CHAPTER 3 OVERHEADS Overheads are costs, which are not traced directly to cost units.

In other words, overhead is the total of indirect material costs, indirect labour costs, and indirect expenses. The terms burden, supplementary costs, on costs and indirect expenses are used interchangeably for overhead. Overheads are aggregated under some account head (e.g. supervisors salary, office lighting, depreciation, and building up keep) and then assigned to cost units on some equitable basis. Overheads are usually classified in terms of functions: factory overhead, administration overhead, selling overhead, and distribution overhead. The terms factory overhead, manufacturing overhead and production overhead are used interchangeably. Manufacturing overheads Manufacturing overheads are indirect costs associated with the manufacturing process. In a product manufacturing set up manufacturing process is the sequence of operations that begin with supplying materials to work stations and end with the primary packing of the product. In the context of producing services, the manufacturing process is the process of performing activities, concurrently or in sequence, which are directly related to creating the service. For example, in the context of an organisation providing road transport services, manufacturing overheads are overheads associated with the operation of the vehicles. Indirect costs incurred in stores department and in departments providing support services are also included in manufacturing overhead. Administration overheads Administration overheads are costs of formulating the policy, directing the organization and controlling the operations which are not directly related to production, selling, distribution and research or development or any other function. Cost of factory administration is a part of manufacturing overhead. Similarly, the cost of administration of marketing offices is a part of selling overhead. Selling overheads Selling overheads are costs associated with marketing and selling (excluding distribution) activities.

Distribution overheads Distribution overheads are costs associated with the distribution of finished products. Distribution includes such activities as moving finished goods to central or local storage, moving finished goods to and from prospective customers as in case of goods on sale or return basis. In gas, electricity and water industries, distribution means pipes, mains and services which may be regarded as equivalent to packing and transportation. 3.1 ACCOUNTING FOR MANUFACTURING OVERHEADS Manufacturing overheads form part of the product cost. Accounting for manufacturing overheads aims to equitably assign overheads to units produced during a period. Overheads for a period are aggregated and then assigned to units produced using a method that reasonably captures the demand of the units on resources represented by overheads. Usually, an average rate per unit is calculated and the same is applied to assign overheads to units produced. Overheads are aggregated at the cost centre level and average rate is calculated for each cost centre because the incidence of cost is different at different cost centres and different products consume varying amount of resources at each cost centre. Conventional method for assigning overheads to units produced during the period involves the following four steps: Allocation

Apportionment

Reapportionment

Absorption

Total overheads for a particular period are collected under production cost centres and separate overhead absorption rates are used for different production cost centres. This is a refinement over the earlier practice of using a single absorption rate for the factory/facility. In past, most firms used to produce a single product or similar products, and the demand used to be created by each unit of such products on resources represented by fixed factory overheads did not vary significantly. Consequently, use of the blanket rate did not impair the product cost. Firms felt the need for refinement when they added different types of products which either do not use the resources of all the cost centres or the time spent by them in a particular cost centre is not uniform. The conventional method required further refinement because it fails to produce result with desired accuracy for firms that produce variety of products using the same facility in situations where the amount of resources consumed by a unit in a particular cost centre does not depend on the time spent by it in the cost centre.. Activity based costing (ABC) method, which is a refinement over the conventional method, provides result with much higher accuracy than that obtained by using the conventional method. We shall discuss the ABC method in chapter 14. 3.1.1 Allocation Overheads that can be identified to a cost centre are assigned to the cost centre. For correct allocation of factory overheads, source document which is used for collection of overheads must clearly indicate the cost centre which has received the benefit from the expenses covered under the document. Notification of account-headings (standing order number) and cost centres is essential for allocating factory overheads to various cost centres. Examples of overheads that can be identified with cost centres are: depreciation, insurance, and repair and maintenance of equipment located in different cost centres, remuneration to supervisors and indirect workers dedicated to different cost centres, and power (if separate meters are installed in different cost centres). 3.1.2 Apportionment Apportionment refers to proportionate allotment of overheads common to various cost centres to those cost centres on some equitable basis. Examples of common overheads are: rent, rates, depreciation, repairs and maintenance of the building in which cost-

centres are located, lighting of the premises, works-managers salary, medical directors salary in a hospital, and managing partners salary in an accounting firm. Allocation of directly identifiable items and apportionment of common items of factory overheads result in collection of total factory overheads under various cost centres, including support-service cost centres. The following are some of the common bases used for measurement of benefits:

Basis Floor area

Cost item Rent, rates, depreciation, maintenance of building and other expenses connected with the premises; lighting and heating (if a better basis is not available); fire protection service, etc.

Number of employees Value of materials passing through cost centres Capital values Direct labour hours and/or machine hours Technical estimates

Any expense associated with employees, such as canteen expenses, recreation expenses, timekeeping, supervision, etc. Expenses associated with material such as material handling expenses Depreciation, insurance and maintenance of production facilities Majority of general overhead items (a)Lighting: capacity of lighting or number of lights (b)Electric power: horse power of machines coupled with operating time (c)Steam (d)Water.

