Preparation of Cost Sheet under Operating Costing

For preparing a cost sheet
under operating cost, costs are usually accumulated for a specified period viz., a month, a
quarter, or a year etc.
All of the accumulated costs should be classified under the following three heads:
1. Fixed costs or standing charges,
2. Variable costs or running charges,
3. Semi-variable costs or maintenance costs.

Meaning of Operating Costing

It is a method of ascertaining costs of providing or
operating a service. This method of costing is applied by those undertakings which
provide services rather than production of commodities. The emphasis under operating
costing is on the ascertainment of cost of services rather than on the cost of
manufacturing a product. This costing method is usually made use of by transport
companies, gas and water works departments, electricity supply companies, canteens,
hospitals, theatres, schools etc.

Economic Batch Quantity

In batch costing the most important problem is the
determination of optimum size of the batch (how much to produce) or Economic Batch
Quantity.
The determination of economic batch quantity involve two types of costs viz., (i) set up
cost (or preparation cost) and (ii) carrying cost. With the increase in the batch size, there
is an increase in the carrying cost but the set up cost per unit of product is reduced; this
situation is reversed when the batch size is reduced. Thus there is one particular batch
size for which both set up and carrying costs are minimum. This size is known as
economic or optimum batch quantity.

Meaning of Batch costing

This is a form of job costing. Under job costing,
executed job is used as a cost unit, whereas under batch costing, a lot of similar units
which comprises the batch may be used as a cost unit for ascertaining cost. In the case of
batch costing separate cost sheets are maintained for each batch of products by
assigning a batch number. Cost per unit in a batch is ascertained by dividing the total cost
of a batch by number of items produced in that batch. Such a method of Costing is used in
the case of pharmaceutical or drug industries, ready-made garments, industries manufacturing
electronic parts of T.V., radio sets etc.

Cost plus Contract

Under Cost plus Contract, the contract price is ascertained
by adding a percentage of profit to the total cost of the work. Such type of contracts are
entered into when it is not possible to estimate the Contract Cost with reasonable accuracy
due to unstable condition of material, labour services, etc.
Cost plus contracts have the following advantages and disadvantages :
Advantages :
(i) The Contractor is assured of a fixed percentage of profit. There is no risk of incurring any
loss on the contract.
(ii) It is useful specially when the work to be done is not definitely fixed at the time of making
the estimate.

Estimated profit

It is the excess of the contract price over the estimated total cost of
the contract.

Notional profit

It represents the difference between the value of work certified and cost
of work certified. It is determined :
Notional profit = Value of work certified – (Cost of work to date – Cost of work not yet
certified)

Work-in-progress

In Contract Accounts, the value of the work-in-progress consists of (i)
the cost of work completed, both certified and uncertified; (ii) the cost of work not yet
completed; and (iii) the amount of profit taken as credit. In the Balance Sheet, the work-inprogress
is usually shown under two heads, viz., certified and uncertified. The cost of
work completed and certified and the profit credited will appear under the head ‘certified’
work-in-progress, while the completed work not yet certified and the cost of labour,
material and expenses of work which has not yet reached the stage of completion are
shown under the head “uncertified” work-in-progress.

Retention money

A contractor does not receive full payment of the work certified by the
surveyor. Contractee retains some amount (say 10% to 20%) to be paid, after sometime,
when it is ensured that there is no fault in the work carried out by contractor. If any
deficiency or defect is noticed in the work, it is to be rectified by the contractor before the
release of the retention money. Retention money provides a safeguard against the risk of
loss due to faulty workmanship.

Cost of work certified

All building contractors received payments periodically known as
“running payment” on the basis of the architect’s or surveyor’s certificates. But payments
are not equal to the value of the work certified, a small percentage of the amount due is
retained as security for any defective work which may be discovered later within the
guarantee period.
Mathematically :
Cost of work certified = Cost of work to date – (Cost of work uncertified + Material in hand
+ Plant at site)
The amount retained is called retention money. The full value of the work certified should
be credited to the Contract Account and debited to the account of the contract. Since the
cash received from him will be less, the balance in his account will be shown as an asset
in the balance sheet.

