How to Link Manufacturing Overhead to Cost Units: Formula, Examples and Procedure

In this article we will discuss about the procedure for linking manufacturing overhead to cost units. How to Link Manufacturing Overhead to Cost Units: Rate Formula, Examples and Procedure.

In order to arrive at the total cost of production, overhead is added to the prime cost. The overhead, being common/general cost incurred for number of units/cost centres, is to be allocated and apportioned to various departments and then to cost centres and finally absorbed by cost units.

Procedure for Linking Manufacturing Overhead  to Cost Units:

The procedure involved for the final absorption is as under:

(A) Collection of Production overhead.

(B) Departmentalisation of overhead.

(C) Allocation of overhead.

(D) Apportionment of overhead.

(E) Absorption of overhead by cost units.

(A) Collection of Production Overhead:

Generally, each item of production or factory overhead is identified with Standing order Numbers’. These numbers are noted in all the source documents for factory overheads.

For accumulation of the overhead costs the following are some of the documents used:

(1) Stores requisition

(2) Job cards

(3) Purchase vouchers

(4) Pay-bill

(5) Subsidiary records.

Indirect materials are accumulated from stores requisitions. Each of the stores requisitions specifies the standing order number and the department for which stores are issued. The overheads are departmentalised at source. Based on the material/stores requisitions material issue analysis is prepared. At the end of the period the total of indirect materials is charged to factory overhead control account and credited to stores ledger control account.

Indirect labour is collected from time cards and pay rolls. Wages paid to indirect workers against each standing order is obtained from time tickets/job cards. From these documents wage analysis sheet is prepared at the end of the period. The total amount is debited to factory overhead control account and credited to the wages control account.

Indirect expenses are collected from various sources such as cash book vouchers and subsidiary records. In case of cash payments the entries originate in the cash book. Expenses like, depreciation, outstanding expenses, notional rent, etc. Which do not originate from cash book are taken from subsidiary records. At the end of the period the total of indirect expenses is debited to factory overhead control account and credited to cost ledger control account.

Examples of manufacturing overheads:

Factory rent, lighting, heating and power

Fuel and depreciation of machinery

Repairs and insurance of machinery

Factory supervisors’ salary

Unproductive and indirect wages

Miscellaneous material used in production

Normal wastage of materials

Canteen and welfare department expenses

Storekeeping and time keeping expenses

Internal transport and material handling expenses

Tool room expenses

Production or works manager’s salary

Inspection cost

Drawing office cost

Material reconditioning expenses during storage

Training cost

Fire prevention expenses

(B) Departmentalisation of Overheads:

When all the overheads are collected under suitable account headings, the next step is allocation and apportionment of overhead costs to cost centres or departments. This is also called departmentalisation or primary distribution of overhead.

A factory may be divided and subdivided into departments for smooth and efficient functioning. The sub division is done in such a manner as to represent the functions or the activities such as stores department, workshop, cash department, costing department, etc.

Types of Departments:

In a manufacturing company there are three types of departments:

(1) Production departments.

(2) Service Departments.

(3) Partly producing departments.

(1) Production Departments:

These are the departments where actual manufacturing activity is undertaken. In these departments the raw materials are converted into finished products with the help of manual and machine operations. The number and nature of such departments depends on the type of the industry.

For example a cement factory and cotton mill usually have the following production department:

(2) Service Departments:

In these departments there is no production activity but they render service for the benefit of other departments.

The following are the features of service departments:

(1) They are auxiliary departments

(2) They are not directly engaged in production but their existence is essential for continuous production.

(3) They render special type of service for the benefit of other departments.

Depending on nature of industry, size of factory and nature of service to be rendered, a company may have four service divisions, viz., Productive, plant, general and administrative.

Production Services:

Planning

Receipt of material

Material handling.

Plant Services:

Plant engineering

Plant maintenance

Tooling

Plant protection

Sanitation

Boiler house

Safety

General Services:

Welfare

Personnel

Cafeteria

Inspection

Purchasing

General Manager

Works Manager

Administrative Services:

Budgeting

General accounting

Invoicing

Cost accounting

Cash and general office

(3) Partly Producing Departments:

In every concern there may be a few miscellaneous departments. The nature of work done by these departments is such that it is not possible to place them into a particular category of either production or service. They fall within the purview of both categories. For example, if a tool room manufactures some special tools for utilisation in the main job orders, it is acting as a production department even though it is a service department.

Advantages of Departmentalisation:

(1) It separates production overhead costs, and ascertains the total over-head cost of each service department, so that the service department’s costs are correctly distributed to production departments.

(2) It helps in control of costs by assigning and identifying costs with particular departments.

(3) It helps in arriving at the cost of jobs which pass through these departments.

