,

4

Overheads Classification, Distribution and Control

There are certain costs which belong to more than one cost unit. It is not easy to identify then to a specific cost unit. Nowadays, overheads constitute a major portion of the total cost in any organization, particularly industrial organizations. The terminology and the use of overheads vary widely. In this chapter, the meaning of overheads, its classification, method of apportioning them, the accounting treatment of the different items of overheads in cost accounts and how can it be controlled are all explained in detail.

4.1 MEANING AND DEFINITION OF OVERHEADS

The terminology of CIMA defines overheads as “the total cost of indirect materials, indirect labour and indirect expenses”.

Some costs in an organization are indirect in nature. They cannot be allocated easily to the product, job or process. Besides this, some expenses that are incurred on material labour cannot be economically identified with specific saleable units. Such costs are referred to as “overhead costs”. These overhead costs are also known as “convenience costs”.

Overheads include the following:

1. indirect materials.
2. indirect labour.
3. all indirect expenses that cannot be charged to a product or job or process. For example, expenses incurred for maintenance, supervision, rent, rates and taxes, lubricants and cleaning materials, personnel department and sales department which cannot be easily identified with the cost units produced.

4.2 CLASSIFICATION OF OVERHEADS

Classification is the process of grouping costs depending upon their common characteristics. Overheads have to be classified in order to ascertain cost, product pricing, planning and control.

Classification may be defined as, “the arrangement of items in logical groups having regard to their nature (subjective classification) or the purpose to be fulfilled (objective classification)”.

Overhead costs may be classified as follows:

1. Functional classification.
2. Element-wise classification.
3. Behaviour-wise classification.

4.2.1 Functional Classification

Under this method, the classification of overheads is based according to the functions of an organization. Some important functional classifications of overheads of an organization are as follows:

1. Production overhead:
   • It is also known as factory overhead, manufacturing overhead, or works overhead.
   • It is the aggregate of indirect material cost, indirect wages, and indirect expenses incurred with respect to the manufacturing activity.
   • The manufacturing activity begins with the supply of materials and ends with the primary packing of products.

   Production overhead includes carriage inwards, consumable stores, rent, rates and taxes of a factory: Wages, salaries and other expenses incurred in a factory for stores personnel; design-and-drawing office staff; quality-control personnel; staff-maintenance records; insurance premium for the factory buildings, plant, machinery and equipments, and furniture and fixtures; depreciation for factory buildings, furniture and fixtures, and plant machinery and equipments; and idle-time wages, welfare-expenses stationery and communication expenses incurred in a factory.

2. Administration overhead: It is the aggregate of indirect material, indirect wages and indirect expenses incurred with respect to administration of an organization.

   Examples: Salary of administrative-office personnel, rent, taxes of general office, remuneration and sitting fees of directors, lighting, heating and other expenses of general office; all stationery and communication of expenses of office, audit fees, legal fees, insurance premium of office buildings, furnitures and fixtures and their respective depreciation and bank charges.

3. Research and development overhead: This is the aggregate of indirect material, indirect wages and indirect expenses incurred on the research and development (R&D) activities of an organization.

   Examples: Salaries of R&D personnel, patent changes, cost of maintenance of R&D office, insurance premium, depreciation and repair and maintenance expenses with respect to R&D office buildings, equipments, lab, furniture and fixtures, materials used in research, contributions made to research institutions, periodicals and books relating to R&D.

4. Selling overhead: This is the aggregate of indirect materials, indirect wages and all indirect expenses which are incurred for creating and stimulating demand for a firm’s products.

   Examples: Salary and all incentives offered for sales personnel, travelling expenses of sales personnel, rebates and discounts in the cost of price list, brochures, samples, collection costs for debts, repair and maintenance, insurance premium paid and depreciation with respect to sales office building, sales office equipments, furnitures and fixtures.

5. Distribution overhead: This is the aggregate of indirect materials, indirect wages and indirect expenses incurred for making a firm’s products available to customers.

   Examples: Carriage outwards, expenses on the delivery vehicles, delivery and packing expenses, salary and wages of godown keeper, drivers, packers, delivery personnel, rent, rates, taxes on the finished goods, repairs and maintenance costs, insurance premium, depreciation with respect to godown and distribution outlets.

4.2.2 Element-Wise Classification

Under this classification, the overhead is split into the following elements:

1. Indirect materials.
2. Indirect expenses.
3. Indirect labour.

1. Indirect materials: Indirect materials are those which cannot be identified with specific products. They cannot be measured in any standardized physical units. But they are essential for the smooth running of the manufacturing process.

   Examples: Cotton waste used for cleaning plant and machinery consumable stores, industrial lubricants, coolants, printing and stationery and so on.

2. Indirect labour: Costs that cannot be conveniently identified with a product are known as “indirect labour costs”. Indirect labour in no way alters the construction or composition of a product.

   Examples: Wages and salaries relating to supervisors, management personnel, stores personnel, production personnel, security personnel, administrative personnel, secretarial and accounts personnel and so on.

3. Indirect expenses: Indirect expenses are those which cannot be easily identifiable with a product or a job or a process. These cannot be directly allocated to cost units. These expenses are common to all the products, processes or jobs and are incurred for carrying out all business activities in toto.

   Examples: Rent, rates, taxes, postage, telegram, fax, e-mail expenses, insurance premium, lighting and heating.

4.2.3 Behaviour-Wise Classification

Overheads exhibit different characteristics (in the short term) with respect to the volume of production and sales. This is known as the “behaviour of overheads”. The behaviour-wise classification clarifies overheads in accordance with their behaviour. They are:

1. Variable overhead: Variable-overhead costs change in the same ratio in which the output changes (volume of output). But it remains constant per unit.

   Examples: Power consumption, selling commission, consumption of stores and consumables and so on.

2. Fixed overheads: The fixed costs remain unaffected by the change in the volume of output. Costs are fixed for a given period over a relevant range of output.

   Examples: Insurance premium and depreciation with respect to fixed assets, rent, rates and taxes. Fixed cost is also known as “period cost”.

3. Semi-variable overhead: This is also called “semi-fixed overhead”. These costs are partly fixed and partly variable. Some overheads possess characteristics of both fixed and variable costs. These costs do not change in the same ratio in which the output changes.

   Examples: Maintenance expenses, telephone expenses and stationery expenses.

Importance and the need of classifying overheads into fixed and variable kinds are as follows:

1. Flexible budgeting: The gap between the expected results and the achieved ones will vary. To make meaningful comparisons between the budgeted and the actual performance, it is necessary to prepare budgets for different volumes of output. This is known as “flexible budget”. Unless and until the total costs are divided into variable and fixed, it will not be easy to prepare such flexible budgets.
2. Decision-making: The classification of costs into fixed and variable elements facilitates the management to comprehend how costs change with changes in the volume of activity. This helps the management in assessing the accurate projections of the expected changes in the total costs with the changes in the volume. It helps the management to a great extent in the decision-making process.
3. Cost control: Effective cost control can be achieved only if which costs are to be controlled and who is responsible to control those costs are planned in advance. The segregation of costs into fixed and variable kinds will serve the purpose. Variable costs can be controlled by the persons who are at the lower level of management. Fixed costs can be controlled by the top-level management.
4. Cost–volume–profit analysis and Marginal-costing techniques: The management relies to a greater extent on the techniques of cost–volume–profit analysis and marginal costing for the purpose of decision-making. These techniques are based on the principle of segregation of costs into fixed and variable elements.

4.3 METHODS OF SEGREGATING SEMI-VARIABLE COSTS INTO FIXED AND VARIABLE COSTS

The identification of costs into variable and fixed categories can be made easy for any item of cost. But the real problem arises when semi-variable costs are identified. In order to separate the semi-variable overheads into fixed and variable, the techniques are most-widely applied as discussed in the following:

4.3.1 Method 1: (Technique 1) Levels of Output Compared with the Levels of Expenses Method

Under this method, as the very name implies, the output at two different levels is compared with the corresponding levels of expenses. As the fixed expenses remain constant, the variable overheads are ascertained by the ratio of change in expenses to the change in output.

Illustration 4.1

From the following data, you are required to compute the amount of fixed, variable and total semi-variable expenses for the month of October 2009, where the production is 50 units.

Month	Production (Units)	Semi-Variable Expenses (Rs.)
April 2009	60	320
May 2009	40	280
June 2009	70	340
July 2009	100	400
August 2009	80	360
September 2009	90	380

Solution

Step 1: Take the figures for any two months:

For instance, take April and August.

 

Month	Production (Units)	Semi-Variable Expenses (Rs.)
April 2009	60	320
August 2009	80	360

Step 2: Compare the difference between these two levels: 20                      40

Step 3: Variable part

Step 4: Now calculate the variable overhead for April:

Step 5: Therefore, fixed costs for April = Rs. 320 – Rs. 120 = Rs. 200.

Step 6: Similarly, for August = 80 × Rs. 2 = Rs. 160.

Therefore, Fixed costs = (Rs. 360 – Rs. 160) = Rs. 200.

Step 7: Variable costs for October 2009:

 

(i)	Variable costs = No. of units × Rs. 2 = 50 × Rs. 2	= Rs. 100.
(ii)	Fixed overheads (Ref Step 4 & 6) (It remains constant)	= Rs. 200.
(iii)	∴ Total semi-variable overheads (Add i + ii)

4.3.2 Method 2: High- and Low-Point Method: (or) Range Method

Although this method is similar to the previous method it differs by taking into account only the highest and lowest volumes of production and cost. The procedure is the same as follows: The difference between the outputs and costs (highest and lowest levels of output) are determined. The incremental cost is divided by the incremental output to ascertain the variable cost per unit. Then multiply this variable cost per unit with either the highest or level output to find out the total variable cost. To ascertain the fixed cost, the total variable cost is deducted from the total cost (at the same level of output). This is explained in the following illustration.

Illustration 4.2

Ref: Illustration 4.1.

Solution

Step 1: The highest production is in the month of July, which is 100 units. The lowest production is in the month of May where the corresponding semi-variable expenses are taken and the differences are computed.

Step 2:

Month	Units	Semi-Variable Expenses (Rs.)
May	40	280
July	100	400
Differences	60	120

Step 3: Variable cost per unit

Step 4:	Variable overheads for May: 40 × Rs. 2	= Rs. 80.
Step 5:	Therefore, fixed overheads for May = Rs. 280 – 80	= Rs. 200.
Step 6:	Similarly, variable overheads for July = 100 × Rs. 2	= Rs. 200.
Step 7:	Therefore, fixed overhead for July: Rs. 400 – Rs. 200	= Rs. 200.
Step 8:	October 2009:

 

(i)	Variable costs = No. of units × Rs. 2 = 50 × 2	= Rs. 100.
(ii)	Fixed overheads (Ref Step 6 & 7)	= Rs. 200.
(iii)	Total semi-variable overheads	= Rs. 300.

4.3.3 Method 3: Degree of Variability Method

Under this method, the degree of variability has to be assigned for each item of semi-variable expenses. Variability percentage ranges normally from 30% to 70% depending on the nature of items. In this method, the determination of the degree of variability is arbitrary and no accuracy can be possible.

Illustration 4.3

Same illustration no. 4.1.

Solution

 

Step 1:	→	Assume that the degree of variability is 70% of the total semi-variable expenses. Take the month of September.
Step 2:	→	Variable element = 70% of Rs. 380 = 266.00.
Step 3:	→	Fixed element: Rs. 380–Rs. 266 = Rs. 114.
Step 4:	→	For the month of October:

1. For 90 units, variable expenses = Rs. 266.

   (Ref: Step 2)

2. ∴ for 50 units, variable expenses
   
3. Total variable expenses for October 2009 = Rs. 266 + Rs. 147.78
   = Rs. 413.78

4.3.4 Method 4: Scattergraph Method

Under this method, the given data are plotted on a graph paper and the line of best fit (total cost line) and the variable cost at any level may be determined by the quantum of difference between the fixed cost line and the total cost line. This method is explained by way of an illustration as follows:

Illustration 4.4

Take the same figures as given in illustration no. 4.1.

Solution

Step 1: Take a graph paper.

Step 2: On the horizontal axis (x axis), volume of production or sales (output, here) is plotted on a predetermined suitable scale, say 1 cm = 50 units.

Step 3: On the vertical axis (y axis), the costs corresponding to volume are plotted on a predetermined suitable scale, say 1cm = 100 Rs.

Step 4: A straight line is drawn connecting the points plotted on the graph. This line is known as the line of best fit or total cost line.

Step 5: The point, where this total cost line cuts the y axis represents the fixed (costs) element.

Step 6: A line is drawn parallel to the x axis, from the point where the total cost line (line of best fit) intersects the y axis. This is the fixed cost line.

Step 7: The variable element at any level may be determined by the difference between the fixed cost and the total cost lines.

Production (units)

Graph shows fixed expenses are Rs. 200.

For the months of October 2009:

For 50 units, the total semi-variable costs are Rs. 300 (shown in …lines).

Therefore, variable expenses = Rs. 300 – Rs. 200 = Rs. 100.

Like this, for any level of output, the results can be read from the graph at a glance.

4.3.5 Method 5: Method of Least Squares

This method segregates the cost into variable and fixed elements and determines their relationship to the changes in volume. In this method, we select one variable as a dependant variable and another as an independent variable to study the relationship between the cause and effect. Regression is the measure of the average relationship between two or more variables in terms of the original units of data. This method is also known as “simple linear regression analysis method”. The regression line can be used to determine the values of the dependent variable where two variables possess a linear relationship. The linear equation may be assumed as:

 

	y	=	a + bx;
where	y	=	total cost,
	a	=	fi xed proportion of total cost,
	b	=	variable component and
	x	=	number of units.

Illustration 4.5

Ref: Illustration 4.1.

Solution

Based on the figures in illustration 4.1, a linear equation is obtained from the following values shown in the tabular column:

Take two sub-equations.

 

	Σy = Σa + bΣx2	(1)
	Σxy = aΣx + bΣx2	(2)

Substituting the values in the equations, we get:

 

	2,080 = 6 × a + 440 b	(3)
	1,57,200 = 440 a + 34,600 b	(4)

Multiplying (2) by 440 and (3) by 6, we get

 

2,080 × 440	=	(6a + 440b) × 440	(5)
1,57,200 × 6	=	(440a × 34,600b) × 6	(6)
9,15,200	=	2640a + 440 × 440b (1,93600 b)	(7)
9,43,200	=	2640a + 6 × 34600b (2,07,600b)	(8)

(8) – (7)

 

	28,000	=	0 + 14,000b
	14,000 b	=	28,000
	b	=	28,000/14,000 = 2.

Substituting the value of b in equation (3), we get

 

	2,080	=	6 × a + 440 × 2
	2,080	=	6a + 880
	2,080–880	=	6a
	1200	=	6a.
	a	=	1200/6 = 200
	a	=	fixed cost = Rs. 200
	b	=	variable cost = Rs. 2.

For the month of October 2009, we get:

Total semi-variable overhead for 50 units:

 

Variable cost@ Rs. 2/unit (a)	= Rs. 100
Fixed cost (b)	= Rs. 200
∴ Total semi-variable overheads:

4.4 CODIFICATION OF OVERHEADS

Costs have to be collected on a systematic basis under properly defined accounting headings. The account heads have to be defined well. Adequate number of account heads has to be selected to avoid confusion. The terminology of CIMA defines coding as “a system of symbols designed to be applied to a classified set of items, to give a brief accurate reference facilitating entry, collection and analysis”. It involves a system of allotment of code numbers to individual head, sub-head and group of expense.

