LU4: Accounting for Overhead

LU4: Accounting for Overhead

Contents Introduction Applied manufacturing overheads Allocation of manufacturing overheads

Learning objectives Define overhead costs Distinguish between manufacturing and nonmanufacturing costs Explain why estimated overhead costs (rather than actual overhead costs) is used in the costing process Describe and implement the process of allocating overhead costs to products and services Compute predetermined overhead rates Explain why multiple overhead rates are needed in many organizations Compute applied overhead as well as the over- or under-applied overhead costs

Introduction CIMA defines an overhead as expenditure on labour, materials or services that cannot be economically identified with a specific saleable cost unit Also referred to as indirect costs and comprises indirect material, indirect labour and indirect expenses The indirect nature means that they need to be shared among the costs units as fairly and accurately as possible One of the main reason for absorbing overhead costs into the cost of the units is for inventory valuations purposes IAS 2

Introduction Overheads Manufacturing Nonmanufacturing Infrastructure Indirect labour Indirect materials Distribution Building Administration Equipment Selling Marketing costs

Applied overheads Work on estimates as actual costs takes too long to arrive We need to use information for: Inventory valuation Pricing decisions Profitability Product costs = DM + DL + Overheads DM and DL is easy to get Overheads includes telephone, electricity, water, indirect material, indirect labour, insurance, cleaning costs, maintenance, etc which only becomes known when invoices are received and it could take up to two months (E.g. COW)

Applied manufacturing overheads Overheads allocated to the production process and/or products manufactured during the manufacturing period according to a predetermined rate Predetermined rate Based on the budgeted overheads Use suitable base

Applied overheads (cont.) Formula BMO Allocation rate* = ------------------ suitable basis *Allocation rate also known as a Pre-determined Overhead Rate (PRO)

Applied overheads (cont.) Use a predetermined rate based on: Products i.e. Number of units produced/sold Labour hours Machine hours Primary costs Material costs Labour costs

Applied overheads The following information is applicable to the budget of a company that manufactured one product: Budgeted Material cost N$20 000 Budgeted Direct Labour costs N$30 000 Budgeted Manufacturing overheads - Fixed N$10 000 - Variable cost N$ 5 000 Budgeted labour hours 10 000 Budgeted machine hours 5 000 Budgeted material cost per unit N$10 Required: Calculate the overhead rates on the basis of the following: a) Production units (3 Marks) b) Labour hours (3 Marks) c) Machine hours (3 Marks)

a). Production unit basis = Budgeted manufacturing overheads Budgeted units manufactured = N$ 15 000 (N$20 000/ N$10) = N$15 000 2 000 = N$7, 50 per unit b) Labour hour basis = Budgeted manufacturing overheads Budgeted labour hours = N$15 000 10 000 = N$1, 50 per labour hour c) Machine hour basis = Budgeted manufacturing overheads Machine hours = N$15 000 5 000 = N$3 per machine hour

Over- or Under applied overheads (cont.) Represents the difference between the applied and actual overheads We have to reconcile back to actual cost Over applied = applied overheads > actual overheads Under applied = applied overheads < actual overheads

Example Use the same information as in the previous exercise and consider the Following additional information: Actual overheads N$15 500 Actual machine hrs 5 100 Calculate the amount over or under applied using machine hours as basis. Amount applied (5 100 x 3) N$15 300 Actual overheads N$15 500 Difference (N$ 200) Under applied

Allocation of overheads What if we have more than 1 departments Follow a 2 stage approach Primary allocation overheads are allocated to departments or cost centres Includes services departments (cleaning, canteen, maintenance, etc) which are not directly involved with the production process but provide support services for the production cost centres. Could be through cost allocation and apportionment Cost allocation: when we can identify the cost as specifically attributable to a particular cost centre Cost apportionment: when it is not possible to allocate a costs to a specific cost centre. Cost is than shared out over two or more cost centres according to the estimate benefit received.

Example JPS CC collected the following statistics in order to allocate their overheads among the various departments during the year ended 2016: Cost items Production A Production B Service C Value of equipment N$15 000 N$9 000 N$6 000 Number of employees 36 24 20 Floor space 400m² 300m² 200m² Material used N$40 000 N$30 000 N$5 000 Direct labour hours 1 300 700 905 Machine hours 450 305 195

Example (continued) The following amounts represent the budgeted overheads for 2016: N$ Depreciation on equipment 900 Rent of factory building 2 250 Electricity (Factory) 900 Protective clothing 800 Cafeteria 720 Insurance Building 450 Insurance machinery 750 Overhead allocation rates are based on labour hours, while the secondary apportionment of the service department takes place according to machine hours. Required: Calculate the overhead rates of each of the two production departments for 2016. [15 Marks]

Primary allocation Basis Total Production A Production B Service Rental Floor space 2 250 1 000 750 500 Depreciation Value of equipment 900 450 270 180 Electricity Floor space 900 400 300 200 Protective clothing Number of 800 360 240 200 employees Cafeteria Number of 720 324 216 180 employees Insurance: Buildings Floor space 450 200 150 100 Equipment Value of equipment 750 375 225 150 Secondary allocation 6 770 3 109 2 151 1 510 900 610 (1 510) 6 770 4 009 2 761 Application rates Labour hours 4 009 2 761 1 300 700 Application rates per labour hour R3,08 R3,94

