Essentials of Cost Accounting — Module 4

1. Overheads: Conceptual Foundation, Classification & Codification In cost accounting terminology, Overheads represent the aggregate of all indirect expenditures incurred in running an enterprise. Formally defined by CIMA (London), overheads comprise Indirect Materials + Indirect Labour + Indirect Expenses. Because overheads cannot be directly traced to specific cost units, they must be systematically collected, departmentalized, apportioned, and absorbed to ascertain the true full cost of products and services. 1.1 Multi-Dimensional Classification of Overheads

1. Functional: Classification

• Factory / Works Overheads: Incurred inside factory premises (factory rent, machine power, supervisor salaries, consumable oils).
• Administration Overheads: Incurred in general corporate governance (executive salaries, office legal fees, audit fees).
• Selling & Distribution Overheads: Incurred to stimulate demand and deliver goods (sales commissions, advertising, delivery van expenses).

1. Behavioural: Classification

• Fixed Overheads: Remain constant in total amount regardless of production volume within the relevant range (building rent, managerial salaries).
• Variable Overheads: Vary in direct proportion to output fluctuations (machine electricity, packaging materials).
• Semi-Variable Overheads: Contain fixed base charge plus variable usage fees (telephone bills, maintenance contracts). 1.2 Codification & Collection of Overheads To accumulate thousands of overhead transactions without confusion, cost accounting assigns pre-structured numerical or alphanumeric Cost Account Codes (Standing Order Numbers for factory overheads; Cost Account Numbers for administration/selling expenses) linked directly to source documents such as Material Requisition Slips, Invoices, Wage Summaries, and Journal Vouchers. 1.3 Accounting Treatment: Financial Items Excluded from Cost Accounts Financial Item Category Representative Items Cost Accounting Treatment & Justification

1. Purely: Financial Charges Loss on sale of fixed assets, interest on bank debentures, discount on issue of shares, penalty fines.

• Strictly Excluded: Non-operating financial transactions that do not relate to manufacturing activity.

1. Purely: Financial Incomes Dividend received on investments, interest on bank fixed deposits, capital gain on property sale.

• Strictly Excluded: Non-operating financial revenues excluded to reflect genuine factory operating efficiency.

1. Appropriations of: Profit Income tax payments, dividends paid to shareholders, transfers to general reserves, charitable donations.

• Strictly Excluded: Distribution of earned corporate profits, not a cost of production.

1. Notional /: Imputed Costs Rent on owned factory premises, interest on owned capital, salary to proprietor.

• Included for Decision-Making: Calculated for cost comparison parity, though absent in financial accounts.

2. Departmentalization, Allocation & Primary Distribution of Overheads Departmentalization is the process of dividing an entire manufacturing plant into distinct functional cost centers: Production Departments (which directly process products, e.g., Machining, Assembling, Painting) and Service Departments (which provide auxiliary maintenance and utility support, e.g., Boiler House, Tool Room, Canteen, Stores). 2.1 Overhead Allocation vs. Overhead Apportionment Overhead Allocation (Direct Whole Charging) The allotment of whole items of overhead cost directly to a single specific department or cost center without division (e.g., salary of the Assembly Department supervisor charged 100% to Assembly).

Overhead Apportionment (Proportionate Division) The distribution of common overhead expenses across multiple departments on an equitable, scientific, and measurable basis (e.g., dividing factory building rent among all departments based on floor area). 2.2 Master Bases for Primary Overhead Apportionment Overhead Expenditure Category Most Equitable & Scientific Apportionment Basis

1. Factory: Building Rent, Rates & Taxes, Building Insurance Floor Area Occupied (Square Feet / Square Meters) by each department.
2. Electric: Lighting & Heating Expenses Number of Light Points (or Floor Area if light points are unavailable).
3. Electric: Motive Power for Plant & Machinery Horsepower of Machines × Machine Operating Hours (HP-Hours).
4. Depreciation &: Insurance of Machinery Capital / Book Value of Plant and Machinery in each department.
5. Canteen: Subsidies, Welfare, Timekeeping, HR Expenses Number of Employees / Workers in each department.
6. Material: Handling & Storekeeping Costs Weight or Monetary Value of Materials Consumed.

7. Employer's PF & ESI Statutory Contributions Direct Wages Paid in each department. ∑ Worked Illustration: Primary Overhead Distribution Schedule

• Total Factory Overheads Incurred: Rent = ₹20,000 | Depreciation = ₹15,000 | Canteen = ₹10,000 | Power = ₹25,000. Total = ₹70,000.

