Overhead Allocation

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					ACCG304 Lecture 6:

Overhead Allocation
Lecture Objectives
Upon completing this lecture, students should be able to understand costing and accounting procedures relating to the treatment of factory overhead. In particular, the procedures associated with the use of a predetermined overhead rate will be considered.

Lecture Outline
6.1
Definition of Factory Overhead: • Overhead Contrasted to Direct Materials and Labour, • Overhead Cost Behaviour. Allocation of Factory Overhead.

6.2 6.3 6.4

Plant Wide overhead rates

Departmental Overhead Rate.

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6.1 Definition of Factory Overhead
Overhead Contrasted to Direct Material and Labour
Direct material becomes a component part of the finished product and can be measured in relation to units of production. Direct labour is expended on the product in the course of its manufacture and can be measured in relation to units of production. FACTORY OVERHEAD (referred to as INDIRECT manufacturing costs) in most cases does not bear a direct relationship to the product, either physically or in cost per unit – nevertheless, these costs need to be accounted for and be allocated to units of production.

FACTORY OVERHEAD MAY BE DEFINED AS EITHER: 1. ALL FACTORY COSTS OTHER THAN DIRECT MATERIALS AND DIRECT LABOUR. ALL THOSE FACTORY COSTS WHICH CANNOT BE TRACED OR ARE NOT WORTHWHILE TRACING TO INDIVIDUAL UNITS OF PRODUCTION.

2.

Materials

INDIRECT

DIRECT

Factory Overhead

Work in Progress

Finished Goods

Cost of Goods Sold

INDIRECT

DIRECT

Labour

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Examples of factory overhead include: • • • • • Indirect Materials and Indirect Labour Depreciation of Factory Buildings & Equipment Insurance on Factory Buildings and Equipment Power and Electricity Repairs and maintenance Semi-variable cost Fixed Cost Fixed Cost Semi-variable cost Semi-variable cost

Most overhead cost items are either Semi-variable or Fixed Costs. Overhead costs have to be allocated to units of production. In the calculation of the predetermined overhead rate, the very first step is to categorise all overhead costs into fixed and variable categories. This can be accomplished using the High-Low method of cost analysis and estimation.

6.2 Allocation of Factory Overhead
This is accomplished by the use of a Predetermined Overhead Rate. In essence this rate is calculated by the use of the following formula.

Total Budgeted Factory Overhead = $ per unit of activity Budgeted Level of Activity (usually normal capacity)

This may be determined as a rate for each productive department in the factory or for the factory as a whole (plant wide).

6.3 Single plant-wide application rates
A SINGLE PLANT WIDE overhead application rate may be used in those situations where: (i) where all departments use similar operating processes, be it mechanised or labour intensive; where the factory only produces a single product or the entire factory consists of a single process; the factory is small with production moving through all departments.

(ii)

(iii)

Where there are departures from the above production scenarios, due to multiple products being manufactured, or diversity of production operations due to different types of production processes etc., the use of a Plant Wide Overhead rate will lead to mis-costing and consequently mis-pricing of products as:

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• •

single cost allocations make a dangerous assumption that costs are driven by a single activity variable do not provide product cost information useful for managerial decision making.

The calculation of a Plant Wide Factory Overhead rate to be used for applying overhead to units of production, is accomplished by dividing the total expected overhead costs for the coming period by a single activity cost driver. For example : Forecast Total Overhead for the coming Year Expected Machine Hours for the coming year $300,000 60,000

Plant Wide Overhead Rate

=

Forecast Overhead -------------------------------------------Expected Machine Hours

= =

$300,000 / 60,000 $5.00 per Machine Hour

The overhead rate of $5.00 per machine hour is used to apply overhead to all production irrespective of whether the production order is labour intensive or machine intensive. Consequently, a single plant wide overhead rate may lead to a misallocation of resources.

6.4 Calculation of Predetermined DEPARTMENTAL Overhead Rate
Overhead is charged (applied) to production on the basis of a Predetermined Rate which is calculated in advance of production. The steps involved in the calculation of the predetermined overhead rate are : Step 1. Allocating budgeted overhead costs to both Service and Producing Departments. Redistribution of Service department costs to Producing Departments. Calculating the Cost Allocation (overhead application) rates to enable the allocation of Producing Department costs to Units of Production.

Step 2. Step 3.

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Step 1 - Distributing Budgeted Overhead Costs to Departments
Factory overhead is distributed to departments as accurately as is possible. Direct Department Costs - Any costs directly attributable to a service or production department are allocated first, for example, foreman's salary, indirect materials etc. Indirect Department Costs - the remaining overhead costs are allocated to both service and producing departments using cost drivers, or allocation bases selected because of an empirical or logical relation between the cost and the department.