Two secondary criteria, other than the proportionate benefit, which are sometimes used for apportionment of factory overheads, are as follows: (a) Ability to pay. One of the accepted principles of taxation is what the traffic will bear. This principle is sometimes applied in cost accounting for cost apportionment. For example, sales office expenses may be apportioned to various product groups on the basis of sale value. The assumption is that a product with a higher sale value can bear a higher

burden of sales expenses, although actual efforts involved in selling an easy selling line but having higher sales must be lower as compared to the effort involved in other product lines having a lower sales value. (b) Efficiency or incentives. In some organizations, overheads are apportioned on the basis of a predetermined activity level (often budgeted production or sales level). If actual performance exceeds the predetermined level, average per unit overhead cost would be lower as compared to predetermined rate while failure to achieve the predetermined activity level would result in a higher average per unit overhead cost. This provides an incentive for better performance. 3.1.3 Re-apportionment Overheads of service cost centres are reapportioned to other cost centres based on the proportionate benefit derived by those cost centres. The following are some of the most apparent bases for reapportionment: Basis Number of employee Value of material used or requisitioned Capital value (This basis is likely to give inaccurate results. A more appropriate basis would be the actual maintenance hours and the actual issue of spares.) Technical estimates Floor area Energy/power consumed Cost centres Canteen, welfare and recreation centres, time office Stores and internal transport Maintenance

Tool room Building service Boiler house and power house

Usually technical estimates are used to reapportion overheads assigned to support-service cost centres to production cost centres, because, often it is difficult to identify appropriate criteria for reapportioning service cost centre overheads. One of the following methods is used to reapportion overheads of service cost centres to production cost centres: (a) Direct redistribution method (b) Step distribution method 5

(c) Reciprocal services method. Direct redistribution method A service cost centre renders services to production cost centres as well as to other service cost centres. This method ignores the services rendered by one service cost centre to other service cost centres. Service cost centre overheads are apportioned to production cost centres in the ratio of benefits received by them. This is a simple, but an inaccurate method. Illustration 3.1 Maria Limited (ML) has three production centres, A, B and C and two service cost centres, X and Y. Costs allocated to service centres are required to be apportioned to the production centres to find out cost of production of different products. It is found that benefit of service cost centres is also received by each other along with the production cost centres. Overheads as allocated to the five cost centres and estimates of benefit of service cost centres received by each of them are as under: Cost centres A B C X Y Overheads as allocated (CU) 80,000 40,000 20,000 20,000 10,000 Estimates of benefits received by other cost centres (%) X 20 30 40 10 Y 20 25 50 5

Required: Work out final overhead of each of the production departments including reapportioned overheads of service centres using direct redistribution method. (Adapted, ICWA, Inter) Solution Total overhead accumulated under the cost centre X is to be distributed to A, B and C in the ratio of 2:3:4. Similarly, total overhead accumulated under the cost centre Y is to be distributed to A, B and C in the ratio of 2:2.5:5. Calculations are shown below: 6

Cost

Overheads apportioned(CU)

Reapportionment of Xs overhead (CU) 20,000 (2/9) = 4,444 20,000 (3/9) = 6,667 20,000 (4/9) = 8,889

Reapportionment of Ys overhead (CU) 10,000 (2/9.5) = 2,105 10,000 (2.5/9.5) = 2,632 10,000 (5/9.5) = 5,263

centres allocated and A B C 80,000 40,000 20,000

The final overhead of production cost centres are as follows: A: CU 80,000 + 4,444 + 2,105 = CU 86,549 B: CU 40,000 +6,667 + 2,632 = CU 49,299 A: CU 20,000 + 8,889 + 5,263 = CU 34,152 Step distribution method Under this method service cost centres are ranked in order of the magnitude of overhead to be reapportioned. Sometimes, support-service cost centres are ranked on the basis of the number of service cost centres to whom services have been rendered by the particular service cost centre. Overhead of the support-service cost centre, which is ranked first, is reapportioned to all other cost centres including service cost centres. The overhead of the service cost centre ranked second would then be reapportioned to all other cost centres except to the service cost centre ranked first. In this manner, overhead of a service cost centre would be reapportioned to all cost centres including service cost centres ranked lower to that service cost centre. This method provides more accurate results as compared to the direct redistribution method. However, it often fails to provide the desired result, because in reapportioning the overhead of a particular support-service cost centre, support-service cost centres ranked higher are ignored. Illustration 3.2 Based on the information provided in illustration 3.1, work out final overhead of each of the production departments, including reapportioned overheads of service centres using step redistribution method. Solution Overheads as allocated to the five cost centres and estimates of benefit of service cost centres received by each of them are as under:

Cost centres A B C X Y

Overheads as allocated (CU) 80,000 40,000 20,000 20,000 10,000

Estimates pf benefits received by other cost centres (%) X 20 30 40 10 Y 20 25 50 5

Based on the magnitude of overhead, service centre X is ranked I and Y is ranked II. Therefore, we allocate the overhead of the service centre X to A, B, C and Y as per calculations below: A: CU 20,000 (2/10) = CU 4,000 B: CU 20,000 (3/10) = CU 6,000 C: CU 20,000 (4/10) = CU 8,000 Y: CU 20,000 (1/10) = CU 2,000 The total overhead of Y, including reapportioned overhead of X is CU 12,000. In reapportioning overhead of Y, we shall ignore the service received by X from Y, because, X is ranked higher than Y. The following are the calculations: A: CU 12,000 (2/9.5) = CU 2,526 B: CU 12,000 (2.5/9.5) = CU 3,158 C: CU 12,000 (5/9.5) = CU 6,316 The final overhead of production cost centres are as follows: A: CU 80,000 + 4,000 + 2,526 = CU 86,526 B: CU 40,000 +6,000 + 3,158 = CU 49,158 A: CU 20,000 + 8,000 + 6,316 = CU 34,316 Reciprocal service method This is the most accurate method because it recognises and gives due weightage to inter service transfers. The following methods deal with reciprocal services: (i) Simultaneous equation method (ii) Repeated distribution method (iii) Trial and error method