Departmental Parameters:

• Production Dept A: Floor Area = 40% | Asset Value = 50% | Workers = 40% | HP-Hours = 50%.
• Production Dept B: Floor Area = 30% | Asset Value = 30% | Workers = 30% | HP-Hours = 30%.
• Service Dept S1: Floor Area = 30% | Asset Value = 20% | Workers = 30% | HP-Hours = 20%.

1. Dept A: Share = (40% of ₹20k Rent) + (50% of ₹15k Depr) + (40% of ₹10k Canteen) + (50% of ₹25k Power) = ₹8,000 + ₹7,500 + ₹4,000 + ₹12,500 = ₹32,000.
2. Dept B: Share = (30% of ₹20k) + (30% of ₹15k) + (30% of ₹10k) + (30% of ₹25k) = ₹6,000 + ₹4,500 + ₹3,000 + ₹7,500 = ₹21,000.

3. Service S1 Share = (30% of ₹20k) + (20% of ₹15k) + (30% of ₹10k) + (20% of ₹25k) = ₹6,000 + ₹3,000 + ₹3,000 + ₹5,000 = ₹17,000.

• RECONCILIATION: Total Primary Overhead = ₹32,000 + ₹21,000 + ₹17,000 = ₹70,000. 2.3 The Three Stages of Overhead Accounting: Synthesis Stage of Overhead Costing Analytical Action Direction of Flow Stage 1: Overhead Allocation Allotting whole specific overhead items to identifiable cost centers.

Whole Expense → Single Department. Stage 2: Overhead Apportionment Dividing common factory expenses across all departments on an equitable basis.

Common Expense → Multiple Departments. Stage 3: Overhead Absorption Charging accumulated departmental overheads to individual output units.

Department Overheads → Product Cost Units.

1. Secondary: Distribution: Re-Apportionment of Service Department Costs Because service departments (e.g., Boiler House, Maintenance, Stores) render services to production departments but do not produce saleable goods themselves, their accumulated primary overhead costs must be re-allocated to production departments. This process is termed Secondary Overhead Distribution. 3.1 Secondary Distribution Methodologies Secondary Method Operational Nature Applicability Scenario
2. Direct: ReApportionment Service costs apportioned exclusively to production departments, completely ignoring services rendered between service departments.

When inter-service department reciprocal services are negligible.

1. Step-Ladder (Non-Reciprocal): Service departments arranged sequentially based on the breadth of services rendered. The highest service provider is apportioned first and closed permanently.

When service departments render services to other service departments non-reciprocally.

1. Simultaneous: Equation Method Algebraic linear equations formulated to determine the true total reciprocal cost of each service department before final distribution to production departments.

• The Most Accurate Method: When service departments render mutual, reciprocal services to each other.

1. Repeated: Distribution Method Iterative passes continuously reapportioning service department balances until figures diminish to negligible fractions.

Practical continuous apportionment in complex multi-service factories. ∑ Worked Illustration: Simultaneous Equations Reciprocal Re-Apportionment

• Primary Overhead Totals: Service S1 (Stores) = ₹10,000 | Service S2 (Maintenance) = ₹6,000.
• S1 renders 20% service to S2 | S2 renders 10% service to S1. Production Depts share the rest.
• Equation 1: $S_1 = 10,000 + 0.10 S_2$ | Equation 2: $S_2 = 6,000 + 0.20 S_1$.

Substitute Eq 2 into Eq 1: $S_1 = 10,000 + 0.10 (6,000 + 0.20 S_1) = 10,000 + 600 + 0.02 S_1 implies 0.98 S_1 = 10,600$.

1. True: Cost of S1 = ₹10,600 / 0.98 = ₹10,816.33.
2. True: Cost of S2 = ₹6,000 + 0.20 (₹10,816.33) = ₹6,000 + ₹2,163.27 = ₹8,163.27.