Extra work

The extra work amount payable by the contractee should be added to the
contract price. If extra work is substantial, it is better to treat it as a separate contract. If itis not substantial, expenses incurred should be debited to the contract account as “Cost of
Extra work”.

Sub-Contract

Sub-contract costs are also debited to the Contract Account.

Plant and Machinery

The value of the plant in a contract may be either debited to
contract account and the written down value thereof at the end of the year entered on the
credit side for closing the contract account, or only a charge (depreciation) for use of the
plant may be debited to the contract account.

Indirect Expenses

Indirect expenses (such as expenses of engineers, surveyors,
supervisors etc.) may be distributed over several contracts as a percentage of cost of
materials, or wages paid or of the prime cost. If however, the contracts are big, the labour
hour method may be used for the distribution of expenses.

Direct Expenses

Direct expenses (if any) are directly charged to the concerned contract.

Labour Cost

Labour actually employed on the site of the contract is regarded as direct
(irrespective of the nature of the task performed) and the wages paid to them are charged
to the concerned contract directly or on the basis of a wage analysis sheet (if concurrently
a number of contracts are carried on and labourers are required to devote their time on
two or more contracts).

Material Cost

All materials supplied from the
stores or purchased directly for the contract are debited to the concerned contract
account. In the case of transfer of excess material from one contract to other contract,
their costs would be adjusted on the basis of material transfer note, signed both by the
transferee and the transferor foreman. In case the return of surplus material appears
uneconomical on account of high cost of transportation, the same is sold and the
concerned contract account is credited with the sale price. Any loss or profit arising therefrom
is transferred to the Profit and Loss Account.

Meaning of Contract Costing

Contract or terminal costing, as it is termed, is one
form of application of the principles of job costing. In fact a bigger job is referred to as a
contract. Contract costing is usually adopted by building contractors engaged in the task
of executing Civil Contracts. Contract costing have the following distinct features :
1. The major part of the work in connection with each contract is ordinarily carried out at the
site of the contract.
2. The bulk of the expenses incurred by the contractor are considered as direct.
3. The indirect expenses, mostly consist of office expenses of the yards, stores and works.

CONTRACT COSTING

A contract usually takes several years to get itself completed. If the
profit on such contracts is recorded only after their completion, then wide fluctuations may
be noted in the profit figures of contractors from year to year. To avoid these fluctuations
in the reported profits and to reflect the revenue in the accounting period during which the
activity is undertaken, the profit in respect of each contract in progress is transferred to
the profit and loss account of the year by calculating the notional profit. The portion of
notional profit to be transferred to the profit and loss account depends on the stage of
completion of a contract. To determine such a profit figure the knowledge of various
concepts as discussed below is essential in contract costing.

Treatment of spoiled and defective work

Spoiled work is the quantity of production that
has been totally rejected and cannot be rectified. Defective work on the other hand refers
to production that is not as perfect as the saleable product but is capable of being
rectified and brought to the required degree of perfection provided some additional
expenditure is incurred.Normally, all the manufacturing operations are not fully successful; they result in turning
out a certain amount of defective work. Nonetheless, over a period of time it is possible to
work out a normal rate of defectives for each manufacturing process which would
represent the number of defective articles which a process shall produce in spite of due
care.

Price of a job

Price of a job may be arrived by adding the desired percentage of profit to
the total cost of the job.

Accounting for Overhead

Manufacturing overheads are collected under suitable standing
order numbers and selling and distribution overheads against cost accounts numbers.
Total overhead expenses so collected are apportioned to service and production departments
on some suitable basis. The expenses of service departments are finally
transferred to production departments. The total overhead of production departments is
then applied to products on some realistic basis, e.g. machine hour; labour hour;
percentage of direct wages; percentage of direct materials; etc. It should be remembered
that the use of different methods will lead to a different amounts being computed for the
works overhead charged to a job hence to different total cost.

