OVERHEADS

 Direct Costs

These are costs that can be identified or traced to a cost object or cost center.

 Indirect Costs

These are costs that cannot be traced to a cost object or cost center. Indirect costs are collectively termed overheads. Indirect costs
comprise of indirect materials, indirect labour and indirect expenses

Cost

Material Cost Labour Cost Expenses

Direct Material Indirect Material Direct Labour Indirect Labour Direct Expenses Indirect Expenses

Overheads

 Indirect Cost/ Overhead Components

a. Indirect Material Costs

This would include all other material costs not directly used or consumed in production or service. Examples include lubricants
and fuel for Plant & Machinery, spare parts and loose tools for repairs and maintenance etc.

b. Indirect Labour Costs

This would include wages and salaries to paid to workers not directly involved in production or service delivery. These may include
cost of workers engaged in supervision, quality control, selling and distribution, administration, research and development etc.

c. Indirect Expenses

This would also include expenses not specifically incurred in the production of a cost object or service delivery. These may include
establishment costs such as pre-operational expenses, interest expenses, electricity expenses, taxes of all forms, research expenses,
permits etc.

 Cost Assignment

Cost assignment is the process by which direct or indirect costs are charged to or made the responsibility of particular cost centres, and
ultimately charged to a cost object or services.

 Cost Allocation

Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre.

 Cost Apportionment

Apportionment is a procedure whereby indirect costs are spread fairly between cost centres.

 Cost Absorption

This is the process of including overhead cost into cost object.

Direct Costs Allocation

Cost Object

Allocation (Apportionment) Allocation (Absorption)

Indirect Costs Cost Centres
 Overhead Allocation

Allocation of overhead is the process of assigning cost to a cost object. The basis of allocation of overheads to cost objects is called allocation
base or cost driver. Two types of systems can be used to assign indirect (overhead) costs to cost objects. They are;

a. Traditional Costing Systems

b. Activity Based Cost (ABC) systems.

The objective of allocating overheads to cost objects is to include in the total cost of the product or service an appropriate share of the
organization’s total overhead costs.

Overheads are to be apportioned to different cost centres based on following two principles:

i. Cause and Effect - Cause is the process or operation or activity and effect is the incurrence of cost. Apportionment of overheads
based on this criterion ensures better rationality as it is guided by the relationship between cost object and cost.
ii. Benefits received – overheads are to be apportioned to the various cost centres in proportion to the benefits received by them.

 Cost Centres

CIMA defines Cost Centre as “a production or service, function, activity or item of equipment whose costs may be attributed to cost units.
A cost centre is the smallest organizational sub-unit for which separate cost allocation is attempted.”

 Production and Service Cost Centres

a. Production Cost Centre

Production cost centres’ are engaged in production activity by conversion of raw material into finished production.

b. Service Cost Centre

Service cost centres are those which are ancillary to and render service to other production and service cost centres

 Process of Allocating Overheads

1. Apportioning/assigning all manufacturing overheads to production and service cost centres. This is called primary allocation;
2. Reapportioning/reassining the costs assigned to service cost centres to production cost centres. This is called secondary
allocation;
3. Computing separate overhead rates for each production cost centre;
4. Assigning cost centre overheads to products or other chosen cost objects.

The above process is often referred to as the two-stage process of allocating overheads under the traditional costing system.

 Bases of apportionment

It is considered important that overhead costs should be shared out on a fair basis. Due to the complexity of items of cost it is rarely possible
to use only one method of apportioning costs to the various departments of an organisation. The bases of apportionment for the most usual
cases are given below.

Overhead to which the basis applies Basis

Rent, rates, heating and light, repairs and depreciation Floor area occupied by each cost centre
of buildings
Depreciation, insurance of equipment/plant Cost or book value of equipment/plant

Personnel office, canteen, welfare, wages and cost offices, first Number of employees, or labour hours worked in each cost
aid centre

 Overhead Absorption

Overhead absorption is the process whereby overhead costs allocated and apportioned to production cost centres are added to unit, job
or batch costs. Overhead absorption is sometimes called overhead recovery.

 Predetermined Overhead Absorption Rate (OAR)

Overheads are usually added to cost units using a predetermined overhead absorption rate, which is calculated using figures from the
budget.
 𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑 𝑂𝐴𝑅 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐵𝑎𝑠𝑖𝑠 𝑜𝑓 𝐴𝑏𝑠𝑜𝑟𝑏𝑖𝑛𝑔 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

 Methods of Absorbing Overhead

a. percentage of direct materials cost

b. percentage of direct labour cost
c. percentage of prime cost
d. rate per machine hour
e. rate per direct labour hour
f. rate per unit
g. percentage of factory cost (for administration overhead)

Percentage of direct materials cost

𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝐴𝑅 𝑢𝑠𝑖𝑛𝑔 𝐷𝑖𝑟𝑒𝑐𝑡 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝐶𝑜𝑠𝑡

Percentage of direct labour cost

𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝐴𝑅 𝑢𝑠𝑖𝑛𝑔 𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐶𝑜𝑠𝑡 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐿𝑎𝑏𝑜𝑢𝑟 𝐶𝑜𝑠𝑡

Percentage of prime cost

𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝐴𝑅 𝑢𝑠𝑖𝑛𝑔 𝑃𝑟𝑖𝑚𝑒 𝐶𝑜𝑠𝑡 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑃𝑟𝑖𝑚𝑒 𝐶𝑜𝑠𝑡

Rate per machine hour

𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝐴𝑅 𝑢𝑠𝑖𝑛𝑔 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐻𝑜𝑢𝑟 𝑅𝑎𝑡𝑒 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 𝐻𝑜𝑢𝑟

Rate per direct labour hour

𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟 𝑅𝑎𝑡𝑒 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟

Rate per unit

𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑈𝑛𝑖𝑡 𝑅𝑎𝑡𝑒 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑈𝑛𝑖𝑡

Percentage of factory cost (for administration overhead)

𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝐶𝑜𝑠𝑡 𝑂𝐴𝑅 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝐶𝑜𝑠𝑡

 Blanket Rates & Departmental Absorption Rates

1. Blanket/ Plant – Wide Overhead Rates: this is used to describe where an organization uses one single overhead rate for the entire
organization as a whole.
2. Departmental Overhead Rates: this is used to describe where an organization uses separate overhead rates for cost centers/cost
pools within the organization.

