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LO3.1
The Cost Of materials, labour and
overheads
Costs
OVERHEAD ANALYSIS
Objectives of Cost Accounting:
To calculate the cost of any work-in-progress
To attempt to control costs by comparing actual with estimated
To estimate the cost of each product
Three elements of Cost
– raw materials, stationery, stores from
all departments.
– wages, salaries, commission paid to
employees.
– admin, selling, distribution and
financial expenses.
Direct Materials
Direct Labour
Other expenses
‘Other Expenses'
Direct Materials + Direct Labour + Direct Expenses =
These ‘Other Expenses’ can be DIRECT or INDIRECT:
DIRECT – traceable to a particular product or job.
They vary in proportion to production.
PRIME COST
They fall into 3 groups –
Indirect Expenses
Indirect– these are expenses which cannot be
traceable to a particular job or product.
Normally known as
Overheads
They are essential to the running
of the business.
Manufacturing
Selling and Distribution
Administration and Financial
Prime Cost + Manufacturing Overheads =
TOTAL COST
PRODUCTION COSTS
Production Costs + Selling and Distribution
+ Administration and Financial =
COST CENTRES
• In order to control costs it is necessary to
trace them to the area responsible for the
costs.
These areas are known as COST CENTRES
A Cost Centre can be a location, person or equipment
The Cost Centre acts as a collecting place for costs eg a manufacturing
department, a machine, an operating theatre in a hospital.
2 types of Cost Centre
Service Cost
Centres
– these are involved in the
manufacturing process such as
machining and assembly Cost
Centres.
– these are not involved in the actual
manufacturing process but provide
services to the production Cost
Centres such as the maintenance
and stores departments.
Production
Cost Centres
A Cost Unit is the final product or service being costed
• Examples of Cost Units might be:
Cost Units
a ball-bearing made on a machine
a television set manufactured
a heart transplant operation
a bus journey in terms of operating cost per passenger mile travelled
HOW TO TRACE COSTS TO COST
CENTRES
• Step 1
Direct Costs
– are ALLOCATED to a Cost Centre.
Power, Lighting and Heating
(when separately metered),
Repairs and Maintenance to a
machine
Allocation of Costs to Cost
Centres
For example, if the canteen is treated as a
separate cost centre, then the wages of the
canteen manager are allocated to that cost
centre.
Cost Allocation refers to the allotment of
whole items of overhead costs to cost
centres; that is, overhead costs can be
allocated directly to a Cost Centre.
Indirect Costs
A suitable basis could be:
Depreciation, Rent, Rates, Heating and
Lighting (not separately metered), Canteen
costs, Supervision etc
– are APPORTIONEDto
Cost Centres on a suitable basis.
Floor space for Heating and Lighting Number of Employees for Canteen Costs.
Cost Apportionment overhead costs are shared out among various Cost Centres
on some fair and equitable basis since the overhead cannot
be directly allocated to any one particular cost centre.
Apportionment of Costs
Overhead Cost Basis of Apportionment
Rent, rates, heating and
lighting
Depreciation and insurance
of plant and machinery
Canteen, factory
administration costs
Power
floor area, size of department
book value of the fixed
assets
number of employees
horse power of machines
Step 2
These departments exist for the whole business not just one department and
therefore these Service Costs must be APPORTIONED among the other Production
Departments, again using a suitable basis.
However, all businesses will incur
Service Costs eg
So far we have dealt with Production Department Cost Centres.
Maintenance or Personnel
Departments.
Basis of Apportionment
Service Overhead Cost Basis of Apportionment
maintenance man hours or value of the
capital equipment
cost of materials used or material
requisitions
number of employeesCanteen, personnel and
security guards' wages
Maintenance
Cleaning
Step 3
ABSORPTION OF COSTS
This is often also referred to as Overhead Recovery.
Now that Overhead Costs have been Apportioned to Cost Centres, they must
now be Absorbedinto the Total Cost.
Overhead Absorption refers to the
method of charging a proportion of
the final production cost centres'
overheads onto a particular job on
the basis of for example,
the number of labour hours or
machine hours taken to complete
the job.
