Overheads | CMA Inter Syllabus

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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.

With the advent of time service sector organisations have become more and more prominent and this have contributed to overhead costs becoming more and more significant. Also with the modern trend towards the mechanization, automation, and mass production, overhead costs have grown considerably, magnitude wise. In other organisations the proportion of overhead costs to the total costs of products is appreciably high. High overheads do not indicate inefficiency if the increase in overheads is due to the following likely causes:

1. Improved methods of managerial control like Accountancy, Production Control, Work Study, Cost and Management Accountancy etc. In the process of reducing costs of other elements viz direct material and direct labour, overhead costs are likely to increase.
2. Large scale production or mass production.
3. Use of costly machines and equipments leads to increase in the amount of depreciation, maintenance expenditure and similar other items of overhead costs.
4. Less human efforts are necessary with automatic machines. A major portion of the cost is attributed to use of machines, thus increasing the machine overhead costs.
5. Increased efficiency and productivity of labour has the effect of pushing up the overhead to direct labour ratio.

Paragraph 6 of Cost Accounting Standard 3 (CAS – 3) issued by The Institute of Cost Accountants of India states that while assigning Production or Operation Overheads, traceability to a cost object in an economically feasible manner shall be the guiding principle. The cost which can be traced directly to a cost object shall be the guiding principle. The cost which can be traced directly to a cost object shall be directly assigned.

Assignment of Production or Operation overheads to the cost objects shall be based on either of the following two principles:

1. Cause and Effect – Cause is the process or operation or activity and effect is the incurrence of cost.
2. Benefits received – Production Overheads are to be apportioned to the various cost objects in proportion to the benefits received by them.

In case of facilities created on a standby or ready to serve basis, the cost shall be assigned on the basis of expected benefits instead of actual.

The variable production or operation overheads shall be absorbed to products or services based on actual production.The fixed production or operation overheads shall be absorbed based on the normal capacity.

Overhead Accounting

The ultimate aim of overhead accounting is to absorb them in the units produced by the firm. Absorption of overhead means charging each unit of a product with an equitable share of overhead expenses. 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. Collection, Classification and Codification of Overheads
2. Allocation, Apportionment and Reapportionment of Overheads
3. Absorption of Overheads.

As mentioned above, the ultimate concept of overhead accounting is ‘absorption’ in the units produced by the firm. 

This is extremely important as accurate absorption will help in arriving at accurate cost of production. Overheads are indirect costs and hence there are numerous difficulties in charging the overheads to the units produced.

Following is a pictorial representation of the various aspects of overhead accounting.

 

Collection, Classification, Apportionment and Allocation of Overheads

1. Collection and Codification of Overheads

Overheads collection is the process of recording each item of cost in the records maintained for the purpose of ascertainment of cost of each cost centre or unit. 

Documents	Overhead Costs	Nature
Stores Issue note, purchase voucher	Indirect Material	Consumables, Lubricants etc
Payroll sheets, time sheets	Indirect Labour	Wages, Salaries, Contribution to statutory benefits, Bonus, Incentives, Idle time
Cash Book	Indirect Material, Indirect Labour, Indirect Expenses	All types of costs
Subsidiary records – Journal	Indirect Material, Indirect Labour, Indirect Expenses	For provisions of costs that are not actually paid for
Other reports	Indirect Expenses	Depreciation, Scrap, Wastage, etc

For the purpose of overhead accounting, collection of overheads is very important. It is necessary to identify the indirect expenses and the above mentioned source documents are used for this. Proper collection of overhead expenses will help to understand accurately the total overhead expenses.

Codification of Overhead

It is always advisable to codify the overhead expenses. Codification helps in easy identification of different items of overheads. There are numerous items of overheads and a code number to each one will facilitate identification of these items easily. Codification can be done by allotting numerical codes or alphabetical codes or a combination of both. Whatever, system is followed, it should be remembered that the system is simple for understanding and easy to implement without any unnecessary complications.

Cost Centre Code	Name of the Department
1100	Turning Departmen
1200	Grinding Department
1300	Components manufacturing
1400	Assembly
2100	Maintenance
2200	Quality control
2300	Stores
3100	HR and Administration
3200	Accounts

All codes starting with ‘1’ are production departments, all codes starting with ‘2’ are factory related services and all codes starting with ‘3’ are general services. This codes helps in collection of costs on functional basis and also to identify an item of expense directly to a department or cost centre.

2. Classification

Classification is defined by CIMA as, ‘arrangement of items in logical groups having regard to their nature (subjective classification) or the purpose to be fulfilled (objective classification). In other words, classification is the process of arranging items into groups according to their degree of similarity. Accurate classification of all items is actually a prerequisite to any form of cost analysis and control system. Classification is made according to the following basis

Elementwise classification –

According to this classification, overheads are divided according to their elements. The classification is done as per the following details:

1. Indirect Material – Materials which cannot be identified with the given cost objective is called indirect materials. As per CAS – 3 indirect material cost is defined as ‘Materials, the cost of which cannot be directly attributed to a particular cost object’. For example, lubricant used in a machine is an indirect material, similarly thread used to stitch clothes is also indirect material. Small nuts and bolts are also examples of indirect materials.
2. Indirect Labour – As per CAS – 3, indirect employee cost is the employee cost, which cannot be directly attributed to a particular cost object. Wages and salaries paid to indirect workers, i.e., workers who are not directly engaged on the production are examples of indirect wages.
3. Indirect Expenses – As per CAS – 3, indirect expenses are expenses, which cannot be directly attributed to a particular cost object. Expenses such as rent and taxes, printing and stationery, power, insurance, electricity, marketing and selling expenses etc are the examples of indirect expenses.

3. Functional Classification

1. Factory (or Manufacturing or Production) Overhead
   As per CAS – 3, Indirect Cost involved in the production process or in rendering service. These overheads are the aggregate of indirect materials cost, indirect wages and indirect expenses associated with manufacturing activities. For example, factory power, works manager’s salary, factory insurance, depreciation of factory machinery and other fixed assets, etc. The expenses incurred for manufacturing cannot be directly identified with the units produced.
   Manufacturing is a separate function like administration, selling and distribution. The term manufacturing stands for activities, which begin with receipt of order and end with completion of finished product.Manufacturing overheads represents all manufacturing costs other than direct materials and direct labour. These costs cannot be identified specifically with or traced to cost object in an economically feasible way. Manufacturing overhead are indirect manufacturing costs. The term overhead is peculiar and therefore, there is a growing tendency to prefer the term indirect manufacturing cost to overhead.
   
   
2. Office and Administration Overhead
   Indirect expenses incurred for running the administration are known as Administrative Overheads. Paragraph 4.3 of CAS 11 defines Administrative Overheads as cost of all activities relating to general management and administration of an entity. This paragraph also states that Administrative overheads shall exclude production overheads, marketing overheads and finance cost. On the other, production overheads include administration cost relating to production, factory, works or manufacturing. As per the functional classification, administration overheads comprise of those indirect costs which are related to the general administrative function in the company. Such functions are related to policy formulation, directing the organisation and controlling the operations of the company. Administration overheads are incurred for the benefit of organisation as a whole. Controlling them is difficult for they do not vary with most of the variables viz production or sales. Examples of such overheads are, office salaries, printing and stationery, office telephone, office rent, electricity used in the office, salaries of administrative staff etc. The size as well as control over these overheads depends largely on decisions of management. Organisations at the development stage face the problem of controlling administrative overheads. Multiple location set up leads to duplication of many administrative overheads.
   
   Controlling Administrative Overheads
   Given the nature of these expenses, they cannot be controlled at the lower level of management. They can be better controlled by top management as they pertain to formulating policy and directing the organisation. The first step in the control mechanism is proper classification of expenses and departmentalization. The actual expenses are collected for each department and then compared with a bench mark. Deviations are analysed and causes for increase are mitigated by fixing responsibility on the departmental head.
   
   The control benchmarking can be done with respect to:
   
   
   1. Figures of the previous year: Expenses could be compared with the figures of previous year and increase or decrease are analysed. However, comparison with previous year may not help as the condition may have totally changed from one year to the other.
   2. Use of budgets: Budgets are estimates for the current year, and they take into account the changed conditions. They also built in the year’s complete plan which would factor all changes in the cost structure. It is advisable to compare budgeted overheads with actual for control purpose.
   3. Use of standard: Although very scientific, this method is difficult to operate. Administrative activities (being very subjective) cannot be standardized. On a certain level it can be applied e.g., the time taken to process a voucher by accountant can be standardized, or time taken for processing a payment could be standardized. 
      
      
3. Selling and Distribution Overhead
   Selling overheads are all the costs associated with creating or stimulating demand or of securing orders. Examples of such overheads are sales office expenses, advertisements, the sales manager’s salary, and travel expenses.
   
   While distribution overheads are all the expenses incurred from the time the product is finished in the factory until it is delivered to end consumers. Examples include warehouse rent, warehouse utility bills, maintenance for delivery vans, carriage on sales, and packing charges.
   
   Paragraph 4.9 of CAS 15 defines selling overheads as overheads are the expenses related to sale of products or services and include all indirect expenses incurred in selling the products or services. The para provides the following as example of selling overheads:
   
   a. Salaries of sales personnel
   b. Travelling expenses of sales personnel 
   c. Commission to sales agents
   d. Sales and brand promotion expenses including advertisement, publicity, 
   e. sponsorships, endorsements and similar other expenses
   f. Receivable Collection costs
   g. After sales service costs
   h. Warranty costs
   
   Paragraph 4.4 of CAS 15 defines distribution overheads as overheads, also known as distribution costs, are the costs incurred in handling a product or service from the time it is ready for despatch or delivery until it reaches the ultimate consumer including the units receiving the product or service in an inter-unit transfer. The para provides the following as example of distribution overheads.
   
   The cost of packing, repacking, labelling, etc. at an intermediate storage location will be part of distribution cost.
   For Example:
   
   a. Packing, repacking / labelling at an intermediate storage location
   b. Transportation cost
   c. Cost of warehousing (cover depots, godowns, storage yards, stock yards etc,)
   
   Collection and Absorption of Selling and Distribution Overheads
   While classifying the selling and distribution costs are properly bifurcated and coded accordingly. This could be done by having separate account codes for selling overheads such as: advertising, sale commission, travelling expense, communication, exhibition, market survey, free samples, credit and collection costs, bad debts, and distribution expenses such as: transportation vehicle related expenses, warehousing and storage at different places, depreciation. Depending upon the size of the organisation, there may be proper departmentalization of selling and distribution activities. The departments could be:
   
   1. Sales head office
   2. Sales regional office
   3. Depots
   4. Direct selling department
   5. Dealer’s management
   6. Credit and collection (commercial)
   
   The costs are collected through various source documents under the above heads and for the above departments. For absorption, the basis to be used will have practical difficulties, as one will have to look for a relationship between the expenses and the cost unit. Some expenses like sales commission,shipping costs, and direct selling expenses can be absorbed directly. The other expenses can be absorbed on the basis of either sales value, cost of goods sold, gross profit or number of units sold. Out of these the sales value method is the most commonly used.
   
