Cost Accounting - Costing and Control of Factory Overheads

 

COST ACCOUNTING

Costing and control of factory overheads

Part A: Discussion of basic theories and concepts including definitions and explanations of different important terms relevant to the understanding of the topic.

Part B: Twelve illustrations with solutions.

Part A

Definition of overhead

The basic elements of cost are: 1) Material cost, 2) Labour cost, and 3) Other expenses. Each of these costs may be again direct or indirect like direct material and indirect material, direct labour and indirect labour, and direct expenses or indirect expenses. Sum of indirect materials, indirect labour and indirect expenses is called overheads, whereas sum of direct materials, direct labour and direct expenses is known as prime cost.

 

A direct cost is a cost which can be easily identified with respect to a cost centre or cost unit or which can be conveniently allocated to different cost centres or cost units.

 

An indirect cost is a cost which cannot be easily identified with respect to any cost centre or cost unit or which cannot be conveniently allocated to any of the different cost centres or cost units.

 

A cost centre is a location, person or item of equipment (or group of persons or group of equipment) in terms of which different elements of cost can be ascertained and used for the purpose of cost control. Cost centres may be of two types: production cost centres and service cost centres. Cost centres are also known as departments, like production departments and service departments.

 

A cost unit refers to one unit of the product manufactured or one unit of the service provided (or combination of these) in terms of which different elements of cost can be ascertained in order to calculate cost per unit of such product or service.

 

Overhead expenses, therefore, can also be defined as expenses which cannot be conveniently allocated to any product or service, but can only be apportioned to, or absorbed by, the products or services.

 

Classification of overhead

Overhead may be classified in various ways as stated below:

(a)          Function-wise classification;

(b)          Element-wise classification;

(c)          Behaviour-wise classification;

(d)          Control-wise classification.

 

Function-wise classification

(i)  Factory overhead (also known as Production overhead, Manufacturing overhead and Works overhead);

(ii)  Administration overhead (also known as Office overhead); and

(iii)    Selling and distribution overhead.

 

Element-wise classification

(i)        Indirect material;

(ii)        Indirect labour; and

(iii)       Indirect expenses.

 

Behaviour-wise classification

(i)            Fixed overhead;

(ii)           Variable overhead; and

(iii)           Semi-variable or semi-fixed overhead.

 

Control-wise classification

(i)          Controllable overhead; and

(ii)          Uncontrollable overhead.

 

Distribution of factory overhead

There are basically three stages in distribution of factory overhead:

1.     Primary distribution of overhead,

2.     Secondary distribution of overhead, and

3.    Absorption (also called recovery or application) of    overhead.

 

Primary distribution

Distribution of factory overhead among different production and service cost centres is known as primary distribution. Examples of service departments / service cost centres are:

(a)     Store;

(b)     Water treatment plant;

(c)     Power generation unit / captive power plant;

(d)     Maintenance department;

(e)      Staff canteen; etc.

 

Primary distribution involves either allocation or apportionment of different items of overhead to all the production as well as service cost centres of the factory.

 

Secondary distribution

Distribution of total factory overhead of service cost centres after the primary distribution among different production cost centres is known as secondary distribution.

 

Secondary distribution involves only apportionment of the total of service cost centre overheads after the primary distribution among the different production cost centres.

 

Format for primary and secondary distribution of factory overheads

Absorption (also called recovery or application)

Distribution of total factory overhead of each production cost centre after the secondary distribution among the units of output of that cost centre is known as absorption or recovery or application of factory overhead.

 

Definition of allocation and apportionment

Allocation means charging to a department or cost centre that expense which has been incurred exclusively for that department or cost centre. In other words, when an item of overhead can be identified directly with respect to a specific department it is charged to that department only, and this process of identification and charging of overhead is called allocation. Different amounts of an item of overhead to be allocated among different departments may be obtained / calculated from the original records and documents like purchase voucher, stores requisition, electric bills, records of defective works, repair and maintenance register, etc.

 

Apportionment means allotment to two or more departments or cost centres of proportions of common items of cost on estimated basis. In other words, when the items of overhead cannot be directly identified with respect to specific departments and thus, cannot be allocated to these departments, these items of overhead are required to be allotted among the said departments on estimated basis, and this process of allotment of overhead is called apportionment.

