INTRODUCTION TO COST ACCOUNTING

OVERHEADS
Cost is simply the aggregate of all the expenses incurred in bringing a product to its present
condition and location, it will be discovered that while some expenses are directly traceable to
the cost object, some are not. The problem remains that production overhead, which is not
directly traceable, should form part of the production cost of a product.
IAS No. 2 requires that historical cost of manufactured stocks (inventories) should
include production overhead costs that relate to putting the stocks in their present
location and condition.
Overheads: These refer to indirect materials, indirect labour and indirect expenses. That is,
there could be production overheads, administrative overheads, selling overheads, etc.
Whereas, all these would eventually form part of the total cost of production (rates can also
be set for each of these types of overheads), it is important to understand the distinction
between these overheads. This is because, most organisations are more concerned with
absorbing production overheads for purposes of stock valuation, and when doing so, it is only
production overheads that should be covered.
IMPORTANT CONCEPTS
Overheads: By overheads, is meant, the aggregate of indirect materials, indirect labour and
indirect expenses.
Production

Overheads:

Indirect

costs

associated

with

manufacturing

activities.

Manufacturing activities are the sequence of operations, which begin with supplying
materials to work stations and end with the primary packing of the product. Examples of
these would include depreciation of plant and machinery, and production salaries.
Administrative Overheads: It encompass the costs of formulating policy, directing the
organisation, and controlling the operations of an undertaking which is not related to
production, selling, distribution, research or development activity or function. Examples of
these include office rent, office electricity, office salaries, printing and stationery, audit and
professional fees, etc.

 Selling Overheads: Indirect costs, which are associated with marketing and selling (excluding
distribution) activities. Examples of these will include salaries of sales staff, advertisement,
sales commissions, etc.
Distribution Overheads: Indirect costs associated with the distribution of finished products.
Examples of these would include haulage costs to customers, warehouse rents, etc.
STEPS IN OVERHEAD ACCOUNTING
Overhead cannot be charged directly to cost units or jobs like direct expenses (direct material,
direct labour and direct wages among others). True cost of production can be ascertained only
when factory(production) overhead has been added to the prime cost. The following processes
are needed before adding the indirect expenses to the prime cost, Allocation, apportionment and
absorption.
Allocation
Allocation of overhead: Allotment of whole items of cost to cost centres or cost units.
Overhead costs arising solely from the existence of a particular dep. (production or service
dept) can be charged or allocated to that dept., e.g. salary of a departmental head.
Apportionment of overhead: Means the allotment but of a portion of cost to costs centers
or cost units. Apportionment of overhead is the process of distributing those items of
overhead which cannot be allocated to a cast centers or dept between cost centers or depts.on
an equitable basis. Overhead such as factory rent, factory insurance, factory lighting, power,
salary of factory manager incurred for the entire factory require apportionment to different
production and service depts on some equitable or reasonable basis.
BASIS OF APPORTIONMENT OF OVERHEAD
There is no hard and fast rule with regard to apportionment of overhead. However, the basis to be
used shall be determined with reference to the nature of the particular item of overhead. Some
common bases are;
1. Floor area/floor space e.g. rent rates, insurance of building, lighting e.t.c.
2. Direct wages this base is use for those items which are related to direct wages, e.g. pension
fund, contribution to employees insurance scheme.
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3. Number of workers overhead is apportioned in the ratio of no of workers engaged in each