   Control over Selling and Distribution Expense
   
   The selling and distribution expenses are related to sales and distribution activity which is externally focused. The extent of these expenses depends mainly on external factors like consumer profile, changing habits, technology improvements etc. Controlling these expenses does not mean capping them. It aims at increasing the effectiveness of these expenses e.g., getting maximum sales per rupee of selling and distribution expenses. For control purpose, a great care should be taken to ensure correct classification and collection of selling and distribution overheads. The collected expenses must be analysed to assess the effect of them on sales. Such analysis could be done as follows:
   
   a. Analysis of sales and selling and distribution expenses by geographical location – This could be regions, zones, domestic and international etc.
   b. Analysis by type of customers – This could be done as institutional, government, retail etc.
   c. Analysis by products or service – This may be done as range of products, the application of products, brands etc.
   d. Analysis by salesmen.
   e. Analysis by channel of distribution – The analysis pertains to wholesalers, retailers, commission agents etc.
   
   The analysis of sales, profits and selling and distribution expenses on the basis of above factors will be a good insight into the performance as well as control over expenses. All these three parameters may be compared with:
   
   a. Previous year
   b. Budget for the current year or
   c. Standards for the current year

a. Research and Development Cost

Research Cost is defined as the cost of searching for new or improved products, new applications of material, or new or improved methods, process, systems or services. In the modern days, firms spend heavily on research and development. Expenses incurred on research and development is known as Research and Development Overheads. Research may be of the following types:

1. Pure or basic research to gain general know how regarding the production or market, not directed towards any particular product.
2. Applied research which applies the basic knowledge in practice i.e., improvement of existing products, new process, exploring of new products, improved measures of safety, etc.

Development cost is the cost of the process which begins with the implementation of the decision to use scientific or technical knowledge to produce a new or improved product or to employ a new or improved method, process, system, etc. and ends with the commencement of formal production of that product by that method. Development starts where the research ends. Development cost is the expenditure incurred for putting the results of research on a practical commercial basis.

Special features of Research and Development Costs

The features are as follows:

1. Expenditure is incurred ahead of the actual production and may not be charged to current production.
2. The amount of expenditure may often be substantial.
3. The expenditure may at times be entirely infructuous, yielding no tangible results.
4. Benefits of the expenditure may be realised over a number of years.
5. Difficulty in fixation of standards for control

Collection of Research and Development Overheads

Accumulation of Research and Development Overheads is essential for the following reasons:

1. For review cost to date.
2. For planning the activities subsequent to research.
3. For evaluation of performance with relation to past performance or for inter-firm comparison.

The collection of research and development overheads is made though the following documents. Material requisitions, labour time cards, invoices, vouchers (royalty, patent, license etc). Research and development expenditure may be identified by its nature i.e., basic or applied research or development by the elements of cost, by business sector, by project. Each research and development project is allotted a project work order number. Separate series of work orders or codes should be used to distinguish from regular work orders.

Research and Development Costs can be accumulated as follows:

1. All expenditure under the direct elements (direct material, labour and expenses) must be charged to the work orders.
2. Expenses like supervisor salary, material handling charges, maintenance of equipments can be directly allocated to particular research work order.
3. Items of general overheads like depreciation of building, depreciation of maintenance equipment, share of purchase department expenses may be suitably apportioned to the research work order.

Accounting of Research and Development Overheads

Accounting of Research and Development Cost arise due to the following causes:

1. The expenditure is in the nature of pre-production costs and there is a considerable time lag between the incidence and expenditure and realization of benefit.
2. There is no immediate production, or the production is so small that it becomes difficult to charge such cost to products.

It is because of these difficulties that the accounting of research and development costs has been a subject of some controversy. Three methods are available for charging research and development costs as:

1. Charging off to the current year profit and loss account.
2. Capitalization so that cost may be amortized on a long term basis.
3. Deferment and charge off to costs of the next two or three years – a short / medium term amortization.

Research and Development may be regarded as a function of production and the research and development costs may be charged to costs to be recovered through the general overhead rates. There are many arguments for and against charging the research and development costs in current revenue. The arguments in support of this method are as follows:

1. All research and development expenses may not result in new processes or saleable products.
2. Some of the research and development projects may result in failures.
3. These expenses may be incurred simply to maintain the present competitive position of the concern.
4. It is difficult to assess the period over which the know how or knowledge acquired may be spread over.
5. It may be more advantageous to recover a substantial portion of the cost immediately, as the life of the new products are uncertain.
6. f. In certain case, the effect of these research costs on future revenues may be doubtful.

The classification used for cost collection is mostly combination of elemental and functional. The behavioural classification cannot be used for booking of costs; it is used only for analysis and decision making 

Table 2.1: Elements of Cost

Functions	Elements of Cost
	Material	Labour	Expenses
Factory or Production or Manufacturing or Works Overheads	Nuts & bolts, consumables, lubricants, welding electrodes, cleaning materials, nails, threads, ropes etc	Salaries and wages to foremen, supervisors, inspectors, maintenance, labour, idle time	Factory lighting and heating, factory rent, power and electricity, factory insurance, depreciation on machinery, repairs
Administrative Overheads	Printing and Stationery, Office Supplies	Salary of office staff, managers, directors, and other administrative departments as IT, Audit, Credit, Taxation	General office rent, insurance, telephones, fax, travel, legal fees, depreciation on office assets
Selling Overheads	Price lists, catalogues, mailings, advertising material such as leaflets, danglers, samples, free gifts, exhibition material	Salaries of staff and managers, commission on sales, bonus on schemes	Sales office expenses, travelling, subscription to sales magazines, bad debts, rent and insurance of showrooms, cash discount, brokerage, market research
Distribution Overheads	Secondary packing, material items used in delivery vans	Salaries of delivery staff such as drivers, dispatch clerk, logistic manager	Carriage outwards, forwarding expenses, rent and insurance of warehouses and depots, insurance, running expenses and depreciation of delivery vans

iii. Classification based on behaviour

Overheads may be classified on the basis of relation with the volume of production. Behaviour wise overheads may be classified as Fixed, Variable and Semi-Variable.

1. Fixed Overheads / Period Costs The amount of overhead tends to remain fixed for all volumes of production within a certain range. Examples of fixed overheads are depreciation of plant and machinery, insurance, rent of buildings etc. A 
   fixed overhead represents constant expenditure incurred during a period without regarding to the volume of production during that period. Even when production completely ceases in a particular period, this constant amount of expenditure will continue to be incurred partially, if not wholly. Therefore, the fixed overheads are also known as period costs. Sometimes these costs are also termed as shutdown or stand by costs.
   
   Features of Fixed Costs 
   Fixed costs are stated to be by and large uncontrollable, in the sense they are not influenced by the action of a specified member of an undertaking. For example, the supervisor has practically no control over the fixed costs like depreciation of plant and machinery. The production supervisor can only see that the maximum possible utilization of the assets is made. 
   
   The fixed overhead amount is constant per period, the cost per unit of production varies with the volume. This variation is inverse since with increase in production, fixed cost per unit decreases as the same amount of fixed overheads is spread over larger units of production.
   
   Factors affecting the Fixed Overheads
   When a plant or a department is completely idle and there is no production, several items of fixed overheads disappear. Fixed overheads are thus, of two types, viz. a lower standing fixed cost when production is nil and a higher running fixed cost when the plant is running. For instance, maintenance expenditure incurred at plant shutdown has to be increased to a higher level when production starts.
   
   Any long term change in the productive capacity of an undertaking also affects the basic characteristic of fixed overhead. Fixed costs are constant for short term period only, within a limited range of capacity.Another factor that affects the fixed nature of fixed overhead is the change in basic price level.
   
   Graphical representation of fixed costs is depicted as below: 
   
   
   
   Fixed costs may be broadly classified into three basic types:
   
   
   1. Fixed costs that have no causal relationship with the volume of output and are incurred mainly as results of policy decisions of the management. Research, development, design, employee training, advertisement and marketing expenses are examples of this expenditure. Accountants term such costs as discretionary fixed costs (also known as programmed costs or managed costs).
   2. Fixed costs that do not change significantly in the short term such as depreciation, rent etc.
   3. Fixed costs that are fixed for short period for a particular capacity, but change considerably when there is a long term change in the volume or capacity.
      
      
2. Variable Overheads
   Variable Costs are those which vary totally in direct proportion to the volume of output. These costs remain relatively constant with changes in production. Thus, variable costs fluctuate in total amount but tend to remain constant per unit as production activity changes. Examples are material, labour, lubricants, cost of utilities, fuel cost, commission to salesman etc.
   
   The variable overhead costs seldom reveal the characteristics of perfect variability i.e., an expenditure which varies directly with variation in the volume of output. They simply tend to vary rather than vary directly in direct proportion of output. We come across three types of variable overhead expenses in actual practice as explained below:
   
   i. 100% variable expenses. For all production the variable expenditure per unit remains constant
   ii. The expense per unit of production is low at lower ranges of output but gradually increases as production goes up.
   Iii. The expenses per unit of production are more at lower ranges of output but gradually decrease with the decrease with the increase in production.
   
   Graphical representation of variable cost is depicted as below:
   
   
   
   
3. Semi – Variable Overheads
   These are a sort of mixed or hybrid costs, partly fixed and partly variable costs. For example, telephone expenses, include a fixed portion of annual charge plus variable charge according to the calls. Thus, total telephone expenses are semi – variable.
   
   Semi – variable overheads are of two types:
   
   i. These expenses which change with the change in volume of output, but the variation cost is less than proportionate to change in output. Examples are power and fuel, lighting, repairs and maintenance of buildings etc.
   Ii. The costs tend to remain constant with certain range of output, then jump up and remain constant for another range and so on.

