SEM-II- Cost & Management Accounting-I

Overhead Costing
The third important element of costs of any product or service is overheads. Overheads may be
manufacturing or non-manufacturing. Later we briefly discuss the classification of overheads. Before that let us see
what are overheads? Defining overheads particularly focuses on the concept of direct and indirect expenses which
in turn depends on the traceability of the expenses with the product or service. In other words, expenses that cannot
be directly traceable to any product or service are known as overheads. Simply, overheads are sum of all indirect
expenses i.e.
Overheads = Indirect materials+ Indirect labour + Indirect expenses

Classification of overheads: In general, overheads may be classified as

Overheads

Element wise Function wise Behaviour wise

a) Indirect material a) Factory Overhead a) Variable overhead
b) Indirect labour b) Office & Administrative b) Fixed overhead
c) Indirect expenses Overhead c) Semi-variable overhead
c) Selling & Distribution
Overhead
Of the above classification functional and behavioural classification are included in the syllabus.
Functional classification- Functionally, overheads are classified into Factory overheads, Office and Administrative
overheads, and Selling and Distribution overheads. Factory overhead is actually manufacturing overhead while other two
are non-manufacturing overhead. Factory rent and taxes, indirect wages, are examples of factory overhead while, salary
of office staff is an example of office and administrative overhead, and commission of salesman is an example of selling
and distribution overhead.

Behavioural Classification- On the basis of behaviour, overheads can be classified as variable overhead, fixed overhead
and semi-variable overhead.
Variable overheads- are those overheads that vary in direct proportion with the level of activity. For example, indirect
wages, salesman’s commission etc.
Fixed Overheads- are those overheads that remain fixed irrespective of the level of activity within a relevant range. For
example, factory rent.
Semi-variable Overhead- are those overheads that vary with the level of activity but not in direct proportion. Examples
are repair and maintenance, electricity charges etc.
We shall first discuss overhead costing of manufacturing overhead.
Methods of segregating semi-variable cost into variable and fixed- For segregating semi-variable cost into fixed
and variable, the following methods are generally followed-
i) High-point and Low-point method
ii) Simultaneous equation method
iii) Methods of Least Square
iv) Scatter Diagram method.
Of the above, method (i) and (ii) are discussed for solving the problems in the preliminary level.
The above two methods are stated with following example. Units produced and total semi-variable costs are as
below-
Units Total Costs
1000 Rs 5000
2000 Rs 6000
3000 Rs 7000
4000 Rs 8000
 (2)
Sol: (i) Under High-point and Low- point method-
High-point cost – Low-point cost
Variable cost per unit =
High-point unit – Low-point unit

So, variable cost per unit =( Rs 8000- Rs 5000)/ (4000- 1000) = Rs 3000/3000 = Re 1 per unit
Fixed cost = Total cost- variable cost per unit at any level can be applied
= Rs 8000 – 4000 x 1 = 8000- 4000 = Rs 4000.

(ii) Under simultaneous equation method – Here we have to form two equations to find fixed and variable portion
of semi-variable cost.
Let, a = variable cost per unit and b = fixed cost, applying we get

1000a +b = 5000 ……………..(i)

4000a +b = 8000 …………….(ii) ,
Solving we get, a= 1 and b= 4000.

Steps of Factory Overhead costing- Manufacturing overhead costing comprised of the following steps-
(i) Collection of factory overhead costs
(ii) Allocation of overhead costs
(iii) Apportionment or distribution of overhead costs
(iv) Re-distribution of service department cost to production department
(v) Absorption of overheads.

• Allocation and apportionment- allocation refers to identification of overhead costs to the cost centre.
But apportionment refers to the distribution of overhead cost on some logical base when identification to
cost centre is not possible. A cost centre may be a person or location or an equipment or group of these in
respect of which cost is ascertained for the purpose of cost control. It may be production cost centre or
service cost centre.
• Apportionment or distribution of overhead costs- When overheads are not allocable, overheads
would be apportioned or distributed on some logical bases, some of these are as below-