Bases for Absorbing Overhead Costs:
Rate per Direct Labour Hour
Total Predetermined Overheads / Total Labour Hours
Machine Hour Rate: either
Total Predetermined Overheads / Total Machine Hours
when Labour Hours in the relevant
factor
Area occupied by machine –
rates, rent etc
Cost of operating – depreciation,
power etc
Alternative Overhead Absorption
Rates
Overheads as a percentage of Direct Wages
Overheads as a percentage of Direct Materials
Overheads as a percentage of Prime Costs
Rate per Unit Produced
SUITABILITY OF DIFFERENT OVERHEAD ABSORPTION OR
RECOVERY RATES
most suitable for machine
intensive jobs
Direct Machine Hour Rate
most suitable for labour intensive
jobs
Direct Labour Hour Rate
This means that the 2 most accurate methods of recovering overheads
will be:
One of the most important facts about Overheads is that they are incurred
OVER TIME.
All the other Overhead Absorption bases generally do not allow
for the time element but nonetheless are often used:
There is obviously no relationship between the cost of
raw materials and overheads. For example, rent and
rates and electricity do not change simply because the
cost of raw materials have changed.
Percentage of Direct
Materials
Where there is only slight variation in the rates of pay
for different grades of labour this method will produce
similar results to the direct labour rate.
Percentage of Direct Wages
Since the Cost units are likely to have different
production processes and different lengths of
time in the production processes it would not be
suitable to apply the same cost unit absorption
rate to all the different products produced.
Rate per Unit Produced
Same reasons as for the percentage of direct
wages and percentage of direct material
overhead absorption rates.
Percentage of Prime Cost
ACTUAL OVERHEADS AND PREDETERMINED/BUDGETED OVERHEADS
But since you have to charge overheads onto the job when it is done or indeed
even before it is done, particularly if the customer wants an estimate of how much
the job will cost, then you will have to use some method of "guessing" what the
overheads will be.
A difficulty in using overhead absorption or recovery rates in practice is that you will
not know what the actual overheads are until after the accounting period is finished
– for example, a month or year.
The way round this problem is to use PREDETERMINED or
BUDGETED Overhead Costs.
any anticipated price increases.any anticipated increases or decreases in
production, and
This is simply an estimate of what overhead costs will be in the next financial year
based on an extension of what they were in the past year after allowing for:
What this means is that when we come to the end of the
accounting period the actual overhead costs incurred will in all
probability differ from the overheads absorbed into the cost
units.
On the other hand, if the actual
overheads for the accounting
period are less than the
overheads absorbed then we will
have overabsorbed costs and so
we will have to make an
adjustment by crediting the gain
to the Costing Profit and Loss
Account.
If the actual overheads for the
accounting period are greater than the
overheads absorbed then we will have
underabsorbed costs and so we will
have to make an additional charge for
the difference to the Costing Profit and
Loss Account.
EXAMPLE – OVERHEAD UNDERABSORBED
overheads absorbedactual overheads incurred –
Overhead over / under absorbed =
budgeted overhead rateactual direct labour hours x
Overhead absorbed =
Calculate the underabsorption of overheads
5,050 hours5,000 hoursDirect Labour Hours
£52,000£50,000Overheads
Actual DataBudgeted DataCost Centre A
Step 1
Overhead Absorbed = 5,050 hours x £10 per hour = £50,500
Calculate the Overhead Absorbed using the rate from Step 1 and the Actual Hours
worked:
Step 2
£50,000 / 5,000 hours = £10 per Labour Hour
Budgeted Overheads / Direct Labour Hours
Calculate the Budgeted Overhead Rate based on Direct Labour Hours.
Step 3
As a result the Profit and Loss Account would be charged with an expense of
Overhead Underabsorbed of £1,500.
Overhead Underabsorbed = £52,000 - £50,500 = £1,500
Compare this Budgeted Cost with the Actual Cost
EXAMPLE – OVERHEAD OVERABSORBED
Cost Centre A Budgeted Data Actual Data
Overheads £50,000 £49,400
Direct Labour Hours 5,000 hours 4,950 hours
Calculate the overabsorption of overheads.
Overhead over / under absorbed =
actual overheads incurred – overheads absorbed
Overhead absorbed =
actual direct labour hours x budgeted overhead rate
Step 1
Overhead Absorbed = 4,950 hours x £10 per hour = £49,500
Calculate the Overhead Absorbed using the rate from Step 1 and the Actual Hours
worked:
Step 2
£50,000 / 5,000 hours = £10 per Labour Hour
Budgeted Overheads / Direct Labour Hours
Calculate the Budgeted Overhead Rate based on Direct Labour Hours.
Step 3
As a result the Profit and Loss Account would be charged with an expense of
Overhead Overabsorbed of £100.