Accounting for Labour

All direct labour cost must be analysed according to individual
jobs or work orders. Similarly, different types of indirect labour cost also must be collected
and accumulated under appropriate standing order or expenses code number.
The analysis of labour according to jobs or work orders is, usually, made by means of job
time cards or sheets. All direct labour is booked against specific jobs in the job time cards
or sheets. All the idle time also is booked against appropriate standing order expense
code number either in the job time card for each job or on a separate idle time card foreach worker (where the job time card is issued job-wise). The time booked or recorded in
the job time and idle time cards is valued at appropriate rates and entered in the labour
abstract or analysis book.

Accounting for Materials

An essential requirement of job cost accounting is that direct
materials and their cost must be traced to and identified with specific job or work order.
This segregation of materials cost by jobs or work orders is brought about by the use of
separate stores requisitions for each job or work order. Where a bill of material is
prepared, it provides the basis for the preparation of these stores requisitions. But when
the entire quantity of materials specified in the bill of materials is drawn in one lot or in
instalments, the bill itself could be made to serve as a substitute for the stores requisition.

JOB COSTING

According to this method costs are collected and accumulated according to jobs, contracts,
products or work orders. Each job or unit of production is treated as a separate entity for the
purpose of costing. Job costing is carried out for the purpose of ascertaining cost of each job
and takes into account the cost of materials, labour and overhead etc. The job costing method
is also applicable to industries in which production is in batches since batch production
basically is of the same character as the job order production, the difference being mainly one
in the size of different orders. The method then may also be described as “Batch Costing”.

Overhead Adjustment Account

This account is to be debited for under-recovery of
overhead and credited with over-recovery of overhead amount. The net balance in this
account is transferred to Costing Profit & Loss Account.
Sometimes, Overhead Adjustment Account is dispensed with and under/over absorbed
overheads is directly transferred to Costing Profit & Loss Account from the respective
overhead accounts.

Costing Profit & Loss Account

The net profit or loss in this account is transferred to
Cost Ledger Control Account.

Cost of Sales Account

This account is debited with the cost of finished goods
transferred from Finished Goods Account for sale as well as with the amount of selling
and distribution overhead costs recovered. The balance of this account is ultimately
transferred to Sales Account or Costing Profit & Loss Account.

Selling and Distribution Overhead Account

This account is debited with Selling and
Distribution Overhead incurred and credited with the recovered Overhead. The difference
between incurred and recovered overhead is transferred usually to Overhead Adjustment
Account.

Administrative Overhead Account

This account is debited with overhead incurred
and credited with Overhead recovered. The Overhead recovered are debited to Finished
Goods Account. The difference between Administrative Overhead incurred and recovered
are transferred to Overhead Adjustment Account.

Manufacturing/Production/Works Overhead Account

This account is debited with
Indirect costs of production such as indirect material, indirect labour, indirect expenses
(carriage inward etc.). Overhead recovered is credited to this Account. The difference
between overhead incurred and overhead recovered is transferred to Overhead
Adjustment Account.

Wage Control Account

This account is debited with total wages paid (direct and
indirect). Direct wages are further transferred to Work-in-Progress Account and indirect
wages to Production Overhead; Administration Overhead or Selling & Distribution
Overhead Account, as the case may be. Wages paid for abnormal idle time are
transferred to Costing Profit & Loss Account either directly or through Abnormal Loss
Account.

Finished Goods Control Accounts

This account is debited to the tune of “value of
goods” transferred from work-in-progress account, administration costs recovered. This
account is credited with the cost of goods sold and Cost of Sales Account is debited. The
balance of this account represents the value of goods lying at hand.

Work-in-Progress Control Account

This account is debited with the total cost of
production, which includes—direct materials, direct labour, direct expenses, production
overhead recovered, and is credited with the amount of finished goods completed and
transferred. The balance in this account represents total balances of jobs/works-inprogress,
as shown by several job accounts.

Stores Ledger Control Account

Total of material purchases are debited to this
account. Whereas issues of material are credited. The balance in this account indicates
the total balance of all the individual stores accounts. Abnormal losses or gains if any in
this account, are transferred to Costing Profit & Loss Account.

