Chapter 05 Overhead Costs
- 1. CHAPTER 05: OVERHEAD COSTS CONDUCTED BY: P. Ayanthi Madumali
- 2. Intended Learning Outcomes • At the end of the chapter, you will able to 01.Understand the concept of ‘Overheads’. 02.Understand classification, allocation, apportionment and absorption of overheads. 03. Understand the Primary and Secondary Distribution of Overheads. 04. Understand the Traditional & Activity Based Costing methods 05. Identify the value added & non value added activity
- 3. Overhead Costs • According to CIMA, overhead costs are defined as, the total cost of indirect materials, indirect labor and indirect expenses • Examples of overhead expenses are rent, taxes, depreciation, maintenance, repairs, supervision, selling and distribution expenses, marketing expenses, factory lighting, printing stationery etc.
- 4. Types of Overheads Overhead Cost According to elements According to functional classification According to behavior Indirect material Indirect labour Indirect Expenses Manufacturing Administration Selling & Distribution Fixed Semi variable Variable
- 5. Steps in overhead accounting 01.Collection of Overheads 02. Allocation of Overheads 03. Apportionment of Overheads 04.Reapportionment of overheads 05.Absorption of Overheads.
- 6. 01. Collection of Overheads • Overheads collection is the process of recording each item of cost in the records for the purpose of ascertainment of cost of each cost center or unit. • The following are the source documents for collection of overheads. i. Stores Requisition ii. Wages Sheet iii. Cash Book iv. Purchase Orders and Invoices
- 7. 02.Allocation of overheads • Before the allocation and apportionment process starts, the first step 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 department. • Ex: Machining, personnel, assembling, maintenance, power, tool room, stores, accounts, costing
- 8. Allocation of overheads • Allocation is the process by which cost items are charged directly to a cost unit or cost center. • For example, electricity charges can be allocated to various departments if separate meters are installed & Salary of stores clerk can be allocated to stores department, cost of coal used in boiler can be directly allocated to boiler house division
- 9. 03.Apportionment of Overheads • Wherever possible, the overheads are to be allocated. However, if it is not possible to charge the overheads to a particular cost center or cost unit, they are to be apportioned to various departments on some suitable basis. • Electricity- light point , machine hour • Rent, repair of building- Floor space • Insurance & depreciation of machinery -Value of machinery • Power – horsepower • Employee insurance ,expenses & canteen expenses – No of Employee • A statement showing the apportionment of overheads is called as ‘Primary Distribution Summary’ of overheads. (see Q:01 , part “A” )
- 10. 04.Reapportionment of Overheads • The departments are broadly divided into Production Departments and Service Departments. • Reapportionment of Overheads means, the overheads of the service departments are reapportioned to the production departments • This process is called as preparation of ‘Secondary Distribution Summary’ of overheads
- 11. The methods of reapportionment are divided into two types. 01.Non Reciprocal Method 02. Reciprocal Method 01.Non Reciprocal Methods :- Under this method, the assumption is that while service departments render services to the production departments, they do not render services to each other ( see q.02)
- 12. • 02.Reciprocal Method :- Under this method, the assumption is that the service departments do render services to the production departments, they also render services to other service departments. • The following method are used under Reciprocal Methods i. Repeated Distribution Method ii. Simultaneous Equation Method
- 13. i. Repeated Distribution Method • Under this method, services rendered by services departments to the production departments and other services departments are quantified in the form of percentages. • The services departments costs are reapportioned to the production departments on the basis of these percentages. The process is repeated again and again till a negligible figure is reached (See Q: 01 Part B & Q :04)
- 14. ii. Simultaneous Equation Method • This is an algebraic method in which simultaneous equations are formed and amount of overhead expenses of each service department are found out, by solving the equations. • The total expenses thus obtained are then directly transferred to the production departments • ( See Q: 03 & Q:04)
- 15. 05.Absorption of Overheads. • Absorption means charging equitable share of overhead expenses to the products. • The absorption is to be made on some suitable basis. • The basis is the ‘absorption rate’ which is calculated by dividing the overhead expenses by the base selected. ( See Q: 05) • Overhead Absorption Rate = Overhead Expenses Units of the base selected.
- 16. The methods used for absorption are as follows. • Basis of production units • Basis of Direct labour hour • Basis of percentage of direct material • Basis of percentage of direct labour cost • Basis of Machine hour • Basis of percentage of primary cost
- 17. Value added activity An activity that increases the worth of a product or service such as, • Engineering design • Assembling • Painting • Packing • Production • R & D
- 18. Non Value added activity An activity that adds to or increases time spent on a product/service without increasing its market value such as, • Repair of machine • Storage of inventory • Building maintenance • Inspections • Moving materials
- 19. Traditional Costing Method • Typically used one rate to allocate overhead to products. This rate was often based on direct labour cost or direct labour hour. • Problems with Traditional costing system, manufacturing process and products are now more complex , this results in over costing or under costing - Complex products are not allocate an adequate amount of OH costs - Simple products get too much ( See q: 06)
- 20. Activity Based Costing (ABC) • An overhead cost allocation system that allocates overhead to multiple activity cost pools and assigns the activity cost pools to products or services by means of cost drivers that represent the activity used. ( See Q:06) • Steps of ABC, 1. Identify activities 2. Identify cost drivers 3. Compute overhead rate 4. Assign overhead costs
- 21. Benefits & Limits ofABC • Benefits: - ABC leads to more cost pools - ABC leads to enhanced control over overhead costs - ABC leads to better management decisions • Limits: - ABC can be expensive - Some arbitrary allocations continue
- 22. When to useABC 1. Products line are numerous, divers 2. Products differ greatly in volume & manufacturing complexity 3. OH costs constitute a significant portion of total costs Level of Activity under ABC method: Unit level Batch level Product level Facility level
- 23. Thank You….