dept. this is common where expenditure depends on the number of workers in dept. labour
welfare, medical expenses, transports, canteen expenses.
4. Direct labour hours overheads are apportioned in proportion to the number of of direct
labour hours worked in various dept. e.g. salary of a supervisory staff is apportioned on this
basis.
5. Number of machine hours this is used where machines are more dominant factor than men in
the dept.
6. Value of asset this is used as the basis for apportionment of for e.g. depreciation, insurance,
repairs and maintenance of plant and machinery.
7. Lighting point the electricity charges of the manufacturing concern are apportioned on the
basis of the number of lighting points.
8. Kilowatt hours this is based on the cost of electricity power.
ILLUSTRATION ONE
Daura Ltd provides the following for the month of April, 2012
Indirect materials
N
Production Department
X
1900
Production Department
Y
2400
Production Department
Z
400
Maintenance Department
A
3000
Stores Department
B
800
Indirect wages
Production Department
X
2700
Production Department
Y
3300
Production Department
Z
900
Maintenance Department
A
2000
Stores Department
B
1300
Power and light
15000
Rent and rate
5600
Insurance on asset
3000
Meal charges
7500
Depreciation is to be provided @ 12% on capital value of asset per annum
Additional information
Production department
Basis of apportionment X
Y
Z
Area(sq. ft)
4000 4000 3000
3

Service department
A
B
2000
1000

Cap. Value of asset N

50000 60000 40000 30000
20000
Kilowatts hrs.
2000 2200 800
750
250
No. of employee
90
120
30
40
20
Prepare a summary showing the distribution of OHD (Primary distribution)

SOLUTION ILLUSTRATION ONE

Summary of overhead distribution (Primary distribution)
Item
Basis of apportnmt. Total Production dept
XN
YN
Indirect material
Allocation
8500 1900 2400
Indirect labour
Allocation
10200 2700 3300
Power
Kilo watt
1500 5000 5500
Rent and rates
Flour area
5600 1600 1600
Insurance on assets
Value of assets
3000 750
900
Depr. on asset (1) month Value of assets
2000 500
600
Meal charge
No. of employers
7500 2250 3000
Total; dept. ohd
51800 14700 17300

Service Dept
ZN
AN BN
400 3000 800
900 200
1300
2000 1875 625
1200 800
400
600 450
300
400 300
200
750 1000 500
6250 9425 4125

Workings
Total hrs consumed for the company: X, +Y, +Z+A+B = 2200+2000+800+750+250 = 6000 Hrs.
N
For department X, 2000 x 15000 = 5000
6000
Y,

2200 x 15000 = 5500

6000

Z,

800 x 15000 =2000

6000

A,

750 x 15000 = 1875

6000

B,

250 x 15000 = 625

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6000
RE-APPORTIONMENT OF SERVICE DEPARTMENT EXPENSES TO PRODUCTION
DEPARTMENT
After the apportionment of the overhead cost to production and service dept., the nest step is to
apportion the expenses of various service department to production. This is so because the
service department are not engaged in actual output, it becomes necessary to apportion the cost
of the production process of doing so is called secondary distribution,
Base on re-apportionment (secondary distribution)
Generally it is done on the basis of the benefits derived by the production department from the
service department, the more conventional way is on the following;
1. Time keep dpt. Wages or pay roll
department

a. No. of workers
b. Labour hrs. worked
c. Machines hrs worked
No. of employees in each dept.
a. No. of purchase order placed
b. Cost of material purchased
a. No. of material requisition
b. Value of material used
a. No. of labour hrs. worked
b. Machines hrs. worked
Floor space occupied

2. Personal dept./Adm. Dept.

3. Purchase department
4. Stores department
5. Maintainace department
6. Building service/ estate department
7. Canteen dept./welfare, recreation,
ambulance service department
8. Internal transport department

No. of employees in each department

Weight or value of material handled

ILLUSTRATION TWO
AA has three production departments and two service department. The summary of the primary
distribution for the month of May 2012 is as follows
Production department
X
14700
Production department Y
17300
Production department
Z
6250
Maintenance
A
9425
Stores
B
4125
Additional Information
Direct lab hrs.
No. of required.