Example: Service Department Cost Allocation
A factory comprises four departments as follows: Two Service Departments namely: • ( 1 ) Storeroom ( 2 ) Repairs & Maintenance Two Producing departments namely: • ( 1 ) Machining ( 2 ) Assembly Details of expected costs and operating characteristics are as follows: Storeroom R&M Machining Direct Department Costs Salaries Indirect Labour Indirect Material Other direct costs Total Direct Costs 10,400 2,000 8,000 20,400 19,800 3,000 1,300 6,000 30,100 15,600 6,000 4,200 14,000 39,800

Assembly

Total

17,300 8,400 6,000 13,000 44,700

63,100 17,400 13,500 41,000 135,000

Indirect Department Costs Rent Factory Administration Insurance on Buildings Insurance on Plant Total Indirect Department Costs

$ 8,000 12,000 5,000 10,000 35,000

Operating Characteristics Floor Space Occupied Number of Employees Value of Plant Expected Material Requisitions Expected Machine Hours Expected Direct Labour Hours

Storeroom R & M Machining Assembly 2 2 2 200m 100m 400m 300m2 5 8 20 27 1,000,000 6,000,000 3,000,000 20 60 40 50,000 10,000 42,000 84,000

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The initial problem is to allocate the Indirect Departmental Costs to both Service and Producing Departments. This initial allocation should be accomplished using "cost drivers" or allocation bases that are closely related to the incurrence of the cost. In the above example: • Rent and Insurance on Buildings should be allocated on the basis of floor space occupied, • Insurance on Plant on the basis of plant values, • Factory Administration on the basis of the number of employees in each department. Thus the allocation is as follows: Direct Department Costs Rent Factory Administration Insurance on Buildings Insurance on Plant Total Indirect Costs
Storeroom R&M Machining Assembly Total

In summary, the total overhead for each department is as follows:
Storeroom R&M Machining Assembly Total

Direct Department Costs Indirect Department Costs Total Indirect Costs

Step 2 - Redistributing Service Department Costs to Producing Departments
After the factory overhead costs have been distributed to each department, the next step is to redistribute service department costs to producing departments. The reason for this type of distribution becomes evident when it is considered that producing departments are the only departments through which the products being manufactured flow. In addition, if overhead rates are to be reasonable estimates of the amount of factory overhead applicable to units produced, such rates must include: • costs incurred within the producing departments, as well as • costs incurred for the service departments.

Service departments (storeroom, repairs and maintenance, factory office, etc.) exist solely for the purpose of facilitating the operations of the producing departments, and thus they are in effect costs of the producing departments. There are many methods of redistributing service department costs to producing departments the main ones being:

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• Direct Method - where the costs of each service department are reallocated to the producing departments (with no service department costs being allocated to any other service department). • Step Method - where a sequence of reallocation is used, starting with that service department that renders the greatest amount of service to other service departments; the sequence continues in step by step fashion and ends with the reallocation of costs of that service department that renders service to the lowest amount of other service departments.

Example:

Direct Method
The Direct Method reallocates each service department's total costs directly to the producing departments with no service department's cost being allocated to any other service department

Using the above example:
The storeroom would be reallocated to producing departments according to the service rendered to producing departments as measured by the number of materials requisitions in each producing department. Repairs and maintenance would be reallocated to producing departments according to the service rendered to producing departments as measured by the expected machine hours in each producing department.
Storeroom R&M Machining Assembly Total

Total Indirect Costs Reallocation Storeroom R&M Total

25,000

33,000

55,000

57,000

170,000

Step Method:
Using the example outlined previously, the costs of:
• • • The storeroom would be reallocated to the other departments according to the service rendered by way of material requisitions ; The repairs and maintenance department would be reallocated according to machine hours. Further, as a sequence of reallocations needs to be determined, it is presumed that the storeroom renders greater service to repairs and maintenance, hence it would be allocated first.
Storeroom R&M Machining Assembly Total

Total Indirect Costs Reallocation Storeroom R&M Total

25,000

33,000

55,000

57,000

170,000

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Step 3 - Cost Allocation from Producing Departments to Products
The third and final step in the calculation of the predetermined departmental overhead rate is to divide the total factory overhead costs distributed to each producing department (including its share of service department costs) by the

Measure Of Activity most appropriate for each producing department. The objective of this step is to determine the amount of overhead that is to be allocated to units of production. The allocation base (denominator level of activity) may be based on, number of units expected to be produced, expected machine hours, expected direct labour hours, expected direct labour cost or some other appropriate activity measure.

