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Indirect
Cost Allocation
One of the classification of costs is on the basis of ‘Nature’
in which costs are classified as ‘Direct’ and ‘Indirect’. Direct costs are those
which are identifiable with a cost object or a cost center while indirect costs
are not traceable to cost object or cost center. In other word indirect costs
cannot be linked with the product offered by the firm. If a firm manufactures
only one product all costs are direct but if more than one product is offered
the indirect costs incurred are not traceable with a particular product. So
while direct costs are allocable to a job process service cost unit or a cost
center indirect costs cannot be so allocated. These indirect costs are called as
‘Overhead’ costs. Overhead costs are defined as ‘the total cost of indirect
materials indirect labour and indirect expenses.’ Thus all indirect costs like
indirect materials indirect labour and indirect expenses are called as
‘overheads’. Examples of overhead expenses are rent, taxes, depreciation,
maintenance, repair, supervision, selling and distribution expenses, marketing
expenses, factory lighting, printing, stationery etc.
Q.1.
Indirect costs are called as ‘Overhead’ costs. (True)
Q.2.
Give examples of overhead expenses.
Ans.2.
Examples of overhead expenses are rent, taxes, depreciation,
maintenance, repair, supervision, selling and distribution expenses, marketing
expenses, factory lighting, printing, stationery etc.
Overhead Accounting
The ultimate aim of overhead accounting is to absorb them in
the product units produced by the firm. Absorption of overhead means charging
each unit of a product with an equitable share of overhead expenses. In other
words as overheads are all indirect costs it becomes difficult to charge them to
the product units. In view of this it becomes necessary to charge them to the
product units on some equitably basis which is called as ‘Absorption’ of
overheads. The important steps involved in overhead accounting are as follows.
A. Collection,
Classification and Codification of Overheads
B. Allocation,
Apportionment and Reapportionment of overheads
C. Absorption
of Overheads.
Q.3. What are the
steps involved in overhead accounting?
Ans.3.
The important steps involved in overhead accounting are as follows.
A.
Collection, Classification and Codification of Overheads
B.
Allocation, Apportionment and Reapportionment of overheads
C.
Absorption of Overheads.
As mentioned above the ultimate of overhead accounting is
‘Absorption’ in the product units. This is extremely important as accurate
absorption will help in arriving at accurate cost of production. Overheads are
indirect costs and hence there are numerous difficulties in charging the overheads
to the product units. In view of this lot of care is to be taken in the
absorption of overheads. The steps in overhead accounting are discussed below.
A. Collection, Classification and Codification of
Overheads: - These concepts are discussed below
I. Collection of Overheads:
- Overheads collection is the process of recording each item
of cost in the records maintained for the purpose of ascertainment of cost of
each cost center or unit. The following are the source documents for collection
of overheads.
i. Stores
Requisition
ii. Wages Sheet
iii. Cash Book
iv. Purchase Orders
and Invoices
v. Journal
Entries
vi. Other Registers
and Records
For the purpose of overhead accounting collection of
overheads is very important. It is necessary to identify the indirect expenses
and the above mentioned source documents are used for this.
II. Classification of
Overheads: - Classification is defined as ‘the arrangement of items in
logical groups having regard to their nature (subjective classification) or the
purpose to be fulfilled (Objective classification). In other words classification
is the process of arranging items into groups according to their degree of
similarity. Accurate classification of all items is actually a prerequisite to
any form of cost analysis and control system. Classification is made according
to following basis.
i. Classification according
to Elements: - According to this classification overheads are divided
according to their elements. The classification is done as per the following
details.
• Indirect
Materials: - Materials which cannot be identified with the given product unit of
cost center is called as indirect materials. For example lubricants used in a
machine is an indirect material similarly thread used to stitch clothes is also
indirect material. Small nuts and bolts are also examples of indirect
materials.
• Indirect Labour: -
Wages and salaries paid to indirect workers i.e. workers who are not directly
engaged on the production are examples of indirect wages.
• Indirect Expenses:
- Expenses such as rent and taxes, printing and stationery, power, insurance, electricity,
marketing and selling expenses etc. are the examples of indirect expenses.
ii. Functional Classification:
- Overheads can also be classified according to their
functions. This classification is done as given below.
• Manufacturing Overheads:
- Indirect expenses incurred for manufacturing are called as manufacturing
overheads. For example factory power, works manager’s salary, factory insurance,
depreciation of factory machinery and other fixed assets indirect materials used
in production etc. It should be noted that such expenditure is incurred for
manufacturing but cannot be identified with the product units.
