University of Limpopo

School of Accountancy
Department of Financial Management

BACHELOR OF ACCOUNTANCY
(B ACC)
MANAGEMENT ACCOUNTING AND FINANCE
(MACN 350)
MODULE NOTES 2
OVERHEAD ALLOCATION

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BACKGROUND

Determination of a product cost is very important. For financial reporting purposes

(preparation of annual financial statements) it is used to value inventory (i.e Cost per unit x
Quantity), for management accounting purposes it used for decision making, determining
selling prices, planning etc. i.e Financial reporting is concerned with the manufacturing
cost of the product, whereas in management accounting we are concerned with contribution
that the product makes to the profit (Selling price – all costs) of the company. From time to
time management makes decision to either close down a branch, or discontinue a product
line, simply because it is not profitable.

On 31 January 2020, Wheels 24 published an article indicating that the Mercedes X-Class
bakkie production will come to an end, an extract of the article read “With the company
facing profit pressure going into 2020, after a sharp income drop in 2019, there is no margin
to support a failing product line”. Management of Mercedes will obviously not be able to
determine whether the X-Class bakkie is profitable or not, without knowing the total cost of
producing this bakkie. Remember both direct and indirect costs are included in the total cost
of a product. The direct costs are not a problem, because they are easy to trace to a specific
product. E.g Management will know the cost of seats fitted in one X-Class bakkie. However,
they may be unable to determine how much electricity was used on one X-Class bakkie, or
how much of the factory general manager’s salary is attributable to one X-Class bakkie,
without going through the overhead allocation process.

The purpose of this module is to address the allocation of such overheads (indirect costs) to
products. Two methods of allocating overheads are discussed, traditional methods (Plant-
wide or Departmental rates) and Activity based costing.

ASSUMED PRIOR KNOWLEDGE

Students in Managerial Accounting and Finance 350 are expected to have an understanding
absorption costing, cost classification and behaviour principles, as a foundation.

LEARNING OUTCOMES

By the end of this module you should be able to:

• Accumulate and allocate overheads numerically using various methods

• Allocate service costs using different approaches

• Understand background of traditional approach to overhead allocation and activity-

based costing

• Identify characteristics of an organisation where ABC will be of most use

• Perform ABC calculations and apply in costing of cost objects

• Discuss context of various uses of ABC and Discuss strengths and weaknesses of
ABC
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ALLOCATION OF OVERHEADS

Directly traceable to aAllocation

product needed ABC/Traditional

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METHODS OF ASSIGNING OVERHEADS

Traditional absorption costing

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SINGLE PLANT WIDE RATE ALLOCATION METHOD

With this method all overheads are added together and divided by one allocation base to
calculate a rate that will be used to allocate the overheads to products. Refer to example below

Working Example 1

The company manufactures 3 types of products, Product 1, Product 2 and Product 3. Total
overheads for the period amounted to R150 000. The overheads are allocated based on
number of units produced. The company produced equal number of units for all 3 products,
i.e 10 000 units for Product 1, 2 and 3

Required:

Allocate the overheads to each product

Suggested solution

Allocation rate: 150 000 / (10 000 x3) = R5 per unit produced

Product 1: R5 x 10 000 = R50 000

Product 2: R5 x 10 000 = R50 000

Product 3: R5 x 10 000 = R50 000

You will notice that this method assumes that all units produced consume the same amount
of overheads. Is this always accurate?

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Imagine a situation whereby Product 2 consumes 70% of the overheads alone. Do you
agree that this method of allocation will lead to understatement product cost for Product 2,
which will result in under pricing of this product. On the other hand, Product 1 and 3 will be
overpriced, because they were allocated more overheads than necessary. This will also lead
to wrong decisions by management, as profitable products might be incorrectly discontinued
etc.

In an effort to address the shortcomings of a plant wide rate, a department rate method was
formulated. Refer below

DEPARTMENTAL RATE ALLOCATION METHOD

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 Methods of re-allocating service/support departmental costs to
production departments

WORKING EXAMPLE 2

Dunstan Ltd manufactures tents and sleeping bags in three separate production
departments. The principal manufacturing processes consists of cutting material in the
pattern cutting room and sewing the material in either the tent or the sleeping bag
departments. For the year to 31 July cost centre expenses and other relevant information
are budgeted as follows:

Cutting Tents Sleeping Raw Canteen Maintenance Total

room (R) bags (R) Material (R) (R) (R)
(R) stores(R)
Indirect 6 400 19 500 20 100 41 200 15 000 45000 147 200
wages
Consumable 5 300 4 100 2 300 - 18 700 24 200 54 600
material
Plant 31 200 17 500 24 600 2 500 3 400 5 000 84 200
depreciation
Power ? ? ? ? ? ? 31 700
Heat and light ? ? ? ? ? ? 13 800
Rent and ? ? ? ? ? ? 14 400
rates
Building ? ? ? ? ? ? 13 500
insurance
Floor area 8 000 10 000 7 000 1 500 2 500 1 000 30 000
(sq. m)
Est. power 17 38 32 3 8 2 100
usage %
Direct labour 7 000 48 000 57 000 - - - 112 000
hours
Machine 87 000 2 000 40 000 45 000 - - 87 000
usage (hours)
Value of raw 62.5 12.5 12.5 - - 12.5 100
material
issues %

