Accounting for Factory

Overhead
 Learning Objectives

• Definition of Overheads
• Assignment of direct and indirect costs
• Classification of Overheads
• Identify cost behavior patterns
• Understand the principles of overheads
apportionment and absorption.
 Learning Objectives
• Distinguish between Allocation and
Apportionment of Overheads.
• Know how to deal with the overheads of
service departments.
• Apply factory overhead using predetermined
rates.
• Calculate Machine Hour Rate
 Definition
• Overheads is an aggregate of indirect
materials, indirect wages and indirect
expenses. Thus the total of indirect
expenditure is called Overheads.

• It is therefore “Any expenditure over and

above the Prime Cost [Direct materials and
Direct labour].”
 Assignment of direct and indirect costs

• Direct costs can be specifically and exclusively

identified with a given cost object –hence they can be
accurately traced to cost objects.

• Indirect costs cannot be directly traced to a cost

object – therefore they are assigned to cost objects
using cost allocations.
 Classification of Overheads

• Cost classification is the process of grouping

costs according to their common
characteristics and establishment of a series of
special groups according to cost class
 Classification of overheads
Overheads

Function Elements Behaviour

1. Production overheads 1. Indirect Material 1. Fixed overheads

2. Administration
overheads 2. Indirect Labour 2. Variable overheads
3. Selling and packaging
4. Distribution overheads 3. Indirect expenses or 3. Semi-variable overheads
Overheads
Factory Overhead Analysis Sheets
• These sheets may be used to keep a
subsidiary record of factory overhead
expenses.

– Expense-type analysis spreadsheet

– Department-type analysis
spreadsheet
 General Factory Overhead Expenses

• When factory overhead expenses are not identified

with a specific department, they are charged to
departments by a process of allocation.

• May be made for each item of expense incurred, or

expenses may be accumulated as incurred and the
allocation made at the end of the accounting period.
 Summary of Factory Overhead
Summary of Factory Overhead
Dept. A Dept. B Dept. C Total

Expenses
Indirect $500 $200 $80 $780
materials

Indirect labor 150 60 50 260

Power 100 40 100 240
Depreciation 200 100 70 370

General factory 150 140 100 390

expenses

Total $1100 $540 $400 $2040

 Stages in Overheads Accounting

• Administrative
1.Collection of Overheads
2.Classification and codification of overheads

• Computing
1.Direct/ specific allocation
2. Apportionment of overheads
3. Re-apportionment of service departments costs to
production departments. (Absorption by production
units)
• Codification- Coding is technique of
intelligent description of numerous cost
accounting heads for recording and
controlling. It helps to group items of
overheads of similar nature.
• Allocation- it is process of identification of
overheads with a specific production or
service department . E.g. Overtime wages
paid to department A.
• Apportionment- It is the allotment of
proportions of items to departments or
units. E.g: rent, depreciation, repairs
charges
 Distributing Service Department
Expenses
• Service departments are an essential part of the
organization, but they do not work directly on the
product.
• Production departments perform the actual
manufacturing operations that physically change the
units being processed.
• The costs of the service departments must be
apportioned to the production departments.
• An analysis of the service department’s relationship
to other departments must be done.
Assign all factory overheads to cost
centers
• Cost Allocation

• Cost apportionment

• Remember cost centers are…

 Cost allocation

• Where a cost can be clearly identified with a

cost center or a cost unit, then it can be
allocated to that cost center or cost unit.
 Cost apportionment

• It is not possible to identify a discrete item of

cost with a cost center and it is necessary to
split a cost over several cost centers on some
agreed basis
How the overheads costs are distributed

1. Direct/specific Allocation

2. Primary allocation (Apportionment)

3. Secondary allocation (Re- apportionment)

How the overheads costs are
distributed...expained

1. Direct allocation- It is the allotment of total item

cost (e.g. rent) to a particular department.
2. Primary allocation (apportionment)- It refers to
spreading the overheads costs to all production and
services department on the common basis of
distributing.
3. Secondary allocation (Re- apportionment)-
It refers to apportioning of all service dept. costs to
production dept . There are four methods for re-
apportionment.
 Example of direct allocation:
Overhead analysis sheet
centre Service centre
Production
Items of Total Machine X Machine Y Assembly Repair and
expenditure (P) maintenan
ce
Indirect 85 00 2800 3200 1000 1500
material
Indirect 5000 2000 1800 600 600
wage and
supervision
 Basis of Apportionment

• Apportionment of indirect expenses to cost

centers must be made on fair and reasonable
bases

• Different types of expense require different

bases according to their individual
characteristics
 Common Bases for Primary
Allocation/apportionment
COST Basis for Distribution
Building Floor space occupied by departments
Maintenance,Rent
Depreciation of Book value of machinery
machinery
Insurance of building Area occupied
Salary of works Number of employees in department.
manager
Purchasing Number of purchase orders
Property taxes Area occupied
Stores Units of materials requisitioned
Tool Room Total direct labor hours in departments
served
 Methods of Re-apportionment
(Secondary allocation) :
1.Direct distribution method

2. Step-down or sequential distribution method

3.Repeated distribution method

4. Simultaneous or Algebraic method

Methods of re-apportionment continued…
• Direct Distribution Method
– The costs of Service department are
directly apportioned to production
department only.
• Sequential Distribution or Step-Down
Method
– Distributes service department costs
regressively to other service departments
and then to production departments.
• Algebraic Distribution Method
– Distributes costs by simultaneous
equations recognizing the relationship of
services rendered by departments to each
other.
 Methods continued…

• Repeated distribution method:

Under this, the service department costs are
repeatedly allocated among the production and
service department in the specified percentages
until the figures become too small to be
significant

(NB: Our focus will be on Direct, Repeated

and Algebraic distribution methods)
Overhead Absorption Rates (OAR)

To determine overheads to be absorbed by a cost center,

it is necessary to establish overhead absorption rate
(OAR)

OAR= Total Overhead expenses

Quantity or value of basis

The basic procedure for calculation of OH rate is to divide

the total overhead of a cost center by total number of
units of absorption applicable to a cost center.
 Main Overheads rates

The following are the main overhead absorption

rates usually referred in cost accounting

 Predetermined overhead rate

 Blanket(Plant wide) OH rate
 Multiple overhead rate
 Predetermined Factory Overhead Rates

Predetermined overheads means that the overhead

absorption rate is calculated prior to the accounting
period, using estimated or budgeted figures for overheads
and units of the absorption base chosen

= Budgeted Total Overhead for cost Center

Budgeted total number of units of absorption base
 Predetermined continued…
• An appropriate OAR should reflect the effort
taken to produce the products

• Some commonly used predetermined absorption

bases are as follows:
– Direct Labor Hours Method
– Machine Hours
– Direct Labor Cost Method
Continuation…
• Direct Labour Hours: It is frequently used in
the labour intensive department because
overheads assigned to this department are
closely related to the direct labour hours
worked
• Machine Hours: It is most appropriate for the
machining department since most of the
overheads are closely related to machine hours
 Machine Hour Method
• This method best serves highly automated
departments where the amount of factory
overhead cost incurred on a job is primarily a
function of the machine time that a job requires.
Cutting Dept
Direct materials $1,000
Direct labor (1800 hours) 3,000
Factory overhead (6000 machine hours @ 231809
$38.70)

Total cost of completed job $235809