ACCOUNTING FOR OVERHEADS

After studying the contents of this chapter you should be able to:
 Define and classify overheads costs
 Understand the meaning and computation of absorption costing
 Explain the meaning of allocation of overheads
 Understand the concept of overhead apportionment and the methods of apportionment
 Explain the meaning of overhead absorption and the methods of calculating overhead absorption rates
 Explain the concept of over or under absorbed overheads
5.0 MEANING OF OVERHEAD
Overhead is the cost incurred in the course of making a product, providing a service or running a department,
but which cannot be traced directly and in full to the product, service or department. Overhead is actually the
total of the following:
a. Indirect materials b. Indirect labour and c. Indirect expenses
The total of these indirect costs is usually split into the following categories
 Production overhead
 Selling and distribution overhead
 Administration overhead
5.1 ABSORPTION COSTING
This is a method of accounting for overheads. It is basically a method of sharing out overheads incurred among
units produced. The objective of absorption is to include in the total cost of a production an appropriate share of
the organisation’s total overhead. An appropriate share is generally taken to mean an amount which reflects the
amount of time and effort that has gone into producing a unit or completing a job.
5.1.1 REASONS FOR USING ABSORPTION COSTING
a. Inventory valuation i.e. to value closing stocks and cost of sales
b. Pricing decision i.e. some organisations use full cost of production to fix selling price
c. Establish profitability of different products
5.1.2 STAGES OF ABSORPTION COSTING
The three stages of absorption costing are:
i. Allocation stage ii. Apportionment stage and iii. Absorption
5.2 ALLOCATION OF OVERHEAD
This is the process by which the whole cost items are charged directly to a cost unit or cost centre without sharing.
Cost centre may be one of the following:
i. Production department, to which production overheads are charged
ii. Administrative department, to which administration overheads are charged
iii. Selling or distribution department, to which sales and distribution overheads are charged
iv. An overhead cost centre, to which items of expenses which are shared by a no. of department such as
rent and rates, heat and light and the canteen are charged
Illustration 5.1
Consider the following cost of a company
N
Wages of the foreman of department A 200
Wages of the foreman of department B 150
Indirect materials consumed in department A 50
Rent of the premises shared between department A & B 300
The cost accounting system includes three overhead cost centres as follows:
Cost centres: 101 - Department A
102 - Department B
103 - Rent
Department A & B share rent in the ratio of 2:1
How will you treat these costs?

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SUGGESTED SOLUTION: Allocation of Overhead cost
Department A Department B
₦ ₦
Wages of the foreman 200
Wages of the foreman 150
Indirect materials consumed 50
Rent (2:1) 200 100
Total allocation 450 250

5.3 OVERHEAD APPORTIONMENT

Apportionment is a procedure whereby indirect costs are spread fairly between cost centers; service cost centre
cost may be apportioned to production cost centres. Bases of apportionment commonly used are:

Overheads Items Basis of Apportionment

Rent, rate, heating & lighting, insurance of Floor area occupied by each of the cost centre
building, depreciation of building, repairs
Depreciation and insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, wages and No. of employees or labour hours worked in
first aid each cost centre
Electricity and power Kilowatt

Service Cost Centre Possible Basis of Apportionment

Stores Number or cost value of material requisition
Maintenance Hours of maintenance work done for each
cost centre
Production planning Direct labour hours worked in each
production cost centre

Illustration 5.2
The following estimated figures for twelve months are made available for a factory which has two production
departments and a production control department.
N
Rent 2,000
Depreciation of plant 8,000
Heat &lighting 1,000
Power 2,800
Factory administration overhead 6,300

Statistics in respect of the three departments are as follow:

Dept. A Dept. B Production control
Area in square metres 5,000 4,000 1,000
Value of plant ₦30,000 ₦20,000 -
No. of employees 120 80 10
Estimated kilowatt 2,700 2,300 -
You are required to prepare the overhead analysis sheet showing how the overhead costs will be apportioned.