 

Bases used for apportionment in primary distribution

Sl. No.	Bases	Items of overhead
1	Floor area	(i) Depreciation of building, (ii) rent, rates and taxes, (iii) insurance of building, (iv) repair and maintenance of building, (v) lighting expenses.
2	Capital values of assets	(i) Depreciation of plant and machinery, (ii) insurance of plant and machinery, (iii) repair and maintenance of plant and machinery.
3	KWH / HP	Cost of electric power [when the hours of work in different departments vary widely the basis should be (KWH / HP x Machine hours) instead of KWH / HP only].
4	Light points	Lighting expenses (if wattage of the light points is uniform).
5	Wattage	Lighting expenses (if wattage of the light points is not uniform).
6	Number of employees Or Labour hours	(i) Canteen expenses, (ii) personnel department expenses, (iii) ESI, (iv) group insurance, (v) welfare expenses, (vi) time-keeping expenses, (vii) supervision expenses, (viii) general expenses.
7	Cubic content	Heating cost.
8	Weight or volume or ton-mile	Delivery expenses.
9	Direct wages	(i) Indirect wages, (ii) general expenses, (iii) ESI, (iv) workmen’s compensation insurance premiums, (v) supervision expenses.
10	Machine hours	(i) Works management expenses, (ii) general overtime expenses, (iii) general expenses.

 

Bases used for apportionment in secondary distribution

Sl. No	Bases	Service cost centres
1	Labour hours / Machine hours	(i) Repair and maintenance shop, (ii) tool room, (iii) workshop.
2	Number of employees / Labour hours	(i) Canteen, (ii) welfare and recreation, (iii) hospital and dispensary, (iv) personnel department, (v) time-keeping department.
3	Number of stores requisitions / Value of materials issued / Direct materials	Stores department.
4	Number of purchase orders / value of materials purchased	Purchase department.
5	Direct wages	Office and administration.
6	KWH / HP	Captive power plant.
7	KWH / HP × Machine hours [when hours worked in different departments vary widely]	Captive power plant.
8	Cubic content	Water treatment plant.
9	Weight / volume / ton-mile	Transport department.
10	Capital values of assets	Fire protection department.
11	Inspection hours	Inspection department.
12	Computer hours	Computer department.

 

Important note:

In primary distribution ‘general expenses’ should be distributed on the basis of ‘Labour hours’. But, if ‘Labour hours’ are not given in the problem, ‘general expenses’ should be distributed on the basis of ‘Direct wages’.

 

Methods of secondary distribution

Direct distribution method

Under this method service department costs are apportioned only to the production departments ignoring the services rendered by one service department to other service departments.

 

Step distribution method

Under this method it is recognised that one service department renders services to other service departments and production departments. But here again, the reciprocal services are ignored for the purpose of distribution. Under this method the cost of that service department which serves the largest number of other departments is apportioned first. After this is done the cost of that service department which serves the next largest number of other departments is apportioned. This process continues till the cost of last service department is apportioned. The cost of last service department is apportioned among the production departments only.

 

Trial and error method

Under this method reciprocal services amongst the service departments are recognised. In this case, the cost of each service department is apportioned to other service departments on the basis of services rendered. Since there is reciprocal service, each service department gets share from the other service departments after its own cost is apportioned. So the process has to be repeated until the amount becomes negligible. The cost ultimately coming to the share of each service department being the total of the shares coming from a number of apportionments is apportioned to the production departments on some equitable basis or on the basis of the given proportion.

 

Repeated distribution method

This method also recognises reciprocal services amongst the service departments. In this case, the cost of the first service department is apportioned to other service departments and production departments so that the first service department shows a nil balance. The total cost of the second service department including the share of the first is similarly apportioned to other service departments and production departments so that the second service department shows a nil balance. The first service department now gets a share of the second and this amount has to be again apportioned. This process goes on until the balances of the service departments become very small which are then transferred to the production departments only.

 

Simultaneous equations method

This method also recognises reciprocal services amongst the service departments. Under this method true costs of the service departments are ascertained first with the help of simultaneous equations. These are then apportioned among the production departments on some equitable basis or on the basis of the given proportion.

 

Methods of absorption / recovery / application

The most widely used methods of absorption of factory overhead are:

1)        Production unit method;

2)        Percentage of direct materials cost method;

3)        Percentage of direct wages cost method;

4)        Percentage of prime cost method;

5)        Labour hour rate method;

6)        Machine hour rate method.