 Over/Under Absorption

Over and under absorption of overheads occurs because the predetermined overhead absorption rates are based on estimates.

The rate of overhead absorption is based on estimates (of both numerator and denominator) and it is quite likely that either one or both
of the estimates will not agree with what actually occurs.

Over absorption: means that the overheads charged to the cost of sales are greater than the overheads actually incurred.
Under absorption: means that insufficient overheads have been included in the cost of sales.

 Reapportioning Service Department Costs

Only production departments produce goods that will ultimately be sold. In order to calculate a correct price for these goods, we must
determine the total cost of producing each unit – that is, not just the cost of the labour and materials that are directly used in production,
but also the indirect costs of services provided by such departments as maintenance, stores and canteen.

Methods of allocating the service department costs:

1. repeated distribution (reciprocal) method;

2. simultaneous equation method;
3. specified order of closing method;
4. direct allocation method

Question 1

The annual overhead costs for ADARA MAJA which has three production centres (two machine centres and one assembly centre) and
two service centres (materials procurement and general factory support) are as follows:

(£) (£)

Indirect wages and supervision

Machine centres: X 1 000 000

Y 1 000 000

Assembly 1 500 000

Materials procurement 1 100 000

General factory support 1 480 000 6 080 000

Indirect materials

Machine centres: X 500 000

Y 805 000

Assembly 105 000

Materials procurement 0

General factory support 10 000 1 420 000

Lighting and heating 500 000

Property taxes 1 000 000

Insurance of machinery 150 000

Depreciation of machinery 1 500 000

Insurance of buildings 250 000

Salaries of works management 800 000 4 200 000

11 700 000

The following information is also available:

Book value of Area occupied Number of Direct labour Machine

Machinery (£) (sq. metres) employees hours hours
Machine Shop X 8,000,000 10,000 300 1,000,000 2,000,000
Machine Shop Y 5,000,000 5,000 200 1,000,000 1,000,000
Assembly 1,000,000 15,000 300 2,000,000 -
Stores 500,000 15,000 100
 Maintenance 500,000 5,000 100

Details of total materials issues (i.e. direct and indirect materials) to the production centres are as follows:
£
Machine shop X 4,000,000
Machine shop Y 3,000,000
Assembly 1,000,000
8,000,000
Required: Prepare ADARA MAJA overhead analysis sheet

Question 2

Given below is data relating to Cost Centre 52 for period 9 for BOLE KAJA

Total Overhead for period ₦6,000

Total Direct Labour Hours for period 800

Total Direct Wages ₦1,600

Total Direct Material used ₦3,000

Total Machine Hours 1,200

Total Units Produced 45

Required:

Using the above data compute overhead absorption rates using;

1. Percentage of Direct Material Cost

2. Percentage of Direct Labour Cost
3. Percentage of Prime Cost
4. Rate per machine hour
5. Rate per direct labour hour
6. Rate per unit

Question 3

Calculate the amount of over/under absorption of overheads (if any) given the following information in relation to:

Cost Centre 258 for Period 2

Budgeted Actual

Direct Labour Hours 5,600 5,925

Direct Wages ₦19,040 ₦20,450
Machine Hours 3,300 3,418
Direct Materials ₦26,200 ₦28,213
Units Produced 81,000 85,296
Overheads ₦57,500 ₦61,257

It is considered that overhead absorption based on labour hours is the most appropriate basis for Cost Centre 258.

Required;

1. Calculate the Overhead Absorption Rate using the appropriate method

2. Calculate the over/under absorption
3. Calculate the factory cost of production

Question 4
The budgeted and actual data for KOKOBIRI Products Co for the year to 31 March 20X5 are as follows.
Budgeted Actual
Direct labour hours 9,000 9,900
Direct wages $34,000 $35,500
Machine hours 10,100 9,750
Direct materials $55,000 $53,900
Units produced 120,000 122,970
Overheads $63,000 $61,500
The cost accountant of River Arrow Products Co has decided that overheads should be absorbed on the basis of labour hours.
Required
Calculate the amount of under- or over-absorbed overheads for River Arrow Products Co for the year to 31 March 20X5

Question 4

MAZAMAZA has three production departments and two service departments. The overhead analysis sheet provides the following totals of
the overheads analysed to production and service departments:

(£)
Production department X 48 000
Y 42 000
Z 30 000
Service department 1 14 040
2 18 000
152 040
The expenses of the service departments are apportioned as follows:

Production departments Service departments

X Y Z 1 2

Service department 1 20% 40% 30% — 10%

Service department 2 40% 20% 20% 20% —

Calculate the charge for overhead to each of the three-production cost centres, including the amounts reapportioned from the two
service centres, using:

i. the continuous allotment (or repeated distribution) method

ii. an algebraic method