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Required

Prepare in a column form, a statement calculating the overhead absorption rates per
machine hour and per labour hour for each of the three production departments. Clearly
state your bases of apportionment.
(16 Marks)

SOLUTION

Overhead analysis sheet

Total Cutting
Production
Tents Bags Stores
Service
Canteen Maintenance
Stage 1
(£) (£) (£) (£) (£) (£) (£)
Indirect wages 147 200 6 400 19 500 20 100 41 200 15 000 45 000
Consumable materials 54 600 5 300 4 100 2 300 — 18 700 24 200

Plant depreciation 84 200 31 17 500 24 600 2 500 3 400 5 000

200
Powera 31 700 5 389 12 046 10 144 951 2 536 634
Heat and lightb 13
800
Rent and ratesb
Building insuranceb
14
400
13
11
120
13 900 9 730 2 085 3 475 1 390
Stage 2
359 59 67 046 66 874 46 736 43 111 76 224
Reapportionment: 400 409

Storesc – 29 5 842 5 842 (46 — 5 842

210 736)
Canteend – 2 694 18 476 21 941 (43 —
111)
Maintenancee – 1 887 37 731 42 448 (82
359 93 129 095 137 105 Allocation rate for
Machine hours 87 2 000 40 000 45 000 products
000
Labour hours 112 7 000 48 000 57 000
Machine hour rate £46.60 £3.23 £3.05
Overheads per labour hour £13.31 £2.69 £2.41

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 Bases of apportionment: a estimated power usage; b area; c value of issues; d direct labour hours; e
machine hours. Actual basis for other costs.

PLANT WIDE, DEPARTMENTAL AND ABC ALLOCATION METHODS

RANKED

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Remember allocation of overheads affects selling prices, if overheads
are not allocated accurately, products might be over/under price and fail

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to be profitable or measure up to the competition in the market

WORKING EXAMPLE 3 (ABC)

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IT Solutions (Pty) Ltd produces only two products, computer hard drives and cell phones.
The company uses a traditional costing system and overhead costs are currently
allocated using direct labour hours. An external cost consultant has recommended the
use of an activity based costing system (ABC). The company expects to produce 4 000
computer hard drives and 2 000 cell phones. Each computer part requires two direct
labour hours to produce and each cell phone requires one and half hours to produce.
Further information is provided below:

Directs costs:

Item Computer hard Cell-phone

drive

Direct material (per unit) R30 R17

Direct labour (per unit) R16 R4

Overheads for both products:

Activity Budgeted overhead

Production set up costs R80 000
Material handling costs R70 000
Packing and shipping costs R120 000
Total factory overheads R270 000

REQUIRED
a) Calculate the cost per unit for each product using the traditional costing [9]
system

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SOLUTION

a) The cost of each product using plant wide rate based on direct labour hours

Calculation of overhead rate:

Total budgeted DHL= 4 000 computers parts x 2 labour hours per part + 2 000 cell
phones x 1.5 labour hours per phone= 11 000√

OH Rate= Total Budgeted Overhead / Total Budgeted direct labour hours = R270 000/11
000= R24.54 per labour hour √p

Calculation of each product’s cost using a plant wide rate:

Cost item Computer parts Cell phones

Direct labour R30.00√ R17.00√
Direct Labour R16.00√ R4.00√
Manufacturing Overhead R49.08.00√p R36.81.81√p
Total unit R95.08.00√p R57.81.00√p

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*2 labour hours @ R24.54 per labour hour = R49.08 & **1.5 labour @ 24.54 per
labour hour = R36.81

b) . The Activity Cost Rates for (1) Setups, (2) Material Handling and (3) Packaging
and shipping:

(1) (2) (3)

Activity Budgeted Estimated volume Activity cost rates
overheads level
Production setups R80 000 20 setups R4 000 per setup
√p
Material handling R70 000 5 000 lbs R14 per lbs √p
Packaging & R120 000 6 000 boxes R20 per box √p
Shipping

c) Cost of the two products using and ABC system

Cost item 4 000 computer parts 2 000 cell

phones
Direct material 120 000 34 000
Direct labour 64 000 8 000
Manufacturing overheads
-Production setups 20 000√
5 setups @ R4 000 per setup= R20 000 60 000√
15 setups @ R4 000 per setup= R60 000
-Material Handling 14 000√
1 000 lbs @ R14 per lbs= R14 000
4 000 lbs @ R14 per lbs= R56 000 56 000√
-Packaging & shipping 80 000√
4 000 boxes @ R20 per box= R80 000
2 000 boxes @ R20 per box= R40 000 40 000√
Total manufacturing cost for all units R 298 000√p R198 000√p
Total units produced 4 000 parts √ 2 000 parts √
Total cost per unit R74.50 per part √p R99.00 per phone
√p

*R298 000/4 000 = R74.50 per part

*R198 000/2 000 = R99.00 per phone

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