• Administrative Overheads:
- Indirect expenses incurred for running the administration are known as
Administrative Overheads. Examples of such overheads are office salaries,
printing and stationery, office telephone, office rent, electricity used in the
office, salaries of administrative staff etc.
• Selling and
Distribution Overheads: - Overheads incurred for getting orders from consumers are
called as selling overheads. On the other hand overheads incurred for execution
of order are called as distribution overheads. Examples of selling overheads are
sales promotion expenses, marketing expenses, salesmen’s salaries and
commission, advertising expenses etc. Examples of distribution overheads are
warehouse charges, transportation of outgoing goods, packing, commission of
middlemen etc.
• Research and Development Overheads: - In the modern days
firms spend heavily on research and development. Expenses incurred on research
and development is known as Research and Development overheads.
iii. Classification according
to Behaviour: - According to this classification overheads are classified
as fixed variable and semi-variable. These concepts are discussed below.
• Fixed Overheads: -
Fixed overheads are commonly described as those that do not vary in total
amount with increase or decrease in production volume for a given period of
time may be a year. Salaries, depreciation of fixed assets, property taxes are
some of the examples of fixed costs. Total fixed costs remain same irrespective
of changes in volume of production but per unit of fixed cost is variable. It
increases if production decreases while if production increases it decreases.
• Variable Overheads: - Variable overheads are those which go
on increasing if production volume increases and go on decreasing if the volume
decreases. Such increase or decrease may or may not be in the same proportion.
Variable overheads are generally considered to be controllable as they are
directly connected with the production.
• Semi-variable Overheads: - These types of overheads remain
constant over a relatively short range of variation in output and then are
abruptly changed to a new level. In other words they remain same up to a
certain level of output and after crossing that level they start increasing.
For example supervisor’s salary is treated as fixed but if a decision is taken
to operate a second shift additional supervisor may have to be appointed which
results into increase in the salary of the supervisor. This indicates that it
is a semi-variable overhead. Similarly maintenance expenditure, fire insurance is
also semi-variable overheads.
III. Codification of
Overheads: - It is always advisable to codify the overhead
expenses. Codification helps in easy identification of different items of
overheads. There are numerous items of overheads and a code number to each one
will facilitate identification of these items easily. Codification can be done by
allotting numerical codes or alphabetical codes or a combination of both.
Whatever system is followed it should be remembered that the system is simple
for understanding and easy to implement without any unnecessary complications.
B. Allocation, Apportionment and Reapportionment
of Overheads: - After the collection classification and codification of
overheads the next step is allocation, apportionment wherever allocation is not
possible and finally absorption of overheads into the product units. The
following steps are required to complete this process.
• Departmentalization: - Before the allocation and apportionment
process starts the first step in this direction is ‘Departmentalization’ of
overhead expenses. Departmentalization means creating departments in the firm so
that the overhead expenses can be conveniently allocated or apportioned to
these departments. For efficient working and to facilitate the process of allocation,
apportionment and reapportionment process an organization is divided into
number of departments like machining, personnel, fabrication, assembling,
maintenance, power, tool room, stores accounts costing etc. and the overheads
are collected allocated or apportioned to these departments. This process is
known as ‘departmentalization’ of overheads which will help in ascertainment of
cost of each department and control of expenses. Thus departmentalization is
the first step in allocation and apportionment process.
Q.4. What do
you mean by departmentalization of overhead expenses?
Ans.4.Departmentalization
means creating departments in the firm so that the overhead expenses can be
conveniently allocated or apportioned to these departments.
• Allocation: - cost allocation is ‘the charging of discrete
identifiable items of cost to cost centers or cost units. Where a cost can be
clearly identified with a cost center or cost unit then it can be allocated to
that particular cost center or unit. In other words allocation is the process by
which cost items are charged directly to a cost unit or cost center. For
example electricity charges can be allocated to various departments if separate
meters are installed, depreciation of machinery can be allocated to various
departments as the machines can be identified, salary of stores clerk can be
allocated to stores department and cost of coal used in boiler can be directly
allocated to boiler house division. Thus allocation is a direct process of
identifying overheads to the cost units or cost center.
Q.5. Cost
allocation is ‘the charging of discrete identifiable items of cost to cost centers
or cost units. (True)
• Apportionment: - Wherever possible the overheads are to be
allocated. However if it is not possible to charge the overheads to a
particular cost center or cost unit they are to be apportioned to various
departments on some suitable basis. This process is called as ‘Apportionment’
of overheads. For example if separate meters are provided in each department
the electricity expenses can be allocated to various departments. However if
separate meters are not provided electricity expenses will have to be
apportioned to the departments on some suitable basis like number of light
points. Similarly rent will have to be apportioned to various departments on
the basis of floor space, insurance of machinery on the basis of value of
machinery, power on the basis of horse power etc. A statement showing the
apportionment of overheads is called as ‘Primary Distribution Summary’ of
overheads.
