LEARNING UNIT 7: ASSIGNMENT OF PRODUCTION

OVERHEADS

SPECIFIC LEARNING OUTCOMES FOR THIS LEARNING UNIT

After studying this learning unit, you should be able to:

x determine the fixed and variable cost elements of mixed costs
x assign production overheads according to predetermined rates

ASSESSMENT CRITERIA

After working through this learning unit, you should be able to do the following:
x assign manufacturing overheads by means of primary and secondary allocation processes in
a traditional costing system
x calculate the overhead absorption rate per production department
x calculate over- and under-applied overheads

OVERVIEW

This learning unit is divided into the following sections:

7.1 Introduction
7.2 Budgeting for production overheads
7.3 Apportioning production overheads
7.4 Correlation of variables and relevant range
7.5 Methods of separating mixed costs

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7.1 INTRODUCTION
We divide direct costs into the cost of direct materials and the cost of direct labour. These costs
belong to the goods being produced, and we can trace them directly to the goods. Generally, it is
easy to establish the direct costs of each product. For example, a pillow is made with two pieces
of fabric (each measuring 75 cm x 40 cm) and 500 grams of duck feathers. If the fabric is 78 cm
wide and it costs R100 per metre, and the feathers cost R170 per kilogram, you will agree that it
is easy to trace the cost of the direct materials in the quantities mentioned directly to the cost of
each pillow. Similarly, if it takes a seamstress 30 minutes to stitch and fill one pillow and her hourly
wage is R80, it is easy to trace the cost for half an hour's labour to the cost of each pillow. However,
we cannot trace production overheads directly to the products manufactured. For example, how
much of the rent for the factory building should we charge to the cost of each pillow that is made?

In learning units 4 and 6, we considered the actual (historical) costs incurred for materials and
labour. We recorded the actual cost of materials purchases by debiting the relevant materials
inventory control account and crediting either bank or trade payables; we recorded the actual
labour cost by debiting the wages clearance account and crediting, amongst others, the wages
payable account. You will also recall that we assigned the cost of direct materials to the units being
produced by debiting the work-in-progress account and crediting the inventory of materials control
account as soon as the materials were issued to production. We assigned the cost of direct labour
to the units being produced by debiting the work-in-progress account and crediting the wages
clearance account.

It is important to understand that we literally assign the direct material and direct labour costs that
are debited to the work-in-progress account to the actual units of production to which these costs
apply. For example, if a factory that manufactures canned foods makes only cans of pilchards in
week 1, then the direct material costs and direct labour costs debited to the work-in-progress
account in week 1 will be assigned to those cans of pilchards. None of the direct costs for week 1
will be assigned to the cans of corned beef that will be manufactured in week 2. The direct material
and direct labour costs transferred to the work-in-progress account in week 2 will be assigned to
the cost of the cans of corned beef.

In learning unit 3, we saw that there are three alternative bases that we can use for assigning the
costs of direct materials, direct labour and production overheads to production, namely actual
costing, normal costing and standard costing. Actual costing is used primarily in companies
manufacturing only one product and where all production costs (direct materials, direct labour and
production overheads) can be traced directly to that single product. Actual costing is not an
appropriate basis for measuring input costs where multiple products are produced. Consider our
example of the company that manufactures canned foods again: we cannot assign all the
overheads incurred in week 1 to the pilchards produced in week 1 only. Suppose the company
paid the annual insurance premium, the monthly rent and the monthly electricity account for the
factory in week 1. You will agree that it would be ludicrous to assign all these overheads to the
cost of the pilchards that were manufactured in week 1.

Overheads are not incurred evenly throughout the year (i.e. overheads are not more or less the
same every week). If a manufacturer of multiple products wanted to assign actual overheads to
production, they would have to wait until the end of the year before they will know for sure what
the actual cost of overheads was. Unfortunately, by then it would be too late to assign the costs
to production, since many of the goods produced during the year would have been sold already.
It therefore makes sense to apply a normal costing basis for assigning input costs to production.
Normal costing assigns direct material and direct labour costs to production at actual (historical)
cost; it also assigns production overheads to all the products manufactured at a predetermined
rate that will distribute overheads fairly.

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We could determine and apply a single predetermined rate for all departments, which is called a
plant-wide rate, or a predetermined rate per department. The latter is more appropriate in a
process costing system. In a standard costing system, we will determine separate rates for fixed
and variable overheads.

7.2 BUDGETING FOR PRODUCTION OVERHEADS

In learning unit 2, we defined cost drivers as factors that cause a change in the cost of something.
For example, the number of units produced will drive the total cost of direct material and direct
labour. Therefore, the greater the number of pillows made, the more the pieces of fabric and the
feathers that will be used and the longer the seamstress will have to work. All of these contribute
to a higher total cost of direct materials and direct labour.

When the management accountant prepares the budget of the company, it is important that he or
she is aware of the drivers of the different costs. Information such as historical data, agreements
with suppliers, agreements with trade unions and economic forecasts will assist the accountant in
budgeting for the direct material and direct labour costs per unit for the coming year. The
accountant should also recognise that the total number of units produced drives the cost of direct
materials and direct labour.

We already know that production overheads are also product costs and must be included in the
production budget. The management accountant of a company must therefore also know what the
drivers of overheads are. Once these drivers are known, the accountant can decide on fair bases
on which to assign the overheads to production.

The drivers that drive the cost of production overheads will be any of a number of levels of activity.
These levels of activity could include the total number of units produced, machine hours or direct
labour hours worked and the total weight of direct materials converted. The driver of indirect
materials will be total production, while the driver of the cost of electricity will probably be machine
hours. Every cost is analysed in terms of its own cost driver. It is therefore important to establish
what driver causes a cost to increase or decrease.

In learning unit 2, we learnt that we classify product costs, amongst others, according to their
behaviour. Cost behaviour refers to how a cost behaves at different levels of activity. We classify
product cost as a variable cost, a fixed cost or a mixed cost (i.e. a mix of fixed costs and variable
costs). Total variable costs and the variable portion of mixed costs will increase with an increase
in activity; total fixed costs and the fixed portion of mixed costs will remain constant regardless
activity levels (within the relevant range, of course; see section 7.4).

Direct material and direct labour costs are classified as variable costs: the total cost of direct
materials and the total cost of direct labour vary in proportion to the number of units produced.
Overheads consist of variable, fixed and mixed costs. For planning purposes, especially for the
preparation of a flexible budget, it is important to separate mixed overheads into their variable and
fixed components. (In section 7.5, we will look at methods used to separate mixed costs into their
fixed and variable components.) A flexible budget can be adjusted for changes in the level of
activity, for example the number of units sold, the number of units produced, etc.

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 Example 7.1

Windhoek Limited manufactures quality fold-up foam mattresses. These mattresses are very
popular for camping holidays. The following is an extract from the flexible production overheads
budget of the company for the year at production levels 10 000, 20 000 and 40 000:

Number of mattresses produced 10 000 20 000 40 000

Variable overheads at R150 1 500 000 3 000 000 6 000 000
Fixed overheads (R) 1 500 000 1 500 000 1 500 000
Total overheads (R) 3 000 000 4 500 000 7 500 000

Production overheads per mattress R300,00 R225,00 R187,50

Fixed overheads per mattress R150,00 R75,00 R37,50
Variable overheads per mattress R150,00 R150,00 R150,00

Production levels of 10 000, 20 000 and 40 000 all fall within the relevant range (see section 7.4).
The total overheads per mattress decreases as the number of mattresses manufactured increases:
R300,00; R225,00; and R187,50. This is because fixed costs (R1 500 000) are spread over more
units: R1 500 000 / 10 000 = R150,00; R1 500 000 / 20 000 = R75,00; and R1 500 000 / 40 000 =
R37,50. The variable cost per unit remains the same at R150,00 per unit.

Variable overheads consist of the costs incurred for indirect materials and labour, repairs and
maintenance of manufacturing equipment, electricity (variable component), etc. The total cost of
variable overheads varies with the production activity of the company, although not to the same
extent as the total direct material and direct labour cost.

Fixed overheads consist of the costs incurred for salaries paid to factory supervisors and security
staff, depreciation of manufacturing equipment and the factory building, municipal rates, insurance
of factory facilities, electricity (fixed component), etc. In the short to medium term, the total cost of
fixed overheads does not vary with manufacturing activity within the relevant range.

Under absorption costing, we assign the cost of fixed and variable overheads to the cost of goods
manufactured. In budgeting for production overheads, the management accountant will do the
following:

¾ budget for total production overheads

¾ separate the budget into variable and fixed overheads
¾ identify an appropriate driver/basis for assigning the overheads to production
¾ determine the rate to be used to apportion the overheads to the units of production

The apportionment rates are also called recovery or absorption rates. We will now take a closer
look at the processes followed in budgeting for variable production overheads and fixed production
overheads respectively.

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7.2.1 Budgeting for variable production overheads

Behaviour of variable production overheads

Although we have mentioned only a few examples of variable overheads above, in practice there
can literally be hundreds of variable overheads items. All variable overheads items does not vary
at the same rate with changes in activity levels, neither do they vary with the same activity levels:
some costs may vary with changes in machine hours, some with changes in direct labour hours
and others with changes in number of units manufactured.

You will recall that Woodpecker (Pty) Limited uses varnish (indirect material) in its manufacturing
process. The amount of varnish used will increase with every piece of furniture (unit) produced,
because every unit is painted with varnish. Figure 2.3 of learning unit 2 depicts the cost behaviour
of the varnish graphically. Woodpecker also uses oil and grease (consumables) to lubricate the
manufacturing equipment. However, the equipment may require lubrication only after every 10 000
units produced. Figure 2.5 of learning unit 2 depicts the cost behaviour of the oil and grease
graphically.

Appropriate bases for applying variable costs to cost objects

We now know that the different items of variable production overheads display different
consumption patterns. However, since it would be impractical to use a different basis for assigning
the cost of each of the many variable cost items, most companies select a single measure for
assigning variable overheads to production. The most commonly used bases are the number of
units produced, the number of direct labour hours and the number of machine hours. Direct labour
hours are more appropriate in a labour-intensive environment, while machine hours will be more
appropriate in a more automated environment where machines rather than people perform the
majority of the manufacturing tasks.

Determining a variable production overhead absorption (recovery) rate

The master budget of a company is compiled from several other budgets, amongst others, the
sales budget, the production budget and the production overheads budget. The sales budget is
typically prepared first, because we have to know how many units of each product the company
plans to sell before we can prepare a production budget to ensure that sufficient units of the
products will be available for sale. Similarly, we need to know what we plan to produce in order to
budget for the production overheads that will be incurred at the budgeted production levels. (See
example 7.1)

The overheads budget is to a large extent prepared from information obtained from previous years'
actual results. Also taking into account factors like planned production levels, inflation, trade
agreements and economic forecasts, the management accountant estimates the total variable
overheads that will be incurred at different levels of production. Assume that direct labour hours
is chosen as the basis for allocating variable overheads to production; then the total estimated
variable overheads are divided by the total estimated direct labour hours to determine a rate for
apportioning variable overheads to production.