Semi-variable cost needs to be classified into fixed and variable due to the following reasons:

1. Effective Cost Control: Fixed costs are in the nature of policy costs or discretionary costs and as such can be controlled by the management. However, variable costs can be controlled at lower levels.Separation of two elements facilitates the fixation of responsibility, preparation of overhead budget and exercise effective control.
2. Decision Making: The classification is very useful in management decisions relating to utilization of capacity. If cost information is to be of use in such problems, it is essential that fixed and variable costs which behave differently with changes in volume should be segregated.
3. Preparation of Break Even Charts: Separation of fixed and variable cost is essential for the study of cost volume profit relationship and for the preparation of breakeven charts and profit charts.
4. Marginal Costing: The basic requirement of the technique of marginal costing is the separation of fixed and variable costs. While the latter are taken into consideration for the determination of marginal cost and contribution, the fixed costs are treated separately.
5. Method of Absorption Costing: Separate method may be adopted for determination of rates for fixed and variable costs for absorption in production. Further a separate fixed overhead rate also serves as a measure of utilization of the facilities of the undertaking; any under recovery or under absorption denotes the idle or surplus capacity or production efficiency.
6. Flexible Budget: In a flexible budget, the budgeted amounts vary with the levels of activity and fixed cost remains constant. It is the variable cost that varies. Breakup of overhead cost into fixed and variable is therefore necessary for establishment of budget and for the purpose of variance analysis.

Methods of classification of semi-variable cost into fixed and variable

1. Graphical Method – The costs at number of levels are plotted on a graph, x – axis represents the volume and y – axis represents the amount of expenditure. A straight line known as regression line or line of best fit is drawn between the points, plotted in such a manner that there are equal number of points on both the sides of a line and as far as practicable, pairs of points on either side are in equal distance from the line. Points falling far beyond the line are erratic and are not considered. If the regression line is drawn carefully so that most of the plotted points are on the line or not far from it, the scatter chart provides a fairly accurate method for the separation of fixed and variable.

1. Simultaneous Equations – This uses the straight line equation of y = mx + c where y represents total cost, m is variable cost per unit, x is the level of output and c is fixed cost. The total costs at two different volumes are put into these equations which are solved for the values of m and c.
2. High and Low Method – The highest and lowest levels of output and costs are taken and the differential is found. This difference arises only due to variable costs. The remaining portion will be fixed costs. Under this method the variable cost per unit will be computed first and then the fixed cost will be derived. Variable cost per unit is computed by dividing the difference in cost at highest level and lowest level with the difference in volume between highest and lowest level.
3. Least Square Method – This statistical tool uses straight line equation and finds the line of best fit to solve the equations. Also known as simple regression method. Under this method first the mean of volume and mean of costs are computed. The deviations in volume (x) from the mean and deviation in cost (y) from mean are computed. 

iv. Control-wise Classification

Overhead costs which can be controlled by the exercise of proper wisdom and expertise of management are controllable and overhead costs that cannot be controlled in spite of the best exercise of managerial prudence are uncontrollable costs.

This distinction may not be absolute or unconditional. A cost which is uncontrollable to one management may be controllable by the other. Some cost may be uncontrollable in short run become controllable in long run.

3. Allocation, Apportionment and Reapportionment of Overheads

After the collection, codification and classification of overheads, the next step is allocation and apportionment of overheads to the units produced. The following steps are required to complete this process.

A. Departmentalization

Before the allocation and apportionment process starts, the first step in this direction is ‘Departmentalization’ of overhead expenses. Departmentalization means creating departments in the firm so that the overhead expenses can be conveniently allocated or apportioned to these departments. For efficient working and to facilitate the process of allocation, apportionment and reapportionment process, an organisation is divided into number of departments like, machining, personnel, fabrication, assembling, maintenance, power, tool room, stores, accounts, costing etc and the overheads are collected, allocated or apportioned to these departments. This process is known as ‘departmentalization’ of overheads which will help in ascertainment of cost of each department and control of expenses

B. Allocation and Apportionment

Allocation of overhead means charging of overhead to a particular cost centre 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. For example, electricity charges can be allocated to various departments if separate meters are installed. Depreciation of machinery can be allocated to various departments as the machines can be identified, salary of stores clerk can be allocated to stores department, cost of coal used in boiler can be directly allocated to boiler house division. Thus, allocation is a direct process of identifying overheads to cost units or cost centres.

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. For example, the benefits of rent or electricity cannot be identified with any particular department. So, these overheads have to be apportioned. The basis for apportionment is normally predetermined and is decided after a careful study of relationships between the base and the other variables within the organisation. The Cost Accountant must ensure that the selected basis is the most logical. A lot of quantitative information has to be collected and constantly updated for the purpose of apportionment. The basis selected should be applied consistently to avoid vitiations. However, there should be a periodical review of the same to revise the basis if needed.

In simple words, distribution of various items of overheads in proportions to the departments or products on logical or equitable basis is called apportionment.

A general example of various bases that may be used for the purpose of apportionment is as follows:

Overhead item	Basis of Apportionment
Rent, Rates and Taxes	Floor Area Occupied
Repairs to Building	Value of Buildings / Floor Space
General Lighting	No. of light points in each department
Power	Horse Power of Machines
Telephones	No. of extensions in a department
Supervision	No. of employees
Material Handling	No. of material requisitions or value of material used

The above list is not exhaustive and depending upon peculiarities of the organisation, it could be extended. This allocation and / or apportionment is called as primary distribution of overheads.

Distinction between Allocation and Apportionment

Although the purpose of both allocation and apportionment is identical, i.e., to identify or allot the costs to the cost centres or cost unit, both are not the same.

Allocation deals with the whole items of cost and apportionment deals with proportion of items of cost.

Allocation is direct process of departmentalization of overheads, where as apportionment needs a suitable basis for sub-division of the cost.

Whether a particular item of expense can be allocated or apportioned does not depends on the nature of expense, but depends on the relation with the cost centre or cost unit to which it is to be charged.

Principles of Apportionment of Overhead Cost

1. Services Rendered
   A production department which receives maximum services from service departments should be charged with the largest share of the overheads. Accordingly, the overheads of service departments are charged to the production departments.
2. Ability to Pay
   This method suggests that a large share of service department’s overhead costs should be assigned to those production departments whose product contributes the most to the income of the business firm. However, the practical difficulty in this method is that, it is difficult to decide the most paying department and hence difficult to operate.
3. Survey or Analysis Method
   This method is used where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable. For example, the postage cost could be apportioned on a survey of postage used during the year.
4. Efficiency Method
   The apportionment of overhead is made on the basis of production targets. If the target is exceeded, the unit cost reduces indicating a more than average efficiency. If the target is not achieved, the unit cost goes up, disclosing thereby, the inefficiency of the department.

Illustration 48

A factory has 3 production departments (P1, P2, P3) and 2 service departments (S1 and S2). The following overheads and other information are extracted from the books for the month of January 2022.

Expenses	Amount (₹)
Rent	6,000
Repair	3,600
Depreciation	2,700
Lighting	600
Supervision	9,000
Fire Insurance for stock	3,000
ESI contribution	900
Power	5,400

 

Expenses	P1	P2	P3	S1	S2
Area sq ft	400	300	270	150	80
No. of workers	54	48	36	24	18
Wages	18,000	15,000	12,000	9,000	6,000
Value of plant	72,000	54,000	48,000	6,000	-
Stock Value	45,000	27,000	18,000	-	-
Horse power of plant	600	400	300	150	50

Allocate or apportion the overheads among the various departments on suitable basis.

Solution:

The primary distribution of overheads is as follows:

Expenses	Total	Basis	P1	P2	P3	S1	S2
Rent	6,000	Area sq ft  40:30:27:15:8	2,000	1,500	1,350	750	400
Repair	3,600	Value of plant  12:9:8:1	1,440	1,080	960	120	-
Depreciation	2,700	Value of plant  12:9:8:1	1,080	810	720	90	-
Lighting	600	Area sq ft  40:30:27:15:8	200	150	135	75	40
Supervision	9,000	No. of workers  9:8:6:4:3	2,700	2,400	1,800	1,200	900
Fire Insurance for stock	3,000	Stock Value  5:3:2	1,500	900	600	-	-
ESI contribution	900	Wages  6:5:4:3:2	270	225	180	135	90
Power	5,400	Horse power of plant 12:8:6:3:1	2,160	1,440	1,080	540	180
Total	31,200		11,350	8,505	6,825	2,910	1,610

Secondary Distribution of Production Overheads

After the primary distribution the next step is to reapportion the service department costs over the production departments. This also needs to be done on some suitable basis, as there may not be a direct linkage between services and production activity. 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.

The basis of secondary distribution is dependent on:

1. The nature of service given e.g., it may be maintenance department or stores.
2. Measurement of service based on surveys or analysis.
3. General use indices

In the Illustration 48, the cost of S1 is ₹ 2,910 and that of S2 is ₹ 1,610 which will be apportioned on to the totals of P1, P2 and P3.

Some examples of basis of apportionment that can be used to distribute cost of different service departments:

Service department	Basis
Quality	No. of inspection done
Maintenance	No. of maintenance calls
	Material usage for maintenance
	Time spent on maintenance
Stores	Indirect material cost
	No. of issue slips
	Quantity of material issued for
	Value of stock handled
Canteen, Welfare	No. of workers
Internal Transport	No. of truck or trolleys used for
	Tonne miles consumed
Payroll office	No. of labour hours
Purchase office	No. of purchase orders
	Value of material purchased

This is not an exhaustive list and could differ from company to company. Many times, percentage estimation is also done for such distribution if the service cannot be measured on the basis of any of the above basis of apportionment.

Methods of Secondary Distribution

a. Direct Distribution Method

This method is based on the assumption that one service department does not give service to other service department/s. Thus, between service departments there is no reciprocal service exchange. Hence, under this method, service costs are directly loaded on to the production departments. This is simple, but the assumption may not be correct. It is incorrect to assume that canteen service is not available to other service departments like labour office or stores or maintenance department and thus, the method should not be used as far as possible. 

In the Illustration 48: The cost of S1 and S2 is apportioned as follows: 

Production Department
Service Department	P1	P2	P3
S1	40%	30%	30%
S2	5/10	3/10	2/10

Distribution of cost of service departments is as follows: 

Department	Total	Basis	P1	P2	P3
As per primary distribution	26,680	300	11,350	8,505	6,825
Distribution of S1	2,910	40:30:30	1,164	873	873
Distribution of S2	1,610	5:3:2	805	483	322
Total	31,200		13,319	9,861	8,020

b. Step Distribution Method or Non-reciprocal Method

This method is based on the assumption that one service department gives service to the other but does not receive service from other service department. In Illustration 48, it may be assumed that S1 may render services to S2 but not vice versa, i.e., S2 may not render service to S1. In such situation, cost of that service department will be distributed first which render services to maximum number of other service departments. After this, the cost of service department serving the next large number of departments is distributed. This process is continued till all service departments are over, because it is done in steps, it is called as Step Distribution Method.