1. Production unit method

Overhead rate per unit =

(Actual or estimated overhead) ÷ (Actual or estimated Number of units of production)

 

2. Percentage of direct materials cost method

Overhead rate (%- age of direct material) =

[(Actual or estimated overhead) ÷ (Actual or estimated Direct materials cost)] x 100

 

3. Percentage of direct wages cost method

Overhead rate (%- age of direct wages) =

[(Actual or estimated overhead) ÷ (Actual or estimated Direct wages cost)] x 100

 

4. Percentage of prime cost method

Overhead rate (%- age of prime cost) =

[(Actual or estimated overhead) ÷ (Actual or estimated prime cost)] x 100

 

5. Labour hour rate method

Overhead rate (LHR) =

[(Actual or estimated overhead) ÷ (Actual or estimated direct labour hours worked or to be worked)]

 

6. Machine hour rate method

Overhead rate (MHR) =

[(Actual or estimated overhead) ÷ (Actual or estimated machine hours worked or to be worked)]

 

Important notes:

1.  When a Comprehensive Machine Hour Rate is required to be calculated, wages of the machine operators (i.e. direct wages) should be included in the factory overhead.

2.    In case of all the above methods of absorption of factory overhead, estimated figures are to be used when predetermined overhead rates are required to be calculated. Predetermined overhead rates are usually calculated for the purpose of submitting price quotation, project evaluation, etc.

Blanket Overhead Rate

Overhead rates are usually calculated for each of the production departments. But sometimes a single overhead rate is also calculated for the entire factory which is known as Blanket Overhead Rate. A Blanket Overhead Rate is calculated as follows:

Blanket overhead rate =

[(Overhead cost for the entire factory for the period) ÷ (Base for the period i.e. direct labour hours or machine hours worked for the entire factory)]

 

Over- or under-absorption of overhead

Under historical costing system when overhead recovery rate is ascertained on the basis of actual figures of a period the overhead actually incurred equals the overhead recovered or absorbed during the same period. So, there is no chance of overhead being over-absorbed or under-absorbed. But when the recovery rate is predetermined on the basis of expected or estimated figures of a period there is every possibility of having a difference between the overhead incurred and overhead recovered or absorbed during the same period. Where the amount of overhead incurred exceeds the amount of overhead absorbed it is called under-absorption of overhead. On the other hand, where the amount of overhead absorbed exceeds the amount of overhead incurred it is called over-absorption of overhead.

 

Under-absorption or over-absorption may arise due to any one or both of the following two reasons:

(i)  The actual amount of overhead incurred being more or less than the estimated amount of overhead,

(ii) The actual amount of the absorption base (materials, wages, labour hours worked, machine hours worked, etc., as the case may be) being different from the estimated amount of absorption base.

 

Treatment of over-absorption and under-absorption of overhead in cost accounts

In cost accounts over and under-absorption of overhead may be treated in three different ways:

 

First method: carrying forward to the next period’s account

This method is applied where the normal business cycle extends over a number of years. Under this method, the amount of over-absorbed or under-absorbed overhead is transferred to a reserve or suspense account to carry forward the same to the next accounting period for absorption.

 

Journal entries:

(a)  For charging under-absorbed factory overheads ─

Date	Particulars	LF	Debit (Rs)	Credit (Rs)
	Fy OH Suspense A/c   Dr
	To Fy OH Control A/c

 

(b)   For adjusting over-absorbed factory overheads ─

Date	Particulars	LF	Debit (Rs)	Credit (Rs)
	Fy OH Control A/c      Dr
	To Fy OH Reserve A/c

 

Second method: writing off to costing profit and loss account

This method is applied where the amount of over-absorption or under-absorption is insignificant and the reasons of over-absorption or under-absorption are:

(a)      Defective planning,

(b)      Factory inefficiency,

(c)      Abnormal factors (such as abnormal over or            under capacity utilisation),

(d)      Unusual events.

 

Under this method, the amount of over-absorbed or under-absorbed overhead is transferred to costing profit and loss account without disturbing the production cost.

 

Journal entries:

(a)  For charging under-absorbed factory overheads ─

Date	Particulars	LF	Debit (Rs)	Credit (Rs)
	Costing P/L A/c          Dr
	To Fy OH Control A/c

 

(b)  For adjusting over-absorbed factory overheads ─

Date	Particulars	LF	Debit (Rs)	Credit (Rs)
	Fy OH Control A/c      Dr
	To Costing P/L A/c

 

Third method: using supplementary recovery rate

This method is applied where the amount of over-absorption or under-absorption is very considerable i.e. significant and the reasons of over-absorption or under-absorption are:

(a)   An error in estimating either the budgeted factory   overhead or the activity base,

(b)   A normal increase in the overhead costs,

(c)   A major change in the method of production,

(d)   A substantial change in the level of activity.

Under this method, the amount of over-absorbed or under-absorbed overhead is adjusted to the values of work-in-progress, finished goods stock and cost of sales using supplementary recovery rate.

