00 per hour Required: Calculate overhead absorbed by each product, using a departmental labour hour overhead absorption rate and a blanket overhead absorption rate. Calculating the Departmental OAR means breaking up the cost per department: Machining Units x Hours = Total Time Assembly Units x Hours = Total Time Product A 1000 x 1 = 1000 1000 x 1 = 1000 Product B 2000 x 2 = 4000 2000 x 0.5 = 1000 Product C 500 x 0 = 0 500 x 4 = 2000 Total= 5000 Total = 4000 Machining OAR = 100000 (Total Cost) / 5000 (Total Hours) = $20 an Hour Assembly OAR = 150000 (Total Cost) / 4000 (Total Hours) = $37.5 an Hour Total Cost: Direct Costs Material Labour (Total Time x p/h rate) Total Direct (Prime) Costs Indirect Costs (Overheads) Machining (Mach OAR x Mach Time) Assembly (Ass OAR x Ass Time) Total Indirect (Overhead) Costs Total Cost (Prime Costs + OH Costs) Machining $100,000 Assembly $150,000

Product A 20 2x7= 14 34

Product B 30 2.5x7= 17.5 47.5

Product C 40 4x7= 28 68

20x1= 20 37.5x1= 37.5 57.5 $91.5

20x2= 40 37.5x0.5= 18.75 58.75 $106.25

20x0= 0 37.5x4= 150 150 $218

Calculating the Blanket OAR means adding together the resources: Blanket OAR = 250000 (Total Cost) / 9000 (Total Hours) = $27.78 an Hour Total Cost: Direct Costs Material Labour (Total Time x p/h rate) Total Direct (Prime) Costs Indirect Costs (Overheads) Machining (OAR x Total Time) Total Indirect (Overhead) Costs Total Cost (Prime Costs + OH Costs)

Product A 20 2x7= 14 34

Product B 30 2.5x7= 17.5 47.5

Product C 40 4x7= 28 68

27.78x2= 55.56 55.56 89.56

27.78x2.5= 69.45 69.45 116.95

27.78x4= 111.12 111.12 179.12

Under and Over Absorption What we have done so far is calculate a budget rate at which we charge overheads to the Profit and Loss account (Income Statement) i.e. the OAR. We now need to see what happens when our actual overhead invoice is charged to our P&L plus we enter into production and obtain our actual production figures. Under / Over absorption is the difference between the budgeted overhead charged to the P&L for our actual production compared to the actual overhead charged. Exercise 4 Using the information in exercise 3 and assuming we have used a blanket labour hour OAR, calculate whether we are under or over absorbed given the following information: Actual Production: Product A Product B Product C 1,200 units 1,900 units 700 units

Actual overheads incurred were $280,000. Predicted Overheads: Product A = 55.56 x 1200 = 66672 Product B = 69.45 x 1900 = 131955 Product C = 111.12 x 700 = 77784 66672 + 131955 + 77784 = 276411 We have under absorbed. Profit The over-or under-absorption will go through the profit and loss account. Under-absorption: Profit will decrease when adjustment is made Over-absorption: Profit will increase when adjustment is made

Exercise 5 Budget $80,000 20,000 Actual $90,000 22,000

Overheads Hours worked Required:

Calculate the over / under-absorption for the period. Budgeted OAR = 80000 / 20000 = $4 4 x 22000 = 88000 Under absorbed by $2000

Allocation and Apportionment of Overheads When we were looking at production overheads above, we were given the total amount of overhead. This section deals with how those overhead totals are arrived at. There are two types of production overhead: 1. Overheads that arise solely in a department: o e.g. indirect labour working in the assembly department o e.g. indirect materials used by a department These are allocated to that department 2. Overheads that are factory wide: o e.g. rent, rates, heating, administration etc These are apportioned (shared) between departments. Overheads should be apportioned between the departments on a fair basis. Common examples include: o o o o o Floor area Value of machinery Hours spent working for a particular department Number of requests Machine time

Each particular overhead should be apportioned on the most appropriate basis.

Exercise 6 Kings of Leon Ltd has 2 production departments (Assembly and Finishing) and two service departments (Maintenance and Canteen). The following are budgeted costs for the next period: Indirect materials Rent Electricity Machine depreciation Indirect labour Direct labour $20,000 $15,000 $10,000 $5,000 $16,520 $125,000

The following information is available: Assembly Finishing Maintenance Canteen

Area (sq. metres) KW hours consumed Machine value Number staff Direct labour hours Indirect mats. Budget ($) Indirect lab. Budget ($) Required:

1,000 2,750 $45,000 20 3,175 7,000 1,600

2,000 4,500 $35,000 30 3,800 8,000 2,220

500 1,975 $11,000 10 3,000 11,200

500 775 $9,000 2 2,000 1,500

Calculate the total budgeted overheads for each department, entering the figures in the table below:

Overhead

Apportionmen t basis Allocated

Assembly 7000

Finishing 8000

Maint. 3000

Canteen 2000

Total 20000

Indirect materials Area Rent (15000/400 0)x1000= 3750 (10000/100 00)x2750= 2750 (5000/1000 00)x45000 = 2250 1600 (15000/400 0)x2000= 7500 (10000/100 00)x4500= 4500 (5000/1000 00)x35000 = 1750 2220 (15000/400 0)x500= 1875 (10000/100 00)x1975= 1975 (5000/1000 00)x11000 = 550 11200 (15000/400 0)x500= 1875 (10000/100 00)x775= 775 (5000/1000 00)x9000= 450 1500 15000

KW Hour Electricity

10000

Machine Value Machine depreciation Allocated Indirect labour

5000

16520

17350 Total

23970

18600

6600

66520

Reapportioning service department costs As only production departments are directly involved in manufacturing output, service departments' overheads, having been allocated and apportioned, must then be reapportioned amongst the production departments before absorption. Exercise 6 (Continued) In the above exercise, suppose that the following additional information is available. Proportion of its time spent by the maintenance department servicing equipment in the other departments: Assembly 60% Finishing 40%

The canteen department overheads are to be apportioned on the basis of number of employees in the other three departments. Required: Re-apportion service centre costs to the production departments.

Note: a. A suitable basis for sharing out canteen costs is the number of employees. b. A suitable basis for sharing out the maintenance costs is the time spent servicing equipment. c. First re-apportion canteen costs since they do work for maintenance but maintenance do NOT work for the canteen.

Overhead Total as above Canteen Subtotal Maint. Total

Apportionment basis

Assembly 17350 (6600/60)x20= 2200 19550 (19700/100)x60= 11820 31370

Finishing 23970 (6600/60)x30= 3300 27270 (19700/100)x40= 7880 35150

Maint. 18600 (6600/60)x10= 1100 19700

Canteen 6600

Total 66520 6600 66520 19700 66520

Exercise 6 (Continued) Calculate the Overhead Absorption Rate (OAR) for the two production departments using a labour hour basis. One of the products produced by Kings of Leon Ltd is product A. This takes 15 minutes of labour time in the assembly department and 30 minutes of labour time in the finishing department. What is the departmental overhead charge per unit for product A? Assembly = 31370 / 3175 = $9.88 p/h Finishing = 35150 / 3800 = $9.25 p/h OAR = (9.88x0.25)+(9.25x0.5)= $7.10