Simultaneous equation method There are two steps in this method. First, overheads of service cost centres are ascertained using simultaneous equation method; and second, overheads collected under service cost centres are reapportioned to production cost centres on the basis of certain predetermined percentages. Repeated distribution method Simultaneous equation method can get quite complicated if there are several service cost centres. Repeated distribution method is the easiest to follow. Under this method, overheads of service cost centres are reapportioned to other service and production cost centres on the basis of predetermined percentages. The process continues until the figures under service cost centres either get exhausted or become too small to be of any consequence. Trial and error method Under this method, the first step is to ascertain overheads of service cost centres by repeated distribution method. The second step is to reapportion the total overheads of service cost centres to the production cost centres on the basis of predetermined percentages. Illustration 3.3 Based on the information provided in illustration 3.1, work out final overhead costs of each of the production departments including reapportioned cost of service centres using (a) continuous distribution method and (b) simultaneous equation method. Solution Overheads as allocated to the five cost centres and estimates of benefit of service cost centres received by each of them are as under: Cost centres A B C Overheads as allocated (CU) 80,000 40,000 20,000 Estimates pf benefits received by other cost centres (%) X 20 30 40 Y 20 25 50

X Y (a) 80,000 4,000 84,000 2,400 86,400 120 86,520 12 86,532 1 86,533 A (CU)

20,000 10,000 Continuous distribution method B (CU) 40,000 6,000 46,000 3,000 49,000 180 49,180 15 49,195 1 49,196 1

10 C (CU) 20,000 8,000 28,000 6,000 34,000 240 34,240 30 34,270 34,271 X (CU) 20,000 (20,000) 600 600 (600) 3 3 (3)*

5 Y (CU) 10,000 2,000 12,000 (12,000) 60 60 (60)

*The amount being insignificant, it is equally distributed to production departments. (b) Simultaneous equation method Equations will be: X = 20,000 + 5% of Y Y = 10,000 + 10% of X (1) (2)

Solving equations (1) and (2) we get X = CU 20,063; and Y = CU 12,060 Overheads of A, B and C will be as follows: Particulars Allocated and apportioned Share of X (Ratio 20:30:40) Share of Y (Ratio 20:25:50) Ad hoc of residual amount (CU 3) Total A (CU) 80,000 4,120 2,412 1 86,533 B (CU) 40,000 6,180 3,015 1 49,196 C (CU) 20,000 8,240 6,030 1 34,271

Management perspective

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We may compare the results obtained under different methods. Cost centre Direct redistribution method A B C CU 86,549 49,299 34,152 Step redistribution method CU 86,526 49,158 34,316 Continuous distribution method CU 86,533 49,196 34,271 Simultaneous equation method CU 86,533 49,196 34,271

Considering that in our example only two service cost centres are considered and the quantum of reciprocal services are not significant (10 % of X to Y and 5% of Y to X), the variation in results obtained by using different methods is significant. Continuous distribution method and simultaneous equation method give the same result. The accuracy of those two methods is much higher than the other methods. Firms use continuous distribution method because with the present computing power, the method is easy to use, while the simultaneous equation method becomes complex with more than two service centres. 3.1.4 Absorption Commonly used methods for assigning overheads to units produced in a particular period assume that volume is the only cost driver. In other words, they assume that the amount of resources (represented by overheads) consumed by units produced vary in proportion to the quantity produced during the period. Therefore, the absorption rate per unit is calculated by dividing total overhead for the period by number of units produced. However, in most situations, units of different products produced are not uniform. For example, a firm producing pumps of different types and different sizes cannot use a rate per unit for overhead absorption. It has to establish rate per equivalent unit, taking a particular type of pump as the measurement unit, provided it can convert one unit of each variety of pumps into equivalent units. Usually firms use machine hour rate for machineintensive cost centres and direct-labour hour rate for labour-intensive cost centres. Use of an hourly rate provides accurate result in situations where the amount of resources, in a particular production cost centre, consumed by different units routed through that cost centre varies in direction proportion to the time spent by those units in that cost centre.

