Accounting for Overhead Cost

Accounting for Overhead Cost

Introduction to Overhead Costs

• Definition of Overhead Cost (CIMA Official Terminology): 'Expenditure on labour, materials or services that cannot be economically identified with a specific saleable cost unit.'

• Key Points of Overhead Costs:

  • Comprise the total of all indirect costs.

  • Costs that cannot be traced directly to a specific cost unit.

  • Considered 'shared' costs.

  • Examples: Rent, insurance, advertising, salaries, electricity, depreciation.

  • Represent a significant expense, typically amounting to between $30\%$ and $40\%$ of sales.

• Cost Units:

  • A quantitative unit of product or service for sales.

  • Examples: A meal served in a restaurant, a room night sold in a hotel, a drink served at a bar.

• Cost Centres:

  • A location, a person, or an item of equipment for which costs can be ascertained.

  • Hotel Example: Restaurant, Accommodation, Bar.

  • Aid in understanding where costs are being incurred.

Controlling Overhead Costs

• To effectively control overheads, management needs to know:

  1. Overhead cost per cost centre/department.

  2. Overhead cost per unit (% of sales).

Accounting for Overhead Allotment and Apportionment

• Overhead Allotment:

  • Occurs when an overhead cost can be identified with a particular cost centre.

  • The whole cost is directly assigned to that specific cost centre.

• Overhead Apportionment:

  • When an overhead cost cannot be identified with just one particular cost centre.

  • The cost must be divided and distributed to the various cost centres that it relates to, in a 'fair' proportion.

  • Each overhead type is examined, and a suitable basis for sharing out the cost is established.

• Illustration - Apportioning Rent Overhead:

  • Overhead cost for rent: $€1,000$.

  • Selected basis for apportionment: Floor space.

  • Total floor space: $500$ square metres.

    • Department A: $300$ square metres.

    • Department B: $200$ square metres.

  • Calculation:

    • Department A's share of rent: $€1,000 \times (300 / 500) = €600$

    • Department B's share of rent: $€1,000 \times (200 / 500) = €400$

Bases for Apportioning Overhead Costs

• Number of employees: Suitable for supervision, employee benefits, canteen costs.

• Floor space: Suitable for rent, rates, electricity.

• Book value of assets: Suitable for depreciation of assets, contents insurance.

• Value of material issues: Suitable for costs related to material movements, stores, and warehousing.

• Number of material requisitions: Also suitable for costs related to material movements, stores, and warehousing.

• Example 3.1: Fashion Retailing Ltd - Overhead Statement Preparation

  • Objective: To apportion overhead costs to four departments (Men's Clothing, Women's Clothing, Children's Clothing, Footwear).

  • Overheads Provided Directly: Indirect labour.

  • Overheads Requiring Apportionment and Their Bases:

    • Electricity: Floor Area

    • Rent and Rates: Floor Area

    • Personnel Costs: Number of Staff Members

    • Depreciation of Assets: Fixed Asset Value

    • Insurance of Assets: Fixed Asset Value

  • Calculation Breakdown (Proportionate Sharing):

    • Indirect Labour: Directly provided for each department.

      • Men's: $€16,750$; Women's: $€12,250$; Children's: $€12,050$; Footwear: $€7,450$; Total: $€48,500$

    • Electricity ($€50,000$ total) based on Floor Area (Total $3,000$ sq m):

      • Men's ($600$ sq m): $€50,000 \times (600 / 3,000) = €10,000$

      • Women's ($1,500$ sq m): $€50,000 \times (1,500 / 3,000) = €25,000$

      • Children's ($600$ sq m): $€50,000 \times (600 / 3,000) = €10,000$

      • Footwear ($300$ sq m): $€50,000 \times (300 / 3,000) = €5,000$

    • Rent and Rates ($€70,000$ total) based on Floor Area (Total $3,000$ sq m):

      • Men's: $€70,000 \times (600 / 3,000) = €14,000$

      • Women's: $€70,000 \times (1,500 / 3,000) = €35,000$

      • Children's: $€70,000 \times (600 / 3,000) = €14,000$

      • Footwear: $€70,000 \times (300 / 3,000) = €7,000$

    • Personnel Costs ($€35,000$ total) based on Number of Staff (Total $35$ staff):

