Overhead

Accounting
Overheads include cost of indirect material, indirect labour,
indirect expenses which cannot be conveniently charged to
any job, process, cost unit etc. For example, costs like rent,
rates, administration and supervision, depreciation,
maintenance, selling and distribution expenses, cleaning
materials etc. cannot be directly attributed to cost units
produced.
 Definition of Overheads:
• CIMA defines Overhead Cost as 
• “the total cost of
indirect materials,
indirect labour and
indirect expenses”.
 Example of Direct & Indirect Costs

unit manufactures two products – Leather

shoes & Leather wallets Material (Leather)
used for both the products is traceable to
them individually.
However, expenditure of a common machine
used in making both the products cannot be
traceable to them.Therefore in the above
case ‘Material’ would be a direct cost and
‘Machine expenses’ would be indirect cost.
Importance of Overhead allocation
• Total cost of product constitutes Direct
Material, Direct Labor & Overheads. Direct
Material and Direct Labor are directly traceable
to the products manufactured. Accuracy of
product cost computation depends on accurate
distribution of overheads to products.
Inaccuracies would lead to incorrect decisions
– especially the pricing decisions.
• However, the method of overhead distribution
should be chosen by considering time and cost
factors in addition to accuracy.
 Classification of Overhead
• Based on this overheads are
classified as follows
• Factory overheads
• Administrative overheads
• Selling & Distribution overheads
Research & Development overheads
 Behavioral Classification
• Fixed Overhead
• Variable Overhead
• Semi-Variable overhead
 Overhead
•Allocation
•and
•Apportionment
 Departmentalization
• For efficient working, and for collection,
allocation and absorption of costs, an
organization is divided into number of
departments like machining, fabrication,
assembling, maintenance, power,
personnel, tool room, stores, accounts,
costing, etc. and the overheads are
collected, allocated or apportioned to the
respective departments.
 departmentalization
• When all the items are collected properly
under suitable account heading, the next
step is allocation and apportionment of
such expenses to cost centers. This
process is called ‘departmentalization’ of
overheads.
 Allocation
• A cost allocation can be defined as “the
partitioning of a cost among a set of cost
objects”. For this purpose, the cost object could
be production units, machines, groups of
machines, individual products or groups of
products. Companies that price all or a large
part of their output on a cost- plus basis certainly
need to include overheads in their cost of
production. Financial reporting is another reason
for allocating costs.
• Allotment of whole item of cost to cost
center or cost unit or charging of
expenses which can be identified
wholly with a particular department.
• The cost of repairs of a particulars
department can easily by charged to
that particular department.
• iii. Apportionment:
• CIMA defines apportionment as “the
allotment of two or more cost centres of
proportions of the common items of cost
and the estimated basis of benefits
received”.
• Some costs cannot be identified as arising from
the activities of one specific department or
function. Non-allocable costs, however, must be
apportioned on some logical basis to be divided
between the related cost centres.
• For example, rent, rates and taxes incurred for
the entire factory cannot be directly allocated to
different cost centres, but can be apportioned to
more than one cost centre on some equitable
basis for benefits received.
Basis for apportionment
• Methods of Secondary Distribution of
overhead (Redistribution)
• First, the management should determine
the basis for redistribution of service
departments. Then, the actual
redistribution can be done by any one of
the following methods.
 1. Direct Redistribution Method
• Under this method, the costs of one
service department are apportioned only
to the production departments ignoring the
service rendered by one service
department to another. If this method is
followed, the number of secondary
distribution will be equal to number of
service departments.
 2. Step Method/ step ladder
method
• This method is also known as non-
reciprocal method. This method ignores
the service rendered by one service
department to another. Moreover, there is
no two-way distribution of costs between
two service departments. It means that the
costs of one service department cannot be
distributed to other service departments
even though service rendered to them.
 For example:
• Canteen expenses are distributed to
stores department because canteen
renders service to stores department
employees. But, no part of stores
department cost is not distributed to
canteen even if stores department render
service to canteen.
 Reciprocal Service Method
• Under this method, the costs of one
service department are distributed to other
service department on the basis of
rendering service. Here, there is a two-
way distribution of costs between two
service departments. It means that the
costs of one service department can be
distributed to other service departments if
service rendered to them.
 Reciprocal distribution method
• Simultaneous Equation method
• Repeated Distributed method
• Trial and error method
 Simultaneous Equation
Method
• Under this method, the total costs of
service departments are ascertained with
the help of simultaneous equation. Then,
the costs of service departments are
apportioned on agreed percentage only
among production departments.
Repeated Distribution Method
• This method is otherwise called as
continued distribution and attrition method.
The service department costs are
distributed to other service departments
and production departments on agreed
percentage. In this way, this process is
repeated till the costs of service
department are too small. Then, the costs
of service department are distributed only
among production department.
 Trial and Error Method
•  Under this method, the cost of one
service department is apportioned to
another service department. Now, the cost
of another service department plus the
share of costs received from the first
service department is again apportioned to
first service department. In this way, this
process is going on till the balancing figure
becomes negligible.
 Absorption
• The process of recovering overheads to cost of products
is called ‘absorption’.
• In other words all the overheads allocated & apportioned
to a department are finally absorbed by the units
produced.