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SUGGESTED SOLUTION: Apportionment of Overhead costs
Overhead Prod.
Items cost Basis of Apportionment Dept. A Dept. B Control
Rent 2,000 Area in square metres 1,000 800 200
Depreciation 8,000 Value of plant 4,800 3,200
Heating 1,000 Estimated kilowatt 540 460
Power 2,800 Estimated kilowatt 1,512 1,288
Factory administration 6,300 No. of employees 3,600 2,400 300
Total 11,452 8,148 500
Apportionment of service department overhead cost to production department:
Service department overhead cost may be apportioned to production cost centres using any of the methods:
 Direct method or One step apportionment: under this method the overheads of service departments are
apportioned to only production department ignoring apportionment to other service departments. However
this method can be used only when the inter service departmental service is comparatively insignificant.
 Elimination method: Under this method, service department costs are apportioned over other departments,
production as well as service, according to agreed percentage. However once a service department is
assigned, it is eliminated from the process till all service department are assigned to production department.
 Reciprocal method:
- Simultaneous equation method: Under this method the total overhead cost for each service department is
expressed in the form of an algebraic equation with the help of the percentage distribution of the service
cost. But this method may not be easy and practicable to apply if the numbers of interdependent service
departments are more than two.
- Repetitive Distribution Method or Continuous Allotment Method: Under this method, service
department costs are apportioned over other departments, production as well as service, according to agreed
percentage. This process continues till the amount to be transferred to a particular service department
becomes very small or nil.
Illustration 5.3
Foundation Limited Company has two service departments and two production departments. Information for
each department for 2015 is as follows;
Service department Production department
Admin. Maintenance Molding Assembly
₦ ₦ ₦ ₦
Budget overheads 80,000 120,000 460,000 540,000
Direct labour hours 500 2,000 25,000 32,000
Machine hours 200 300 6,000 12,000
Number of employees ----- 500 2,500 10,000
Note: Administration costs are allocated based on number of employees and factory maintenance costs are
allocated based on machine hours.
Required: Allocate the service department overhead costs using the three methods and determine the total
overhead cost for Molding and Assembly departments
SUGGESTED SOLUTION:
Overhead Apportionment (Direct Method/One Step Apportionment)
Basis of Admin Maintenance Molding Assembly
Items Apportionment ₦ ₦ ₦ ₦
Overhead cost 80,000 120,000 460,000 540,000
Admin No. of employees (80,000) 16,000 64,000
Maintenance Machine hours (120,000) 40,000 80,000
Total 516,000 684,000
Total overhead costs for Molding = ₦516,000 and Assembly = ₦684,000

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 Overhead Apportionment (Sequential/Elimination Method)
Basis of Admin. Maintenance Molding Assembly
Items Apportionment ₦ ₦ ₦ ₦
Overhead cost 80,000 120,000 460,000 540,000
Admin. No. of employees (80,000) 3,076.92 15,384.62 61,538
123,076.92 475,384.62 601,538.46
Maintenance Machine hours (123,076.92) 41,025.64 82,051.28
Total 516,410.26 683,589.74
Total overhead costs for Molding = ₦516,410.26 and Assembly = ₦683,589.74
Overhead Apportionment (Continuous Allotment Method)
Admin Maintenance Molding Assembly
Items Basis of Apportionment ₦ ₦ ₦ ₦
80,000 120,000 460,000 540,000
Admin No. of employees (80,000) 3,076.92 15,384.62 61,538
123,076.92 475,384.62 601,538.46
Maintenance Machine hours 1352.49 (123,076.92) 40,574.81 81,149.62
1,352.49 515,959.43 682,688.08
Admin No. of employees (1,352.49) 52.02 260.09 338.12
52.02 516,219.52 683,026.20
Maintenance Machine hours 0.57 (52.02) 17.15 34.30
0.57 516,236.67 683,060.50
Total overhead costs for Molding = ₦516,236.67 and Assembly = ₦683,060.50
5.4 OVERHEAD ABSORPTION
This is the process whereby overhead costs allocated and apportioned to production cost centres are added to
unit, job or batch costs. Overhead absorption is sometimes called OVERHEAD RECOVERY. Overheads are
usually added to cost unit using predetermined absorption rate, which is calculated using figures from the budget.
5.4.1 CALCULATION OF OVERHEAD ABSORPTION RATES
In calculating overhead absorption rate, the following steps are to be followed:
i. Estimate the overhead likely to be incurred during the coming period
ii. Establish the activity level for the period. This could be total hours, units or direct costs or whatever it is
upon which the overhead absorption rates are to be based
iii. Divide the estimated overhead by the budgeted activity level. This gives the overhead absorption rate (OAR)
iv. Absorb the overhead into the cost unit by applying the calculated absorption rate.
Illustration 5.4
Well-Praises Ventures makes two products, the Greek and the Roman. Greeks take 2 labour hours each to make
and Romans take 5 labour hours. The budgeted overhead cost is ₦50,000 and budgeted activity level is 100,000
labour hours. What is the overhead cost per unit for Greeks and Romans respectively if overheads are absorbed
on the basis of labour hours?
SUGGESTED SOLUTION: Overhead Absorption Rate (OAR) = ₦50,000/100,000 = ₦0.50/DLH
Overhead cost for Greeks = ₦0.50 X 2 = ₦1
Overhead cost for Romans = ₦0.50 X 5 = ₦2.50
Illustration 5.5
Using the data in illustration 5.3, calculate the overhead recovery rate for each of the production departments
SUGGESTED SOLUTION:
Direct Labour Hour Machine Hour
Molding = ₦460,000/25,000 = ₦18.40/DLH ₦460,000/12,000 = ₦38.33/MH
Assembly = ₦540,000/32,000 = ₦16.88/DLH ₦540,000/6,000 = ₦90/MH