Types of expenses Basis of apportionment

i) Rent, rates and taxes i) Area occupied/Floor space

ii) Insurance of Stock ii) Value of Stock
iii) Insurance of other fixed assets iii) Value of fixed assets
iv) Depreciation of fixed assets iv) Value of fixed assets
v) Stores overhead v) Value of materials
vi) Indirect wages vi) Direct wages
vii) Indirect materials vii) Direct materials
viii) Lighting/Electricity expenses viii) wattage x working hours or No of light points or
Space occupied
ix) Power ix) Kw x working hours or H.P. of machine
x) Canteen expenses x) No of workers
xi) Supervisor’s salary xi) No of workers
xii) Employee welfare expenses xii) No of workers
xiii) Workers’ compensation insurance xiii) direct wages
xiv) General expenses xiv) Working hours or direct wages
xv) Repair & maintenance of assets xv) Value of assets
 (3)
The above is illustrative and not exhaustive.
Let us discuss the distribution of overheads and re-distribution of service department cost to production department
with an illustration.
Ill-1. P.Ltd is a manufacturing company having three production departments A,B and C, and two service
departments X and Y. The following is the budget for December, 2019:

Total
Rs
Rent and rates 5000
General lighting 600
Indirect wages 1500
Power 1500
Depreciation of machinery 10000
Sundry expenses 10000

Additional information: A B C D E
Rs Rs Rs Rs Rs

Area (sq.m) 2000 2500 3000 2000 500

Value of machinery (Rs) 60000 80000 100000 5000 5000
Machine hour 1000 2000 4000 1000 1000
Light points ( nos) 10 15 20 10 5
Direct wages 3000 2000 3000 1500 500
H.P. of machines 60 30 50 10 ---
Working hours 6226 4028 4066 --- ---

The expenses of D and E are allocated as follows

D 20% 30% 40% --- 10%

E 40% 20% 30% 105 ---

You are required to do the following:

i) A statement showing distribution of overheads
ii) A statement showing re-distribution of service department cost to production department
iii) Compute overhead recovery rate
iv) Ascertain total cost of an article if material cost is Rs 50, labour cost is Rs 30 and it passes through
departments A,B and C for 4,5 and 3 hours respectively.

Sol: We shall discuss the theory while solving the problem:

(i)Statement showing distribution of overheads
Item of expenses Basis of apportionment Total (Rs) Production Deptt Service Deptt
A B C D E
Rent and rates Floor Space 5000 1000 1250 1500 1000 250
General Lighting Light points 600 100 150 200 100 50
Indirect wages Direct wages 1500 450 300 450 225 75
Power H.P. of machine 1500 600 300 500 100 ---
Depreciation Value of machine 10000 2400 3200 4000 200 200
Sundries Direct wages 10000 3000 2000 3000 1500 500
Direct wages Actual 2000 --- --- --- 1500 500
TOTAL 30600 7550 7200 9650 4625 1575
 (4)
Note: Direct wages of production departments are included in the prime cost. However, direct wages of service
department though it is direct in nature, but from the point of view of production as it is not producing any goods or
services, hence direct wages of service department should be treated as indirect wages and accordingly overhead
from the point of view of production department. So is the case for direct materials of service department.

• Re-distribution of service department cost to production department

For re-distribution of service department cost to production department the following methods are used depending
upon the services rendered by the service department.
i) Direct service to production department only
ii) One-way service to production department and service department i.e besides giving service to
production department one service department gives service to another service department only.
iii) Reciprocal service given by the service departments i.e the service departments are giving services to
each other.

Case-I- Suppose in the above illustration both the service departments D and E gives service in the ratio of 3:1:1
and 2:2:1 to A, B and C respectively. In that case re-distribution statement will be as under:

Statement showing re-distribution of overheads

Item of expenses Production Deptt Service Deptt

A B C D E
Total Overhead 7550 7200 9650 4625 1575
Service department D 2775 925 925 (4625) ---
(3:1:1)
Service department E 945 315 315 --- (1575)
(2:2:1)
Total 11270 8440 10890 Nil Nil

Case-II- Service department D renders service to E worth Rs 2000 and the balance to A,B and C in the ratio of
3:1:1, while service department E provides service only to A,B and C in the ratio of 2:2:1. In that case re-
distribution will be as under-

Statement showing re-distribution of overheads

Item of expenses Production Deptt Service Deptt

A B C D E
Total Overhead 7550 7200 9650 4625 1575
Service department D to E --- --- --- (2000) 2000
Service department D to 1575 525 525 (2625) ---
Production Deptt(3:1:1)
Total 9125 7725 10175 Nil 3575
Service department E to 2145 715 715 --- (3575)
Production Deptt(2:2:1)
11270 8440 10890 Nil Nil