Cost Ledger Control Account

This account is also known as General Ledger
Adjustment Account. This account is made to complete double entry. All items of
expenditure are credited to this account. Sales are debited to this account and net
profit/loss is transferred to this account. The balance in this account represents the net
total of all the balances of the impersonal accounts.

Finished Goods Ledger

It contains an account for each item of finished product
manufactured or the completed job. If the finished product is transferred to stores, a credit
entry is made in the work-in-progress ledger and a corresponding debit entry is made in
this ledger.

Work-in-Progress Ledger

This ledger is also known as job ledger, it contains
accounts of unfinished jobs and processes. Each job account is debited with direct and
indirect costs related with the job and credited with the amount of finished goods
completed and transferred. The balance in a job account represents total balance of
job/work-in-progress, as shown by the job account.

Stores Ledger

It contains an account for each item of stores. The entries in each
account maintained in this ledger are made from the invoice, goods received note,
material requisitions, material received note etc. Accounts in respect of each item of
stores show receipt, issue and balance in physical as well as monetary terms.

Cost Ledger

This is the principle ledger of the cost department in which impersonal
accounts are recorded. This ledger also contains a Control Account for each subsidiary
ledger.

NON-INTEGRATED ACCOUNTING SYSTEM

It is a system of accounting under which separate ledgers are maintained for cost and
financial accounts by Accountants. Under such a system the cost accounts restricts itself to
recording only those transactions which relate to the product or service being provided. Hence
items of expenses which have a bearing with sales or, production or for that matter any other
items which are under the factory management are the ones dealt with in such accounts. This
leads to the exclusion of certain expenses like interest and, bad debts and revenue/income
from ‘other than the sale of product or service’.

Night shift allowance

Workers in the factories, which operate during night
time are paid some extra amount known as ‘night shift allowance’. This extra amount is
generally incurred due to the general pressure of work beyond normal capacity level and
is treated as production overhead and recovered as such.
If this allowance is treated as part of direct wages, the jobs/production carried at night will
be costlier than jobs/production performed during the day. However, if additional
expenditure on night shift is incurred to meet some specific customer order, such
expenditure may be charged directly to the order concerned. If night shifts are run due to
abnormal circumstances, the additional expenditure should be charged to the costing
profit and loss account.

Expenses for welfare activities

All expenses incurred on the welfare
activities of employees in a company are part of general overheads. Such expenses
should be apportioned between factory, office, selling and distribution overheads on the
basis of number of persons involved.

Carriage and cartage expenses

It includes the expenses incurred on the
movement (inward and outwards) and transportation of materials and goods.
Transportation expenses related to direct material may be included in the cost of direct
material and those relating to indirect material (stores) may be treated as factory
overheads. Expenses related to the transportation of finished goods may be treated as
distribution overhead.

Canteen expenses

The loss incurred by the firm in running the canteen should be
regarded as a production overhead. If the canteen is meant only for factory workerstherefore this loss should be apportioned on the basis of the number of workers employed
in each department. If office workers also take advantage of the canteen facility, a
suitable share of the loss should be treated as office overhead.

Training expenses

Training is an essential input for industrial workers. Training
expenses in fact includes wages of workers, costs incurred in running training department,
loss arising from the initial lower production, extra spoilage etc. Training expenses of
factory workers are treated as part of the cost of production. The training expenses of
office; sales or distribution workers should be treated as office; sales or distribution
overhead as the case may be. These expenses can be spread over various departments
of the concern on the basis of the number of workers on roll.
Training expenses would be abnormally high in the case of high labour turnover such
expenses should be excluded from costs and charged to the costing profit and loss
account.

Bad debts

There is no unanimity among different authors of Cost Accounting
about the treatment of bad debts. One view is that ‘bad debts’ should be excluded from
cost. According to this view bad debts are financial losses and therefore, they should not
be included in the cost of a particular job or product.
According to another view it should form part of selling and distribution overheads,
especially when they arise in the normal course of trading. Therefore bad debts should be
treated in cost accounting in the same way as any other selling and distribution cost.
However extra ordinarily large bad debts should not be included in cost accounts.