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Moreover, use of an hourly rate avoids the complexity of converting one unit of each variety of products in to equivalent units. Pre-determined overhead rates Firms use predetermined overhead absorption rate computed for a normal period (usually, one year) of business activity. Usually budgeted figures are used to calculate the overhead absorption rate. Therefore, the method does not involve additional clerical work. The following are the advantages in using predetermined overhead absorption rate: (i) Product costs can be worked out promptly. (ii) Product costs can be estimated correctly even before production activity commences and this helps the management in deciding the prices to be quoted to prospective customers. However, this may not be counted as a true advantage for two reasons. First, price of a product is determined by factors operating at the market place; and second, product cost determined for use in valuing stock cannot be used for decision making except in rare circumstances. (iii) Product costs are not unnecessarily affected by seasonal fluctuations in costs and activity levels. Some cost accountants suggest use of moving average rate for overhead absorption. Under this method, moving average is calculated with reference to figures for the twelve months immediately preceding the month for which the rate has to be determined. For example, if rate is to be determined for the month of August 2008, figures for twelve months ended July 2008 will be considered in calculating the absorption rate. This method uses figures pertaining to some of the months falling in the previous accounting year and to that extent the rate gets distorted because past figures fail to incorporate changes planned in the budget for the current year. Although under this method, delay is less as compared to delay in calculating the actual rate; it fails to provide data well in advance for the purpose of cost estimation. Therefore, it is preferable to use predetermined overhead absorption rate. Length of the period The general principle governing the selection of the period is that the period should be long enough to normalize the rate. In industries which are subject to cyclical fluctuations

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in business, perhaps the best alternative is to select a period which covers all the phases of a cycle. The period in such a case may be longer than one year. Selection of period is also influenced by seasonality of costs. Many overhead items such as repairs and maintenance, rates and taxes, heating and insurance are not incurred evenly throughout the year. If there is a predominance of such items, the period selected should longer as compared to that in industries in which costs accrue evenly. Similarly, in industries in which production is seasonal, the period selected should be longer as compared to that in which production volume does not fluctuate from period to period. The objective is to determine the normal rate. Usually, predetermined overhead absorption rates are calculated at the beginning of each accounting year. What activity level should be used? Overhead rate per unit or per hour is influenced by the activity level used as denominator in calculating the rate. The estimated activity level can be based on: 1. Average output of past years; 2. Estimated output of the current year; 3. Normal production capacity. The average output of past few years does not represent the normal capacity. Therefore, the rate calculated by using the average output as denominator is not the normal rate. This method is suitable for small firms because of its simplicity. In large firms conditions are rarely static and, therefore, average output of past years should not be used for computation of predetermined overhead rates. Estimated output of the current year (the period in which the rate will be used) may or may not represent the normal capacity. In the year of depression, estimated production level is likely to be lower as compared to the normal production level. Similarly, in boom period estimated production level is likely to be higher as compared to the normal production level. Overhead absorption rate determined based on estimated output would be comparatively higher during recession and lower during boom. In other words, during the period of reduced activity and falling prices, the cost of production would be higher as compared to

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the cost during the period of normal business. Similarly during the period of increased activity and rising prices the cost of production would be lower. This is highly illogical. Moreover, it is against the basic cost-accounting principle that products should neither be loaded with abnormal costs nor benefit from abnormal gains. According to this principle, abnormal costs should be directly charged to the costing profit and loss account and abnormal gains should be directly credited to the costing profit and loss account. In accordance with this principle, the predetermined overhead absorption rate should be a normal rate and should be such that the total overhead is absorbed if normal production is achieved. If the actual production is below the normal production, the unabsorbed overheads arising due to idle capacity should be transferred to the costing profit and loss account. Similarly, if the actual production exceeds the normal production, over-absorbed overheads should be credited to the costing profit and loss account. Normal capacity refers to the expected average production over a sufficiently long period covering a business cycle. Expected average production is determined taking into account the practical capacity and the average market demand. Normal capacity should be used as denominator for calculating predetermined overhead absorption rates and temporary fluctuation in output level should be disregarded. The following are the advantages in using normal production capacity in calculating the predetermined overhead absorption rates: (a) It helps calculate and recover the true cost of production. If a factory or a cost centre is operating below normal capacity, it cannot be said that the whole of the fixed cost has been incurred in achieving the actual output. (b) It helps calculate and highlight losses due to idle time. The twin objectives of cost accounting, namely, determination of normal product cost and cost control are best achieved by using normal recovery rate. Therefore, normal capacity should be used for calculating the predetermined overhead absorption rate. Illustration 3.4 (Machine hour rate) Three machines P, Q and R, which are of different nature, are used in a department of a factory. From the following information, compute machine-hour rate of machine R:

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(i) Total cost of machine P, Q and R is CU 50,000, out of which cost of machine R is CU 10,000. Its estimated scrap value and working life are CU 1,000 and 18,000 hours, respectively; (ii) Rent (total area 1,000 sq. ft and machine R occupies 250 sq. ft): CU 780 per annum; (iii) Lighting (total light points 12, out of which 2 points are used for machine R): CU 288 per annum; (iv) Insurance premium for all machines: CU 45 per quarter; (v) Consumable stores for machine R: CU 60 per month; (vi) Salary for supervisor (supervisor denotes 1/4th of his time for machine R): CU 6,000 per annum; (vii) Repair and maintenance for the entire life of machine R: CU 1,800; (viii) (ix) Machine R consumes 5 units of power per hour at a cost of CU 16 per 100 units; Machine R will work 2,000 hours per annum out of which normal idle time

estimated at 8% of total working hours and time for routine maintenance estimated at 40 hours per annum. (Adapted, B.Com, CU) Solution Computation of Machine Hour Rate Particulars Per annum (CU) Standing charges: Rent Insurance Salary of supervisor Running charges: Depreciation Repairs and maintenance Lighting (CU 10,000 Rs. 1,000)/18,000 CU 1,800/18,000 CU 288 (2/12) (1/1,800) 0.500 0.100 0.027 CU 780 (250/1000) CU 45 4 (10,000/50,000) CU 6,000 (1/4) 195 36 1,500 2,731 1.517 Per hour (CU)

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Consumable stores Power Machine-hour rate

(CU 60 12)/1,800 (CU 16/100) 5 2,000 40) = 1,800 hours.