Illustration 49

A manufacturing company has two production departments Fabrication and Assembly and 3 service departments as Stores, Time Office and Maintenance. The departmental overheads summary for the month of March 2022 is given below:

Fabrication	₹ 24,000
Assembly	₹ 16,000
Stores	₹ 5,000
Time office	₹ 4,000
Maintenance	₹ 3,000

Other information relating to the department was:

Pariculars	Production departments		Service departments
	Fabrication	Assembly	Stores	Time office	Maintenance
No. of employees	40	30	20	16	10
No. of stores requisition slips	24	20	-	-	6
Machine Hours	2,400	1,600	-	-	-

Apportion the costs of service departments to the production departments.

Solution:

The overheads of the service departments have to be allocated to the production departments. The sequence and the bases on which the service departments should be selected has to be determined first. The following logical bases are decided based on the additional information given:

Service Departments	Basis of allocation
Time Office	No. of employees
Store	No. of stores requisition slips
Maintenance	Machine Hours

Number of employees exist in all the departments. So, overhead of the time office department is allocated first. No. of stores requisition slips is used by three departments, hence overhead of the stores department is allocated next and machine hours is used by only production department. So, overhead of the maintenance department is allocated last.

Hence, the sequence of distribution of overheads will be time office, stores and maintenance.

Expenses	Total	Basis	Fabrication	Assembly	Stores	Time office	Maintenance
As per primary distribution	52,000	As given	24,000	16,000	4,000	5,000	3,000
Time Office	4,000	No. of Employees (4:3:2:1)	1,600	1,200	(4,000)	800	400
Store	5,800	No. of stores requisition slips(12:10:3)	2,784	2,320	-	(5,800)	696
Maintenance	4,096	Machine Hours(3:2)	2,458	1,638	-	-	(4,096)
Total			30,842	21,158	-	-	-

When the cost of Time Office is distributed first, the charge to stores department is ₹ 800. This makes the total cost of stores to be distributed as ₹ 5,800 (i.e., ₹ 5,000 + ₹ 800). Same is the logic for ₹ 4,096 i.e., the cost of Maintenance.

c. Reciprocal Service Method

This method takes cognizance of the fact that service departments may actually give as well as receive services from and to the other service departments on reciprocal basis. such inter-departmental exchange of service is given due weight in the distribution of the overheads. There are two methods used for distribution under this logic. One is reciprocal distribution method and the other simultaneous equation method. 

1. Repeated Distribution Method
   This is a continuous distribution of overhead costs over all departments. The decided ratios are used to distribute the costs of service departments to the production and other service departments. This is continued till the figures of service departments become ‘nil’ or ‘negligible’.

Illustration 50

The summary as per primary distribution is as follows:

Production departments A - ₹ 2,400; B - ₹ 2,100; C - ₹ 1,500

Service departments X - ₹ 700; Y - ₹ 900

Expenses of service departments are distributed in the ratios of:

X Department: A – 20%, B – 40%, C – 30% and Y – 10%

Y Department: A – 40%, B – 20%, C – 20% and X – 20%

Show the distribution of service costs among A, B and C under repeated distribution method.

Solution:

Pariculars	Production departments		Service departments
	A	B	C	X	Y
As per primary distribution	2,400	2,100	1,500	700	900
Service department X (2:4:3:1)	140	280	210	(700)	70
Service department Y (4:2:2:2)	388	194	194	194	(970)
Service department X (2:4:3:1)	38.8	77.6	58.2	(194)	19.4
Service department Y (4:2:2:2)	7.76	3.88	3.88	3.88	(19.4)
Service department X (2:4:3:1)	0.776	1.552	1.164	(3.88)	0.388
Total	2,975.336	2,657.032	1,967.244	-	0.388

Ignore the fraction of the undistributed amount of the Service Department Y.

ii. Simultaneous Equations Method

Under this method, simultaneous equations are formed using the service departments’ share with each other. Solving the two equations will give the total cost of service departments after loading the interdepartmental exchange of services. These costs are then distributed among production departments in the given ratio.

In Illustration 3, service department X gives 10% of its service to Y and receives 20% of Y’s service.

Let ‘x’ be the total expense of Department X and ‘y’ be the total expense of Department Y

So, x = 700 + 0.20y ------ equation (1)

and, y = 900 + 0.10x ------ equation (2)

putting y = 900 + 0.10x in equation (1)

=> x = 700 + 0.20 (900 + 0.10x)

=> x = 700 + 180 + 0.02x

=> 0.98 x = 880

=> x = 880/0.98 = 898

Now putting x = 898 in equation (2)

=> y = 900 + 0.10 × 898 = 900 + 90 = 990

⸫ total cost of S1 = ₹ 898 and of S2 = ₹ 990

Redistribution Statement 

	Department
	A	B	C	X	Y
primary distribution	2,400	2,100	1,500	700	900
primary distribution of X	180	359	269	(898)	90
primary distribution of Y	396	198	198	198	(990)
Total	2976	2657	1967	-	-

iii. Trial and Error Method

This method is to be followed when the question of distribution of costs of service cost centres which are interlocked among them arises. In the first stage, gross costs of services of service cost centres are determined. In the second stage cost of service centres are apportioned to production cost centres.

Limitations of Apportionment

Whichever method we may use, it still depends on a suitable basis used. The basis will always lead to approximations. If an approximate data is used for analysis, control and decision making, it may cause erroneous results. Thus, one has to be careful in relating the cost data to cost centre or cost unit. The natural relation of most of the indirect costs i.e., overheads is to a time period. In other words, as almost all overheads are period costs and hence an attempt to link it to cost unit will always be arbitrary. As such, the traditional methods of allocation and apportionment are often challenged by many in the industry. The techniques like marginal costing owe their origin to such limitations of Traditional Costing.

Capacity and Overhead Rate

Influence of activity level on overhead rate

In determination of overhead rate, a good deal depends upon the activity level, which is assumed. In other words, capacity consideration influence overhead rate. Overhead rate will be different at different capacity levels. Efficient utilization of capacity is desirable both for society and management. Following capacity concepts merit consideration for overhead rate determination: -

a. Theoretical or Maximum Plant Capacity

Maximum Capacity or the Ideal Capacity is the capacity for which plant is designed to operate. It is only Theoretical Capacity. It does not give allowance for waiting, delays and shut down. The capacity is significant for designing the plant mechanically. For cost considerations, this capacity is not important. Ideal capacity is never used to determine overhead rates for its disregard to even necessary interruptions in production process.

b. Practical Capacity

When this capacity is determined, allowance is given for unavoidable interruptions like time lost for repairs, inefficiencies, breakdown, delay in delivery of raw material and supplies, labour shortages and absence, sunday, holidays, vacation, inventory taking etc. Thus, practical capacity is the maximum theoretical capacity with minor unavoidable interruptions. These unavoidable interruptions are based mostly on internal influences and do not consider main external causes like lack of customers orders. The practical capacity is determined with reference to nature of industry and circumstances in which a particular factory is situated. Normal unavoidable interruptions account for 15% to 25% of the maximum capacity. The practical capacity, thus ranges between 75% and 85% of maximum capacity after giving allowance for normal unavoidable interruptions.

c. Normal Capacity

Idle capacity due to long term sales trend only is reduced from practical capacity to get normal capacity. Calculation of normal capacity of a plant presents considerable problems. Normal capacity is determined for the business as a whole. Then, it is broken down by plants and departments. For normal capacity determination, prime considerations are physical capacity and average capacity and average sales expectancy. It should be noted that average sales expectancy to be considered for this purpose takes into account a period enough to level out cyclical fluctuations.

The determination of normal capacity helps in:

1. The preparation of flexible budgets and computation of predetermined factory overhead rates.
2. The use of standard costing.
3. Estimating sales price etc.
4. Scheduling production.
5. Inventory valuation.
6. Determination of breakdown point.
7. Controlling costs.

Importance of determining normal capacity

The normal capacity considerations are important for:

1. Budget preparation.
2. Determination of overhead rate.
3. Determination of standard cost, and
4. Preparation of operation of operational plans.

For determining the normal capacity, machinery purchased for future use and outmoded machinery should be excluded for consideration.

d. Capacity based on Sales Expectancy

Capacity may be based on sales expectancy for the year. The distinction between normal capacity and capacity based on sales expectancy should be properly understood. While normal capacity considers the long term trend analysis of sales, which is based on sales of a cycle of years, the capacity based on sales expectancy is based on sales for the year only. When long term sales trends are determined, cycle of years long enough to even out cyclical fluctuations are considered. Capacity based on sales expectancy is influenced more by general economic conditions and forecast of industry than long term sales trends.

The main advantages of determining overhead rate based on sales expectancy are:

1. Overhead rate is linked with actual sales expectancy.
2. Overheads costs are adequately spread over the production and
3. Overhead rate determined for this purpose is very useful for making decisions like price fixation, etc.

e. Idle Capacity and Excess Capacity

Practical capacity is determined after allowance to unavoidable interruptions like time lost for repairs, inefficiencies, breakdown and labour shortages, etc. Even this practical capacity is not normally fully achieved. Same losses due to idleness of workers and plant facilities to occur even in most carefully administered companies. These losses are not taken into account for determining the practical capacity, because for the purpose of determining practical capacity only unavoidable interruptions are considered. Thus, the difference between practical capacity and normal capacity, i.e., the capacity based on long term sales expectancy is the idle capacity. However, if actual capacity happens to be different from capacity based on sales expectancy, the idle capacity will represent difference between practical capacity and actual capacity. Idle capacity is that part of practical capacity which is not utilized due to factors like temporary lack of orders, bottlenecks and machine breakdown etc. Idle capacity represents unused productive potential, which fails to be realized due to interruptions that are not unavoidable. Idle capacity is that part of practical capacity which is not utilized due to irregular interruptions.

Idle capacity is different from excess capacity. Idle capacity refers to temporary idleness of available resources due to irregular interruptions. Excess capacity results either from managerial decision to retain larger production capacity or from unbalanced equipment or machinery within departments. Excess capacity refers to that portion of practical capacity which is available, but no attempt is made for its utilization for strategic or other reasons. If the excess capacity results from purchase of assets not required, it will be a prudent policy for company to dispose of the assets which cause excess capacity. Alternatively, action should be taken for utilization of resources in the form of excess capacity. Excess capacity also results from imbalance or bottlenecks in certain departments. This situation can be remedied by attempting synchronization in the working departments, working overtime, running double shift and temporary off-loading to departments having spare capacity. While overhead rate includes cost of idle capacity, excess capacity is excluded from overhead rate consideration.

Idle time is distinguished from idle capacity and its cost is separated in the accounts. Idle time represents lost time of men and machines arising from lack of business or of material, a breakdown of equipment, faulty supervision or other similar causes whether avoidable or not. Idle capacity is the difference between practical capacity and actual capacity and represents the unused production potential.

