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Cost allocation

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Cost allocation

  1. 1. Cost Allocation <ul><li>What is overhead? </li></ul><ul><li>Basis of classifying overheads </li></ul><ul><li>Various types of overheads </li></ul><ul><li>Steps in overhead accounting </li></ul><ul><li>Basis of Apportionment of Overheads </li></ul><ul><li>Principles of Apportionment </li></ul><ul><li>Methods of Reapportionment </li></ul><ul><li>Absorption of overheads </li></ul><ul><li>Methods of absorption </li></ul><ul><li>Under absorption </li></ul><ul><li>Over absorption </li></ul>
  2. 2. Definition of Overheads <ul><li>The CIMA defines overhead cost as “the total cost of indirect materials, indirect labor and indirect expenses. In short, it is the cost of materials, labor and expenses that cannot be economically identified with specific saleable cost unit. </li></ul>
  3. 3. Classification of Overhead Costs
  4. 4. Element wise Classification
  5. 5. Steps on Overhead Accounting <ul><li>The various steps in an overhead accounting are: </li></ul><ul><li>Collection of overhead details </li></ul><ul><li>Distribution of overhead to cost centers </li></ul><ul><li>Reapportionment of service department costs to production departments </li></ul>
  6. 6. Primary Distribution of Overheads and Reapportionment of Overheads <ul><li>Refer to the Word file Attached </li></ul>
  7. 7. Basis of apportionment of overheads <ul><li>Direct Allocation </li></ul><ul><li>Direct Labor Hours </li></ul><ul><li>Direct Wages </li></ul><ul><li>Number of workers </li></ul>
  8. 8. Methods of Reapportionment <ul><li>Direct Redistribution </li></ul><ul><ul><ul><li>Chances of overcharge or under charge </li></ul></ul></ul><ul><ul><ul><li>Non accuracy in department overhead rates </li></ul></ul></ul><ul><li>Step Method </li></ul><ul><ul><ul><li>Apportioning service department costs </li></ul></ul></ul><ul><li>Reciprocal Service Method </li></ul><ul><ul><ul><li> Simultaneous equation method </li></ul></ul></ul><ul><ul><ul><li>Repeated distribution method </li></ul></ul></ul><ul><ul><ul><li>Trial and error method </li></ul></ul></ul>
  9. 9. Illustrations… <ul><li>Refer to the Word file Attached </li></ul>
  10. 10. Absorption of Overheads <ul><li>“Process of allocating the overhead expenses to the cost centers/cost units is known as overhead absorption” </li></ul>
  11. 11. Absorption rates <ul><li>Actual rate </li></ul><ul><li>Predetermined rate </li></ul><ul><li>Moving average rate </li></ul><ul><li>Blanket and multiple rates </li></ul>
  12. 13. Rate per unit of production <ul><li>OH rate = Budgeted overhead expenses Budgeted production </li></ul><ul><li>Features: </li></ul><ul><ul><ul><li>Simple /easy to use </li></ul></ul></ul><ul><ul><ul><li>Suitable for extractive industries </li></ul></ul></ul>
  13. 14. Direct Wages Method <ul><li>OH rate = Budgeted overhead expenses                                Direct wages </li></ul><ul><li>Advantages: </li></ul><ul><ul><ul><li>Consideration of time factor </li></ul></ul></ul><ul><ul><ul><li>Stability of labor rates </li></ul></ul></ul><ul><ul><ul><li>Proportional charge to production </li></ul></ul></ul><ul><ul><ul><li>Easy availability of data </li></ul></ul></ul><ul><ul><ul><li>Most appropriate in certain  situations </li></ul></ul></ul><ul><li>Limitations: </li></ul><ul><ul><ul><li>Not related to efficiency of workers </li></ul></ul></ul><ul><ul><ul><li>Consideration of time factor (piece rate basis) </li></ul></ul></ul><ul><ul><ul><li>Ignores contribution by other factors of production </li></ul></ul></ul><ul><ul><ul><li>No distinction between fixed and variable expenses </li></ul></ul></ul>
  14. 15. Production hour method <ul><li>OH rate = Budgeted overhead expenses                 Total productive hours of direct labor </li></ul><ul><li>  Advantages: </li></ul><ul><ul><ul><li>When job is labor-oriented </li></ul></ul></ul><ul><ul><ul><li>Uniform time for various jobs </li></ul></ul></ul><ul><ul><ul><li>No impact on rate by the method of wage payment/grade/rate of workers </li></ul></ul></ul><ul><li>Limitations: </li></ul><ul><ul><ul><li>Faulty distribution of overhead </li></ul></ul></ul><ul><ul><ul><li>Not suitable where piece rate system is used </li></ul></ul></ul><ul><ul><ul><li>Expenses not related to labor hours are ignored </li></ul></ul></ul><ul><ul><ul><li>No clear distinction between types of labor/costs/workers </li></ul></ul></ul>
