OVERHEAD

COSTING
 PREDETERMINED OVERHEAD
• It is not possible to find out actual overhead cost every day. Actual overhead costs are traced
at the end of a period; it may be a month, three months or a year.
• It means that for a long period of time we are unaware of the actual overheads.
• In that case how do we cost our products?
• Say Dell computer receives an order to deliver 20 units of customised lap tops within a
week, Dell computer has to be aware of the total cost of the laptops. Dell will know about
its direct material and labour cost but it cannot wait for a long period to know the actual
overhead cost to add overhead costs to its product.
• The order has to be fulfilled within a week’s time. So Dell has to include overhead cost to
the product on a basis of predetermined rate.
 PREDETERMINED OVERHEAD
• Companies find out the cost of product by adding overhead costs on a
predetermined basis.
• BHEL calls for a tender to supply 20000 units of Chairs of a particular specification,
initially the bidder has to bid for the tender.
• The bid will quote unit cost of Chair based on actual direct materials, direct labour
and predetermined overheads.
• Assigning of overheads to products based on predetermined rates is known as
normal costing.
• Actual costing is costing of products based on actual material labour and overhead
costs. In practice actual cost is seldom used as it is difficult to find out actual
overheads on a timely basis.
 PREDETERMINED OVERHEAD RATE
Predetermined overhead rate is the rate that is found out by dividing total budgeted overheads with a
unit level of activity.
Unit level of activity assumes that the activity level is directly proportional to the volume of
production. Thus unit level of activity is volume driven. Any one of the following activity level can
be adopted.
• Direct labour hour
• Direct labour cost
• Direct material cost
• Machine hour
• Units
 PREDETERMINED OVERHEAD RATE

Predetermined overhead rate = Total budgeted overheads

Unit activity level
• Once the predetermined overhead is determined, it is applied to actual level
of activity to determine the variance.
• Predetermined overhead rate or POR can be blanket level rate or
departmental level rate.
 BLANKET LEVEL OVERHEAD RATE

• Blanket level of POR is the total budgeted overheads of the organisation divided by the activity level.

EXAMPLE 1: There are three departments in an organisation and their annual overheads are as follows:

Department Total budgeted overheads

Mixing Rs. 400000
Canning Rs. 200000
Quality control Rs. 60000
Total overheads Rs.660000
 EXAMPLE 1: CONTINUED
The company absorbs overheads on the basis of machine hour. Total budgeted machine hours of
the company are 1,32,000 hours. Actual machine hours of the company are 1,40,000 and actual
overhead is Rs. 7,20,000. Units of production are 20,000. Direct material cost is Rs. 20,00,000 and
direct labour cost is Rs.15,00,000
Blanket POR will be calculated as follows
Total budgeted overheads
Machine hours

Rs. 660000 = Rs. 5.00 / Machine hour

132000
APPLIED OVERHEAD AND PRODUCT
COSTING
Applied Overhead= POR X actual machine hours = Rs.5 x 140000 = Rs. 700000

For selling one unit of product, costing would be done as follows:

Direct material cost = Rs. 200000/20000 = Rs. 100

Direct labour = Rs. 1500000/ 20000= Rs. 75
Overheads = Rs. 700000/ 20000 = Rs. 35

Total unit cost = Rs. 210

 OVER AND UNDER APPLIED
OVERHEAD
At the end of the year, the company realises that the actual overheads are Rs. 720000, whereas as per the
predetermined overheads, Rs.700000 overheads for 20000 units has been added to cost of product. Here,
Actual overheads are more than the applied overheads. This is under applied or under absorbed
overheads.
Thus actual overheads = Rs. 720000
Applied overheads = Rs. 700000
Under applied overhead= Rs. 20000 (The difference of Rs. 720000 and Rs. 700000)
When actual overheads exceed applied overheads, it is known as under applied overheads and is added to
cost of goods sold.
When actual overheads are less than applied overhead, it is known as over applied overhead or over
absorbed overhead and is subtracted from the cost of goods sold.
 DEPARTMENTAL RATE OVERHEAD
RATE
Departmental overhead rate
In departmental overhead rate, overheads of each department are divided by the activity level
of that department.
Some department may be machine intensive where machine hour is predominant where as
department like assembly will be using more of labour hours and very little machine hours as
compared to labour hour.
Therefore in departmental overhead rates, that level of activity is chosen which is predominant
in the department.

