# BBA Study Material to Cost Accounting Topic Wise Short Notes of Overheads

### Direct Labour Hour Rate Method

Under this method, overhead absorption rate is calculated by dividing the overhead with the number of direct labour hours.

For example, the budgeted overhead of production centre is Rs. 2,00,000 and the budgeted direct labour hours for the period is 40,000.

• This method takes into account the time spent by the labour in production of each unit where the production units are not uniform or identical.
• It is more appropriate in a labour intensive cost centre where proper records are maintained for time booking.
• It is adopted where labour is the limiting factor.

• It is not suitable in mechanised and capital intensive production.
• Maintenance of labour time records is difficult.
• distinction of hours spent by skilled worker and unskilled worker.

### Machine Hour Rate Method

CIMA defines machine hour rate as an “actual or predetermined rate of cost apportionment or overhead absorption, which is calculated by dividing the cost to be apportioned or absorbed by an number of hours for which a machine or machines are operated or expected to be operated.”

In a manufacturing environment where automatic and semi – automatic capital intensive machinery used , machine hour rate is applied in absorption of overheads. This is the most scientific method of absorption of factory overheads, the budgeted overhead cost to be absorbed is divided by the budgeted hours for which the machine or machines will work. The machine hour rate is calculated as follows:

For example, the budgeted production overhead is Rs. 3,00,000 and estimated machine is 15,000. Then machine hour rate is:

• It is used in mechanised production environment where machine time is vital and limiting factor.
• Machine hour rate will be able to account for varying lengths of time taken by production or jobs as they are worked on by the various machines in the department.
• It is more realistic because machine hour rate is applied only when the machine is used in production of the job or cost unit.
• Machine hour rate can be computed for the entire plant (called composite machine hour rate) or machine hour rate for individual machines (simple machine hour rate).

• In labour intensive industries machine hour rate is not suitable.
• It is difficult to maintain detailed record of machine usage.
• Ascertainment of machine hour rate requires skill and detailed working knowledge.

## Blanket Absorption Rate and Departmental Absorption Rate

A common absorption rate used through a factory and for all jobs and units of output irrespective or the department in which they were produced is called ‘blanket absorption rate’. Such rate is not appropriate where there are number of departments in the factory and jobs do not spend an equal amount of time in each department. In some cases, all the jobs or units may not pass through all the departments, in the factory. In such circumstances departmental overhead rate of respective department is applied to the jobs or units depending on time spent in each department instead of blanket absorption rate. If  all jobs do not spent approximately the same time in each department then, to ensure that all jobs are charged with their fair share of overheads, it is essential to establish separate overhead rates for each department.

### Predetermined Absorption Rates

In practice, actual overhead costs are not always readily available for application since the total figure of overhead cost incurred during the period will be ascertained only at the end of the accounting period and application of actual overhead absorption is not possible. To overcome the difficulty a predetermined overhead absorption rate is calculated at the beginning of the accounting period and is applied to the completed units during the period. The major objective of using predetermined absorption rate is to recover the overhead as soon as the product has been completed, to arrive at the product cost. It is calculated with the budgeted figures of the forthcoming accounting period basing on the expected level of activity.

## Over and Under Absorption of Overheads

By application of predetermined overhead absorption rates, overheads are absorbed into actual production throughout the accounting period. Because of the predetermined rates are based on expected overheads to be incurred and the estimated production, generally the overheads absorbed into the product cost do not agree with the actual overhead incurred for the period. If the overheads absorbed are higher than the actual overheads incurred it incurred during the accounting period. It is called ‘under absorption’.

### Reasons for Over or Under Recovery

The reasons for over or under recovery of overheads are as follows:

• The actual hours worked may be more or less than the estimated hours.
• Both actual overhead costs and actual activity level are different from the budgeted costs and levels.
• The absorption method used may not be correct.
• Extraordinary expenses might have been incurred during the accounting period.
• Major changes might have taken place for example replacement of manual labour with machines, replacement of general purpose machine with automatic high speed machine, increase in level of capacity etc.
• Seasonal fluctuations in the overhead expenses from period to period.

### Treatment of Under/over Absorption of overheads in Cost Accounts

The methods use in treating the under or over absorbed overheads in cost accounts are given below:

• Application of Supplementary Rates –

The under or over recovered overhead is adjusted by application of supplementary rates. The supplementary rate is calculated by dividing the under or over absorbed amount by the actual base. In case of under absorption, by applying the supplementary rate the unrecovered amount will be adjusted and vice verse.

• Write off to Costing Profit and Loss Account –

If the under or over absorbed overhead is small then it will be written off by transferring it to the costing profit and loss account.