• After allocation and 

apportionment of overheads to their departments, we
have to include it in the cost of production. The process
of including these overhead in the cost of production is
called absorption of overheads
• Ques
• Prepare cost sheet from the following particulars in the books of B. M. Rehman
• Raw material purchased = Rs. 1, 20,000
• Paid freight charges = Rs 10,000
• Wages paid to labourers = Rs 35,000
• Directly chargeable expenses = Rs 25,000
• Factory expenses = 20% of prime cost
• General and administrative expenses = 4% of factory cost
• Selling and distribution expenses = 5% of production cost
• Profit 20% on sales
• Opening stock Closing stock
• Raw material 15,000 20,000
• Work in progress 17,500 24,000
• Finished goods 20,000 27,500
Profit 56,956.50
 Methods
a) On the basis of ‘Production units’
b) As a % of ‘Direct Labour Cost’
c) As a % of ‘Direct Material Cost’
d) As a % of ‘Prime Cost’
e) On the basis of ‘Direct Labour Hours’ i.e.
Labour Hour Rate
f) On the basis of ‘Machine Hours’ i.e.
Machine Hour Rate
 1. Direct Material Cost
Method 
• According to the material cost method, we calculate the
rate of overhead on the basis of past actual direct
material and past actual overheads.
• For example, past actual direct material's cost is Rs.
10,000 and past actual overhead cost is Rs. 2000. So,
Overhead rate will be 20%. If we have obtained any
specific order for producing any product, we will include
the 20% cost of overhead.
• Production Overhead
• ---------------------------- X 100
• Direct material cost
 Limitations
• Fluctuations in price of materials
• No distinction between skilled labour and
unskilled labour.
• Raw material does not pass through all
stages
2. Direct Labour Cost Method
•  According to the Direct Labour Cost
method, we calculate the rate of overhead
on the basis of past actual cost of direct
wages and past actual overheads
following is the formula

= Actual Overhead Cost

------------------------------------- X 100
Direct Labour Cost
 
 3. Prime Cost Method
•  Under prime cost method, we calculate the
actual or estimated prime cost in which direct
material cost and direct labour cost will be
added. We also calculate the budgeted
Overhead Cost. After this, we calculate the rate
of overhead. On this rate, we absorb our
overhead cost on any new production.
• Following is the formula of overhead rate

= Budgeted Overhead Expenses

• ---------------------------------------------- X 100
• Anticipated Prime Cost 
 4. Direct Labour Hour
Method 
• Under this method , first we calculate the total
direct labour hours .Then, We also see the total
cost of overhead in these labour hours. After
dividing this overhead cost with direct labour
hours, we can easily calculate the rate of
overhead. On this rate, we can absorb the
estimated amount of overhead in any unit or
units of production.

Following is the formula

= Overhead Cost / Direct labour Hours 

• For example,
• total direct labour hours are 10,000. Total
overhead cost in these hours are Rs.
5,000. Our overhead rate is the 50% of
labour hours in any production.
5.Machine Hour Rate Method 
• This is very good method of absorption of
overhead cost in the industry where we do
all works with the help of machines. We
just have to calculate the machine hour
rate and same rate will be the overhead
rate and on this basis, we can absorb the
estimated cost of overhead when we
produce any unit of production.