This is the second post which deals with Overhead Costs which form part of Unit 6: Evaluating Costs and Revenues (ECR).  It explains the book-keeping aspects and absorption of overheads

The amount that a company’s production department charges internally for overheads is not necessarily the same as the company actually paid suppliers for those overheads. This difference is called the under- or over-absorption of overhead.

We have already looked at how Budgeted indirect costs and budgeted production are used to calculate the overhead costs for the goods produced. Overhead costs are an important part of the cost of producing a product. These costs can affect pricing decisions and profit. All the information we need to calculate overhead absorption rates comes from budgeted figures which allows for accurate calculation of prices.

Working out Budgeted Overhead Absorption Rates
To start recording overhead costs in our accounting system, we don’t need the budgeted costs or the budgeted hours. We do need the budgeted overhead absorption rates (OARs). These will be used in the accounting system.

In the skills test and in the exam the data provided needs to spell out clearly whether the figures are budgeted costs or actual costs.

How do I calculate the absorption rates?
Tip: If you look at the Isted Pottery scenario you can see:

The overhead absorption rates are:

• For Moulding £16,800 divided by 4,000 labour hours = £4.20 per labour hour.
• For Glazing £21,600 divided by 6,000 machine hours = £3.60 per machine hour.

In that example we would assume that those rates were worked out based on the previous month’s figures. We are now at the end of the month and are trying to record the appropriate transactions in the accounts.
This information will help us to complete calculations later:

Monthly Costs Required to Calculate Absorption Rates

1.    In the Moulding department, the payroll clerks have told us that 4,200 direct labour hours have been worked.
2.    In the Glazing Department, the works manager has told us that 5,600 machine hours have been worked.
3.    The accounting system has recorded the production overhead charged (debited) to each of the departments, which would cover costs like rent, insurance and power. These are as follows:
a.    Production overhead control account – Moulding Centre: £17,200
b.    Production overhead control account – Glazing Centre: £20,850

Tip:  Overheads are absorbed on the basis of the actual hours worked

In the Moulding Centre
4,200 direct labour hours were worked.

Remember the overhead absorption rate we calculated before the accounting period started? It was £4.20 per direct labour hour.

We calculate the overhead like this:

Direct labour hours x overhead absorption rate = production overhead absorption

4,200 hrs x £4.20 per hr = £17,640

We record £17,640 as absorbed into the Moulding Centre.

In the Glazing Centre
5,600 machine hours were worked.

We use the overhead absorption rate we calculated before the accounting period started: £3.60 per machine hour.

We calculate the overhead as above:

5,600 hrs x £3.60 per hr = £20,160

We record £17,640 as absorbed into the Moulding Centre.

How do I record these costs?

The T-account transactions would be as follows.

Under- and Over-absorbed Production Overhead

We need to find:

1. How much production overhead each department absorbed into production – how much they of the overheads costs they decided were part of the production costs.
2. Is there production overhead left over to be absorbed into the accounts? This amount would be called under-absorbed. Have more production overheads than the original budgeted production costs been absorbed? Have the overheads been over-absorbed?

We now have two amounts in our Production overhead control accounts:

a.    The absorbed overhead we have just entered.
b.    The actual overhead that was incurred (see Monthly Costs Required to Calculate Absorption Rates).

Writing them in this order makes it easier to identify if they are under- or over-absorbed.

Subtract the actual cost from the absorbed cost.

If absorbed cost less actual cost gives a + answer (more absorbed than actual) we have over absorbed the overhead.

If absorbed less actual gives a – answer (more actual than absorbed) we have under absorbed the overhead.

Compare the two departments:

The T-account transactions would be as follows.

The £440 over-absorbed by the Moulding Cost Centre has been credited to the under/over absorbed account for Moulding as an entry for the accounting period. This notes the difference as being separate from the production of moulded clay.  Accounting the costs this way can help in control.

The £440 will eventually be debited in the Under-/Over-Absorbed Overhead Account and then credited to the Profit and Loss account. Therefore it effectively increases the profit for the period by £440.

The £690 under-absorbed by the Glazing Cost Centre has been debited to the under/over absorbed account for Glazing as an entry for the accounting period. This keeps the difference separate from the glazing of clay products and can help in control.

The £6900 will eventually be credited in the Under-/Over-Absorbed Overhead Account and debited to the Profit and Loss account effectively decreasing the profit for the period by £690.

What will I see in the exam and the simulation?

This example is based on the June 2009 ECR exam. The exam doesn’t always test under/over absorption.