0.400 0.800 3.344

Note: Effective working hours = (20,000 0.08 Under- or over-absorption of overheads

When a firm use pre-determined rate to absorb overhead, factory overhead incurred during a period may exceed the factory overhead applied to units produced during that period. The excess is under-absorbed overhead. For example, if overhead incurred was CU 100,000 and overhead applied to production units was CU 90,000, there was underabsorption of CU 10,000. If applied overheads exceed overheads incurred, the difference is over-absorbed overhead. For example, if actual overhead was CU 100,000 and overhead applied to production was CU 120,000, there was over-absorption of CU 20,000. In either case, the difference must be analyzed to determine the causes of the variance. Under or over absorption may arise either due to the difference between actual expenditure and budgeted expenditure or due to difference in budgeted production volume and actual production. Over or under absorption of overheads should be calculated at the end of each accounting period. More frequent calculations may give rise to seasonal variations which offset each other over the full accounting period. Under-absorbed overheads are written-off to the profit and loss account and overabsorbed overheads are credited to the profit and loss account if the following conditions are fulfilled: (i) Over- or under-absorption has arisen due to the difference between the output achieved and the normal output level; or (ii) The amount is not significant in relation to the total factory overhead incurred. In both the above situations, production costs are normal and require no correction. Under-absorption arising due to idle capacity should always be charged to the profit and loss account. Similarly, over-absorption arising due to higher (as compared to normal) capacity utilization should always be credited to the profit and loss account. If the variance is significant and has arisen from an error in the fixation of rates, production costs should be adjusted. The total variance is apportioned between

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inventories (finished goods and work-in-progress) and cost of goods sold by using supplementary rates. Some firm use Suspense Account and transfer the amount of under- or over- recovery to the suspense account. The suspense account is carried over to subsequent accounting years for writing off as deferred charge or for crediting as deferred credit. This method is justified only under the following circumstances: (i) Variances have arisen due to seasonal fluctuations and business cycle which cover more than one period. (ii) Variances have arisen in initial periods of a new project which is yet to achieve 100% utilization of the normal capacity. This method is not in common use. Illustration 3.5 In a manufacturing unit overhead was recovered at a pre-determined rate of CU 25 per man-day. The total factory overhead incurred and the man-days actually worked were CU 4,150,000 and 150,000, respectively. Out of the 40,000 units produced in a period, 30,000 units were sold. There were also 30,000 incomplete units which may be reckoned at 66.67 per cent complete. On analyzing the reasons, it was found that 40% of the unabsorbed overheads were due to defective planning and the rest were attributable to increase in overhead costs. How would an absorbed overhead be treated in cost accounts? (Adapted, ICWA, Inter) Solution (A) Computation of under- or over-absorbed overheads Overhead actually incurred Overhead under-absorbed CU 4,150,000 CU 400,000 CU 160,000 Overhead absorbed: CU 25 150,000 man-days = CU 3,750,000 (B) Reasons for under-absorption Due to defective planning 40% of CU 400,000 Due to increase in overhead cost (Balancing figure) CU. 240,000 Under absorbed amount of CU 160,000, attributable to defective planning is to be treated period cost and is to be directly charged to profit and loss account. Product cost needs to be adjusted for Rs. 240,000, being the amount of under-absorbed overheads arisen due

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to error in estimating overhead costs. It is assumed that the difference in expenditure has not arisen from an abnormal transaction or event. (C) Apportionment of CU 240,000 between cost of sales, finished good and incomplete units: (i) Total production during the period in terms completed unit (a)Number of units completed: 30,000 + 10,000 = 40,000 units (b) Incomplete units in terms of completed unit: 66 .67% of 30,000units = 20,000 units Total production in terms of completed unit: 60,000 units (ii) Apportionment in the ratio of completed units (a) To cost of sales: CU 240,000 (30,000/60,000) = CU 120,000 (b) To finished goods: CU 240,000 (10,000/60,000) = CU 40,000 (c)To incomplete units: CU 240,000 (20,000/60,000) = CU 80,000 (D) Treatment of under-absorbed overheads in cost accounts 120,000 40,000 80,000 CU 400,000 3.1.5 Capacity Levels Capacity generally implies the maximum that can be achieved by the best possible use of the available facilities and other resources (e.g. human resources, basic organization structures, funds, etc.). Capacity depends upon the fixed amount of resources with which the management expects to run the business. The concept is applicable to plant and equipment and other resources such as human resources and material. Usually capacities of different operations in the production process are not balanced. Therefore, the bottleneck operation, which has the minimum capacity among all operations, determines the capacity of the complete production process. Let us take an example, assume that there are five operations A, B, C, D and E in the production process. Capacities of A, B, C, and D are 1,000 units. The capacity of E is 900 units. The capacity of the production process is 900 units. Usually, capacity is expressed in terms of number of units or standard hours per annum. To be written off to costing profit and loss account: CU 160,000 To be absorbed in cost of sales: To be absorbed in stock of finished goods To be absorbed in Stock of work-in-progress