Expenses on removal and re-erection of machines

Expenses are sometime
incurred on removal and re-erection of machinery in factories. Such expenses may be
incurred due to factors like change in the method of production; an addition or alteration in
the factory building, change in the flow of production, etc. All such expenses are treated
as production overheads. When amount of such expenses is large, it may be spread over
a period of time.
If such expenses are incurred due to faulty planning or some other abnormal factor, then
they may be charged to costing Profit and Loss Account.

Fringe benefits

These are the additional payments or facilities provided to the
workers apart from their salary and direct cost-allowances like house rent, dearness and
city compensatory allowances. These benefits are given in the form of overtime, extra
shift duty allowance, holiday pay, pension facilities etc.
These indirect benefits stand to improve the morale, loyalty and stability of employees
towards the organisation. If the amount of fringe benefit is considerably large, it may be
recovered as direct charge by means of a supplementary wage or labour rate; otherwise
these may be collected as part of production overheads.

Packing expenses

Cost of primary packing necessary for protecting the product
or for convenient handling, should become a part of the prime cost. The cost of packing to
facilitate the transportation of the product from the factory to the customer should become
a part of the distribution cost. If the cost of special packing is at the request of the
customer, the same should be charged to the specific work order or the job. The cost of
fancy packing necessary to attract customers is an advertising expenditure. Hence, it is to
be treated as a selling overhead.

Depreciation

Depreciation “is the diminution in the intrinsic value of an asset due
to use and/or the lapse of time.” Depreciation is thus the result of two factors viz., the use,
and the lapse of time. We know that each fixed asset loses its intrinsic value due to their
continuous use and as such the greater the use the higher is the amount of depreciation.
The loss in the intrinsic value may also arise even if the asset in question is not in
service.
In Cost Accounting depreciation is charged to the cost of production.

Treatment of interest and financial charges

There is controversy whether
financial charges, specially interest, should be included in the costs or not. The following
arguments are generally advanced in favour of interest to be included in overhead
expenses.
(1) Computation of total cost is impossible unless interest is taken into account. Interest
is an element of cost and therefore, should be included in cost. This is specially true
in business where raw materials in different stages can be used. Thus a timber
merchant, if he buys standing trees and seasons the timber himself, would incur a
large amount of costs as interest. Another merchant who buys his timber already
seasoned would automatically have to pay a higher price; obviously, this price
includes interest.

Idle facility

The term ‘facility’ has a wider connotation which may also include
prediction capacity. Facilities may be provided by fixed assets such as building space,
plants equipment capacity, etc. or by various service functions such as material services,
production services, personal services etc. If a firm fails to make full use of the facilities of
its disposal, the firm may be said to have idle facilities. Thus idle facilities refer to that
part of total facilities which remains unutilised due to any reason such as non-availability
of raw material, power, lack of demand etc. In Cost Accounting idle facilities are treated in
the same way as those of idle capacity.

Idle capacity cost

Costs associated with idle capacity are mostly fixed in nature. These
include depreciation, repairs and maintenance charges, insurance premium, rent, rates,
management and supervisory costs. These costs remain unabsorbed or unrecovered due to under-utilisation of plant and service capacity.

Idle capacity

It is that part of the capacity of a plant, machine or equipment which
cannot be effectively utilised in production. In other words, it is the difference
between the practical or normal capacity and capacity utilisation based on expected
sales. For example, if the practical capacity of production of a machine is to the tune
of 10,000 units in a month, but is used only to produce 8,000 units, because of
market demand of the product, then in such a case, 2,000 units will be treated as idle
capacity of the machine.

Actual capacity

It is the capacity actually achieved during a given period. This
capacity may lie between practical capacity and capacity based on sales expectancy.