X
1800
90

Y
1600
60
5

Z
1100
50

Required apportion the expenses of service departments to production departments only

SOLUTION TO ILLUSTRATION TWO
Item
Basis of apportn Total
Total ohd
51,800
Exps of Dept A Direct Labour Hr
Exps of Dept B No. of requisition Total ohd

Production Dept
XN
YN
ZN
14,700 17,300 6250
3,770 3,351 2,304
1,856 1,238 1,031
20,326 21889 9,585

Service Dept.
AN
BN
9425
4125
(-)9,425
(-)4,125
-

APPORTIONMENT TO PRODUCTION DEPARTMENT AND OTHER SERVICE

DEPARTMENT
This is the process of apportioning the service costs to production department. It is done by
either Ladder, repeated distribution simultaneous equation method
OVERHEAD ABSORPTION
After the overheads have been allocated or apportioned to various production departments, the
total cost of the production department will comprise of;
a. the expenses allocated to the production department e.g. salary of departmental head, cost of
indirect materials issued to production
b. The factory share of the common expenses apportioned to it. E.g. factory rent and rates,
factory power, salary of work manager, factory lighting e.t.c.
c. The share of the expenses of the service department re-apportioned to it. E.g. expenses of
personnel department, expenses of stores department, expenses of pay roll department e.t.c.
consequently, the total amount of overhead accumulated for a production department is
ultimately to be charged to the various coast unit of that department. The distribution of the
accumulated overhead of a production department amongst its cost unit is known as overhead
absorption. It is also refers to the allotment of overhead to cost unit. Therefore, absorption
overhead is the function of apportioning overhead costs to individual units,jobs, production lots,
work orders.
STEPS FOR TO BE TAKEN IN THE APPORTIONMENT OF OVERHEADS
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There are two steps needed to be taken in the apportionment of overheads. These are as follows;
i) Computation of overhead: this is made by diving the total overhead costs of a department by
the number of units in the BASE. The base could be direct materials costs, direct labor costs
direct labor hour among others. Thus, the general formula is
Overhead rate = Total overhead of the department
Total unit base used
ii) Application of the overhead rate to cost units: in order to ascertain the cost of each unit, the
overhead rate calculated above, is multiply to the unit of base direct materials costs, direct labor
costs direct labor hour) in the particular cost unit.
Overhead chargeable to a cost unit = unit of base in cost unit X overhead rate
The activity level or production volume is estimated based on what is believed largely influences
overhead costs. Traditionally, the following measures are used:
(i) Machine Hours;
(ii) Labour Hours;
(iii) Amount of Material Cost;
(iv) Amount of Labour; and
(v) Amount of Prime Cost.
The following Overhead absorption/recovery rates are in use:
(a) Machine Hour Rate = Estimated Amount of Overhead
Estimated Machine Hours
(b) Labour Hour Rate = Estimated Amount of Overhead
Estimated Labour Hours
(c) Percentage of Material Cost = Estimated Amount of Overhead x 100%
Estimated Amount of Materials
(d) Percentage of Labour Cost =Estimated Amount of Overhead x 100%
Estimated Labour Cost

(e) Percentage of Prime Cost = Estimated Amount of Overhead x 100%

Estimated Prime Cost
ILLUSTRATION THREE
The below data relate to a company:
Total overhead of the company amounted to N600,000.
Total direct labour hours 5,000hrs
Total direct wages

N160,000

Total direct materials used N350,000

Total machine hours

10,000hrs

Unit produced

4,000 units

Calculate the following rates: (i) direct labour hours, (ii) direct wages, (iii) direct materials, (iv)
machine hour (v) Prime cost, (vi) unit cost
SOLUTION TO ILLUSTRATION THREE
DLH OAR = Total OH/ Total No of Units = 600, 000/5,000 = N120 overheads per labour hour
DW OAR = 600,000/160,000 = N3.75 overheads per N of wages
DM OAR = 600,000/350,000 = N1.71 overheads per N of materials
MH OAR = 600,000/10,000 = N60 overheads per machine hour
PC OAR = 600,000/510, 000 = N1.18 overheads per N of Prime cost
Cost Unit OAR = 600,000/4000 = N150 overheads per unit produced
FORMAT OF A COST STATEMENT
Direct materials
Direct labour
Direct expenses
Prime cost
Production Overhead
Factory or Production Cost
Add: other Overheads
Selling and Distribution X
Administrative
X
Total Cost