Q.6. Explain
‘Apportionment’ of overheads.
Ans.6. if it is
not possible to charge the overheads to a particular cost center or cost unit
they are to be apportioned to various departments on some suitable basis. This
process is called as ‘Apportionment’ of overheads.
Q.7. A
statement showing the apportionment of overheads is called as ‘____________Distribution
Summary’ of overheads.
Ans.7. Primary
• Reapportionment of Overheads: - As discussed above one of the
important step in overhead accounting is ‘Departmentalization’ of overheads.
The departments are broadly divided into Production Departments and Service
Departments. Production Departments are the departments where actual production
takes place while Service Departments are the departments which render services
to the Production Departments. Stores Department, Maintenance Department, Human
Resource Department, after Sales Service Departments are some of the examples
of Service Departments. In Primary Distribution Summary the overheads are
apportioned to all the Departments i.e. Production and Service. For the purpose
of absorption it is necessary that the overheads of the service departments are
reapportioned to the production departments. This process is called as
preparation of ‘Secondary Distribution Summary’ of overheads. The following example
will clarify this point.
Suppose there are five departments in a manufacturing firm P1,
P2 and P3 are the production departments and S1 and S2 are the service
departments. The following results are available from the Primary Distribution
Summary.
|
Particulars
|
Dept.
P1
|
Dept.
P2
|
Dept.
P3
|
Dept.
S1
|
Dept.
S2
|
|
From
Primary Distribution Summary
|
150000
|
175000
|
125000
|
75000
|
50000
|
In the secondary distribution summary the overheads of S1 and
S2 will have to be charged to Production Departments P1, P2 and P3. This will
have to be done on some suitable basis. The matter becomes complicated if S1
and S2 are rendering services to each other in addition to the services
rendered to the production departments. The methods of reapportionment are
divided into two types.
Q.8. For the
purpose of absorption it is necessary that the overheads of the service
departments are reapportioned to the production departments. This process is
called as ‘___________Distribution Summary’ of overheads.
Ans.8. Secondary
• Non Reciprocal Methods: - Under this method the assumption
is that while service departments render services to the production departments
they do not render services to each other. Hence their overheads are not
apportioned to each other. The following methods are used under non reciprocal
methods.
• Services Rendered: - The principle followed in this method
is quite simple. A production department which receives maximum services from
service departments should be charged with the largest share of the overheads.
Accordingly the overheads of service departments are charged to the production
departments.
• Ability to Pay: - This method suggests that a large share
of service department’s overhead costs should be assigned to those producing
departments whose product contribute the most to the income of the business
firm. However the practical difficulty in this method is that it is difficult to
decide the most paying department and hence difficult to operate.
• Survey or analysis Method: - This method is used where a
suitable base is difficult to find or it would be too costly to select a method
which is considered suitable. For example the postage cost could be apportioned
on a survey of postage used during a year.
• Reciprocal Method: - Under this method the assumption is
that the service departments do render services to the production departments
they also render services to other service departments. In other words the
service department S1 and S2 render services to each other besides rendering
services to the production departments. Hence share of overhead expenses of S1
and S2 should be charged to each other along with the production departments.
The following method are used under Reciprocal Methods.
• Repeated Distribution Method: - Under this method services
rendered by services departments to the production departments and other services
departments are quantified in the form of percentages. The services departments’
costs are reapportioned to the production departments on the basis of these
percentages. The process is repeated again and again till a negligible figure is
reached. This method becomes complicated for calculation if the figures are too
large.
• Simultaneous Equation Method: - This is an algebraic method
in which simultaneous equations are formed and amount of overhead expenses of
each service department are found out by solving the equations. The total
expenses thus obtained are then directly transferred to the production
departments.
Q.9.
Under non reciprocal method the assumption is that while service departments
render services to the production departments they do not render services to
each other. (True)
Q.10.
Under reciprocal method the assumption is that the service departments do
render services to the production departments they also render services to
other service departments. (True)
C.
Absorption of Overheads: - The most important step in the
overhead accounting is ‘Absorption’ of overheads. Absorption is ‘the process of
absorbing all overhead costs allocated or apportioned over a particular cost
center or production department by the units produced.’ In simple words
absorption means charging equitable share of overhead expenses to the products.
