Calculation of overhead absorption rate

Report
THE INSTITUTE OF CHARTERED ACCOUNTANTS
OF SRI LANKA
POSTGRADUATE DIPLOMA IN BUSINESS AND
FINANCE - 2013/2014
Principles of Financial and Cost Accounting
Thilanka Warnakulasooriya
B.Com Special (Col), ACA
Accounting for Overhead
Overhead is the Expenditure incurred in the
course of making a product, providing a service or
running a department, but which cannot be
traced directly and fully to the product, service or
department
Classification of Overhead

Overhead can be classified under 3 basis
Overhead
Element Base
Behavior based
Function Based
Indirect Material
Fixed Overhead
Production OH
Indirect Labor
Variable OH
Administration OH
Indirect Expense
Semi-Variable
OH
Selling &
Distribution OH
General OH
Overhead Allocation, apportionment & absorption

1.
Steps.
Identify OH cost & Accumulate the cost
i.e.
2.
Rent , Electricity,
Identify the Cost Center of the Organization
Identify the activity or item or equipment where the cost are
accumulated.
Cost centers can be either production cost center or service
cost center
i.e Garment Factory
Production cost centers
Service cost centers
Cutting, Sawing, washing,
Packaging
Maintenance , HRM, Planning

3.
Allocation of OH cost to cost centers

Some OH can be directly identify to a particular cost centers. Accordingly
that OH cost can be allocated to that cost center called “allocation”
i.e. Cutting supervisor salary directly identified to the cutting cost
4.
center
Apportioning overhead cost to cost centers
Some OH can not be directly identified to particular cost center.
Accordingly such cost should be shared among the cost centers. These cost
should be divided among cost centers based on most reasonable basis.
(Apportionment of overhead is distribution of overheads to more than one cost centre on
some equitable basis)
OH
Basis for Apportionment
Rent, rates, heating and light, Floor area occupied by each cost
repairs
and
depreciation
of centre
building
Deprecation
equipment
and
insurance
of Cost or book value of equipment
Personnel,
office,
canteen, Number of employees, or labor
welfare, wages and costs of offices hours worked in each cost centre
i.e. Garment factory monthly electricity bill was Rs. 200,000. Factory consist of 4 cost
centers . The floor area occupied by each cost center are as follows.
Cost Center
Floor area (Sq. Feet)
Cutting
3,000
Sawing
5,000
HR
Warehouse
500
1,500
Apportion the electricity between cost centers.
5. Reapportioning the service cost centre cost to production cost
centers.
Service cost centers cost should charged to production cost
centers since salable units does not pass through service
departments. The reasonable apportionment basis should be used
Service cost centre
Possible basis of
apportionment
Stores
Number of cost value of
material requisitions
Maintenance
Hours of maintenance work
done for each cost centre
Production planning
Direct labor hours worked in
each production cost centre
Reapportioning the service cost centre cost to production
cost centers
Secondary Distribution with reciprocal Servicing overhead absorption rates
To production & service
department
Simultaneous Equation
Method
Repeated Distribution
Method
Step Down Method
Direct Method
Only to
Production
Department
6. Calculate the overhead absorption rate & absorb the cost

Overhead absorption is the process whereby overhead costs
allocated and apportioned to production cost centers are added to
unit, job or Cost object.

Overhead absorption is sometimes known as overhead recovery

Overheads are usually added to costs units using a predetermined
overhead absorption rate, which is calculated using figures from
the budget.
Overhead absorption rate (OAR)
“Attributing OH to particular product or service based on particular
basis”
Generally OAR calculated by dividing the OH cost of the cost center
by number of units/ Volume of absorption base which is appropriate
for the cost center
Calculation of overhead absorption rate
OAR
= Budgeted Overhead cost
Budgeted volume

Estimate the overhead likely to be incurred during the period

Estimate the activity level for the period

Divide the estimated overhead by the budgeted activity level

Absorb the overhead into the cost unit by applying the calculated
absorption rate
Ex 06.
There is no ideal OAR, depending on the company some use machine
hours or labor hours. The most appropriate OAR depends on factors
such as cost, information availability, nature of the product,
technology used etc.
Choosing
the
absorption base








appropriate
A percentage of direct materials cost
A percentage of direct labor cost
A percentage of prime cost
A rate per machine hour
A rate per direct labor hour
A rate per unit
A percentage of factory cost (for admin
overhead)
A percentage of sales or factory cost ( for selling
and distribution overhead)
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Over and under absorption of
overheads

The rate of overhead absorption is based on estimates ( of both
numerator and denominator) and it is quite likely that either one or
both of the estimates will nit agree with what actually occurs
◦ Over absorption means that the overheads charged to the cost of
sales is more than the overheads actually incurred
◦ Under absorption means that insufficient overheads have been
included in the cost of sales
Actual Overhead incurred
Overhead absorbed
(budgeted OAR * actual activity level)
Under/ Over absorption
xxxx
xxxx
xxx
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The reasons for over/under absorbed overheads
The overhead absorption rate is predetermined from budget
estimates of overhead cost and the expected volume of activity.
 Over or under recovery of overhead will occur in the following
circumstances:◦ Actual overhead costs are different from budgeted overhead
◦ The actual activity level is different from the budgeted activity
level
◦ Actual overhead costs and actual activity level differ from the
budgeted costs and levels

◦i.e . Following information with regard to “ A” Company
◦Budgeted overhead cost per month
◦Actual Overhead cost per month
◦Budgeted units plan to produce
◦Actual units Produced
80,000
70,000
10,000
8,000
◦Calculate over or under absorption of overhead per month
13

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