A code number is allotted to each account code and individual cost centres. Code numbers allotted to factory expenses and code numbers that are allotted to administration, selling and distribution expenses are known by different names.

“Standard order numbers” is the name christened to codes allotted to factory expenses. “Cost-account numbers” is the name given to administration, selling and distribution expenses.

The methods used to allot symbols or code numbers are as follows:

4.4.1 Numeric or Numerical or Straight-Number Coding

In this method, each type of expenditure is allotted a fixed number.

For instance,

 

S. No.	28	Indirect material
S. No.	108	Indirect labour

Numbers are allotted an each heading and sub-heading of an expense like:

 

Item	Depreciation -1	Code No.
	Plant	11
	Land and Building	12
	Furniture and Fixtures	13
Item	Repairs 2 -
	Plant	21
	Land and Building	22
	Furniture and Fixtures	23

4.4.2 Alphabetical or Mnemonic Method

In this method, alphabets are used for identifying the expenses of cost centres:

Example:

 

	AC	Assembly cost
	MC	Maintenance cost
	AD	Administration

4.4.3 Alphabetical Cum Numerical Method

Under this method, both alphabetical as well as numerical numbers are used. Alphabet to denote the main expenditure and the numerals to represent its subdivision.

Example:

M1, M2, M3…

Where M denotes maintenance, M1 denotes maintenance of plant, M2 maintenance of building and M3 maintenance of machinery and so on.

4.4.4 Decimal Method

In this method, the whole number is allotted for the head of the expenditure on master group whereas decimals are allotted to primary or secondary items.

Example:

 

1.	Factory overheads:
1.1.	Indirect materials
1.1.1	Cotton waste
1.1.2.	Spare parts
1.2.	Indirect labour
1.2.1.	Stores
1.2.2.	Inspection and so on.

4.4.5 Field Method

In this method, the codes used are numeric. Each code number consists of 9 digits. For example:

        Code 20        120        01        05

1. First 2 digits denote – variable cost – 20.
2. The next 3 digits denote – idle time – 120.
3. The next 2 digits denote – power failure – 01.
4. The last 2 digits denote – the particular machinery – 05.

In order to facilitate the collection of overhead, it should be ensured that all source documents must have the correct cost-centre number and the correct standing-order number or cost-account number. If the account headings are properly defined, it is easy to estimate the overheads properly. These figures are the base for determining the predetermined overhead rates.

4.4.6 Advantages of Codification of Accounts

1. As homogeneous items are grouped, they serve as a proper basis for apportionment of expenses.
2. It saves much time as account headings need not be written on all documents.
3. Codification is essential for computerization.

4.5 DISTRIBUTION OF OVERHEADS

Distribution of overheads is the division of total overheads in an equitable manner to each unit of the cost object. The cost object may be a process, a unit of production, a production order and so on. The distribution of overheads is a three-stage process, as explained in the following:

4.5.1 Stage I: Allocation of Overheads

• Allocation involves the identification of overheads with a given cost centre.
• Cost allocation may be defined as “the charging of discrete, identifiable items of costs to cost centres or cost units. Where a cost can be clearly identified with a cost centre or cost unit, then it can be allocated to that particular cost centre or cost unit”.
• An organization must try to allocate as many items as possible.
• Estimation of the benefits received by each cost centre is essential for the apportionment of overheads.
• The cost centres should be mentioned on the documents that are used to collect overheads, which is essential for correct allocation of factory overheads.

4.5.2 Stage II: Apportionment of Overheads

• The terminology of 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 overheads are common to more than one cost centre or department. Such overheads are to be apportioned to various cost centres or departments.
• A proper assessment of the benefits which different cost centres or departments have received from each head of expense is the proper basis for the apportionment of the common overheads.
• The measurement of benefits must be assessed properly for each expense head.

Some common overheads and their basis of apportionment are as follows:

Overhead	Basis of Apportionment
1. Depreciation, repairs and maintenance of of plant machinery and other production Activities like insurance premium on assets	Capital values (original cost or book value of assets)
2. Depreciation, rent, heating, lighting rates and taxes, maintenance of building and other expenses with respect to the premises and fire-protection services.	Floor area
3. Electric power	Machine horse power + Operating time
4. Water, steam	Technical estimates
5. Store expenses	Value of materials issued
6. Any expense related to workers such as supervision, canteen expenses, dispensary expenses and recreational expenses	Number of workers
7. Other general overhead expenses	Machine hours or labour hours
8. Delivery expenses	Weight, volume etc
9. Audit fees	Sales or total cost

At times, other than proportionate benefit, secondary criteria are used for apportionment of overheads which are:

1. incentives or efficiency: a pre-determined activity level is used for apportionment of overhead and
2. ability to pay: apportionment of costs is based on their ability to bear the costs.

Distribution of overhead consists of allocation and apportionment of overhead costs to the different departments or cost centres on a suitable basis. The distribution is to be followed by redistribution of the costs assigned to certain departments. The distribution may be classified into two types: primary distribution and secondary distribution.

4.5.2.1 (Stage I) Primary Distribution of Overheads

Primary distribution of overheads is the process of allocating and apportioning the overhead costs to all the departments or cost centres. This is done on a suitable and equitable basis. While primary distribution is done, no distinction is made whether it is production department or service department. This is done to all the departments.

Bases of apportionment: To ascertain the correct cost of cost centres and cost units, suitable bases have to be adopted for allocation and apportionment of overhead expenses.

Following are the some of the bases used for apportionment of manufacturing overheads:

1. Direct allocation: If overheads are traceable, they may be directly allocated to a particular job or department. E.g., power.
2. Labour hours: Wherever direct labour hours are shown distinctly, overheads should be apportioned on the basis of direct labour hours for different departments.
3. Machine hours: Where activities are entirely dependent on machineries, overheads are distributed on the basis of machine hours.
4. Direct Materials: Indirect materials, material-handling charges and the like are apportioned on the basis of the value of direct materials consumed.
5. Direct wages: Indirect wages and general overheads are apportioned on the basis of direct wages.
6. Number of staff: Number of employees in each department is used as a basis for apportioning overhead costs that are incurred for the welfare of workers.
7. Floor area: The area occupied by different departments is taken as the basis for apportioning expenses such as rent, tax, lighting and building-maintenance expenses.
8. Capital value: Depreciation, insurance premium, repairs and maintenance, etc., would be apportioned on the basis of the capital value of assets.
9. Light points: The light points in various departments serve as the basis for apportioning lighting expenses.
10. Kilowatt hours: Power expenses are to be apportioned on the basis of kilowatt hour (KWH).

Primary distribution (apportionment) of overhead expenses can be best understood from the following illustration:

Illustration 4.6

X Ltd has three production departments A, B and C and two service departments D and E. The following figures are extracted from the records of the company:

	Rs.
Rent and rates	10,000
Indirect wages	3,000
Depreciation of machinery	20,000
General lighting	1,200
Power	3,000
Sundries	20,000

The following further details are available:

You are required to apportion the costs to various departments on the most equitable basis by preparing a primary distribution summary.

 

[Delhi – B.Com – Modified]

Solution

 

NOTE:

Apportionment means nothing but distribution. Distribution of costs has to be made on a basis. Every expense is to be distributed properly which is explained in the following steps:

Step 1: Expense given: Rent and Rates: Rs. 10,000.

• Now, refer to further details in the table.
• From among the items, choose the appropriate basis for distributing this expense.
• Floor space is the suitable basis for apportionment of this type of expense.
• Floor space is given as 10,000 sq ft. (in Total column)
• It is shown in different values for different departments.
• Based on these figures, a ratio is determined, i.e., 2,000 for A, 2,500 for B, 3,000 for C, 2,000 for D and 500 sq. ft. for E.

Based on their ratio, Rent & Rates Rs. 10,000 will be found out as:

For Department A: Ratio × Total rent and rates: 4/20 × 10,000 = Rs. 2,000.

For Department B: 5/20 × 10,000 = Rs. 2,500.

For Department C: 6/20 × 10,000 = Rs. 3,000.

For Department D: 4/20 × 10,000 = Rs. 2,000.

For Department E: 1/20 × 10,000 = Rs. 500.

Step 2:

1. Indirect wages: Rs. 3,000.
2. Suitable basis: Direct wages (Ref: Table).
3. Ratio determination:
   
4. Apportionment:

   For Department A:

   For Department B:

   For Department C:

   For Department D:

   For Department E:

Step 3:

1. Item of expense: Depreciation: Rs. 20,000.
2. Suitable basis: Value of machinery (Ref. Table).
3. Ratio determination:
   
4. Apportionment:

   For Department A =

   For Department B =

   For Department C =

   For Department D =

   For Department E =

Step 4:

1. Item of expense: General lighting: Rs. 1,200.
2. Suitable basis: Light points (Ref: Table)
3. Ratio determination:
   
4. Apportionment:

   For Department A =

   For Department B =

   For Department C =

   For Department D =

   For Department E =

Step 5:

1. Item of expense: Power (Rs. 3,000).
2. Suitable basis: H.P. of machines (Ref. Table)
3. Ratio determination:
   
4. Apportionment:

   For Department A =

   For Department B =

   For Department C =

   For Department D =

   For Department E = —                     = Nil.

Step 6:

1. Item of expense: Sundry expenses (Rs. 20,000).
2. Suitable basis: Direct wages (Same as in Step 2).
3. Ratio : 6 : 4 : 6 : 3 : 1
4. Apportionment:

   For Department A =

   For Department B =

   For Department C =

   For Department D =

   For Department E =

Step 7:

1. Item of expense: Direct wages (Ref: Table).
2. Basis: Direct allocation – It means expenses are allocated directly.
3. Ratio: The same amount shown in the table to be taken into account.
4. Apportionment: Only for service departments:

Important Note

Direct wages of service departments are to be included.

Step 8: These figures are transfered to the table as follows:

 

Secondary distribution of overheads is explained in Stage III as follows:

(Stage III) Re-apportionment of service-cost-centre overheads or Secondary distribution of overheads

• The overheads of service-cost centres are reapportioned to the production departments only. The reason is that the service-cost centres provide services to the production department. The process of redistribution of service-cost-centre costs to production department is called “reapportionment”. This is also known as “secondary distribution of overheads”.
• The proportionate benefit received by the other cost centres forms the basic criterion for reapportioning the overheads relating to the service-cost centres.
• The methods that are used for the reapportionment of service-cost centre overheads are:

1. Direct redistribution method.
2. Step distribution method.
3. 1. Reciprocal method – Simultaneous equation method.
   2. Reciprocal method – Repeated distribution method.
4. Trial-and-Error method

4.5.2.2 Direct Redistribution Method

This method is based on the assumption that service-cost centres provide services to production departments only. The overheads of service cost centres are reapportioned to the production-cost centres. This is done on the basis of the proportion of benefits received by the production departments.

Illustration 4.7

You are required to apportion and reapportion the service department costs to production departments using direct distribution method.

The expenses of the service department are shared between P₁ and P₂ in the ratio of 1:2. The total direct labour hours per month are estimated to be 4,304 and 6,790 for P₁ and P₂, respectively.

Solution

Basic calculations needed for each item of expense are determined as follows:

1. Depreciation of building:
   1. Formula for determining the apportionment
      
   2. Substituting the figures, we get
      1. 
      2. 
      3. 
2. Taxes on building:
   1. Formula:
      
   2. Substituting the figures, we get
      1. 
      2. 
      3. 
3. Power:
   1. Formula:
      
   2. 1. 
      2. 
      3. 
4. Sundry expenses:
   1. Formula
      
   2. 1. 
      2. 
      3. 

Now Departmental Distribution Summary (Primary Distribution) is to be prepared as follows:

Secondary Distribution

4.5.2.3 Step-distribution Method

• Under this method, limited consideration is made of the services provided by the service departments to other service departments. Hence, a series (sequence) of reapportionments are made.
• The sequence begins with the department that has the largest amount of overhead or provides the highest percentage of its total services to other service departments.
• The sequence continues in step-by-step manner and ends with the reapportionment of the costs of the service department that has the lowest amount of overhead or the lowest percentage of its total services to other service departments.
• It is important to note that once a service department’s costs are reapportioned, no further reapportionment of costs is made to it.

Illustration 4.8

XYZ Ltd. has three production departments and two service departments. The estimated figures for a certain period are as follows:

	Rs.
Lighting & Electricity	20,000
Rent, rates and taxes	1, 00,000
Power	10,000
Wages of store staff	20,000
Depreciation of machinery	30,000
Insurance premium	20,000
	2, 00,000

Further details:

You are required to apportion the cost to production-cost centres using the step method.

Solution

For each item, expenses have to be apportioned as follows:

1. Item of expense: Lighting and Electricity.
   1. Basis for apportionment, i.e., Formula
      
   2. 1. X = × Rs. 20,000 = Rs. 10,000
      2. Y = × Rs. 20,000 = Rs. 4,000
      3. Z = × Rs. 20,000 = Rs. 2,000
      4. S₁ = × Rs. 20,000 = Rs. 2,000
      5. S₂ = × Rs. 20,000 = Rs. 2,000
2. Item of expense: Rent, Rates and Taxes.
   1. Formula
      
   2. 1. X = × Rs. 1,00,000 = Rs. 40,000
      2. Y = × Rs. 1,00,000 = Rs. 20,000
      3. Z = × Rs. 1,00,000 = Rs. 20,000
      4. S₁ = × Rs. 1,00,000 = Rs. 10,000
      5. S₂ = × Rs. 1,00,000 = Rs. 10,000
3. Item of expense: Power
   1. Formula
      
   2. 1. X = × Rs. 10,000 = Rs. 4,000
      2. Y = × Rs. 10,000 = Rs. 2,000
      3. Z = × Rs. 10,000 = Rs. 2,000
      4. S₁ = × Rs. 10,000 = Rs. 1,000
4. Item of expense: Depreciation of Machinery
   1. Formula
      
   2. 1. X = × Rs. 30,000 = Rs. 10,000
      2. Y = × Rs. 30,000 = Rs. 8,000
      3. Z = × Rs. 30,000 = Rs. 6,000
      4. S₁ = × Rs. 30,000 = Rs. 4,000
      5. S₂ = × Rs. 30,000 = Rs. 2,000
5. Item of expense: Insurance Premium
   1. Formula
      
   2. 1. X: × Rs. 20,000 = Rs. 6,000
      2. Y: × Rs. 20,000 = Rs. 5,000
      3. Z: × Rs. 20,000 = Rs. 4,000
      4. S₁: × Rs. 20,000 = Rs. 3,000
      5. S₂: × Rs. 20,000 = Rs. 2,000

1. For secondary distribution of overheads, reapportionment of service departments 2 and 1’s items of expenses are to be calculated in a similar way.
2. Wages of store staff—as it is identified with stores department, they are allocated to that department only directly.

NOTE:

1. S-2 has the highest amount of overhead. So, it is to be reapportioned first in the ratio of materials used as follows:
   
2. Then, S₁—the total amount of overhead is Rs. 26,600. This amount has to be reapportioned on the basis of the number of workers.
   