Idle capacity costs are represented mostly by the fixed charges of owing and maintaining plant and equipment and of employing services, which are not used to their maximum potential.

The principal causes of idle capacity are:

A. Production Cause

These causes primarily result from poor organisation of operational plan. Following production causes often lead to idle capacity:

1. Repetitive machine adjustment
   1. Setup and change over
   2. Repairs and adjustment
2. Lack of materials and tools
   1. Internal
   2. external
3. Lack of supervision, inspection and instruction
4. Lack of power
   1. Internally produced
   2. Externally produced

B. Administrative Causes

Sometimes various administrative decisions taken at various level of management result in idle capacity. Major administrative causes that lead to idle capacity are:

1. Excess plant for anticipated expansion
2. Special machines prepared for particular jobs
3. Strike / Lockouts.

C. Economic Causes

Sometimes demand for the goods is seasonal as in wool, ice cream and furs and production cannot be evenly distributed. This is especially true, when there exists danger of deterioration of the product or where carrying charges for stock are too large. Thus, seasonal, cyclical and industrial causes also lead to idle capacity.

Various practices are followed in different companies for disposing of idle capacity cost. It is often agreed in principle that normal production losses should be absorbed in product costs. Abnormal losses should be treated as non-operating expenses in product costs. Abnormal losses should be treated as non-operating expenses by direct debit to Profit and Loss Account. Certain companies follow the practice of computing idle time costs on their leading products by use of statistical techniques. Cost Accountants should particularly analyse the reasons for idle plant and equipment not used during the period for non controllable causes. The review of practices of different companies reveals that idle capacity is a somewhat flexible concept. It iss an individual problem which should be considered after taking into account the special situations. For the growth and survival of the organisation, the management is keenly interested to know the idleness, its causes, its cost and its available remedies. Normally different companies follow a bit varying restricted accounting concept of idle capacity. In many cases unabsorbed fixed overhead represents losses due to managerial decisions and it becomes a subjective matter to refer it as idle capacity cost. Overhead rates of different capacity levels will be different due to influence of fixed overhead.

 

Absorption and Treatment of Over or Under Absorption of Overheads

Absorption of Overheads

Total cost of production department is calculated once the steps of primary and secondary distribution are carried out. The next step is to assign these totals to the individual units produced. A job or a product pass through all or many production departments before it is formed into a finished saleable product. It is necessary to know the cost of each department the product passes through. The absorption of overhead enables a Cost Accountant to recover the overhead cost spent on each unit of the product. Overhead absorption is also known as levy or recovery of overheads. How is this done? If a total of 1,200 tubes are turned and the overhead cost of turning department is ₹ 72,000 then the overhead absorption rate is ₹ 6 per tube.

Absorption means ‘recording of overheads in Cost Accounts on an estimated basis with the help of a predetermined overhead rate, which is computed at normal or average or maximum capacity’

In general, the formula for overhead absorption rate is = Amount of Overhead/Number of units of the base

Overhead Absorption Rates: For the purpose of absorption of overhead in costs of jobs, processes or products overhead rates related to suitable factors or bases to be determined. There are several methods in use for determining the overhead rates i.e. Actual or Pre-determined Overhead Rate, Blanket or Multiple Rates.

A. Actual Overhead Rate

Actual overhead rate is obtained by dividing the overhead expenses incurred during the accounting period by actual quantum on the base selected. Assuming that the rates are worked out on a monthly basis the formula is –

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

Absorption of overheads based on actual rates may not be adopted due to the following reasons:

1. Actual overhead rate can be computed only after the accounting period is over.
2. The incidence of some of the items of expenses like repairs, overhauling, etc is not uniformly spread over all the accounting periods.
3. Actual overhead rates do not provide any basis for cost control.

B. Pre-determined Overhead Rate

Predetermined rate is computed by dividing the budgeted overhead expenses for the accounting period by the budgeted base (quantity, hours etc)

Overhead Rate = Budgeted overhead expenses for the period/Budgeted Base for the period

Advantages of Pre-determined Overhead Rate

1. Enables prompt preparation of cost estimates, quotations and fixation of selling prices.
2. Cost data is available to management along with financial data.
3. In case of cost plus contracts prompt billing is possible through pre-determined recovery rates.
4. In concerns having budgetary control system, no extra clerical efforts are required in computing the predetermined overhead rate.

C. Blanket (single) Overhead Rate

A single overhead rate for the entire factory may be computed for the entire factory. So, this is known as factory wide or blanket overhead rate method.

Blanket Rate = Overhead Cost for the factory/Total Quantum of the base

Blanket Rate of overheads may be applied suitable in a small concern. Blanket Rates are easy to compute. The use of Blanket rate of overheads gives erroneous and misleading results, where several products passing through number of different departments. With blanket rate of overhead, satisfactory level of managerial control is not possible.

D. Multiple Rates

This method is most commonly used to determine the multiple overhead rates i.e., separate rate:

1. For each production department
2. For each service department
3. For each cost centre; and
4. For each product line.

The multiple rates are worked out as: 

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

The number of overhead rates a firm may compute would be fixed taking into consideration of two opposing factors viz clerical costs involved and the degree of accuracy level desired. 

Methods of Overhead Absorption:

A. Production Unit Method

The concept here is to average out the total overheads on total units produced. In a tube manufacturing unit, the total overheads are ₹ 72,000 and total tubes processed are 12,000. The overhead absorption rate is ₹ 6 per tube. If this rate is based on the budgeted costs and number of units, and if the factory now gets an order for 2,500 tube processing, the amount of production overheads to be charged to that order will be (2,500 × 6) ₹ 15,000.

B. Percentage of Direct Wages

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. If the overhead to be absorbed is ₹ 1,20,000 and the direct wages are estimated at ₹ 8,00,000, the predetermined rate will be calculated as ((₹1,20,000/₹8,00,000) * 100 )15%. If a job is received where direct wages are estimated at ₹ 9,000, then the production overheads to be absorbed will be 15% of ₹ 9,000 i.e., ₹ 1,350. This method is useful if the direct labour hours can be standardized and the labour rates do not fluctuate too much. However, this method ignores the contribution made by other resources like machinery. The method also ignores the fact that there may be different types or grades of workers and each may cost differently and also ignores the fact that most of the production overheads are time related.

C. Percentage of Direct Material Cost

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. It is useful if material grades and rates do not fluctuate too much. If production overhead to be absorbed is ₹ 2,000 and the material cost is expected to be ₹ 4,000, then the absorption rate will be (₹2,000/₹4,000)*100 )50%. Thus, for a job requiring direct material of ₹ 200, the production overheads to be absorbed will be ₹ 100 (i.e., 50% × ₹ 200). However, many overhead items bear no relationship with material cost, and also the fact of time dimension of overheads is not taken into account by this method.

D. Percentage of Prime Cost

This method combines the benefits of direct wages and direct material cost methods as we know prime cost means the sum total of direct material cost, direct labour cost and direct expenses. 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. If the prime cost is expected to be ₹ 50,000 and the production overheads are estimated at ₹ 2,250, then the absorption rate will be (₹2,250/₹50,000)*100) 4.5% of prime cost. If a job has a prime cost of ₹ 800, then overhead absorbed on that job will be (4.5% of ₹ 800) ₹ 36.

E. Direct Labour Hour

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. This method is superior to the earlier ones, because it takes cognizance of the time factor. If the direct labour hours for a month is 10,000 and the overheads to be absorbed are ₹ 5,000, then the absorption rate is (₹5,000/10,000 hrs) ₹ 0.50 per labour hour. If a job requires labour time of 250 hours, the production overheads to be loaded on the job will be (250 hrs × ₹ 0.50) ₹ 125. The data related to labour hours has to be properly collected or estimated. The labour hour rate may be calculated as a single rate or different for different group of workers.

F. Machine Hour Rate

In the days of mechanized production processes, the most relevant rate to be applied is the machine hour rate. This is the rate calculated by dividing the actual or budgeted overhead cost related to a machine or a group of machines by the appropriate number of machine hours. These hours could be actual hours or budgeted hours. When budgeted hours are used, they are taken at average capacity at which a factory normally operates. Full capacity hours cannot be taken as the factory may not operate at that level and then the absorption rate may be unnecessarily fixed at a lower level. 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. If a machine normally runs for 2,000 hours in a month and monthly overheads to be absorbed are ₹ 15,000, then the machine hour rate will be calculated as (₹15 000/2,000)₹ 7.50 per machine hour. If a job takes 75 hours on that machine, then (75 × ₹ 7.50) ₹ 562.50 will be the cost of using the machine for that job.

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 are 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. While calculating machine hour rate, the wages paid to machine operators may be added to the total costs. This is because these operators directly work on the machines and thus related to machine operation. At times a factory may have more than one similar machine simultaneously working. In such case, a group machine hour rate may be calculated.

Factors influencing the selection of Overhead Recovery rate

The particular method or methods selected for application in a company would depend upon the factors mentioned below. Selection of the most equitable method is of paramount importance since a method that is not suitable will distort costs and thus make them useless for control and decision making purpose.

Selection of overhead recovery rates depends on the following factors:

1. Nature of the product and process of manufacture
2. Nature of overhead expenses
3. Organisational set up of the undertaking into departments and or cost centres
4. Individual requirements with regard to the circumstances prevailing policy of the management
5. Accuracy vis-à-vis cost of operating the method. Some of the methods are comparatively more accurate and provide equitable bases for overhead absorption.

The main features of a satisfactory overhead rate are as follows:

1. Simple, easy to operate, practical and accurate
2. Economic in application
3. Fairly stable so that cost from period to period does not vary
4. Related to time factor as far as practical
5. Departmental rates are preferable to blanket rates
6. Area of activity selected for computation of the rate should be homogeneous cost unit
7. Base for the rate should lay stress on the main production element of the concern

Under-absorption and Over-absorption of Overhead

The amount of overhead absorbed in costs is the sum total of the overhead costs allotted to individual cost units by application of the overhead rate. When a predetermined rate worked out on the basis of anticipated or budgeted overhead and base is applied to the actual base, the amount absorbed may not be identical with the amount of overhead expenses incurred if either the actual base or the actual expenses or both deviate from the estimates or the budget.

If the amount absorbed is less than the amount incurred, which may due to actual expenses exceeding the estimate and / or the output or the hours worked being less than the estimate, the difference denotes under absorption.

On the other hand, if the amount absorbed is more than the expenditure incurred, which may be due to the expense being less than estimate and / or the output or hours worked being more than the estimates, this would indicate over-absorption, which goes to inflate the costs.