Let's return to example 7.1 for a moment. In this example, the variable overheads per unit is
estimated at R150. Let's assume that variable overheads were apportioned on the basis of direct
labour hours (DLH). It is very important that you understand that the R150 is the overhead rate
per unit of production and NOT the direct labour rate per hour. The two rates are different and are
calculated as follows:

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Direct labour rate = total direct labour cost ÷ total DLH
Variable overheads rate per DLH = total variable overheads ÷ total DLH

If variable overheads are apportioned on the basis of direct labour hours, the accountant must first
determine how many labour hours are required to produce one unit before he can determine the
overheads per unit. Assume that the overheads rate per direct labour hour is R75 and that it takes
two hours to produce one unit; then the overheads per unit is R150 (2 hours x R75 per direct
labour hour).

7.2.2 Budgeting for fixed production overheads

In terms of IAS 2.12, the cost of fixed production overheads must be included in the cost of finished
goods. IAS 2:13 further states the following:

The allocation of fixed production overheads to the costs of conversion is based on the normal
capacity of the production facilities. Normal capacity is the production expected to be achieved on
average over a number of periods or seasons under normal circumstances, taking into account
the loss of capacity resulting from planned maintenance.

Capacity can be expressed as machine hours, units produced, quantity of direct materials
converted, etc. We distinguish between the following different levels of capacity in a manufacturing
environment, among others:

Theoretical capacity is a factory's capacity based on the assumption of 100% efficiency all the
time.

Practical capacity is a factory's capacity where the theoretical capacity has been reduced by
expected interruption in production, such as planned maintenance.

Normal capacity is a factory's average level of activity for meeting the company's production
demands, taking into account expected interruptions and seasonal fluctuations. Normal capacity
is a realistic measure of what the company is likely to produce, rather than what it can produce.

Budgeted capacity is the anticipated use of available capacity based on planned production levels.

Within the relevant range, we assume that fixed costs will remain the same regardless of the level
of activity. In example 7.1, production activity levels of 10 000, 20 000 and 40 000 all fall within the
relevant range, hence the fixed overheads remained the same ("fixed"). The relevant range is
likely to fall within the normal and budgeted capacity. Therefore, the numerator (total fixed costs)
used in calculating an absorption rate will remain the same regardless of the denominator
(capacity level) used for calculating an absorption rate. Because there is no cause and effect
relationship between fixed costs and capacity levels, the larger the denominator, the smaller the
amount of fixed overheads that will be allocated to each unit of activity:

Units of production 10 000 20 000 40 000

Fixed cost (R) 1 500 000 1 500 000 1 500 000
Fixed overheads per unit R150,00 R75,00 R37,50
Calculations 1 500 000 / 10 000 1 500 000 / 20 000 1 500 000 / 40 000

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From your school mathematics, you will recall that numbers can be whole numbers (also called
integers) or fractional numbers. Integers can be positive or negative whole numbers like 1, 7, 12,
-5, -16, etc. Fractions are numbers that contain "parts" of whole numbers and they are written like
division sums, for example, ½ and ¾ are fractions; ½ means 1 ÷ 2 and ¾ means 3 ÷ 4. Fractional
numbers can also be written as decimals, so instead of writing ½ we can also write 0,5 (because
1 ÷ 2 = 0,5), and instead of ¾, we can also write 0,75 (because 3 ÷ 4 = 0,75). Fractions can also
be positive or negative.

The top number in a fraction is called the numerator, while the bottom number is called the
݊‫ݎ݋ݐܽݎ݁݉ݑ‬
denominator: Therefore, if total fixed production overheads is R1 500 000 and the
݀݁݊‫ݎ݋ݐܽ݊݅݉݋‬
ୖଵହ଴଴଴଴଴
activity level is 20 000, then R1 500 000 is the numerator and 20 000 is the denominator:
ଶ଴଴଴଴
= R75 per unit.

Activity 7.1 (myUnisa forum)

1 Explain cost drivers.

2 What is an overhead absorption rate?
3 Explain what capacity means.
4 How is an overhead absorption rate determined?

7.3 APPORTIONING PRODUCTION OVERHEADS

In learning units 4 and 6, we saw that production overheads (indirect materials and indirect labour)
are debited to the production overheads clearance account (not the work-in-progress account). The
word "clearance" in the production overheads clearance account is important. It indicates that the
account is a temporary account where the actual costs incurred can be "parked" until they can be
transferred elsewhere. After the final transfer, the balance of the clearance account must be nil.

The actual costs of direct materials and direct labour are debited to the work-in-progress account
when the costs are incurred. We do this because we can trace direct production costs directly to the
units of production. The actual cost of indirect materials issued to production and of indirect labour
and other production overheads (e.g. the cost to rent the factory) are debited (or "parked") in the
production overheads clearance account until they are apportioned to production.

We use the predetermined absorption rate to assign overheads to the units of production. We then
credit the production overheads clearance account and debit the work-in-progress account. The
balance of the work-in-progress account will then reflect the total cost of unfinished units in respect
of actual direct material and direct labour costs as well as the apportioned production overheads.
Consider transaction K in example 2.3 of learning unit 2 for the activity that follows.

Activity 7.2

1 Explain the purpose of a clearance account. Mention examples of clearance accounts

found in the general ledger.
2 How do production overheads flow through the accounting records?

Feedback on activity 7.2

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 1 A clearance account is a temporary account in which costs are held until they can be
transferred to another account. At the end of the accounting period, the balance of the
clearance account should be nil. Examples of clearance accounts are the following:
x the production overheads clearance account, where actual costs incurred for
overheads are debited and held until the overheads are assigned and transferred to
the work-in-progress account
x the wages clearance account, where total actual gross wages and employer
contributions to employee benefits are debited and held until allocated to either the
work-in-progress account or the production overheads clearance account

2 The cost of production overheads flows through the accounting records as follows:
x When actual overheads are incurred, the production overheads clearance account is
debited and the inventory/wages clearance/bank/trade payables account is credited with
the actual (historical) cost of the transaction.
x When overheads are apportioned to production (based on predetermined rates), the
work-in-progress account is debited and the production overheads clearance account is
credited with an amount determined by multiplying the predetermined rate by an actual
measure of output (e.g. actual direct labour hours or actual machine hours).

The production overheads clearance account will thus reflect the following entries:

Production overheads clearance account

R R
Materials inventory (indirect materials) xxxx Work-in-progress (apportionment) xxxx
Wages clearance (indirect labour) xxxx
Bank/Payables (rent, insurance, etc) xxxx

We can apportion fixed and variable overheads to production separately by applying different
absorption rates. This will especially be the case with standard costing. Fixed and variable
overheads can also be apportioned by applying the same predetermined absorption rate.

The predetermined absorption rates can be a single rate or multiple rates. A single rate (plant-
wide rate) is determined for the entire plant. Multiple rates are determined for each production
department and is used in process costing.

7.3.1 Single absorption rate

Earlier, we saw that IAS 2.12 states that the costs of conversion of inventories include … a
systematic allocation of fixed and variable production overheads ….

IAS 2.13 further states that the allocation of fixed production overheads … is based on the normal
capacity of the production facilities.

We also indicated earlier that we can use several capacity bases to assign overheads to units
produced. The bases can be volume or cost-based. All these bases refer to the capacity of the
factory. Therefore, we can measure total capacity by, amongst others, the total units produced,
the total machine hours or total direct labour hours worked, the total value of direct materials
converted, etc. We will discuss capacity in detail later on in this learning unit.

A single rate (or plant-wide rate) is sometimes used for apportioning production overheads to
production output (the units produced). This approach is suitable when the company manufactures
similar products where all overheads are driven by approximately the same measure of capacity,

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for example machine hours. We calculate the single rate by dividing the total budgeted production
overheads by the capacity basis selected for the absorption of overheads (e.g. machine hours).

Example 7.2

Gaborone makes a variety of hand-crafted items. Because the production process is labour
intensive, total direct labour hours will be used as the denominator in determining an overheads
absorption rate. The factory budgeted for total production overheads of R600 000 and 5 000 direct
labour hours (DLH) in the current financial year to achieve its target production levels.

The single rate that will be used to absorb the overheads into the cost of units produced is
R600 000 ÷ 5 000 hours = R120 per direct labour hour. Assume that the actual production output
of Gaborone was as follows:

Hand-crafted item produced Total units completed Total DLH

Fairies 500 1 500
Squirrels 300 1 200
Vases 2 000 3 000

To determine the overheads apportioned to each unit produced, we must first calculate the total
overheads apportioned to the different products and then divide the total overheads by the number
of units produced:

Total overheads apportioned

Item produced Calculation Total overheads apportioned

Fairies 1 500 direct labour hours x R120 per DLH R180 000
Squirrels 1 200 direct labour hours x R120 per DLH R144 000
Vases 3 000 direct labour hours x R120 per DLH R360 000

Overheads absorbed per unit of production

Item produced Calculation Overheads per unit

Fairies R180 000 / 500 units produced R360
Squirrels R144 000 / 300 units produced R480
Vases R360 000 /2 000 units produced R180

You probably noticed that the total overheads actually apportioned to production amounted to
R684 000 (180 000 + 144 000 + 360 000). This is more than the total budgeted overheads of
R600 000. Let's assume that the actual total overheads incurred were R712 500. We now have
three figures, all of which are relating to the same cost, namely total production overheads:

Budgeted overheads R600 000

Absorbed overheads R684 000
Actual overheads R712 500

It is very important that you understand that the budget is not a part of the formal accounting
records (general ledger) of the organisation; therefore, the budgeted overheads of R600 000 will
not flow through the general ledger accounts of Gaborone at all. Only actual transactions are
160
recorded in the accounting records. The actual overheads of R712 500 will flow into the general
ledger (production overheads clearance account), and the absorbed overheads of R684 000 will
flow out of the general ledger (production overheads clearance account).

It is also important that you understand that a budget is merely a best estimate of what will occur
in the forthcoming year. We prepare a budget for future production. As you know, no one can
predict the future with certainty. The management accountant uses all relevant information
available to estimate what will happen in the future (i.e. the forthcoming financial year). What
actually transpires during that year is seldom, if ever, exactly according to the budget. There are
several reasons why budgeted overheads are different from the actual overheads, for example
unexpected price increases or decreases, inefficiencies or better than expected efficiencies, etc.

Let's now have a closer look at the amounts that affect the accounting records. You will recall that
the production overheads clearance account is used to record production overheads. In our
example above, the production overheads clearance account will appear as follows:

Production overheads clearance account

R R
Bank/Payables etc. 712 500 Work-in-progress 684 000
(actual overheads) (absorbed overheads)

Earlier, we said that a clearance account is a temporary account into which costs are held until
they can be transferred, at which point the balance of the account must be nil. However, after we
have transferred the cost in our example, a debit balance of R28 500 (712 500 – 684 000)
remains. This means that the actual overheads were more than the overheads absorbed in
production. We call this an under absorption of overheads: we absorbed too little overheads into
the cost of production. Had the actual overheads been less than the overheads absorbed, we
would have had an over absorption of overheads.

What do we do with the balance of R28 500 to get this clearance account to a nil balance? We
now know that the actual cost of overheads was R712 500 and that the actual labour hours were
5 700. An absorption rate based on these actual figures would have been R712 500 / 5 700
= R125 per labour hour. However, based on budgeted figures, we used an absorption rate of R120
per labour hour (i.e. R5 per labour hour was under absorbed).

