FACTORY OVERHEAD

 Factory overhead is the costs incurred during the manufacturing process, not including the costs of direct labor, direct
materials and direct expenses
 Costs that cannot practically be assigned directly to the production or sale of a particular product. In accounting terms,
such costs are not directly identifiable with a specific cost objective
 Costs of minor amount may be treated as indirect costs
 Overheads are to be classified on the basis of functions to which overheads are related
 Production overheads
 Administrative overheads
 Selling overheads
 Distribution overheads
 Overheads may also be classified on the basis of behavior such as variable overheads, semi-variable overheads and fixed
overheads
 Overheads comprise of indirect materials, indirect employee costs and indirect expenses which are not direct expenses
which are not directly identifiable or allocable to a cost object in a economically feasible way
 Manufacturing overhead consists of three primary costs: indirect materials, indirect labor, and indirect expenses

6.1 Indirect Material

 Indirect materials include factory supplies such as sandpaper to smooth rough edges, blades to cut materials, oil for the
production machines & lubricants and other factory-related materials and supplies that do not directly become part of a
product
 Indirect material costs differ from direct materials in that indirect costs are not traceable to a particular product

6.2 Indirect Labor

 Indirect labor includes factory supervisor salaries, factory maintenance workers salaries or wages, production supervisor
salaries, quality assurance salaries, materials management salaries, employee benefits, materials handling, overtime
premium, plant security, Workers’ Compensation Insurance and other costs for factory-related workers who do not
directly contribute to producing a particular product
 Indirect labor costs differ from direct labor in that indirect costs are not traceable to a particular product

6.3 Indirect Expenses

 Some examples are factory rent, factory insurance, factory building and equipment depreciation, factory utilities,
Equipment setup costs, factory small tools and factory, defective work, fuel, heat and light, power, property tax,
Telephone/Fax, Water and equipment maintenance

Example 6.1: A Company makes two products X and Y. During a given period, the company makes 2,000 units of each
product. The direct cost of product X is Rs. 120,000 and direct cost of Product Y is Rs. 100,000. Overhead cost for the
period is Rs. 200,000.

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If we want to establish a cost for Product X and Product Y, the direct costs of each product are easily established, but what
about the Overhead? Should each product be given a share of the overhead cost? If the overhead cost are to be divided
between the two products, on what basis should the total cost be shared?

6.4 Accounting Treatment for Overheads (Absorption Costing)

 The product, services or activities are charged with a fair share of indirect cost
 There are four-step process involved in charging overhead cost to product are services
 Overhead Allocation, Overhead Apportionment, Overhead Re-Apportionment and Overhead absorption Rate also
called Overhead Recovery

6.4.1 Overhead Allocation

Overhead allocation is first of the three stages in establishing a full cost for a product or services
Overhead allocation is the process of charging a whole item of cost to a cost centre
Cost Centre is defined as to a unit or organization for which costs are accumulated or computed
In other words, cost centre is area, machine, or person to whom direct and indirect costs are allocated
Factory overhead costs are incurred in three main centers:
 Production centers costs arising in production departments such as the costs of fuel, indirect material, depreciation
and supervision
 Service centers the cost of operating support departments or sections within the factory, for example, the costs of
materials handling, production control etc.
 General costs centers general production overhead such as factory rent/taxes, heating and lighting and canteen
An item of expenses which can be directly related to a cost centre is to be allocation to the cost centre. For example ,
depreciation of a particular machine should be allocated to a particular cost centre if the machine is directly attached to
the cost centre
When factory overhead expenses are not identified with a specific product, they are charged to product by a process of
overhead allocation
Allocations may be made for each item of expense incurred and the allocations made at the end of the accounting period
The purpose of cost accounting is to provide information to the management. Management need to know cost per unit as
a basis for decision making

Example 6.2: A manufacturing business operates with two production departments P and Q and a department S. It
manufactures soup and shampoo. It incurs the following costs in a given period.

