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Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
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LESSON # 16
FACTORY OVERHEAD COST
(Apportionment & Variance Analysis)
Reciprocal Apportionment
This method recognizes the fact that if a service department receives from other service e
department, the department receiving services should be charged. Thus the costs of
interdepartmental services are taken into account on reciprocal basis.
There are two main methods which may be used for reciprocal distribution:
1. Repeated distribution method
2. Algebraic method
Repeated distribution method
Under this method, the total of overhead costs of the service departments are distributed to other
service and product ion department according to the given percentage till the expense of all service
departments are exhausted or remains insignificant.
PRACTICE QUESTION
Following is the cost of summary of allocated indirect cost of an organization
Machining
Finishing
Maintenance
Air-conditioning Allocated
indirect cost
100,000
70,000
40,000
30,000
240,000
The above costs of service departments are apportioned among the departments in the following
ratios.
Machining Finishing
Air-
conditioning
Maintenance
60%
15%
25%
Appropriation
Air
70%
25%
5%
Conditioning
Production
Service
Machining
Finishing
Maintenance
Air-
Allocate
conditioning
Indirect cost
Rs. 240,000
100,000
70,000
40,000
30,000
Maintenance
24,000
6,000
(40,000)
10,000
Air-
28,000
10,000
2,000
(40,000)
conditioning
Maintenance
1200
300
(2,000)
500
Air-
350
125
25
(500)
conditioning
Maintenance
15
3.50
(25)
6.50
Air-
5
1.50
0.50
(6.50)
conditioning
153,570
86,430
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Solution (Algebraic method)
Maintenance Dept
=X=
(40,000)+5% of Air condition
Air conditioning Cost
=Y=
(30,000)+25% of maintenance
X =40,000+5% of y
X = 30,000 + 25% of x
X =40,000+0.05(30,000+0.25x)
X =40,000+1500+0.0125x
X =0.0125x = 41,500
0.9875x = 41,500
X = 41,500
0.9875
Cost of Maintenance Dept
X = 42,025
Y = 30,000 + 25% of x
Y = 30,000 + 0.25 (42,025)
Y = 30,000 +10,506 = 40,506
Y = 40,506
Apportionment
Machinery
Finishing
Maintenance
Air-condition
1,00,000
70,000
40,000
30,000
(42,025)
25,215
6,304
2,025
10,506
(40,506)
28,354
10,127
2,025
40,506
1,53,569
86,431
0
0
Over/under-absorption of overhead
In the previous LESSON s reference was made to an accounting problem associated with the use
of predetermined absorption rates.
Where the amount of overhead absorbed exceeds the actual overhead cost incurred, the excess is
known as over-absorption; if the amount absorbed is less than the cost incurred then the
difference is know as under-absorption.
Accounting for over/under absorptions
The extent of any over/under-absorption is a balancing figure in the production overhead account.
This is normally transferred to the costing profit and loss account each month. Though it may be
carried forward in the production overhead account until the end of the year when any net
over/under-absorption for the year is transferred to profit and loss account. This treatment, it is
argued, is reasonable because the predetermined absorption rate is based on annual costs and
activity levels.
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PRACTICE QUESTION
Q. 1
From the following data calculate the over/under absorption and show how the transactions
would be recorded in the production overhead account.
Absorption rate
= Rs.5.00 per direct labor hour
Number of direct labor hours = 1,400
Production overhead incurred = Rs. 6,900
Solution
Rs.
Production overhead absorbed = Rs.5.00 x 1,400
7,000
Production overhead incurred
6,900
Over-absorption
100
Production overhead account
Rs.
Rs.
6,900 Work-in-progress
7,000
Creditors
100
Balance (over-absorption)
7,000
7,000
Q. 2
From the following data relating to four departments of a factory you are required to:
(a) Journalize departmental overheads incurred
(b) Journalize departmental overheads recovered
(c) Give the journal entry recording under or over-absorbed overhead expenditure.
Actual expenses
Absorption rates (based on pre-determined
Rs.
annual estimates}
Department A
1,000
Rs.0.10 per machine hour
Department B
4,000
Rs.0.75 per direct labor hour
Department C
7,000
100% on direct wages
Department D
3,500
Rs.0.25 per unit
Machine
Direct
Direct wages
Units produced
hours worked
labor hours
worked
Rs.