Overhead Overabsorbed = £49,400 - £49,500 = £100
Compare this Budgeted Cost with the Actual Cost

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Lo3 overheads

  • 1. LO3.1 The Cost Of materials, labour and overheads
  • 3. OVERHEAD ANALYSIS Objectives of Cost Accounting: To calculate the cost of any work-in-progress To attempt to control costs by comparing actual with estimated To estimate the cost of each product
  • 4. Three elements of Cost – raw materials, stationery, stores from all departments. – wages, salaries, commission paid to employees. – admin, selling, distribution and financial expenses. Direct Materials Direct Labour Other expenses
  • 5. ‘Other Expenses' Direct Materials + Direct Labour + Direct Expenses = These ‘Other Expenses’ can be DIRECT or INDIRECT: DIRECT – traceable to a particular product or job. They vary in proportion to production. PRIME COST
  • 6. They fall into 3 groups – Indirect Expenses Indirect– these are expenses which cannot be traceable to a particular job or product. Normally known as Overheads They are essential to the running of the business. Manufacturing Selling and Distribution Administration and Financial
  • 7. Prime Cost + Manufacturing Overheads = TOTAL COST PRODUCTION COSTS Production Costs + Selling and Distribution + Administration and Financial =
  • 8. COST CENTRES • In order to control costs it is necessary to trace them to the area responsible for the costs. These areas are known as COST CENTRES A Cost Centre can be a location, person or equipment The Cost Centre acts as a collecting place for costs eg a manufacturing department, a machine, an operating theatre in a hospital.
  • 9. 2 types of Cost Centre Service Cost Centres – these are involved in the manufacturing process such as machining and assembly Cost Centres. – these are not involved in the actual manufacturing process but provide services to the production Cost Centres such as the maintenance and stores departments. Production Cost Centres
  • 10. A Cost Unit is the final product or service being costed • Examples of Cost Units might be: Cost Units a ball-bearing made on a machine a television set manufactured a heart transplant operation a bus journey in terms of operating cost per passenger mile travelled
  • 11. HOW TO TRACE COSTS TO COST CENTRES • Step 1 Direct Costs – are ALLOCATED to a Cost Centre. Power, Lighting and Heating (when separately metered), Repairs and Maintenance to a machine
  • 12. Allocation of Costs to Cost Centres For example, if the canteen is treated as a separate cost centre, then the wages of the canteen manager are allocated to that cost centre. Cost Allocation refers to the allotment of whole items of overhead costs to cost centres; that is, overhead costs can be allocated directly to a Cost Centre.
  • 13. Indirect Costs A suitable basis could be: Depreciation, Rent, Rates, Heating and Lighting (not separately metered), Canteen costs, Supervision etc – are APPORTIONEDto Cost Centres on a suitable basis. Floor space for Heating and Lighting Number of Employees for Canteen Costs. Cost Apportionment overhead costs are shared out among various Cost Centres on some fair and equitable basis since the overhead cannot be directly allocated to any one particular cost centre.
  • 14. Apportionment of Costs Overhead Cost Basis of Apportionment Rent, rates, heating and lighting Depreciation and insurance of plant and machinery Canteen, factory administration costs Power floor area, size of department book value of the fixed assets number of employees horse power of machines
  • 15. Step 2 These departments exist for the whole business not just one department and therefore these Service Costs must be APPORTIONED among the other Production Departments, again using a suitable basis. However, all businesses will incur Service Costs eg So far we have dealt with Production Department Cost Centres. Maintenance or Personnel Departments.
  • 16. Basis of Apportionment Service Overhead Cost Basis of Apportionment maintenance man hours or value of the capital equipment cost of materials used or material requisitions number of employeesCanteen, personnel and security guards' wages Maintenance Cleaning
  • 17. Step 3 ABSORPTION OF COSTS This is often also referred to as Overhead Recovery. Now that Overhead Costs have been Apportioned to Cost Centres, they must now be Absorbedinto the Total Cost. Overhead Absorption refers to the method of charging a proportion of the final production cost centres' overheads onto a particular job on the basis of for example, the number of labour hours or machine hours taken to complete the job.
