CHAPTER 4

OVERHEAD
P R E P A R E D B Y : A F A F I Z Z AT I N A F H A H B I N T I R A D Z I
 LEARNING OUTCOMES

• At the end of this topic, students should be able to :

• Define & classify overhead cost
• Allocate & apportion overhead costs to different cost centres.
• Re-apportion overhead costs of service cost centres to production cost
centres.
• Calculate absorption of overhead into product costs.
• Calculate over or under absorption of overhead.
 DEFINITION OF OVERHEAD COST
 Overhead is indirect cost and cannot be traced to the physical unit.
 Overhead, on the other hand, is a term which embraces indirect materials, indirect wages
and indirect expenses.

• Materials which are not traceable to the product being made.

• Ex: oil and grease used in operating and maintaining machine,
Indirect Material
glue in shoe-making, etc.

• They are wages paid to factory employees who are not directly
Indirect Wages involved in production.
• Ex: Supervisors, sweepers, etc.

• Expenses other than direct expenses.

• Those expenses are incurred for the business as a whole.
Indirect Expenses • Ex: Heat, light, rent, insurance, etc.
 CLASSIFICATION OF OVERHEADS

1. Production 2. Administration 4. Distribution

3. Selling Overhead
Overhead Overhead Overhead

Cost incurred in Cost incurred in the Cost incurred for Cost incurred to
product-making administration of the the purpose of deliver product
activities business selling goods to customers.

E.g.: indirect E.g.: Stationery E.g.: Advertising E.g.: Transportation

factory materials, expenses, Clerk expenses, Salesman charges, packing
indirect factory salary, Audit Commission, etc. costs, etc.
wages, etc. fees, etc.
PRODUCTION AND SERVICE DEPARTMENTS

• Overhead are apportioned to the cost centres or departments to facilitate

absorption of overheads into cost units.
• In making the apportionment, it is important that a distinction be made
between a production cost centre or department and a service cost centre or
department.
• There are two broad categories of cost centres or departments:

1. Production Cost Centre 2. Service Cost Centre

• A department where production • A department that provides
activities take place services/support production
• E.g.: Painting, Machining, activities
Assembly • E.g.: Cleaning, Maintenance,
Inspection
 OVERHEAD COSTS

Direct Apportionment
Allocation

Production Service Department

department X Y
A B
Re apportionment service dept
costs to production dept

Absorption
Only
(OAR) cost the prod
centr uctio
at th es wil n
e end l exist
calcu of th
latio e
n.
PRODUCTS COST
 COST ALLOTMENT

• Cost Allotment is the distribution of overheads to cost centres.

• Overhead can be distributed using 2 methods:

1. Cost
Allocation 2. Cost
Apportionment

7
 1. Cost Allocation

• Cost allocation has been defined as “the allotment of whole items

of cost to cost centres or cost units”-CIMA
• Indirect material and indirect wages that are specific to a cost centre
can be allocated.
• An overhead can be allocated directly if the following conditions
are met :
i. If overhead cost are given specific & direct to a particular cost
centre.
ii. If the exact amount of overhead is known.

• E.g.: If the air-conditioning unit is used separately by one

department, the entire cost of using the air conditioner will be
allocated to that specific department.
 2. Cost Apportionment
• Cost apportionment has been defined as “the allotment to two or more
cost centres of proportions of common items of cost on the estimated
basis of benefit received”.-CIMA

• Where costs cannot be allocated directly to a particular cost centre, they

must be apportioned to the cost centres on a fair basis.
•
• The choice of a suitable basis is matter of judgement and common sense.