:
 EXAMPLE 2
Department Total budgeted overheads
Mixing Rs. 4,00,000
Canning Rs. 2,00,000
Quality control Rs. 60,000
Total overheads Rs.6,60,000
The activity level of the departments is as follows
Department Level of activity
Mixing Budgeted machine hours: 80,000 hours,
Budgeted labour hours: 20,000 hours
 EXAMPLE 2: CONTINUED
Canning Budgeted machine hours, 50,000 hours
Budgeted labour hour, 10,000 hours
Quality control Budgeted man hour of the department: 10,400 hours
Budgeted machine hours: 2,000 hours
Machine hour is dominating factor in Mixing and Canning department where as labour hour is
predominant factor in the quality control department.
In the above illustration of departmental overhead rate, if the actual machine hour of mixing
department is 90000, 45000 machine hours are for canning department, actual man hour of
10500 of quality control department. Actual overheads of these departments are Rs.440000,
Rs. 215000 and Rs. 65000.
 DEPARTMENTAL VS. BLANKET
METHOD
• Departmental overhead method takes care of individual departmental overheads. If a department
is labour intensive then the activity level is taken as labour hour and in case of machine intensive
department, it is machine hours.
• On the contrary, in case of blanket or plant wide overhead rate, only one level of activity is
considered even if some departments may be labour intensive and some may be dominated by
machines.
• Blanket department rate may de motivate a department head if she is trying to control overhead
cost because her department would be charged on total overheads of the entire organisation. To
take an example, say, Department A has total overhead of Rs. 500000 and the labour hours of
10000, whereas Department B has total overhead of Rs. 600000 and labour hours of 10000.
Taking departmental rates, POR of A is Rs. 50/ LH and POR of B is Rs.60/LH. But Blanket
rate of the plant is (Rs. 500000+Rs. 600000) / (10000+10000) = Rs. 55/LH.
• The two methods will not make a difference if the product spends same amount of time and resource in all the
departments.
• Say a product spends 3 hours in department A and 3 hours in department B, applied overheads as per blanket rate will be 6
x 55= Rs. 330 and as per departmental rate, POR for A will be Rs150 and for B will be 180.
• Thus total applied overhead will be Rs. 330. Departmental overhead rate is preferred in case the product takes different
time in different departments and/or the departments do not have the same nature. i.e. labour intensive or machine
intensive.
• In the above two examples, it was seen that as per the blanket method in example 1, there was an under applied overhead
for the entire firm. But in example 2, Mixing department and Canning department had an over- applied overhead of Rs.
10000 and Rs. 35000 respectively where as quality Control department had an under applied overhead of Rs. 4415. Thus Rs.
40585 will be subtracted from cost of goods sold. (Rs. 10000+Rs. 35000-Rs. 4415)
 EXAMPLE 3: SOLVE IT YOURSELF
Coolest Ltd. has got an offer to sell 1000 units of water purifier. Annual data
of Coolest Ltd for the entire plant is as follows.
Budget Department A Department B
Budgeted overhead cost (Rs.) 36,000 55,000
Budgeted machine hours 10,000
Budgeted Direct labour hours 18,000
Actual machine hours 9,000
Actual labour hours 20,000
Actual overhead (Rs.) 40,000 50,000
Direct Material Rs. 3000 per unit
Direct labour rate is Rs. 50 per hour
Units of production 1,000

Each unit of product passes 5 hours in department A and 6 hours in department B. Calculate departmental overhead
rate. Also calculate the cost per unit of the product using applied overhead rate.
Calculate the price per unit that Coolest Ltd. should quote if it wants to have a margin of 25% on total cost.