Indirect labor cost in department S Rs. 6,500 Direct labor cost in department P Rs. 4,700
Cost of supervision in department Q 2,100 Direct material cost in department P 10,300
Lighting and heating 900 Machine repair cost, department Q 800
Indirect material in department S 1,100 Depreciation of machinery, department S 700
Indirect material consumed by department P 500 Cost of works canteen 1,500

Requirement: Allocate these costs as overhead cost to the following cost centres:
Production Cost Centre (P), Production Cost Centre (Q), Service Cost Centre (S) and General Cost Centre (G)

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Solution:
Overhead Allocation
Cost Centres
Description
P Q S G

Total 500 2,900 8,300 2,400

6.4.2 Overhead Apportionment

 Once overhead costs have been allocated to cost centres, general overhead must be shared out or apportioned. This may
be to production or services cost centres
 Overhead apportionment is the process of sharing out overhead costs on fair basis
 Overheads are to be apportionment to different cost centres based on following two principle
o Cause and Effect: Cause is the process or operation or activity and effect is the incurrence of cost
o Benefits received: Overheads are to be apportioned to the various cost centres in proportion to the benefits
received by them

Example 6.3: A general cost in a manufacturing company is factory rental. Annual rental costs are Rs. 80,000. How this cost
should be apportioned between production cost centres and services cost centres? Rental costs are usually apportioned
between cost centres on the basis of the floor space taken up by each centre. Suppose that three cost centres have floor space
of 50,000 square meters; Production cost centre (A) has 10,000 square meters, Production cost centre (B) has 15,000 square
meters and Service cost centre (C) has 25,000 square meters.

Solution:
Production Cost Centre (A) =
Production Cost Centre (B) =
Service Cost Centre (C) =

6.4.2.1 Bases for Overhead Apportionment:

¤ Basis of apportionment must be rational to distribute overheads
¤ Once the base is selected the same is to be followed consistently
¤ However, change in basis for apportionment can be adopted only when it is considered necessary due to change in
circumstances like change in technology, degree of mechanization product mix etc.

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 Common Bases for Apportionment of Overheads
Costs Basis for Apportionment
Building Maintenance Floor space
Inspection and Packing Production volume
Asset Maintenance Book value of an asset

Heating and Lighting Floor space

Oil for Machine Lubrication Machine hours or number of machine

Supervision or Employee Benefits Number of workers

Canteen Costs Number of workers

Petrol for Vehicles Number of vehicles or mileage of vehicles

Rent and Electricity Floor space

Cost of material, Store and Warehouse Number of material requisitions

Depreciation of assets or Insurance Book value of an asset

Power or Fuel Machine hours

Labor welfare cost Number of employees

Example 6.4: An organization has two production department A and B and two services departments, Stores and canteen.
The general overhead costs for the organization in total are as follows:
Rent Rs. 32,000 Building maintenances costs Rs. 5,000
Machinery insurance 2,400 Machinery depreciation 11,000
Machinery running expenses 6,000 Power 7,000

There are also specific costs that have already been allocated to each cost centre as follows:
Department A Rs. 5,000 Department B Rs. 4,000
Stores 1,000 Canteen 2,000

The following information about the various cost centres is also available:
Basis for Apportionment Total Dept. A Dept. B Stores Canteen
Floor Space (sq ft) 30,000 15,000 8,000 5,000 2,000
Power usage 100% 45% 40% 5% 10%
Book value of machine 250,000 140,000 110,000 - -
Machine hours 80,000 50,000 30,000 - -
Book value of equipment 20,000 - - 5 15
Number of employees 40 20 15 3 2
Value of stores requisitions 150,000 100,000 50,000 - -

Required: Allocate and apportioned the cost to the four departments by making Overhead Analysis Sheet?