(C) Allocation of Overhead Costs:

I.C.M.A., London has defined cost allocation as the allotment of whole items of cost to cost centres or cost units. In other words allocation is allotment of overhead incurred for a particular cost centre to that specific cost centre. To the extent possible it is better to allocate overheads.

The main conditions for allocation of costs are:

(1) The cost centre should be responsible for incurring such costs.

(2) The amount of overhead to be allotted should be specific.

(D) Apportionment of Overhead Costs:

Charging a fair share of overhead to each cost centre is termed as apportionment. I.C.M. A., London defined it as “the allotment to two or more cost centres of proportions of common items of cost on estimated basis of benefit received”.

If an item of overhead cost cannot be allocated to cost centres, it has to be apportioned. For apportionment suitable basis has to be selected so that overheads are equitable distributed between various cost centres.

Distinction between Allocation and Apportionment:

There is clear distinction between cost allocation and apportionment. It is necessary to understand the difference clearly so that the terms are not loosely used. No doubt the objective of both allocation and apportionment is to identify the overhead costs with different cost centres and cost units.

But they differ in several aspects-

(1) Allocation deals with whole items of cost while apportionment deals with parts or portions’ of items of cost.

(2) Allocation is directly attributing the items of overheads to cost centres and units. Apportionment takes recourse to the indirect method of equitable subdivision of items of cost.

(3) Allocation does not need any basis. Apportionment is mainly dependent on suitable ‘Bases’ for subdivision of items of overhead.

(4) Sometimes apportionment starts when allocation ends. For example factory rent is allocated fully to the factory. But, it has to be apportioned to different department or division in the factory.

Distribution of overhead consists of apportioning and allocation of overhead to the different departments. The distribution fs followed by redistribution of the costs assigned to certain departments.

The distribution is of two types:

(I) Primary distribution of Overheads, and

(II) Secondary distribution of Overheads.

(I) Primary Distribution of Overheads:

Primary distribution of overheads is the process of allocating and apportioning the costs on suitable basis to all the departments or cost centres. Primary distribution is done without distinction between production and service departments.

Bases of Apportionment:

In order to ascertain the correct cost of cost centres and cost units, suitable bases have to be adopted for allocation and apportionment of overhead.

The undermentioned are some of the bases adopted for apportionment of manufacturing overheads:

(1) Direct Allocation:

Wherever traceable, overheads are to be directly allocated to particular departments. Examples are power, overtime premium of particular departments.

(2) Labour Hous:

Overheads are apportioned on the basis of direct labour hours of different departments.

(3) Machine Hours:

Overheads are distributed on the basis of machine hours worked in each department.

(4) Value of Direct Material Consumed:

This basis is used for apportioning indirect materials and material handling charges.

(5) Direct Wages:

Direct wages is used as basis to apportion indirect wages and general overheads.

(6) Number of Staff:

Number of employees in each department is taken as basis to apportion overheads cost incurred for the welfare of workers.

(7) Floor Area of Departments:

The area occupied by different departments is taken as basis to apportion expenses like rent, property tax, and lighting, heating and building maintenance expenses.

(8) Capital Values of Assets:

Capital values of assets of different departments is taken as basis to apportion depreciation, repairs and maintenance, insurance of assets, etc.

(9) Light Points:

The light points of various departments is taken as basis to apportion lighting expenses.

(10) Kilowatt Hours:

The kilowatt hours of various departments is taken as basis to apportion power expenses.

Principles or Criteria for Apportionment of overheads:

The following are the methods of apportionment, based on the principles or criteria:

(1) Service or Use Method:

Under this method the service or benefit rendered to different department is the basis of apportionment of overhead. The service rendered to various departments can be measured and it is fair and equitable to use, since benefit received is the criterion for apportionment. For example rent charges are apportioned on “area occupied” basis.

(2) Analysis or Survey Method:

For some items of overhead it may not be possible to measure the proportion of benefit derived. In such a case a survey or analysis is made to reveal the extent of overheads to be charged to different departments. Examples are foreman’s salary, power expenses when meters are not maintained separately, etc.

(3) Ability to Pay Method:

Under this method overhead costs are apportioned on the basis of capacity to bear, i.e., sales volume or profits of different departments. Higher the profits/sales value of the job more is the overhead charged. This method is generally not used since it is considered inequitable. It penalises the efficient and profitable units of a business to the advantage of the inefficient ones.

(4) Efficiency or Incentive Method:

This is a scientific method of apportionment. Under this method the output is budgeted and efficiency is measured by comparing actual with budgets. If the actual output exceeds the budget the incidence of overhead cost is reduced and the cost per unit is lowered. If the targets are not achieved the unit cost goes up revealing the inefficiency of the department.

An organisation may use one or more criteria depending on its nature and size. The following table shows, different items of overhead cost and the basis to be adopted for apportionment.