4.5.2.4 Reciprocal Method

This method reapportions the costs by explicitly including the mutual services provided among departments. This method is used when the service department provides services to another reciprocally. For instance, the stores department provides service to the repairs and maintenance department while the stores department receives some services from the repairs and maintenance department. That is why it is termed as “reciprocal”.

*There are two approaches under this method:

1. Simultaneous equation method.
2. Repeated distribution method.

4.5.2.5 Simultaneous Equation Method

In this approach, the overheads of service-cost centres are first determined using simultaneous equations. Then, based on the given predetermined percentages, they are to be reapportioned to production-cost centres.

Illustration 4.9

The total departmental expenses of ABC Co. Ltd are as follows:

You are required to prepare a statement showing the distribution of service department cost to production departments using the simultaneous equation method.

Solution

Step 1 → Let x represents the total overhead of Service Department 1.

Let y represents the total overhead of Service Department 2.

 

Step 2 → (i) x = 468 + 20% of y	(1)
y = 600 + 10% of x	(2)

(Simultaneous equations are formed as above with the figures available to find the total overhead cost.)

	(ii) (or) x =	(3)
	y =	(4)
	(iii) (or) x = 468 + 0.2y	(5)
	y = 600 + 0.1x	(6)
	(iv) (or) x − 0.2y = 468	(7)
	y − 0.1x = 600	(8)

Step 3 → Multiplying (7) and (8) by 10 to remove decimal, we get

 

	10x − 2y = 4680	(9)
	10y − x = 6000	(10)

Step 4 → Multiplying (9) by 5, we get

 

	5 × 10x − 2y × 5 = 4680 × 5
	50x − 10y = 23,400	(11)
	−x + 10y = 6,000	(12)

Step 5 → Add (11) + (12): 49x + 0 = 29,400

Step 6 → Substituting the value of x in equation (12) we get,

Step 7 →

Now, based on these values, reapportionment of service-department expenses are to be ascertained.

(a) For service department S₁:

1. X = 20% of Rs. 600; Y = 40% of 600; Z = 30% of 600

      = Rs. 120;                = Rs. 240;          = Rs. 180.

Step 8 →

(b) Reapportionment of service department 2 ’s expenses:

1. X = 40% of Rs. 660; Y = 20% of Rs. 660; Z = 20% of Rs. 660

      = Rs. 264; Y             = Rs. 132;               = Rs. 132

Step 9 → Departmental Distribution Summary

4.5.2.6 Repeated Distribution Method

Under this method, the predetermined percentages are used for the reapportion of service-cost centre’s costs to production-cost centres and the other service departments. The redistribution goes on till the accounts in the service-cost-centre columns become “zero” or “too small value”.

Illustration 4.10

Same as the previous illustration no. 4.9.

Solution

NOTE 1:

The percentage given in the problem is the basis for the reapportionment of service department overheads to the other departments.

S₁’s expense is reapportioned as follows:

S₁’s expense = Rs. 468.

X = 20% (Given) Rs. 468 × = 93.6 or 94 (approx)

Y = 40% (Given) Rs. 468 × = 187.2 or 187 (approx)

Z = 30% (Given) Rs. 468 × = 140.4 or 140 (approx)

S₁ = 10% (Given) Rs. 468 × = 46.8 or 47 (approx)

In a similar manner, the service departments are to be reapportioned and tabulated as follows:

 

NOTE:

The results under both these methods will be the same. (Variation of 1 or 2 may be due to round-off of fractions.)

4.5.2.7 Trial-and-Error Method

Under this method, the cost of one service department is apportioned to another service department. The cost of another service department PLUS the share received from the first cost centre is again apportioned to the first service department. This process is continued till the amount to be apportioned becomes “nil” or “too small value”.

Illustration 4.11

[As same illustration No. 4.9]

Solution

Take the same figures as in the previous illustration. The cost of one service-cost centre is apportioned to another in the following way:

 

4.6 ABSORPTION OF FACTORY OVERHEAD

Absorption of overheads means charging of overheads to individual products or jobs. The terminology of CIMA defines the absorption of overhead as “the process of absorbing all overhead costs allocated or apportioned over a particular cost centre or production department by the units produced”. A fair proportion of the total factory overhead should be assigned to each unit of production. This requires the identification of the main factor which causes the overhead to be incurred and then measuring the production in terms of that factor. Overhead absorption rates are applied for the absorption of overhead to individual jobs, processes or products. The factors that should be considered for the choice of proper overhead absorption rate are as follows:

1. Base to be used.
2. Actual or predetermined overhead rate to be used.
3. Activity level to be used.
4. Length of the period for accounting of overheads.
5. The use of single blanket or multiple overhead rates

Actual or pre-determined overhead rate: The overhead absorption rate may be ascertained either based on the actual cost or on the estimated cost. Formulae for computing the overhead rates are as follows:

1. Actual overhead rate:

   Formula for computing the actual overhead rate is:

   Actual overhead rate

   
2. Predetermined overhead rate:

   Pre - determined overhead rate

   
3. Blanket overhead rate:

   Blanket overhead rate

   
4. Multiple overhead rate
   

4.6.1 Methods of Overhead Absorption

The overhead costs should be properly applied to the production units. Several factors should be considered for selecting a proper method to charge the overheads to jobs or products. Some of them are as follows:

1. Factors mainly responsible for the incurrence of overhead.
2. Nature of the product passing through the specific cost centre.
3. Differences in the time taken by various products.
4. Clerical costs.
5. Selection of a suitable base.
6. Neither over-recovery nor under-recovery of overheads.
7. Amount charged should be equitable.

A suitable base is said to be the one which is economical, common to all products produced and distributes overhead in an equitable manner.

4.6.1.1 Method 1: Units of Production: (Rate Per Unit of Production)

Under this method, the charge per unit is computed by dividing the total estimated factory overhead by the total estimated units. The overhead absorption rate is calculated as follows:

This method is suitable when an organization produces only one product. In case an organization produces more than one product and they are similar too (differs only in volume and weight), then this method can be used by the conversion of physical units into equivalent units, which is done by using “points” or “weights”.

Illustration 4.12

From the following data, you are required to calculate the overhead absorption rate per unit:

 

Products produced	A	B
Normal capacity (units)	45,000	55,000

The estimated factory overhead for the budget period is Rs. 2,00,000.

Solution

1. Formula:

   Overhead absorption rate

   
2. Substituting the figures in the above formula, we get:
   

Illustration 4.13

ABC Co. Ltd is a manufacturing company. It produces two products A and B. It has assigned 2 and 5 points to A and B, respectively, in order to compensate for the basic differences in products. The estimated factory overhead for the budget period is Rs. 2, 40,000. The normal capacity is:

 

	A	5,000 units
	B	6,000 units

You are required to calculate the overhead absorption rate.

Solution

1. Total points for the normal capacity are to be calculated.
2. Estimated overhead is to be divided by these total points to arrive at the overhead absorption rate (rate per point).
3. Finally, this rate per point is to be multiplied by the points assigned to arrive at the rate per unit.

Overhead absorption rate per unit =

                            (rate per point) = Rs. 6.

Next, this rate per point is converted into rate per unit as follows:

4.6.1.2 Method 2: Direct Material Cost

Under this method, the cost of direct materials is used as the base in the absorption of factory overheads. This is determined by expressing the estimated factory overhead as a percentage of direct material cost. The over head rate is calculated by using the formula:

Merits of this method:

1. This method is simple to understand and easy to apply.
2. When the prices of materials are stable, this method will be a more suitable one.
3. Overhead cost relating to up-keep and handling of materials are absorbed equitably by this method.

Demerits:

1. Most of the overheads accrue on the basis of time. This method ignores this factor.
2. During the fluctuation of prices, this method will not at all be suitable as the factory overhead will not respond to such price-level changes.

4.6.1.3 Method 3: Direct Wages

In this method, the factory overhead expenses are charged as a percentage of direct wages incurred on jobs. The overhead rate is computed by dividing the estimated factory overhead by direct wages. The formula is as follows:

Merits:

1. This method is easy as the needed information is readily available.
2. This method considers the time factor.
3. Change in the wage rate will not occur frequently. As such, the overhead rate is stable.

Demerits:

1. The wage structure varies among the workers. So, it is not a suitable basis.
2. The payment of overtime may create further complications.
3. No distinction is made between jobs done by manual labour and those done by machines.

4.6.1.4 Method 4: Direct Labour Hours

This is a variation of direct wages method. In this method, the overhead rate is computed by dividing the factory overhead expenses by the direct labour hours. Formula is as follows:

The direct labour hours are estimated by taking into account the leave with wages, holidays and all normal wastage of time.

Merits:

1. In case the labour operations dominate the manufacturing process, this is the most suitable method.
2. This method recognizes the time factor.

Demerits:

1. This is not suitable if cost centres mainly rely on machines.
2. This method does not recognize the skill of workers.

4.6.1.5 Method 5: Prime Cost

Under this method, the overhead rate is determined by expressing the estimated factory overhead as a percentage of the estimated prime cost, where prime cost = direct material + direct labour. The prime cost method may be said to be a combination of two methods namely direct material method and direct wage method. The overhead rate is calculated as follows:

Merits:

1. It is simple and easy to calculate.
2. This method is suitable where the uniform labour hours and the uniform quality of materials are required in the manufacturing process.

Demerits:

1. This method does not recognize the time factor. Overheads vary with time whereas both the material costs and labour costs do not vary with time as they do not bear any direct relationship with time.
2. As the material prices are subject to frequent fluctuations, the amount of manufacturing overheads recovered would also fluctuate widely.
3. This method does not recognize the skill of the workers.

4.6.1.6 Method 6: Machine Hours

This method is based on the time required by machines. Under this method, the factory overheads are charged to production on the basis of the number of hours a machine was put to use. This is similar to direct labour hours method. This is calculated as follows:

• This method requires accumulation of machine hours used for each job or production unit.
• In case the operations are highly mechanized, the major portion of overheads is dependant upon the machines. For example, power, depreciation, machine oil, repairs and maintenance, insurance and so on. That is, only indirect expenses that are immediately connected with the operation of machine should be taken into account.
• Besides the expenses mentioned above, there are still some other manufacturing expenses like supervision charges, consumable stores, shop general labour, rent and taxes. These expenses are not charged to any machine. Hence, a proportionate amount of such expenses have to be added.
• Rate for charging the general departmental expenses to production has to be calculated separately on the basis of the direct labour hours. To arrive at an accurate result, both machine hour as well as labour hour rates must be applied.

ADVANTAGES:

1. This method is suitable where machinery is the prime factor in production.
2. This method is suitable where one operator uses many machines or several operators involve in one machine.
3. This method recognizes the time factor, as a major portion of overheads vary with time.

DISADVANTAGES:

1. The method is not suitable for labour-intensive cost centres.
2. Additional work is involved in computing separate machine hour rate for each machine.
3. Maintenance of operating time of machines may not be easy as it involves much time and additional labour.

Illustration 4.14

Model: Combination of Labour hour and Machine hour methods

The following information relates to the activities of a production department for a certain period in a factor:

		Rs.
Materials used		36,000
Direct wages		30,000
Hours of machine operation	10,000
Labour hours worked	12,000
Overheads chargeable to the department		24,000

On one order carried out in the department during the period, the relevant data collected were as follows:

		Rs.
Materials used		2,000
Direct wages		1,650
Labour hours	825
Machine hours	600

You are required to prepare a comparative statement of cost of this order by using the following three methods of recovery of overheads:

1. Direct labour-hour-rate method
2. Direct labour-cost-rate method
3. Machine-hour-rate method.

[B.Com., Hons. (Delhi) – Modified]

Solution

(i) Direct labour hour rate; (ii) Direct labour cost %; and (iii) Machine hour rate will be calculated as follows:

Step 1: Calculation of direct labour-hour rate:

1. Formula:
   
2. Substituting the values in the formula, we get:
   

Step 2: Calculation of direct labour cost:

1. Formula:
   

Step 3: Calculation of machine hour:

1. Formula:
   

Step 4: Preparation of comparative statement of cost:

Illustration 4.15

Model: Plant-wise and departmental rates based on direct labour hours.

Trichy manufacturing company produces several product lines which are processed through these production departments – A, B and C.

The information concerning the relevant data for a year is as follows:

Production records at the end of the year indicated the following for the product line XX′.

You are required to:

1. Calculate the departmental and plant-wise overhead rates based on direct labour hours.
2. Compare the cost of XX′ line for the year using (i) plant-wise rate and (ii) departmental rates.
3. Comment on the results

[B.Com – (Hons) – Modified]

Solution

1. Departmental overhead rates are calculated on the basis of direct hours as follows:
   1. Department    
   2. Department    
   3. Department    
2. Plant-wise overhead is to be calculated on the basis of total factory overheads and total direct labour hours for all the three departments:
   
3. Computation of the cost of XX′ line using departmental rates.
   
4. Computation of cost of XX′ line using plant-wise rate.

   	Rs.
   (i) Prime cost (Total of A, B & C)	1,20,000
   (ii) Add: Factory overheads: (5,000 + 6,000 + 9,000) × Rs. 2.94	58,800
   (iii) FACTORY COST	1,78,800

Illustration 4.16

Model: Machine hour rate

A machine is purchased for cash at Rs. 18,400. Its working life is estimated to be 36,000 hours after which its scrap value is estimated at Rs. 400. It is assumed from the past experience that:

1. the machine will work for 3,600 hours annually.
2. the repair charges will be Rs. 2,160 during the whole period of life of the machine.
3. the power consumption will be 10 units per hour at Re 0.10 per unit.
4. other annual standing charges are estimated to be:

   	Rs.
   (a) Rent of department	1,560
   (b) Light (24 points in the departments – 4 points engaged in the machine)	576
   (c) Foreman’s salary	12,000
   (d) Insurance premium for machinery	72
   (e) Cotton waste	120

You are required to compute the machine hour rate on the basis of the above data for allocation of work expenses to all jobs for which the machine is used.

 

[M.Com – University of Madras – Modified]

Solution

 

Particulars	Per Annum Rs.	Per Hour Rs.
(a) Machine-running costs:
Step 1: Depreciation:	1,800,	0.50
Step 2: Repairs & Maintenance:	216	0.06
Step 3: Power: (10 units/hr × Re 0.10 × 3, 600 hrs)	3,600	1.00
		1.56
(b) Other overheads:
(a) Rent	312	0.09
(b) Lighting:	96	0.03
(c) Insurance premium	72	0.02
(d) Cotton waste	120	0.03
(e) Foreman’s salary	3,000	0.83
	3,600	1.00
Total A + B		2.56

Illustration 4.17

Model: Machine hour rate

You are required to calculate the machine hour rate from the following:

 

	Rs.
Cost of machine	40,000
Cost of installation	4,000
Scrap value after 10 years	4,000
Rates and rents for a quarter of the shop:	1,200
General lighting	400 p.m.
Shop supervisor’s salary per quarter	12,000
Insurance premium for a machine	240 p.a.
Repairs (estimated)	400 p.a.
Power 3 units per hour @ Rs. 200 per 100 units
Estimated working hours	4000 p.a.

The machine occupies 1/4 th of the total area of the shop. The supervisor is expected to devote 1/6 th of his time for supervising the machine. General lighting expenses are to be apportioned on the basis of floor area.