Example Question 1
At the end of the quarter (to 30 September) the actual overheads incurred in the Ingredients mixing department were found to be £450,060, and the actual machine hours operated were 6,800 hours.  The budgeted overhead recovery (absorption) rate was £62.95 per machine hour

Task 1: (14 minutes)

(a)    Using your budgeted overhead recovery (absorption) rate and the above data, calculate the under/over absorption for the quarter (to 30 September). Clearly state whether the overheads were under or over absorbed during the quarter.

Task 2:

(b)    Complete the following table to show the journal entries for the absorption of overheads in the quarter (to 30 September).

Tip: 2009 was the first time the current examiner tested journal entries in the context of under-/over- absorption of overhead. Where it says “Overhead absorbed” this refers to the overhead that is absorbed into the work-in-progress account.

Example Question 2
This is an older past exam question.

Cutting department fixed overheads are absorbed on the basis of budgeted machine hours.  Stitching department fixed overheads are absorbed on the basis of budgeted direct labour hours.  The following information relates to the cutting and stitching departments for May:

Task 1: Calculate the production overhead absorbed for May in:

(i)    the cutting department
(ii)    the stitching department

Task 2: Calculate the under or over absorbed production overheads for May, indicating clearly whether the overheads are under or over absorbed for:
(ii)    the cutting department
(ii)    the stitching department

Task 3: Use the above information to prepare the journal entry for the absorption of fixed overheads in the cutting department and finishing department for May.

The tasks in skills tests for the under-/over- absorption of overheads are quite similar to the exam.

Skills tests often add narrative tasks, so it is worth considering what sort of thing you might be asked to write about.

If you refer back to Isted Pottery, the Glazing department had an under-absorbed overhead value of £690.

If the owner of the business was concerned about this under-absorption he or she might say:

“I think that the machine hour rate of absorption rate is the cause of the under-absorption of overheads in recent months. It might be better to use a direct labour hour rate there? The Moulding department does not have the same problem”.

Tip: Don’t be convinced by what seems to be a logical argument. It is true that Moulding uses labour hours. It is also true that Moulding over-absorbed overhead. It is not true, that Moulding over-absorbed because Moulding uses labour hours.

Stick to basic principles of what type of absorption rate to use:

• If a department is labour intensive – then direct labour hours are appropriate. When labour time is the crucial for the running of the department, and most of the department’s costs are for labour, then most of the overheads may be incurred there too.
• If a department is capital intensive – then machine hours are appropriate. The machine hours are the key to the running of the department and a good guide to where the overhead is being incurred.

I will leave any discussion of the arbitrary nature of overheads to the discussion that follows from the blog.

This blog picked up the budgeted overhead absorption rates calculated before the accounting period started.

These rates were multiplied by the hours worked in the appropriate cost centres to give the overhead absorbed.

Actual overhead costs were found.

The difference was calculated. Under or over absorbed overhead was identified.

The appropriate book-keeping entries were then made.

This blog looks at Overhead Costs.

This is part of Unit 6, Evaluating Costs and Revenues (ECR).  It will look at Overheads, Allocated Costs and Apportioned Costs.

We have already covered Stock – understanding materials costs, valuing stock, and the First-in, First-out rule. After that, we looked at AVCO or Weighted Average Cost and LIFO, the Last-In, First-Out rule. We also looked at labour costs.

What are overheads?

Direct costs are obviously – or ‘directly’ – linked to products. They are needed to make the product, like materials.  Indirect costs can be more difficult to identify, but they are essential for the business to operate.  Indirect costs are also called Overheads.

Overheads often don’t relate to specific jobs. They could include electricity, heating, and depreciation of equipment.

Example of Overheads

For example, when my car is repaired at the garage, they tell me that the car needs a new distributor.  This part is essential, and so it is a direct cost of fixing my car.

Direct versus Indirect Costs

When my car is fixed the garage owner had to pay rent for the premises, put toner in the printer and take account of the depreciation of equipment. These costs are overheads.

I am charged £70 per hour for labour plus parts by the garage, although the actual mechanic may only earn £10 per hour. Where do the other costs come from?  They will include overheads as well as other operating costs.

In the garage office they have decided to include overheads as part of each Labour Hour, or hour of work done.  They also add profit on top of their costs.

This table explains how they calculate the job cost and then charge £70 per hour:

Calculating Costs including Labour and Overheads

Why do we need to identify overhead costs?

As cost accountants we want to code, or allocate expenses correctly. To do this, we need to know what the expenditure paid for, and then we need to code it to the correct centre so to show who is responsible for the expenditure.  This identifies where money is spent, and helps to calculate future budgets.