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Different Bases of Overhead Absorption Rate (OAR) or Overhead Recovery Rates (ORR)
 A percentage of direct material cost
 A percentage of direct labour cost
 A percentage of prime cost
 A rate per machine hour
 A rate per direct labour hour
 A rate per unit
 A percentage of factory cost (for administrative overhead)
 A percentage of sales or factory cost (for selling and distribution overhead)
5.4.2 BLANKET OVERHEAD ABSORPTION RATE AND COST CENTRE OR DEPARTMENTAL
ABSORPTION RATE
A blanket overhead absorption rate (single overhead absorption rate) is an absorption rate used throughout a
factory and for all jobs and units of output irrespective of the department in which they are produced. For instance
if total overhead were N500,000 and there were 250,000 machine hour during the period, the blanket overhead
rate would be N2/MH and all jobs passing through the factory would be charged at that rate.
Blanket overhead rate are not appropriate in the following circumstances:
i. Where there is more than one department
ii. Where jobs do not spend an equal amount of time in each department.
If a single overhead absorption rate is used, some products will receive higher overhead charges than they ought
to bear whereas other products will be undercharged. If a separate overhead absorption rate (cost
centre/departmental overhead absorption rate) is used for each department, overhead charges will be fair and the
full cost of item will represent the amount of the effort and resources put into making them.
5.4.3 OVER AND UNDER ABSORPTION OF OVERHEADS
Over and under absorption of overhead occur because the predetermined overhead absorption rates are based on
estimates. It is likely that the actual overhead will not agree with budgeted overheads.
i. OVER ABSORPTION
This means that the overheads absorbed to the cost of sales are greater than the overhead actually incurred. Over
absorption will increase profit.
ii. UNDER ABSORPTION
This means that the overhead absorbed into cost of sales is less than the overhead actually incurred. Under
absorption will reduce profit.
Illustration 5.6
Suppose that the budgeted overhead in a production is ₦80,000 and the budgeted activity is 40,000 direct labour
hours. Actual overhead during the period are ₦84,000 and 45,000 DLH are worked. Determine the over/under
absorption of overhead.
SUGGESTED SOLUTION:
Overhead Absorption Rate = ₦80,000/40,000 = ₦2/DLH
Absorbed Overhead for activity level of 45,000 DLH = 45,000 x ₦2 = ₦90,000
Over absorption = ₦90,000 – ₦84,000 = ₦6,000
Illustration 5.7
The budgeted overhead of a company is ₦64,000 and the budgeted units of production are 8,000. Actual result
for the period is as follows: Actual production 7,500 units, Actual overhead cost is in line with budget. What is
the over/ under absorption of overhead?
SUGGESTED SOLUTION:
Overhead Absorption Rate = ₦64,000/8,000 = ₦8/unit
Absorbed Overhead for activity level of 7,500 units = 7,500 x ₦8 = ₦60,000
Under absorption = ₦60,000 – ₦64,000 = (₦4,000)
Class work
Budgeted overheads were ₦615,000 and actual consulting hours were 32,150. Overheads were under recovered
by ₦35,000. If actual overheads were ₦694,075, what was the budgeted overhead absorption rate per hour?

