Welcome to Overhead Costs and Job Costing!

Ever wondered how a company like Nike or a local bakery decides the price of a single product? It’s easy to count the cost of the leather in a shoe or the flour in a cake. But what about the factory rent, the electricity for the ovens, or the manager's salary? These are Overhead Costs, and in this chapter, we will learn the "art" of sharing these costs among the products being made.

This is a core part of Unit 1: The Accounting System and Costing. Don't worry if it seems like a lot of steps at first—we will break it down into a simple, logical journey!

1. What are Overhead Expenses?

Overheads are indirect costs. They are costs that cannot be easily or cheaply traced to a specific unit of production. For example, you can't easily say exactly how many cents of the factory's "security guard's salary" went into one specific loaf of bread!

Types of Overheads

Overheads behave differently depending on how much you produce. Understanding these is vital for your exams:

  • Fixed Overheads: These stay exactly the same regardless of how many items you make (e.g., Factory Rent or Insurance).
  • Variable Overheads: These change in direct proportion to production (e.g., Indirect materials like cleaning supplies—the more you work, the more you use).
  • Semi-Fixed Overheads: These stay constant for a while but "jump" to a new level at certain production points (e.g., Supervisor salaries—you might need one supervisor for every 20 workers).
  • Semi-Variable Overheads: These have both a fixed and a variable element (e.g., a Electricity bill with a fixed standing charge plus a cost per unit of power used).

Quick Review: If a cost doesn't change when you produce more, it's Fixed. If it does, it's likely Variable or Semi-Variable.

2. Allocation and Apportionment

Before we can figure out the cost of a product, we need to get all the factory overheads into the right "departments" (Cost Centres). We do this in two ways:

A. Allocation

This is simple! If a cost can be traced entirely to one specific department, we "allocate" it there. Example: The salary of the manager of the Cutting Department is allocated 100% to the Cutting Department.

B. Apportionment

This is used for "shared" costs. We split the cost between departments using a fair basis. Here are common bases you should memorize for the exam:

  • Rent / Rates / Heating: Shared based on Floor Area (square meters).
  • Depreciation / Insurance of Machinery: Shared based on the Value of Machinery.
  • Canteen Costs / Personnel Costs: Shared based on the Number of Employees.
  • Electricity/Power: Shared based on Kilowatt hours or Capacity of machines.

The Calculation:
To find a department's share, use this formula:
\( \text{Department Share} = \left( \frac{\text{Total Cost}}{\text{Total Basis}} \right) \times \text{Department's Basis} \)

3. Service Department Re-apportionment

In a factory, some departments don't actually make anything. These are Service Departments (like Maintenance or the Canteen). However, their costs still need to be covered by the products!

We must move these costs into the Production Departments. We do this using continuous allotment (or the reciprocal method if they serve each other). Basically, you keep sharing the service department costs until they are zero.

Key Takeaway: By the end of this step, only the Production Departments should have costs assigned to them.

4. Overhead Absorption Rates (OAR)

Now that we have the total overheads for each production department, we need to "absorb" (attach) them to the products passing through. We calculate an Overhead Absorption Rate (OAR).

There are two main methods used in the Pearson Edexcel syllabus:

Method 1: Labour Hour Rate

Used when the department is Labour Intensive (most work is done by hand).
\( \text{OAR} = \frac{\text{Budgeted Overheads}}{\text{Budgeted Direct Labour Hours}} \)

Method 2: Machine Hour Rate

Used when the department is Capital Intensive (most work is done by machines).
\( \text{OAR} = \frac{\text{Budgeted Overheads}}{\text{Budgeted Machine Hours}} \)

Example: If the Assembly department has overheads of \$10,000 and works 2,000 machine hours, the OAR is \( \$5 \) per machine hour. If a product takes 2 hours in that machine, it "absorbs" \( \$10 \) of overhead.

5. Under and Over Absorption

The OAR is usually calculated at the start of the year using budgeted (estimated) figures. At the end of the year, the actual costs and actual hours might be different. This leads to a mismatch!

  • Over-absorption: When the overheads you "charged" to products are more than what you actually spent. (Good news! Profit increases).
  • Under-absorption: When the overheads you "charged" to products are less than what you actually spent. (Bad news! Costs were higher than expected).

How to calculate the Under/Over amount:
1. Calculate Absorbed Overheads: \( \text{Actual Hours Worked} \times \text{Predetermined OAR} \)
2. Compare this to Actual Overheads Spent.
3. \( \text{Difference} = \text{Under or Over Absorption} \)

6. Job Costing

Job Costing is used when a business does "one-off" unique jobs for customers (like a printer making wedding invitations or a mechanic repairing a specific car).

Characteristics of Job Costing:

  • Each job is unique and built to customer specifications.
  • Costs are collected for each individual job on a Job Cost Sheet.
  • It is used for batch production (where a group of identical items are made together).

Calculating the Price of a Job:

To find the total cost of a job, we add everything up:

Direct Materials (Actual cost used)
+ Direct Labour (Actual hours \(\times\) wage rate)
+ Direct Expenses (e.g., special tool hire for that job)
= Prime Cost

+ Production Overheads (Hours \(\times\) OAR calculated earlier)
= Total Production Cost

+ Non-production Overheads (e.g., admin or selling costs, if applicable)
= Total Cost

+ Profit Markup (e.g., 20% of cost)
= Selling Price

Common Pitfalls to Avoid

  • Using the wrong basis: Don't apportion Rent based on the number of employees! Always look for the most logical link (Rent \(\to\) Area).
  • Confusing OAR types: If a question says a department is "highly automated," always use Machine Hours for your OAR.
  • Math delimiters: When showing your workings in the exam, always show the formula first. It helps you get "method marks" even if your final answer is slightly off!

Summary Checklist

Before moving on to the next chapter, "Analysis of accounting statements," make sure you can:

  • Define Fixed, Variable, and Semi-variable costs.
  • Apportion a shared cost using a given basis.
  • Calculate a Labour Hour and Machine Hour OAR.
  • Determine if overheads were Under or Over absorbed.
  • Prepare a simple Job Cost Sheet to find a selling price.

Note: For inventory valuation (FIFO/LIFO) or labour remuneration (Piecework/Bonus), please refer to the separate chapters in Unit 1.