• FINAL STEP: Net ₹10,816.33 from S1 and ₹8,163.27 from S2 are now distributed to Production Departments according to their operational utilization percentages. 3.2 Comparison: Step-Ladder vs. Repeated Distribution Method

1. Step-Ladder (Sequential): Method Service departments are arranged in descending order of services rendered. Once a service department's overheads are apportioned, no subsequent department can apportion costs back to it (One-way traffic).
2. Repeated: Distribution (Iterative) Method Service department expenses are repeatedly apportioned in cyclic rotation across all departments (including other service departments) until the residual balances drop to zero.
3. Overhead: Absorption Methods & Machine Hour Rate (MHR) Overhead Absorption is the ultimate phase of overhead accounting, whereby the total accumulated overheads of production departments are systematically charged to individual cost units or jobs. 4.1 Master Overhead Absorption Methodologies Absorption Method Mathematical Formula Ideal Industrial Application
4. Direct: Material % Rate (Production Overheads ÷ Direct Material Cost) × 100 Only when raw material prices are stable and uniform across all jobs.
5. Direct: Labour % Rate (Production Overheads ÷ Direct Labour Wages) × 100 Suited for labor-intensive shops where wage rates are uniform.
6. Direct: Labour Hour Rate Production Overheads ÷ Total Direct Labour Hours The Standard for Manual Operations:

Reflects the time element perfectly.

1. Machine: Hour Rate (MHR) Production Overheads ÷ Total Productive Machine Hours The Gold Standard for Automated & Mechanized Manufacturing. 4.2 Computation of Machine Hour Rate (MHR) MHR represents the total overhead cost incurred per hour of machine operation. Costs are segregated into Standing (Fixed) Charges (apportioned across total annual machine hours) and Machine (Variable) Expenses (computed directly on an hourly basis):

• MATHEMATICAL FORMULA: COMPREHENSIVE MACHINE HOUR RATE CAS-3 Overhead Absorption Engineering MHR = [ To tal Annual Standing Charges / P ro duc tiv e Mac hine Ho urs ] + Ho urly D eprec iatio n + Ho urly P ow er + Ho urly Repairs Key Components:
• Hourly Depreciation: [ (Asset Cost − Scrap Value) / Total Working Life in Machine Hours ].
• Hourly Power: Units Consumed per Hour × Electricity Rate per Unit. ∑ Worked Illustration: Machine Hour Rate (MHR) Computation
• Machine Parameters: Cost = ₹1,05,000 | Scrap Value = ₹5,000 | Useful Life = 10,000 operating hours.
• Annual Operating Hours = 2,000 hrs | Annual Standing Factory Rent & Supervisor Charges = ₹12,000.
• Power: 10 units/hr @ ₹2.00/unit | Annual Repairs & Maintenance = ₹4,000.

1. Standing: Charges per hour = ₹12,000 / 2,000 hrs = ₹6.00 / hr.

2. Depreciation per hour = (₹1,05,000 − ₹5,000) / 10,000 hrs = ₹1,00,000 / 10,000 = ₹10.00 / hr.

3. Power per hour = 10 units × ₹2.00 = ₹20.00 / hr.

4. Repairs per hour = ₹4,000 / 2,000 hrs = ₹2.00 / hr.

COMPREHENSIVE MACHINE HOUR RATE (MHR) = ₹6.00 + ₹10.00 + ₹20.00 + ₹2.00 = ₹38.00 per Machine Hour. 4.3 Simple Machine Hour Rate vs. Comprehensive Machine Hour Rate

1. Simple: Machine Hour Rate Includes only machine-specific direct running expenses (Depreciation, Power, Machine Maintenance, Consumables). Factory standing fixed overheads are absorbed via separate labor hour rates.
2. Comprehensive: Machine Hour Rate Integrates both direct machine running expenses and general factory standing fixed charges (plus direct machine operator wages if dedicated exclusively to one machine) into a single composite hourly rate. 4.4 Decision Matrix: Selecting the Appropriate Absorption Base Manufacturing Environment Recommended Absorption Base Operational Rationale
3. Highly: Automated / Capital-Intensive Machine Hour Rate (MHR) Machine time drives over 80% of operating costs (power, depreciation, specialized tooling).
4. Manual: Craftsmanship / Labor-Intensive Direct Labour Hour Rate (DLHR) Direct human labor time is the primary determinant of manufacturing duration and supervision.
5. Uniform: Piecework Production Rate Per Unit of Output Standardized mass production where all units consume identical manufacturing effort.
6. Under/Over: Absorption of Overheads & Master Cost Sheet Formulation Because overhead absorption rates are predetermined at the beginning of the year based on estimated budgets and forecasted capacity, actual overheads incurred almost never match the absorbed overheads charged to production. 5.1 Mechanics of Under-Absorption vs. Over-Absorption
7. Under-Absorption (Unabsorbed: Overhead) Actual Overhead Incurred > Overhead Absorbed.

Represents an under-recovery of cost from production jobs.

