Fundamental Cost Accounting

Faculty of Accountancy
Eveana Mosuin
UiTM Sabah
MAF151
 Learning Objectives
❑ Definition & classification of overhead
❑ Allocation & apportionment
❑ Reapportionment
❑ Absorption of production overheads
 Introduction
Overhead Costs
Overhead costs are costs that cannot be
identified directly with a particular
product.
 These costs cannot be charged directly to costs units, but must be
shared equitably between them through allocation and
apportionment of overheads to cost centers and absorbing them
into cost unit.
 One of the most important factors influencing the amount of
overheads costs – changes in volume.
Overhead costs = indirect costs.

 Consist of : i) Indirect materials

ii) indirect wages
iii) indirect expenses
Indirect Material Indirect
Indirect Wages
cost Expenses
• Material other • Wages other • Expenses
than direct than direct other than
material wages i.e. direct
• e.g. glue in who are not expenses
shoe making, directly • e.g. heat,
Nails in involved in light,
furniture trade production depreciation,
• e.g. rent, rates
supervisors, and
sweepers and insurance
maintenance
inspectors
 CLASSIFICATION OF OVERHEAD
4 MAIN GROUPS
Production overhead Administration Selling Overhead Distribution
▪ costs that overhead overhead
incurred in the ▪ costs that incurred ▪ Costs incurred ▪ Costs incurred
production for administrative for the purpose for the
department. activities at the of selling the distributing the
administration goods to the goods or product
department. market . to the market
(sending them to
the customer)
Examples: Examples: Examples: Examples:
•Factory rent & rates •Heating & lighting cost of •Rent & rates of the •Rent & rates of the
•Insurance on plant and administrative sales department warehouse
machinery department •Heating & lighting •Heating & lighting cost
•Cost of power •Rent & rates of costs of sales of the warehouse
•Maintenance of administrative department •Transport charges
machinery department •Advertising costs •Packing costs
•Depreciation of plant •Office salaries •Market research •Wages of the workers
and machinery •Audit fees •Travelling expenses at the warehouse
•Indirect factory wages •Stationary expenses •Salaries & commission •Insurance on the
& materials to sales representatives goods keep in the
etc warehouse
 Overview of Cost Allotment
• Overheads CANNOT BE charged DIRECTLY to
cost units.
• WHY?
• It is simply because overhead cost usually
shared by more than one department or cost
centre.
• Example, electricity. Can we easily determine
what is the exact cost of electricity to charge
to one product or cost centre?
 Overview of Cost Allotment
• The answer is NO, WE CAN’T.

• Compare with direct material, can we know

exactly how many kg of flour, for example, we
need to bake a cake?

• Also, can we know directly, how much we pay

a direct labour to produce, for example, 100
units of butter cup cakes?
 Overview of Cost Allotment
• Because of this reason, we need to find a
suitable basis so that overhead cost can be
charged or allotted to the cost centres or cost
unit on a fair basis.
• The term to use for the distribution of
overheads to cost centres or cost units is
called COST ALLOTMENT.
 COST ALLOTMENT
• Can be allocated if the following conditions are
met:
Cost Allocation • 1) If caused solely by a particular cost centre
(Direct • 2) If the exact amount of overhead is known
Allocation) • (No need to find the basis of apportionment as
overhead costs has been identified to specific cost
centre)

• Where cost cannot be directly allocated to a

particular cost centre, they must be apportioned to
the cost centres on a fair basis.
Cost
• The choice of a suitable basis is a matter of
Apportionment judgment and common sense.
• (Must find suitable basis of apportionment)
 COST ALLOTMENT

• The costs which are either directly allocated or

apportioned to production centres are usually
presented on an OVERHEAD ANALYSIS SHEET
(OAS)

• The purpose of OAS is to show the overhead

charged to each cost centre.
OVERHEAD ANALYSIS SHEET (OAS)
• In order to prepare OAS, we need to know:
1. The overhead costs to be allotted.
2. Whether overhead costs are directly
allocated or needs to be apportioned.
3. The suitable basis of apportionments for
each type of overhead costs
4. How to calculate the overhead cost charged
to each cost centre.
 Format of Overhead Analysis Sheet
Overhead Total Basis Production Production Service Dept
costs Amount Dept Dept