Budgeted indirect costs and budgeted production are used to calculate the overhead costs for the goods produced. Overhead costs are an important part of the cost of producing a product. These costs can affect pricing decisions and profit.

How do we use overhead costs?

We take budgeted indirect production expenses and turn them into a series of costs.  These costs can be matched to cost centres (or departments) within the production.

Once we have budgeted costs on a cost centre by cost centre basis, then we look at producing absorption rates to work out production overhead costs.  These production overhead costs can be included in product costs.

For example, we looked at overtime premium [link opens PDF] in the labour cost blog.  We saw that often firms treat this as an indirect labour cost.  This is also known as the production overhead and has to be factored into budgets and pricing decisions.

What will I see in the exam and the simulation?

In the AAT simulation, you will often be given documents which you have to read them to find the data you need. These could be letters outlining future rents or service contracts from suppliers.

In the AAT exam the budgeted overhead cost information is usually provided in a simpler format, sometimes as two tables of data plus supplementary information.

Tip: In other exam sections, such as the direct cost questions, the examiner may have inserted errors as part of the test. This does not normally happen in Overheads questions.

Sample exam question on Isted Pottery

Details – company information:

This general information helps you to build a picture of the company to help you to answer the questions.

Isted Pottery is a small company that makes pottery. Their manufacturing department takes up 5,000 square metres of floor space, divided into four separate departments.  Each department is also a cost centre:

Cost Centres in Isted Pottery

These details are important, as some of the overhead costs for the whole of the manufacturing department will need to be divided up between the 4 cost centres – Moulding, Glazing, Facilities, and Canteen – and coded correctly.

Tip: The amount of floor space each cost centre takes up could be a possible basis for dividing up those overhead costs.

What factors can be used to divide up overhead costs?

This table shows five factors that could each be used as a basis for dividing up overhead costs:

Possible bases for dividing overheads between cost centres

Tip: In the exam, you may not be given the total floor space.  One of the purposes of the test or exam could be to see whether you understand that you need it.

This particular question is comparatively easy, as the money value of the expenses used in each department is given for most of the costs.

Detail: Total Budgeted Overheads

This information is for all of the manufacturing departments, which includes all four cost centres.

Total Budgeted Overheads

Now we have to divide these total cost values appropriately across the four cost centres, Moulding, Glazing, Facilities and Canteen. We divide them into Allocated Costs and Apportioned Costs.

Allocated Costs and Apportioned Costs

Allocated costs require no further calculations. These are costs that the accounting system can divide up for us.

Tip: When we produce labour cost calculations we often note both the cost centre and expenditure code so that they are posted appropriately.

Isted Pottery have budgeted £8,910 for indirect labour costs.  This could include training, overtime premiums, and cleaning. This budgeted total has already been broken down as below, so the total cost has been allocated across the four cost centres.

Notes on Isted Pottery’s Allocated Overheads:

i.    Indirect materials will all be used in the glazing department, so we allocate all £1,140 to glazing.

ii.    Power costs have been specified on a cost centre basis, based on how much power they use.

iii.    Machine depreciation has also been stated.

Apportioned costs are those costs which we have to divide up ourselves.

How to apportion Costs – Rent Costs

1.    Look for a suitable basis for apportioning a cost. In this case rent and other property costs need to be apportioned. Five possible options were given in the table called Possible bases for dividing overheads between cost centres.

We need to decide which of those five bases is likely to give us the most accurate figures for how much each cost centre will cost the company in property related expenditure.

In this case, we chose floor space as the basis for apportioning costs.

2.    There are several ways of carrying out the next step. Here is a quick method:

a.    Find the total of the basis. We are using total floor space as the basis (check the detail information at the beginning of the question)

3,000 + 1,000 + 500 + 500 = 5,000 square metres, or 5000 total floor space

b.    Find the total budget cost for rent in the Total Budgeted Overheads table.

Divide the total rent cost by the total floor space to get the charge per square metre

£15,000 ÷ 5,000 = £3.00 per square metre

c.    If you use a normal (non-scientific) calculator you can press the x button twice to create a constant in the calculator memory.

Then simply type in the square metres in each department and press = to find the rent cost to apportion.

If you don’t have a calculator, multiply the amount of square metres by the cost per metre to get the apportioned cost.

3000 = gives us £9,000, 1000 = gives us £3,000, and 500 = £1,500

d.    Enter the amounts on the overhead analysis table.  This shows the apportioned costs for each cost centre.  Note that we will not be able to complete the Canteen Row yet.