Let's assume that there were no inventories on hand at the beginning of the year, but that 100
fairies, 20 squirrels and 400 vases were left in inventory at the end of the year. That means that
400 (500 – 100) fairies were sold, 280 (300 – 20) squirrels were sold and 1 600 (2 000 – 400)
vases were sold. Let's see where the under absorption occurred:

Actual Total under Total Units Units in Under Under absorbed in

labour absorption : units sold inventory absorbed in units in inventory
hours (ALH) ALH x R5 produced sold units (D / B) x A
(C / B) x A
A B C D
Fairies 1 500 7 500 500 400 100 6 000 1 500
Squirrels 1 200 6 000 300 280 20 5 600 400
Vases 3 000 15 000 2 000 1 600 400 12 000 3 000
R28 500 R23 600 R4 900

Explanation of calculations (fairies only):

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Total under absorbed cost (A) R7 500
Therefore, under absorption in:
sold units (400 / 500 x R7 500) R6 000
inventory (100 / 500 x R7 500) R1 500

Alternative calculation:
Under absorption per unit produced = R7 500 ÷ 500 = R15
Under absorption in:
sold units (400 x R15) R6 000
inventory (100 x R15) R1 500

The total under absorption of overheads in units sold is R23 600, and the total under absorption of
overheads in units still in inventory is R4 900. That means that cost of sales is understated by R23 600,
and that inventory is understated by R4 900. Strictly speaking, we should adjust cost of sales by
R23 600 and inventory by R4 900. However, because the R4 900 is considered an immaterial amount,
the full R28 500 will be adjusted against the cost of sales account, which will clear the production
overheads clearance account:

Production overheads clearance account

R R
Bank/Payables (actual overheads) 712 500 Work-in-progress (absorbed overheads) 684 000
Cost of sales (under absorption) 28 500
712 500 712 500

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 Example 7.3

The following information pertains to the fixed production overheads budget of Harare Limited for
production outputs within the relevant range:
R
Salaries and benefits:
Supervisor 360 000
Quality controllers 600 000
Wages and benefits:
Cleaning staff 240 000
Security staff 480 000
Insurance premium:
Factory plant 150 000
Factory equipment 100 000
Property rates 60 000
Fixed portion of electricity 120 000
Depreciation of factory equipment 300 000
Total 2 410 000

Cleaning and security staff are employed on a shift basis. Each staff member works an eight-hour
shift per day, for which they receive a fixed wage per week. The cleaning and security staff are
not expected to work overtime. Therefore, their wages and benefits are considered as fixed costs.
Because the total cost is not dependent on any variable level of activity and production is within
the relevant range, the wages will be the same (fixed) regardless of the number of units produced.

The following are the normal annual production capacity levels of Harare:

Total units produced 920 000

Total machine hours 85 000
Total direct labour hours 350 000
Total kilogram of direct materials converted 240 000

Required
Calculate an absorption rate for fixed overheads using each of the above capacity levels as
denominator.

Answer

The numerator in each instance is the total budgeted fixed production overheads of R2 410 000, while
the denominator is one of the capacity levels:

Numerator A R2 410 000 R2 410 000 R2 410 000 R2 410 000

Denominator B 920 000 units 85 000 machine hrs 350 000 DLH 240 000 kg
Allocation rate A/B R2,6196 per R28,3529 per R6,8857 per DLH R10,0417 per
unit produced machine hour kg converted

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Assume that Harare Limited produces standard umbrellas and that there is very little difference
between the different types of umbrellas produced. It would then make sense for Harare to use units
of production as denominator in determining an overheads apportionment rate. Where more than
one type product is manufactured, an apportionment rate based on units of production may not be
fair.

Activity 7.3

Use the information provided in example 7.3. Assume that Harare Limited produces two very
different types of umbrellas: an umbrella that could double as a walking stick, and an umbrella that
can fold up and fit into a handbag. The following information pertains to the production budget of
Harare Limited for the year ending 30 September:

Large umbrella Fold-up umbrella Total

Budgeted units of production 370 000 550 000 920 000
Budgeted machine hours 25 000 60 000 85 000
Budgeted direct labour hours 110 000 240 000 350 000
Budgeted kilograms of direct materials 142 000 98 000
converted 240 000

Using the fixed overheads (FOH) absorption rates for each of the four possible denominators
determined in activity 7.3, for each umbrella type calculate the budgeted fixed production
overheads per unit as well as the total fixed overheads budget.

Feedback on activity 7.3

Calc Rate per Umbrella type Total FOH

activity 7.3 Large Fold-up apportioned
Apportionment basis↓ R R R R
Completed units
A Units of production 370 000 550 000
Apportionment rate 2,6196
Total FOH apportioned A x rate 969 252 1 440 780 2 410 032

Calc Rate per Umbrella type Total FOH

activity 7.3 Large Fold-up apportioned
Apportionment basis↓ R R R R
Machine hours
B Total machine hours 25 000 60 000
C Machine hours per unit B/A 0,0676 0,1091
D Fixed overheads per unit C x rate 28,3529 1,9157 3,0930
Total FOH apportioned AxD 708 823 1 701 174 2 409 997
Labour hours
E Total direct labour hours 110 000 240 000
F Direct labour hours per unit E/A 0,2973 0,4364
G Fixed overheads per unit F x rate 6,8857 2,0471 3,0047
Total FOH apportioned AxG 757 427 1 652 568 2 409 995
Materials converted

164
 H Materials consumption 142 000 98 000
I Kilogram per unit H/A 0,3838 0,1782
J Fixed overheads per unit I x rate 10,0417 3,8538 1,7892
Total FOH apportioned AxJ 1 425 921 984 087 2 410 008

Explanation
Allocation base: completed units
The allocation rate of R2,6196 is already per unit of production. Therefore, we multiply the
budgeted units of production per product (type of umbrella) by the rate per unit.

Apportionment base: machine hours

The absorption rate is provided per machine hour. We therefore need to first calculate the machine
hours required for each unit of production (total machine hours ÷ total units of production). We can
then multiply the machine hours per unit by the rate per machine hour to obtain the fixed overheads
per unit (umbrella) produced.

Apportionment base: direct labour hours

The absorption rate is provided per direct labour hour. We therefore need to first calculate the
direct labour hours required for each unit of production (total direct labour hours ÷ total units of
production). We then multiply the direct labour hours per unit by the rate per direct labour hour to
obtain the fixed overheads per unit.

Apportionment base: direct materials converted

The absorption rate is provided per kilogram converted. We therefore need to first calculate the
kilograms required for each unit of production (total kg ÷ total units of production). We then multiply
the kilogram per unit by the rate per kilogram to obtain the fixed overheads per unit.
The small difference between the total fixed overheads apportioned (see last column) for each of
the four bases and the actual fixed overheads of R2 410 000 is the result of rounding.

Because the units are not of the same manufacturing standards, it may not be fair to allocate the
fixed overheads based on completed units. Let's assume that the variable costs per umbrella are
as follows:

Large Fold-up
R R
Direct materials cost per unit 171 79
Total variable conversion cost per unit 69 90
Direct labour cost per unit 24 35
Variable overheads per unit 45 55
Total variable cost per unit 240 169
The following is the potential cost apportioned
per umbrella (see activity 7.4):
Completed units 2,6196 2,6196
Machine hours 1,9157 3,0930
Direct labour hours 2,0471 3,0047
Materials used 3,8538 1,7892

Although the materials cost of the large umbrella is more than double that of the fold-up umbrella,
the conversion cost of the fold-up umbrella is more than 30% higher than that of the large umbrella.

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In the case of umbrellas, it is likely that all the direct materials are added to production right at the
beginning of the manufacturing process. In addition, overheads are conversion costs. Therefore,
it would make sense to apportion fixed overheads on a basis consistent with the conversion of
each product. We could consider either machine hours or direct labour hours as a basis for the
apportionment of fixed overheads. If we assume that the production process is more labour
intensive, we will select direct labour hours as the basis for the apportionment of fixed production
overheads. Therefore, the total budgeted unit cost of production will be as follows:

Large Fold-up
R R
Direct materials cost per unit 171,00 79,00
Total variable conversion cost per unit 69,00 90,00
Direct labour cost per unit 24,00 35,00
Variable overheads per unit 45,00 55,00
Total variable cost per unit 240,00 169,00
Fixed overheads per unit 2,05 3,00
Total budgeted unit cost 240,05 172,00

We have now seen how we can use a single absorption rate to apportion production overheads
to production output. We have also seen that we can use several capacity activity levels as the
denominator to determine the apportionment rate, and that each activity level will yield a different
result. When considering which activity level to apply, we must bear in mind that the resulting
overheads assigned should reflect the cost of each product fairly.

As mentioned, a single rate is suitable for smaller companies that manufacture similar products or
companies that use the job-costing method for assigning production costs. A single rate would be
inappropriate for companies that manufacture a diverse range of products – often in more than
one department – and use equipment of varying sophistication, like in a process costing system.
These companies would apply an overhead rate per production department.

7.3.2 Assigning overheads to departments

In most manufacturing environments, direct materials undergo a process of conversion in more
than one production department. In order for us to include production overheads in the total cost
of production, we must determine the cost of production overheads incurred by each production
department.

A typical factory set-up will have production departments as well as service departments, which
render essential services to the production departments. All the manufacturing activities required
to convert direct materials into finished goods take place in the production departments. The
activities of services departments do not convert direct materials into finished goods. However,
service departments render essential services that enable the production departments to perform
their activities. (Note that service departments can also render services to other service
departments.) Since the goods manufactured receive an indirect benefit from the activities of
service departments, we must add the total costs of service departments to the total production
overheads and ultimately apportion these costs to the goods produced. For this purpose, we must
divide the costs incurred by service departments between the production departments on a
reasonable basis. The steps followed for the distribution of production overheads are the following:

Step 1: primary allocation and apportionment

We also refer to this step as the departmentalisation of overheads. It involves the allocation of
overheads (e.g. indirect salaries) that we can trace directly to production as well as service

166
departments. It further involves the apportionment of common overheads (e.g. rent) on suitable
bases to both the production and service departments.

Step 2: secondary apportionment

During this step, we reapportion the costs of service departments to production departments. The
different methods for apportioning service department costs to production departments include the
following:

Direct method
This method apportions the costs of service departments directly to production departments;
however, it ignores the fact the service departments also render services to other service
departments.

Step method
Also called the sequential method, this method apportions the costs of service departments on a
one-by-one basis to production and other service departments. This method recognises the fact
the service departments also render services to other service departments, but ignores the fact
that services departments render reciprocal services (i.e. services to each other). Under this
method, we first apportion the costs of the department that provides most services to other
departments to the other service departments and the production departments. Then we apportion
the costs of the service department that provides the second most services, and so forth until we
apportion the costs of the last service department to the production departments.

Reciprocal method
This method recognises that services departments also render services to each other. For
example, a canteen in the factory will render a service to the factory administration, and the factory
administration will also render a service to the canteen. Under the reciprocal method, we must
apportion some costs of the canteen to the administration department and some costs of the
administration department to the canteen. Since this method of apportionment can become very
complicated and require software to perform the intricate calculations, it falls beyond the scope of
this learning unit.

Step 3: absorption rates

The final step involves determining the absorption rates (recovery rates) for apportioning the
overheads to units of production. We distinguish between the allocation and apportionment of
production overheads:

Allocation
When we assign overheads directly to a department, we say we allocate them to that department.
In the example of Woodpecker (Pty) Limited, we can allocate the salaries of canteen staff directly
to the canteen. Allocation does not require any calculations.