 

[C.S. – Inter – Modified]

Solution

 

Particulars	Per Year Rs.	Per Year Rs.
(a) Machine-running costs:
(i) Cost of the machine:    40,000
Add: Installation             4,000
44,000
Less scrap                     4,000
(Rs. 40, 000 ÷ 10 yrs: 4000 ÷ 4,000) = 40,000 ÷ 4,000 ÷ 10 yr.		1.00
(ii) Repairs − Rs. 400 ÷ 4,000 hrs =		0.10
(iii) Power units: 3 units @ Rs. 2 per units		6.00
		7.10
(b) Other overheads:
(i) Rent and rates	1,200
(ii) General lighting as per floor area:	1,200
(iii) Supervisor’s salary	8,000
(iv) Insurance premium	240
Total	10,640
(v) Hourly rate: Rs. 10,640 ÷ 4,000 hrs		2.66
(a) + (b) → Machine hour rate		9.76

Illustration 4.18

Model: Determination of selling price

The following information relates to the cost records of a company.

	Rs.
Direct materials	1,25,000
Direct labour	1,00,000
Direct expenses	10,000
Work overheads	80.000
Office expenses	47,250

The total number of direct labour hours were 50,000 involving 20,000 machine hours. What should be the price quoted for a job involving 2,000 labour hours@ Rs. 3 per hour, 1000 machine hours and Rs. 10,000 in direct materials if the profit desired is 20% on the selling price?

Solution

Apportionment of production overheads is computed as follows:

Step 1. Percentage on direct workers

Step 2. Productive labour hour rate

Step 3. Machine hour rate

Step 4. Percentage of offi ce expenses to works cost:

Step 5. Statement of cost is to be prepared as follows:

 

Illustration 4.19

Model: Machine-hour-rate determination

Calculate the machine hour rate for recovery of overheads for a group of four machines from the following data:

Original cost of four machines Rs. 1,53,600.

Depreciation@ 10% per annum – straight line method.

Maintenance cost – average Rs. 16 per day of 8 hours for the group of machines.

Power – 50 paise per running hour per machine.

Supervision for the machine group – Rs. 1,280 per month.

Allocation of building depreciation for the four machines on a floor area basis@ Rs. 160 per month.

Share of manufacturing overheads – Rs. 480 per month for the group.

Normal working days in a year – 300 days.

Normal idle time – 20%.

Normal running – 1 shift of 8 hours.

[M.Com; Madras University – Modified]

Solution

Step 1: Effective running hours per year:

        = No of days × Hours per day × Productive hours

        = 300 × 8 × (100% − 20% idle time) 80%

        = 300 × 8 × = 1,920 hours.

Step 2: Machinery-running expenses:	Per Hour
	(Rs.)
(i) Power	0.50
(ii) Depreciation:	2.00
(iii) Maintenance	0.62

Step 3: Other overheads (fixed)

 

		Per Annum	Per Hour
		Rs.	Rs.
(i)	Supervision:	3,840
(ii)	Building depreciation:	480
(iii)	Manufacturing overhead:	1,440
		5,760 ÷ 1,920	= 3.00

Step 4: Machine hour rate (Step 2 + Step 3)

Illustration 4.20

Model: Absorption of factory overheads

The following figures have been extracted from the cost records of a manufacturing company. All jobs pass through the company’s two departments:

	Working Department Rs.	Finishing Department Rs.
Materials used	24,000	2,000
Direct wages	12,000	6,000
Production overhead	7,200	4,800
Direct labour hours	24,000	10,000
Machine hours	20,000	4,000

The following information relates to Job No. J 115.

	Working Department Rs.	Finishing Department Rs.
Materials used	480	40
Direct wages	260	100
Direct labour hours	520	140
Machine hours	500	50

You are required to:

1. Enumerate four methods of absorbing factory overheads by jobs showing the rates for each department under the methods quoted.
2. Prepare a statement showing the different cost results for Job J 115 under any of the two methods referred to.

[M.Com; Madras University]

Solution

(a) Absorption of factory overheads is to be calculated under four different methods as follows:

STAGE I:

Method 1: Percentage on a direct material cost

1. (Working department) Overhead rat =
2. Finishing department overhead rate

STAGE II:

Method 2: Percentage on direct wages

1. Working department:
   
2. Finishing department:
   

STAGE III:

Method 3: Labour hour rate

1. Working department:
   
2. Finishing department   

STAGE IV:

Method 4: Machine hour rate:

1. Workingdept
   
2. Finishing department

(b) Now, going to the second part of the question, the cost of production for Job No. 115 has to be computed.

I: “Percentage on direct wages” method is used for overhead absorption.

 

II: “Machine hour rate method” is used for overhead absorption:

 

Illustration 4.21

Model: Machine hour rate

The following annual charges are incurred in respect of a machine shop where the manual labour is almost nil.

There are five identical machines in the shop.

 

(i)	Cost of each machine is Rs. 32,000 and the residual value after the expiry of the useful life of 10 years is	Rs. 8,000
(ii)	Power consumption p.a. as per metre reading (each machine uses 10 units of power@ 0.50 paise per unit)	Rs. 30,000
(iii)	Repairs and maintenance for 5 machines p.a	Rs. 6,000
(iv)	Rent and rates for the shop p.a.	Rs. 24,000
(v)	Electricity and lighting for the shop	Rs. 2,400
(vi)	Supervision: Two supervisors for the shop salary being Rs. 100 p.m. each.
(vii)	Sundry supplies such as lubricating oil, cotton waste, etc., for the shop	Rs. 2,000
(viii)	Canteen expenses for the shop p.a.	Rs. 1,200
(ix)	Hire-purchase annual instalment payable for the machines including Rs. 600 as interest	Rs. 2,500

You are required to compute the machine hour rate for a machine.

 

[M.Com; Bharathidasan University]

Solution

First, the machine-running hours are calculated as follows:

 

Step 1. Value of power consumed:	Rs. 30, 000.
Step 2. Rate per unit:	Re 0.50.
Step 3. Total units used:
Step 4. Share of each machine:
Step 5. No. of units used/hour:	10.
Step 6. ∴ Total no. of hours:	= 1, 200 hours p.a. per machine.

Next, machine hour rate is to be computed as follows:

 

Particulars	Per Annum Rs.	Per Hour Rs.
(a): Machine-running expenses (variable)
Step1: Depreciation: [Rs. 32, 000 – Rs. 8, 000 (residue) ÷ 10 years]	2,400	2.00
Step 2: Power (10 units × 0.50 per unit)	–	5.00
Step 3: Repairs and maintenance	1,200	1.00
Step 4 Sundry expenses (2, 000 ÷ 5)	400	0.33
		8.33
(b) Other overheads (fixed):
Step 5: Rent and rates (24, 000 ÷ 5)	4,800	4.00
Step 6: Electricity & Lighting (24,00 ÷ 5)	480	.40
Step 7: Supervision: (Rs. 100 × 12 × 2 ÷ 5)	480	.40
Step 8: Canteen (Rs. 1, 200 ÷ 5)	240	.20
Step 9: HP interest (Rs. 600 ÷ 5)	120	.10
		5.10
(c): Step 10: MACHINE HOUR RATE – (A) + (B)		13.43

4.7 OVER ABSORPTION OR UNDER ABSORPTION

In case of factories, the overhead expenses are based on predetermined rates. In practice, the amount of expenses incurred will vary from the predetermined expenses. Some differences persist. In case the actual overhead incurred is higher than the overhead absorbed (applied), it is known as “under-absorption of overhead”. But if the overhead absorbed is higher than the actual overhead incurred, it is known as “over-absorption of overhead”. This kind of over- or under-absorption of overhead is termed as “overhead variance”. The amount of over-absorption is represented by the credit balance on the variance account. The amount of under-absorption is represented by a debit balance on the variance account. The organization should analyse such under- or over-absorption of overheads and find out the causes responsible for such overhead variance.

4.7.1 Reasons for Under-Absorption of Overheads

1. It may be caused due to idle capacity.
2. There may not be a proper basis for predetermining the overhead rates.
3. Failure to consider all vital factors may lead to errors in determining the estimates.

4.7.2 Reasons for Over-Absorption of Overheads

1. When the actual level of operations exceed the normal level.
2. Errors made in determining the overhead rates without considering factors like correct estimation of normal production level, methods of production, etc.

4.7.3 Accounting Treatment of Over- or Under-Absorbed Overheads

The under- or over-absorbed overheads must be disposed. When the product cost gets distorted due to overhead variances it has to be rectified. The important methods followed for the disposal of under- or over-absorbed overheads are as follows:

Method 1: Use of supplementary rates:

• The cost of a product may be adjusted by using supplementary rates. This is used when the difference is high and it is caused by errors in determining the overhead rates.
• This supplementary rate is calculated by dividing the amount of variance (over- or under-absorption) by the base which was used for absorption.
• In case of under-absorption, the respective amount is set right by a negative rate while doing adjustment.
• At the end of the accounting period, over- or under-absorption amount is adjusted in work-in-progress (WIP), finished stock, the cost of sales in proportion to direct labour hours or machine hours or the value of the balances of such accounts by use of a supplementary rate. The amount so adjusted will be shown in the balance sheet as deductions from the WIP or finished goods, as the case may be.

Method 2: Transfer to overhead reserve or suspense account:

• This method is used in two different situations. First, in the case of new organizations, when the difference arises to non-utilization of 100% of capacity, in the initial years. Second, when the difference arises due to seasonal fluctuations and the business cycle is a prolonged one.
• Overhead difference is transferred to either the overhead reserve or suspense account.
• In case of under-absorption, this amount is carried forward to subsequent accounting periods and written off as a deferred charge.
• In case of over-absorption, it is carried forward and credited as a deferred credit.

Method 3: Written off to costing and profit-and-loss account:

• In the case of under absorption, the difference is debited to the costing and profit-and-loss account (P&L A/c).
• In the case of over absorption, the difference is credited to the costing and P&L A/c.

Illustration 4.22

Model: Over- or Under-absorption

The budgeted activity and cost data for each half year of XY Ltd were as follows:

 

	Rs.
Direct labour hours	34,000
Direct wages	21,250
Overhead:	18,700
Fixed variable	32,300

During the first six months, the following actual results were achieved:

 

Direct labour hours incurred	32,500
Direct wages	42,750
Overhead:	19,350
Fixed variable	32,900

The existing method of absorbing overhead is by a direct-wage percentage rate. A proposal has been made to change the overhead absorption to a direct labour-hour rate analysed into fixed and variable overhead.

You are required to calculate under the new proposal (i.e., using direct labour-hour rates of absorption) for the first six months period:

1. The budget of direct labour-hour rates of overhead absorption for fixed and variable overheads.
2. The absorbed overhead.
3. The over- or under-absorbed overhead.

[B.Com. (Hons) – Delhi – Modified]

Solution

Step 1: Write the formula for computing the overhead rates.

  Overhead absorption rate (Based on direct labour hours)

Step 2: Overhead rate or fixed overheads
Step 3: Overhead rate for variable overheads
Step 4: Total (Step 2 + step 3)

Step 5: Absorbed overheads = Total rate × Direct labour hour

 

Step 6: Actual overheads = Rs. 19, 350 + Rs. 32, 900 = Rs. 52,250.

Step 7: Absorbed overheads is less than actual overheads.

        Hence, it is under-absorption.

 

Under-absorption	=	Actual overheads − Absorbed overheads
	=	Rs. 52, 250 − Rs. 48, 750
	=	Rs. 3, 500.

Illustration 4.23

Model: Treatment of under-recovery

In a manufacturing unit, the overhead was recovered at a predetermined rate of Rs. 30 per man-day. The total factory overhead expenses incurred and the man-days actually worked were Rs. 65 lakhs and 2 lakhs days, respectively.

Out of the 60,000 units produced during a period, 40,000 units were sold. On analysing the reasons, it was found that 60% of the unabsorbed overheads were due to defective planning and the rest were attributable to the increase in the overhead costs. How would the unabsorbed overheads be treated in cost accounts?

 

[B.Com – Delhi – Modified]

Solution

 

Step 1: Recovered overheads	=	Rate × actual man-days
	=	Rs. 30 × 2 lakhs
	=	Rs. 60 lakhs.

 

Step 2: Under-recovery of overheads	=	Actual overheads − Recovered overhead
	=	Rs. 65 lakhs − Rs. 60 lakhs
	=	Rs. 5 lakhs.

Step 3: Reasons for under-recovery:

1. Defective planning = 60% of Rs. 5 lakhs
   
2. Increase in overhead costs = 40% of Rs. 5 lakhs
   

Step 4: Treatment of under-recovery:

1. Under-recovery of Rs. 3 lakhs due to a defective planning would be charged to costing P&L A/c, as it is an abnormal occurrence.
2. Under-recovery of Rs. 2 lakhs due to an increase in the overhead rates would be recovered from the cost of sales account and the finished goods stock in the ratio of *2:1.
3. A positive supplementary rate is charged.

Step 5: Amount to be charged:

1. Cost of sales A/c: Rs. 2 lakhs × = Rs.1.33 lakhs.
2. Finished goods stock A/c: Rs.2 lakhs × = Rs. 0.67 lakhs.

*NOTE: Ratio between the cost of sales and finished goods stock is:

    40,000 units sold : 20,000 not sold (finished stock)

Illustration 4.24

Model: Unabsorbed overheads and Supplementary rate

The total overhead expenses of a factory are Rs. 4,50,000. Taking into account the normal working of the factory, the overhead was recovered from production at Rs.1.40 per hour. The actual hours worked were 2,80,000. How would you proceed to close the books of accounts, assuming that besides the 4,500 units that were produced of which 3,800 were sold, there were 500 equivalent units in WIP. On investigation, it was found that 50% of the unabsorbed overhead was on account of increase in the cost of indirect material and indirect labour and the other 50% was due to the factory’s inefficiency.

 

[B.Com (Hon) – Delhi – Material]

Solution

• First, the unabsorbed overheads are to be ascertained.
• Then, 50% of the unabsorbed is to be taken to find the supplementary rate.
• Finally, it has to be apportioned between the cost of sales, finished goods and WIP.

STAGE I: Computation of unabsorbed overheads:

 

		Rs.
Step 1:	Overheads recovered (2,50,000 hrs × Rs. 1.40)	= 3,92,000
Step 2:	Actual overheads	= 4,50,000
Step 3:	Unabsorbed overheads (3 − 2)	= 58,000

STAGE II: Calculation of supplementary rate:

Out of the total unabsorbed overheads of Rs. 58,000, 50% was due to an increase in the cost of indirect material and indirect labour. Hence, this 50% amount, that is, Rs. 29,000 has to be charged to units produced by “supplementary rate”, which is calculated as follows:

 

		Rs.
Step 4:	Unabsorbed overheads on account of increase in the cost of indirect material and indirect labour	= 29,000
Step 5:	Units produced: (Produced + WIP = 4,500 + 500)	= 5000 units.
Step 6:	Supplementary rate: (Step 4 ÷ Step 5)
		= Rs. 5.80 per unit.