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Theoretical capacity (Ideal capacity) It refers to the output that can be achieved if production is carried out at a maximum speed without interruption. With reference to plant and equipment, it indicates the rated capacity, that is, the capacity specified by the manufacturer or erector of the plant. Thus, theoretical capacity assumes no loss of time. Practical capacity This represents the production volume that can be achieved by efficient operation. Practical capacity provides for unavoidable operating interruptions such as weekly off, time lost for repair, unavoidable inefficiencies, normal down-time, normal breakdown, set-ups, etc. Practical capacity should be determined taking into account the maximum number of hours for which the facility can be used during the year. Practical capacity is determined by deducting unavoidable operating interruptions from theoretical capacity, and is usually expressed as a percentage of theoretical capacity. The percentage varies from industry to industry. On an average, practical capacity is expected to be between 7585 per cent of the theoretical capacity. Normal capacity The level of capacity utilization which satisfies the average customer demand is termed as normal capacity. Average is calculated by taking expected sales over a reasonably long period (35 years). Selection of a sufficiently long period levels out the peaks and troughs which come with seasonal and cyclical variations. Normal capacity is also termed as average capacity and is often less than 100 per cent of practical capacity. Budgeted capacity Budgeted capacity represents the expected (planned) level of activity for the budget period. Usually budget period covers one year.. Capacity based on sales expectancy Products are manufactured to be sold and, therefore, if a firm is unable to sell what it can produce, it would restrict its output for a particular period to the quantity expected to be sold during the period. Expected sales volume is determined after a careful analysis of the competitive conditions, general demand of the product and the influence of price changes on the sales volume. While capacity based on sales expectancy is a short-term concept,

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normal capacity is a long-term concept. Usually budgeted capacity represents capacity based on sales expectancy. Actual capacity Output achieved during the year is often termed as actual capacity. Usually, actual capacity fluctuates from year to year and may be more or less than the normal capacity. It cannot be more than the practical capacity. Idle capacity Idle capacity represents the temporary idleness of production or distribution facilities due to slow down in the inflow of orders. Idle capacity is the difference between the normal capacity and the actual capacity. Idle capacity may be divided into normal idle capacity and abnormal idle capacity. The difference between the normal capacity and the budgeted capacity may be viewed as normal idle capacity. The difference between the budgeted capacity and actual capacity may be viewed as abnormal idle capacity. Excess capacity Excess capacity represents the capacity which the firm does not expect to utilise in the near future (35 years). Firms create excess capacity because either the investment is indivisible or it expects increase in demand in the long term. Excess capacity is the difference between the practical capacity and the normal capacity. Excess capacity in a workstation might arise due to imbalance in practical capacities among different workstations. This excess capacity can be reduced by attempting synchronization of capacities of different workstations. 3.1.6 Accounting for Some Specific Cost Items Estimating and drawing office expenses Estimating and drawing office should be treated as a service cost centre. The overheads are usually reapportioned to production cost centres for final recovery. However, a portion of overheads collected under this cost centre is often treated as selling overhead and the balance is reapportioned to production cost centre. For example, expenses associated with preparation of tender estimates are treated as selling overhead. In a heavy engineering factory manufacturing specific on-off jobs, drawing hours for each job are recorded, and drawing office expenses are directly apportioned to jobs by using an hourly rate.

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Canteen expenses If the canteen runs on no profit, no loss basis, cost to the firm is zero. If the canteen is subsidized, the amount of subsidy is treated as factory overhead. The canteen is treated as a separate service cost centre and the net subsidy is reapportioned to production cost centres. If there is more than one canteen (e.g. workers canteen, supervisors canteen, officers canteen), each canteen should be treated as a separate cost centre. Similarly, subsidy to canteens supporting sales or administration offices should be treated as sales/administration overhead. Costs auxiliary to salaries and wages Costs auxiliary to salaries and wages include contribution to P.F., E.S.I., gratuity funds, pension funds and costs for providing fringe benefits to employees. If possible, auxiliary costs related to direct workmen should be charged to units produced by inflating the wage rates to be applied for the recovery of direct wages. Alternatively, those should be treated as overhead of the respective cost centres. Auxiliary costs related to indirect workers and other employees should be treated as overhead. Maintenance and repair of plant and buildings Maintenance and repair cost should be analyzed separately under the following categories: (a) Costs of preventive maintenance (b) Costs of major overhaul (c) Costs of repairing breakdowns Maintenance and repair costs include costs of maintenance spares and other materials, employee costs, and expenses of the maintenance department. The method of issuing service order authorizing each maintenance and repair work helps accumulate costs. Usually, repair hours are booked against each service order along with costs of spares and other materials. Maintenance department expenses are apportioned to each service order on the basis of maintenance hours. Costs accumulated against service orders are allocated to respective production cost centres. Cost for maintenance hours, not accounted for by service order, is reapportioned to production cost centres on some equitable basis.

