Chapter 19: Overhead Costs
Overhead Costs: indirect costs of production that cannot be specifically linked to an
individual product or activity
o However, in order to price products and services appropriately, they must be
accounted for and absorbed into part of the selling price.
Types of Overhead Costs:
o Fixed Costs
Costs that do not vary with the level of activity or production.
Examples: management salary, rent, interest on loans
o Semi-Fixed Costs
Costs that do not vary within certain ranges of levels of activity or
production
Examples: Supervisor salaries
o Variable Costs
Costs that are in direct proportion to the level of activity or production
Examples: direct materials and direct labour
o Semi-Variable Costs
Costs that have a fixed component and a variable component that increases
in proportion to level of activity or production
Examples: Electricity charges
Allocation of Overheads
o First we allocate all overheads that are directly attributable and specific to particular
departments or cost centres
Examples: Salary of a manager in one particular department; the rent of
building used only by one department, etc.
Apportionment of Overheads
o Then other overheads that cannot be directly attributed to any particular
department is apportioned amongst all departments using a reasonable basis
Example: Rent will be apportioned according to floor space; staff canteen
will be apportioned according to number of employees, etc.
o After all overheads have been apportioned to each department, service department
overheads will need to be reapportioned to production departments only
Production departments: involved in the manufacturing of products; Service
departments: only provide services to other departments
Three methods of reapportionment:
Direct apportionment
o Suitable when all service departments provide services only
to production departments
o Apportion service department overheads using reasonable
basis
o Example: Maintenance department overheads can be
reapportioned using cost of non-current asset in production
departments
Step-down method
o Suitable when
Some service departments serve only production
departments
Some service departments serve other service
departments as well
o First reapportion overheads of service departments that
serve other service departments using reasonable basis
o Then reapportion overheads of remaining service
departments that only serve production departments
o Example: first reapportion staff canteen overheads by
number of employees, then maintenance overheads by non-
current asset cost of production departments
Continuous allotment method
o Suitable when all service departments serve other service
departments as well
o Continuously reapportion service department overheads to
all other departments until the overheads become
immaterial
o Once immaterial, they are apportioned only to production
departments.
Absorption of Overheads
o After all overheads have been apportioned to all production departments, we need
to calculate the overhead absorption rate (OAR)
o The OAR allows us to incorporate overhead costs into products based on the level of
activity used in each production department
o OAR for a department = (budgeted overheads)/ (budgeted quantity of basis)
o The basis chosen for a department is based on the nature of the departments job
within the manufacturing process
o For example, if a production department uses a lot of labour then its overheads may
be best apportioned using labour hours
Over and Under absorption of overheads
o OAR is calculated using budgeted figures
o Actual figures can be significantly different for a variety of reasons
o This difference is called the over or underabsorption
o Over/Underabsorption = Actual overheads – Budgeted Overheads based on actual
activity levels
If positive -> underabsorption (the OAR was too low)
If negative -> overabsorption (the OAR was too high)
Budgeted Overheads based on actual activity levels
= OAR x actual quantity of basis consumed
o Explanations for:
Overabsorption
Activity level was higher than planned but the actual overheads did
not increase along with the increased activity
Underabsorption
Activity level was lower than planned but the actual overheads did
not decrease along with the decreased activity
For both:
Initial OAR may have used inaccurate figures or the basis chosen
may have been inappropriate.