(II) Secondary Distribution of Overheads:

Secondary distribution is the process of redistribution of service department costs to production departments.

This is done as output or jobs pass through one or more production cost centres only. This kind of distribution is called secondary apportionment. Suitable bases have to be adopted for redistribution of service department cost to production departments.

The basis to be selected depends on the nature of service rendered by service department. The following are some of the general bases selected for apportionment of service department costs.

Methods of Secondary Distribution:

Once the basis of apportionment of service department costs has been finalised the apportionment can be done by using any of the following methods of secondary distribution.

Direct Reapportionment Method (Without Considering Inter Service):

Under direct redistribution method overhead of service departments are apportioned to production departments only while inter service by service departments to each other is ignored. This method fails to obtain correct cost of each service department as service cost from other cost centres is not included. Control of costs of service cost centres is in effective as the full cost of service departments is not available.

Apportionment, Considering Inter Service:

Here service rendered by service departments to each other is considered. Therefore service department costs are redistributed to other service departments and production departments.

This may be either:

(a) Non Reciprocal Apportionment.

(b) Reciprocal Apportionment Method.

(a) Non Reciprocal Apportionment:

Under this method service departments are arranged in the descending order of serviceability. The service department which renders service to all or maximum number of the other service department which production departments is taken up for distribution. Then the second service cost centres have been distributed to production departments. This method is also called step method (or) step ladder method because the tabulation of the distribution resemble a step ladder.

(b) Reciprocal Apportionment Methods:

These methods consider mutual service rendered by service departments among themselves along with the service rendered to production departments.

These method recognise service rendered by service departments to each other to arrive at correct cost of each department and finally accurate production costs. Costs arrived at are more accurate but voluminous clerical work is involved.

The following are the reciprocal apportionment methods:

(1) Repeated distribution or Attrition method.

(2) Simultaneous equation method.

(3) Trial and error method.

(1) Repeated Distribution or Attrition Method:

Under this method the overheads of service departments are distributed to production and service departments on the basis of the percentages agreed upon as reasonable. The process is repeated till the service department overhead cost becomes negligible. In other words the process of apportionment of service department overheads is repeated till the balance of service departments becomes nil and the service department costs are fully transferred to production departments.

(2) Simultaneous Equation Method:

In this method the service rendered by each service department to other departments is estimated. One service department may render service to another service department and also receive its service in return. Based on the percentage of service estimates, simultaneous algebraic equations are formed, assuming the total overhead of one service department as ‘x’ and that of another service department as ‘y’. The simultaneous equation are solved for the values of ‘x’ and ‘y’. Based on these values, the overhead of each service department is directly transferred to production departments.

(3) Trial and Error Method:

Under this method the process of repeated distribution is used in respect of service departments only. It is done on the basis of agreed percentages for the mutual service. After several divisions, the overhead balance for each department becomes negligible. At this stage further division is stopped and the total amounts of each department at this stage are ascertained. These total overheads of the service departments are then distributed to the production departments.

(E) Absorption of Overhead:

The last step is the process of accounting for manufacturing overhead is ‘Absorption’ of the overhead.

The process of charging the overhead cost of a cost centre to the cost units is called overhead absorption.

According to I.C.M.A, overhead absorption is “the allotment of overhead to cost units by means of rates separately calculated for each cost centre.” The terms ‘overhead absorption’, ‘recovery’, ‘charge’ and ‘application of overheads’ are used interchangeably. Allotment of overhead to cost units is of great importance as each unit of output should share a reasonable portion of overhead, besides bearing the cost of direct material and wages. Overhead absorption is accomplished by overhead rates.

Overhead Rates:

Absorption of overheads is the ‘charging’ of overheads of a department or a cost centre to the cost units which pass through the department or cost centre. In order to equitably charge the overhead expenses to cost units a suitable base must be adopted. The base selected is used to calculate a uniform ‘Rate’ to absorb the overheads which is called ‘Absorption rate’.

The absorption rate is calculated by dividing the overhead by the units of base selected such as units of production, labour hours, machine hours, etc. The overhead cost of products or jobs is arrived at by multiplying the rate by units of base contained in the job product or process, etc.

The absorption rate and the overhead to be absorbed by a product can be ascertained as given below:

Overhead absorbed by a product = Overhead rate x Number of units of base contained in the product.

Types of Overhead Rates:

The following are the main overhead rates generally discussed in cost accounting literature:

(I) Actual Overhead Rates:

Actual overhead rate is obtained by dividing the actual overhead incurred during a period by the actual quantum of the base selected.

Under actual overhead rate method the overheads are recovered on actual basis. It is not desirable to use actual rate for recording overheads, since it suffers from the following disadvantages.

