UNIVERSITY OF THE WEST

Mona School of Business & Management

Introduction to Cost & Management Accounting –ACCT 1003 (MS15B)

A Closer Look at Manufacturing Overhead

Overheads are those costs that cannot be traced directly to a cost object e.g. supervisor’s salary, rent and
rates, electricity expense, indirect material, and indirect labour costs. Overheads fall into two broad
categories:

a) Manufacturing overhead costs

b) Non-manufacturing overhead costs

Manufacturing overhead costs include all indirect costs that are related to the manufacturing operation.
These include indirect material costs e.g. spices used in the baking of buns, lubricants for machinery;
indirect labour such as wages and salaries of plant managers, timekeepers and inspectors, and indirect
expenses such as factory utilities, insurance of manufacturing plant and depreciation of plant and
machinery.

Non-manufacturing overhead costs consist of selling and distribution expenses relating to the activities of
the sales department, depreciation of delivery vehicles, advertising, property taxes on office building and
administrative expenses relating to management and clerical staff.

Manufacturing overhead costs are allocated for:

i) Determining cost of production. (IAS 2 recommends that production overhead costs be
included with prime cost when preparing published accounts.)
ii) Making pricing decisions e.g. quotation on jobs.
iii) Determining profitability of different products. To determine profits costs must first be
determined.

Cost Allocation v Cost Apportionment.

Overhead allocation refers to the process of assigning a specific overhead cost to a cost centre e.g.
maintenance cost to the maintenance department. A cost centre is a responsibility centre, where managers
are accountable for expenses that are under their control. A department for example is deemed to be a
cost centre. Cost centres are usually either production or service departments e.g. assembly department,
maintenance department, canteen and legal department. Cost centres usually incur expenses but do not
generate revenues.

Overhead apportionment refers to the process of sharing among two or more cost centres overhead costs
that cannot be allotted to a particular cost center e.g. rent and rates which cannot be allocated in full to any
one cost center and so must be apportioned on some equitable basis.
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Unlike DM, DL and DE that apply to specific jobs, manufacturing overhead relates to the production
operation as a whole. These overhead costs therefore cannot be assigned to a specific product or job on
the basis of actual costs incurred. Most companies assign overheads to products using a two-staged
procedure. In the first stage overheads are allocated & apportioned to the cost centers; while in stage two,
these assigned overhead costs are passed on to products using overhead absorption rates (OARs).
Overheads are passed on to products using some allocation base or cost driver i.e. the primary factor that
causes a cost. Traditionally manufacturing companies have used direct labour hours, direct labour cost
and machine hours. These bases are also referred to as traditional cost drivers. OARs are calculated by
dividing the total budgeted overheads in each cost center by the total budgeted units of the cost driver.
Manufacturing overhead costs are then passed on/applied to the products by multiplying the OAR by the
actual quantity of the allocation base consumed by the product.

Calculating Overhead Absorption Rates (Summary)

1. Assign factory overheads to production and service cost centres. Overheads are assigned using
some equitable bases.
Example:
COST BASIS
Rent and rates Floor space
Supervisory salaries Number of employees
Canteen costs Number of employees
Depreciation and insurance of machinery Machinery value
Material handling Weight of material

2. Re-allocate service cost centre costs to the production cost centres.

3. Identify the cost driver for each production cost centre.
4. Calculate the pre-determined manufacturing overhead rates for each cost centre by dividing the
total budgeted overheads by the units of the cost driver.
5. Assign/apply cost centre overheads to products using the rates calculated.

Summary Diagram

A A
Overhead Costs

B B Product

C C

Allocation Calculate
& OARs
Apportionment

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Example
i) Total overheads allocated to cost centre $100,000 (After steps 1 & 2)
ii) Allocation base/Cost Driver 20,000 direct labour hours (Step 3)
iii) OAR = $100,000/20,000 direct labour hours (Step 4)
=$5.00/direct labour hour
iv) If a product consumed 30 direct labour hours, the overhead expense applied or passed on to that
product would be $150 i.e. 30 @ $5.00. (Step 5)

Some organizations do not assign manufacturing overheads to cost centers, but instead use what is called
a blanket overhead rate or a plant-wide rate i.e. a rate that is established for the plant as a whole. Hence
the total overheads for the plant would be divided by the total budgeted units of the cost driver, for the
plant.

Where a factory consists of a number of production cost centers, the plant-wide rate is not an acceptable
basis of allocation, as products consume cost center overheads in varying proportions i.e. the product does
not spend the same amount of time in each cost center. Department overhead rates therefore produce a
more accurate overhead cost allocation, since they recognize the variation in intensity of the resources in
the different cost centers.

Recall
Service departments, also referred to as support departments, render essential services that support the
production process e.g. maintenance costs incurred in the maintenance department.

Pre-determined Overhead Rates

The calculation of OARs based on actual overheads incurred in the accounting period causes a number of
problems

1. Production cost calculation would have to be delayed until the end of the accounting period.
However, this may be necessary before the end of the accounting period, especially where
selling prices has to be estimated.

2. OARs may have to be calculated on a monthly basis. This would lead to fluctuation in these
rates, making it volatile. Also some costs such as repair and maintenance are incurred evenly
throughout the year.

As a result of these, overhead rates should be based on standard rather than actual data.

Where pre-determined rates are used, very often these rates will be different from the actual rates. In this
case, there will be variance i.e. either an over- or under-recovery/absorption of overheads. Any under- or
over-recovery of overheads (variance) should be treated as a period cost adjustment i.e. it should be
written off against profits in the current accounting period.