      • Men's ($11$ staff): $€35,000 \times (11 / 35) = €11,000$

      • Women's ($9$ staff): $€35,000 \times (9 / 35) = €9,000$

      • Children's ($7$ staff): $€35,000 \times (7 / 35) = €7,000$

      • Footwear ($8$ staff): $€35,000 \times (8 / 35) = €8,000$

    • Depreciation of Assets ($€18,000$ total) based on Fixed Asset Value (Total $€6$m):

      • Men's ($€1.5$m): $€18,000 \times (1.5 / 6) = €4,500$

      • Women's ($€3.5$m): $€18,000 \times (3.5 / 6) = €10,500$

      • Children's ($€0.9$m): $€18,000 \times (0.9 / 6) = €2,700$

      • Footwear ($€0.1$m): $€18,000 \times (0.1 / 6) = €300$

    • Insurance of Assets ($€45,000$ total) based on Fixed Asset Value (Total $€6$m):

      • Men's: $€45,000 \times (1.5 / 6) = €11,250$

      • Women's: $€45,000 \times (3.5 / 6) = €26,250$

      • Children's: $€45,000 \times (0.9 / 6) = €6,750$

      • Footwear: $€45,000 \times (0.1 / 6) = €750$

  • Total Overhead per Department:

    • Men's Clothing: $€67,500$

    • Women's Clothing: $€118,000$

    • Children's Clothing: $€52,500$

    • Footwear: $€28,500$

    • Total Apportioned Overhead: $€266,500$

Absorption Costing

• Definition: A process for sharing out the overhead costs of each cost centre to each product or service provided by that cost centre.

• Nature: The traditional approach to charging overhead costs to cost units.

Steps in Absorption Costing

1. Apportion all overheads to cost centres: This involves the initial allocation and apportionment as discussed in Example 3.1.

2. Identify and re-apportion support/service cost centres' costs: Redistribute these costs to the cost centres directly involved in producing products or services.

3. Calculate the Overhead Absorption Rate (OAR): Determine an OAR for each production cost centre using the most appropriate base.

4. Use the OAR to establish the overhead cost per unit: Apply the calculated OAR to individual products or services.

Re-apportionment of Support or Service Centre Costs

• Purpose: Service departments (e.g., canteen, maintenance, administration) do not directly produce income-generating products/services.

• To determine the full cost of a saleable unit, these service department overheads must be absorbed into product/service unit costs. This requires apportioning their costs to production departments.

• Example 3.2: FunZone Limited - Re-apportioning Service Centre Costs

  • Cost Centres: Bowling, Snooker, Maze (Production); Admin, Maintenance (Service).

  • Initial Overhead Apportioned:

    • Bowling: $€362,000$; Snooker: $€187,000$; Maze: $€245,000$

    • Admin: $€96,000$; Maintenance: $€78,000$

    • Total: $€968,000$

  • Policy for Re-apportionment:

    • Maintenance: Using maintenance hours.

    • Administration: Using revenue earned.

  • Additional Information:

    • Maintenance Hours (Total $5,000$ hrs): Bowling: $2,600$ hrs; Snooker: $1,000$ hrs; Maze: $1,400$ hrs.

    • Revenue Earned (Total $€1,000,000$): Bowling: $€450,000$; Snooker: $€230,000$; Maze: $€320,000$.

  • Workings for Re-apportionment:

    • Re-apportion Administration Costs ($€96,000$) based on Revenue:

      • Bowling: $€96,000 \times (450,000 / 1,000,000) = €43,200$

      • Snooker: $€96,000 \times (230,000 / 1,000,000) = €22,080$

      • Maze: $€96,000 \times (320,000 / 1,000,000) = €30,720$

    • Re-apportion Maintenance Costs ($€78,000$) based on Maintenance Hours:

      • Bowling: $€78,000 \times (2,600 / 5,000) = €40,560$

      • Snooker: $€78,000 \times (1,000 / 5,000) = €15,600$

      • Maze: $€78,000 \times (1,400 / 5,000) = €21,840$

  • Final Total Overhead per Production Cost Centre After Re-apportionment:

    • Bowling: $€362,000 + €43,200 + €40,560 = €445,760$

    • Snooker: $€187,000 + €22,080 + €15,600 = €224,680$

    • Maze: $€245,000 + €30,720 + €21,840 = €297,560$

    • Admin: $€96,000 - €96,000 = €0$

    • Maintenance: $€78,000 - €78,000 = €0$

    • Total (remains $€968,000$): Validates re-apportionment.