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 Overhead Analysis Sheet

Production Cost Centres Service Cost Centres

Description Total
Dept. A Dept. B Stores Canteen

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 Difference between Cost Allocation and Cost Apportionment
Cost Allocation Cost Apportionment

1. Deals with whole items of costs 1. Deals with proportions of items of cost

2. Is an Indirect Process for which suitable bases are

2. Is a direct Process
to be selected
3. Apportionment does not depend upon the nature
3. Cost allocation depends upon the nature of cost
of cost

6.4.3 Re-Apportionment
ö Organizations may have service departments (canteen, maintenance and administration) which cannot be related to any
income producing activity
ö To find the full cost of a cost unit these department costs should also be absorbed into the unit cost
ö Therefore, service departments must be apportioned to the various departments producing the products or services
ö There are three methods are used for re-apportionment

6.4.3.1 Direct Distribution Method

 In this method services cost centres will be re-apportioned to production cost centre only
 In this situation where service cost centres do not service each other (Non-Reciprocal Apportionment)

Example 6.5: Using the information produced in the previous example, the allocated and apportioned overhead costs are:

Production Cost Centres Service Cost Centres

Description Total
Dept. A Dept. B Stores Canteen

Total Allocation and Apportionment Rs. 75,400 Rs. 37,904 Rs. 24,813 7,517 5,166

The apportionment of the stores cost centre will be on the basis of the value of requisitions by each production cost centre.
The apportionment of the canteen costs should be on the basis of the number of employees in production dept. A and B

Basis for Apportionment Total Dept. A Dept. B Stores Canteen

Number of employees 40 20 15 3 2

Value of stores requisitions 150,000 100,000 50,000 - -

Requirement: Show how the service cost centre costs should be re-apportioned and the resulting total overhead costs of each
production cost centre assuming that store cost centre does not work for canteen and canteen does not work for store cost
centre?

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 Overhead Analysis Sheet

Production Cost Centres Service Cost Centres

Description Total
Dept. A Dept. B Stores Canteen

6.4.3.2 Step-Down Method

 Some organizations use the step-down method, also called the sequential or repeated allocation method
 Which allocates services-department costs to other services departments and to production departments in a sequential
manner that partially recognizes the mutual services provided among all service depts. (Reciprocal Apportionment)
 Distributes service department costs regressively to other service departments and then to production departments.

Example 6.6: A company has three production departments and two service departments. Distribution summary of
overheads is as follows:

Production Department Service Departments

A Rs.3,000 D Rs.234

B Rs.2,000 E Rs.300

C Rs.1,000

The expenses of service departments are charged on a percentage basis which is as follows:
Production Department Service Departments
Departments
A B C D E
D 20% 40% 30% - 10%

E 40% 20% 20% 20% -

Requirement: Find out the total overheads of production departments by step-down method?

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 Overhead Analysis Sheet

Production Cost Centre Service Cost Centre

Items A B C D E

6.4.3.3 Algebraic Distribution Method

 It is also reciprocal apportionment using equation
 Distributes costs by simultaneous equations recognizing the relationship of services rendered by departments to
each other

Example 6.7: A company has three production departments and two service departments. Distribution summary of
overheads is as follows:

Production Department Service Departments

A Rs.3,000 D Rs.234
B Rs.2,000 E Rs.300
C Rs.1,000

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The expenses of service departments are charged on a percentage basis which is as follows:
Production Department Service Departments
Departments A B C D E
D 20% 40% 30% - 10%

E 40% 20% 20% 20% -

Requirement: Find out the total overheads of production departments by Algebraic Distribution Method?

Overhead Analysis Sheet

Production Cost Centre
Items A B C

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6.4.3.4 Overhead absorption Rate
¤ An absorption rate is the rate at which overheads are added to costs
¤ Production overhead costs are absorbed into product costs on a particular bases selected by the organization
¤ The calculation of an overhead absorption rate requires two elements i.e. the total overhead attributable to a cost centre
and the absorption base
¤ The absorption bases should be appropriate. The most common bases of absorption are:
 Percentage of direct material cost
 Percentage of direct labor cost
 Percentage of prime cost
 Rate per unit produced
 Rate per labor hour
 Rate per machine hour

Estimated Total Factory Overhead

Overhead Absorption Rate = Estimated Base
*100

¤ Once an Overhead absorption rate has been calculated, the amount of overhead absorption can be calculated as follow:
¤ Overhead absorption = Actual Activity Level * Overhead Absorption Rate

Example 6.7: The Company estimated that it would incur Rs. 320,000 in manufacturing overhead costs and would work
40,000 direct labor-hours. What is the company’s Overhead Absorption rate?

Solution:

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