 

STAGE III :

The amount of overheads of Rs. 29,000 has to be apportioned between the cost of sales, finished goods and WIP as follows:

 

		Rs.
Step 7:	Cost of sales account: (No. of units sold × Supplementary rate)
	(3,800 × Rs. 5.80)	= 22,040.
Step 8:	Finished goods A/c (No. of units × Supplementary rate)
	(5000 – (3,800 + 500)) = (5000 – 4300) = 700 × Rs. 5.80	= 4,060
Step 9:	WIP A/c (500 units × Rs. 5.80)	= 2,900

Step 10:

The remaining balance 50% of Rs. 29,000 should be transferred to costing P&L A/c—because this part of the unabsorbed overhead is due to the factory’s inefficiency—an abnormal factor.

FOR PROFESSIONAL COURSES

Illustration 4.25

Model: Comprehensive hour rate

A machine shop has eight identical handling machines manned by six operators. The machines cannot be worked without an operator wholly engaged to it. The original cost of all these 8 machines works out to Rs. 8 lakhs.

These particulars are furnished for a six-month period:

 

Normal available hours per month	= 208
Absenteeism (without pay) hours	= 18
Leave (with pay) hours	= 20
Normal and idle unavoidable hours	= 10
Average rate of wages per day of 8 hours	= Rs. 20
Production bonus estimated	= 15% on wages
Value of power consumed	= Rs. 8,050
Supervision and indirect labour	= Rs. 3,300
Lighting & Electricity	= Rs. 1,200
These particulars are for a year:
Repairs & Maintenance including consumables	= 3% on value
Insurance	= Rs. 50,000
Other sundry-work expenses	= Rs. 15,000
General-management expenses allocated	= Rs. 60,000.

You are required to work out a comprehensive machine hour rate for the machine shop.

 

[C.A. (Inter) – Adapted & Modified]

Solution

A comprehensive machine hour rate charges a production unit with the costs of running a machine, cost of direct labour and all the other overheads.

Effective and productive available machine hours and direct labour cost per hour are to be calculated, as these values are necessary to ascertain comprehensive machine-hour rate

I. Calculation of effective productive available machine hours:

		Hrs
Step 1:	Normal available hours per operator for each month (given)	208hrs
Step 2:	Less:
	(i) Absenteeism	18 hrs
	(ii) Leave with pay	20 hrs
	(iii) Normal idle time	10 hrs
		48 hrs
Step 3:	Effective working hours per operator (Step 1 – Step (i), (ii), (iii))	= 160
Step 4:	Effective working hours for six operators (6 × 160):	= 960
Step 5:	Effective working hours for a year = (960 hrs × 12 months)	= 11,520

II. Calculation of direct labour cost per hour:

 

		Rs
Step 1:	Normal wages per hour:	= 2.50
Step 2:	Wages per operator per month: Hrs × Rate/hr: (208 − 18 × Rs. 2.50)	= 475
Step 3:	Production bonus estimated (15% of Rs. 475)	= 71.25
Step 4:	(Step 2 + Step 3)       = Total cost
Step 5:	Effective labour cost per hour	= Rs. 3.41 (Ref I: Step 3)

III: Comprehensive machine hour rate is computed as follows:

Particulars	Per Annum Rs.	Per Hour Rs.
Step 1: Direct labour cost (Ref: Stage II: Step 5)		3.41
Step 2: Machine-running costs:
(i) Value of power	16,100
(ii) Depreciation: (10% of Rs. 8 lakhs)	80,000
(iii) Repairs & Maintenance (3% ofRs. 8 lakhs)	24,000
(1,20,100 ÷ 11,520 hrs)	1,20,100	10.43
Step 3: Other overheads (standing charges)
(i) Supervision & Indirect labour	6,600
ii) Lighting & Electricity	2,400
(iii) Insurance	50,000
(iv) Sundry workers’ expenses	15,000
(v) General-management expenses allocated	60,000
(1,34,000 ÷ 11,520) = 11.63	1,34,000	11.63
Step 4: Comprehensive machine hour Rate (Add: Step1 + Step2 + Step3)		25.47

Illustration 4.26

Model: Blanket rate and Departmental rates

The following budgeted information is available from ABC Ltd records:

You are required to calculate:

(c) The blanket rate and departmental rates.

(d) Overheads absorbed by Job No. 108 using blanket rate and departmental rates.

 

[C.A. – (Inter) – Modified]

Solution

• While using “blanket rate”, as the very name implies, the total overheads are divided by total machine hours to arrive at the blanket rate.
• Again, the total machine hours will be multiplied by the blanket rate to get the overhead absorbed.

These are shown in the table as follows:

1. Computation of blanket rate and overhead absorbed by using blanket rate:
   
2. Computation of departmental rates and overhead absorbed by using departmental rate:
   

Illustration 4.27

Model: Unabsorbed overheads

Using the following date relating to ABC Ltd, you are required to treat the under-noted unabsorbed overhead in the cost accounts.

 

Actual factory overhead	=	Rs.1,50,000
Actual man-days	=	Rs. 5,000
Actual production (units)	=	2,500
Sales during the period (units)	=	1,500
Semi-finished product ( 50% complete) units	=	500

Factory overhead is absorbed at the rate of Rs. 20 per man-day. It is found that 50% of the unabsorbed overhead is due to the increase in the overhead and the rest is due to a wrong estimation of output at the time of determination of the overhead absorption rate.

Solution

STAGE I: Calculation of unabsorbed overheads:

 

	Rs.
(i) Actual overheads	= 1,50,000
(ii) Absorbed overheads (5,000 man-days × Rs. 20)	= 1,00,000
(iii) Unabsorbed overheads (i – ii)	= 50,000

Here, it is under-absorbed overhead.

STAGE II: Under-absorption: Splitting based on causes:

 

(i) Increase in overheads 50%	= 25,000
(ii) Wrong fixation 50%	= 25,000
	50,000

STAGE III: (A) Apportioning under-absorbed overheads:

(A): Total production in equivalent units:

 

(i) Actual sales	= 1,500 units
(ii) Finished stock (Actual production – Actual sales) 2,500 – 1,500 units	= 1,000 units
(iii) WIP: ( 50% of 500 units)	= 250 units
	2,750 units

STAGE III: (B) Apportionment:

 

	Rs.
(i) Cost of sales =	= 13,635
(ii) Finished goods:	= 9,090
(iii) WIP:	= 2275

STAGE IV: Accounting treatment:

 

		Rs.
(i) Wrong fi xation overhead due to an error in the estimation of normal output − 50%.		25,000
To be written off to costing P&L A/c
(ii) Use of SUPPLEMENTARY RATE:	Rs.
(i) Cost of sales	13.635
(ii) Finished stock	9,090
(iii) WIP	2,275	25,000
		50,000

Illustration 4.28

Model: Machine hour rate (Effective hours per machine)

From the following data of a factory machine room, you are required to compute an hourly machine hour rate, assuming that the machine room will work at 90% capacity throughout the year and that a breakdown of 10% is reasonable.

There are three days holidays for Deepavali, two days for Christmas, two days for Holi, exclusive of Sundays. The factory works for 8 hours a day and 4 hours on Saturdays.

No. of machines (each of same type) =         40

 

Expenses per annum:	Rs.
Power	15,600
Light	3,200
Salaries to foreman	6,000
Lubricating oil	330
Repairs to machines	7,230
Depreciation	3,928
	36,288

 

[C.A. Modified]

Solution

Step 1: Calculation of number of working days in a year:

 

		Days
(i) No. of days in a year		365
(ii) Less: Holidays	Days
(Deepavali + Holi + X’mas):	7
(iii) Weekly-off Sundays in a year):	52	59
(iv) ∴ No. of working days in a year		= 306

Step 2: Calculation of effective hours per machine:

 

	Hours
(a) No. of hours on Saturdays (52 days × 4 hrs/day):	208
(b) No. of hours on normal working days:
(Working days in a year – Saturdays) × 8 hrs/day (306 – 52) × 8 hrs	= 2,032
(c) Available hours per machine@ 100% capacity	2,240
(d) Available hours per machine@ 90% capacity (90% of 2,240 hrs)	2016
(e) Less: Normal idle hours (10% of 2,016 hrs)	201.60
(f) Effective hours per machine (Step d – Step e)	1814.40
(g) Effective total machine hours: 40 machines × 1,814.40 hr	= 72,576 hrs.

Step 3: Computation of machine hour rate

Particulars	Per Annum Rs.	Per Hour Rs.
(a) Machine-running costs:
(i) Power	15,600
(ii) Lubricating oil	330
(iii) Repairs to machines	7,230
(iv) Depreciation	3,928
	27,088	0.3732
(b) Other overheads:
(i) Salary of foreman	6,000
(ii) Light	3,200
	9,200	0.1268
		0.5000

Illustration 4.29

Model: Apportionment of overhead of service departments to production department

A company is having three production departments, A, B and C and two service departments—boiler house and pump room. The boiler house has to depend upon the pump room for the supply of water and pump room in its turn is dependent upon the boiler room for supply of steam power for the functioning of pumps. The expense incurred by the production departments are:

A – Rs. 3,00,000; B – Rs. 2,62,500; and C – Rs. 1,87,500.

The expense for the boiler house and pump house are Rs. 87,750 and Rs. 1,12,500, respectively. The expense of the boiler house and pump room are apportioned to the production department on the following basis:

You are required to show clearly how the expense of boiler house and pump room would be apportioned to A, B and C departments.

 

[C.S. – Inter – Modified]

Solution

 

Illustration 4.30

Model: Machine hour rate

Gama Enterprises undertook three different jobs X, Y & Z. All of them require the use of a special machine and also the use of a computer. The computer is hired and the hire charges work out to Rs. 2,10,000 p.a. The expenses regarding the machine were estimated as follows:

	Rs.
Rent for the quarter	8,750
Depreciation per annum	1,00,000
Indirect charges per annum	75,000

During the first month of operation, the following details were taken from the job together:

You are required to compute the machine hour rate:

1. For the firm as a whole, for the month when the computer was not used.
2. For the individual jobs X, Y & Z.

[C.A. – Inter – Modified]

Solution

1. Hourly-standing charges are computed as follows:
   
2. Hourly computer-hire charges are calculated as follows:
   
3. Computation of machine hour rate (comprehensive)
   
4. Statement showing machine hour rate for individual job

Illustration 4.31

Model: Machine hour rate and Cost of a job

XL Ltd having 25 different types of automatic machines furnishes the following data in respect of machine C:

 

1. Cost of machine	Rs. 25,000
Life – 10 years	Scrap value is Nil
2. Overhead expenses:	Rs.
Factory rent	25,000 p.a
Healing and Lighting	20,000 p.a
Supervision	75,000 p.a
Reserve equipment for machine C	2,500 p.a
Area of the factory	40,000 Sq ft
Area occupied by machine C	1,500 Sq ft
Power cost (while in operation/hr)	Re 1.

 

3. Wages of operator are Rs. 24 per day of 8 hours including all fringe benefits. He attends to one machine when it is being set up and two machines while under operation.

4. Estimated production hours (in hours)    2,300 p.a.

    Estimated set-up time (in hours)        200 p.a.

You are required to prepare a schedule of comprehensive machine hour rate.

 

[C.A. – Modified]

Solution

 

Illustration 4.32

Model: Predetermined machine-hour rate

From the following data, work out the predetermined machine hour rates for departments A and B of a factory:

The final estimates are to be prepared on the basis of the above figures after taking into consideration the following factors:

1. An increase of 10% in the price of spare parts.
2. An increase of 20% in the consumption of spare parts for department B only.
3. Increase in the straight-line method of depreciation from 10% on the original value of machinery to 12%.
4. 15% general increase in the wage rates.

The following information is also available:

	Department A	Department B
Estimated direct labour hours	80,000	1, 20, 000
Ratio of KW ratings	3	2
Estimated machine hours	25,000	30,000
Floor space (Sq. ft)	15,000	20,000

[I.C.W.A. – Inter]

Solution

 

Particulars	Department A (Machine hrs – 25,000)	Department B (Machine hrs – 30,000)
	Rs.	Rs.
Total overhead according to departmental distribution summary (as above)	48,700	73,200
Overhead absorption rate
	= Rs. 1.95	= Rs. 2.44

4.8 TREATMENT OF CERTAIN SPECIFIC ITEMS OF OVERHEADS IN COSTING

4.8.1 Packing Expenses

The packing department is a service-cost centre. Packing may be classified into two broad categories: (a) primary packing and (b) secondary packing.

Primary packing: The main objective underlying the primary packing is to protect the finished products and to facilitate movement from place to place. The cost incurred in primary packing is treated as the factory overhead, e.g., bottles, tins, etc.

But, in certain cases, fancy packing of products is made to attract customers and it is also included in this category of primary packing. Such costs incurred in the fancy packing are to be treated as an advertisement. Costs are charged as “selling overhead”.

Secondary packing: This packing is done to transport finished products from the factory to the distribution outlets. The cost of secondary packing is treated as distribution overhead, e.g., cardboard boxes.

Packing department is to be treated as a separate cost centre. The total expenses incurred in the packing department are to be apportioned to primary packing, secondary packing and fancy packing based on the technical estimates. Then, reappointment of costs is made which had been apportioned to primary packing. This is carried out on an equitable basis.

4.8.2 R&D Costs

“Research is the original and planned investigation undertaken with the hope of gaining new scientific or technical knowledge and undertaking”. The treatment of research cost is based on (i) basic research and (ii) applied research.

Basic research: The main underlying object of basic research is the discovery of new ideas and advancement of knowledge. Such costs are to be treated as factory overhead and absorbed into the product cost for the period in which it is incurred.

Applied research: This aims at resolving the current problems. These costs are to be treated as factory overhead and absorbed into the product costs. If benefits will occur in future, then these costs are to be deferred to the future periods.

Development cost: Development may be defined as, “the translation of research findings or other knowledge into a plan or design for the production of new or substantially improved materials, devices, products, processes systems or services prior to the commencement of commercial production”. Development begins where research ends.

Development costs are to be treated in the same way as research costs. But, if these costs are incurred exclusively for a customer, then they are to be changed directly to that particular customer.

4.8.3 Interest on Capital

There persists a lot of controversy whether interest on capital should be included in cost accounts or not. One has to understand the difference between “own capital” and “borrowed capital”.

“Borrowed capital” includes the loans and debentures and “own capital”—the very name suggests that capital is contributed from personal resources and not from any external resources. Interest on loan and debentures is payable to outsiders and hence there exists no objection to include it in the cost accounts. However, when the question of interest on own capital arises, views differ and has become a debatable issue. Most of their favour is for its inclusion in cost accounts.

Arguments for inclusion of interest on capital in cost accounts are as follows:

1. Interest is the reward for capital. It is a production cost just like wages—which is the reward for labour. So, it should be included in cost accounts.
2. Time factor plays an important role. In certain industries, one has to wait for a long period after investing the capital. For example, brewing of wine and timber. The effect of time factor—i.e., the period the capital is locked—can be assessed judiciously when the interest on capital is included.
3. To ensure stability and growth of a firm, it should be included.
4. Interest on the borrowed capital is included in cost accounts. In the same way, interest on the own capital is also to be included, logically.
5. Profit on articles of different values and requiring different amounts of capital may not be compared till the interest on capital is included in cost accounts.
6. Accurate and reliable results, including profit, can be arrived at only when it is included in the cost accounts.

