Overhead costs, absorption and job costing

Introduction to Overheads and Job Costing

In your previous studies, you looked at Prime Costs—the direct costs like raw materials and factory wages that go straight into a product. But what about the factory rent? The electricity for the lights? Or the salary of the supervisor who watches over everyone? These are Overhead Costs.

In this chapter, we will learn how to "catch" these indirect costs and share them out fairly between different products. This ensures that when we sell a product, the price covers all our costs, not just the obvious ones. This process is vital for Job Costing, where we calculate the cost of a specific customer order or a batch of items.

1. Types of Overhead Expenses

Not all overheads behave the same way. We classify them based on how they react when we produce more items:

• Fixed Overheads: These stay the same regardless of how many items you make (within a certain limit). Example: Factory rent or insurance.
• Variable Overheads: These change in direct proportion to production. Example: Small tools or lubricants used in machines.
• Semi-Fixed (or Step) Overheads: These stay the same for a while but "jump" to a higher level once production hits a certain point. Example: Hiring a second supervisor because the factory floor got too busy.
• Semi-Variable Overheads: These have a fixed "standing charge" plus a cost that increases with use. Example: A telephone bill with a monthly line rental plus a charge per call.

Quick Tip: Think of a taxi fare. The "starting price" on the meter is fixed, but the "price per mile" is variable. Together, they make the total fare semi-variable!

2. Allocation and Apportionment

To find the total cost of a department, we use two methods to assign overheads:

A. Allocation

This is used when a cost can be wholly identified with a specific department. For example, if the Woodworking Department has its own specific machine, the repairs for that machine are allocated directly to that department.

B. Apportionment

This is used for shared costs. We must "split" the cost using a fair basis. Here are the common bases you need to know for your exam:

C. Re-apportionment of Service Departments

Some departments don't make products—they support those that do (e.g., the Maintenance Department or the Stores). In the exam, you may need to move these "Service Department" costs into the "Production Departments."

If service departments serve each other, we use the continuous allotment (or repeated distribution) method. You keep sharing the costs back and forth until the amounts become so small they reach zero.

3. Overhead Absorption Rates (OAR)

Once we know the total overheads for a production department, we need to "absorb" them into the products. We do this by calculating a Predetermined Overhead Absorption Rate.

The formula is:
\( \text{OAR} = \frac{\text{Budgeted Overheads}}{\text{Budgeted Activity Level}} \)

Which Activity Level should I use?

• Labour Hour Rate: Used if the department is "labour intensive" (mostly manual work).
  \( \text{OAR per labour hour} = \frac{\text{Total Budgeted Overheads}}{\text{Total Budgeted Direct Labour Hours}} \)
• Machine Hour Rate: Used if the department is "capital intensive" (mostly automated/machine work).
  \( \text{OAR per machine hour} = \frac{\text{Total Budgeted Overheads}}{\text{Total Budgeted Machine Hours}} \)

Don't worry if this seems tricky: Just remember that the OAR tells us how much "extra" cost to add to a product for every hour we spend making it.

4. Under and Over Absorption

Because the OAR is calculated at the start of the year using estimates (budgets), it is rarely perfect. At the end of the year, we compare the overheads we absorbed (charged to products) with the actual overheads we paid.

• Over-absorption: We charged too much to our products. This happens if actual costs were lower than expected or we worked more hours than planned.
• Under-absorption: We charged too little to our products. This is a "loss" because we didn't recover all our costs from our customers.

The Calculation:
1. \( \text{Absorbed Overheads} = \text{Actual Hours Worked} \times \text{OAR} \)
2. \( \text{Compare this result to the Actual Overheads paid.} \)

Example: If you absorbed \( \$5,000 \) but your actual bills were \( \$5,500 \), you have under-absorbed by \( \$500 \).

5. Job Costing

Job Costing is a technique used when a business performs a specific, unique task for a customer (like building a custom kitchen) or produces a batch of identical items (like 500 wedding invitations).

Characteristics of Job Costing:

• Each job is unique and has its own "Job Number."
• Costs are collected on a Job Cost Sheet.
• Work is often done to a customer's specific instructions.

How to calculate the Total Cost of a Job:

To find the price to charge a customer, follow this structure:

1. Direct Materials + Direct Labour + Direct Expenses = Prime Cost
2. Prime Cost + Absorbed Overheads = Total Production Cost
3. Total Production Cost + Profit Margin = Selling Price

Did you know? A "Markup" is profit as a percentage of cost, while a "Margin" is profit as a percentage of the selling price. Make sure to read the exam question carefully!

Note: For more on how to value the materials used in these jobs, see the chapter on "Introduction to costing: inventory valuation." For details on calculating the labour costs, see "Labour costs and methods of remuneration."