• Causes: Under-estimation of expenses; actual output falling far short of budgeted capacity (idle plant).

1. Over-Absorption (Over-Recovered: Overhead) Overhead Absorbed > Actual Overhead Incurred.

Represents excess cost charged into product costs.

• Causes: Over-estimation of overhead budget; unexpected surge in factory production volume. 5.2 Accounting Treatment of Under/Over Absorption

1. Use of: Supplementary Overhead Rate: Applied when the variance is substantial and arises from normal estimation miscalculations. A supplementary rate is calculated to adjust the value of Work-inProgress (WIP), Finished Goods, and Cost of Sales accounts.
2. Transfer to: Costing Profit and Loss Account: Applied when under-absorption is caused by abnormal factors (strikes, machine fires, major lockdowns); charged directly to Costing P&L as a period loss.
3. Carrying: Forward to Suspense Account: Carried forward into next year's suspense account in cyclical/seasonal industries where winter surpluses offset summer deficits. 5.3 The Supplementary Overhead Rate: Formula & Disposal

• MATHEMATICAL FORMULA: SUPPLEMENTARY OVERHEAD RATE Variance Rectification Supplementary O v erhead Rate = [ Ac tual O v erheads I nc urred − Abso rbed O v erheads ] ÷ Ac tual E quiv alent P ro duc tio n U nits ∑ Worked Illustration: Supplementary Rate Disposal of Under-Absorbed Overhead
• Operating Data: Actual Factory Overheads Incurred = ₹2,40,000 | Overheads Absorbed = ₹2,00,000 → Under-Absorbed Overhead = ₹40,000.
• Inventory Distribution: Completed & Sold = 8,000 units | Finished Goods Stock = 1,000 units | Work-in-Progress (WIP) = 1,000 units. Total = 10,000 units.

1. Supplementary: Rate = ₹40,000 ÷ 10,000 units = +₹4.00 per unit.

• Charged to Cost of Sales (8,000 × ₹4) = ₹32,000.
• Charged to Finished Goods Inventory (1,000 × ₹4) = ₹4,000.
• Charged to Work-in-Progress Inventory (1,000 × ₹4) = ₹4,000.
• RECONCILIATION: ₹32,000 + ₹4,000 + ₹4,000 = ₹40,000 Under-absorbed overhead completely rectified across current inventory and sales. 5.4 Master Tender / Quotation Cost Sheet Construction ∑ Worked Illustration: Tender Quotation Price Determination Client Tender Specifications for 1,000 Custom Units:
• Estimated Direct Materials = ₹80,000 | Estimated Direct Labour = ₹50,000.

1. Estimated: Prime Cost = ₹80,000 + ₹50,000 = ₹1,30,000.

• Factory Overheads absorbed at 60% of Direct Labour = 60% × ₹50,000 = ₹30,000.

1. Estimated: Works Cost = ₹1,30,000 + ₹30,000 = ₹1,60,000.

• Administration Overheads absorbed at 20% of Works Cost = 20% × ₹1,60,000 = ₹32,000.

1. Estimated: Cost of Production = ₹1,60,000 + ₹32,000 = ₹1,92,000.

• Selling & Distribution Overheads absorbed at ₹8.00 per unit = 1,000 × ₹8.00 = ₹8,000.

1. Estimated: Total Cost of Sales = ₹1,92,000 + ₹8,000 = ₹2,00,000.
2. Target: Profit (20% on Selling Price = 25% on Cost) = 25% × ₹2,00,000 = ₹50,000 → MINIMUM TENDER QUOTATION BID = ₹2,50,000 (₹250.00 / Unit). 5.5 Production Account vs. Cost Sheet & Ledger Control Accounts Analytical Dimension Cost Sheet (Statement of Cost) Production Account (T-Account Ledger)
3. Document: Format A statistical statement arranged in analytical columnar hierarchy (Prime Cost → Works Cost → Cost of Sales).

A formal double-entry ledger account prepared in traditional 'T' shape (Debit:

Costs; Credit: Output/Sales).

1. Double-Entry: Integration Memorandum statement; does not form part of the double-entry financial bookkeeping ledger.

Forms an integral part of double-entry cost accounting ledgers.

1. Unit: Cost Disclosure Shows total cost alongside Cost Per Unit in a separate dedicated column.

Shows only aggregate lump-sum totals; per-unit breakdown is typically omitted.

1. Future: Estimation Role Can be prepared for past historical periods or forecasted future tender quotations.

Strictly prepared post-facto for past completed accounting periods.