• Carry Forward to Subsequent Year –

Treating the under or over absorbed overheads as seasonal fluctuations may be carried forward to the subsequent accounting year. This may be transferred to overhead suspense account or overhead reserve account.

## Idle Capacity costs

Idle capacity is that part of capacity of a plant, machinery or equipment which cannot be effectively utilised in production, due to lack of demand, shortage of raw material, power, labour etc. idle capacity is the difference between the practical capacity and capacity utilised. The idle capacity may exist due to internal problems or problems beyond the control of organisation the cost associated with the idle capacity are  generally of fixed in nature like depreciation, repairs and maintenance, insurance premium, rent , management and supervisory costs. These costs cannot be absorbed fully due to under utilisation of capacity available with the organisation.

The idle capacity costs are treated in the cost accounts in the following ways:

• Idle capacity costs due to unavoidable cause are absorbed into capacity utilised.
• Idle capacity costs due to avoidable causes are transferred to costing profit and loss account.
• Idle capacity costs due to seasonal fluctuations are absorbed into the cost of production by using supplementary overhead rates.

## Interest on Capital

The interest on capital employed in the manufacture is to be included or not in the cost account is a debated question. The arguments for and against inclusion of capital are given below:

### Arguments in Favour of Inclusion

• When wages is the reward of labour, interest is the reward of capital.
• Interest should either be ignored entirely or else included in respect of all capital employed whether such capital requires the payment of interest or not to avoid distortion of accounts.
• The exclusion of interest in cost accounts would distort cost of product in industries like seasoning if timber, brewing of wine etc. where substantial time is waited after the investment of capital, for which interest must be considered for ascertainment of profitability of the product.
• In many management decisions, the cost of capital will be crucial consideration especially when such decisions affect the organisation’s long – term prospects. It necessitates the inclusion of capital in cost accounts.
• The comparison of cost and profitability of different jobs, cost units or organisation time periods cannot be done without the inclusion of interest on capital.
• The importance of time value of money is recognised only when interest is considered as an element of cost.
• For long – run survival of the organisation it must earn sufficient profit to pay interest on capital provided for its business. Hence, importance of interest in cost accounts need not be over emphasised.
• Capital investment decisions are taken only after consideration of interest on capital otherwise it would be disastrous.

### Arguments against Inclusion

• The amount of interest paid depends entirely upon the method of capitalization and the financial policy of the organisation and its financing pattern.
• It is the argument of economists, “wages is the reward of labour, interest is the reward of capital”, and it is not the argument of costing.
• It interest is included in manufactured stock it has to be written back for balance sheet purposes.
• It is difficult to calculate the cost of capital. Its calculation may lead to various interpretations like interest on term loans, debentures, owner’s capital, working capital facilities etc. and other factors such as risk, period of maturity , bank rate etc.
• Interest is merely an anticipation of profit.
• It is difficult to apportion cost of capital to different cost centres and absorption of it into product cost.

In view of difficulties mentioned above, interest on capital cannot be included in cost accounts, but interest on capital should be given due consideration in all managerial decision making and comparative purposes.

## Depreciation

CIMA defines depreciation as “the measure of wearing out, consumption or other loss of value of a fixed asset whether arising from use, effluxion of time or obsolescence through technology and market changes”.

Depreciation is provided in cost accounts before working out the profitability of a job or cost unit. Depreciation is a gradual diminution, loss , or shrinkage in the utility of value of an asset due to wear and tear in use, effluxion  of time or obsolescence. Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. The cost of a product consists of not only normal expenses like direct material, direct labour , factory cost etc., which involve in cash outgo but also non – cash costs like depreciation which does not involve in cash outgo. Depreciation does not mean money set aside for the future replacement of assets. It  is provided to match the use of asset, its deterioration and obsolescence with the income it generates.

Depreciation and Cash Flow

Depreciation is neither a source nor use of funds. The use of funds obviously began when the fixed asset  was purchased. It would be double counting to regard each year’s depreciation as a further use of funds. The relevant figure for profit from operation is profit before charging depreciation. The quantum of operational funds flow cannot be influenced by the method of depreciation charged.

Depreciation and Inflation

Depreciation should be provided irrespective of the increase in value of asset due to inflation. It is not appropriate to omit charging depreciation of a fixed asset on the grounds that its market value is greater than its net book value. If account is taken of such increased value writing up the net book value of a fixed asset, then, an increased charge for depreciation will become necessary.

### Methods of Providing Depreciation

The principal methods of providing depreciation are as follows:

Straight Line Method – under this method an equal periodic charge for depreciation is made over the estimated economic life of the machine. In this method, a percentage of the original cost of the asset concerned less the residual value, if any, is written off every year till the end of its estimated life.