As the overhead expenses are indirect expenses the absorption is to be made on
some suitable basis. The basis is the ‘absorption rate’ which is calculated by
dividing the overhead expenses by the base selected. A base selected may be any
one of the basis given below. The formula used for deciding the rate is as
follows
Overhead Absorption Rate = Overhead Expenses/ Units of the
base selected.
The methods used for
absorption are as follows.
• Direct Material Cost: - Under this method the overheads are
absorbed on the basis of percentage of direct material cost. The following
formula is used for working out the overhead absorption percentage.
Budgeted or Actual Overhead Cost/ Direct Material Cost * 100
Thus if the overhead expenses are SR 200000 and Direct
Material Cost is SR 400000 the percentage of overheads to
direct material cost will be 200000/400000 X 100 = 50%. Overheads will be thus
absorbed on the basis of percentage of 50% to material costs.
Q.11. What do you
mean by ‘Absorption of Overheads’?
Ans.11.
Absorption means charging equitable share of overhead expenses to the products.
Illustration: - A
firm produces two products A and B. Direct material costs for A are SR 250000
and for B SR 150000. The overheads will be charged to these products as shown
in the following statement assuming the rate of absorption as 50% as shown
above.
|
Particulars
|
Product A
|
Product B
|
|
Direct Materials
|
250000
|
150000
|
|
Overheads 50% of Direct Materials
|
125000
|
75000
|
|
Total Materials + Overheads
|
375000
|
225000
|
This method is suitable in those organizations where material
is a dominant factor in the total cost structure. Simplicity to understand and
operate is also one of the positive points of this method. However it has been
observed that the material prices are fluctuating and hence overhead absorption
may become difficult.
• Direct Labour Cost Method: - This method is used in those
organizations where labour is a dominant factor in the total cost. Under this
method the following formula is used for calculating the overhead absorption
rate.
Budgeted or Actual Overheads/ Direct Labour Cost * 100
Thus if the overheads are SR 300000 and Direct Labour Cost is
SR 400000 the % of absorption will be 300000/400000 * 100 = 75%. Overheads will
be charged to each product as 75% of labour cost.
This method is also simple to understand and easy to operate.
However it ignores the time taken by each worker for completion of the job.
Similarly it ignores the work performed by machine where a labour is a mere
attendant.
• Prime Cost Method: - This method is an improvement over the
first two methods. Under this method the Prime Cost is taken as the base for
calculating the percentage of absorption of overheads by using the following
formula.
Budgeted or Actual Overheads/ Prime Cost * 100
Illustration: -
A manufacturing firm produces two products A and B. The direct material cost for
A is SR 500000 and for B SR 300000 direct labour cost is SR 300000 and SR
200000 respectively for A and B direct expenses are SR 100000 and SR 200000
respectively for A and B. The overhead expenses are SR 960000. The statement of
cost will appear as follows.
|
Particulars
|
Product A
|
Product B
|
Total
|
|
Direct Materials
|
500000
|
300000
|
800000
|
|
Direct
Labour
|
300000
|
200000
|
500000
|
|
Direct
Expenses
|
100000
|
200000
|
300000
|
|
Prime Cost
[D.M. + D.L. + D.E.]
|
900000
|
700000
|
1600000
|
|
Overheads –
60% of Prime Cost
|
540000
|
420000
|
960000
|
|
Works Cost
|
1440000
|
1120000
|
2560000
|
Note: - Overhead absorption rate is calculated as –
960000/1600000 * 100 = 60%
• Production Unit Method: - This method is used when all
production units are similar to each other in all respects. Total overhead
expenses are divided by total production units for computing the rate per unit
of overheads and overheads are absorbed in the product units. If a firm produces
more than one products and if they are not uniform to each other equivalent units
are calculated to find out the rate of overheads per unit. The formula of
absorption of overheads is as follows.
Overhead absorption rate = Budgeted or Actual
Overheads/Production Units
• Direct Labour Hour Method: - Under this method the rate of
absorption is calculated by dividing the overhead expenses by the direct labour
hours. The formula is as follows -
Budgeted or Actual Overhead Expenses/Direct Labour Hours
This method takes into account the time spent by the labour
in production of each unit where the production units are not uniform or
identical. However it is not suitable if the firm is capital intensive and
highly mechanized.
• Machine Hour Rate: - Where machines are more dominant than
labour machine hour rate method is used. Machine hour rate is ‘actual or
predetermined rate of cost apportionment or overhead absorption which is
calculated by dividing the cost to be appropriated or absorbed by a number of
hours for which a machine or machines are operated or expected to be operated’.