Apportionment
When we cannot assign overheads directly, we must apportion them to the departments using
one or more arbitrary bases. For example, we can apportion rent and insurance cost based on
the floor space occupied by each department. Apportionment requires calculations.
We will explain the allocation and apportionment of production overheads to production and
service departments and the further apportionment of the costs of service departments to
production departments by means of example 7.4.

Example 7.4

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Maputo Limited is a manufacturing company with two production departments, namely P1 and P2.
The company also has two service departments, namely S1 and S2 that provide services to the
production departments and each other. S2 provides the most services to the other departments.
The management accountant is finalising the budget for next year. She has budgeted for total
production overheads of R960 000 for the year. She must apportion this cost in the ratio
35:25:20:20 to P1, P2, S1 and S2 respectively, using the step method. Overhead absorption rates
are based on machine hours. It is estimated that P1 and P2 will work 12 000 and 6 000 machine
hours respectively.

Apportion the budgeted production overheads and determine an overhead absorption rate per
production department.
P1 P2 S1 S2
Apportionment ratio → 35 25 20 20
Initial apportionment 960 000 / (35 + 25 + 20 +20) = 9 600
9 600 x 35; 9 600 x 25; 9 600 x 20;
9 600 x 20 336 000 240 000 192 000 192 000
Apportionment S2 192 000 / (35 + 25 + 20) = 2 400
2 400 x 35; 2 400 x 25; 2 400 x 20 84 000 60 000 48 000 (192 000)
Sub-total 420 000 300 000 240 000
Apportionment S1 240 000/(35 + 25) = 4 000
4 000 x 35; 4 000 x 25 140 000 100 000 (240 000)
Total overheads per production department 560 000 400 000
Total machine hours budgeted 12 000 6 000
Absorption rate per machine hour: 560 000 / 120 00; 40 000 /
6 000 46,667 66,667
Rounded R47 R67

Activity 7.4

In this activity, we will expand on the information provided in example 2.2. The factory of
Woodpecker (Pty) Limited is organised into eight departments. The production departments
directly involved in the manufacturing of furniture are as follows:

Preparation – cuts wood, bends metal frames and prepares upholstered panels
Assembly – assembles components from Preparation into chairs, tables and cabinets
Finishing – applies varnish

The service departments are as follows:

Administration (manager, supervisors, security and quality control)
Maintenance
Canteen
Materials store
Finished goods store

168
 Figure 7.1

A basic floor plan of the factory of Woodpecker is as follows:

1 8
Materials Preparation Assembly Finishing
store department department department
(300 m2) (250 m2) (250 m2) (250 m2)
2

3 4 5 7
Administration Canteen Maintenance Finished goods store
offices (1 200 m2)
(250 m2) (300 m2) (200 m2) 6

Solid lines indicate physical walls, and diagonal lines indicate door entrances. Broken lines
between the three production departments indicate that no physical walls separate the
departments; this allows for the unhindered movement of work-in-progress from one department
to the next. The floor space occupied by each department is indicated in brackets.

Deliveries of materials from suppliers are received at door 1. Stores personnel also use this door
to enter the stores. Only the store personnel have keys and are allowed to enter through this door.
Door 2 has appropriate security and provides general access for all staff working at the plant. Only
administration staff have keys for door 3. Only canteen staff have keys for door 4. Only
maintenance and cleaning staff have keys for door 5. Sold goods leave the finished goods store
through door 6. Proper controls ensure that only authorised goods leave the store. Finished goods
enter the finished goods store through door 7. Door 7 have proper access control. Materials are
issued to the preparation department through door 8. Proper controls ensure that only authorised
materials leave the store.

Woodpecker uses the following equipment in the manufacturing process: panel dividing saws,
beam saws, circular saws, spindle moulders, surface planers, thickness planers, band saws, edge
banding machines, processing and finishing machines. The carrying value of the equipment
invested in each of the production departments is as follows:

Preparation R7 000 000

Assembly R2 000 000
Finishing R1 000 000

In example 2.2, we saw that these departments employ the following staff members (excluding
technicians):

Materials stores 3 (manager + 2)

Finished goods store 5 (manager + 4)
Preparation 2 (1 supervisor + 1 quality controller)
Assembly 2 (1 supervisor + 1 quality controller)
Finishing 2 (1 supervisor + 1 quality controller)

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 Administration 10 (factory manager + PA + 2 cleaners + 6 security guards)
Canteen 4 (manager + 3)
Maintenance 2 (as stated in example 2.2)

The budget for the production overheads of Woodpecker for the forthcoming year is as follows:
R
Indirect materials and consumables
Glue 15 000
Staples 20 000
Varnish 50 000
Oil and grease 10 000
Diesel for generator used to drive equipment 365 000
Indirect labour*
Factory management 380 000
Supervisors and quality controllers # 1 200 000
Maintenance 280 000
Cleaning and security 686 000
Stores 1 000 000
Canteen 294 000
Factory overheads
Rent and insurance 840 000
Depreciation of manufacturing equipment 1 500 000
Electricity 210 000
Refreshments (canteen) 650 000
Total budgeted production overheads 7 500 000

*Note that the salaries of the technicians are excluded, because they are direct labour costs.
#Assume all quality controllers and supervisors are paid the same salary.

The total direct machine hours budgeted for each production department are as follows:
Preparation 18 000
Assembly 14 000
Finishing 8 000

Required

1 Allocate the overheads that can be traced directly to the production and service
departments of Woodpecker (Pty) Limited.
2 Using suitable bases, apportion common overheads to the production and service
departments.
3 Apportion the costs of service departments to the production departments according to
the following:
3.1 direct method
3.2 step method
4 Determine a suitable absorption rate for each production department.

170
 Feedback on activity 7.4

We will now explain the allocation and apportionment of the production overheads of Woodpecker
(Pty) Limited. Please take note that although the materials store and the finished goods store are
physically removed from each other and are accounted for as two separate departments, we will
treat them as a single department for the purposes of the allocation and apportionment of
overheads in this example.

1 Step 1: primary allocation of overheads that can be traced directly to departments

Identify the costs that can be traced directly to departments:

Salaries can be traced directly to departments.
Indirect materials can be traced directly to departments: glue and staples are used for putting the
different parts of the furniture together; therefore, only the assembly department will consume glue
and staples. Varnish is applied in the finishing department only. Refreshments are used in the
canteen only.

Allocate the costs that can be traced directly to departments:

Total Prep Assembly Finish Stores Admin Maint Canteen
R R R R R R R R
Glue 15 000 15 000
Staples 20 000 20 000
Varnish 50 000 50 000
Salaries:
Manager 380 000 380 000
Sup & QA 1 200 000 400 000 400 000 400 000
Maint. 280 000 280 000
Clean & sec 686 000 686 000
Stores 1 000 000 1 100 000
Canteen 294 000 294 000
Refreshm. 650 000

2 Step 1 (continued): apportionment of common overheads to departments

The remaining common overheads that must be apportioned to the departments are the following:

R
Rent and insurance 840 000
Depreciation of manufacturing equipment 1 500 000
Diesel for generator 365 000
Electricity 210 000
Oil and grease 10 000

We now have to identify suitable bases for apportioning these overheads. From the available
information, we can use four possible bases to apportion the common overheads to departments:
floor space, number of employees, number of machine hours and value of equipment.

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We summarise these bases per department below:

Floor space m2 Employees Machine hours Equipment value (R)

Preparation 250 2 18 000 7 000 000
Assembly 250 2 14 000 2 000 000
Finishing 250 2 8 000 1 000 000
Stores 1 500 (300 + 1 200) 8 (3 + 5)
Administration 250 10
Maintenance 300 2
Canteen 200 4
Total 3 000 30 40 000 10 000 000

The most appropriate bases for the allocation of the common overheads would be the following:

Rent and insurance – rent and insurance payments based on the size of the factory plant;
therefore, floor space is the most appropriate of the bases available.
Depreciation of manufacturing equipment – the value of equipment in use will be the most
appropriate basis.
Diesel for generator – the generator is used to power the manufacturing equipment; therefore,
machine hours will be the appropriate basis.
Electricity – since equipment is powered by diesel, machine hours will be an inappropriate
apportionment basis for the absorption of electricity costs; instead, we will use the number of
employees in this example.
Oil and grease (used for lubricating the manufacturing equipment) – the more the machines are
used, the higher the quantity of grease will be. Machine hours would therefore be appropriate as
a basis for apportionment.

Apportioning common overheads to departments using appropriate bases

Total Prep Assembly Finish Stores Admin Maint Canteen
R R R R R R R R
Glue 15 000 15 000
Staples 20 000 20 000
Varnish 50 000 50 000
Salaries:
Manage 380 000 380 000
Sup & QA 1 200 000 400 000 400 000 400 000
Mainten 280 000 280 000
Clean & sec 686 000 686 000
Stores 1 000 000 1 100 000
Canteen 294 000 294 000
Refreshm 650 000 650 000
Rent & ins 840 000 70 000 70 000 70 000 420 000 70 000 84 000 56 000
Depr 1 500 000 1 050 000 300 000 150 000
Electricity 210 000 14 000 14 000 14 000 56 000 70 000 14 000 28 000
Diesel 365 000 164 250 127 750 73 000
Oil & 10 000 4 500 3 500 2 000
grease
7 500 000 1 702 750 950 250 759 000 1 476 000 1 206 000 378 000 1 028 000

172
Calculation

Total Prep Assembly Finish Stores Admin Maint Canteen

Rent & ins 840 000 70 000 70 000 70 000 420 000 70 000 84 000 56 000
840 000 / 3 000 x 250 250 250 1500 250 300 200
Depr 1 500 000 1 050 000 300 000 150 000
1 500 000 / 10 x 7 2 1
Electricity 210 000 14 000 14 000 14 000 56 000 70 000 14 000 28 000
210 000 / 30 x 2 2 2 8 10 2 4
Diesel 365 000 164 250 127 750 73 000
365 000 / 40 x 18 14 8
Oil & 10 000 4 500 3 500 2 000
grease
10 000 / 40 x 18 14 8

Explanation of calculation

Rent: Total rent = R840 000, and total square metres are 3 000 m2. Therefore, rent per square
metre = R840 000 / 3 000. Preparation occupies 250 m2; therefore, rent for Preparation =
R840 000 / 3 000 x 250 = R70 000.
Depreciation: Total depreciation is R1 500 000, and total value of equipment = R10 000 000.
Therefore, depreciation per R1 of equipment value = R1 500 000 / 10 000 000. The value of
equipment in Preparation is R7 000 000; therefore, depreciation for Preparation =
R1 500 000 / 10 000 000 x 7 000 000 = R1 050 000, OR R1 500 000 / 10 x 7 = R1 050 000.

R R
Preparation 7 000 000 ÷ 1 000 000 = 7
Assembly 2 000 000 ÷ 1 000 000 = 2
Finishing 1 000 000 ÷ 1 000 000 = 1
10 000 000 10

We have now allocated and apportioned the total budgeted production overheads to the
production and service departments and can now apportion the cost of the service departments
to the production departments.

3 Step 2: secondary apportionment

We can re-apportion the service department costs based on either the direct method or the step
method.

3.1 Re-apportionment based on the direct method

According to this method, we re-apportion the overheads accumulated in the service departments
to the production departments on bases that reflect the service provided by the service department
concerned. This method ignores the fact that service departments render services to other service
departments. An advantage of this method is its simplicity, although it may not necessarily produce
the same accurate results as the other methods.