N
X
X
X
X
X
X
X
XX
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ILLUSTRATION FOUR
KT manufacturer ltd had the following information for the year ended December 2000. Materials
used N60,000; Direct labour hour (wages)N30,000; overheadN18, 000;direct labour hour 12,000;
machine hours 10,000.the below info relates to a job No. 106: materials usedN1200; Direct labor
(wages) N650;Direct labor hour 265; machine hours 255. Prepare a statement showing the toatal
cost of the job using; a)% of DM b) % of DL cost c)DLH method d) MH method
SOLUTION TO ILLUSTRATION FOUR: WORKINGS IN THE CLASS

ILLUSTRATION FIVE
Tutors Nig Ltd manufactures two products COS and COR. The following details relate to the
product.
DM

Product Cos

Product Cor

N50

N45

DL Cost:
Machine at N10 per hr

60hrs

80hrs

Assembly at N5 per hr

20hrs

40hrs

The company plans to produce 6,000 units of product Cos and 3,300 units of product Cor during
the forthcoming month and estimates it overhead for that month at 700,000
You are required to calculate overhead absorption rate using: i) percentage of prime cost, ii)
direct labour hour, iii) machine hr. work to the nearest decimal places.
SOLUTION TO ILLUSTRATION FIVE: WORKINGS IN THE CLASS
ACTUAL AND PREDETERMINED OVERHEAD RATE
Actual overhead rate is that rate which is based on the actual amount of overhead to be absorbed
and the actual value of the based selected, i.e. its relied on actual overhead and base value (DM,
MH etc). actual overhead rate enables the absorption(recovery) of actual amount of overhead.
However, it is main drawback is that It is based on historical cost in nature which can be
ascertained after the overhead have been incurred. For this reason, the actual overhead rate is
useless.
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Predetermined rate, this rate is based on the anticipated amount of overhead and the anticipated
value of the base selected. It is worked out by dividing the estimated amount of overhead by the
estimated value of the base before the actual production commences. It is then applied for the
absorption of the overhead during the period which it has been computed for.
For the purpose of evaluation, the actual sand the predetermined rate are compared. The
comparison will give one of the three outcomes equal, under or over absorption. This will now
take us to the next sub heading.

UNDER AND OVER ABSORPTION OF OVERHEAD

Where the absorption of overhead is made by a rate based on the actual data, the overhead must
be equal to the actual overhead incurred. But where a predetermined is employed, there is
generally a difference between the overhead absorbed and the one incurred. If the absorbed
amount is less than the actual overhead incurred, there is under-absorption of overhead. For
example, in 2004 company X overheads absorbed areN9, 500 and the actual incurred are
N10,000. There is under-absorption of N500. In this case the cost of production is deflated to the
extent of amount under absorbed. Contrary to the above, is that , if the the absorbed is in excess
of actual amount, there is over-absorption. For example,

in 2005 company X overheads

absorbed areN10, 800 and the actual incurred are N10,000. There is over-absorption of N800. In
this case of over absorption, the cost of production is inflated to the extent of the amount being
over absorbed.
CAUSES OF UNDER AND OVER ABSORPTION OF OVERHEAD
*Under utilization of the production capacity
*Seasonal fluctuations in the production in the case of seasonal factories
*errors in the anticipating the overhead cost or value of the base
*major change in the method of production
*change in the working capacity
TREATMENT OF UNDER AND OVER ABSORPTION OF OVERHEAD