Case-III- Reciprocal services by one service department to another as given in the illustration:
In this case we may follow either a) Repeated distribution method or b) Simultaneous equation method
Repeated distribution method: in this case, service department with higher cost may be considered first and
distributing in the given ratio to production and other service department. This process will continue until the entire
service department costs are exhausted.
 (5)
Statement showing re-distribution of overheads
Item of expenses Production Deptt Service Deptt
A B C D E
Total Overhead 7550 7200 9650 4625 1575
Service department D 925 1388 1850 (4625) 462
(2:3:4:1)
Service department E 815 407 611 204 (2037)
(4:2:3:1)
Service department D 41 61 82 (204) 20
(2:3:4:1)
Service department E 8 5 7 --- (20)
(4:2:3:1)

Total Overhead 9339 9061 12200 Nil Nil

In the last step, share of cost of D from E will be distributed to A,B and C as it is negligible.

Simultaneous equation method- In this case we first construct two simultaneous equations to find the total cost of
each service department, then the same will be distributed.
Let,
a = Total cost of department D after receiving 10% share of E department’s cost
b = Total cost of department E after receiving 10% share of D department’s cost

Then, a = 4625 + 0.10 b ……………………..(i)

b = 1575 + 0.10 a ……………………..(ii) solving we get a = 4831 and b = 2058

Statement showing re-distribution of overheads

Item of expenses Production Deptt Service Deptt
A B C D E
Total Overhead 7550 7200 9650 4625 1575
Service department D 966 1449 1932 (4831) 483
(2:3:4:1)
Service department E 823 412 618 206 (2058)
(4:2:3:1)
9339 9061 12200 Nil Nil

• Absorption/ recovery of overheads: The above table shows that each department’s total overhead cost represent
its own cost plus share of joint cost and share of service department cost. This total cost is now be charged to cost
unit on some reasonable basis. This is called absorption of overhead. Basis of overheads absorption depends upon
the process of production adopted in a particular department. There are different methods of absorption of
overheads. Such methods are –
a) Production unit method (applicable in case of same products)
b) Percentage of value of raw material
c) Percentage of Direct labour cost(Applicable in case production process is labour intensive and
depends on labour time and type)
d) Labour hour rate method (Applicable in case production process is labour intensive and depends on
labour time)
e) Machine hour rate method. (Applicable in case production process is machine based)
The method of overhead absorption to be applied depends upon the production process in operation in a particular
department. For example, where the production is labour intensive, labour hour rate method may be most
appropriate; similarly where production is machine based only, machine hour rate method should be applied.
Thus in the given illustration, let us calculate overhead absorption or recovery rate depending upon the working
hours given. The absorption rate may be computed separately or it may be computed in the re-distribution
statement itself.

Overhead absorption rate = (Total overheads of the cost centre)/ quantum of absorption base
 (6)
Here, Overhead absorption rate will be –
Department A = Rs 9339/6226 hrs = Rs 1.50
Department B = Rs 9061/4026hrs = Rs 2.25
Department C = Rs 12200/4066hrs = Rs 3.00

After determining the overhead absorption rate the cost of product is determined as below. In the give illustration
the same is computed as below:

Statement showing cost of the articles

Rs
Raw materials 50
Labour cost 30
Overheads:
Deptt A = 4 hrs x Rs 1.50 6.00
Deptt B = 5 hrs x Rs 2.25 11.25
Deptt C = 3 hrs x Rs 3.00 9.00 26.25

Total Cost 106.25

• Absorption of overheads on the basis of Machine Hour Rate: Where the production in the factory is purely
based on machine work, absorption rate will be adopted is machine hour rate. A standard format of which may be
followed as below-
Computation of Machine Hour Rate
Original Cost of Machine- √
(+) Installation Charges - √
(+) Carriage etc -√
Capital Cost √
Less: Scrap value √
Depreciation √
Estimated Life --- yrs

Items of expenses Amount (Rs) Amount (Rs per

hour)
A. Fixed Expenses (illustrative only)
Rent, rates and taxes ---
Insurance ---
Electricity Charges ---
Supervisor’s Salary ---
Total fixed expenses ---
B. Effective Machine Hour
Machine Hour booked ---
Less: Normal Idle Time ---
Effective machine hour ---

C. Fixed expenses per hour (A/B)

---
D. Variable expenses per hour
Depreciation = Annual Dep/ B ---
Repair and maintenance = Total Reair cost/ B ---
Power = Power cost/ B ---