Department A
10,000
11,000
6,000
100,000
Department B
3,000
5,300
6,000
48,900
Department C
6,000
18,000
6,800
52,000
Department D
14,000
30,000
10,000
13,800
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Solution
(a) Departmental overheads incurred.
Dr -
Cr
Rs.
Rs.
Department A overhead account
1,000
Department B overhead account
4,000
Department C overhead account
7,000
Department D overhead account
3,500
Factory overhead control account
15,500
Transfer of actual departmental expenses
15,500
15,500
for period
(b) Departmental overheads recovered
Dr
Cr
Rs.
Rs.
Work in progress account
15,225
Department A overhead account
1,000
Department B overhead account
3,975
Department C overhead account
6,800
Department D overhead account
3,450
Transfer of absorbed departmental expenses for period
15,225
15,225
(c) Under- or over-absorbed overhead expenditure
Dr
Cr
Rs.
Rs.
Profit and loss account
275
Department B overhead account
25
Department C overhead account
200
Department D overhead account
50
275
275
Transfer of under-absorbed departmental expenses for period
(c) Under or over-absorbed overhead expenditure
Department A
10.000 machine hours x Rs.0.10
1,000
Department B
5.300 labor hours x Rs.0.75
3,975
Department C
100% of Rs.6.800
6,800
Department D
13,800 units x Rs.0.25
3,450
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If predetermined absorption rates are used. It is likely that there will be under or over-absorption
of overheads. This is the balance on the production overhead account and will be debited or
credited in the costing profit and loss account.
Absorption of non-production costs
Non-production costs are costs incurred for non-manufacturing reasons such as administration
or selling and marketing cost.
The cost of administration, marketing, research and development etc. has a great impact on the
fortunes of a business, and thus must be allowed for in cost-per-unit. Calculations which provide
information for cost control and disclose the effect of management decisions on other function
costs, and vice versa.
Marketing
Marketing comprises the activities of selling, publicity and distribution.
The cost accounting system should show:
Suitable cost centre analysis to identify costs with responsibility
Analysis between fixed and variable, especially for distribution costs, e.g. packaging and
delivery
Statistical bases to measure and compare costs, e.g. salesmen's calls, number of orders
General administration
General administration represents the costs of general management, secretarial accounting and
administrative services except for any such costs which can be directly related to production,
marketing, research or development.
Once again the cost accounting emphasis will be on analysis by cost centre for control.
Research and development
Research costs are those incurred in seeking new or improved products or methods. Development
costs are those incurred by those stages from decision implementation to production.
Cost analysis will usually relate to natural classification, such as materials or laboratory services and
will accumulate costs by specific project.
Attributing non-production costs to output
IAS 2 regulates the valuation of stocks and work-in-process for financial accounting purposes and
states that only production costs should be included in stock valuations. This defeat the argument
for attributing non-production costs to output. However, as has been stated above, such costs are
often significant, and their inclusion in internal unit costs may be necessary in order to ensure that
they are fully recognized in any pricing policy discussions undertaken by management accountants.
For pricing purposes the most common method of attributing non-production costs to output
units is by an absorption rate calculated as a percentage of production cost. The alternative to this
is to treat non-production overheads as period costs and write them off in full as an expense of the
period in which they are incurred, with no absorption into units produced in the period.
Multiple Choice Questions
1 The following statements relate to the effects or advantages of using a predetermined overhead
absorption rate, rather than calculating overhead costs on the basis of actual costs and actual
activity levels.
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(a) IAS 2 requires the absorption of production overhead to be based on normal levels of
activity rather than actual levels of activity.
(b)  Using a pre-determined absorption rate avoids fluctuations in unit costs caused by
abnormally high or low overhead expenditure or activity levels.
(c) The net profit each year, allowing for the under- or over-absorbed overhead adjustment
to profit, will be the same with pre-determined overhead rates as with actual rates.
(d) Using a pre-determined absorption rate offers the administrative convenience of
being able to record full production costs sooner.