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(a) Supplementary rate, under or over absorption is apportioned to work in progress, finished
goods, and cost of sales by means of supplementary rate. The amount of under absorbed is
adjusted by adding (+) it back to cost of production. While, over absorption is deducted through
a negative (-) supplementary rate. Supplementary rate is calculated as :
Supplementary rate = overhead incurred overhead absorbed
Value of the base
(b)Carry forward to next accounting period, the amount of over/under absorbed overhead is
transferred to an overhead reserve or a suspense account to be carried forward to the next period
account for absorption.
(c) Transfer to costing P and L account
The amount of over/under absorbed overhead is transferred to costing P and L account as
abnormal gain for under absorption and abnormal loss for over absorption of overheads.
CHOICE OF OVERHEAD ABSORPTION METHOD
At this stage we are fully aware that there exist a number of methods which can be used for
absorbing the factory overhead for e.g. DL, DM,MH etc. the method selected for absorbing the
overhead must be suitable and equitable, failing which the costing result may be misleading. The
below factors should be considered while selecting a method of factory overhead absorption;
1. Type of industry whether job order, continuous production
2. Nature of the manufacturing process whether manual or mechanical
3. The main constituents of overhead and their nature whether fixed or variable
4. The organization set up of the undertaking into departments, cost centers
5. The capacity at which the factory is working full capacity or under capacity
6. Policy of the management
CHARACTERISTICS OF A GOOD OVERHEAD ABSORPTION METHOD
1. it should be simple and convenient in its application and should not be require the
maintenance of unnecessary clerical records

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2. It should be adequate ensuring the recovery (absorption) of overhead is more or less equal to
the actual amount of overhead
3. it should give due consideration of the time factor involved in the production
4. It would make proper distinction between the work done by skilled and unskilled workers
5. it should make proper distinction between work done by manual labor and mechanics
6. Multiple rates should be preferred to blanket rate or overall overhead rate of the whole factory
BLANKET ABSORPTION RATE AND DEPARTMENTAL ABSORPTION RATE
These terms are used in relation to recovery or absorption of overhead. The common absorption
rate used throughout a factory and for all jobs and units of production irrespective of the
department they were produced is known as Blanket absorption rate. Whereas departmental
absorption rate, refers to overhead absorption rate calculated separately for each department of
the factory. It is advisably to establish separate overhead rates for each department in order to
ensure that all jobs and units of production are charged with fair share of overheads in cases
where these jobs and units do not spend approximately the same time in each department.
ILLUSTRATION SIX
KKY ltd provides the following budgeted information for the year 2010
Department Machine hrs Overhead Machine hrs required for Job Q
Fabrication 15,000
N150,000 40
Machining 12,000
N180,000 50
Assembly
5,000
N120,000 30
Finishing
8,000
N100,000 20
Required: Calculate the blanket and departmental overhead absorption rates and overhead to be
charged to Job Q.
SOLUTION TO ILLUSTRATION SIX
Calculation of departmental absorption rates
Department (a) Machine hrs (b) Overhead (c)
Fabrication
15,000
N150,000
Machining
12,000
N180,000
Assembly
5,000
N120,000
Finishing
8,000
N100,000
550,000
N40,000
Calculation of blanket overhead absorption rate:

12

Machine hrs required for Job Q [(b)/(c)]

N10
N15
N24
N12

Overhead rate = Total overhead = N550, 000 = N13.75

Total machine hrs
40, 000
Calculation of overhead to be charged to job Q (departmental absorption rate)
Department Machine hrs required Deptl Overhead rate Overhead to be absorbed
Fabrication 40
10
400
machining 50
15
750
Assembly
30
24
720
finishing
20
12.50
250
Total overhead chargeable to job Q N2,120
Calculation of overhead to be charged to job Q (Blanket absorption rate)
Total machine hrs to be used on job Q = 40+50+30+20 = 140 machine hrs
Blanket overhead rate = N13.75
Overhead to be charged to job Q = 140 x N13.75 = N1, 925

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