If there is over-absorption, these accounts are credited applying the supplementary rate, debit being given to factory overhead account. If there is under-absorption, these accounts are debited applying the supplementary rate, credit being given to factory overhead account. The aim of applying supplementary rate is to create such effect that actual overhead incurred equals the overhead absorbed. The supplementary rate is worked out on the basis of –

(a)  The money value of each account (work-in-       progress, finished goods stock and cost of sales),

(b)   The direct materials cost in each account,

(c)   The direct wages in each account,

(d)   Direct labour hours in each account, or

(e)   Machine hours in each account.

 

Journal entries:

(a)  For charging under-absorbed factory overheads ─

Date	Particulars	LF	Debit (Rs)	Credit (Rs)
	WIP Ledger Control     Dr
	F. G.   Ledger Control  Dr
	Cost of sales A/c         Dr
	To Fy OH Control A/c

 

      (b) For adjusting over-absorbed factory overheads ─

Date	Particulars	LF	Debit (Rs)	Credit (Rs)
	Fy OH Control A/c      Dr
	To  WIP Ledger Control
	To  F. G. Ledger Control
	To  Cost of sales A/c

 

Part B

Illustration: 1

A manufacturing company has two production departments Fabrication and Assembly and 3 service departments as Stores, Time Office and Maintenance. The departmental overheads summary for the month of March 2016 is given below:

	Rs
Fabrication	24,000
Assembly	16,000
Stores	5,000
Time office	4,000
Maintenance	3,000

 

Other information relating to the department was:

	Production Depts.		Service Depts.
Particulars	Fabrication	Assembly	Stores	Time office	Maintenance
No of employees	40	30	20	16	10
No of stores requisition slips	24	20			6
Machine hours	2,400	1,600

 

Apportion the costs of service departments to the production departments.

 

Click here for Solution: 1 in PDF

Illustration: 2

The summary as per primary distribution is as follows:

Production departments A- Rs 2400; B- Rs 2100 & C- Rs 1500

Service departments X – Rs 700; Y- Rs 900

Expenses of service departments are distributed in the ratios of:

X department: A- 20%, B- 40%, C- 30% and Y- 10%

Y department: A- 40%, B- 20%, C- 20% and X- 20%

Show the distribution of service costs among A, B and C under repeated distribution method.

Click here for Solution: 2 in PDF

 

Illustration: 3

In an Engineering Factory, the following particulars have been extracted for the quarter ended 31st December, 2015. Compute the departmental overhead rate for each of the production departments, assuming that overheads are recovered as a percentage of direct wages.

	Production Depts.			Service Depts.
	A	B	C	X	Y
D/wages (Rs)	30,000	45,000	60,000	15,000	30,000
D/material (Rs)	15,000	30,000	30,000	22,500	22,500
No of workers	1,500	2,250	2,250	750	750
Electricity (KWH)	6,000	4,500	3,000	1,500	1,500
Asset Value (Rs)	60,000	40,000	30,000	10,000	10,000
No of light points	10	16	4	6	4
Area (Sq. Yards)	150	250	50	50	50

 

The expenses for the period were:

	Rs
Power	1,100
Lighting	200
Stores overhead	800
Staff welfare	3,000
Depreciation	30,000
Repairs	6,000
General overheads	12,000
Rent and taxes	550

 

Apportion the expenses of Service Dept. Y among the three production departments according to direct wages and those of Service Dept. X in the ratio of 5: 3: 2 to the three production departments.

 

Click here for Solution: 3 in PDF

Illustration: 4

The New Enterprises Ltd. has three producing 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	5,000
General Lighting	600
Indirect wages	1,500
Power	1,500
Depreciation on machine	10,000
Sundries	10,000

 

The following further details are available:

	Production Depts.			Service Depts.
	A	B	C	D	E
Floor Space (Sq. Mts.)	2,000	2,500	3,000	2,000	500
Light Points	10	15	20	10	5
Direct Wages	3,000	2,000	3,000	1,500	500
H. P. of Machines	60	30	50	10	-
Working Hours	6,226	4,028	4,066	-	-
Value of Material	60,000	80,000	1,00,000	-	-
Value of Assets	1,20,000	1,60,000	2,00,000	10,000	10,000

 

The expenses of D and E are allocated as follows:

	A	B	C	D	E
D	20%	30%	40%	-	10%
E	40%	20%	30%	10%	-

 

What is the factory cost of an article if its raw material cost is Rs 50, labour cost Rs 30 and it passes through Departments A, B and C for 4, 5 & 3 hours respectively.

Click here for Solution: 4 in PDF

Illustration: 5

The following information relates to the activities of a production department of factory for a certain period.

