In this article for our level 3 AAT students, we’re going to focus on indirect expenses, in other words, overheads; what are they, how are they budgeted and how are they absorbed.
Management accounting aids the planning, decision making and control cycle used within businesses by enabling the cost of output to be calculated. This is done by combining the three elements of cost; material, labour and expenses. But how to indirect expenses, or overheads, factor into it?
What are overheads?
Overheads can be defined as all the costs of a business that are not direct materials, labour or expenses, that is, they are costs not directly attributable to units of output.
Overheads are a business’s indirect day to day running expenses such as rent, insurance, utilities, telephone and internet costs.
They also include indirect material costs, which are items that can not be directly traced to a unit of output and indirect labour costs, for example, the salaries of all employees who are non-production workers.
How are overheads budgeted?
Management, as opposed to financial, accounting is generally concerned with using financial information to project into the future and produce forecasts and budgets. Historical overhead costs will be used as the basis of upcoming budgets.
Let’s imagine we are the cost accountant for Charlie’s Chocolates Ltd, a company that makes premium quality hand-finished chocolates, and are preparing the budget for the first quarter of the next financial year.
Using the actual overhead costs from the current quarter and adjusting them for expected changes, we have estimated the overheads will be:
Depreciation charge for machinery £186,000
Rent, rates & insurance £72,000
Supervisors’ wages £94,000
Indirect labour £77,000
Light, heat & power £18,000
How are overheads absorbed?
The total budgeted overheads are £447,000.
This means that the company needs to absorb £447,000 into the cost of production over the course of the quarter in order to recover the money to pay these costs.
However, overheads by definition are not part of the cost of output, in this case, chocolates. The direct cost of the chocolates will be calculated (the ingredients and production workers’ labour cost), and an additional amount will be added to cover a proportion of the overheads. This is called the overhead absorption or recovery rate.
Estimated overheads are absorbed into the cost of production, in order for money to be recovered from customers to pay the actual overheads.
The rate is sometimes referred to as a recovery rate and sometimes an absorption rate, so it’s important to realise that they’re the same.
How is the overhead absorption rate (OAR) calculated?
Overheads can be absorbed into the cost of production on either a unit, machine hour or labour hour basis, depending on which is most appropriate.
Let’s say that Charlie’s Chocolates Ltd has five departments, all of which incurred some of the overheads but not equally. However, only two of them, production and finishing, are profit centres, which means they generate income as well as incurring costs.
The production department is machine intensive, but finishing and packing is done by hand. Therefore, machine hours should be used to calculate the production department’s OAR and labour hours for finishing.
However, before we can calculate the OAR’s we need to allocate and apportion the overheads to all five departments, and then reapportion the support department’s costs to the two profit centres in order for the OAR’s to be accurate.
The table below shows the departments and overheads:
This second table shows information that can be used to allocate overheads to a specific department, if they have been entirely incurred by it, or to apportion overheads between departments, if they can’t be allocated to just one.
Allocating the overheads
The first step is allocation. In this case, we have the indirect labour costs for each department and can allocate them accordingly:
Everything else will need to be apportioned, either between all the departments, for example, rent, rates and insurance, or just between a couple, for example, depreciation will only be shared between production and finishing.
Apportioning the overheads
In order to apportion an overhead, we first need to decide on the most appropriate basis of apportionment. This will relate to how the cost has been incurred.
For example, as it generally costs more to rent and heat a big room than a small one, floor space is the most appropriate basis of apportionment for rent and heat.
The basic calculation for apportionment works on proportions.
For example, the £186,000 depreciation cost must be divided between the production and finishing departments. The carrying amount of machinery is the most appropriate basis to use and is valued at £3,000,000 in total, the majority of which is for machinery in the production department.
Therefore, production should be apportioned
£167,400 (£2,700,000 ÷ £3,000,000 x £186,000)
and finishing £18,600 (£300,000 ÷ £3,000,000 x £186,000)
as these amounts are in proportion to the basis of apportionment.
The same method is applied to all the other costs.
Then the totals for each department calculated and cross cast to the overall total of £477,000.
If you would like to have a go, before reading on, you can check your answers with mine once you have done so.
Be careful when you need to round figures that you don’t end up £1 out with any overhead’s total. Apportion the supervisors’ wages on the basis of the production workers labour costs.
The total overheads are now divided between the five departments. The extra rows are used to reapportion the support department costs to the two departments to which the output is directly traceable.
Maintenance staff spend 85% of their time in the production department, administration costs are to be reapportioned equally and stores on the most appropriate basis.
Again if you would like to have a go before reading further, my answers are below for you to check your figures against.
Now we have allocated and apportioned the overheads we can calculate the OARs.
If expected production levels result in budgeted machine hours of 600,000 in the production department and 18,000 budgeted labour hours in the finishing department for the quarter, then the OAR for production will be:
£0.53 per machine hour (£317,951 ÷ 600,000 hours)
and £7.17 per labour hour (£129,049 ÷ 18,000 hours) for finishing.
In the next article we look at how the actual overheads differ from the overheads recovered via the OAR’s, and what that means for over and under absorption.
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Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.