Example:
For the Machining department (because it is an automated department) Machine hours would be the activity base, whereas the Assembly department is a labour intensive department, hence direct labour hours (or direct labour cost) would be more appropriate

Using the example above:
The predetermined overhead rate would be determined as follows:

Direct Method - Overhead Rates
Predetermined Overhead Rate Calculation

Machining

Assembly

Step Method - Overhead Rates
Predetermined Overhead Rate Calculation

Machining

Assembly

The amount of overhead that is to be allocated to units of production is based on the above calculation.

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Lecture Demonstration Problem:
Billy Long Company has departmentalised its operations into TWO Service Departments, General Factory Office and Employee Relations and THREE Production Departments, Mixing, Fabricating and Finishing. For the year ending December 31, the firm budgeted the following DIRECT DEPARTMENTAL COSTS: General Employee Factory Relations Office $40,000 $70,000 2,000 4,000 1,000 5,000 $43,000 $79,000 Mixing Fabricating Finishing Total

Salaries & Wages Depreciation Supplies

$180,000 35,000 18,000 $233,000

$210,000 40,000 16,000 $266,000

$250,000 50,000 20,000 $320,000

$750,000 131,000 60,000 $941,000

The company estimates that INDIRECT DEPARTMENT COSTS will be: Insurance Rent, Heating & Lighting $32,200 $97,200

It will use the following bases to allocate indirect expenses to departments: 1. Insurance expense is allocated on the basis of equipment values : General Employee Factory Relations Office $20,000 $25,000 Mixing Fabricating Finishing Total

Equipment Values 3.

$130,000

$175,000

$110,000

$460,000

Rent, heating and lighting costs are to be allocated on the basis of floor space occupied. General Employee Factory Relations Office 1,000 800 Mixing Fabricating Finishing Total

Space Occupied

4,000

2,000

3,000

10,800

General Factory Office is allocated first on the basis of labour-hours and Employee Relations is allocated second on the basis of number of employees. The company provides the following estimated data for use in this allocation: General Employee Factory Relations Office 10,000 12,000 60 30 Mixing Fabricating Finishing Total

Labour-hours Number of Employees Machine Hours Required: (a)

23,200 144 63,540

25,600 228 105,800

19,200 168 85,725

90,000 630 255,065

Using the DIRECT Method of service department reallocation, prepare departmental overhead expense allocations. Develop overhead rates per machine hour. Using the STEP Method of service department reallocation, prepare departmental overhead expense allocations. Develop overhead rates per machine hour. Calculate the PLANT WIDE overhead rate using Machine Hours as the denominator level of activity.

(b)

(c)

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SOLUTION (a) DIRECT METHOD of Service Department Reallocation
General Factory Office Direct Dept. Costs Salaries & Wages Depreciation Supplies Indirect Dept. Costs Insurance Rent, Heating & light $40,000 2,000 1,000 $43,000 Employee Relations Mixing Fabricating Finishing Total

$70,000 4,000 5,000 $79,000

$180,000 35,000 18,000 $233,000

$210,000 40,000 16,000 $266,000

$250,000 50,000 20,000 $320,000

$750,000 131,000 60,000 $941,000 32,200 97,200 129,400 $1,070,400

Total Dept Overhead DIRECT METHOD of Reallocating Service Department Costs General Factory Office Employee Relations TOTAL O/H In PRODUCING DEPARTMENTS Denominator Level of Activity PREDETERMINED OVERHEAD RATE

The TOTAL COLUMN relates to control totals as well as facilitating the calculation of PLANT-WIDE Overhead rate.

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SOLUTION (b) STEP METHOD of Service Department Reallocation
General Factory Office Direct Dept. Costs Salaries & Wages Depreciation Supplies Indirect Dept. Costs Insurance Rent, heating & light. $40,000 2,000 1,000 $43,000 Employee Relations Mixing Fabricating Finishing Total

$70,000 4,000 5,000 $79,000

$180,000 35,000 18,000 $233,000

$210,000 40,000 16,000 $266,000

$250,000 50,000 20,000 $320,000

$750,000 131,000 60,000 $941,000 32,200 97,200 129,400 $1,070,400

Total Dept Overhead STEP METHOD of Reallocating Service Department Costs General Factory Office Employee Relations TOTAL O/H In PRODUCING DEPARTMENTS Denominator Level of Activity PREDETERMINED OVERHEAD RATE