Arguments against the inclusion of interest on capital are as follows:

1. Interest is exclusively a matter of pure finance. So, it should be excluded from the cost accounts.
2. Interest on capital is an anticipation of profit. It is to be enjoyed by the owner. Hence, it should not be included in the cost of production.
3. It is difficult to compute the capital employed and select the interest rate. Its inclusion would result in complication.
4. Rate of interest on capital fluctuates from time to time. So, if interest is taken into consideration, there will not be uniformity in the cost of production. Hence, comparison would be difficult and meaningless.
5. While valuing an inventory, it has to be excluded from the cost accounts. If it is included, it should be written back for balance-sheet purposes.

Considering the complexity and intricacies involved, it is advisable not to include in cost accounts. However, it is necessary to include interest in accounts. It is also necessary to include interest on capital in the product costs for purposes of cost management and managerial decisions.

4.8.4 Capacity Levels

Capacity means the maximum volume attainable by putting into the best possible use other resources and available facilities. The concept “capacity” will apply to plant, machinery, equipment, material, labour, etc. Capacity may be grouped under the following heads: (i) Theoretical capacity; (ii) Periodical capacity; (iii) Normal capacity; (iv) Actual capacity; (v) Capacity based on sales expectancy and (vi) Idle capacity.

4.8.5 Capacity Costs

A going business must have physical facilities and an organization in readiness for use. These things provide the capacity of manufacture and sale. The continuing costs of capacity incurred in anticipation of a future activity are termed as “capacity costs”.

Capacity costs include:

1. Costs of creating production facilities. For example, cost of plant, machinery, other facilities and key personnel.
2. Costs of administration. For example, cost of administrative building, office equipment, key personnel and other facilities.
3. Costs of selling and distribution. For example, cost of warehouses, godowns, delivery vans, etc.
4. Costs of depreciation.
5. Costs of taxes on property and all fixed assets.
6. Insurance premium for fixed assets.
7. Salaries of key personnel.

Capacity costs are generally fixed in nature. They will not be affected by the current rate of activity as long as the same capacity is maintained.

4.8.6 Capacity Ratios

Capacity ratios are applied to express the relationship between various levels of production capacity. These ratios consist of a combination of ratios. The various kinds of capacity ratios and the formula to determine them are as follows:

1. Efficiency ratio
   
2. Production volume ratio
3. Capacity ratio
   
4. Idle capacity ratio
   

Example:

ABC Co. provides you the following data:

 

Std. hours at full capacity	500
Std. hours at practical capacity	475
Budgeted direct labour hours	450
Budgeted std. hours at 92% efficiency	405
Actual direct labour hours	425
Std. hours produced	340

You are required to calculate all capacity ratios:

1. Efficiency ratio .
2. Production volume ratio .
3. Capacity ratio .
4. Idle capacity ratio .

Overheads may be defined as the total cost of indirect materials, indirect labour and indirect expenses. Overhead costs may be classified into (i) Functional Classification, (ii) Element-Wise classification and (iii) Behaviour-Wise Classification. Each Classification is explained in detail (Ref: Text).

Methods of Segregating Semi-variable Costs into Fixed Variable Costs: (i) Levels of Output Compared with Level of Expenses Method (ii) Range Method (iii) Degree of Variability Method (iv) Scattergraph Method and (v) Method of Least-Squares all are explained by way of Illustrations (No 1 to 5). Methods of Codification: (i) Numeric Coding; (ii) Alphabetical Method (iii) Alphabetical Cum Numerical Method (iv) Decimal Method and (v) Field Method.

Allocation of Overheads means identification of overhead with a given cost centre.

Apportionment of Overheads means the allotment of two or more cost centres of proportions of the common items of cost and the estimated basis of benefits received. Some items of common overhead and their basis of apportionment are discussed in the Text.

Primary distribution of overhead is explained by way of illustration No 6.

The Methods for Re-apportionment of Service Cost Centre and Overheads—Secondary Distribution (i) Direct Redistribution Method, Step Distribution Method, Reciprocal Method—Simultaneous Equation Method and Repeated Distribution Method are explained by way of illustrations (Nos 6 to 11).

Absorption of Factory Overhead means charging of overheads to individual products or jobs. The overhead absoption rate may be ascertained either based on actual cost or on estimated cost. Computation of actual overhead rate, predetermined overhead rate, blanket overhead rate and multiple overhead rate are explained through illustrations. Method of overhead absorption: (i) Rate/Unit of Production (ii) Direct Material Cost Method (iii) Direct Wages Method (iv) Direct Labour Hours (v) Prime Cost (vi) Machine Hours. Each method is explained by way of illustrations (No 12 to 21).

Under absorption of overhead: If the actual overhead incurred is higher than the overhead absorbed, it is termed as under absorption of overheads.

Over-absorption of overheads: If the overhead absorbed is higher than the actual overhead incurred, it is termed as over absorption of over head.

Reasons for under and over absorption of overheads are explained in detail (Ref: Text).

Accounting treatment of over or under absorbed overheads are explained through illustration (Ref: illustration No 22 to 24).

Accounting treatment of certain specific items of overheads: (i) Primary Packing (ii) Secondary packing (iii) Research and Development Cost (iv) Interest on Capital (iv) Capacity Costs and (vi) Capacity Rations: (Refer text).

Overhead: The total cost of indirect materials, indirect labour, and indirect expenses.

Primary Distribution of Factory Overheads: Apportionment of factory overheads among production and service departments.

Secondary Distribution of Factory Overheads: Apportionment of service department overheads among the production departments.

Coding: A system of symbols designed to be applied to a classified set of items, to give a brief accurate reference facilitating entry, collation and analysis.

Standing-Order Number: Code number assigned to the item of factory overhead.

Absorption of Overhead: Allocation or apportionment of overhead costs to cost venture or production department by the units produced.

Allocation of Overheads: Full amount of overhead charged to a particular cost centre.

Apportionment of Overheads: A process of splitting up an item of overhead cost and charging it to the cost centre on an equitable basis.

Machine Hour Rate: Cost for running the machine per hour.

Predetermined Overhead Absorption Rate: Overhead absorption rate ascertained before the beginning of the period, obtained by dividing the budgeted overheads for a period by the budgeted base.

Blanket Rate: A single overhead absorption rate used throughout a factory.

Unabsorbed Overhead: Use of a predetermined rate will result in a difference between the actual overhead incurred and the overhead absorbed. It may be under- or over-absorbed.

Capacity Costs: The continuing costs of having capacity incurred in anticipation of future activity.

QUESTION BANK

 

I: State whether the following statements are true or false

1. Overhead costs are common to move than one cost unit.
2. Overheads contribute a small proportion of the total cost.
3. Overheads are first charged to the departments where they are incurred.
4. Production overhead is different from the factory overhead.
5. Variable overhead remains constant per unit.
6. Allocation of overheads and apportionment of overheads are synonymous.
7. The overheads of service-cost centres are reapportioned to production departments.
8. Cost behaviour ignores changes in the production methods.
9. Several overhead absorption vales are used in “blanket rate”.
10. Idle capacity costs are either included in products or charged to costing P&L A/c.
11. Over- or under-absorption of overheads arise only when predetermined overhead rates are used.
12. Over-absorption of overhead is caused due to idle capacity.
13. Capacity ratios are employed to express the relationship between various levels of production capacity.
14. Foreman’s salary is an iron of factory overhead.
15. The process of charging production department overhead to the output is known as absorption of overhead.
16. Machine hour rate of absorption is suitable for labour-intensive operations.
17. Depreciation is a semi-variable expense.
18. Basis of apportionment of depreciation of the plant is the floor area of that plant occupied.
19. When the cost of material is the basis for absorption of overhead, the time factor is ignored.
20. Fixed overhead cost is a committed cost.

Answers:

 

1. True	2. False	3. True	4. False
5. True	6. False	7. True	8. True
9. False	10. True	11. True	12. False
13. True	14. True	15. True	16. False
17. True	18. False	19. True	20. True

 

II: Fill in the blanks with apt word(s)

1. Overhead cost is the aggregate of indirect _____; _____ and _____
2. Any expenditure over and above the _____ cost is known as overhead.
3. Variable costs vary in total but remain _____ per unit.
4. A cost is said to be _____ that does not change with the changes in the level of activity.
5. _____ are fixed costs which will continue to incur even if there is no production.
6. Expenses of small amount are classified as _____.
7. Insurance premium for factory buildings is to be treated as _____ overhead.
8. _____ is the name given to codes allotted to factory expenses.
9. Code numbers allotted to administration, selling and distribution expenses are called _____.
10. _____ is the basis of apportionment of general overheads.
11. The process of redistribution of service-cost centre costs to production departments is know as _____.
12. _____ rate is not suitable for labour-intensive cost centres.
13. Predetermined overhead absorption rate is computed on the basis of the amount of budgeted overhead and _____ production volume.
14. The process of collecting, allocating and apportioning the overheads incurred to the respective departments is called _____ of overheads.
15. _____ is a single overhead absorption rate used throughout a factory.
16. _____ of the period determines the frequency of revision of overhead-absorption rates.
17. When _____ for absorbing factory overheads are used, under- or over-absorption of overheads will occur.
18. If the actual level of operations is higher than the normal level, it results in _____ of overheads.
19. The cost of last service department is apportioned only to _____ departments under step method of reapportionment of costs.
20. When the factory-overhead control account has an ending _____ balance, the factory overhead is said to be under–applied.

Answers:

1. materials; labour; expenses
2. prime
3. constant
4. fixed
5. committed
6. overheads
7. factory
8. standard-order number
9. cost-account number
10. machine hour/ labour hour
11. secondary distribution of overhead
12. machine hour
13. predetermined
14. departmentalization of overhead
15. Blanket rate
16. Length
17. predetermined rates
18. overabsorption
19. production
20. debit

III. Multiple choice questions. Choose the correct answer

1. Overhead means
   1. The aggregate of indirect materials, indirect labour and indirect expenses.
   2. All expenses with respect to materials.
   3. All expenses with respect to labour.
   4. Only indirect expenses.
2. Power and fuel is an iron of
   1. factory overhead.
   2. administration overhead.
   3. selling and distribution overhead.
   4. none of these.
3. The allotment of two or more cost centres of proportions of the common items of cost on the estimated basis of benefits received is called
   1. reapportionment of cost.
   2. cost allocation.
   3. absorption of cost.
   4. apportionment of cost.
4. Overhead is also known as
   1. committed cost
   2. notional cost
   3. on cost
   4. none of the above
5. Departmentalization of overhead is known as
   1. secondary distribution
   2. primary distribution
   3. over-absorption of overhead
   4. allocation
6. Comprehensive machine-hour rate includes
   1. value of machine
   2. salary of foreman, supervisor, etc.
   3. machine operators’ wages
   4. depreciation allowed on machine
7. When the actual overhead is more than the absorbed overhead, it is called
   1. over-absorption
   2. under-absorption
   3. capacity costs
   4. none of these
8. All except one item given below is factory overhead
   1. lubricants
   2. wages of indirect workers
   3. staff-welfare expenses
   4. maintenance expenses of delivery names
9. Factory overhead is absorbed on the basis of all except one of the under-mentioned methods:
   1. direct wages
   2. direct materials
   3. production unit
   4. none of these
10. Semi-variable cost is segregated into fixed and variable elements using:
    1. ABC analysis
    2. least-square method
    3. marginal costing
    4. standard costing
11. Appropriate basis of apportionment of material-handling charges is
    1. material consumed
    2. material in the opening stock
    3. material in WIP
    4. material in the closing stock
12. Overhead may be absorbed by using all, except one of the following:
    1. departmental rates
    2. blanket rate
    3. variable and fixed overhead rates
    4. none of these
13. Predetermined overhead rate is computed by using the formula:
    1. standard overhead/standard base
    2. actual overhead/standard base
    3. estimated overhead for the budget period/estimated base
    4. estimated overhead/actual base
14. Normal capacity represents
    1. an optimum capacity in the previous year.
    2. an average capacity based on the sales expectancy for a long period
    3. an estimated output for the next year
    4. a maximum production capacity
15. Idle capacity represents the difference between:
    1. practical capacity and normal capacity
    2. maximum capacity and actual capacity
    3. normal capacity and minimum capacity
    4. practice capacity and maximum capacity

Answers:

 

1. (a)	2. (a)	3. (d)	4. (c)	5. (b)
6. (c)	7. (b)	8. (d)	9. (c)	10. (b)
11. (a)	12. (d)	13. (c)	14. (b)	15. (a)

1. Define the term: overheads.
2. What constitutes overheads?
3. Define “classification”.
4. Name the functional, basic classification of overheads.
5. Name the element-wise classification of overheads.
6. What are the behaviour-wise classification of overheads?
7. Name the techniques of separation of costs into fixed and variable.
8. Explain the necessity of classifying overheads into fixed and variable.
9. Define the term “coding”.
10. Name the systems of coding with an example.
11. What do you mean by “allocation of overheads”?
12. What is meant by “apportionment of overheads”?
13. Suggest some suitable basis of apportionment for common overheads.
14. What is meant by reapportionment? Name a few methods for the reapportionment of service-cost-centre overheads.
15. What are the factors that determine cost behaviour?
16. Define “absorption of factory overhead”.
17. What are the methods of overhead absorption?
18. Write short notes on machine hour rate.
19. What is predetermined overhead absorption rate? What are its advantages?
20. Explain: “Departmentalization of overheads”.
21. What is meant by “blanket rate”?
22. What is an idle-capacity cost?
23. What is under- or over-absorption of overheads? What are the reasons for them?
24. How would you treat under- or over-absorbed overheads in cost accounting?
25. How will you treat the following items of overheads in cost accounting:
    1. Packing cost: Primary and secondary packings.
    2. Repair of plans.
26. Write notes on “interest on capital in cost accounts”.
27. Why depreciation is an important item of overhead?
28. What are capacity levels? How can they be grouped?
29. What are capacity costs?
30. How would you determine:
    1. capacity ratio
    2. idle capacity ratio
31. What is secondary distribution of overhead?
32. What is primary apportionment of overhead?
33. Distinguish between cost allocation and cost classification.
34. Distinguish between cost apportionment and overhead absorption.
35. Define chargeable expenses. Give any four examples.

1. Define “overhead”. Explain the different methods of classifying overheads with suitable examples.
2. Discuss the function-wise classification of overheads.
3. Explain the element-wise classification of overheads.
4. Do you advocate for behaviour-wise classification of overheads? Substantiate your answer with reasons?
5. Explain the different methods of separating the variable and fixed portion of semi-variable overhead.
6. Explain the following:
   1. Allocation
   2. Apportionment
   3. Absorption of overhead
7. Explain the bases of apportionment of expenses.
8. Describe in detail the primary apportionment of overheads.
9. Analyse the different methods of secondary apportionment of overheads.
10. Explain the different methods of overhead absorption.
11. What is meant by overhead-absorption rate? What are the methods of overhead absorption?
12. Define “machine hour rate”. How would you determine it?
13. What are the causes for unabsorbed overheads? Explain “under-absorption” and “over-absorption” of overheads. How would you treat them in cost accounts?
14. What are the general conditions that should decide your choice of bases for distribution of overhead costs to departments?
15. Do you think that inclusion of interest on capital in cost accounts is necessary? Substantiate your answer with reasons.