In other words machine hour rate is the cost of operating a machine on per hour
basis. The formula for calculating the machine hour rate is -
Budgeted or Actual Overhead Expenses/ Machine Hours – Actual
or Budgeted
• Selling Price Method: - In this method selling price of the
products is used as a basis for absorbing the overheads. The logic used is that
if the selling price is high the product should bear higher overhead cost.
Ratio of selling price is worked out and the overheads are absorbed.
Example.1.
Primary and
Secondary Distribution Summary
A
company has three production departments A, B and C and two service
departments, X and Y.
The
following data are extracted from the records of the company for a particular
period.
|
Sr. No.
|
Particulars
|
Amount (SR)
|
|
1
|
Rent and Taxes
|
25,000
|
|
2
|
General lighting
|
3,000
|
|
3
|
Indirect Wages
|
7,500
|
|
4
|
Power
|
7,500
|
|
5
|
Depreciation of Machinery
|
50,000
|
|
6
|
Sundries
|
50,000
|
Additional
Data
|
Particulars
|
Total
|
Dept. A
|
Dept. B
|
Dept. C
|
Dept. X
|
Dept. Y
|
|
Direct Wages (SR)
|
50,000
|
15,000
|
10,000
|
15,000
|
7,500
|
2,500
|
|
Horsepower of Machines
|
150
|
60
|
30
|
50
|
10
|
—
|
|
Cost of Machinery (SR)
|
12,50,000
|
3,00,000
|
4,00,000
|
5,00,000
|
25,000
|
25,000
|
|
Production hrs worked
|
—
|
6226
|
4028
|
4066
|
—
|
—
|
|
Floor space (sq.mtrs)
|
10,000
|
2,000
|
2,500
|
3,000
|
2,000
|
500
|
|
Lighting points
(Nos.)
|
60
|
10
|
15
|
20
|
10
|
05
|
Service Departments’ Expenses Allocation:-
|
Department
|
A
|
B
|
C
|
X
|
Y
|
|
X (%)
|
20
|
30
|
40
|
-
|
10
|
|
Y (%)
|
40
|
20
|
30
|
10
|
-
|
You are required to,
A. Prepare primary and
secondary distribution summary according to repeated distribution System.
Solution:
Example.2.
A
company has three production departments, A, B and C and two service
departments, P and Q. The following figures are available from the primary
distribution summary.
|
Department
|
Dept A
|
Dept B
|
Dept C
|
Dept P
|
Dept Q
|
|
From Primary Distribution (
SR )
|
3,150
|
3,700
|
1,400
|
2,250
|
1,000
|
The
expenses of the service departments are to be apportioned on a percentage basis
as follows.
|
Department
|
Dept A
|
Dept B
|
Dept C
|
Dept P
|
Dept Q
|
|
P (%)
|
40
|
30
|
20
|
-
|
10
|
|
Q (%)
|
30
|
30
|
20
|
20
|
-
|
Prepare
Secondary Distribution Summary as per the Simultaneous Equations Method.
Solution:
Example.3.
X, Y and Z have two production departments and three service
departments. Expenses incurred for these departments and other available
information is given below.
|
Particulars
|
Prod. Dept. A
|
Prod. Dept. B
|
Service Dept.
Maintenance
|
Service
Dept. Power
|
Service Dept.
Personnel
|
|
As per
Primary
Distribution
|
1,20,000
|
1,50,000
|
20,000
|
48,000
|
40,000
|
|
Allocation Basis
|
|
|
|
|
|
|
Maintenance
Hours
|
80
|
20
|
—
|
40
|
20
|
|
KWH
Consumed
|
4
|
16
|
2
|
—
|
2
|
|
Number of
Employees
|
60
|
30
|
30
|
18
|
|
Allocate
the cost of service departments to the production departments.
Solution:
Example.4.
The
production department of a factory furnishes the following information for the
month of March, 2012.
Materials used SR 54,000
Direct Wages SR 45,000
Overheads SR 36,000
Labour hours worked - 36,000
Hours of machine operation - 30,000
For an order executed by the department during
the period, the relevant information was as under.
Materials used SR 600000
Direct Wages SR 320000
Labour hours worked - 3,200
Machine hours worked - 2,400
Calculate the overhead charges chargeable to
the job by the following methods;
i.
Direct materials cost percentage rate
ii.
Labour hour rate and
iii.
Machine hour rate.
Solution:-
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