1. Accounting for Overheads and Marginal
costing
Overheads
Overhead is the cost incurred in the course of making a product, providing a service or running a
department, but which cannot be traced directly and fully to the product, service or department.
Overhead is actually the total of the following:-
 Indirect materials
 Indirect labor
 Indirect expenses
In cost accounting, there are two schools of thoughts as to the correct method of dealing with
overheads:-
 Absorption costing
 Marginal costing
There are four categories of overheads.
1. Production/ manufacturing overheads
2. Marketing/ selling and distribution overheads
3. Research and development overheads
4. Administration overheads
Allocating Overheads to Products
In general, overheads are charged to products through two stages.
1. Overheads are assigned to cost centers
2. Accumulated costs at cost centers allocated to the products
Overhead Cost Allocation & Apportionment
1. Costs are specifically allocated, where they can be ascertained specifically and charged to a
particular cost centre.
Example: The depreciation of machines in production division.
In here, the depreciation of machines in production division, which is considered as a cost centre, can
be charged (allocated) to that cost centre.
2. When overhead item is a common cost, the cost item is apportioned to the cost centers that
benefit from the cost on an appropriate basis (e.g. machine hours, number of employees etc.).
3. The overheads are to be allocated to service department as well as to production
departments.
4. Service department overheads are to be absorbed through jobs or products passing through
production department. So service department costs are re-apportioned to production
departments.
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2. Absorption costing stages
Allocation Apportionment Absorption
Overhead allocation
Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre
For example, the following cost will be charged to the following cost centers via the process of
allocation:-
 Direct labor will be charged to the production cost centre
 The cost of warehouse security will be charged to the warehouse cost centre
 Costs such as canteen are charged direct to the various overhead cost centers.
Overhead Apportionment
Apportionment of overhead is distribution of overheads to more than one cost centre on some
equitable basis.
When the indirect costs are common to different cost centers, these are to be apportioned to the
cost centers on an equitable basis. For example, the expenditure on general repair and
maintenance, If the department is involved in the production of a single product, the whole repair
& maintenance of the department may be allocated to the product. If not it will be apportioned
according to their use of the above-mentioned cost. We can use several ways as basis of
apportionment, when dividing the cost between different cost centers. Examples,
Overhead to which basis apply Basis of apportionment
Rent, rates, heating and light, repairs and Floor area occupied by each cost centre
depreciation of building
Deprecation and insurance of equipment Cost or book value of equipment
Personnel, office, canteen, welfare, wages and Number of employees, or labor hours worked in
costs of offices, first aid each cost centre
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3. For services…
Service cost centre Possible basis of apportionment
Stores Number of cost value of material requisitions (requisitions - An official
order laying claim to the use of property or materials)
Maintenance Hours of maintenance work done for each cost centre
Production planning Direct labor hours worked in each production cost centre
Overhead Absorption
Determine an absorption rate at which the cost of each cost centre is charged to jobs / products
passing through the cost centre.
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑐𝑒𝑛𝑡𝑟𝑒
𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 𝐴𝑝𝑝𝑟𝑜𝑝𝑟𝑖𝑎𝑡𝑒 𝑏𝑎𝑠𝑖𝑠
Overhead costs absorbed by individual products at an absorption rate based on the total expected
output or volume of input. Example,
 Total Overhead of dept = Rs. 10,000
 Total labor hrs = 250
 Absorption rate = 10,000/250 = Rs. 40 per labor hr
Example:
Job 232 is one of many jobs that pass through the assembly cost center during a period. The
only work done on job 232 is assembly work and its direct costs are,
 Direct materials 65
 Direct labor ( 5 hours @ Rs 18) 90
 Total Overhead on Assembly cost center 225000
Expected that 9,000 hours will be worked in total during the period, what is the total
production cost of job 232?
Overhead absorption rate = 225000/90000 = 25
Total Direct Cost = 155
Total production cost = Total Direct Cost + OAR = 155 + 25 = 180
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4. Re – apportionment of service department costs
Once the overhead have been allocated and apportioned to production and service
departments and totaled, the next step is to reapportion the service department costs to
production departments.
Here is an Example that talks about full cycle of allocation, apportion, absorption, and re-
apportion. Here we talk about three basic methods of allocating service department costs.
1. Continuous Allotment
2. Simultaneous Equation method
3. Specified order of Re-Allocation
Choice of Overhead Rates
• The overhead rate is calculated based on several alternative bases. The basis chosen should be
suitable for the cost centre activities.
𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝐷𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟 𝑟𝑎𝑡𝑒 =
𝐷𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠
𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟 𝑟𝑎𝑡𝑒 =
𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠
𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟 ℎ𝑒𝑎𝑑
𝐷𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑒 =
𝐷𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡
In above example we used the second way, 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟 𝑟𝑎𝑡𝑒 = (𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑)/(𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠)
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5. Absorption and marginal costing
Absorption - Before we allocate all manufacturing costs to products regardless of whether they are
fixed or variable. This approach is known as absorption costing/full costing. It is costing system, which
treats all manufacturing costs including both the fixed and variable costs as product costs
Marginal - However, only variable costs are relevant to decision-making. This is known as marginal
costing/variable costing. It is a costing system, which treats only the variable manufacturing costs as
product costs. The fixed manufacturing overheads are regarded as period cost
Practical reasons for using absorption costing
Inventory in hand must be valued for two reasons, In absorption costing, closing inventory is valued at
fully absorbed factory costs :-
 For the closing inventory figure in the statement of financial position
 For the cost of sales figure in the statement of comprehensive income
Many companies attempt to fix selling prices by calculating the full cost of production or sales of each
product, and then adding a margin for profit. Without using absorption costing, a full cost is difficult to
ascertain.
If a company sells more than one product, it will be difficult to judge how profitable each individual
product is, unless overhead costs are shared on a fair basis and charged to the cost of sales of each
product
Here is a example for absorption and marginal costing
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6. Difference between absorption and marginal costing
Absorption costing Marginal costing
Treatment for Fixed manufacturing overheads are Fixed manufacturing overhead is treated
fixed treated as product costing. It is believed as period costs. It is believed that only
manufacturing that products cannot be produced the variable costs are relevant to
overheads without the resources provided by fixed decision-making.
manufacturing overheads
Fixed manufacturing overheads will be
incurred regardless there is production or
not.
Value of closing High value of closing stock will be Lower value of closing stock that
stock obtained as some factory overheads are included the variable cost only
included as product costs and carried
forward as closing stock
Argument for absorption costing
 Compliance with the generally accepted accounting principles
 Importance of fixed overheads for production
 Avoidance of fictitious profit or loss
o During the period of high sales, the production is small than the sales, a smaller
number of fixed manufacturing overheads are charged and a higher net profit will be
obtained under marginal costing
o Absorption costing is better in avoiding the fluctuation of profit being reported in
marginal costing
Arguments for marginal costing
 More relevance to decision-making
 Avoidance of profit manipulation
o Marginal costing can avoid profit manipulation by adjusting the stock level
 Consideration given to fixed cost
o In fact, marginal costing does not ignore fixed costs in setting the selling price. On the
contrary, it provides useful information for break-even analysis that indicates whether
fixed costs can be converted with the change in sales volume
Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my-
business-economics-and-financial.html