Overhead analysis table

3.    Add up the columns for each cost centre. Double check your arithmetic to see if the sum of the totals is equal to the £38,400 in the total column. Remember, we haven’t got onto the Canteen row yet.

4.    We already know that the manufacturing department has four cost centres.

Moulding and Glazing can be called “production cost centres” where the pottery is actually produced.

Facilities and the Canteen cost centres are “service cost centres” – they provide a service to the Moulding and Glazing which is not directly related to manufacturing the pottery products.

One of the reasons that we apportion overheads to different cost centres is to find an overhead amount that to include in product costs. We should not apportion expenses from Facilities and the Canteen to working out the cost of manufacturing the product.

It is easy to identify the overheads incurred by the production cost centres, Moulding and Glazing, to include this in product costs. It is harder to work out the work out the overheads for the service departments.   It is best to apportion their total overhead using the same factor that you used to apportion the rent costs – we used floor space.

How can I check if I have apportioned the costs correctly?

You can use a direct approach, or a step-down approach. Direct means that expenses from the service cost centres are charged directly to the production cost centres. For example, Isted Pottery could take the total cost of the Canteen and using a suitable basis, divide up the cost between Moulding and Glazing. Then they would repeat the process with the Facilities total cost.

Here we use the step-down approach. Identify whether one Service cost centre, such as the Canteen, provides services to another department and reapportion that cost before any others.

1.    First, we reapportion the Canteen Costs:

The Canteen column total in the Overhead Analysis table was £3,800. (We assume that all the employees will use the Canteen)

Divide the total by expenditure by the total number of employees (38). So the Canteen costs £100 per employee, and using the x x approach, I apportion £2,600 to Moulding, £800 to Glazing and £400 to Facilities, and minus £3,800 to Canteen. The Canteen costs have now been re-apportioned.

2.    Next we reapportion the Facilities Costs:

When re-apportioning Facilities costs under the step-down approach you need to be clear precisely how much has to be re-apportioned. In the initial analysis [link back to original table] I found the total overhead costs for Facilities were £5,550. Since then we have apportioned £400 of the Canteen costs to the Facilities cost centre. as well. Now the total of £5,950 needs to be re-apportioned.

The Facilities department records for the period show that they typically spend 80% of their time working in the Moulding department, and 20% of their time working in Glazing department.

So on the basis that 80% of the work of the Facilities work is for the benefit of glazing, then 80% of the £5,950 is reapportioned there, and as 20% of the work benefits moulding £1,190 is re-apportioned to moulding.

3.    Total the production cost centre columns and check that the sum of these adds up to the overall total.

4.

Tip: Knowing the budgeted overheads on a cost centre basis is useful, but to be able to find how much overhead to charge to each product requires the calculation of an overhead absorption rate.

Can overheads be absorbed in other ways?

There are two methods of absorbing overheads in the AAT unit standards, and these tend to be the most popular ones used by the examiner. They are not the only ones, and certain questions set in service industries require alternatives.

You can also absorb overheads by calculating them on the production bases.  You would use the machine hours or the direct labour hours to do this. You have probably realised from looking at the Isted Pottery data that there are far more labour hours than machine hours needed in moulding the clay, but more machine hours than labour hours needed in Glazing.

The budgeted labour hours for moulding are 4,000

The budgeted machine hours for glazing are 6,000

5.    The overhead absorption rates are calculated by dividing the total budgeted overhead cost for each cost centre (found in your completed Overhead Analysis Table) by the budgeted number of hours and are expressed in terms of either labour or machine hours.

For Moulding £16,800 divided by 4,000 labour hours = £4.20 per labour hour.

For Glazing £21,600 divided by 6,000 machine hours = £3.60 per machine hour.

Doing a Job Cost Calculation

Isted Pottery has to fulfil an order for Amber Ceramics and we know the following information:

Materials cost –             £35

Direct labour costs – Moulding,    8 hrs at £7.50 per hour

Direct labour costs – Glazing    4 hrs at £8.00 per hour

Machine hours – Glazing        5 machine hours

Job cost calculation for Amber Ceramics

The absorbed overheads absorbed are added to the direct costs of material and labour. We can describe them as being absorbed because the order ‘absorbs’ or incorporates the overhead absorption rate per hour, on the basis of the number of hours used to make the order.

Here 8 labour hours will be needed in moulding so the £4.20 per labour hour is multiplied by the 8 hours. Similarly the £3.60 per machine hour is multiplied by the 5 hours of machine time needed in glazing to find how much is absorbed there.

We add the direct labour charges to the overheads and materials to get an accurate job cost calculation.