  15. 16. Machine hour rate method <ul><li>OH rate = Total running expenses                  Number of working hours for the machine </li></ul><ul><li>Advantages: </li></ul><ul><ul><ul><li>Scientific/practical/accurate </li></ul></ul></ul><ul><ul><ul><li>Comparison of relative efficiencies </li></ul></ul></ul><ul><ul><ul><li>Decision making by the management </li></ul></ul></ul><ul><ul><ul><li>Detection of idle time </li></ul></ul></ul><ul><li>Limitations: </li></ul><ul><ul><ul><li>Higher cost </li></ul></ul></ul><ul><ul><ul><li>Not useful when blanket rate is used </li></ul></ul></ul><ul><ul><ul><li>Inaccurate results if use of labor is equally important </li></ul></ul></ul><ul><ul><ul><li>Doesn’t consider expenses that are not proportionate to working hours </li></ul></ul></ul>
  16. 17. Direct material cost method <ul><li>OH rate = Budgeted overhead expense                      Expected direct material cost </li></ul><ul><li>  Advantages: </li></ul><ul><ul><ul><li>Simple /easy to use </li></ul></ul></ul><ul><ul><ul><li>Suitable when </li></ul></ul></ul><ul><ul><ul><ul><li>Output is uniform </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Stable material cost </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Proportion of OH to total cost is significant </li></ul></ul></ul></ul><ul><li>Limitations: </li></ul><ul><ul><ul><li>Unstable and inaccurate </li></ul></ul></ul><ul><ul><ul><li>No consideration for time factor </li></ul></ul></ul><ul><ul><ul><li>No distinction between fixed and variable costs </li></ul></ul></ul><ul><ul><ul><li>No distinction between production of workers and machines </li></ul></ul></ul>
  17. 18. Prime cost method <ul><li>OH rate = Budgeted overhead expense                       Prime cost </li></ul><ul><li>Advantages: </li></ul><ul><li>Simple /easy to use </li></ul><ul><li>  Suitable when there is no wide fluctuations in processing </li></ul><ul><li>Limitations: </li></ul><ul><li>  No consideration for time factor </li></ul><ul><li>No distinction between fixed and variable costs </li></ul>
  18. 19. Sale price method <ul><li>OH rate = Budgeted overhead expenses                  Sale price of units of production </li></ul><ul><li>Suitable for the absorption of : </li></ul><ul><ul><ul><li>Administration </li></ul></ul></ul><ul><ul><ul><li>Selling and distribution </li></ul></ul></ul><ul><ul><ul><li>Research and development </li></ul></ul></ul><ul><ul><ul><li>Design costs </li></ul></ul></ul>
  19. 20. Factors to be considered for determining the basis of apportionment <ul><li>Adequacy : The OH rate should be in such a way that equitable apportionment can be made to the cost centers or cost units. </li></ul><ul><li>Convenience: The OH rate should be simple and easy to understand and also convenient in application. </li></ul><ul><li>Time factor: The OH rate should have some relation to the time taken by various jobs for completion. </li></ul><ul><li>Manual or machine work: There can be different OH rates for manual and machine work. </li></ul><ul><li>Differential OH rates: If the nature of work done by the various departments is not same, different OH rates can be ascertained. </li></ul><ul><li>Information : The availability of information affects the selection of the OH rates. </li></ul>
  20. 21. Under absorption/Over absorption <ul><li>The OH costs are fully recovered from production, if actual rate method of absorption is adopted. If the OH rate absorbed is less than the overheads incurred, it is called as under absorption of overheads. </li></ul><ul><li>If the OH rate absorbed is more than the actual overheads incurred, it is known as over absorption of overheads. </li></ul>
  21. 22. Accounting of Under absorption and Over absorption <ul><li>Use of supplementary rates </li></ul><ul><li>To carry out adjustment for the difference between overhead absorbed and overhead incurred </li></ul><ul><li>Under or over absorbed overheads/actual base </li></ul><ul><li>Writing off to costing P/L account </li></ul><ul><li>Under/Over absorption due to abnormal situations </li></ul><ul><li>Distortion in the value of stock </li></ul><ul><li>Absorption in the accounts of subsequent years </li></ul><ul><li>Deferred charge </li></ul><ul><li>Suitable when the business period is more than one year </li></ul>
  22. 23. Summary <ul><li>How we can define overhead? </li></ul><ul><li>Classification and types of overheads </li></ul><ul><li>Major steps involved in overhead accounting </li></ul><ul><li>What are the basis for apportioning the overheads? </li></ul><ul><li>What are the principles of apportionment? </li></ul><ul><li>Trace the common methods of reapportionment. </li></ul><ul><li>What do you mean by absorption of overheads? </li></ul><ul><li>Methods of absorption </li></ul><ul><li>Under absorption and over absorption. </li></ul>

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