Direct materials used (Rs)	36,000
Direct wages paid (Rs)	30,000
Labour hours worked (hours)	12,000
Machine hours operated (hours)	20,000
Overhead chargeable to the dept. (Rs)	25,000

 

On one order carried out in the department during the period the relevant data were:-

Direct materials used (Rs)	6,000
Direct wages paid (Rs)	4,950
Labour hours worked (hours)	1,650
Machine hours operated (hours)	1,200

 

Calculate the overheads chargeable to the job by four commonly used methods.

 

Solution: 5

Illustration: 6

Your company uses a historical cost system and applies overheads on the basis of “Predetermined” rates. The following are the figures from the Trial Balance as at 30-9-2015:

	Dr (Rs)	Cr (Rs)
Manufacturing overheads	4,26,544	-
Manufacturing overheads – applied	-	3,65,904
Work-in-progress	1,41,480	-
Finished Goods Stock	2,30,732	-
Cost of Goods Sold	8,40,588	-

 

Give three methods for the disposal of the under absorbed overheads and show the profit implications of the method.

 

Solution: 6

Illustration: 7

In a factory the expenses of factory are charged on a fixed percentage basis on wages and office overhead expenses are calculated on the basis of percentage of works cost.

 

	Order I (Rs)	Order II (Rs)
Material	12,500	18,000
Wages	10,000	14,000
Selling price	44,850	61,880
%-age of profit on cost	15%	12%

 

Find the rate of Factory OH and Office OH.

 

Solution: 7

Illustration: 8

Self-help Ltd. has gensets and produced its own power Data for power costs as follows:-

	Prodn. Depts.		Service Depts.
	A	B	X	Y
Horse Power Hours (HPH) required at maximum capacity utilisation	10,000	20,000	12,000	8,000
Actual HPH used during the month of May	8,000	13,000	7,000	6,000

 

During the month of May costs for generating power amounted to Rs 9,300, of this Rs 2,500 was considered to be fixed. Dept: X renders service to other Depts. in the ratio of 13: 6: 1, while Dept: Y renders service at A & B in the ratio of 31: 3. If direct labour hours worked in Dept: A and Dept: B are 1,650 hours and 2,175 hours respectively, find the power cost per labour hour in each of these two departments.

 

Solution: 8

Illustration: 9

For a department the standard overhead rate is Rs 2.50 per hour and the overhead allowances are as follows:

Activity Level (Hours)	Budgeted overheads (Rs)
3,000	10,000
7,000	18,000
11,000	26,000

 

Calculate:

a)   Fixed cost, and

b)  The standard activity level on the basis of which the standard overhead rate has been worked out.

 

Solution: 9

Illustration: 10

In a manufacturing unit, overhead is recovered at a predetermined rate of Rs 25 per man-day. During a cost period the total factory overhead incurred and the man-days actually worked were Rs 41, 50,000 and 1, 50,000 respectively. Out of the 40,000 units produced during the period 30,000 units were sold. There were also 30,000 uncompleted units which may be reckoned at 66.67% complete.

 

On analysing the reasons, it was found that 40% of the unabsorbed overheads were due to defective planning and the rest were attributable to increase in overhead costs.

 

How would unabsorbed overhead be treated in Cost Accounts?

 

Solution: 10

Illustration: 11

XYZ manufactures household pumps which pass through three departments, viz. Foundry, Machine Shop and Assembling. The manufacturing expenses are as follows:

	Foundry (Rs)	Machining (Rs)	Assembling (Rs)	Total (Rs)
Direct wages	10,000	50,000	10,000	70,000
Works overhead	5,000	90,000	10,000	1,05,000

 

The factory cost of manufacturing a type of ‘C’ pump was prepared by the company as follows:

Particulars	Rs	Rs
Direct Material		16
Direct Wages:
Foundry	2
Machining	4
Assembling	2	8
Works overhead (150% of D/Wages)		12
Factory cost		36

 

It seems that there is some fallacy. Try to correct it.

 

Solution: 11

Illustration: 12

In a factory, there are two service departments P and Q and three production departments A, B and C. In April 2015, the departmental expenses were:

Departments	A	B	C	P	Q
Rs	6,50,000	6,00,000	5,00,000	1,20,000	1,00,000

 

The service department expenses are allocated on a percentage basis as follows:

	A	B	C	P	Q
P	30%	40%	15%	-	15%
Q	40%	30%	25%	5%	-

 Prepare a statement showing the distribution of the two service departments’ expenses to the three production departments by

a)       Simultaneous Equation Method, and

b)       Repeated Distribution Method.

 

Click here for Solution: 12 in PDF