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5.4.4 REASONS FOR OVER/UNDER ABSORPTION OF OVERHEAD
i. Actual overhead costs are different from budgeted overhead costs
ii. The actual activity level is different from the budgeted activity level
iii. Actual overhead costs and actual activity level differ from the budgeted costs and activity level
Illustration 5.8
Budgeted overhead cost of ₦50,000 and budgeted activity level of 25,000 DLH are in place. Calculate the
over/under absorption of overhead and give reasons for the over/under absorption in the following instances:
a. Actual overhead cost ₦47,000 and 25,000 DLH are worked
b. Actual overhead cost ₦50,000 and 21,500 DLH are worked
c. Actual overhead cost ₦47,000 and 21,500 DLH are worked
SUGGESTED SOLUTION:
Overhead Absorption Rate = ₦50,000/25,000 = ₦2/DLH
a. Absorbed Overhead for activity level of 25,000 DLH = 25,000 x ₦2 = ₦50,000
Over absorption = ₦50,000 - ₦47,000 = ₦3,000
b. Absorbed Overhead for activity level of 21,500 DLH = 21,500 x ₦2 = ₦43,000
Under absorption = ₦43,000 – ₦50,000 = (₦7,000)
c. Absorbed Overhead for activity level of 21,500 DLH = 21,500 x ₦2 = ₦43,000
Under absorption = ₦43,000 – ₦47,000 = (₦4,000)
Reasons for over/under absorption of overhead:
a. Absorbed overhead greater than actual overhead costs
b. Absorbed overhead is less than actual overhead costs
c. Absorbed overhead is less than actual overhead costs

5.5 PRACTICE QUESTIONS

1. The use of pre-determined rates for overhead absorption may lead to under-absorption or over-absorption
of overheads. You are required to discuss the above statement
2. Agape Co. Ltd. operates two production departments (Machining and Assembling) and one service
department which is responsible for maintenance. The data below was extracted from the books of the
company on 31st August 2008.
Machining Assembling Maintenance
Hours spent:
Direct labour hours - 600 -
Machine hours 300 - -
Expenses: ₦’000 ₦’000 ₦’000
Indirect labour 200 250 120
Indirect materials 420 450 500
Machine handling - - 80
Housekeeping 50 70 100
Air conditioning 30 30 50
Rent and rates 160 120 150
Supervision 240 180 200

Expenses of the maintenance centre are subsequently re-apportioned to the two production centres in proportion
to the total expenses incurred by those departments during the month. Pre-determined overhead rates were
established as follows:

Machining Assembling
Budgeted monthly overhead ₦ 2,000,000 ₦ 1,200,000
Planned machine hours 500 -
Planned direct labour hours - 400

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You are required to:
i. Calculate the overhead absorption rates which were in operation during August
ii. Prepare a statement showing the actual overhead borne by the production departments in August
iii. State the extent to which overhead was under-absorbed or over-absorbed by the production departments
during the month of August

3. Apple ltd makes wooden crates which are sold to brewers and soft drinks bottling companies. The production
work involves three production departments, Sawing, Assembling and Finishing. There are also two service
department, Maintenance and Materials Handling,
During the year ended 31st December 2009, 40,000 crates were made:

Sawing Assembling Finishing

Cost incurred: N N N
Materials issued 800,000 600,000 100,000
Direct wages 300,000 150,000 250000
Overheads 120,000 80,000 30,000

Material handling wages totaled ₦21,000

Maintenance wages totaled ₦45,000
Consumable stores totaled ₦15,000 (Maintenance)
The departments benefits from the service departments as follows:
Sawing Assembling Finishing Materials Handling
% % % %
Maintenance 30 40 20 10
Materials Handling 50 20 30 -
Required: using the elimination method:
a) Prepare a statement showing the overheads allotted to each production department
b) Calculate the unit cost of a wooden crate.