Capacity based on sales expectancy

It is the capacity of a plant utilised based on
sales expectancy

Practical capacity

It is defined as actually utilised capacity of a plant. It is also
known as operating capacity. This capacity takes into account loss of time due to
repairs, maintenance, minor breakdown, idle time, set up time, normal delays,
Sundays and holidays, stock taking etc. Generally, practical capacity is taken
between 80 to 90% of the rated capacity. It is also used as a base for determining
overhead rates. Practical capacity is also called net capacity or available capacity.

Rated capacity

It refers to the capacity of a machine or a plant as indicated by its
manufacturer. In fact this capacity is the maximum possible productive capacity of a
plant. It is also known as installed capacity of a plant. Due to the loss of operating
time of a plant it is difficult to achieve this rated capacity. In other words, it is only a
theoretical capacity and is therefore, seldom achieved.

Control of Selling & Distribution Overheads

Control of selling and distribution
expenses is a difficult task. The reasons for this are as follows :
1. The incidence of selling and distribution overheads depends mainly on external
factors, such as distance of market, extent and nature of competition, terms of sales,
etc. which are beyond the control of management.
2. These overheads are dependent upon the customers, behaviour, their liking and
disliking, tastes etc. Therefore, as such control over the overheads may result in loss
of customers.
3. These expenses being of the nature of policy costs, are not amenable to control.
In spite of the above difficulties, the following methods may be used for controlling them.

Accounting of selling and distribution overheads

The collection and
accumulation of each expense is made by means of appropriate standing order numbers
in the usual way. Where it is decided to apportion a part of the administrative overhead to
the selling division the same should also be collected through appropriate standing order
numbers.
As in the case of administrative overheads, it is not easy to determine an entirely
satisfactory basis for computing the overhead rate for absorbing selling overheads. The
bases usually adopted are : (a) Sales value of goods; (b) Cost of goods sold; (c) Gross
Profit on sales; and (d) Number of orders or units sold.

ACCOUNTING AND CONTROL OF SELLING AND DISTRIBUTION OVERHEADS

Selling cost or overhead expenses are the expenses incurred for the purpose of promoting
the marketing and sales of different products. Distribution expenses, on the other hand,
are expenses relating to delivery and despatch of goods sold. Examples of selling and
distribution expenses have been considered earlier in this booklet. From the definitions it
is clear that the two type of expenses represent two distinct type of functions. Some
concerns group together these two type of overhead expenses into one composite class,
namely, selling and distribution overhead, for the purpose of Cost Accounting.

Control of Administrative Overheads

Mostly administrative overheads are of fixed
nature, and they arise as a result of management policies. These fixed overheads are
generally non-controllable. But at the same time these overheads should not be allowed to
grow disproportionately. Some degree of control has to be exercised over them. The methods
usually adopted for controlling administrative overheads are as follows :
(i) Classification and analysis of overheads by administrative departments according
to their functions, and a comparison with the accomplished results: According to this
method the expenses incurred by each administrative department are collected under
standing order numbers for each class of expenditure. These are compared with similar
figures of the previous period in relation to accomplishment. Such a comparison will
reveal efficiency or inefficiency of the concerned department.

Treating Administrative Overheads as a separate addition to Cost of

This method considers administration as a separate function like
production and sales and, as such costs relating to formulating the policy, directing the
organisation and controlling the operations are taken as a separate charge to the cost of
the jobs or a product, sold along with the cost of other functions. The basis which are
generally used for apportionment are :
(i) Works cost
(ii) Sales value or quantity
(iii) Gross profit on sales
(iv) Quantity produced
(v) Conversion cost, etc.

Treating Administrative Overheads as a separate addition to Cost of

This method considers administration as a separate function like
production and sales and, as such costs relating to formulating the policy, directing the
organisation and controlling the operations are taken as a separate charge to the cost of
the jobs or a product, sold along with the cost of other functions. The basis which are
generally used for apportionment are :
(i) Works cost
(ii) Sales value or quantity
(iii) Gross profit on sales
(iv) Quantity produced
(v) Conversion cost, etc.