Machine Hour Rate ---

Comprehensive machine hour rate- In case of comprehensive machine hour rate, wages of operator will be
added with the above determined rate. This is mainly because when the production process is entirely machine
operated except operators are engaged for its running, then in that case instead of charging operator’s wages as
direct wages the same is added with the overhead cost to find comprehensive rate.
 (7)
• Over or Under Absorption of Overheads: Before we discuss over or under absorption let us say how many
overhead absorption rates are there. There are four absorption rates.
i) Normal rate = Actual overhead incurred/ Actual quantum of absorption base
ii) Pre-determined Rate = Budgeted overhead / Budgeted quantum of absorption base
iii) Blanket Overhead Rate = Total Budgeted overhead/ Total quantum of estimated base
iv) Departmental Overhead Rate = (Total Budgeted or estimated overhead
for each department) / Departmental absorption base

Where overhead absorption rate is based on historical cost, there will be no over or under absorption of
overhead. However, where absorption of overheads is done on the basis of estimated overheads, the rate
determined will be pre-determined overhead rate and there will be a chance of over or under absorption of
overhead. Blanket rate is basically applicable for single product organisation, while departmental overhead rate
is applicable in case of multiple product organisations. However, over or under absorption occur if-

Over absorption of overhead = Estimated Absorbed > Actual Overhead incurred

Under absorption of overhead = Estimated Overhead < Actual Overhead

Such over or under absorption of overheads occur may be due to –

i) Wrong estimation of overheads or wrong estimation of absorption base.
ii) Unanticipated change in the level of production
iii) When there is significant change in the prices of materials and direct labours and recovery is done on
the basis of materials and labour costs
iv) If technology or production process is changed and as a result there is a change in overhead costs.

Ill 2- The budget of a machine shop for 2018-19 is as follows:

Normal working week 42 hours
Number of machines 15
Hours spent on maintenance per week (normal loss) 5 hrs per machine
Estimated annual overhead Rs 5,55,000
Number of working weeks in 2018-19 50
The actuals in respect of 4-week period in 2018-19 are :
Overhead incurred Rs 49,000
Machine hour worked 2400

Calculate : a) Overhead rate per machine hour for 2018-19

b) The amount of over or under absorption of overhead in respect of the 4-week period.

Sol. Machine hour worked = Working weeks x working hours per week x no of machine- Normal idle time
= 50 weeks x 42 hours x 15 - 15 x 5 x 50
= 31,500 – 3750 = 27750 hrs
Machine hour rate = Total estimated annual overhead / machine hour worked
= Rs 5,55,000 / 27750 = Rs 20
Computation of Over or under absorption of Overhead
Rs
Overhead incurred 49,000
Overhead absorbed 48,000
[Rs 20 x 2400 hrs]
Under absorption 1,000

• Treatment of over or under absorption of overhead: Over or under absorbed overheads may treated in
three different ways. However a particular method is applicable depending upon the reasons of arising over or
under absorption of overheads.
i) The amount may be carried forward to next year
ii) The amount may be charged to costing profit & loss account.
iii)The amount may be adjusted through supplementary rate.
 (8)

• Carried forward to next year- In this case over or under absorption of overhead is carried forward to next
year through overhead reserve account for charge. However, such treatment is not acceptable as it ignores
matching concept, because instead of charging or crediting current year’s item in current year, the same is
deferred for adjustment. It is basically accepted when, reasons for over or under absorption are not readily
determinable.
• Charging to Costing Profit & Loss Account – When the over or under absorption of overhead is negligible
or even where it is significant but it arises due to abnormal reasons the same should be charged to costing
profit and loss account.
• Use of Supplementary Rate - This method is used when such over or under absorption arises due to wrong
estimation of overheads, major change in the production method, error in estimating the recovery base. Let
us first understand use of supplementary rate in case of under absorption of overhead. Later over
absorption will follow automatically. Suppose overhead absorbed = Rs 1, 00,000 and overhead incurred
= Rs 1,20,000. So there is under absorption = Rs 20,000. Overheads charged to current year’s cost is
Rs1,00,000, thereby cost is lower by Rs 20,000 and accordingly, increase in profit by the same amount.
Thus, adjustment to be made in the current year with respect to the output produced. But output produced
consists of full finished or half-finished goods and even for full finished goods a portion may remain
unsold. So adjustment to be made to finished goods sold and the balance to be deferred for charge through
Stock of WIP and that of Finished Goods.
Over or under absorption of Overhead
Supplementary rate =
Actual activity level