As we know the overhead charges or on-costs cannot be directly charged to a specific job or item produced in the factory. In industries producing single product the total overhead costs may be simply divided by the number of items produced. However, in the industries where two or more items are produced, the distribution of overheads i.e., determination of overhead charge per unit, is a complicated task. There are several methods used for allocation of overheads to different jobs and the choice of method depends on the type of organisation. Following are some important methods of allocation of overhead costs :
1. Allocation by cost proportion. 2. Allocation by hourly rate. 3. Allocation by unit rate. 1. Allocation by Cost Proportion
This method is sub-divided into three categories :
(a) Proportional to prime cost : In this method the total overhead costs of the industry are expressed as a fraction or percentage of the prime cost. This percentage multiplied by the prime cost of individual item gives the part of total overheads to be allocated to that item of manufacture. The formula for calculating the percentage of overheads is :
Percentage of overheads = Total overhead cost × 100 Total prime cost
This method of distribution of overhead costs ignores the difference in labour rates and material and machines employed for the manufacture of different items.
Example 1 : A factory has total overheads of Rs. 12,000 and total prime cost Rs. 25,000 for the year 2003–04. Find out the share of overheads to be allocated to products X and Y by proportional to prime cost method using the following data :
Product X Product Y
Direct material cost Rs. 60 Rs. 100
Direct labour cost Rs. 80 Rs. 40
Direct other expenses Rs. 30 Rs. 30
Solution :
Percentage of overheads = Total overhead cost × 100 Total prime cost
= 12,000 25,000 × 100 = 48% Product X : Prime cost = 60 + 80 + 30 = Rs. 170 Overheads = 170 × 48 100 = Rs. 81.60 Rs. 82 Product Y : Prime cost = 100 + 40 + 30 = Rs. 170
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Overheads = 170 × 48
100 = Rs. 81.60 Rs. 82
(b) Proportional to direct labour cost : In this method the percentage of overhead costs to be allocated is given by
Percentage of overheads = Total overhead cost × 100 Total direct labour cost
This percentage of overheads multiplied by the direct labour cost on the manufacture of the item gives the part of total overhead costs allocated to that item.
This method is used where parctically all the work is done by hand (manually) and the wages paid to direct labour are quite uniform.
Example 2 : Total overheads of a manufacturing concern for the year 2003-04 were Rs. 54,000 and total direct labour wages during that year were Rs. 36,000. Find out the overheads allocation to a product for which direct labour cost is Rs. 72. Use allocation by proportional to direct labour cost method.
Solution :
Percentage of overheads = Total overhead cost × 100 Total direct labour cost
= 54,000
36,000 × 100 = 150%
If P = The overhead costs to be allocated to the item with direct labour cost of Rs. 72
P = 72 × 150
100 = Rs. 108
(c) Allocation proportional to direct material cost : According to this method, the percentage of overhead cost equals the total overhead cost of the factory expressed as a fraction of the total direct material costs.
Percentage of overheads = Total overhead cost × 100 Total direct material cost
The percentage of overhead costs multiplied by the direct material cost of the manufacture of the item gives overhead costs to be allocated to that item. This method does not consider the fact that values of materials used in different items of manufacture are different. Example 3 : Calculate the selling price of a product from the following data :
Direct material cost per component = Rs. 16
Direct labour cost per component = Rs. 12
Total direct material cost during one year = Rs. 48,000
Total overheads of the factory = Rs. 12,000
Profit = 25 percent on total cost
The overheads are to be allocated on the basis of percentage on direct material cost. Solution :
Percentage of overheads = Total overhead costs × 100 Total direct material cost
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184
= 12,000
48,000 × 100 = 25%
For the component
Direct material cost = Rs. 16 Direct labour cost = Rs. 12
Overheads = 25
100 × 16 = Rs. 4 Total cost = 16 + 12 + 4 = Rs. 32
Profit = 0.25 × 32 = Rs. 8 Selling price = 32 + 8 = Rs. 40 2. Allocation by Hourly Rate
This method is again sub-divided into two categories :
(a) By man-hour rate : The rate of overhead is obtained by dividing the total overhead costs by the total production man-hours worked during that period.
Rate of overhead = Total overhead costs for entire factory Total production man-hours employed
This factor multiplied by production man-hours used in manufacture of the item, gives the overhead costs to be allocated to the item under consideration. This method does not take into consideration use of different types of equipment in manufacture of different products. Example 4 : The total on cost of a factory for a period of 6 months is Rs. 5,400. The factory employs 50 workers and average working days per month is 25 days. 10 percent of total time is allowed for various allowances. Calculate the share of overheads to be allocated to a product requiring 31
2 man-hours. Take 8 hours of working per day. Solution :
Total production man-hours = 25 × 8 × 6 = 1,200 hrs. Allowances = 0.10 × 1,200 = 120 hrs. Effective production man-hours = 1,200 – 120 = 1,080 hrs.
Rate of overheads = 5, 400
1, 080 = Rs. 5 per man-hour
Overheads to be allocated to the product which consumes 31
2man-hours = 5 × 31
2 = Rs. 17.50
(b) By machine hour rate : In this method the overhead costs are allocated on the basis of fraction of the time used on particular machine in the manufacture of an item.
Rate of overhead per machine-hour = Overhead expenses for specific machine Number of machine-hours
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Rate of overhead multiplied by number of machine-hours used in the manufacture of the item, gives part of total overhead costs to be allocated to that item. This method takes into account variation in type and size of equipment, power required etc., for manufacture of different products.
This method is used where most of the work is done with machines. The on-cost for a machine is calculated by taking into account the depreciation of machine, power consumed by the machine, building expenses on the basis of floor area occupied by the machine and other indirect charges.
Example 5 : If the total on-cost for a milling machine for the year 2003–04 is Rs. 10,000 and machine works for 2,500 hours in year, calculate the on-cost allocated to product using
1 1
2 machine-hours by machine-hour rate method. Solution :
Rate of overheads = 10, 000
2,500 = Rs. 4 per machine hour
On cost to be allocated to the product = Rate of overheads × m/c hours consumed by the product
= 4 × 3
2 = Rs. 6 3. Allocation by Unit Rate
In this method of allocation of overhead costs, it is assumed that the overhead expenses are proportional to the total output.
Overheads costs/unit produced = Total Overhead charges for the entire factory Number of units produced
This method is applied in concerns where one type or similar products are manufactured. This method gives a standard rate of overheads for all the components produced.
Example 6 : A manufacturing concern produces 600 machines per year. If the total overheads during that year are Rs. 1,80,000, calculate the overhead cost for each machine.
Solution : By unit rate method
Overheads/unit = Total Overhead charges Number of units produced
= 1,80, 000
600 = Rs. 300 Overhead charges per machine = Rs. 300