Under or over absorption of overhead may arise due to one or the other of the causes given below:

1. Error in estimating overhead expenses
2. Error in estimating the level of production, i.e., the base
3. Major unanticipated changes in the methods of production
4. Unforeseen changes in the production capacity
5. Seasonal fluctuations in the overhead expenses from period to period
6. Overhead rate may be applied to the normal capacity which may be less than the full operating capacity of the undertaking

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. It aims at splitting the total effect between the cost of sale (which is charged to current year’s profits) and stocks (which is carried forward to the next year). 

Illustration 51

Overhead incurred	₹ 1,50,000
Overhead recovered	₹ 1,00,000
Cost of sales	₹10,00,000
Finished goods	₹ 8,00,000
Work-in-progress	₹ 7,00,000

How the under / over-absorbed overhead will be treated?

Solution:

Overhead incurred	₹ 1,50,000
Overhead recovered	₹ 1,00,000
∴ Under-absorption	₹ 50,000

Supplementary Overhead rate is calculated and allocated to Cost of Sales, Finished Goods and Work in Progress.

Total of Cost of Sales, Finished Goods and Work in Progress = ₹ 25,00,000 (10,00,000 + 8,00,000 + 7,00,000)

Supplementary Overhead rate = ₹ 50,000/₹ 25,00,000 = ₹ 0.02

∴ Under absorbed overhead amount will be distributed as follows:

Cost of Sales = (₹ 10,00,000 × 0.02) = ₹ 20,000

Finished Goods = (₹ 8,00,000 × 0.02) = ₹ 16,000

Work in Progress = (₹ 7,00,000 × 0.02) = ₹ 14,000

 

Reporting of Overhead Costs

Presentation

1. Overheads shall be presented as separate cost heads like production, administration and marketing.
2. Element wise and behaviour wise details of the overheads shall be presented, if material.
3. Any under – absorption or over – absorption of overheads shall be presented in the reconciliation statement.

Disclosure

1. The basis of assignment of overheads to the cost objects.
2. Overheads incurred in foreign exchange.
3. Overheads relating to resources received from or supplied to related parties.
4. Any subsidy / grant / incentive or any amount of similar nature received / receivable reduced from overheads.
5. Credits / recoveries relating to the overheads.
6. Any abnormal cost not forming part of the overheads.
7. Any unabsorbed overheads.

Illustration 52

In an Engineering Factory, the following particulars have been extracted for the quarter ended 31st December, 2022. Compute the departmental overhead rate for each of the production departments, assuming that overheads are recovered as a percentage of direct wages.

Pariculars	Production departments		Service departments
	A	B	C	X	Y
Direct Wages ₹	30,000	45,000	60,000	15,000	30,000
Direct Material ₹	15,000	30,000	30,000	22,500	22,500
No. of workers	1,500	2,250	2,250	750	750
Electricity KWH	6,000	4,500	3,000	1,500	1,500
Assets Value	60,000	40,000	30,000	10,000	10,000
No. of Light points	10	16	4	6	4
Area Sq. Yards	150	250	50	50	50

The expenses for the period were: 

	Amount (₹)
Power	1,100
Lighting	200
Stores Overheads	800
Welfare of Staff	3,000
Depreciation	30,000
Repairs	6,000
General Overheads	12,000
Rent and Taxes	550

Solution:

Statement Showing Apportionment of Overheads

Expenses	Basis	Total	A	B	C	X	Y
Material	Actual	45,000	-	-	-	22,500	22,500
Wages	Actual	45,000	-	-	-	15,000	30,000
Power	KWH  (4:3:2:1:1)	1,100	400	300	200	100	100
Lighting	No. of Light Points  (5:8:2:3:2)	200	50	80	20	30	20
Stores Overhead	Direct Material  (2:4:4:3:3)	800	100	200	200	150	150
Welfare of Staf	No. of workers  (2:3:3:1:1)	3,000	600	900	900	300	300
Depreciation	Asset Value  (6:4:3:1:1)	30,000	12,000	8,000	6,000	2,000	2,000
Repairs	Asset Value  (6:4:3:1:1)	6,000	2,400	1,600	1,200	400	400
General Overheads	Direct Wages  (2:3:4:1:2)	12,000	2,000	3,000	4,000	1,000	2,000
Rent and Taxes	Area  (3:5:1:1:1)	550	150	250	50	50	50
Total		1,43,650	17,700	14,330	12,570	41,530	57,520
Cost of X	As given  (5:3:2)		20,765	12,459	8,306	(41,530)	-
Cost of Y	Direct Wages  (2:3:4)		12,782	19,173	25,565		(57,520)
Total Overheads of Production Department			51,247	45,962	46,441	-	-

Computation of Overhead Recovery Rate

Production Overhead	Overhead Amount	Wages	Overhead Recovery Rate
A	51,247	30,000	51,247/30,000 × 100 = 170.82%
B	45,962	45,000	45,962/45,000 × 100 = 102.14%
C	46,441	60,000	46,441/60,000 × 100 = 77.40%

Illustration 53

The Latest Enterprises Ltd has three production departments A, B and C two service departments D and E. The following figures are extracted from the records of the Company.

	Amount (₹)
Rent and Rates	5,000
General Lighting	600
Indirect Wages	1,500
Power	1,500
Depreciation on Machinery	10,000
Sundries	10,000

The following further details are available: 

	A	B	C	D	E
Floor Space (Sq. Mts)	2,000	2,500	3,000	2,000	500
Light Points	10	15	20	10	5
Direct Wages (₹)	3,000	2,000	3,000	1,500	500
H.P. of machines	60	30	50	10	-
Working hours	6,226	4,028	4,066	-	-
Value of Material (₹)	60,000	80,000	1,00,000	-	-
Value of Assets (₹)	1,20,000	1,60,000	2,00,000	10,000	10,000

The expenses of D and E are allocated as follows: 

	A	B	C	D	E
D	20%	30%	40%	-	10%
E	440%	20%	30%	10%	-

What is the factory cost of an article if its raw material cost is ₹ 50, labour cost ₹ 30 and it passes through Departments A, B and C, for 4, 5 and 3 hours respectively.

Solution:

Statement showing apportionment of overheads to departments

Particulars	Basis	Total	Production departments			Service departments
			A	B	C	X	Y
Wages	Actual	45,000	-	-	-	1,500	500
Rent and Rates	Floor Space  (4:5:6:4:1)	5,000	1,000	1,250	1,500	1,000	250
General Lightning	Lights points  (2:3:4:2:1)	600	100	150	200	100	50
Indirect Wages	Direct Wages  (6:4:6:3:1)	1,500	450	300	450	225	75
Power	H.P.  (6:3:5:1)	1,500	600	300	500	100	-
Depriciation on Machinery	Value of Assets  (12:16:20:1:1)	10,000	2,400	3,200	4,000	200	200
Sundries	Direct Wages  (6:4:6:3:1)	10,000	3,000	2,000	3,000	1,500	500
Total		30,600	7,550	7,200	9,650	4,625	1,575

Repeated Distribution Method

Particulars	Production departments			Service departments
	A	B	C	D	E
Total Overhead (As per primary distribution)	7,550	7,200	9,650	4,625	1,575
Cost of Service Department D (2:3:4:1)	925	1,388	1,850	(4,625)	462
Cost of Service Department E (4:2:3:1)	815	407	611	204	(2,037)
Cost of Service Department D (2:3:4:1)	41	61	82	(204)	20
Cost of Service Department E (4:2:3:1)	8	4	6	2	(20)
Cost of Service Department D (2:3:4:1)	-	2	-	(2)	-
Total Overhead of Production Department	9,339	9,062	12,199	-	-
Working Hours	6,226	4,028	4,066	-	-
Overhead Recovery Rate per hour	1.50	2.25	3.00	-	-

Computation of Factory Cost of the Article

Particulars	Amount (₹)
Material	50.00
Labour	30.00
Prime cost	80.00
Add: Overhead(Workibg hours * Rate per hour)
Department A = 4 hours × ₹ 1.50	6.00
Department B = 5 hours × ₹ 2.25	11.25
Department C = 3 hours × ₹ 3	9.00
Factory Cost	106.25

Simultaneous Equation Method

Let total cost of Service Department D be ‘d’

and total cost of Service Department E be ‘e’

or, d = 4,625 + 10/100 e

or, 100 d = 4,62,500 + 10 e

or, 100 d – 10 e = 4,62,500 ................................... equation (1)

and e = 1,575 + 10/100 d

or, 100 e = 1,57,500 + 10 d o

or, 10 e – d = 15,750 ............................................. equation (2)

Adding equation (1) and (2)

or, 100 d – 10 e + 10 e – d = 4,62,500 + 15,750

or, 99 d = 4,78,250

or, d = 4,78,250/99 = 4,831

Now, putting d = 4,831 in equation (2)

or, 10 e – 4,831 = 15,750

or, e = 20,581/10 = 2,058

Overhead Cost of Service Department D = ₹ 4,831

and Overhead Cost of Service Department E = ₹ 2,058

Particulars	Production departments			Service departments
	A	B	C	D	E
Total Overhead (As per primary distribution)	7,550	7,200	9,650	4,625	1,575
Cost of D ₹ 4,831 is distributed (2:3:4:1)	966	1,450	1,932	(4,831)	483
Cost of E ₹ 2,058 is distributed (4:2:3:1)	823	412	617	-	(2,058)
Total Overhead of Production Department	9,339	9,062	12,199	-	-
Working Hours	6,226	4,028	4,066	-	-
Overhead Recovery Rate per hour	1.50	2.25	3.00	-	-

Illustration 54

The following information relates to the activities of a production department of factory for a certain period.

	Amount (₹)
Material used	36,000
Direct Wages	30,000
Labour hours	12,000
Hours of Machinery-operation	20,000
Overhead Chargeable to the Dept	25,000

On one order carried out in the department during the period the relevant data were:-

Material used (₹)	6,000
Direct Wages (₹)	4,950
Labour hours worked	1,650 Hrs.
Machine Hours	1,200

Calculate the overheads chargeable to the job by four commonly used methods.

Solution:

The four commonly used methods of absorbing or recovering overheads are as follows:

1. % of overheads on material = (25,000 / 36,000) x 100 = 69.44%

2. % of overheads on direct wages = (25,000 / 30,000) x 100 = 83.33%

3. Overhead rate per labour hour = 25,000 / 12,000 = 2.083

4. Machine hour rate method = 25,000 / 20,000 = 1.25

The overheads chargeable to job under the above methods is as follows:

1. Material = 6,000 x 69.44% = 4,166.40

2. Wages = 4,950 x 83.33% = 4,125

3. Labour hour rate = 1650 x 2.083 = ₹ 3,437

4. Machine hour rate = 1,200 x 1.25 = ₹ 1,500

Illustration 55

In a machine department of a factory there are five identical machines. From the particulars given below; prepare the machine hour rate for one of the machines.