 

[Model: Primary distribution (apportionment) of overheads]

1. Apportion the overheads among the departments A, B, C and D

	Rs.
Works Manager’s salary	4,000
Power	21,000
Contribution to PF	9,000
Plant maintenance	4,000
Depreciation	20,000
Canteen expenses	12,000
Rent	6,000

Additional information:

[Madras University; Madurai Kamaraj University]

[Ans: Total overheads of departments:

             A: Rs. 32,800;           B: Rs. 30,400;

             C: Rs. 9,700;              D: Rs. 8,100]

2. Y Ltd has four departments A, B, C and D, out of which A, B and C are production departments and D is a service department. The actual costs for a period are as follows:

	Rs.
Rent	4,000
Repairs	2,400
Depreciation	1,350
Lighting	300
Insurance of stock	1,500
Supervision	4,500
Power	2,700

The following data are also available in respect of the four departments:

Apportion the costs to the various departments on the most equitable method.

 

[Madras University]

[Ans: A: Rs. 6742.50;        B: 4,767. 50;

             C: Rs. 3457–50;       D: Rs. 1782–50]

[Model: Secondary distribution (apportionment) of overheads.]

 

3. A factory has three production departments A, B and C and two service departments X and Y. The overhead costs of the different departments incurred during December 2009 are as follows:

Departments	Costs (Rs.)
A	50,000
B	40,000
C	30,000
X	25,000
Y	15,000

The costs of department X have to be charged in the ratio of 2:2:1 and those of department Y equally to departments A, B and C, respectively. Find out the overhead costs of each production department.

 

[Bharathidasan University; Madras University – Modified]

[Ans: A: Rs. 65,000;    B: Rs. 55,000;    C: Rs. 40,000]

4. A manufacturing company has two production departments P₁ and P₂ and three service departments, viz, time-booking, stores and maintenance:

Following are the particulars for December 2009:

Production departments:

 

	P1	Rs. 16,000
	P2	Rs. 10,000	Rs. 26,000

Service departments:

 

	Stores	Rs. 5,000
	Time-booking	Rs. 4,000
	Maintenance	Rs. 3,000	Rs. 12,000
			Rs. 38,000

The other information related to departments are:

Apportion the cost of service departments to production departments as per “step method”.

 

[Madras – B.Com – 1998–2007; Madurai – 1998;
Bharathiar – 2007 – Modified]

[Ans:	Total overheads of production departments:
	P1: Rs. 22,842
	P2: Rs. 15,158]

[Model: Reciprocal services methods: (i) simultaneous equation method].

5. A company has three production departments and two services departments. The distribution summary of overhead is as follows:

The expenses of service departments are charged on a percentage basis which are as follows:

Apportion the cost of service departments by using the simultaneous equation method.

 

[Several Times Repeated Question in All Universities]

[Ans:	Total overheads of production departments:
	A. Rs. 3,192; B: Rs. 2,186 C: Rs. 1,156]

[Model: (ii) Repeated distribution method]

6. The following particulars relate to a manufacturing company which has three production departments A, B and C and two service departments X and Y.

Total department overheads as per primary distribution.

The company decided to change the service department cost on the basis of the following percentages:

Find the total overheads of production departments charging service departmental costs to production departments on the repeated distribution method.

 

[Bharathiar University – 2007; Bharathidasan University – 2005; Madras University –12 times]

[Ans:	Total overheads of production departments:
	A: Rs.: 9,050
	B: Rs.: 9,650
	C: Rs.: 4,300]

[Model: (iii) Trial-and-error method]

7. A company has three production departments and two service departments. The distribution summary of overheads is as follows:

The service departments’ expenses are charged on percentage basis as follows:

You are required to prepare a secondary distribution summary under trial-and-error method and arrive at the overheads finally charged to each production department.

 

[Bangalore University; Rajasthan Vidyapeeth – Modified]

[Ans: Total overheads of service depts.: X: Rs. 4,286

                                                          Y: Rs. 2,857

            Secondary overheads distribution: A: Rs. 11,571

                                                             B: Rs. 10,286

                                                             C: Rs. 10,143]

[Model: When no method of apportionment is specified]

8. A manufacturing company has three production departments and two service departments. The departmental expenses were as follows:

The service departments’ expenses are charged on the following percentage basis:

Prepare a statement showing the apportionment of overheads of the two service departments to the production departments.

 

[Madras University]

[Ans: Note: Repeated distribution method is used.

Ans: Total overhead of the production departments:

                A: Rs. 11,352; B: Rs. 9,763; C: Rs. 13,885

                          (rounded off)   (rounded off)]

[Model: Primary and secondary distribution of overheads]

9. The following figures are extracted from the accounts of a manufacturing concern for a particular month:

Overheads to be apportioned:

	Rs.
Power & Light	30,000
Rent & Rates	14,000
Insurance (Assets)	5,000
Labour amenities	15,000

Depreciation is to be charged at 6% on asset values.

From the above information and the following departmental data, calculate the overhead charges of the production departments with the information that service department X is the maintenance department while Y is the stores department. Ignore the inter-service departmental transfers.

 

[Andhra University]

[Ans: Overheads as per primary distribution:

             A: Rs. 52,975; B: Rs. 62,822; C: Rs. 35,924

             X: Rs. 40,334 Y: Rs. 21,445.

Total overheads of production departments:

        A: Rs. 78,759; B: Rs. 83,597; C: Rs. 51,144]

[Model: Primary and secondary distribution and calculation of absorption rate.]

10. Following are the expenses incurred in respect of two production departments X and Y and one service department Z.

 

	Rs.
(a) Power expenses	8,000
(b) Labour-welfare expenses	4,500
(c) Rent	7,200
(d) Insurance	11,600
(e) Depreciation:
Machinery	20,000
Building	7,000
(f) Lighting	2,400

 

[Andhra University]

Service department Z has rendered service to the production department equally. Ascertain the total cost of the departments and the overhead rate per machine hour for the production departments.

 

[Madurai Kamaraj University]

[Ans: Total cost: X: Rs. 34,000; Y: Rs. 26,700.

             Machine hour rate: X = Rs. 17; Y = Rs. 17.80.]

[Model: Apportionment, absorption and ascertainment of cost of output.]

11. A company has three production departments A, B, and C and two service departments X and Y. The expenses incurred by them during the month of April 2010 are:

 

A   Rs. 80,000	X   Rs. 23,400
B   Rs. 70,000	Y   Rs. 30,000
C   Rs. 50,000

The expenses of service departments are apportioned to the production departments on the following basis:

Show how the expenses of X and Y would be apportioned to A, B and C and the cost per unit of each department.

 

[Madras – Modified]

[Ans:	Total overheads of production departments:
	A: Rs. 99,200; B: Rs. 88,600; C: Rs. 65,600.
	Cost per unit: A: Rs. 99.20; B: Rs. 104.24; C: Rs. 100.92]

12. A machine shop of a factory has three different cost centres having distinct sets of machines. The following estimates are available for a particular year:

Machines are depreciated @ 10% p.a.

1. Compute the machine hour rate of overhead absorption for each of the centres.
2. Job X passes through all the three cost centres as stated in question (a) and the requirements in each centre is as follows: Centre I: 4 hours; Centre II: 3 hours; and Centre III 8 hours. Compute the cost of the job if its direct materials and direct labour cost are estimated at Rs. 500 and Rs. 300, respectively.

[Bombay University – Modified]

[Model: Absorption of overheads]

13. (i) Direct material percentage method.

In a certain factory, during a month, a production department has incurred the following costs:

Direct materials: Rs. 50,000

Production overheads: Rs. 30,000

Calculate the direct-material percentage of overheads.

[Ans: 60%]

[Model: Direct wages percentage method]

14. In a factory, three products are made from different materials by a similar process. For a typical period, the production costs are as follows:

[Ans: X = 50%; Y = ; Z = 40%]

[Model: Prime-cost percentage method]

15. The works overheads of a department: Rs. 2,00,000

 

Direct wages:	Rs. 4,00,000
Direct materials cost:	Rs. 6,00,000

Ascertain the prime-cost percentage of works cost.

[Ans: 20%]

[Model: Rate per unit of production method]

16. During a year, a company spent Rs. 2,50,000 on indirect expenses and produced 50,000 units of its only product. There were no inventories. The company has decided to absorb the indirect expenditure on the basis of its output. Determine the overhead-absorption rate.

[Ans: Rs. 5 per unit]

[Model: Labour-hour-rate method]

17. You are required to find out direct labour-hour rate from the following information:

1. Total no. of operators working in the department are 200.
2. The department works for 300 days in a year and the no. of hours worked in a day is 8.
3. Total department overheads are Rs. 22,800.
4. From the total no. of hours, 5% are to be deducted for idle time.

[Madras 2005]

[Ans: Re 0.05 per hour]

[Model: Machine-hour-rate method]

18. During a year, works overhead incurred in a factory was Rs. 96,000. The machine hours worked during the month were 12,000 hours. Determine the machine hour rate to be changed to the output to recover the works overhead.

[Ans: Rs. 8 per hour]

[Model: Computation of two or more absorption rates]

19. The monthly budget of a department is as follows:

 

Direct materials	Rs. 45,000
Direct wages	Rs. 60,000
Overheads	Rs. 90,000
Direct labour hours	15,000 hours
Machine hours	30,000 hours

Find out the overhead-recovery rate based on:

1. Direct materials-cost method
2. Direct labour-cost method
3. Prime-cost method
4. Machine-hour-rate method.

[Madras – B.A. Corp. – 1997]

[Ans: (a) 200%; (b) 150%; (c) 85.71%; (d) Rs. 3 per hour]

[Model: Absorption rates and ascertainment of job/produce cost]

20. Following are the figures that have been extracted from the books of a manufacturing company. All jobs pass through the factory’s two departments.

	Working Department Rs.	Finishing Department Rs.
Materials used (Rs.)	6,000	500
Direct labour (Rs.)	3,000	1,500
Factory overheads (Rs.)	1,800	1,200
Direct labour hours (Hrs)	12,000	5,000
Machine hours (Hrs)	10,000	2,000

The following information relates to Job No. 10:

	Working Department	Finishing Department
Materials used (Rs.)	120	10
Direct labour (Rs.)	65	25
Machine hours (Hrs)	255	25
Direct labour hours (Hrs)	265	70

You are required to:

1. Enumerate four methods of absorbing factory overheads by jobs, showing the rates of each department under the methods quoted.
2. Prepare a standard showing the different costs resulting for a Job No. 10 using any of the two methods referred above.

[Sri. Sathya Sai University]

[Ans:

Working     Dept

Finishing    Dept

1. (i)	Material-cost method:
   	Percentage on material cost	30%	240%
   	Factory overheads (Rs.)	36	24
   (ii)	Labour cost method:
   	Percentage on direct wage cost	60%	80%
   	Factory overheads (Rs.)	39	20
   (iii)	Labour-hour-rate method:
   	Direct hour rate (Re. per hour)	0-15	0-24
   	Factory overhead (Rs.)	39-75	16-80
   (iv)	Machine-hour-rate method:
   	Machine hour rate (Re. per hr)	0-18	0-60
   	Factory overhead (Rs.)	45.90	15

    

2. Total cost for Job No. 10:

    

   (i)	Material-cost method (Rs.)	221	59
   (ii)	Labour-cost method (Rs.)	224	55
   (iii)	Labour-hour-rate method (Rs.)	224-75	51-80
   (iv)	Machine-hour-rate method (Rs.)

[Model: Under- or over-absorption of overheads]

21. The cost accountant of Nono Chemicals Ltd determined the overhead-recovery rate for the year 2009 (based on direct-labour hours) with the following estimates:

 

	Rs.
Indirect labour	1,15,000
Inspection	70,000
Factory supervision	50,000
Depreciation & Maintenance	1,25,000
	3,60,000
Direct labour hours	75,000 hours
Hourly wage rate	Rs. 15

The actual results for the years are:

 

	Rs.
Indirect labour	99,000
Inspection	73,000
Factory supervision	51,000
Depreciation & Maintenance	1,15,000
	3,38,000
Direct labour hours	67,600
Hourly wage rate	Rs. 16

Calculate the predetermined overhead recovery rate and find out the amount of under- or over-absorption, if any.

[Ans:

1. Direct-labour-hour rate               Rs. 4−80
2. Overhead recovered                     Rs. 3,24,480
3. Under-absorption of overhead     Rs. 13,520]

22. XYZ company uses historical cost system and applies overheads on the basis of predetermined rates. The following data are available from the records of the company for the year that ended on 31 March 2010.

 

	Rs.
Manufacturing overhead	8,50,000
Manufacturing overhead absorbed	7,50,000
WIP	2,40,000
Finished goods stock	4,80,000
Cost of goods sold	16,80,000

Apply the methods of disposal of under-absorbed overheads and show how they would be apportioned

 

[Delhi – Modified]

[Ans: (i) Under-absorption of manufacturing overhead: Rs. 1,00,000; (ii) Apportioned to (a) Cost of sales: Rs. 70,000; (b) Finished goods: Rs. 20,000; (c) WIP: Rs. 10,000]

[Model: Computation of machine hour rate]

                (Q 23 TO Q 30)

23. From the following particulars, compute the machine hour rate:

 

	Rs.
Cost of the machine	11,000
Strap value	680
Repairs for the effective working life	1,500
Standing charges for 4-weekly period	40
Effective working life	10,000 hours
Power used: 6 units per hour at paise per unit	5
Hours worked in 4-weekly period hours	120

 

[Madras – 2007; Periyar – 2005; Bharathiar – 1994]

[Ans: Machine hour rate = Rs. 1.8153]

24. Compute machine hour rate from the following data:

 

	Rs.
Cost of the machine	1,44,000
Installation charges	6,000
Estimated scrap value at the end	6,000
Effective working life of the machine	12,000 hours
Estimated repairs over the effective working life of the machine	12,000
Standing charges allocated to the machine per year	5,760
Power bill per year	7,200
Power consumed by the machine is 20 units per hour at a cost of 25 paise per unit.

 

[Delhi – B.Com]

[Ans: Rs. 22]

25. Calculate machine hour rate of Machine A:

 

	Rs.
Consumable stores	600 for Machine A
Consumable stores	1,000 for Machine B
Repairs	800 for Machine A
Repairs	1,200 for Machine B
Heat and Light	360
Rent	1,200
Insurance of building	4,800
Insurance of machines	800
Depreciation of machines	700
Room service	60
General charges	90

Additional information:

 

	Machine A	Machine B
Working hours (hours)	10,000	25,000
Area (Sq. metre)	100	500
Book value (Rs.)	12,000	20,000

 

[Delhi – B.Com (Pass)]

[Ans: Re 0 – 30]

26. Work out the machine hour rate for the following machine for the month of January 2010:

 

Cost of the machine	Rs. 90,000
Freight and installation	Rs. 10,000
Working life	10 years
Working hours	2,000 per year
Repair charges	50% of depreciation

Consumption of electric power 10 units per hour@ 10 paise per unit.

Lubricating oil at Rs. 20 per day of 8 hours.

Consumable stores at Rs. 100 per day of 8 hours.

Wages of operator at Rs. 40 per day of 8 hours.

 

[Madras University – Modified]

[Ans: Rs. 34.50]

27. From the data given below, calculate the machine hour rate:

 

	Rs.
Rent of the department (Space occupied by machine th of the department	780 p.a.
Lighting (No. of men in the department 12, two men engaged on this machine)	288 p.a.
Insurance, etc.	36 p.a.
Cotton, waste, oil, etc	60 p.a.
Salary of foreman	6,000 p.a.