Diminishing Balance Method – under this method a fixed percentage is written off every year on a diminished book value of the asset till the asset is reduced to its scrap value. This method is also called ‘written down value method’ and ‘reducing balance method’.

Production Unit Method – under this method, an estimate is made of expected number of units that can be produced over the economic life of the machine. The depreciation per unit is arrived at by dividing the cost of asset with number of units it is expected to produce during its useful life.

Machine Hour Rate Method – under this method depreciation charge is calculated by dividing net cost of asset with the estimated production hours over its economic life.

Revaluation Method – under this method the asset is revalued at the end of each accounting period and depreciation is the difference between the value of the asset at the beginning and the end of the accounting period. This method is used in loose tools, furniture of service industry etc.

Replacement Cost Method – the current replacement price is based on the price for which assets might be sold. This valuation assumes continuation of the ordinary course of business and is not based on forced or distressed sale prices. Under this method the depreciation is taken as the difference between the current replacement cost at the beginning and the end of the accounting period.

Repair Provision Method – under this method, an aggregates of depreciation and maintenance cost is provided by means of periodic charges, each of which is a constant proportion of the aggregate of the cost of the asset depreciated and the expected maintenance cost during it s life.

Sinking Fund Method – under this method, an amount equal to the depreciation is invested outside in securities for replacement of the machinery.

Endowment Policy Method – under this method, endowment insurance policy is taken on the life of the asset, so that at the end of a definite period, the insurance company will pay the assured sum with the help of which the asset can be repurchased.

Modified Accelerated Cost Recovery method – under this system each kind of equipment is classified by its useful life and there is no consideration of salvage value under this method. The percentage of the value as stipulated by the government is to taken as depreciation each year.

For detailed study on methods of depreciation, the students are suggested to refer to books in ‘Financial Accounting’ subject.

### Objectives and importance of Sound Depreciation Policy

The sound depreciation policy is to be adopted for the following reasons:

• The original investment of the asset should be fully recovered into the product cost during the economic life of the asset.
• Depreciation acts as tax shield, since these charges against income do not effect the net inflow of funds and hence, proper planning in depreciation charges is necessary to reduce the tax burden on the organisation.
• Failure to recognise depreciation causes overstatement of income with an attendant possible distribution of capital through dividends. The adoption of sound depreciation will prevent distribution of capital through dividends. The adoption of sound depreciation will prevent the ‘impairment of capital’ through dividends based upon overstated earning .
• The method adopted to recover depreciation should be able to generate sufficient funds for replacement of the machinery at the end of its economic life.
• By providing adequate depreciation, the financial position of the company is correctly shown in the balance sheet.
• Depreciation should be a process of allocation of cost and it should not be a process of constantly valuing or revaluing fixed asset according to what they are currently ‘worth’.
• The ideal matching of expired cost against the related revenue and proper measurement of depreciable asset at each accounting date will ensure the uniform rate of return and the depreciation is equitably spread over the useful life of fixed asset.
• The cost of fixed asset is a long – term prepaid expense which by some equitable method must be proportionately charged over its useful life as an expense to be matched against revenue during each period.

### Depreciation and Obsolescence: Distinction

The distinguishing features of depreciation and obsolescence are given below.

### Plant and Other Fixed Assets Registers

A plant register is maintained keeping all details about the plant and machinery. It generally contains the following details:

• Description of each individual machine, identification number, original cost of the machine, name of supplier, date of installation and commercial run etc.
• Technical details like speed , fuel consumption, capacity , grade and quality of output etc.
• Details of the asset located in the factory.
• Details of estimated economic life, estimated output or production run hours during the economic life – time, method of depreciation, estimated residual or scrap value etc.
• Details of capital allowances, balancing charges or other allowances.
• Details of major break – downs and maintenance.
• Details of addition and alterations.
• Details of disposal of asset.

A register is also maintained for other fixed assets like buildings, vehicles, furniture and fixtures etc. similar to that of plant register. These registers will enable calculation of depreciation, book values etc. of each item and it will enable to allocate and apportion depreciation charges and other overhead costs like, repairs and maintenance, insurance etc.

### Using of Asset After Fully Depreciated

Sometime it will happen to continue in use of an asset after it is fully depreciated. The main reason for early recovery of depreciation is due to under estimation of economic life of the asset. In such situation it is usual to continue to charge depreciation so as to maintain cost comparability with previous accounting periods and current cost of the product will reflect the cost of using the asset. The excess depreciation so charged will either be kept in reserve against obsolescence or credited to costing profit and loss account. If before the asset is fully depreciated, its economic life is estimated to be further extended, then the balance depreciation will spread over to such enhanced period, and the problem of using asset after it is fully depreciated will not arise.

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