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True costs of maintenance and repair can be worked out only if costs of other services received by the maintenance cost centre and administration costs are added to maintenance cost centre expenses. However, as the total expenditure on maintenance and repairs is in itself an overhead cost, such precision is usually considered wasteful. Cost for packing Packing may be of the following three types: (i) Primary packing: Packing that is essential for protection and convenient handling of the product; (ii) Secondary packing: Packing that is essential for safe transportation of the product; (iii) Fancy packing: Packing which aims to attract customers attention. Primary packing is treated as factory overhead, secondary packing is treated as distribution cost and fancy packing is treated as advertisement cost. Packing department is a separate cost centre and the total expenses are apportioned between primary packing, secondary packing and fancy packing on the basis of some technical estimate. Costs apportioned to primary packing are then reapportioned to production cost centres on some equitable basis. Royalties and patent fees Royalty based on units produced is treated as factory overhead. Royalty based on units sold is treated as selling expenses. If royalty is a fixed charge like rent, it is treated as factory overhead. The expenditure incurred for registration and renewal of patent is treated as administration overhead. 3.2 ADMINISTRATION OVERHEADS Administration overheads are expenses associated with the administration of an undertaking. Costs of formulating the policy, directing the organization and controlling the operations of an undertaking which are not directly related to production, selling, distribution, research or development activity or function are administration overheads. Thus, administration overheads do not include costs of administering manufacturing activities. Those costs are treated as manufacturing overhead. For example, costs of operating a time office are manufacturing overheads and not administration overheads. Examples of administration overheads are: office rents and rates; expenses of office lighting, heating and cleaning; depreciation, and costs of maintenance, repair and

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insurance of office building, office furniture and office equipment; salaries to office staff; directors remuneration; office supplies and other expenses; expenses on postage, telephone and courier services; printing and stationery; audit fees; legal expenses; and bank charges. Administration is an independent function and is as important as the other major functions. Since no direct relationship can be established between administration overhead and products or jobs manufactured and sold, and because these costs are largely fixed in nature, they are treated as period costs and charged directly to costing profit and loss account. 3.3 SELLING AND DISTRIBUTION OVERHEADS Selling overheads are costs of creating and stimulating demand and securing and executing orders. Costs of manufacturing and distributing finished products are excluded from selling overheads. Distribution overheads are costs of moving finished products to central and local storage, moving finished products to the customers, moving finished products to and from the prospective customers as in the case of goods on sale or return basis and making empty packages reusable. In short, when a product is placed in a saleable condition, production function ends and distribution function begins. Overheads related to distribution function are termed as distribution overhead. Many accountants prefer to deal with selling and distribution overheads together. Examples of selling overheads are: salaries, commissions, travelling expenses of salesmen and technical representatives; sales office expenses; bad debts; brokerage or third-party commissions; cost of operating the marketing information system including market research; expenses on advertisement and publicity; cost of catalogues and price lists; and costs of maintenance of showrooms. Examples of distribution overheads are: carriage and freight outwards; depreciation, cost of repair and maintenance, insurance charges and operating costs of distribution vehicles; costs of secondary packing; warehousing expenses; expenses on insurance of finished goods; and wastage of finished goods. Selling and distribution overheads are treated as period costs and charged directly to costing profit and loss account.

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3.4 RESEARCH AND DEVELOPMENT COSTS Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development is the application of research findings or other knowledge into a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services prior to the commencement of commercial production or use. An enterprise undertakes research to increase the stock of its scientific knowledge and devices new applications which is expected to create competitive advantage for its business. Research activities aim at the discovery of new knowledge which can be used in developing new products, services, processes, techniques or in improving existing products or processes. Development starts where research ends. The results of a research cannot be put directly to commercial use. It requires feasibility study and identifying practical difficulties which may arise in its applications. Development activities include conceptual formulation, design and listing of product/process alternatives, development of prototypes, etc. Research and development costs are likely to benefit future products and, therefore, an elaborate system of absorbing these costs to products, orders or process is hardly justified. Where research has been undertaken at the request of a client, it should obviously be charged to the customer. If research is specifically related to an existing product, it should be directly assigned to the product and considered in analyzing the profitability of the product. Research undertaken for the general interest of the firm should be treated as period cost. 3.5 ACCOUNTING FOR CERTAIN KEY ITEMS Bad debt There are two approaches for treating bad debt in cost accounts. One view is that bad debt is a financial loss only and should be excluded from cost accounts. The other view is that bad debt is similar to other expenses and should not be excluded from cost accounts. Accordingly, bad debt is considered an item of selling overhead. Abnormally high bad debts and bad debts of exceptional nature should be excluded from cost accounts. They should be charged to the profit and loss account.

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Advertisement costs Advertisement costs should be allocated and apportioned to various functions. For example, cost of advertisement for recruitment should be allocated to the personnel function. Costs of advertisements to create and retain demand for products and services should be allocated to selling function. Advertisement cost is an overhead but its accounting depends on its exact nature. Advertisement cost which is likely to result in a long-term benefit should be treated as fixed asset and depreciation on the same should be treated as selling overhead, e.g. the cost of neon signs. Market research costs Market research addresses itself to specific marketing problems. This includes the study of potential markets, customers behaviour, competitors strategy, etc. It is like a policy cost because it does not depend on the activity level, but varies with management policy on market research. The market research cost is treated as a selling overhead. However, if it is high in a particular period, it should be treated as a deferred charge. Only a portion of it should be included in the overhead for the current year and the balance should be carried forward to future years for inclusion in overhead costs for those years. Royalty and patent fees Royalty and patent fees may either be based on the units sold or produced, or may take the form of a periodical payment of a predetermined amount. If royalty and patent fees are fixed charges in the nature of rent, or are based on the number of units produced, they should be treated as manufacturing overheads. On the other hand, if they are based on the number of units sold, they should be treated as selling overhead. After-sales services It is a common practice to offer continued free support/maintenance services during a stipulated guarantee period. Treatment of cost of after-sales services in cost accounts depends upon the cause which has given rise to the after-sales services. If it is to rectify manufacturing defects, the cost is treated as manufacturing overhead. If design department is responsible for the defect, the cost is allocated to design department. If damage is caused in transit, the cost is