Charging to Profit and Loss Account

According to this method administrative
overheads are charged to Costing Profit & Loss Account. The reason for charging to
Costing Profit & Loss are firstly, the administrative overheads are concerned with the
formulation of policies and thus are not directly concerned with either the production or
the selling and distribution functions. Secondly, it is difficult to determine a suitable basis
for apportioning administrative overheads over production and sales departments. Lastly,
these overheads are the fixed costs. In view of these arguments, administrative
overheads should be charged to Profit and Loss Account.
Disadvantages :
(1) Cost of products are understated as administrative overheads are not charged to
costs.
(2) The exclusion of administrative overheads from cost of products is against sound
accounting principle.

Apportioning Administrative Overheads between Production and Sales

sales departments. The reason for the apportionment of overhead
expenses over these departments, recognises the fact that administrative overheads are
incurred for the benefit of both of these departments. Therefore each department should
be charged with the proportionate share of the same. When this method is adopted,
administrative overheads lose their identity and get merged with production and selling
and distribution overheads.
Disadvantages :
(1) It is difficult to find suitable bases of administrative overhead apportionment over
production and sales departments.
(2) Lot of clerical work is involved in apportioning overheads.

ACCOUNTING AND CONTROL OF ADMINISTRATIVE OVERHEADS

Definition - According to I.C.M.A. Terminology, Administrative overhead is defined as “The
sum of those costs of general management and of secretarial accounting andadministrative services, which cannot be directly related to the production, marketing,
research or development functions of the enterprise.” According to this definition,
administrative overhead constitutes the expenses incurred in connection with the
formulation of policy directing the organisation and controlling the operations of an
undertaking. These overheads are also collected and classified in the same way as the
factory overheads.

Machine hour rate

By the machine hour rate method, manufacturing overhead
expenses are charged to production on the basis of number of hours machines are used
on jobs or work orders. There is a basic similarity between the machine hour and the
direct labour hour rate method insofar as both are based on the time factor. The choice of
one or the other method is conditioned by the actual circumstance of the individual case.
In respect of departments or operations in which machines predominate and the operators
perform relatively a passive part, the machine hour rate is more appropriate.

Labour hour rate

This method is an improvement on the percentage of direct
wage basis, as it fully recognises the significance of the element of time in the incurring
and absorption of manufacturing overhead expenses. This method is admirably suited to
operations which do not involve any large use of machinery. To calculate labour hour rate,
the amount of factory overheads is divided by the total number of direct labour hours.Suppose factory overheads are estimated at Rs. 90,000 and labour hours at 1,50,000.
The overhead absorption rate will be Re. 0.60. If 795 direct labour hours are spent on a
job, Rs. 477 will be absorbed as overhead. It can be calculated for each category of
workers.

Percentage of direct labour cost

This method also fails to give full recognition to
the element of the time which is of prime importance in the accounting for and treatment
of manufacturing overhead expenses except in so far as the amount of wages is a product
of the rate factor multiplied by the time factor. Thus, the time factor is taken into
consideration only indirectly or partially in the computation of the overhead percentage
rate. This method therefore, cannot be depended upon to produce very accurate results
where the same type of work is performed in the same time by different type of workers,
skilled and unskilled, with varying rates of pay.

METHODS OF ABSORBING OVERHEADS TO VARIOUS PRODUCTS OR JOBS

Before we describe various methods, it would be better to know how to judge whether a
method will give good results or not. The method selected for charging overheads toproducts or jobs should be such as will ensure :
(i) that the total amount charged (or recovered) in a period does not differ materially
from the actual expenses incurred in the period. In other words, there should not be
any significant over or under recovery of overhead; and
(ii) that the amount charged to individual jobs or products is equitable. In case of factory
overhead, this means :
(a) that the time spent on completion of each job should be taken into
consideration;
(b) that a distinction should be made between jobs done by skilled workers and
those done by unskilled workers. Usually, the latter class of workers needs more
supervision, causes greater wear and tear of machines and tools and waste a
larger quantity of materials.