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In our example, we will apply the following bases for the re-apportionment:

Canteen: we will use the number of employees as basis for re-apportionment, as the canteen
provides service to the employees of the different departments. For this re-apportionment, we will
include direct labour employees, as the technicians will also make use of the service offered by
the canteen. Therefore, the employees per production department are as follows: Preparation – 9
+ 2 = 11; Assembly – 7 + 2 = 9; Finishing – 4 + 2 = 6

Maintenance: the function of the maintenance department is to service and repair manufacturing
equipment. The assumption is that the more the machines are used, the more the maintenance
and repairs will be. Therefore, we will use machine hours as a basis for re-apportioning the
maintenance overheads.

Administration: the administration department is the home department of one factory manager,
one PA, two cleaners and six security guards. Since the service rendered by cleaning and security
is based largely on the space occupied, we will use square meters as a basis for re-apportionment.

Stores: the service provided by the materials store is to issue materials to Preparation, while the
finished goods store renders the service of receiving finished goods from Finishing. However, the
materials issued to production move through all three manufacturing departments before the
completed goods are sent to the finished goods store. For the purposes of this example we will
re-apportion the stores' overheads to the production departments in equal measures.

Re-apportioning service department costs to production departments using the direct method

Basis Total Prep Assembly Finish

R R R R
Total primary allocation – see above 3 412 000 1 702 750 950 250 759 000
Stores Equal 1 476 000 492 000 492 000 492 000
Administration Floor space 1 206 000 402 000 402 000 402 000
Maintenance Machine hours 378 000 170 100 132 300 75 600
Canteen Employees 1 028 000 434 923 355 846 237 231
Total overheads 7 500 000 3 201 773 2 332 396 1 965 831

Calculation
Total Prep Assem Finish
Stores (R1 476 000 / 3 = 492 000) R492 000 x A 1 476 000 492 000 492 000 492
000
A: equal measure → 1 1 1
Admin (R1 206 000 / 750 = 1 608) R1 608 x B 1 206 000 402 000 402 000 402
000
B: floor space → 250 250 250
Maintenance (378 000 / 40 = 9 450) R9 450 x C 378 000 170 100 132 300 75 600
C: machine hours → 18 14 8
Canteen (1 028 000 / 26 = 39 538,5) R39 538,5 x D 1 028 000 434 923 355 846 237
231
D: employees → 11 9 6

174
3.2 Re-apportionment based on the step method
Under this method, we re-apportion the costs of the service department that provides most
services to other departments to the other service and production departments first.

Let's take a closer look at the service departments: administration (factory manager, cleaners and
security) and the canteen provide services to all the departments; the stores and maintenance
departments provide services to the production departments only. The service department with the
highest cost usually provides most of the services based on the assumption that services drive the
costs. We will first re-apportion the costs of the departments that render services to all departments
and thereafter the costs of the departments that render services to the production departments only.
Based on the assumed extent of services rendered, we will re-apportion the costs in the following
order:

Administration R1 206 000 on the basis of floor space

Canteen R1 028 000 on the basis of number of employees
Stores R1 476 000 in equal proportions
Maintenance R378 000 on the basis of machine hours

Preparation Assembly Finishing Stores Admin Maintenance Canteen

R R R R R R R
Primary all 1 702 750 950 250 759 000 1 476 000 1 206 000 378 000 1 028 000
Admin 109 637 109 637 109 637 657 819 (1 206 000) 131 562 87 708
Sub-total 1 812 387 1 059 887 868 637 2 133 819 0 509 562 1 115 708
Canteen 340 911 278 927 185 951 247 935 61 984 (1 115 708)
Sub-total 2 153 298 1 338 814 1 054 588 2 381 754 571 546 0
Stores 793 918 793 918 793 918 (2 381 754)
Maint 257 196 200 041 114 309 (571 546)
Total 3 204 412 2 332 773 1 962 815 0 0

Calculations

Administration is re-apportioned to other departments based on floor space. The other

departments occupy the following floor space:

Total Prep Assembly Finish Stores Maint Canteen

Floor space 2 750 250 250 250 1 500 300 200

Total cost of Administration was R1 206 000; therefore, R1 206 000 / 2 750 = R438,5454 per
square metre. Therefore, the amounts re-apportioned to other departments are as follows:

Total Prep Assembly Finish Stores Maint Canteen

Floor space 2 750 250 250 250 1 500 300 200
x R438,5454 R1 206 000 R409 437 R109 437 R109 437 R657 819 R131 563 R87 708

Canteen is re-apportioned to other departments based on the number of employees. The number
of employees per department is as follows:

Total Prep Assembly Finish Stores Maint

Employees 36 11 9 6 8 2

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The total cost of Canteen was R1 115 708; therefore, R1 115 708 / 36 = R30 991,8889 per
employee. Therefore, the amounts re-apportioned to other departments are as follows:

Total Prep Assembly Finish Stores Maint

Employees 36 11 9 6 8 2
x R30 991,8889 R1 115 708 R340 911 R278 927 R185 951 R247 935 R61 984

The only service departments remaining are Maintenance and Stores. These departments do not
render any services to each other, and therefore we re-apportion to production departments only.

Maintenance is re-apportioned to production departments based on the number of machine

hours. Machine hours in the production departments were 18 000, 14 000 and 8 000 respectively.
To simplify the calculations, we divide the machine hours for each department by 1 000:

Total Prep Assembly Finish

Machine hours 40 18 14 8

Whether we use 18 000:14 000:8 000 or 18:14:8, the ratio remains the same.

The total cost of Maintenance was R571 546; therefore, R571 546 / 40 = R14 288,65 per machine
hour. Therefore, the amounts re-apportioned to other departments are as follows:

Total Prep Assembly Finish

Machine hours 40 18 14 8
x R14 28865 R571 546 R257 196 R200041 R114 309

Stores are re-apportioned to the production departments in equal measure. The total cost of
Stores was R2 381 754; therefore, R793 918 per production department.

We have now re-apportioned the total budgeted production overheads to the production
departments as follows:

Preparation R3 204 412

Assembly R2 332 773
Finishing R1 962 815
R7 500 000

176
4 Step 3: absorption rates

In this step, we have to determine absorption rates for apportioning the overheads to units of
production. We will assume that machine hours are the most appropriate capacity basis for an
absorption rate. Columns A and B below show the apportionment rate based on the step method,
while columns C and D show the apportionment rate based on the direct method:

A B C D
Step method rate Calculation Direct method rate Calculation
per machine hour per machine hour
Preparation 168,653 3 204 412 / 19 000 168,514 3 201 773 / 19 000
Assembly 155,518 2 332 773 / 15 000 155,493 2 332 396/ 15 000
Finishing 218,091 1 962 815 / 9 000 218,426 1 965 831 / 9 000

Activity 7.5

The following information relates to DEF Production:

Direct materials issued to production R650 000

Indirect materials issued to production R120 000
Consumables issued to production R35 000
Direct labour cost incurred R890 000
Indirect labour cost incurred R745 000
Factory overheads incurred R910 000
Production overheads assigned to production R1 800 000
Value of work-in-progress at the end of the year R230 000

There was no work-in-progress at the beginning of the year. There were no finished goods in
inventory at the beginning or the end of the year.

Required
Based on the information above, prepare the following general ledger accounts:

(a) Work-in-progress account

(b) Production overheads clearance account (POCA)
(c) cost of sales account

Feedback on activity 7.5

(a) Work-in-progress account

Inventory: direct materials 650 000 Inventory: finished goods1 3 110 000
Wages clearance: direct labour 890 000 Balance c/f 230 000
POCA: apportioned overheads 1 800 000
3 340 000 3 340 000
Balance b/d 230 000

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 (b) Production overheads clearance account (POCA)
Inventory: indirect materials 120 000 Work-in-progress 1 800 000
Inventory: consumables 35 000 Cost of sales: under absorption2 10 000
Wages clearance: indirect labour 745 000 of overheads
Payables: factory overheads 910 000
1 810 000 1 810 000

(c) Cost of sales account

Finished goods: cost of goods sold1 3 110 000
POCA: under absorption2 10 000
3 120 000

1
The difference between amounts debited to work-in-progress and the closing value of work-in-
progress represents the value of goods completed and transferred to finished goods. There was
no opening or closing inventory of finished goods; therefore, all goods completed during the
period have been sold.
2
The balance remaining on the production overheads clearance account represents an under
absorption of overheads; the apportioned overheads were less than the actual overheads.

7.4 CORRELATION OF VARIABLES AND RELEVANT RANGE

7.4.1 Correlation of variables

A variable is a figure that can increase or decrease over time. In cost accounting, the number of
units produced, direct labour hours worked, machine hours worked, quantity of direct materials used,
cost of direct materials used and the cost of production are all examples of variables. Correlation
("co-relation") expresses the interdependence or relationship between two variables (i.e. it tells us
how dependent one variable is on another variable). The variable that is dependent on the other is
called the dependent variable, while the other variable is called the independent variable. Let's look
at the following two variables:

Variable 1: quantity of units produced

Variable 2: total cost of direct materials used

Which of these variables would you consider the dependent variable, and which would you consider
the independent variable? How do you determine the quantity of units produced? Well, you count
them. How do you determine the total cost of direct materials used? You have to multiply the
materials cost per unit by the quantity of units produced. Clearly, we need to know the quantity of
units produced before we can calculate the total cost of direct materials used. In this relationship,
the total cost of direct materials used depends on the total quantity of units produced. Therefore,
variable 2 (total cost of direct materials used) is the dependent variable, and variable 1 (quantity of
units produced) is the independent variable. We also say that the independent variable (quantity of
units produced) drives the dependent variable (total cost of direct materials used).

In statistics, we express the correlation between two variables as a correlation coefficient. The
correlation coefficient lies between -1,0 and +1,0. A correlation coefficient of +1 indicates a perfect
positive correlation. A perfect positive correlation exists between two variables when one variable
moves a given amount and the second variable moves proportionally in the same direction. A
correlation coefficient of -1 indicates a perfect negative correlation. A perfect negative correlation exists
between two variables when one variable moves a given amount and the second variable moves
proportionally in the opposite direction. A correlation coefficient of 0 indicates that there is no
correlation between the two variables.

178
The correlation grows stronger as the correlation coefficient approaches +1 or -1. The closer the
correlation coefficient is to +1 or -1, the more closely the two variables are related. A correlation
coefficient approaching +1, for example a coefficient of between +0,5 and +0,9 indicates a positive
correlation, which means as the one variable increases (or decreases), the other variable also
increases (or decreases) in the same direction, but not proportionally. A correlation coefficient
approaching -1, for example a coefficient of between -0,5 and -0,9 indicates a negative correlation,
which means as the one variable increases (or decreases), the other variable decreases (or increases)
in the opposite direction, but not proportionally.

When we plot the values of the two variables on a graph, the points on the graph will appear as
indicated in figure 7.2 on the next page.

A perfect positive correlation exists between the two variables quantity of units produced and total
cost of direct materials, because when one variable (quantity of units produced) moves a given
amount, the second (total direct materials cost) moves proportionally in the same direction. One
could expect the correlation coefficient of quantity of units produced and total direct materials cost
to be +1. See figure 7.2, where the coefficient equals +1.

There is a non-perfect positive correlation between the quantity of units produced and the total cost
of indirect materials used, because when the quantity of units produced moves a given amount, the
total cost of indirect materials moves in the same direction, albeit not proportionally. One would
expect the correlation coefficient of quantity of units produced and total indirect materials cost to
approach +1, perhaps to be between +0,5 and +0,9.