Space of the department	10,000 sq.mts.
Space occupied by the machine	2,000 sq.mts.
Cost of the machine (₹)	20,000
Scrap value of the machine (₹)	300
Estimated life of the machine	13 years
Depreciation charged at	7½ % p.a
Normal running of the machine	2,000 hours
Power consumed by the machine as shown by the meter	3,000 p.a

Estimated repairs and maintenance throughout the working life of the machine (₹) 5,200 Sundry supplies including oil, waste etc. charged direct to the machine amount to ₹ 600 p.a.

Other expenses of the department are :	Amount (₹)
Rent and Rates	9,000
Lighting (to be apportioned according to workers employed)	400
Supervision	1,250
Other charges	5,000

It is ascertained that the degree of supervision required by the machine is 2/5th and 3/5th being devoted to other machines.

There are 16 workers in the department of whom 4 attended to the machine and the remaining to the other machines.

Solution:

Computation of Machine Hour Rate

Particulars		Rate per hr.
Standing Charges	9000 x (2000 / 10000) = 1800
Rent & Rates	400 x (4 /16) = 100
Lighting	1250 x (2/5) = 500
Supervision	5000 x (1/5) = 1000
Other Charges
	= 3400
Standing charges per hour	3,400/ 2,000 =	1.70
Machine Expenses
Depreciation	(20000 x 7.5%) ÷ 2,000 = 0.750	2.75
Power	(3,000 / 2,000) = 1.500
Repairs & Maintenance	(5200 / 13) ÷ 2,000 = 0.200
Sundry Supplies	(600 / 2,000) = 0.300
Machine Hour Rate =		4.45

Illustration 56

From the following particulars given below compute Machine hour rate for a machine.

a. Cost ₹ 24,000

b. Scrap value ₹ 4,000

c. Estimated Working life 40,000 hours

d. Estimated cost of repairs and maintenance during the whole life ₹2,000

e. Standard charges of the shop for 4 weekly period ₹ 3,000

f. Working hours in 4 weekly period 100 hours

g. No.of machines in the shop each of which is liable for equal charge are 30 machines.

h. Power used per hour 4 units @ 10p. per unit.

Solution:

Computation of Machine Hour Rate 

Particulars		Rate per hr.
Standing Charges
Standing Charges	[3,000 / (100 x 30)	1.00
Machine Expenses
Depreciation	[(24,000 – 4,000) / 40,000]  = 0.50
Repairs	[2,000 / 40,000] = 0.05
Power	[4 x 0.1] = 0.40	0.95
Machine Hour Rate =		1.95

Illustration 57

The following particulars relate to a processing machine treating a typical material. You are required to calculate the machine hour rate.

The cost of the machine ₹ 10,000

Estimated life 10 years

Scrap value ₹1,000

Working time (50 weeks of 44 hrs. each) 2,200 hrs.

Machine maintenance per annum 200 hrs

Setting up time estimated @ 5% of total productive time

Electricity is 16 units per hour @ 10 paise per unit.

Chemicals required weekly ₹20

Maintenance cost per year ₹1,200

Two attendants control the operations of the machine together with 6 other machines, their combined weekly wages are ₹ 140. Departmental overhead allocated to this machine per annum ₹ 2,000.

Solution:

Annual Working hours: 50 weeks X 44 hrs.	2,200
Less : Maintenance time	200
Productive hours	2,000
Less : 5% Setting up time	100
Effective hours	1,900

Computation of Machine Hour Rate 

Particulars		Rate per hr.
Standing Charges
Chemical Solution	(50 x 20) = 1,000
Attendants wages	(140 x 50 x 1/7) = 1,000
Departmental overheads	= 2,000
	= 4,000
Rate per hour	4,000 / 2,200	1.82
Machine Expenses
Depreciation	[(10,000 – 1,000)/10]÷ 1900 = 0.47
Maintenance	(1,200 / 1,900) = 0.63
Power	(16 x 0.1) = 1.60	2.70
Machine Hour Rate =		4.52

Illustration 58

Your company uses a historical cost system and applies overheads on the basis of “Predetermined” rates. The following are the figures from the Trial Balance as at 30-9-2015:

	Dr. (₹)	Cr. (₹)
Manufacturing overheads	4,26,544	---
Manufacturing overheads-applied	---	3,65,904
Work-in-progress	1,41,480	---
Finished Goods Stock	2,30,732	---
Cost of Goods Sold	8,40,588	---

Give two methods for the disposal of the under absorbed overheads and show the profit implications of the method.

Solution:

	₹
Overheads incurred	= 4,26,544
Overheads absorbed	= 3,65,904
Under absorption	= 60,640

The following are the 3 methods for disposing off this under absorbed overheads:

1. Transferring to the costing P & L A/c under this method, the profit will decrease by ₹ 60,640

2. The amount may be disposed off by carrying forward to the next year. In this case, there will be no effect on profit.

3. Applying Supplementary Overhead Rate and further absorbing, which may be shown as follows

Under this method also, the profit will decrease by ₹ 60,640.

Supplementary OH Rate = [60,640 / 12,12,800] x 100

= 5%

		Suppl. OH (5%)	Total
Work in Progress	1,41,480	7,074	1,48,554
Finished Goods	2,30,732	11,537	2,42,269
Cost of goods sold	8,40,588	42,029	8,82,617
	12,12,800	60,640	12,73,440

Illustration 59

In a factory the expenses of factory are charged on a fixed percentage basis on wages and office overhead expenses are calculated on the basis of percentage of works cost.

	I Order (₹)	II Order (₹)
Material	12,500	18,000
Wages	10,000	14,000
Selling price	44,850	61,880
Percentage of profit on cost	15%	12%

Find the rate of Factory OH and Office OH.

Solution:

Let ‘X’ and ‘Y’ be the % of Works Overhead on wages and Office Overhead on works cost respectively.

Particulars	Order I	Order II
Material	12,500	18,000
Wages	10,000	14,000
Prime Cost	22,500	32,000
(+) Factory OH’s	(10,000 x X/100) = 100X	(14,000 x X/100) = 140X
Works Cost	22,500 + 100X	32,000 + 140X
(+) Office Overheads	XY + 225Y	1.4XY + 320Y
[(100 X + 22,500) x Y/100]
[(140 X + 32,000) x Y/100]
Total Cost	100X + XY + 225Y + 22,500	140X + 1.4XY + 320Y + 32,000
Cost	44,850 x (100/115) = 39,000	61,880 x (100/112) = 55,250

100X + XY + 225Y + 22,500 = 39,000

⇒ 100X + XY + 225Y = 16,500 → Equ. (1)

140X + 1.4XY + 320Y + 32,000 = 55,250

⇒ 140X + 1.4XY + 320Y = 23,250 → Equ. (2)

Equ. (1) x 1.4 ⇒ 140X + 1.4XY + 315Y = 23,100 

Equ. (2) ⇒ 140X + 1.4XY + 320Y = 23,250

 = 5Y = 150

Therefore, Y = 150/50 = 30

Substituting the value of Y in Equ. (1), we get X

100X + 30X + 225 x 30= 16,500 → Equ. (1)

130X + 6750 = 16,500

130X = 9,750

 X = 9,750/130 = 75

% of Factory OH on wages = 75%

% of Office OH on works cost = 30%

Illustration 60

Self-help Ltd. has gensets and produced its own power Data for power costs are as follows :-

	Production Depts.		Service Depts.
	A	B	X	Y
Horse Power Hours	10,000	20,000	12,000	8,000
Needed at capacity production used during the month of May	8,000	13,000	7,000	6,000

During the month of May costs for generating power amounted to ₹ 9,300, of this ₹ 2,500 was considered to be fixed. Dept x renders service to other Depts. in the ratio of 13:6:1, while Y renders service at A & B in the ratio of 31:3. Given that the direct labour hours in Depts. A and B are 1,650 hours and 2,175 hours respectively, find the power cost per labour hour in each of these two departments.

Solution:

Statement Showing apportionment of power cost and computation of cost per hour

Particulars	Basis	Total	A	B	X	Y
Fixed Cost	(5:10:6:4)	2,500	500	1,000	600	400
Variable Cost  (9,300 – 2,500)	(8:13:7:6)	6,800	1,600	2,600	1,400	1,200
		9,300	2,100	3,600	2,000	1,600
Costs of X [(as it renders to more depts. (3)]	(13:6:1)		1,300	600	(2,000)	100
			3,400	4,200	--	1,700
Costs of Y	(31:3)		1,550	150	--	(1,700)
			4,950	4,350	--	--
Labour Hours			1,650	2,175
Cost of power per labour hour			3	2

Illustration 61

At Ltd engineering Co. having 25 different types of automatic machines, furnishes you the following data for 2016-17 in respect of machine B:

1.

Cost of the machine	₹ 50,000
Life - 10 years	Scrap value is nil

2. Overhead expenses are:

Factory Rent	₹ 50,000 p.a.
Heating and Lighting	₹ 40,000
Supervision	₹ 1,50,000 p.a
Reserve equipment of machine B	₹ 5,000 p.a.
Area of the factory	80,000 sq.ft.
Area occupied by machine B	3,000 sq.ft.

3. Wages of operator is ₹24 per day of 8 hours including all fringe benefits. He attends to one machine when it is under set up and two machines while under operation.

4. Estimated production hours

Estimated set up time	3,600 p.a.
Power 0.5 per hour	400 hrs. p.a.

 Prepare a schedule of comprehensive machine hour rate and find the cost of the following jobs:

	JOB 1102	JOB 1308
Set up time (Hrs.)	80	40
Operation time (Hrs.)	130	160

Solution:

Computation of machine hour rate when machine is in operation

Particulars		Amount (₹)
Standing Charges:
Rent	50,000 x 3/80 = 1875
Heating & Lighting	40,000 x 3/80 = 1500
Supervision	1,50,000 x 1/25 = 6000
Reserve equipment	= 5000
	= 14375
Cost per hour	14375/4000	3.59
Machine Expenses:
Depreciation	[50,000 ÷ (10 x 3600)] = 1.39	3.39
Wages	[24/8 x 1/2] = 1.50
Power	= 0.50
Machine Hour Rate		6.98

Computation of machine hour rate when machine is under setup

Particulars		Amount (₹)
Standing Charges:
Rent	50,000 x 3/80 = 1875
Heating & Lighting	40,000 x 3/80 = 1500
Supervision	1,50,000 x 1/25 = 6000
Reserve equipment	= 5000
	= 14375
Cost per hour	14375/4000	3.59
Machine Expenses:
Depreciation	[50,000 x (10 x 3600)] = 1.39	4.39
Wages	[24/8] = 3.00
Power	= ----
Machine Hour Rate		7.98

Computation of cost of the jobs

Particulars	Job 1102	Job 1308
Setup cost
Job 1102 : 80 x 7.98	638.40
Job 1308 : 40 x 7.98		319.20
Operation Cost
Job 1102 : 130 x 6.98	907.40
Job 1308 : 160 x 6.98		1,116.80
Total Cost of the Job	1,545.80	1,436.00

Illustration 62

Ganges Printing Co. has three operating departments:

1. Printing and Binding

2. Lithographing and

3. Engraving.

The company has a job order cost system using a single predetermined expense rate. The management has been made aware of the deficiencies of using such a rate and is now interested in departmentalising factory overhead. A study reveals that:

Department 1 has 3 similar machines representing a large investment and calling for high repairs and depreciation charges.

