Overheads: What the Older Papers Ask, and Where It Belongs
Chapter Twenty-Seven
Syllabus topic None. Beyond MU's two modules; see the note below
Pages 79 to 82 of 82
Why this chapter is here, and how to use it
MU's syllabus for this paper has two modules and neither is overheads. The examinable content of Cost Accounting - I is classification, the cost sheet, reconciliation, material cost and employee cost, and the twenty-six chapters before this one cover all of it.
But the past papers ask overheads in every sitting, because they were set on the older scheme in which this paper carried them, and MU's own Course Outcome 4 on the NEP page promises that the learner will design and justify overhead absorption rates. So this chapter exists, briefly, so that nothing an examiner has actually asked is missing from the book.
Read it last, and read it lightly. If your time is short, everything before this chapter matters more.
What an overhead is
An overhead is an indirect cost - indirect material, indirect labour and indirect expenses added together. It is a cost that cannot be traced economically to one cost object, and that is the whole of the definition.
| By function | What it holds |
|---|---|
| Factory or works overhead | Factory rent, power, depreciation on plant, supervision, indirect wages, factory insurance |
| Administration overhead | Office salaries, office rent, printing and stationery, director's fees, audit fees |
| Selling and distribution overhead | Advertising, salesmen's salaries and commission, carriage outward, warehouse rent, packing for transport |
The four steps, in order
Collection, allocation, apportionment, absorption. They are not synonyms, and a question that says "distribute" means one of them in particular.
| Step | What happens |
|---|---|
| 1. Collection | Overheads are gathered from the financial books under standing order numbers |
| 2. Allocation | A whole item is charged to one department because it belongs wholly to it - the indirect wages of department B |
| 3. Apportionment | An item belonging to several departments is split between them on a fair basis - rent on floor area |
| 4. Absorption | Each department's total is charged onto the units or jobs passing through it, by a rate |
Allocation is whole; apportionment is split. That distinction is worth a mark on its own and is asked as a distinguish-between.
Primary distribution is steps 2 and 3 together, over all departments including service departments. Secondary distribution then closes the service departments into the production departments.
Bases of apportionment
The basis must bear a relation to the cost. These are the ones MU's questions use.
| Overhead | Apportioned on |
|---|---|
| Rent, rates, heating, building insurance, building repairs | Floor area |
| Lighting | Number of light points, or floor area |
| Depreciation, insurance and repairs of plant | Value of plant |
| Power, motive power | Horsepower of machines, or horsepower multiplied by hours |
| Supervision, canteen, welfare, staff insurance, personnel office | Number of workers |
| Stores overhead, material handling | Value of material issued |
| Employer's liability insurance, contributions | Direct wages |
| General overhead where nothing better exists | Direct wages or prime cost |
Overheads: What the Older Papers Ask, and Where It Belongs
Two of these are asked almost every time: welfare and supervision go on the number of workers, and depreciation goes on the value of plant.
Primary distribution, worked
A factory has three production departments A, B and C and one service department S. Overheads for the period are: rent Rs 20,000; lighting Rs 4,000; depreciation on plant Rs 30,000; supervision Rs 12,000. Indirect wages are allocated directly: A Rs 3,000, B Rs 2,500, C Rs 1,500, S Rs 1,000. Floor area is 2,000, 1,500, 1,000 and 500 square feet; light points 20, 15, 10 and 5; value of plant Rs 60,000, Rs 40,000, Rs 30,000 and Rs 20,000; workers 30, 20, 15 and 15.
| Overhead | Basis | A, Rs | B, Rs | C, Rs | S, Rs | Total, Rs |
|---|---|---|---|---|---|---|
| Indirect wages | Allocated | 3,000 | 2,500 | 1,500 | 1,000 | 8,000 |
| Rent | Area, 2,000:1,500:1,000:500 | 8,000 | 6,000 | 4,000 | 2,000 | 20,000 |
| Lighting | Light points, 20:15:10:5 | 1,600 | 1,200 | 800 | 400 | 4,000 |
| Depreciation on plant | Value of plant, 6:4:3:2 | 12,000 | 8,000 | 6,000 | 4,000 | 30,000 |
| Supervision | Workers, 30:20:15:15 | 4,500 | 3,000 | 2,250 | 2,250 | 12,000 |
| Total | 29,100 | 20,700 | 14,550 | 9,650 | 74,000 |
Check the last column against the last row. The four departments add to Rs 74,000 and so do the five overheads. A primary distribution that does not cross-check is wrong, and the check costs one line.
Secondary distribution
The service department's total must be got into the production departments, because only they have units passing through them.
| Method | How it works |
|---|---|
| Direct redistribution | Service departments are closed straight into production departments, ignoring service given to each other |
| Step ladder | The service department serving most others is closed first, then the next, and none is reopened |
| Reciprocal | Service given between service departments is recognised, by repeated distribution or by simultaneous equations |
Continuing the example, S is apportioned to A, B and C on direct wages in the ratio 5:3:2.
| A, Rs | B, Rs | C, Rs | Total, Rs | |
|---|---|---|---|---|
| Primary distribution | 29,100 | 20,700 | 14,550 | 64,350 |
| S apportioned, 5:3:2 | 4,825 | 2,895 | 1,930 | 9,650 |
| Total factory overhead | 33,925 | 23,595 | 16,480 | 74,000 |
The grand total is unchanged at Rs 74,000. Secondary distribution moves overhead sideways; it never creates or destroys any.
