Cost Ascertainment-Overhead Costing

Cost Ascertainment for Overhead cost is the process of identifying cost incurred or paid for the production of a product. There are diverse logistics of handling overhead cost for an absorption rate is necessary to estimate (i.e. absorb) that type of cost to a product

Absorption of Overheads

The term absorption in cost accounting refers to the process estimating the amount of overhead cost to be incurred in production through budgeting. The estimation is done using absorption formula where a rate is computed as follows

Formula (general)

The general formula to estimate the expected overheads to be incurred is as given below;

Overhead Absorption Rate=Total Budgeted Overhead cost

                                             Total budgeted Base to be used

 

NB1: The total budgeted overhead represents either fixed or variable overhead

NB2: The denominator can assume other aspects depending on the correlation the denominator has with the overhead in question.

This  means that once the rate of absorption is established, it will be used to determine the estimated overhead cost to be affiliated to the cost unit or cost product which is compared with the actual overhead incurred at the end of it all.

Example:

The following estimates relate to Deluxe co.  Ltd for the year ending on 31st/05/2021

                                                            Amt.$

Projected Overhead                            78,750

Projected raw materials                      46,200

Projected direct labor cost                  47,250

Projected direct labor hours                12,600

Projected machine hours                    13,125

Projected units of output                      2,625

 

Additional information pertaining 30 units produced on 7th November 2020 are as provided hereunder

                                                                    Amt.$     

Projected material cost                                   88

Projected direct labor cost                              90

Projected direct labor hours                            22

Projected machine hours                                23

Note the following that; experience portrays that overhead is highly correlated with material cost, direct labor cost and direct labor hours.

Required

  1. Determine the overhead absorption rate based on the three aspects aforementioned
  2. Determine the overhead cost to be absorbed in producing the 30 units produced on 7th/Nov 2020

Solution

Overhead Absorption Rate 

Based on Projected Material Cost

Overhead Absorption Rate=Total Projected Overhead cost

                                             Projected Material Cost

                                              = 78750    = 1.704*100= 170.4% of projected material cost

                                               46200

Based on Projected Direct Labor Cost Basis

Overhead Absorption Rate=Total Projected Overhead cost

                                             Projected Direct Labor Cost

                                               = 78750    = 1.67*100= 167% of projected labor cost

                                               47,250

Based on Projected Direct Labor Hours Basis

Overhead Absorption Rate=Total Projected Overhead cost

                                             Projected Direct Labor Hours

                                             = 78750    = 6.25 of projected labor hours

 

Overhead cost to be absorbed in producing the 30 units produced on 7th/Nov 2020

Formula used is Actual Resources utilized for the actual output*Overhead Absorption Rate (OAR)

Therefore;

Based on Projected Material Cost                         

        170.4% *88= 149.952

                                          

Based on Projected Direct Labor Cost Basis     

                167%* 90= 150.3

Based on Projected Direct Labor Hours Basis

                 6.25* 24= 150

Over Absorption of Overheads

This is a case where by absorbed overheads are more than actual overhead cost incurred or paid.

Under Absorption of Overheads

This is a case where by absorbed overheads are less than actual overhead cost incurred or paid.

Reasons for Over or Under absorption of overhead

The reasons for over or under absorption of overheads are as follows.

1. The actual hours worked is either less or more than the budgeted hours.

2. The actual overhead costs are different from planned overheads.

3. Both actual overhead costs and actual activity level are dissimilar from the planned costs and level.

4. The technique of overhead absorption may be incorrect.

5. Unforeseen expenditures may be incurred during the accounting period.

6. Extra ordinary expenses might have been included in the calculation of overhead absorption rate.

7. Major changes like standby of manual labor with machines. This leads to increase in capacity levels.