In learning unit 4, we saw that there is an inverse relationship between ordering costs and holding
costs: as the total ordering costs increase (due to more orders), the total holding costs decrease.
Also, as the total ordering costs decrease (due to fewer orders), the total holding costs increase.
The variable total number of orders placed will be the independent variable, and the variables total
ordering costs and total holding costs will be dependent variables. We say there is a positive
correlation between the variables total ordering costs and total number of orders placed, and there
is a negative correlation between the variables total holding costs and total number of orders placed.

Figure 7.2

● ● ●
● ● ● ●
● ● ●
● ● ●
● ● ●
● ● ●

Positive correlation Negative correlation No correlation

Coefficient approaching +1 Coefficient approaching -1 Coefficient = 0

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 ● ●
● ●
● ●
● ●
● ●
● ●

Perfect positive correlation Perfect negative correlation

Coefficient = +1 Coefficient = -1

Before we discuss methods of separating mixed costs, it is necessary to take a closer look at the
behaviour of costs again. In learning unit 2, we saw that a cost can be classified as fixed, variable
or mixed, depending on the behaviour of the cost at different levels of activity. (You will recall that
cost drivers are activity levels that cause a change in the cost of something.) In learning unit 2, we
said the following:

x Total variable costs will increase with the number of units produced, but variable cost per
unit will remain unchanged regardless of the number of units produced.
x Total fixed costs will remain unchanged regardless of the number of units produced, but
the fixed cost per unit produced will decrease as more units are produced.
x Mixed costs contain a fixed element as well as an element that varies with the number of
units produced; therefore, the total mixed costs will increase with the number of units
produced (caused by the variable component), and the cost per unit will decrease as more
units are produced (caused by the fixed component).

Some mixed costs demonstrate behaviour referred to as either step variable cost or step fixed
cost. Step variable costs are predominantly variable in nature, while step fixed costs are
predominantly fixed. For example, suppose that one quality inspector is required for every 50 000
units produced. At a production range of between 0 and 50 000 units, one inspector will be
required; at a production range of between 50 001 and 100 000 units, two inspectors will be
required etc. The salary cost of one inspector is fixed for a production range of 0 to 50 000 units,
but increases to the salaries for two inspectors and remains fixed again for a production range of
50 001 to 100 000 units, etc.

Earlier in this learning unit, we said that normal capacity refers to a factory's average level of
activity for meeting the company's production demands when taking into account expected
interruptions and seasonal fluctuations. However, what would happen if the average level of
activity increased significantly? It may result in the need to purchase additional manufacturing
equipment leading to additional depreciation charges (i.e. increased fixed costs). At higher levels
of production, more overtime work may also be required, while the unit cost of direct materials
may decrease as a result of larger quantities purchased. This brings us to the concept of relevant
range.

180
7.4.2 Relevant range

Relevant range refers to the activity level at which our assumption about the behaviour of costs
remains valid. Suppose, for example, that a company's normal production capacity is between
100 000 and 140 000 units. At this capacity range, fixed costs of R5 million in respect of rent,
insurance, depreciation as well as salaries for supervisors and quality inspectors remain fixed at
R5 million. Should production fall below 100 000 units, the company may have to retrench some
supervisors and quality inspectors or even reduce the space rented for the factory operations. At
production levels of higher than 140 000 units, the company would incur additional fixed costs for
more inspectors, space, etc. We therefore say that the relevant range of activity is between
100 000 and 140 000 units produced at a fixed cost of R5 million. (The fixed costs are relevant for
a production range of between 100 000 and 140 000 units.)

When the accountant prepares a flexible budget, the possible sales and production levels must fall
within this relevant range. This relevant range is depicted by the shaded area in the graph in figure
7.3.

Figure 7.3
R7 m
Total fixed cost (R)
R5 m
R3 m

0 100 000 140 000

Number of units produced

Activity 7.6

1 Explain by means of examples what is meant by the following in respect of two variables:
- a positive correlation
- a negative correlation
- no correlation

2 Explain what is meant by relevant range.

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 Feedback on activity 7.6

1 An example of a positive correlation is the correlation between school fees payable and
the number of your children attending school; the more children you have at school, the
higher the school fees will be.

An example of a negative correlation is the correlation between levels of alertness and

quantities of alcohol consumed; the more alcohol is consumed, the lower the level of
alertness will be.

An example of no correlation is the correlation between the intelligence quotient (IQ) and
shoe size; there is no correlation.

2 Relevant range refers to activity levels that fall within a minimum and a maximum level of
activity. Within the boundaries of the minimum and maximum activity levels, fixed costs
are expected to remain fixed at the same amount. Activity levels that fall outside the
minimum and maximum of the relevant range will effect changes to fixed costs.

7.5 METHODS FOR SEPARATING MIXED COSTS

We can use several methods to try to predict the portion of mixed costs that will be variable and
the portion that will remain fixed within the relevant range of activity levels. We will look at the high-
low method, the scatter diagram method and the least squares method. All three methods are
based on the equation for a straight line.

From your school mathematics, you will recall that if you know the value of any two points on a
straight line, you can determine the slope (i.e. the steepness) of the line. The slope or steepness
of the line is also called the gradient. The equation for a straight line is y = a + bx, where

a is the y-intercept (i.e. where the line cuts through the y-axis); and
b is the slope of the line; and
bx means b multiplied by x.

If we apply this equation to separate mixed costs, the slope of the line (b in the equation)
represents the variable cost per unit, while the y-intercept (a in the equation) represents the total
fixed costs. We will demonstrate the application of this equation by first considering variable costs
only.

Example 7.5

Maseru Limited manufactures a range of coffins. The direct materials used to make a simple coffin
are six pine wood boards cut into different sizes, two metres of velvet for lining the coffin, six bronze
handles and four hinges. It takes two workers 2½ hours to make one pine wood coffin. Each worker
is paid R90 per hour. The direct cost to manufacture one coffin is therefore as follows:

One set of six pine wood boards R500

Two metres of velvet R350
Six bronze handles at R120 each R720
Four hinges at R25 each R100
Total direct material cost of one coffin: R1 670
182
The direct labour cost per coffin is R450 (R90 x 2½ hours x 2 workers).

At different levels of production, the behaviour of the direct cost (i.e. variable costs) to manufacture
the coffins will be as follows:

Number of coffins produced → (A) 1 2 3 4 5 6

R R R R R R
Direct material cost 1 670 3 340 5 010 6 680 8 350 10 020
Direct labour cost 450 900 1 350 1 800 2 250 2 700
Total direct costs (B) 2 120 4 240 6 360 8 480 10 600 12 720
Direct cost per unit (B/A) 2 120 2 120 2 120 2 120 2 120 2 120

We can plot this information on a graph. The number of coffins produced is the independent
variable, which is shown on the x-axis. The total direct cost is the dependent variable, which is
shown on the y-axis. We make a dot where one coffin is made at a cost of R2 120; a dot where
two coffins are made at a cost of R4 240, a dot where three coffins are made at a cost of R6 360
etc until we have made a dot where six coffins are made for R12 720. We can now connect the
dots with a straight line and extend the line so that it cuts through the y-axis (point a as indicated
by the arrow).

Figure 7.4

12 720 q ●
10 600 p ↓ ●
Total direct cost (R)

8 480 ↓ ●
6 360 ●
4 240 ●
(y-axis)

2 120 ●
a 1 2 3 4 5 6
Coffins produced (x-axis)

You will notice that the line cuts the y-axis at 0. This is because we are showing variable cost only.
At zero production, the total variable cost will be zero.

You can solve the equation y = a + bx by first selecting the coordinates at any two points along
the line. Coordinates indicate the position of every point on the line, much like you can pinpoint
the location of Unisa by putting its coordinates into your global positioning system (GPS).
Coordinates are written in the format (x1,y1) and (x2,y2).

Say we select the points where three coffins and four coffins are made (marked p and q); we write
the coordinates of points p and q as (x3,y6360) and (x4,y8480). We can now determine the slope of
the line, i.e. how much the line rises from point p to point q (or how much the line falls from point
q to point p) by means of the equation for a straight line: y = a + bx. The value of y is the difference
in the value of y in the two selected coordinates (i.e. the value of y at point p, and the value of y at
point q); the value of x is the difference in the value of x in the two selected coordinates (i.e. the

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difference in the value of x at point p, and the value of x at point q). Therefore, the value of
y = (8 480 – 6 360) = 2 120, and the value of x = (4 – 3) = 1. The value of a is 0.

If y = a + bx
then 2 120 = 0 + b multiplied by 1
? 2 120 = b

Therefore, the slope of the line (and the variable cost per unit) is 2 120 or R2 120.

Let's choose two different coordinates: (x5,y10600) and (x2, y4240). Therefore, the value of
y = 6 360 (10 600 – 4 240) and the value of x = 3 (5 – 2).

If y = a + bx
then 6 360 = 0 + 3b
? 6 360 = 3b OR 3b = 6 360 (see information box below)
? b = 2 120 (We divide both sides of the equation 3.)

Again, we find that the slope of the line, and therefore the variable cost per unit, is R2 120. It does
not matter which two coordinates on the straight line you choose – the answer in solving the
equation y = a + bx for b is the same: the slope of the line (b) = 2 120 (i.e. the variable cost per
unit = R2 120).

We will now consider three methods we can use to predict the portion of mixed costs that will be
variable and the portion that will remain fixed within the relevant range. All three methods entail
the analysis of mixed costs at different activity levels over several past periods.

7.5.1 High-low method

In using this method, we select the periods of highest and lowest activity levels as coordinates
and use the changes in cost and activity to determine the variable cost per unit. The high-low
method is based on the assumption that the total fixed costs will be the same at both the highest
and the lowest activity level, and that the change in the total cost at the two activity levels
represents the total change in variable costs.

Example 7.6

The following information relates to those mixed production overheads (POH) of Mbabane Limited
where production output is the driver of the cost:

Month Units POH (R) Month Units POH (R)

1 18 512 443 008 7 36 537 718 557
2 15 224 462 799 8 33 492 691 763
3 21 313 508 470 9 31 053 652 751
4 19 486 515 899 10 29 494 634 043
5 28 620 670 815 11 16 996 484 067
6 25 576 585 806 12 23 103 557 351

184
We will apply the high-low method to establish the variable cost per unit of production and the total
fixed costs.

Identify the periods of highest and lowest activity levels: month 2 had the lowest activity level (only
15 224 units produced), and month 7 had the highest activity level with 36 537 units produced.
You will recall that total production overheads is the dependent variable, because total cost
depends on the number of units produced. If you were to prepare a graph from the information
provided above, you would show the total cost on the y-axis.

Total POH Units produced

(y) (x)
High (month 7) R718 557 36 537
Low (month 2) R462 799 15 224
Difference R255 758 21 313

The high-low method assumes the variable portion of the costs causes the difference in the total
costs, because fixed costs are assumed to be the same at all levels of activity within the relevant
range. The variable cost per unit (b in the equation) is therefore R12,00009 (R255 758 ÷ 21 313).