Absorption rates
Absorption charges a department's overhead onto the work passing through it.
| Rate | Formula | Suits |
|---|---|---|
| Percentage of direct material | Overhead ÷ direct material × 100 | Rarely; only where material dominates |
| Percentage of direct wages | Overhead ÷ direct wages × 100 | Where all workers are paid at similar rates |
| Percentage of prime cost | Overhead ÷ prime cost × 100 | A rough compromise between the two above |
| Direct labour hour rate | Overhead ÷ direct labour hours | Labour-intensive work |
| Machine hour rate | Overhead ÷ machine hours | Machine-intensive work |
| Rate per unit | Overhead ÷ units produced | Only where units are identical |
Overheads: What the Older Papers Ask, and Where It Belongs
The choice follows the work. A department where the machines do the work absorbs on machine hours; one where the people do it absorbs on labour hours. Absorbing on wages in a machine shop charges the most overhead to the cheapest worker, which is exactly backwards.
Machine hour rate, worked
Compute the machine hour rate. Supervisor's salary Rs 4,500 a year, of which the machine takes one tenth of his time. Repairs and maintenance Rs 90 a year. Factory rent Rs 2,400 a year; the machine occupies one quarter of the area. Insurance premium Rs 150 a year. Water Rs 150 and steam Rs 225 a year. The machine cost Rs 35,000 with carriage inward of Rs 5,000, has a scrap value of Rs 10,000 and a life of ten years. It runs 1,500 hours a year and consumes 15 units of power an hour at 10 paise a unit.
Depreciation first. The cost of the machine includes the carriage inward that brought it in, so it is Rs 35,000 plus Rs 5,000, that is Rs 40,000; less the scrap value of Rs 10,000, over ten years, gives Rs 3,000 a year.
| Standing charges, a year | Working | Rs |
|---|---|---|
| Supervisor's salary | One tenth of Rs 4,500 | 450 |
| Repairs and maintenance | as given | 90 |
| Factory rent | One quarter of Rs 2,400 | 600 |
| Insurance premium | as given | 150 |
| Water | as given | 150 |
| Steam | as given | 225 |
| Depreciation | Rs 30,000 over ten years | 3,000 |
| Total standing charges | 4,665 |
| Machine hour rate | Rs |
|---|---|
| Standing charges an hour, Rs 4,665 over 1,500 hours | 3.11 |
| Power an hour, 15 units at 10 paise | 1.50 |
| Machine hour rate | 4.61 |
Two traps in that computation. The carriage inward on the machine is capitalised, not expensed, so it raises depreciation rather than appearing as an expense of the year; that is the same rule as the capital job in the labour chapter. And power is a running charge, computed per hour directly, not spread over the year's hours like the standing charges.
Over- and under-absorption
Overhead is absorbed at a rate fixed in advance, and the actual overhead is never the same figure.
| What it means | Effect on costing profit | |
|---|---|---|
| Over-absorption | Absorbed more than was incurred | Cost is overstated, so costing profit is understated |
| Under-absorption | Absorbed less than was incurred | Cost is understated, so costing profit is overstated |
This is where the appendix rejoins the book. Over- and under-absorbed overhead is one of the standard causes of difference in a reconciliation, and the reconciliation chapters carry it. A student who never computes an absorption rate still has to know which way the difference runs.
Overheads: What the Older Papers Ask, and Where It Belongs
Quick revision
- Overhead = indirect material + indirect labour + indirect expenses.
- Allocation charges a whole item to one department; apportionment splits an item between several.
- Primary distribution covers all departments; secondary distribution closes the service departments into the production ones, by direct, step ladder or reciprocal methods.
- Bases: area for rent, light points for lighting, value of plant for depreciation, horsepower for power, number of workers for welfare and supervision.
- Absorption rates: percentage of material, wages or prime cost; labour hour rate for labour-intensive work; machine hour rate for machine-intensive work.
- Machine hour rate = standing charges an hour plus running charges an hour, with the machine's cost taken inclusive of carriage inward and net of scrap value.
- Over-absorption understates costing profit; under-absorption overstates it.
Test yourself
1. Distinguish allocation from apportionment. Allocation charges the whole of an item to a single department because it belongs wholly to it; apportionment divides an item between departments on a basis that reflects how each benefits from it.
2. On what basis are welfare expenses and depreciation on plant apportioned? Welfare on the number of workers; depreciation on the value of plant.
3. When is a machine hour rate preferred to a labour hour rate? Where the work is done chiefly by machines, so that overhead varies with machine running time rather than with the hours people spend.
4. A machine costs Rs 35,000 with carriage inward Rs 5,000, has a scrap value of Rs 10,000 and a life of ten years. What is the annual depreciation? Rs 3,000. The carriage inward is part of the machine's cost, so Rs 40,000 less Rs 10,000 over ten years.
5. Overhead absorbed exceeds overhead incurred. What has happened to the costing profit? It is understated, because more overhead has been charged to cost than was actually spent, and the difference is added back in the reconciliation.
Answer in one sentence
Explain the treatment of overheads. Overheads, being indirect material, labour and expenses, are collected under standing order numbers, then allocated whole to a department where they belong wholly to it and apportioned between departments on a suitable basis where they do not, which together make the primary distribution; the service departments' totals are then closed into the production departments by direct, step ladder or reciprocal secondary distribution; and each production department's total is absorbed onto the work passing through it by a rate chosen to suit the work, a machine hour rate for machine-intensive work and a labour hour rate for labour-intensive work, the difference between what is absorbed and what is incurred being over- or under-absorption, which is one of the causes of difference between the cost and the financial profit.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.