  • 18. Bases for Absorbing Overhead Costs: Rate per Direct Labour Hour Total Predetermined Overheads / Total Labour Hours Machine Hour Rate: either Total Predetermined Overheads / Total Machine Hours when Labour Hours in the relevant factor Area occupied by machine – rates, rent etc Cost of operating – depreciation, power etc
  • 19. Alternative Overhead Absorption Rates Overheads as a percentage of Direct Wages Overheads as a percentage of Direct Materials Overheads as a percentage of Prime Costs Rate per Unit Produced
  • 20. SUITABILITY OF DIFFERENT OVERHEAD ABSORPTION OR RECOVERY RATES most suitable for machine intensive jobs Direct Machine Hour Rate most suitable for labour intensive jobs Direct Labour Hour Rate This means that the 2 most accurate methods of recovering overheads will be: One of the most important facts about Overheads is that they are incurred OVER TIME.
  • 21. All the other Overhead Absorption bases generally do not allow for the time element but nonetheless are often used: There is obviously no relationship between the cost of raw materials and overheads. For example, rent and rates and electricity do not change simply because the cost of raw materials have changed. Percentage of Direct Materials Where there is only slight variation in the rates of pay for different grades of labour this method will produce similar results to the direct labour rate. Percentage of Direct Wages
  • 22. Since the Cost units are likely to have different production processes and different lengths of time in the production processes it would not be suitable to apply the same cost unit absorption rate to all the different products produced. Rate per Unit Produced Same reasons as for the percentage of direct wages and percentage of direct material overhead absorption rates. Percentage of Prime Cost
  • 23. ACTUAL OVERHEADS AND PREDETERMINED/BUDGETED OVERHEADS But since you have to charge overheads onto the job when it is done or indeed even before it is done, particularly if the customer wants an estimate of how much the job will cost, then you will have to use some method of "guessing" what the overheads will be. A difficulty in using overhead absorption or recovery rates in practice is that you will not know what the actual overheads are until after the accounting period is finished – for example, a month or year.
  • 24. The way round this problem is to use PREDETERMINED or BUDGETED Overhead Costs. any anticipated price increases.any anticipated increases or decreases in production, and This is simply an estimate of what overhead costs will be in the next financial year based on an extension of what they were in the past year after allowing for:
  • 25. What this means is that when we come to the end of the accounting period the actual overhead costs incurred will in all probability differ from the overheads absorbed into the cost units. On the other hand, if the actual overheads for the accounting period are less than the overheads absorbed then we will have overabsorbed costs and so we will have to make an adjustment by crediting the gain to the Costing Profit and Loss Account. If the actual overheads for the accounting period are greater than the overheads absorbed then we will have underabsorbed costs and so we will have to make an additional charge for the difference to the Costing Profit and Loss Account.
  • 26. EXAMPLE – OVERHEAD UNDERABSORBED overheads absorbedactual overheads incurred – Overhead over / under absorbed = budgeted overhead rateactual direct labour hours x Overhead absorbed = Calculate the underabsorption of overheads 5,050 hours5,000 hoursDirect Labour Hours £52,000£50,000Overheads Actual DataBudgeted DataCost Centre A
  • 27. Step 1 Overhead Absorbed = 5,050 hours x £10 per hour = £50,500 Calculate the Overhead Absorbed using the rate from Step 1 and the Actual Hours worked: Step 2 £50,000 / 5,000 hours = £10 per Labour Hour Budgeted Overheads / Direct Labour Hours Calculate the Budgeted Overhead Rate based on Direct Labour Hours.
  • 28. Step 3 As a result the Profit and Loss Account would be charged with an expense of Overhead Underabsorbed of £1,500. Overhead Underabsorbed = £52,000 - £50,500 = £1,500 Compare this Budgeted Cost with the Actual Cost
  • 29. EXAMPLE – OVERHEAD OVERABSORBED Cost Centre A Budgeted Data Actual Data Overheads £50,000 £49,400 Direct Labour Hours 5,000 hours 4,950 hours Calculate the overabsorption of overheads. Overhead over / under absorbed = actual overheads incurred – overheads absorbed Overhead absorbed = actual direct labour hours x budgeted overhead rate
  • 30. Step 1 Overhead Absorbed = 4,950 hours x £10 per hour = £49,500 Calculate the Overhead Absorbed using the rate from Step 1 and the Actual Hours worked: Step 2 £50,000 / 5,000 hours = £10 per Labour Hour Budgeted Overheads / Direct Labour Hours Calculate the Budgeted Overhead Rate based on Direct Labour Hours.
  • 31. Step 3 As a result the Profit and Loss Account would be charged with an expense of Overhead Overabsorbed of £100. Overhead Overabsorbed = £49,400 - £49,500 = £100 Compare this Budgeted Cost with the Actual Cost