Establishing an Overhead Absorption Rate (OAR)

• Purpose: To calculate the overhead cost of a product or service.

• Required Variables:

  1. The total overhead attributable to a cost centre (after allotment and re-apportionment).

  2. The absorption base (e.g., units, labour hours, machine hours).

• Formula: $OAR = \text{Total Overhead} / \text{Absorption Base}$

Different Absorption Bases

1. Number of units:

   • Suitability: Only if all products/services are similar in terms of overhead consumption.

   • Example: Total overhead $€100,000$, units produced $10,000$.

     • OAR: $€100,000 / 10,000 \text{ units} = €10 \text{ per unit}$.

2. Direct machine (operating) hours:

   • Suitability: More appropriate if there is significant difference in machine time for various products/services.

   • Example: Total overhead $€100,000$, total machine hours $33,333$.

     • OAR: $€100,000 / 33,333 \text{ hours} \approx €3 \text{ per machine hour}$.

     • Unit A (takes $4$ machine hours): OH cost $€3 \times 4 = €12$

     • Unit B (takes $2$ machine hours): OH cost $€3 \times 2 = €6$

3. Direct labour hours (DLH):

   • Suitability: Used in labour-intensive situations.

   • Example: Total overhead $€100,000$, total DLH's $25,000$.

     • OAR: $€100,000 / 25,000 \text{ hours} = €4 \text{ per DLH}$.

     • Unit X (takes $2$ DLH's): OH cost $€4 \times 2 = €8$

     • Unit Z (takes $3$ DLH's): OH cost $€4 \times 3 = €12$

4. Percentage direct labour cost:

   • Suitability: Used in labour-intensive situations if all direct workers are paid similar wage rates.

5. Percentage direct material cost:

   • Suitability: Used when direct material is a significant proportion of total cost and appears to drive the overhead cost.

6. Percentage prime cost:

   • Suitability: Used when both direct material and direct labour are significant components of cost.

The Absorption Process Flow

1. Apportion overhead cost to cost centres: Initial distribution of general overheads (e.g., electricity, insurance) to all identified cost centres (e.g., Retail Floor 1, Retail Floor 2, Retail Floor 3, Customer Services, Stores).

2. Re-apportion service centre costs: Costs from support centres (e.g., Customer Services, Stores) are re-distributed to production cost centres (e.g., Retail Floor 1, Retail Floor 2, Retail Floor 3).

3. Calculate overhead absorption rates (OARs): An OAR is determined for each production cost centre (e.g., OAR Retail 1, OAR Retail 2, OAR Retail 3).

4. Establish overhead cost per unit: The OARs are then applied to individual products or services to determine their share of overhead cost, contributing to the total unit cost.

Predetermined Overhead Absorption Rates (OARs)

• Purpose: To estimate the full cost of a product or service during the year, providing more accurate information for pricing decisions ahead of actual results.

• Basis: Predetermined OARs are based on budgeted/forecast figures for both overheads and activity levels.

• Calculation: Can be done prior to the accounting period.

• Example 3.5: City Guides Limited - Predetermined OAR Calculation

  • Budgeted overhead: $€100,000$

  • Budgeted direct labour hours (DLH - chosen absorption base): $20,000$

  • Predetermined OAR: $€100,000 / 20,000 \text{ labour hours} = €5 \text{ per labour hour}$.

  • Implication: Each client will be charged an additional $€5$ per labour hour for overhead, alongside direct costs.

Under- or Over-Absorption (Recovery) of Overheads

• Cause: Predetermined OARs are based on estimates; actual overheads and activity levels usually differ from forecasts.