(a) Delay in Calculating the Rate:

The actual rate can be calculated after incurring the overhead and ascertainment of data for calculation of the rate. This may be possible only at the end of the’ accounting period. It causes delay in determination of cost of jobs and products.

(b) Fluctuations in Rate:

Certain items of overhead costs are not incurred uniformly during the year, such as repairs and leave wages. Some of the items are incurred periodically. Example- insurance premium and overhead cost may also differ from month to month. Due to these reasons the actual overhead rate may fluctuate widely makes comparison of costs very difficult.

Comparisons:

Actual overhead rates are useful for comparison with predetermined rates to assess actual performance. Thus, actual overhead rates are useful only when compared with established standards.

(2) Predetermined Overhead Rates:

Predetermined overhead rates are more practical and useful as the rate is calculated well in advance of an accounting period. Cost of products and jobs can be ascertained as and when they are completed. Moreover rates are calculated and compared with predetermined rates for control purpose.

In every organisation where budgetary control is in operation, the data required for computation of predetermined rates will be readily available without additional clerical cost. The only disadvantages of predetermined overhead rates is that they may result is under/over absorption of overheads.

(3) Blanket Overhead Rates:

A single absorption rate may be calculated for the entire factory. This is known as the blanket rate.

Blanket rates are practicable in small concerns or where all the products pass through all the departments cost centres and operations and overhead is incurred uniformly in all the departments. When these conditions are not satisfied blanket rate may lead to erroneous and misleading results. Therefore multiple rates are calculated.

(4) Multiple Overhead Rates:

When different rates are calculated for different departments, cost centres, fixed overheads and variable overheads, then the rates calculated are known as multiple rates.

Multiple rate is calculated as under:

Under Absorption and Over Absorption of Overheads:

Overheads are absorbed on the basis of actual rate or predetermined rate. If actual rates are used, the overhead absorbed and incurred will be equal. But in practice due to the “time” limitation of actual overhead, overheads are generally charged on the basis of predetermined overhead rates. This may result in difference in overhead absorbed and overhead incurred. Such a difference is called under/over absorption of overheads.

Over Absorption or Over-Recovery of Overhead:

When expenses absorbed are more than actual expenses incurred it is known as over absorption.

Over absorption = Actual expenses < Expenses absorbed

Under Absorption or Under Recovery:

When expenses absorbed are less than the actual overhead incurred it is known as under absorption.

Under absorption = Actual Expenses > Expenses absorbed.

I.C.M.A., London defined under or over absorption of overhead as “the difference between the amount of overhead absorbed and the amount of overhead incurred”.

Causes for over – or under- recovery (absorption) of overheads are as follows:

(1) Actual hours may be more or less than budgeted hours.

(2) Actual output may be more or less than budgeted output.

(3) Actual overhead incurred may be less or more than budgeted overhead.

(4) Expenses which were not anticipated may be incurred.

(5) Mistake in estimation of overhead expenses or bases of calculating predetermined rates.

(6) Seasonal fluctuations in level of production.

(7) Under utilisation of capacity.

(8) Changes in the techniques and methods of production.

Treatment of Over-Or Under-Absorbed Overhead:

Three methods of disposal of under or over absorption of overhead are used:

(1) Use of supplementary rate.

(2) Write off to costing profit and loss account.

(3) Carry Forward to the Next Year’s Account:

(1) Use of Supplementary Rate:

Under this method a rate is calculated by dividing the under or over absorbed overhead by quantum of the base.

The amount of under or over absorbed overhead is adjusted to-

(a) Finished goods

(b) Work-in-progress

(c) Factory cost of sales by supplementary rates.

The amount of under absorbed overhead is adjusted by ‘Positive rate’ by adding the amount to respective accounts.

Over absorbed overhead is adjusted by ‘negative rate’ by deducting the amount from the accounts concerned. This method is applied only when the amount of under/over absorption of overhead is high. The effect of applying supplementary rate is recovering of expenses at actual rates.

(2) Writing Off to Costing Profit and Loss Account:

If the under or over absorption is due to idle facilities and the amount is small, then the amount is written off to costing profit and loss account instead of calculating a supplementary rate by complicated procedure. The main defect of this method is stocks are either under or over-valued due to under or over absorption. Therefore it affects the profits.

(3) Carry Forward to the Next Year’s Account:

Under this method the under or over absorbed amount is carried forward to next year’s account by transferring to ‘Overhead Suspense Account’. This method is suitable when the normal business cycle is more than one year and in case of newly commenced businesses when the output low in the initial stages which cannot bear the entire amount of overhead.

The carried forward amount is absorbed by the production of subsequent years. The main criticism of this method is that it will distort the costs and more over the amount of under or over absorption has to be absorbed in the period of incurring and should not be carried forward.