Department 2 has the workers perform similar tasks and are therefore paid the same hourly wage.

Department 3 however has several classes of workers, each group being paid the same hourly wage.

The estimated factory overhead and production data costs are as follows

	Printing & Binding	Lithographing	Engraving
Factory overhead (₹)	40,000	68,750	1,20,000
Direct labour hours	10,000	20,000	40,000
Direct labour cost (₹)	25,000	55,000	80,000
Machine hours	20,000	NIL	NIL

Required:

1) An analysis to advice the management regarding the types of rates to be used in these departments.

2) A computation of the rates recommenced.

Solution:

1. It is appropriate to use machine hour rate method of absorbing overheads in Dept 1 because there is large investment in machine and therefore they are predominant.

OH rate per machine hour = 40,000 / 20,000 = ₹ 2 per hour.

2. In Dept 2, it is better and appropriate to use labour hour rate of overheads because all the workers are paid at uniform wage rate.

OH rate per labour hour = 68,750 / 20,000 = ₹ 3.4375 per hour.

3. In Dept 3, it is better and appropriate to use overhead rate based on certain % of wages because workers are paid at different rates.

OH % on wages = (1,20,000 / 80,000) x 100 = 150%

Illustration 63

For a department the standard overhead rate is ₹2.50 per hour and the overhead allowances are as follows:

Activity Level (Hours)	Budget overhead Allowance (₹)
3,000	10,000
7,000	18,000
11,000	26,000

Calculate:

a) Fixed cost

b) The standard activity level on the basis of which the standard overhead rate has been worked out.

Solution:

(a) Fixed Cost

 

Variable Cost per hour = Difference in Total Overhead / difference in Activity level 

 =  [(26,000-10,000) / (11,000-3,000)]

  =  ₹ 2 per hour

 Fixed Cost =  10,000 – (3,000 x 2) = ₹ 4,000

(b) Standard activity level at which the rate has been determined

Standard activity level at which the rate has been determined

= Fixed Cost / Fixed OH per hour

= 4,000 / (2.5 – 2) = 8,000 hours

Illustration 64

(A) In a certain factory three products are made from different materials by similar process. For a typical period production costs are as under:

	Product A	Product B	Product C
Material used	1,600	2,000	800
Direct labour cost	1,200	1,000	400
Overhead (actual)	800	650	350

Overhead is charged to cost of each product at the rate of 25% on prime cost.

Do you see anything wrong in principle in this method of charging overheads? If so, suggest a preferable method.

(B) For a department the standard overhead rate is ₹2.50 per hour and the overhead allowances are as follows:

Activity Level (Hours)	Budget overhead Allowance (₹)
3,000	10,000
7,000	18,000
11,000	26,000

Calculate:

a) Fixed cost

b) The standard activity level on the basis of which the standard overhead rate has been worked out.

Solution:

(A) Since, different materials are used for producing products, it is advisable, preferable and appropriate to use the method of absorbing overheads based on % of materials instead of % on prime cost which is shown as follows:

	A	B	C
Materials	1,600	2,000	800
Labour	1,200	1,000	400
Prime Cost	2,800	3,000	1,200
Actual Overhead Incurred	700	750	300
Overhead Recovery Rate is calculated based  on historical data. So, actual overhead is used  to calculate the future recovery rate	₹ 800/₹ 1,600 × 100= 50%	₹ 650/₹ 2,000 × 100= 32.50%	₹ 350/₹ 800× 100= 43.75%

Illustration 65

A company produced a simple product in three sizes A, B and C. Prepare a statement showing the selling and distribution expenses apportioned over these three sizes applying the appropriate basis for such apportionment in each case from the particulars indicated:

Express the total of the costs so apportioned to each size as:

a) Cost per unit sold (nearest paise)

b) A percentage of sales turnover (nearest to two places for decimal).

The Expenses are:

Expenses	Amount (₹)	Basis of apportionment
Sales salaries	10,000	Direct charge
Sales commission	6,000	Sales turnover
Sales office expenses	2,096	Number of orders
Advt. General	5,000	Sales turnover
Advt. specific	22,000	Direct charge
Packing	3,000	Total volume cu.ft. product sold
Delivery expenditure	4,000	--- do ---
Warehouse expenses	1,000	--- do ---
Expenses credit collection	1,296	Number of orders

Data available relating to the three sizes are as follows :

	TOTAL	SIZE A	SIZE B	SIZE C
1. No. of salesmen, all paid same salary	10	4	5	1
2. Units sold	10,400	3,400	4,000	3,000
3. No. of orders	1,600	700	800	100
4. % of specific advt.	100%	30%	40%	30%
5. Sales turnover	2,00,000	58,000	80,000	62,000
6. Volume of cu.ft. per unit of finished products	--	5	8	17

Solution:

Statement Showing apportionment of selling expenses over the sizes and computation of cost per unit and % on sales:

Amount (₹)

Particulars	Basis	Total	A	B	C
Sales Salaries	(4:5:1)	10,000	4,000	5,000	1,000
Sales Commission	(29:40:31)	6,000	1,740	2,400	1,860
Sales Office expenses	(7:8:1)	2,096	917	1,048	131
Advt. General	(29:40:31)	5,000	1,450	2,000	1,550
Advt. Specific	(3:4:3)	22,000	6,600	8,800	6,600
Packing	(17:32:51)	3,000	510	960	1,530
Delivery	(17:32:51)	4,000	680	1,280	2,040
Warehouse	(17:32:51)	1,000	170	320	510
Credit collection	(7:8:1)	1,296	567	648	81
		54,392	16,634	22,456	15,302

 

	Particulars	A	B	C
a)	Cost per unit sold	(16,634/3,400) x 100 = 4.89	(22,456/4,000) x 100 = 5.614	(15,302/3,000) x 100 = 5.10
b)	% on sales	(16,634/58,000) x 100 = 28.67%	(22,456/80,000) x 100 = 28.07	(15,302/62,000) x 100 = 24.68

Working :

	A	B	C
Volume of cu. ft. per unit of finished products	5	8	17
Units sold	3,400	4,000	3,000
Total volume of cu. ft.	17,000	32,000	51,000

Illustration 66

For a production department of a manufacturing company you are required to :

(a) Prepare a fixed budget of overhead;

(b) Prepare a flexible budget of overhead, at 70% and 110% of budget volume;

(c) Calculate a departmental hourly rate of overhead absorption as per (a) and (b) above.

The budgeted level of activity of the department is 5,000 hours per period and the study of the various items of expenditure reveals the following :

	Amount (₹)	₹ per hour
Indirect wages		0.40
Repairs - upto 2,000 hours	100
- for each additional 500 hours
- upto a total of 4,000 hours	35
- Additional from 4,001 to 5,000 hours	60
- Additional above 5,000 hours	70
Rent and Rates	350
Power - Upto 3,600 hours	0.25
- for hours above 3,600	0.20
Consumable supplies		0.24
Supervision - Upto 2,500 hours		400
- Additional for each extra 600 hours
- above 2,500 and upto 4,900 hours		100
- Additional above 4,900 hours		150
Depreciation - upto 5,000 hours		650
- above 5,000 hours and upto 6,500 hours	820
Cleaning - upto 4,000 hour	60
- above 4,000 hours	80
Heat and lighting - from 2,100 hours to 3,500 hours	120
- from 3,500 hours to 5,000 hours	150
- above 5,000 hours	175

Solution:

Fixed and Flexible Budget showing overhead cost per hour:

Amount (₹)

Particulars	(3,500) 70%	(5,000) 100%	(5,500) 110%
Indirect wages (0.4 / hrs.)	1,400	2,000	2,200
Repairs	205	300	370
Rent & Rates	350	350	350
Power	875	1,180	1,280
Consumable Supplies	840	1,200	1,320
Supervision	600	950	950
Depreciation	650	650	820
Cleaning	60	80	80
Heating & Lighting	120	150	175
	5,100	6,860	7,585
OH rate per hour	[5,100/3,500] = 1.457	[6,860/5,000] = 1.372	[7,545/5,500] = 1.372

1. If under absorbed OH is 10% or more of actual OH incurred – Supplementary OH rate is applied. 
  (or)
2. If the amount is considerable, supplementary OH rate applied otherwise we may follow, transferring to P & L A/c or carry forward to next year.

Working Notes:

Amount(₹)

Repairs	100 + (3x35) = 205	100 + (4x35) + 60 = 300	100 + (4x35) + 60 + 70 = 370
Power	(3500 x 0.25) = 875	(900 + 280) = 1,180	900 + 280 + 100 = 1,280
Supervision	400 + (2 x 100) = 600	400 + (4 x 100) + 150 = 950	400 + (4x100) + 150 = 950

Illustration 67

In a manufacturing unit, overhead was recovered at a predetermined rate of  ₹25 per man-day. The total factory overhead incurred and the man-days actually worked were ₹ 41,50,000 and 1,50,000 respectively.

Out of the 40,000 units produced during a period 30,000 units were sold. There were also 30,000 uncompleted units which may be reckoned at 66.67% complete.

On analysing the reasons, it was found that 40% of the unabsorbed overheads were due to defective planning and the rest were attributable to increase overhead costs.

How would unabsorbed overhead be treated in Cost Accounts?

Solution:

	Amount (₹)
Overheads incurred	= 41,50,000
Overheads absorbed (1,50,000 x 25)	= 37,50,000
Under absorption	= 4,00,000

The under absorption of ₹ 4,00,000 being considerable whether due to defective planning or due to increase in prices, would be disposed off by applying supplementary OH rate in the following manner:

Supplementory OH rate = [4,00,000/ (30,000 + 10,000 + (30,000 × 2/3))]

 = 4,00,000 / 60,000 = 20/3

To be absorbed on cost of goods sold = 30,000 x 20/3 = 2,00,000

To be absorbed on closing stock   = 10,000 x 20/3 = 66,667

To be absorbed on Work in progress   = 30,000 x 2/3 x 20/3 = 1,33,333

 = 4,00,000