We can now apply the equation y = a + bx to determine total fixed costs:

Total fixed cost, based on month 7 Total fixed cost, based on month 2

y = a + bx y = a + bx
718 557 = a + (12,00009 x 36 537) 462 799 = a + (12,00009 x 15 224)
718 557 = a + 438 447 462 799 = a + 182 689
?a + 438 447 = 718 557 462 799 – 182 689 = a + 182 689 – 182 689
a + 438 447 – 438 447 = 718 557 – 438 447 ? a = R280 110
? a = R280 110

The formula y = a + bx is known as an equation. An equation indicates the relationship of two

expressions on either side of the equals sign (=), for example 3 x 4 = 6 x 2. Since 3 x 4 = 12 and
6 x 2 = 12, it is true that 3 x 4 = 6 x 2. To solve an equation that contains an unknown element, we
need to isolate the unknown element on one side of the equals sign. (Many people prefer to have
the unknown element in the equation to the left of the equals sign as in the calculation of fixed
costs for month 7 above.) One of the rules in solving an equation is that whatever you do on the
one side of the equals sign, you must also do on the other side. In this way, the relationship
between the two expressions is maintained.

Consider example 7.5 in respect of month 7 when y = a + bx is applied:

The first step is to replace any unknown elements for which we already know the values. Thus,
we replace y (total cost) with R718 557, being the total cost for month 7, and b and x with
R12,00009 (unit variable cost) and 36 537 (total units produced in month 7) respectively:

R718 557 = a + (R12,00009 x 36 537)

In order to find the value of the one remaining unknown element, which is a to the left of the equals
sign, we switch the equation around so that what was previously on the left of the equals sign now
appears on the right, and what was previously on the right side of the equals sign, now appears

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on the left. This does not affect the relationship between to two expressions at all. (Consider:
3 x 4 = 6 x 2 is exactly the same as 6 x 2 = 3 x 4.)

a + R438 447 = R718 557

The next step is to isolate the unknown a. This is achieved by deducting R438 447 on both sides
of the equation:

a + R438 447 – R438 447 = R718 557 – R438 447

Therefore, a = R280 110.

Activity 7.7

An analysis of the production and accounting records of Namaqua Limited for the past financial
year revealed that the lowest level of production activity occurred in March and the highest in
October. The total mixed costs incurred in these two months were as follows:

Total mixed Total production

costs (R) (units)
March 128 000 8 000
October 160 000 12 000
Difference 32 000 4 000

Required
Determine the variable cost per unit and the total fixed costs.

Feedback on activity 7.7

The high-low method assumes that the increase in cost of R32 000 is the result of the variable
costs of the additional units produced (i.e. 4 000 units). We therefore assume that the variable
cost per unit is R32 000 ÷ 4 000 units = R8 per unit. Let's apply this assumption to the information
for March using the formula y = a + bx:

If y = a + bx, then
R128 000 = a + (R8 x 8 000), which is the same as
a + (R8 x 8 000) = R128 000.
Then a + R64 000 = R128 000,
and a = R128 000 – R64 000
? a = R64 000

Let's now accept a fixed cost of R64 000 and a variable cost per unit of R8 for October when
production was 12 000 units:

186
October
R
Variable cost (12 000 x R8) = 96 000
Fixed cost = 64 000
Total cost = 160 000 (as indicated above)

In the activities and examples so far, we have used units produced as the cost driver of the
production overheads. You will recall that cost drivers are activities that cause a change in the
cost of that activity. Therefore, in practice, different activities will be driving different costs. For
example, the cost driver that drives the cost of indirect materials will be total production, but the
cost driver that drives the cost of electricity may be machine hours. In preparing a budget, we will
analyse each major cost in terms of its own cost driver.

Activity 7.8

The total cost of electricity of Kongamato Limited in April was R18 000, when the machines were
operated for 120 000 hours in total. (We say total machine hours were 120 000.) In June, the total
cost of electricity was R16 000, and total machine hours were 100 000. Use the high-low method
to establish the total fixed costs and the variable cost per machine hour.

Feedback on activity 7.8

Total electricity Total machine

cost (R) hours
High (April) 18 000 120 000
Low (June) 16 000 100 000
Difference 2 000 20 000

If we assume that variable cost is R0,10 (R2 000 / 20 000) per machine hour, total fixed costs are as
follows:

Based on April Based on June

y = a + bx y = a + bx
18 000 = a + (0,10 x 120 000) 16 000 = a + (0,10 x 100 000)
18 000 = a + 12 000 16 000 = a + 10 000
18 000 – 12 000 = a + 12 000 –12 000 16 000 – 10 000 = a + 10 000 –10 000
? a = R6 000 ? a = R6 000

7.5.2 Scatter diagram method

In using the scatter diagram method, the total cost at each activity level is plotted on a graph. Total
cost (dependent data, because the total cost is dependent on its driver) is represented on the y-
axis, and activity levels (independent data, i.e. the driver of the costs) are represented on the x-
axis. We follow the four steps below to prepare a scatter diagram:

Step 1: prepare the scatter diagram

Plot data (make dots) on the scatter diagram for the activity level (e.g. number of units, machine
hours etc) along the x-axis and total cost along the y-axis. If the dots rise from left to right, the

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slope of the line is positive, and there is a positive correlation between the two variables. If the
dots fall from left to right, the slope of the line is negative, and there is a negative correlation
between the two variables. If the dots are all over the area, making it impossible to draw a
regression line, there is no correlation between the two variables (see figure 7.2).

Step 2: draw a regression line

Inspect the data points (dots) plotted to establish a trend. Draw the regression line over the scatter
diagram in such a way that you minimise the total vertical distance between the line and all the
points. (Each vertical distance between the line and a data point represents an estimation error.)
Now extend the line to the y-axis.

Step 3: establish the total fixed cost

You will find the total fixed cost at the y-intercept of the regression line (i.e. the point where the
line cuts the y-axis).

Step 4: establish the variable cost per unit

The variable cost per unit is equal to the slope (or gradient) of the line. We determine the slope by
taking any two data points on the line, expressed as (x1,y1) and (x2,y2), and apply the following
formula: (y2 – y1) ÷ (x2 – x1)

Let's consider the information for Maseru in example 7.5 again.

Example 7.7

Number of coffins produced → (A) 1 2 3 4 5 6

R R R R R R
Direct material cost 1 670 3 340 5 010 6 680 8 350 10 020
Direct labour cost 450 900 1 350 1 800 2 250 2 700
Total direct costs (B) 2 120 4 240 6 360 8 480 10 600 12 720
Direct cost per unit (B/A) 2 120 2 120 2 120 2 120 2 120 2 120

We will now plot this data on a scatter diagram (figure 7.5):

Figure 7.5 Figure 7.6

12 720 ● 12 720 ●
10 600 ● 10 600 ●
Total direct cost (R)

Total direct cost (R)

8 480 ● 8 480 ●
6 360 ● 6 360 ●
4 240 ● 4 240 ●
2 120 ● 2 120 ●
1 2 3 4 5 6 1 2 3 4 5 6
Units produced Units produced

188
You will notice that in figure 7.5, the dots rise from left to right on the scatter diagram in a perfect
straight line. This means there is a perfect positive correlation between the two variables. If we
draw a regression line to minimise the total vertical distance between the line and all the points,
you will notice (figure 7.6) that the regression line cuts through all the points (dots). This is because
there is a perfect correlation (in this case positive) between the two variables. Remember that a
perfect positive correlation exists when one variable moves a given amount and the second
variable moves proportionally in the same direction. In this example, for every one upward
movement of the number of coffins produced, the total direct cost moves up by R2 120. However,
in this example, the dependent variable (the total direct cost) contains only the variable costs. If
we added fixed costs, the correlation would no longer be perfect, because for every one upward
movement of the number of coffins produced, the total fixed cost would reduce, while the total
variable cost would increase in tandem with the units produced.

Example 7.8

The following report of maintenance cost and machine hours is an extract from the records of
Lusaka Limited:

Machine Maintenance Month Machine Maintenance

Month hours cost (R) hours cost (R)
1 400 1 000 6 250 700
2 250 900 7 200 600
3 100 500 8 500 1 200
4 400 1 200 9 300 900
5 350 800 10 150 400

We will prepare a scatter diagram following the steps set out above.

We indicate the values for maintenance cost on the y-axis and the values for machine hours on
the x-axis.
We first plot the points in the table on the graph (e.g. for month 1, the cost is R1 000, and the
activity level is 400 hours). We label this data point "q" in the graph. In month 5, the cost is R800,
while the activity level is 350 hours. We label this data point "s".
Inspect the scatter diagram to identify the trend that the data points reveal. Note that the dots rise
from left to right. This indicates a positive correlation between the number of machine hours (driver
and independent variable) and the total cost of maintenance (the dependent variable). However,
the correlation is not perfect, as the dots do not form a straight line.
Draw a line through these data points, minimising the total vertical distance between the line and
all the points. You will notice that points p, q, r, t and u are approximately the same distance from
the straight line; therefore, we have minimised the total vertical distance between the line and all
the points.
Extend the regression line to the y-axis (see broken line).

The point where this extended line intercepts the y-axis indicates the total fixed cost, which is R400.

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 Figure 7.7

● ←o ● ←p
1 200

1 100
Total maintenance cost (R) y-axis

● ←q
1 000

● ● ←r
900

● ←s
800

● ←t
700

● ←u
600

●
500

●
400

300

100 150 200 250 300 350 400 450 500 550 600
Number of machine hours x-axis

We can now determine the variable cost per unit as follows:

Select any two coordinates (x1,y1) and (x2,y2) on the line. Let's take month 4, represented by point
o (x400,y1200) and the y-intercept (x0,y400).

Calculate the variable cost: the difference between the y-values (1 200 – 400) divided by the
difference between the x-values (400 – 0) = 800 ÷ 400 = R2,00 per machine hour.

Activity 7.9

Select another two coordinates from figure 7.6 and determine the variable portion of the
maintenance cost per machine hour.

Feedback on activity 7.9

Let's we use points p and u: (x500,y1200) and (x200,y600)

Variable cost = (1 200 – 600) ÷ (500 – 200) = 600 ÷ 300 = R2,00 per machine hour.

190
7.5.3 Least squares (regression analysis)
The least squares method is also called regression analysis and is based on past information as well.
It aims to estimate changes in a dependent variable (e.g. cost of maintenance) that has one or more
independent variables (e.g. machine hours). When there is only one independent variable, we refer to
a simple regression analysis; when there are two or more independent variables, it is a multiple
regression analysis. We will consider only simple regression analysis.

Consider the line we drew through the data points on the scatter diagram in figure 7.6. Remember
that we prepared the scatter diagram so we could estimate the fixed cost component. If you look at
figure 7.6, you will notice that there is a distance, however small, between each data point (dot) and
the line. These distances exist because the correlation between the two variables is not perfect.
Each vertical distance between a data point and the line represents an estimation error. We indicate
these vertical distances (or estimation errors) with arrows in figure 7.7 below. The least squares
method (regression analysis) minimises the sum of the squares of these estimation errors. The "sum
of the squares" means that every estimation error (represented by an arrow in figure 7.7) is squared
(multiplied by itself) and then added together. Fortunately, we will not have to measure each distance
(arrow), because we can use formulae to determine the least squares, as you will see just now.

Like the scatter diagram, the least squares method is based on fitting a straight line on the plotted
data. The least squares method is based on the principle that the sum of the squares of the vertical
errors of a particular straight line is less than the sum of the squares of the vertical errors of any
other straight line that may be drawn on the same scatter diagram.