• Necessity: In an absorption costing system where a predetermined rate is used, an adjustment is needed in the accounts at the end of the accounting year to reconcile actual costs with absorbed costs.

• Calculation:

  • Under- or Over-recovery = Actual overhead cost for the period - Overhead charged for the period.

  • Overhead charged = Actual hours or units $\times$ Predetermined rate.

• Example 3.6: City Guides Limited - Under-absorption Calculation

  • Predetermined OAR: $€5$ per direct labour hour.

  • Actual overhead incurred: $€106,500$

  • Actual direct labour hours: $21,000$

  • Overhead Absorbed: $21,000 \text{ hours} \times €5/\text{hour} = €105,000$

  • Under-absorbed Amount: $€106,500 \text{ (Actual)} - €105,000 \text{ (Absorbed)} = €1,500$

  • Interpretation: Both actual overhead and activity level were higher than estimates. The company incurred $€1,500$ more overhead than what was absorbed into production.

  • Adjustment: This $€1,500$ under-recovered amount should be charged in the profit statement, reducing the profit figure. Over-absorbed overhead would have the opposite effect (increasing profit).

Arguments For Absorption Costing

• Comprehensive Cost Recovery: Recognizes that selling prices must cover all costs incurred, ensuring all costs are included when setting prices.

• Enhanced Cost Awareness & Control: Requires apportionment of overheads to departments, fostering greater awareness of overheads and facilitating better cost control and management decisions.

• Compliance with IAS2: Production requires overheads, and IAS2 (International Accounting Standard 2: Inventories) mandates that inventory valuations include all costs incurred (including fixed overhead) to bring a product to its current condition and location. Absorption costing helps companies comply with these accounting regulations.

• Pricing Data: Provides essential data for calculating the total cost of a product or service, which is crucial for pricing decisions.

Arguments Against Absorption Costing

• Subjectivity in Apportionment: Choosing a basis to apportion overhead to departments can be subjective, potentially leading to misleading information for management decision-making.

• Subjectivity in OAR Calculation: The selection of an absorption base for the OAR is subjective. Different bases can produce different OARs and, consequently, different overhead costs per unit.

• Risk of Misleading Data: If the underlying apportionment and absorption data are misleading due to subjective choices, it can lead to poor pricing decisions.

Blanket or Single Overhead Absorption Rate

• Concept: A simplified approach where a single overhead absorption base is chosen for the entire organization, rather than separate rates for each department or cost centre.

• Characteristic: This single rate is intended to be most reflective of the organization's overall activity.

Advantages of the Blanket Approach

• Quicker to calculate: Simplifies the computation process.

• Avoids arbitrary apportionment: Eliminates the need for subjective apportionment of overheads between different departments.

Disadvantages of the Blanket Approach

• Ignores departmental differences: Fails to account for the differing nature of operations and activities in various departments.

• Inaccurate overhead incidence: Does not reflect that the incidence (burden) of overhead may vary significantly across departments.

• Fails to reflect product burden: A single rate cannot accurately capture the differing overhead burdens that distinct products place on facilities and resources.

• Difficult departmental control: Makes separate departmental control over overheads more challenging due to the aggregated nature of the rate.

Self-Study Activity (Recommendations from the Transcript)

• Read pages $41-46$. (Regarding Overhead Accounting Part 1)

• Study Example $3.1$.

• Attempt question $3.1$ & $3.2$.

• Attempt part (a) of the first $2$ questions (Grand Harbour Hotel and the Abyss Hotel) on document 'Section $3$ additional questions'. (Solutions are in the document).

• Review pages $48-54$. (Regarding Overhead Accounting Part 2)

• Study Example $3.4$ pages $54-57$.

• Attempt the following Questions: Question $3.3$ (note: equipment depreciation should read $€6,000$ on Page $74$), Question $3.5$ (a) and (b).

• Read pages $57-60$. (Regarding Overhead Accounting Part 3)

• Attempt question $3.7$.

• Solutions to questions are available at: www.blackhallpublishing.com/managementaccounting.htm