Apportioning overhead expenses over various departments and reapportioning

After the
allocable overheads are related to the departments, expenses incurred for several
departments have to be apportioned over each department, e.g. rent, power, lighting,
insurance and depreciation. For distributing these overheads over different departments
benefiting thereby, it is necessary at first to determine the proportion of benefit received
by each department and then distribute the total expenditure proportionately on that basis.

Allocation of overheads over various Departments or Departmentalisation of

different departments in the factory. Where such a division of functions had
been made, some of the departments should be engaged in actual production of goods,
and others in providing services ancillary thereto. At this stage, the factory overheads
which can be directly related to the various production or service departments are
allocated in this manner.
It may, sometime, become necessary to sub-divide a manufacturing organisation into
several cost centres, so that a closer distribution of expenses and a more detailed control
is practicable.

Estimation and Collection of Manufacturing Overheads

The amount of factory
overheads is required to be estimated. The estimation is usually done with reference to
past data adjusted for known future changes. The overhead expenses are usually
collected through a system of standing orders.
Standing Orders : In every manufacturing business, expenses are incurred on direct
materials and direct labour in respect of several jobs or other units of production,
manufacture of which is undertaken. The incurring of these expenses is authorised by
production orders or work orders. The work order numbers are not ordinarily fixed or
permanent. They are generally allotted in a serial order according to the number of
manufacturing jobs undertaken by the business. In addition, indirect expenses are incurred
in connection with the rendering of services to the production departments, or to
the manufacturing process. The term “Standing Order” denotes sanction for indirect
expenses under various heads of expenditure.

Treatment of over and under absorption of overheads

After the year end the total
amount of actual factory overheads is known. There is bound to be some difference
between the actual amount of overheads and the absorbed amount of overheads. The
difference has to be adjusted keeping in view of such differences and the reasons
therefor.
Students will thus see that the whole discussion as above is meant to serve the following
two purposes :
(a) to charge various products and services with an equitable portion of the total amount
of factory overheads ; and(b) to charge factory overheads immediately as the product or the job is completed
without waiting for the figures of actual factory overheads.

Absorption

The production department overheads are absorbed over production
units. The overhead expenses can be absorbed by estimating the overhead expenses and
then working out an absorption rate. When overheads are estimated, their absorption is
carried out by adopting a pre-determined overhead absorption rate. This rate can be
calculated by using any one method as discussed in this chapter at the end.
As the actual accounting period begins, each unit of production automatically absorbs a
certain amount of factory overheads through pre-determined rates. During the year a
certain amount will be absorbed over the various products. This is known as the total
amount of absorbed overheads.

Re-apportionment

The next stage is to re-apportion the overhead costs of service
departments over production departments. Service departments are those departments
which do not directly take part in the production of goods. Such departments provide
ancillary services. Examples of such departments are boiler house, canteen, stores, time
office, dispensary etc. The overheads of these departments are to be re-apportioned over
the production departments since service departments operate primarily for the purpose of
providing services to production departments. At this stage, all the factory overheads are
collected under production departments.

Payroll procedure

The hours worked by each employee as reflected on the
completed clock cards are entered by an accounting department employee (or employees) on
the payroll sheet or payroll summary. All employees authorized for employment by the
personnel department are first listed on the payroll sheet. Hours and hourly rates are then
transferred from the clock cards, and total earnings are computed. Should a clock card for an
employee not listed on the payroll sheet be found, investigation of its propriety is required.
Likewise, there should be an explanation for any missing clock cards

Time-Booking

The clock card is required, essentially, for the correct determination of the
amount of wages due to a worker on the basis of time he has put in the factory. It merely
records day by day and period by period the total time spent by each individual worker in the
factory. But it does not show how that time was put to use in the factory—how an individual
worker utilised his time in completing jobs entrusted to him and how long he was kept waiting
for one reason or another due to lack of work, lack of material and supplies, lack of
instructions, machine breakdowns, power failures and the like. These are all vital pieces of
information necessary for the proper collection of cost data and for effective controlling of
costs. For the collection of all such information, a separate record, generally known as Time
(or Job) card, is kept.