Figure 7.8

● ●
1 200

1 100
Total maintenance cost (R) y-axis

●
1 000

● ●
900

●
800

●
700

●
600

●
500

●
400

300

100 150 200 250 300 350 400 450 500 550 600
Number of machine hours x-axis

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By now, you should be familiar with the equation for a straight line: y = a + bx. This equation can
also be written as a + bx = y and restated as follows: a = y – bx (by deducting bx on both sides of
the equals sign).

The least squares method is also based on this equation. In order to minimize the sum of the
squares, we use the following equations to calculate the
slope of the line (variable cost per unit of activity) b = n(6xy) – (6x)(6y) ÷ n(6x2) – (6x)2
y-axis intercept (fixed costs) a = 6y – b(6x) ÷ n

In these equations, the various symbols have the following meanings:

X = the level of activity, i.e. the independent variable (driver), for example, machine hours
or units of production
Y = the total mixed cost, i.e. the dependent variable (e.g. total cost of maintenance or total
cost of electricity)
A = the total fixed cost (the y-axis intercept)
B = the variable cost per unit of activity (the slope of the line)
N = the number of observations (e.g. the number of months for which data is presented)
6 (pronounced sigma) means "the sum of"; 6y means the sum of all the observations for y
x2 (pronounced "x squared") means x multiplied by x
b(6x) means b multiplied by 6x. Similarly n(6xy) means n multiplied by 6xy, etc.

Using the information in example 7.7, we will now prepare a table of all the values we require to
solve these equations.

Before we apply the least squares method, we must first plot the data to determine if a linear
regression line is plausible for the particular data. We have already plotted the data in example
7.8 and determined that a regression line is plausible.

Example 7.9

N x Y x2 xy
Machine hours
Mont Machine Maintenance Machine hours multiplied by the
h hours cost squared maintenance cost
1 400 1 000 160 000 400 000
2 250 900 62 500 225 000
3 100 500 10 000 50 000
4 400 1 200 160 000 480 000
5 350 800 122 500 280 000
6 250 700 62 500 175 000
7 200 600 40 000 120 000
8 500 1 200 250 000 600 000
9 300 900 90 000 270 000
10 150 400 22 500 60 000
6→ 2 900 8 200 980 000 2 660 000

We can now solve the two equations as follows:

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b = n(6xy) – (6x)(6y) ÷ n(6x2) – (6x)2
= [10(2 660 000) – (2 900)(8 200)] ÷ [10(980 000) – (2 900)2]
= (26 600 000 – 23 780 000) ÷ [9 800 000 – (2 900 x 2 900)]
= (26 600 000 – 23 780 000) ÷ (9 800 000 – 8 410 000)
= 2 820 000 ÷ 1 390 000
= 2,028777

Therefore, the variable portion of maintenance cost is R2,03 (rounded) per machine hour.

a = 6y – b(6x) ÷ n
= [8 200 – 2,028777(2 900)] ÷ 10
= (8 200 – 5 883,45) ÷ 10
= 2 316,55 ÷ 10
= 231,66

Therefore, the total fixed cost portion of maintenance cost is R231,66 (rounded).

Let's compare the results of the least squares method with the results of the scatter diagram in
example 7.7:

Total fixed cost Variable cost per machine hour

(R) (R)
Scatter diagram 400,00 2,00
Least squares metod 231,66 2,03

If we apply these calculated costs to an activity level of 300 machine hours, we find the following:

At 300 machine hours Scatter Least squares

diagram method
Fixed cost as calculated in above examples 400,00 231,66
Variable cost [300 x 2,00] [300 x 2,03] 600,00 609,00
Total cost 1 000,00 840,66
Actual total cost 900,00 900,00

These differences occur because the correlation between the two variables in this example is not
perfect. Remember that the high-low method, the scatter diagram and the least squares are
estimation techniques and not exact science.

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 Activity 7.10

Refer to the information in example 7.8 and use the high-low method to establish the total fixed
costs and the variable cost per machine hour. Apply your answers to an activity level of 300
machine hours.

Feedback on activity 7.10

Total maintenance cost Total machine

(R) hours
Highest activity level: month 8 1 200 500
Lowest activity level: month 3 500 100
Difference 700 400

Variable cost per machine hour is assumed to be R700 / 400 = R1,75.

y = a + bx y = a + bx
1 200 = a + 1,75 x 500 500 = a + 1,75 x 100
1 200 – 875 = a 500 – 175 = a
a = 325 a = 325

At an activity level of 300 machine hours:

Total variable cost (300 x R1,75) R525
Fixed cost R325
Total maintenance cost R850
Actual total maintenance cost R900

Again, there is a difference because the correlation between the two variables is not perfect.
In our examples, we used only one manufacturing cost at a time (e.g. maintenance cost). Of
course, there are many costs with different cost drivers. We will have to consider all these different
costs when preparing the manufacturing budget. In practice, if mixed costs form a very small
percentage of total costs, the organisation may assign all step variable costs as variable costs and
all step fixed costs as fixed costs. Fortunately, sophisticated computer programs are available that
allow even small businesses to apply these and other techniques for separating fixed and variable
costs.
---oOo---
The names used in the examples in this learning unit are those of the capitals of the Southern
African Development Community (SADC) countries geographically closest to South Africa:

Windhoek is the capital of Namibia.

Gaborone is the capital of Botswana.
Harare is the capital of Zimbabwe.
Maputo is the capital of Mozambique.
Maseru is the capital of Lesotho.
Mbabane is the capital of Swaziland.
Lusaka is the capital of Zambia.

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7.6 SELF-ASSESSMENT QUESTIONS

QUESTION 1

Differentiate between budgeted production overheads, actual production overheads and

apportioned production overheads.

QUESTION 2

Explain the over absorption and under absorption of production overheads.

QUESTION 3

Sundown Limited manufactures a single product in three production departments: P1, P2 and P3.
Two departments, S1 and S2, provide a range of services to the production departments. S2
renders no service to S1, but S1 renders service to S2. You are the management accountant of
Sundown Limited, and are preparing a flexible budget for the company. You have prepared the
table below using past records of the company as a basis.

Month Units Production

overheads
(R)
July 10 000 215 000
August 10 200 218 000
September 10 260 218 900
October 10 360 220 400
November 10 400 221 000
December 10 300 …

The direct labour hours that will apply for apportionment purposes are as follows: P1 (15 000), P2
(10 000), P3 (5 000) and S1 (1 000).

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Required

3.1 Use the high-low method to determine the variable cost per unit and the total fixed
overheads per month.
3.2 Use the equation for a straight line and determine the amount of total overheads the
company should budget for in December.
3.3 Apportion the overheads for December to all the departments using the following
apportionment basis: P1 (40%), P2 (20%), P3 (20%), S1 (10%) and S2 (10%). Then use
the step method to apportion the overheads for December to the production departments
based on labour hours. Round off your answers to the nearest R1.
3.4 Use direct labour hours as basis and determine an absorption rate per production
department based on the calculations for December. Round off your answers to the
nearest cent.

QUESTION 6

The following information pertains to Pirates Limited:

Units Total
produced production
overheads
January 450 8 600
February 600 10 200
March 700 11 000
April 650 10 300
May 600 10 100
June 550 9 600
July 550 9 300
August 500 8 800
September 500 9 100
October 450 8 600
November 450 8 400
December 400 8 000

Required
Use the least squares method to determine the fixed cost per month and the variable overheads
per unit.

---oOo---

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7.7 SOLUTIONS TO SELF-ASSESSMENT QUESTIONS

QUESTION 1

We estimate budgeted production overheads at the beginning of the accounting period. Budgeted
figures does not form part of the formal accounting records of the company.

Actual production overheads represent the historical cost of overheads, and we can only
determine the total actual production overheads at the end of the accounting period. Actual
production overheads flow through the accounting records of the company.

Apportioned production overheads represent actual activity levels measured at a predetermined

rate. Production overheads are apportioned throughout the accounting period and flow through
the accounting records of the company.

QUESTION 2

In normal costing, the actual overheads incurred are seldom, if ever, the same as the overheads
apportioned to production. Over absorptions occur when the apportioned amount exceeds the
actual amount, while under absorptions occur when the apportioned amount falls short of the
actual amount.

QUESTION 3

3.1 High-low method

Units Production
overheads
(R)
Highest activity: November 10 400 221 000
Lowest activity: July 10 000 215 000
Difference 400 6 000

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The variable cost per unit is the difference between the costs associated with the highest and
lowest observations of the cost driver (R6 000), which is the nominator, and the difference between
the highest and lowest observations of the cost driver (400), which is the denominator. Therefore,
we calculate the variable cost per unit as follows: R6 000 / 400 = R15. In July, total variable
overheads is therefore calculated as R15 x 10 000 = R150 000. Therefore, the cost of fixed
overheads is R215 000 – R150 0000 = R65 000.

3.2 Determining total overheads for December by applying the equation for a straight line

y = a + bx; where y = total overheads, a = fixed overheads, b = units produced and x = variable
cost per unit

y = 65 000 + 10 300 (15)

y = R219 500

3.3 Apportioning December production overheads

P1 P2 P3 S1 S2
December overheads apportioned a 87 800 43 900 43 900 21 950 21 950
Apportion S2 per DLH* b 10 620 7 081 3 540 708 (21 950)
Apportion S1 per DLH* c 11 329 7 553 3 776 (22 658) -
Total overheads R219 500 R109 750 R58 534 R51 216 -

Workings
a R219 500 / 100 = 2 195 x 40 2 195 x 20 2 195 x 20 2 195 x 10 2 195 x 10
R2 195
b 21 950 / 31 000 = 15 000 x 10 000 x 5 000 x 1 000 x -
0,708065 0,708 0,708 0,708 0,708
c 22 658 / 30 000 = 15 000 x 10 000 x 5 000 x - -
0,755267 0,755 0,755 0,755

The first apportionment (a) is based on the ratio 40:20:20:10:10. The second and third
apportionments (b and c) are based on direct labour hours (DLH).

3.4 Determining absorption rates per production department based on labour hours

P1 P2 P3
Total overheads from 5.3 R109 750 R58 534 R51 216
÷ total direct labour hours (DLH) 15 000 10 000 5 000
= absorption rate per DLH R7,32 R5,85 R10,24

QUESTION 4
x y xy x2
January 450 8 600 3 870 000 202 500
February 600 10 200 6 120 000 360 000
March 700 11 000 7 700 000 490 000
April 650 10 300 6 695 000 422 500
May 600 10 100 6 060 000 360 000

198
 x y xy x2
June 550 9 600 5 280 000 302 500
July 550 9 300 5 115 000 302 500
August 500 8 800 4 400 000 250 000
September 500 9 100 4 550 000 250 000
October 450 8 600 3 870 000 202 500
November 450 8 400 3 780 000 202 500
December 400 8 000 3 200 000 160 000
n = 12 observations 6→ 6 400 112 000 60 640 000 3 505 000

Variable cost (b) per unit

b = n(6xy) – (6x)(6y) ÷ n(6x2) – (6x)2

= 12(60 640 000) – (6 400)(112 000) ÷ 12(3 505 000) – (6 400)2
= (727 680 000 – 716 800 000) ÷ (42 060 000 – 40 960 000)
= 10 880 000 ÷ 1 100 000
= 9,89090909
= R9,891 rounded

Fixed costs (a) per month

a = 6y – b(6x) ÷ n
= [112 000 – (6 400 x 9,890909)] ÷ 12
= [112 000 – 63 302] ÷ 12
= 48 698 / 12
= R4 058 per month (rounded)

---oOo---

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