(RM) A B C
(RM) (RM) (RM)

Repairs & 500 Plant Value 175 150 175

Maintenance

Rent 1,180 Area 480 360 340

Supervision 800 No. of 240 240 320

Employees

Total 2,480 895 750 835

overheads
 OVERHEAD COSTS

Direct Allocation Apportionment

Production department Service Department

A B X Y

Re apportionment service dept costs

to production dept

Absorption
(OAR)

PRODUCTS
 Basis of apportionment
• What would be the suitable basis to apportion
the overhead cost to each cost centre?
• The choice of a suitable basis is a matter of
judgment and common sense.
• As a general guide the basis of apportionment
is as follows:
 Examples for basis of apportionments
Overhead Costs to which the basis applies Basis

Rent and rates, building maintenance, lighting, fire Area/space occupied/floor

prevention, security service, cleaning building. area( e.g. Square feet)

Supervision costs, canteen expenses, welfare expenses, Number of employees.

wages, any other employee related expenditure

Maintenance worker Value of machine serviced

Depreciation, insurance on plant Value of an asset/book value

of assets
Materials handling costs, materials storage costs Number of material
requisitions
Power (electricity) consumed Effective horse
power/Technical estimates/
KWH
Fire insurance on stock / storeroom Value of stock
 Re-apportionment of service OH to
Production dept.

• Once the costs have been allocated and

apportioned to the cost centres, i.e.
production and service cost centers, IT IS
NECESSARY to RE-APPORTION all the service
cost centre overhead costs to the production
cost centres.
 Re-apportionment of service OH to
Production dept.
• It must be remembered that only the
production departments or cost centres are
directly involved in the manufacturing of
products.

• Since the ultimate objective is to determine

the total unit cost, it is important to charge
overheads to the production cost centre.
 Methods of re-apportioning
• The service cost centre’s overheads are
apportioned to the production cost centres and
to other service centres which use its services.
• Method used is called continuous
distribution/repeated distribution method.
• Under this method, the service dept OH cost is
apportioned repeatedly until all the OH cost have
been re-apportioned to production cost centre.
 Basis of re-apportionment

• An important basis of apportioning service

department overhead to production
department is ‘ on the basis of relative
amounts of benefits actually obtained from a
service department’ or it will depend upon
the type of service provided.
Pre-determined Overhead Absorption
Rate (OAR)

What is OAR?
• Once the OH costs of service centres have
been re-apportioned to the production cost
centre, the overheads are now going to be
charged by the cost units passing through the
production cost centre.
Pre-determined Overhead Absorption
Rate (OAR)
• How it is being charged or absorbed to the
cost units is by using a suitable rate called
Overhead Absorption Rate.

• Since it is based on estimate, it is known as

Pre-determined Overhead Absorption Rate.
 Pre-determined Overhead Absorption
Rate (OAR)
• The formula to find OAR….

OAR = Estimated/budgeted OH for the dept

Estimated/budgeted units of base for the dept
Pre-determined Overhead Absorption
Rate (OAR)
• The units of base or absorption method could
be the following depending on suitability:
1) Direct Materials Cost Percentage
2) Direct Labour Cost Percentage
3) Prime Cost Percentage
4) Direct Labour Hour Rate
5) Machine Hour Rate
6) Cost Unit Rate
Note: Only one of these methods will be selected for each cost centre
Over or Under Absorption of Overhead
• Because of absorption rate is based on
estimates, there will be a difference between
the amount of overhead absorbed and the
actual overhead incurred at the end of the
costing period.

• The difference is called over or under

absorption of overheads.
Over or Under Absorption of Overhead
• Actual overhead > Overhead Absorbed
=Under Absorption of Overheads

• Actual overhead < Overhead absorbed =Over

Absorption of Overheads