Primary allocation Man overheads The following tabulation summarizes some commonly used allocation bases: Cost Rent Lighting and heating, property taxes, maintenance & Insurance on buildings Employee related: - Canteen, clothing, etc Depreciation & Insurance of Plant and Machinery Cost of inventory piling Basis of allocation Area No of employees Value of items of P & M Material usage

Re-allocation of service dept costs Support department Render essential services Do not deal directly with products Costs allocated to service departments must be reallocated to production departments using a secondary allocation

Secondary apportionment REMEMBER OUR GOAL: is to allocate overhead costs to the various products of the business Costs of service centres should be borne by production cost centres as they form part of the cost incurred in the production process This is also called Secondary apportionment Principle is normally to apportion the service centre with the highest overhead cost first, but READ EACH CASE STUDY for instructions

Secondary apportionment There are five ways: Repeated distribution Simultaneous equation Specified order of closing Direct allocation Mathematical models Cost of Service centres are allocated repeatedly in specified percentages until the remaining amount is too small An algebraic equation is formulated to solve the amount of overhead that should be allocated to production centres Management determines in which order service centres costs are closed off to production centres All costs related to service centres are directly allocated to production centres This is very complex, and is only mentioned for completeness sake

Example Lion Manufacturing has four departments two service departments and two production departments. The following information has been provided: Department % to be allocated from service department A % to be allocated from service department B Primary allocation Production A 50% 40% N$250 000 Production B 30% 30% N$220 000 Service Dept A - 30% N$40 000 Service Dept B 20% N$60 000 Required: Calculate the amount to be allocated to production departments A and B from the service departments using the following methods: Repeated distribution Simultaneous equation Specified order of closing, with service department A being closed off first Direct allocation method

Suggested solution: Repeated distribution Prod A Prod B Service A Service B Primary allocation 250,000.00 220,000.00 40,000.00 60,000.00 Allocate Service B Allocate Service A 24,000.00 29,000.00 18,000.00 17,400.00 18,000.00 (58,000.00) (60,000.00) 11,600.00 40% 50% 30% 30% 30% 20% Allocate Service B 4,640.00 3,480.00 3,480.00 (11,600.00) Allocate Service A 1,740.00 1,044.00 (3,480.00) 696.00 Allocate Service B 278.00 209.00 209.00 (696.00) Allocate Service A 105.00 62.00 (209.00) 42.00 Allocate Service B 17.00 13.00 12.00 (42.00) Final Allocation Service 8.00 4.00 (12.00) - A (50% / 80%) (30% / 80%) Total overheads 309,788.00 260,212.00

Suggested sol: Simultaneous equation Assume that: A = total overheads of service department A B = total overheads of service department B The total overheads that will be transferred from service departments A and B are therefore: A = 40 000 + (30% x B) B = 60 000 + (20% x A) Re-arrange the above equations, it will give us:

Suggested sol: Simultaneous equation A - 0,3B = 40 000 (1) -0,2A + B = 60 000 (2) We need to have either A or B the same in the two equations. Lets multiply equation (2) by 5 resulting in: - A + 5B = 300 000 (3) A 0,3B = 40 000 (1) (3) + (1) = 4,7B = 340 000 = B = 72 340 (rounded off 72 340,42553) Substituting B in equation (1) will give us: A 0,3(72 340) = 40 000 A = 40 000 + 21 702 = 61 702 Using this values, we will apportion as follows:

Suggested sol: Simultaneous equation Prod A Prod B Serve A Serve B Primary allocation 250 000 220 000 40 000 60 000 Allocate Serve A 30 851 (50%) Allocate Serve B 28 936 (40%) 18 511 (30%) 21 702 (30%) (61 702) 12 340 (20%) 21 702 (30%) 72 340 Total overheads 309 787 260 213 0 0

Suggested Sol: Specified order method Prod A Prod B Serve A Serve B Primary allocation 250 000 220 000 40 000 60 000 Allocate Serve A 20 000 (50%) Allocate Serve B 38 857 (68 000 x 40%/70%) 12 000 (30%) 29 143 (68 000 x 30%/70%) (40 000) 8 000 (20%) 68 000 (68 000) Total overheads 308 857 261 143 0 0

Suggested sol: Direct allocation method Prod A Prod B Serve A Serve B Primary allocation 250 000 220 000 40 000 60 000 Allocate Serve A 25 000 (40 000 x 50%/80%) Allocate Serve B 34 286 (60 000 x 40%/70%) 15 000 (40 000 x 30%/80%) 25 714 (60 000 x 30%/70%) (40 000) (60 000) Total overheads 309 286 260 714 0 0

EXAMPLE A company has three production departments (X, Y and Z) in its factory. After completion of all overhead allocation and apportionment, the production department budgets for Year 6 included the following: Department X Y Z Overhead costs N$51,240 N$ 87,120 N$ 66,816 Direct labour hours 11,520 Machine hours 4,200 5,280 A predetermined overhead absorption rate is established for each production department each year.

Example Cont. Actual data for Month 1 of Year 6 included: Department X Y Z Overhead costs N$4,410 N$7,190 N$5,610 Direct labour hours 985 Machine hours 340 426 Required: (a) Calculate, from the data provided, an appropriate predetermined overhead absorption rate for each production department for Year 6. (4 marks) (b) Calculate the amount of the over/under absorption of overhead in Month 1 in each production department and in total for the factory. (9 marks) (c) Suggest two general causes of overhead under absorption. (3 marks)

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