One fourth of the foreman’s time is occupied by the machine and the reminder equally by other two machines.

The cost of the machines is Rs. 9,200 and it has an estimated scrap value of Rs. 200. It is ascertained from the past experience that

1. the machine will work for 1,800 hours p.a.
2. it will incur the expenditure of Rs. 1,125 in respect of repairs and maintenance over its life time.
3. it consumes 5 units of power per hour at the cost of 6 paise per unit.
4. the working life of the machine will be 18,000 hours

[Madras University – 2007; Bharathiar University – 2007]

[Ans: Rs. 1.86]

28. From the following particulars, compute the machine hour rate

 

	Rs.
Cost of the machine	30,000
Estimated scrap value after the expiry of its life of 5 years	3,000
Rent and rates of the department	2,000
General lighting of the department p.m.	200
Salary of the supervisor p.m.	1,500

Power consumption is 5 units at the rate of 60 paise per unit. Estimated working hours of the machine per year is 2,000. The machine occupies th of the total area of the department. The supervisor is expected to devote th of the time to this machine. General lighting charges are to be apportioned on the basis of floor area. Rent and rate charges are for three months.

 

[Bangalore University; Bharathidasan University]

[Ans: Rs. 8–80]

29. There are five identical machines in a work shop. The annual charges paid for them are as follows:

1. Rent and rates in proportion to floor space occupied Rs. 4800
2. Depreciation for each machine Rs. 500
3. Power consumed as per metre @ 5 paise per unit for the shop Rs. 3,000
4. Repairs and maintenance for 5 machines Rs. 1,000.
5. Electric charges for the light in the shop Rs. 450
6. Attendants:

   There are 2 attendants for the machine and each are paid Rs. 60 per month.

7. Supervision:

   For the five machines in the shop there is one supervisor whose emoluments are Rs. 250 p.m.

8. Sundry supplies such as lubricants and cotton waste for the shop is Rs. 450.

   The machines use 10 units of power per hour. Calculate the machine hour rate for the machine for the year.

[Madras University]

[Ans: Rs. 2.77]

30. Compute the comprehensive machine hour rate from the following:

1. Total cost of machine to be depreciated = Rs. 2,30,000
2. Life = 10 years
3. Departmental overheads (annual):

   Rent                 – Rs. 50,000

   Heat & Light – Rs. 20,000

   Supervision   – Rs.1,30,000

    

4. Depreciation on straight-line method
5. Departmental area – 70,000 sq. m.
6. 26 machines in the department
7. Annual cost of reserve equipment for the machines – Rs. 1,500.
8. Hours run on production = 1,800 hours.
9. Hours for setting and adjusting = 200 hours.
10. Power cost = 0.50 per hour of running time.
11. Labour

1. When setting and adjusting, full-time attention.
2. When machine is producing, one worker can look after three machines.      (l) Labour rate Rs. 6. per hour.

You are required:

 

(h)	to calculate the machine hour rate and
(i)	using the machine hour rate as calculated, work out the amount of factory overhead to be absorbed on the following:

[Madras – Modified]

[Ans:	Comprehensive machine hour rate – Rs. 20.14.
	Labour cost per machine – Rs. 2.
	Labour cost for setting – Rs. 1,200.
	(b) Factory overhead absorbed by:
	Job No. 705 – Rs. 1,611.20.
	Job No. 595 – Rs. 1,409.80.]

 

31. A machine shop has eight identical handling machines manned by six operators. The machines cannot be worked without an operator wholly engaged to it. The original cost of all these eight machines works out to Rs. 8 lakhs. The following particulars are relaxed for a six-month period:

 

Normal available hours per month	208
Absenteeism (without pay) hours	18
Leave (with pay) hours	20
Normal idle unavoidable hours	10
Average rate of wages per day of 8 hrs	Rs. 20
Production hours estimated	15 % on wages
Value of power consumed	Rs. 8,050
Supervision and indirect labour	Rs. 3,300
Lighting & Electricity	Rs. 1,200

These particulars are for a year:

 

Repairs and maintenance including consumables	= 3% on value
Insurance	= Rs. 40,000
Depreciation	= 10% on the original cost
Other sundry-work expenses	= Rs. 12,000
General management expenses allocated	= Rs. 54,530

You are required to work out a comprehensive machine hour rate for the machine shop.

 

[C.A. – Inter]

[Ans: Comprehensive machine hour rate: Rs. 23.8680]

32. The following budgeted information is available from ABC Co. records:

Using the above information, calculate:

1. The blanket rate and departmental rates.
2. Overheads absorbed by Job R using blanket rate and departmental rates.

[I.C.W.A. – Inter]

[Ans:

1. 1. Blanket rate: Rs. 20.
   2. Departmental rates: Cost centre 1: Rs. 10.

                                       Cost centre 2: Rs. 40.

2. Overheads absorbed:
   1. Using blanket rate:            Rs. 2,200.
   2. Using departmental rates: Rs. 2,000.]

33. From the following data of a textile-factory machine room, compute an hourly machine-hour rate, assuming that the machine room will work at 90% capacity throughout the year and that a breakdown of 10% is reasonable.

There are three holidays for Deepavali and two holidays for Christmas, exclusive of Sundays. The factory works for 8 hours a day and for 4 hours on Saturdays.

Number of machines (each of same type) – 40

 

		Rs.
	Power	3,120
	Light	640
	Salaries to foremen	1,200
	Lubricating oil	66
	Repairs to machines	1,446
	Depreciation	785–60
	Total	7,257–60

 

[C.A. – Final]

[Ans: Machine hour rate: Re 0.10]

34. From the following data, work out the predetermined machine hour rates for departments A and B of a factory:

The final estimates are to be prepared on the basis of the above figures after taking into consideration the following factors:

1. An increase of 10% in the price of spares.
2. An increase of 20% in the consumption of spare parts for department B only.
3. Increase in the straight-line method of depreciation from 10% on the original value of machinery to 12%.
4. A 15% general increase in the wage rates.

The following information is available:

	Dept A	Dept B
Estimated direct labour hours	80,000	1,20,000
Ratio of KW ratings	3	2
Estimated machine hours	25,000	30,000
Floor space (sq.ft)	15,000	20,000

[I.C.W.A. – Inter]

[Ans: Overhead absorption rates: Dept A – Rs. 1.95; Dept B – Rs. 2.44]

35. Gemini Enterprises undertook three different jobs A, B and C. All of them require the use of a special machine and also the use of a computer. The computer is hired and the hire charges work out to Rs. 4,20,000 p.a. The expenses of the machine are estimated as follows:

 

	Rs.
Rent for the quarter	17,500
Depreciation per annum	2,00,000
Indirect charges p.a.	1,50,000

During the first month of operation, the following details were taken from the job register:

You are required to compute the machine hour rate:

1. for the firm as a whole, for the month when the computer was not used.
2. for the individual jobs A, B and C

[C.A. – Inter]

[Ans: MHR when computer used: Rs. 27.50

        MHR when computer not used: Rs. 10.00

        MHR – Job A – Rs. 17

                    Job B – Rs. 17

                    Job C – Rs. 27.50]

36. (A) Calculate the machine hour rate of a machine with the information given as follows:

 

Operating date:
Total no. of weeks per quarter	–13
Total no. of hours per week	– 48
Stoppage due to maintenance	– 8 hours p.m
Time taken for set-up	– 2 hours per week
Cost details:
Cost of machine	– Rs. 2,00,000
Repairs & Maintenance	– Rs. 24,000 p.a.
Consumable stores	– Rs. 30,000 p.a
Rent, rates and taxes	– Rs. 8,000 per quarter
Operators’ wages	– Rs. 3,000 p.m
Supervisor’s salary	– Rs. 5,000 p.m
Cost of power	– 15 units per hour at Rs. 3 per unit.

NOTES

1. Life of the machine is 10 years. Depreciation is provided on a straight-line basis and is treated as a variable cost.
2. Repairs and maintenance and consumable stores are variable costs.
3. Power is consumed for production runs only and set-up maintenance. But cost of power is to be borne by the total time excluding the maintenance stoppages.
4. The supervisor is supervising the work for five identical machines including the one now considered.
5. The company hires out excess capacity in the machine shop for outside jobs.
   1. Assuming that hire charges are fixed at variable cost plus 20%, what rate should be quoted by the company?

[I.C.W.A. – Inter]

37. From the following data relating to a production unit, work out the over- or under-absorbed which resulted during the month of review:

The unit having a strength of 20 work men planned for 290 working days of 8 hours each, with an hour break. Based on the earlier year’s trend, it is forecasted that their average absenteeism per workman would be 10 days in addition to the eligibility of 30 days annual leave.

The budgeted overheads related to the unit for the year amounted to Rs. 75,000 and the unit follows a system of recovering overheads on the basis of direct labour hour. The actual overheads during the year amounted to Rs. 71,200 and the following details regarding the actual working of the unit are available:

1. The factory worked for 3 extra days to meet the production target, but one additional paid holiday had to be declared.
2. There was a severe breakdown of a major equipment leading to a loss of 350 man- hours.
3. Total overtime hours (in addition to 3 extra days worked) amounted to 680 hours.
4. The actual average absenteeism per workman was 12 days.

[I.C.W.A. – Inter]

[Ans: Over-absorbed overhead – Rs. 4,460]

38. X Ltd having 15 different types of automatic machines furnishes information as follows:

1. Overhead expenses:
   1. Factory rent – Rs. 96,000 (Floor Area – 80,000 sq. ft)
   2. Heat and gas-Rs. 45,000
   3. Supervision – Rs. 1,20,000
2. Wages of the operator are Rs. 48 per day of 8 hours. He attends to one machine when it is under set-up and two machines while they are under operation.

In respect of machine B (one of the above machines), the following particulars are furnished:

1. Cost of the machine – Rs. 45,000; Life of the machine – 10 years; and scrap value at the end of its life – Rs. 5,000.
2. Annual expenses on special equipment attached to the machine are estimated at Rs. 3,000.
3. Estimated operation time of the machine is 3,600 hours while the set-up time is 400 hours per annum.
4. The machine occupies 5,000 sq ft. of the floor area.
5. Power cost is Rs. 2 per hour while the machine is in operation.

Find out the comprehensive machine hour rate of machine B. Also find out the costs to be absorbed in respect of the user of machine B, on the following two work orders:

 

	Work order 31	Work order 32
Machine set-up time (hrs)	10	20
Machine operation time (hrs)	90	180

 

[C.A. – Inter]

[Ans: Rs. 23; Work order 31 – Rs. 1,110; Work order 32 – Rs. 2,220]

39. A company has three production departments and two service departments. The distribution summary of overhead is as follows:

Production departments:

 

A – Rs. 13,600

B – Rs. 14,700

C – Rs. 12,700

Service departments:

 

X – Rs. 9,000

Y – Rs. 3,000

The expenses of service departments are charged on a percentage basis which is as follows:

Apportion the cost of service departments using the simultaneous equation method.

 

[C.A. – Inter]

[Ans: A – Rs. 18,712; B – Rs. 18,833; C – Rs. 15,555]

40. Find the cost of each unit of production of the service department from the following data for a year:

[I.C.W.A. – Inter]

[Ans: The unit rates of: Steam: Rs. 4 per MT.

          Water: Rs. 1.20 per CM.

          Power: Rs. 0.40 per KWH.]

41. In a factory, the overheads of a particular department are recovered on the basis of Rs. 5 per machine hour. The total expenses incurred and the actual machine hours for the department for the month of August were Rs. 80,000 and 10,000 hours, respectively. Of the amount of Rs. 80,000, Rs. 15,000 became payable due to an award of labour court and Rs. 5,000 was in respect of the expenses of the previous year booked in the current month (August). The actual production was 40,000 units, out of which 30,000 units were sold. On analysing thee reasons, it was found that 60% of the under-absorbed overhead was due to defective planning and the rest was attributed to the normal cost increase. How you treat the under-absorbed overheads in the cost accounts?

 

[I.C.W.A. – Inter; C.A. – Inter]

[Ans:	(a) Under-absorbed recovery of overheads: Rs. 10,000.
	(b): (i) 60% – Rs. 6,000 being abnormal should be charged to costing & A/c.
	(ii) 40% – Rs. 4,000 should be distributed over finished goods and cost of sales by supplementary rate as: finished goods – Rs. 1,000; cost of sales – Rs. 3,000]

42. The following data relate to a manufacturing department for a period:

	Budgeted Data Rs.	Actual Data Rs.
Direct material	1,00,000	1,40,000
Direct labour	2,00,000	2,50,000
Production overhead	2,00,000	2,30,000
Direct labour hours	50,000	62,500
Machine hours	40,000	50,000

Job ZX was one of the jobs worked on during the period. The actual data relating to this job were:

 

Direct material	Rs. 6,000
Direct labour	Rs. 3,000
Direct labour hours	750
Machine hours	750

Required:

1. Calculate the production-overhead absorption rate predetermined for the period based on:
   1. Percentage direct-material cost.
   2. Machine hours.
2. Calculate the production overhead cost to be charged to job ZX based on the rates calculated under (a) above.
3. Assuming that the machine hour rate of absorption is used, calculate the under- or over-absorption of production overheads for the period and state the appropriate treatment in the accounts.

[B.Com – (Hons) – Delhi]

[Ans: (a) (i) 200%; (ii) Rs. 5.

            (b) Rs. 21,000; Rs. 12,750

            (c) over-absorption: Rs. 20,000]

43. Sankalp Industries absorbs factory overhead costs at Rs. 2.50 per direct labour hour. Both opening and closing balances of WIP and finished goods inventories are zero.

Following are the data available for a year and the fact is that all goods produced have been sold.

 

Direct labour hours used	50,000
Direct labour cost	Rs. 1,00,000
Indirect labour cost	Rs. 25,000
Indirect materials cost	Rs. 10,000
Depreciation of plant & equipment	Rs. 50,000
Miscellaneous factory overheads	Rs. 50,000

Assuming that all goods produced have been sold:

1. calculate the factory overheads incurred and factory overheads absorbed: and
2. pass a journal entry for disposing of over- or under-absorbed factory overheads.

 

[B.Com (Hons) – Delhi]

[Ans: Factory overheads incurred	Rs. 1,35,000
Factory overheads absorbed	Rs. 1,25,000
Positive supplementary rate	Re. 0.20 per labour hour]

44. Mayur Ltd has three manufacturing departments P₁, P₂ and P₃ and one service department S1.

The following particulars are available for one month of 25 working days of 8 hours each. All departments work all days with full attendance.

Calculate the “labour hour rate” of each of the departments P₁, P₂ and P₃

 

[B.Com – Hons – Delhi]

[Ans: P₁ – Re. 0.30; P₂ – Re. 0.25; P₃ – Re. 0.40]

45. Work out the machine hour rate for the following machine whose scrap value is nil.

 

Details	Amount (Rs.)
Cost of machine	1,90,000
Freight & installation charges	10,000
Working life	Five years
Repairs & Maintenance	40% of depreciation

Annual power expenses @ 25 paise per unit 6,000 Eight-hourly day charges:

 

	(1) power	24
	(2) lubricating oil	20
	(3) consumable stores	28
	(4) wages	80

 

[B.Com – (Hons) – Delhi]

[Ans: Rs. 47]