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treated as distribution overhead. The following after-sales service costs are usually treated as selling overhead: (a) Costs of routine services (b)Costs of after-sales services rendered only to retain customers goodwill, even though such services are not covered under any agreement. Appropriate accounting of costs of after-sales services requires a careful analysis of the total costs. Costs on after-sales services of an exceptional nature should be charged off to profit and loss account. For example, if suddenly an electrical engineering company incurs an abnormally heavy expenditure in rectifying a defect in a transformer supplied to a customer, inclusion of the same in production or selling costs would distort costs of production or sales. It is, therefore, logical to charge such a heavy expenditure to profit and loss account. ASSIGNMENT 3.1 (Re-apportionment) The Space Production Company manufactures components for radio and television satellites using two service departments and two production departments. The interdepartmental relationship and estimated overhead costs are given below: Percentage of Service Provided Maintenance From: Maintenance Scheduling Total overhead cost Required: (i) Using the direct method, show the amount of scheduling department costs to be allocated to assembly departments. (ii) Repeat (i) using the step method and allocating maintenance first. (iii) Repeat (ii) using the reciprocal method (method of simultaneous equations may be used). [Answer: (i) CU 120,000 (ii) Moulding CU 959,122; Assembly CU 844,878 (iii) Moulding CU 959,122; Assembly CU 844,878.] 3.2 (Overhead absorption) 20% CU 750,000 Scheduling 10% 400,000 Moulding 40% 50% 378,000 Assembly 50% 30% 276,000

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A manufacturing company has two departments X and Y and all products pass through both the departments. The following figures relate to production cost for June, 2008: X Direct labour-hours Machine-hours Raw materials Direct wages Overheads Job card for job no. 1 shows: Raw materials Direct wages Direct labour-hours Machine-hours CU 3,000 CU 250 225 200 CU 1,000 CU 380 200 600 6,000 4,500 CU 100,000 CU 6,000 CU 45,000 Y 4,000 2,000 CU 50,000 CU 8,000 CU 10,000

What method would you recommend for absorbing overhead? Give reasons. Compute the cost of job no. 1 under the method recommended by you and under another method of overhead absorption. (Adapted, ICWA, Inter) [Answer: Using machine-hour rate CU 9,630.00; using labour-hour rate CU 6,817.50.] 3.3 (Overhead absorption) The following particulars related to the production department of a factory for the month of June, 2008. Material used Direct wages Direct labour-hours worked Hours of machine operation Overhead charges allocated to the department 2008 are given below: Material used Direct wages Labour-hours booked CU 8,000 CU 6,250 3,300 CU 80,000 CU 72,000 20,000 25,000 CU 90,000

Cost data of a particular work order carried out in the above department during June,

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Machine-hours booked charging overheads? (i) Direct labour cost rate; (ii) Machine-hour rate; and (iii) Direct labour-hour rate

2,400

What would be the factory cost of the work order under the following methods of

(Adapted, ICWA, Inter) [Answer: (i) CU 22,062.50 (ii) CU 22,890.00 (iii) CU 29,100.00.] 3.4 (Comprehensive machine-hour rate) A machine shop has 6 identical machines manned by 5 operators. The machine cannot be worked without any operator wholly engaged on it. The original cost of all these 6 machines works out at CU 0.6 million. The following estimates are available for the year 2008: (a) Normal working hours per month (b) Absenteeism (without pay) per month (c) Leave with pay per month (d) Normal idle time (unavoidable) (e) Average rate of wages per day of 8 hours (f) Production bonus (g) Cost of power for the period (h) Supervision and indirect labour cost for the year (i) Lighting and electricity per annum (j) Repairs and maintenance of machines (k)Insurance charges (l) General management expenses as allocated for the year (m)Depreciation under straight line method 220 hr 20 hr 20 hr 20 hr CU 40 15% of wages CU 20,700 CU 8,100 CU 3,070 20% of the value of machines p.a. CU. 30,000 p.a. CU 84,000 15% on original cost of machines (Adapted, B.Com, CU) [Answer: Machine-hour rate CU 33.01.] Hint: Working-hours per month: 220 (20 + 20 + 20) = 160 hr. per worker; for 6 machines 5 160 = 800 hr.

You are required to workout a comprehensive machine-hour rate for the machine shops.

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3.5 (Administration overheads) In a certain business, administration costs are absorbed as a percentage of production costs. It is found that tenders for work made of expensive materials are regularly being lost on account of price, whereas, tenders for work using cheap materials are accepted. What explanations and/or recommendations would you make to the management regarding the matter? (Adapted, ICWA, Inter)

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