4. Ade manufacturing company has four production departments and three service departments. Indirect labour
and other indirect costs for a typical month have been allocated as shown below:

Production Department Service Department

Grinding Blending Firing Polishing Personnel Admin Maintenance
N ’000 N ’000 N ’000 N ’000 N ’000 N ’000 N ’000

Indirect 4,600 3,300 5,400 2,900 700 1,800 800

labour
Other 1,400 1,200 2,800 1,600 500 300 1,200
indirect
costs

The service department costs are allocated as follows:

Grinding Blending Firing Polishing Admin Maintenance
Personnel (%) 15 25 30 20 5 5
Administration (%) 10 30 40 15 - 5
Maintenance (%) 15 30 40 5 10 -

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In the Grinding and Firing departments, an overhead rate per machine hour is used; whereas in the Blending and
Polishing departments, an overhead rate per direct labour hour is used. Machine hours are budgeted at ₦620,000
and ₦520,000 respectively in the Grinding and Firing departments. Direct labour hours are budgeted at
₦1,050,000 and ₦450,000 respectively in the Blending and Polishing departments.
Required:
Determine the total overheads for each of the production cost centres using the three methods of apportionment.

6. Kenwood is a jobbing engineering company which has three production departments (forming, machines and
assembly) and two service departments (maintenance and general).The following analysis of overhead costs has
been made for the year just ended:
Forming Machines Assembly Maintenance General
N N N N N
Repairs & maintenance 800 1,800 300 200 100
Departmental expenses 1,500 2,300 1,100 900 1,500
Indirect labour 3,000 5,000 1,500 4,000 2,000

N
Rent and rates 8000
Power 750
Light & heat 5,000
Depreciation:
Plant 10,000
Fixtures & fittings 250
Insurance:
Plant 2,000
Building 500

Other available data are as follows:

Floor area Plant Fixtures Effective Direct Labour Machine
sq.ft value & fittings horse cost hours hours
N N power N worked worked
forming 2,000 25,000 1,000 40 20,500 14,400 12,000
Machines 4,000 60,000 500 90 30,300 20,500 21,600
Assembly 3,000 7,500 2,000 15 24,200 20,200 2,000
Maintenance 500 7,500 1,000 5 - - -
General 500 - 500 - - - -
10,000 100,000 5,000 150 75,000 55,100 35,600
Service department costs are apportioned as follows
Maintenance General
% %
Forming 20 20
Machines 50 60
Assembly 20 10
General 10 -
Maintenance - 10

Required:
Using the data provided prepare an analysis showing the distribution of overhead costs to departments.
Reapportion service cost centre using the reciprocal/repeated method.

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7. The following figures have been extracted from the books of a manufacturing company. All Jobs pass through
the company’s two departments
Assembling Dept. Blending Dept.
Material cost ₦15,000 ₦1,500
Direct labour cost ₦7,500 ₦3,750
Direct expenses ₦1,500 ₦2,250
Factory overhead ₦3,600 ₦2,400
Direct labour hours 12,000 5,000
Machine hours 10,000 2,000
The following information is related to Job 34
Assembling Dept. Blending Dept.
Materials cost ₦500 ₦750
Direct labour cost ₦200 ₦175
Machine hours 290 120
Direct labour hours 340 260

You are required to:

a) Show at least four methods of absorbing factory overhead to jobs in each department
b) Prepare statements showing the total overhead costs absorbed by Job X34 using any two of the methods
referred to that you consider most suitable.
c) Calculate the total selling price of the job if a profit on cost of 25% is required

8. A company has two production departments for which the following budgeted information is available:
A B Total
Budgeted overhead ₦360,000 ₦200,000 ₦560,000
Budgeted direct labour hours 200,000 hrs 40,000 hrs 240,000 hrs
Job Y has a prime cost of ₦100, takes 28 hours in department A and 2 hours in department B. Job X has a prime
cost of ₦100, takes 30 hours in department B and does not involve any work in department A.

What would be the factory cost of each job if:

a. Single factory rate of overhead recovery is used
b. Separate departmental rate of overhead recovery is used