• Ex: If a supervisor is responsible for more than one cost centre, his
wages cannot be allocated because the wages are not specific to any of
the cost centres.
As A General Guidance, The Basis Of Apportionment Is As
Shown Below:
OVERHEAD COST BASIS OF APPORTIONMENT

Electricity Kilowatt hours

Insurance and depreciation of building Cost of building

Electricity, rent, rates, heating, lighting, insurance and depreciation of Area or space occupied
buildings, building service and fire insurance

Insurance and depreciation of machinery Value of assets/ cost / net book value

Supervision, canteen expenses, welfare, wages, cost office expenses, No of employees, direct wages
administration

Machine power Horse power of machine

Inspection expenses No. of inspection
Maintenance expenses Maintenance (%), maintenance hours
Materials handling and material storage No of material requisitions

Materials handling Weight of materials

Fire insurance Value of stock

 RE-APPORTIONMENT

• To re-apportion the total overhead of service cost centres to production cost centres.
• In manufacturing, only the production departments or cost centres are directly
involved in the manufacture of cost units.
• Therefore, the costs in the services cost centres need to be apportion to production
cost centres & this process is call ‘re-apportionment”

• Two methods of re-apportionment:

a) Direct Method –> when there is only ONE service cost centre

b) Repeated method -> More than ONE service cost

centres.

-> The overhead costs of service cost centres are to re-

apportion until the overhead costs become insignificant.
 BASIS OF REAPPORTIONMENT

SERVICE CENTRE COMMONLY USED BASIS OF REAPPORTIONMENT

Maintenance Maintenance Hour
Maintenance (%)
Maintenance Wages
Plant Values
Machine Hours
Stores No. of Material Requisition
Material handling
Weight of Material Issued
Cafeteria/canteen No. of Employees
Personnel No. of Employees
Labour Hours
Inspection No. of Employees
No. of Inspection Tickets
No. of Jobs
Power Generation Meter Usage / Kwh
 OVERHEAD ABSORPTION

• Defined as “the allotment of overhead to cost units by means of rates (i.e

OAR) separately calculated for each cost centre”-CIMA

• Once all the overheads have been apportioned to production cost centres, it is
necessary to charge the overheads into cost units that pass through the
production cost centre.

• Here the cost units are charged with a share of the overheads.

• To absorb the overheads into cost units one has to compute an absorption rate.

• The formula for predetermined overhead rate is:

OAR = Total Budgeted Production Overhead
Total Budgeted Basis
 OVERHEAD ABSORPTION RATE (OAR)

 OAR is a pre-determined rate (estimation rate) use to know

how much overhead has been absorbed during the year.
 There are 2 Type of OAR:

1. Single/ Blanket Overhead • All department using one single rate

Rate

2. Departmental Overhead • Each department have its own overhead

Rate rate based on its core activities.
 WHY PRE-DETERMINED RATE IS USED IN
COMPUTING OVERHEAD?

• The actual costs are not known until the end of costing period.
• The use of pre-determined rate enables product cost to be
calculated as soon as production is completed.
• For planning & controlling purpose.
 CALCULATION OF OAR
OAR = Total Budgeted Production Overhead
Total Budgeted Basis

Absorption Basis Formula Answer

Direct Material Cost Budgeted Overhead / Budgeted DM Cost % of DM Cost

Direct Labour Cost Budgeted Overhead / Budgeted DL Cost % of DL Cost

Direct Labour Hour Budgeted Overhead / Budgeted DL Hour RM per DL Hour

Machine Hour Budgeted Overhead / Budgeted Machine RM per Machine

Hour Hour
Unit of Production Budgeted Overhead / Budgeted output RM per unit of
output
 OVER OR UNDER ABSORPTION OF
OVERHEAD

• Because OAR is based on estimation rate, there will be a

difference between the overhead absorbed & actual
overhead incurred at the end of costing period.

Under Absorption Actual Overhead > Budgeted Overhead

Over Absorption Budgeted Overhead > Actual Overhead

Budgeted Overhead = OAR X Actual Basis

 OVERHEAD ANALYSIS SHEET

• Functions :
• To show the overhead charged to each cost centre.
• Only indirect cost are recorded in the overhead analysis
sheet.
• Steps to follow:
1. Calculation of Total Overhead
2. Calculation of Production Overhead
3. Calculation of OAR
4. Calculation of over / under overhead absorption