All of these statements are correct except:
A. Statement (a)
B. Statement (b)
C. Statement (c)
D. Statement (d)
2 What is cost apportionment?
A. The charging of discrete identifiable items of cost to cost centers or cost units
B. The collection of costs attributable to cost centers and cost units using the costing
methods, principles and techniques prescribed for a particular business entity
C. The process of establishing the costs of cost centers or cost units
D. The division of costs amongst two or more cost centers in proportion to the estimated
benefit received, using a proxy, e.g. square feet
3
Grumpy & Dopey Ltd estimated that during the year 75,000 machine hours would be used
and it has been using an overhead absorption rate of Rs.6.40 per machine hour in its
machining department. During the year the overhead expenditure amounted to Rs.472,560
and 72,600 machine hours were used.
Which one of the following statements is correct?
A. Overhead was under-absorbed by Rs.7,440
B. Overhead was under-absorbed by Rs.7,920
C. Overhead was over-absorbed by Rs.7,440
D. Overhead was over-absorbed by Rs.7,920
PROBLEM QUESTION
You are the cost accountant of an industrial concern and have been given the following
budgeted information regarding the four cost centers within your organisation.
You also ascertain the following points:
(i) The canteen staff is outside contractors.
(ii)  Departments 1 and 2 are production cost centers and the Maintenance department and
Canteen are service cost centers.
(iii) The Maintenance department provides 4,000 service hours to Department 1 and 3,000 service
hours to Department 2
(iv) Department 1 is machine-intensive and Department 2 is labor-intensive.
(v) 6,320 machine hours and 7,850 labor hours are budgeted for Departments 1 and 2 respectively
for 2006.
Required
Prepare an overhead cost statement showing the allocation and apportionment of overhead to the
four cost centers for the year 2006, clearly showing the basis of apportionment. Consider the
following given information:
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Cost & Management Accounting (MGT-402)
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Dept 1
Dept 2
Maint-
Canteen
Total
enance
Rs.
Rs.
Rs.
Rs.
Rs.
Indirect labor
60,000
70,000
25,000
15,000
170,000
Consumables
12,000
16,000
3,000
10,000
41,000
Heating and lighting
12,000
Rent and rates
18,000
Depreciation
30,000
Supervision
24,000
Power
20,000
315,000
You are also given the following information:
Dept 1
Dept 2
Mainte
Canteen
Total
dept
Floor space in
10,000
12,000
5,000
3,000
30,000
square meters
Book value of
150,000
120,000
20,000
10,000
300,000
machinery in Rs
Number of employees
40
30
10
80
Kilowatt hours
4,500
4,000
1,000
500
10,000
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Table of Contents:
  1. COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
  2. IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
  3. FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
  4. FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
  5. PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
  6. MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
  7. MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
  8. CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
  9. ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
  10. ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
  11. LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
  12. PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
  13. PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
  14. LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
  15. ALLOCATION AND APPORTIONMENT OF FOH COST
  16. FACTORY OVERHEAD COST:Marketing, Research and development
  17. FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
  18. JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
  19. PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
  20. PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
  21. PROCESS COSTING SYSTEM:Normal Loss at the End of Process
  22. PROCESS COSTING SYSTEM:PRACTICE QUESTION
  23. PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
  24. PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
  25. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
  26. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
  27. MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
  28. MARGINAL AND ABSORPTION COSTING:Contribution and profit
  29. COST VOLUME PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
  30. COST VOLUME PROFIT ANALYSIS:Target Contribution Margin
  31. BREAK EVEN ANALYSIS MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
  32. BREAKEVEN ANALYSIS CHARTS AND GRAPHS:Usefulness of charts
  33. WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
  34. Production & Sales Budget:Rolling budget, Sales budget
  35. Production & Sales Budget:Illustration 1, Production budget
  36. FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
  37. FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
  38. TYPES OF BUDGET:Format of Cash Budget,
  39. Complex Cash Budget & Flexible Budget:Comparing actual with original budget
  40. FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
  41. DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
  42. DECISION MAKING:Size of fund, Income statement
  43. DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
  44. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
  45. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS