How To Calculate Overhead Cost;5 Methods You Must Know

How To Calculate Overhead Cost.Procedure for calculating cost center overhead rates In this section we focus in more detail on the two-stage overhead process of assigning overheads to products. The procedure is as follows:

  • 1. Assign all factory overheads to production and service cost center.
  • 2. Reallocate service center costs to production cost center.
  • 3. Calculate separate overhead rates for each cost center.
  • 4. Assign cost center overheads to products.

Items 1 and 2 comprise stage one while 3 and 4 relate to stage two of the overhead assignment procedure. Now let us consider each of these items in more detail.

How To Calculate Overhead Cost;5 Methods You Must Know

1.Assigning overheads to production and service departments.

We established in the previous section the advantage of using separate overhead rates for each department. It is therefore necessary to assign all the factory overheads to production cost center. Some overhead expenses, such as machine depredation or indirect materials, can be directly assigned to production cost center. There are certain items of overhead expenditure, however, that cannot be directly attributed to specific departments because they are incurred for the benefit of many departments.

In respect of these items, it is necessary to establish a logical basis for apportioning the overheads to cost center/departments.

Procedure for calculating cost centre overhead rates

The problem with cost apportionment is that it is not possible to allocate costs in a universally acceptable manner. Several alternative methods of apportioning costs may be adopted, which cannot be said to be either right or wrong. More than one method may be acceptable in particular circumstances, and consequently the allocation of overhead costs is often arbitrary. The objective is to choose a method that measures the resources consumed by each department. For example, using floor area to allocate lighting and heating expenses assumes that cost center with large floor areas consume more lighting and heating. Similarly, using the number of employees to allocate supervisory costs assumes that those cost center with a large number of employees consume more supervisory costs. The end result of this stage is that all manufacturing overheads will be allocated to factory production and service departments.

Reallocation of service center overheads to production cost center Service departments are those departments that exist to provide services of various kinds to other units of the organization, for example stores and maintenance departments. They are sometimes called support departments. They render essential services that support the production process, but they do not deal directly with the products. Therefore it is not possible to allocate service department costs to products passing through these departments. Consequently their costs must be apportioned to production departments that actually work on the manufactured product.

The method that is chosen to apportion service department costs to production departments should be related to the benefits that the production departments derive from the service rendered. For example, many firms apportion the total expenditure of the stores department to the production departments on the basis of the number of stores requisitions or the value of materials issued. Similarly, maintenance department costs are often apportioned on the basis of the time recorded in the various production departments by the maintenance staff.

Once the service department costs have been apportioned to production departments, all factory overhead expenditure will be assigned to production departments. This enables an overhead rate for each production depart-ment to be established, and this rate is then charged to all products that pass through the various production departments. Calculation of appropriate departmental overhead rates The second stage of the two-stage procedure is to allocate the overheads of each production department to products passing through that department. The most frequently used allocation bases are volume-related and based on the amount of time products spend in each production centre -for example direct labour hours, machine hours and direct wages.

For a description of other methods that are sometimes used turn to Appendix 4.2. With volume-related allocation bases it is assumed that products consume cost centre resources in proportion to their production volumes. In respect of non-machine departments, direct labour hours are the most frequently used allocation base. This implies that the overheads assigned to a production department are closely related to direct labour hours worked. In the case of machine departments a machine hour overhead rate is preferable since most of the overheads (e.g. depredation) are likely to be more closely related to machine hours. Overhead rates would therefore be calculated as follows:

Procedure for calculating cost centre overhead rates

Charging overheads to products If we assume that, for the illustration shown above, product X spends 10 hours in department A, 6 hours in department B and 5 machine hours in department C, then the overhead allocated to product X will be £49. This is calculated as follows: Assembly department A: 10 direct labour hours at El per hour = £10 Assembly department B: 6 direct labour hours at £4 per hour = £24 Machine department C: 5 machine hours at 0 per hour = £15 £49.

Note that if all products spend the same proportion of time in each department as product X (10:6:5), it will be unnecessary to analyse overheads to departments, since a blanket overhead rate would yield the same overhead allocation. It would be rare, however, for such a situation to occur in practice in organizations that produce a range of different products.

2.Allocation of overheads to production and service departments.

Indirect wages and materials cannot be allocated to specific products, but they can normally be assigned specifically to the appropriate depart-ments. These items are therefore directly charged to departments on an actual basis. The remaining items listed on the overhead analysis sheet cannot be directly assigned to departments on an actual basis. Thus an appropriate method for apportioning the overheads to departments has to be established. We can assume that rent, lighting and heating, and insurance of build-ings are related to the total floor area of the buildings, and the benefit obtained by each department can therefore be ascertained according to the proportion of floor area which it occupies.

The total floor area of the factory in Example 4.1 is 50000 square metres; machine shop X occupies 20% of this and machine shop Y a further 10%. Consequently 20% of rent, lighting and heating and insurance of buildings will be apportioned to machine shop X, while 10% will be apportioned to machine shop Y. The insurance premium paid and depreciation of machinery are gen-erally regarded as being related to the book value of the machinery. Because the book value of machinery for machine shop X is iris of the total book value and machine shop Y is is of the total book value then and 155 of the insurance and depreciation of machinery is apportioned to machine shops X and Y.

It is assumed that the amount of time that works management devotes to each department is related to the number of employees in each department; since 30% of the total employees are employed in machine shop X, 30% of the salaries of works management will be apportioned to this department. Apportionment of service department overheads to production departments We have now allocated all the factory overhead expenditure to production and service departments. The next step is to reapportion the service department costs to production departments according to the benefits they have received.

We shall assume that the value of materials issued provides a suitable approximation of the benefit that each of the production departments receives from the stores department. Therefore 50% of the value of materials is issued to machine shop X, resulting in 50% of the total costs of the stores department being apportioned to X. The maintenance department records the amount of time during which its staff are employed on maintenance work in other departments, and this provides the basis for estimating the benefits which each production department obtains from the maintenance department. As 12 000 hours out of the 25000 hours worked in the maintenance departments are devoted to machine shop X, 48% of the costs’are apportioned to X.

How To Calculate Overhead Cost;5 Methods You Must Know

3.Calculation of overhead rates

The factory overheads have now been analyzed to production departments. The second stage in the two-stage allocation procedure is to establish an overhead rate for each department for charging to the products that pass through the various departments. We shall assume that the company uses a machine hour rate for the machine departments and a direct labour hour rate for the assembly department. The overhead rates are calculated by applying the following formula: departmental overheads departmental direct labour hours or machine hours The calculations using the information given in Example 4.1 are as follows:

Procedure for calculating cost centre overhead rates

The overhead rates are related to time but, since the overheads of the machine departments are predominantly machine-oriented, a machine hour rate is used. In the assembly department, however, no machine work is performed, and a direct labour hour rate is therefore calculated for this department.

Charging overhead to products.

The final step is to allocate overhead to products passing through the production departments. The final step is to allocate overhead to products passing through the production departments. If we assume that product A spends 3 hours in machine shop X, 2 hours in machine shop Y and 1 hour in the assembly department then the overhead allocated to this product will be £28.30.

The overhead allocation procedure is more complicated where service departments serve each other. In Example 4.1 it was assumed that the stores department does not provide any services for the maintenance department and that the maintenance department does not provide any services for the stores department. An understanding of situations where service departments do serve each other is not, however, necessary for a general understanding of the overhead procedure, and the problem of service department reciprocal cost allocations is therefore dealt with in.

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