Chapter 4

Overheads

4.1. Primary apportionment 4.2. Secundary apportionment 4.3. Overheads absorption 4.1. Primary apportionment
It is the allocation and apportionment of expenses to a cost centre. Allocation : expenses are directly identified to cost centre. Apportionment : to split items of cost between severel cost centres on an agreed basis . Example A firm has two production centres and two service centres. It makes two products and its total overhead bill for the year is as follows: m.u. Rent Depreciation: Machinery Building 10,000 8.000 5,000 15.000 58,000 20,000

Electricity Indirect materials

The fallowing statistics are available PC1 Pressing Area (m2) Machine value (mu) KW hour rating of machinery Indirect material consumed (mu) Required: (1) Allocate and primary apportion overheads to cost centres (2) Reapportion service centre costs to production cost centres (secondary apportionment) PC1 use of canteen use of maintenance 50% 55% PC2 30% 40% 5% SC1 SC2 20% 2,500 1,000 10,000 5,000 PC2 Assembly 5,000 5,000 10,000 5,000 SC1 Canteen 1,000 1,000 2,500 3,700 SC2 Maintenance 1,500 3,000 2,500 1,300

(1) Primary apportionment Overheads TOTAL mu Rent Machine depreciation Buildings Electricity Indirect materials 20,000 Area 10,000 Value 8,000 Area 5,000 KW hours 15,000 Allocation Bases PC1 mu 5,000 (1) 1,000 (2) 2,000 (3) 2,000 (4) 5,000 15,000 Workings PC2 mu 10,000 5,000 4,000 2,000 5,000 26,000 SC1 mu 2,000 1,000 800 500 3,700 8,000 SC2 mu 3,000 3,000 1,200 500 1,300 9,000

(1) PC1 = 20,000 * (2,500/10.000) = 5,000 (2) PC1 = 10,000 * (1.000/10.000) = 1,000 (3) PC1 = 8,000 * (2.500/10.000) = 2,000 (4) PC1 = 5,000 * (10.000/25.000) = 2,000

4.2. Secondary apportionment

It is the reapportionment of the total costs of the service cost centres to production cost centres. This secondary apportionment must be done on a fair basis to reflect the benefit derived from the service centre. Service department: (1) Service department only work for other department; (2) Service department do work for other service department; (3) Service department provide reciprocal services to each other as well as providing a service to production. SC1 SC2 PC1 PC2

3 treatments are possible: a) Direct method b) Step-down method c) Reciprocal method : c1) continuous reapportionment; c2) simultaneus equations ( algebric).

a) Direct method

Reciprocal services (if any) are ignored. The service department costs are reapportioned to production centre only. Solution SC1 8,000 SC1 (50; 30) SC2 (55; 40) SC2 9,000 PC1 15,000 PC2 26,000

b) Step-down method Services that do most work for other service centre are allocated first. Reciprocal services are then ignored. Solution SC1 8,000 SC1 (20; 50; 30) SC2 (55; 40) SC2 9,000 PC1 15,000 PC2 26,000

c) Reciprocal methods : may be solved by continuous reapportionment or algebraically. C1) Continuous reapportionment; continuous allotment. The principle involved in this method is that the appropriate proportion of the costs of the first service centre is allotted to the second (20% of Canteen to Maintenance), than the appropriate proportion of the second centre is allotted back to the first centre, and so on until the amounts allotted to and fro became insignificant. Solution SC1 8,000 SC1 (20; 50; 30) SC2 9,000 PC1 15,000 PC2 26,000

SC 2 (5; 55; 40) SC1 (20; 50; 30) SC2 (5; 55; 40) SC1 (20; 50; 30;)

C2) Simultaneous equations Let Let X be the total cost of Canteen after reciprocal services; Y be the total cost of Maintenance after reciprocal services;

Solution X= Y= SC1 8,000 SC1 (20; 50; 30) SC2 (5; 55; 40) SC2 9,000 PC1 15,000 PC2 26,000

4.3. Overheads absorption

4.3.1. Production overhead absorption Two steps: 1. Calculation of an overhead absorption rate for each cost centre(OAR).

OAR=Total overhead cost of a cost centre/Total absorption base applicable to a cost centre
Possible basis: machine hours; labour hours; direct materials cost; direct labour cost; prime cost. 2. Calculation of overhead absorbed into the cost of the cost unit (OAC):

OAC = OAR * units of the base contained in a product.

Supplementary information: Product A B

Direct materials Direct labour PC1: A: 3H/u B: 2H/u PC2: A: 2h/u B: 1h/u Total

7mu/u

5mu/u

15mu/u 10mu/u 8mu/u 4mu/u 23mu/u 19mu/u

Production volume is : 1,000u of A and 2,000u of B. It has been decided to absorb overhead into products on the basis labour hours. Required Calculate the overhead costs of the two products. Solution As firm need to know overhead costs per unit in advance they employ predetermined OAR, calculated on budgeted figures. This can lead to discrepancies between the amount absorbed and the amount spent, called over/under absorption. Continuing with this example, the following figures applied to PC2 Budgeted Overhead Direct labour hours Solution Units Overhead Direct labour hours A B PC1 PC2 32,843mu 4,000H Actual 35,742mu 4,200H

Rate per hour Overhead cost per unit PC1 PC2 Overhead cost per unit Hours A B

4.3.2. Non manufacturing overhead absorption Non production overheads are: selling and marketing, research and development, distribution, administration. These overheads also form part of total cost of a cost unit and have to be absorbed to Profit and Loss account in some fashion. Selling overheads includes: salesmans salaries and commission, show room expenses, advetisment charges, after sales expenses and demonstration and technical advice to potential customers. Distribution overheads: warehouse rent, warehouse staff salaries, insurance, expenses on delivery van and trucks, expenses on special packing for bulk transport like bales, crates,losses in warehous stocks. Administration overheads: office rent, light, heat, salaries, wages of clarks, general manager, diretors. Steps are the same as for production overheads, but absorption bases are different Type of overhead Selling Research Distribution Administration Absorption bases used Sales value or Production cost Production cost or Conversion cost or Added value Production cost or Sales value Production cost or conversion cost or Added value.