Overheads

Determining the overhead cost per unit is a vital part of any costing exercise. This page looks at overheads and how firms derive a cost per unit.

Direct and indirect expenses

 Direct expenses are expenses that can be directly identified with a specific cost unit or cost centre. There are few examples of direct expenses but royalties paid to a designer or fees paid to a subcontractor for a specific job could be classed as direct expenses.

• Direct expenses are part of the prime cost of a product.

Indirect expenses cannot be directly identified with a specific cost unit or cost centre.

• For example, the cost of renting a factory where shirts are manufactured is classified as an indirect cost because it would be impossible to relate such costs to shirts only, if other clothes, such as dresses and suits were also made in the same factory.
• Indirect expenses are also known as overheads.

Production overhead absorption

Fixed production overheads

 Production overheads are the total of indirect production costs:

Fixed production overheads = indirect materials + indirect labour + indirect expenses

• Fixed production overheads of a factory will include the following costs:
  • heating the factory
  • lighting the factory
  • renting the factory.
• The total cost of a product also includes a share of the fixed production overheads.
• This is because organisations must recover their fixed production overheads and they do this by absorbing a fixed amount into each product that they make and sell. Absorption

costing

Production overheads are recovered by absorbing them into the cost of a product and this process is therefore called absorption costing.

• The main aim of absorption costing is to recover overheads in a way that fairly reflects the amount of time and effort that has gone into making a product or service.
• Absorption costing involves the following stages:
  • allocation and apportionment of overheads
  • reapportionment of service (non-production) cost centre overheads
  • absorption of overheads.

Absorption costing can be explored in more detail here.

Allocation and apportionment

Allocation and apportionment of overheads

The first stage of the absorption costing process involves the allocation and apportionment of overheads.

• Allocation involves charging overheads directly to specific departments (production and service).
• If overheads relate to more than one specific department, then they must be shared between these departments using a method known as apportionment.
• Overheads must be apportioned between different production and service departments on a fair basis.

Bases of apportionment

There are no hard and fast rules for which basis of apportionment to use except that whichever method is used to apportion overheads, it must be fair. Possible bases of apportionment include the following:

• floor area - for rent and rates overheads
• net book value (NBV) of fixed assets - for depreciation and insurance of machinery
• number of employees - for canteen costs.

Reapportionment of service cost centre costs to production cost centres

Reapportionment

Service cost centres (departments) are not directly involved in making products and therefore the fixed production overheads of service cost centres must be shared out between the production cost centres(departments) using a suitable basis.

Examples of service cost centres are as follows:

• stores
• canteen
• maintenance department
• payroll department.

Basic reapportionment

• The basic method of reapportionment is used when one service department works or provides a service for other service department as well as the production departments
• For example - the canteen feeds all the staff that work for the company in maintenance, finishing and assembly but the maintenance staff may not provide support for the canteen equipment.

Reciprocal reapportionment

Reciprocal reapportionment (or the repeated distribution method) is used where service cost centres (departments) do work for each other.

• It involves carrying out many reapportionments until all of the service departments' overheads have been reapportioned to the production departments.

Absorption of overheads

Bases of absorption

Once the overheads are allocated and apportioned into the production departments the overheads need to be related to or absorbed into the units of product.

• Overheads can also be absorbed into cost units using the following absorption bases:
  • units produced
  • machine-hour rate (when production is machine intensive)
  • labour-hour rate (when production is labour intensive)
  • percentage of prime cost
  • percentage of direct wages.
• Production overheads are usually calculated at the beginning of an accounting period in order to determine how much cost to assign a unit before calculating a selling price
• The overhead absorption rate (OAR) is calculated as follows:

• The absorption basis is most commonly units of a product, labour hours, or machine hours.

Departmental OARs

It is usual for a product to pass through more than one department during the production process. Each department will normally have a separate departmental OAR.

• For example, a machining department will probably use a machine-hour OAR.
• Similarly, a labour-intensive department will probably use a labour-hour OAR.
• An alternative to a departmental OAR is what is termed a blanket OAR.
• With blanket OARs, only one absorption rate is calculated for the entire factory regardless of the departments involved in production.
• Blanket OARs are also known as single factory-wide OARs.

Under- and over-absorption of overheads

Under- and over-absorption of overheads

If either or both of the estimates for the budgeted overheads or the budgeted level of activity are different from the actual results for the year then this will lead to one of the following:

• under-absorption (recovery) of overheads
• over-absorption (recovery) of overheads.

Calculating an under- or over-absorption

There is a three step procedure:

Step 1 - calculate the OAR (based on budget)

Step 2 - calculate the overhead absorbed by actual activity

Step 3 - Compare absorbed to actual

If at the end of this period, the overheads absorbed are greater than the actual overheads, then there has been an over-absorption of overheads.

If, on the other hand, the overheads absorbed are less than the actual overheads, then there has been an under-absorption of overheads

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