Overheads

Hello Future Accountant! Let's Uncover the Hidden Costs of Business!

Habari! Imagine you've started a small business making delicious samosas in your neighbourhood. You know the cost of the flour, the meat, and the cooking oil for each samosa. Those are easy to calculate, right? But what about the rent for your small kitchen? The KPLC bill for the electricity to power your fryer? The salary of the person who cleans up at the end of the day? These costs are real, but you can't point to a single samosa and say, "This one used 5 shillings worth of electricity."

Welcome to the world of Overheads! These are the 'hidden' but essential costs of running any business, from a jua kali workshop in Kamukunji to a big company like Safaricom. Today, we're going to become detectives and learn how to properly track and assign these costs. Let's begin!

What Exactly Are Overheads?

In cost accounting, we have two main types of costs:

• Direct Costs: Costs that can be directly traced to a single product. For a carpenter making a table, this is the cost of wood and the wages of the fundi who built that specific table.
• Indirect Costs (Overheads): Costs that are necessary for production but cannot be directly traced to a single product. This is the workshop rent, the supervisor's salary, or the electricity bill.

So, Overheads are all the indirect costs involved in running a business. We often group them into three main categories.

Image Suggestion: An illustration of a bustling Kenyan workshop. In the foreground, a carpenter is working on a wooden chair, with labels pointing to the wood ("Direct Material") and the carpenter ("Direct Labour"). In the background, show other elements with labels: a supervisor watching over everyone ("Production Overhead"), a small office with a person on a computer ("Admin Overhead"), and a delivery van being loaded ("Distribution Overhead"). The style should be vibrant and colourful.

The Three Families of Overheads

Think of overheads as having three main families, each with its own role:

1. Production Overheads: All indirect costs happening in the factory or workshop.
   • Factory rent and rates
   • Electricity and water for the factory
   • Salary of the factory supervisor
   • Depreciation of machines
2. Administration Overheads: Costs related to managing and running the entire organisation.
   • Salaries of office staff (accountants, HR)
   • Office rent and stationery
   • Legal and audit fees
3. Selling & Distribution Overheads: Costs incurred to get customers and deliver the product to them.
   • Sales team salaries and commissions
   • Advertising costs (e.g., a billboard on Thika Road)
   • Running costs of delivery vans

The Big Challenge: How Do We Share the Overheads?

Here's the puzzle: If the total electricity bill for our furniture workshop is KES 20,000 for the month, how much of that cost should be included in the price of one wooden chair? We can't just guess! We need a fair and logical system. This is where the magic of Overhead Absorption comes in. It's a three-step dance.

    ASCII Flowchart: The 3-Step Dance of Overheads

    +--------------------------+
    |  Step 1: Allocation &   |
    |      Apportionment       |
    | (Sharing costs among ALL |
    |       departments)       |
    +--------------------------+
                |
                v
    +--------------------------+
    |  Step 2: Re-apportionment |
    | (Moving service dept.    |
    | costs to production depts)|
    +--------------------------+
                |
                v
    +--------------------------+
    |    Step 3: Absorption    |
    | (Assigning costs to the  |
    |       actual products)   |
    +--------------------------+

Step 1: Allocation and Apportionment (The First Share-Out)

First, we collect all the overheads and share them out among all the departments in the factory – both the ones that make things (Production Departments) and the ones that support them (Service Departments like a canteen or maintenance).

• Allocation: This is easy. If a cost belongs to only ONE department, we allocate it directly there. For example, the salary of a supervisor who only works in the Cutting Department.
• Apportionment: This is for shared costs. We need a fair basis to share (apportion) them. For example, we share the rent bill based on the floor area each department uses. More space = bigger share of the rent!

Example Scenario: Pendo Furniture Makers

Pendo Furniture has a total rent bill of KES 100,000. The factory is divided into three departments:

• Cutting Department (Production): 400 sq. metres
• Finishing Department (Production): 500 sq. metres
• Canteen (Service): 100 sq. metres

Total Area: 400 + 500 + 100 = 1,000 sq. metres

How do we apportion the rent?

    --- Rent Apportionment Calculation ---

    Basis: Floor Area (in square metres)

    1. Cutting Dept: (400 / 1,000) * KES 100,000 = KES 40,000
    2. Finishing Dept: (500 / 1,000) * KES 100,000 = KES 50,000
    3. Canteen Dept: (100 / 1,000) * KES 100,000 = KES 10,000

    Total Apportioned: 40,000 + 50,000 + 10,000 = KES 100,000 (It balances!)

Step 2: Re-apportionment (The Second Share-Out)

Look at our Canteen department. It has KES 10,000 of rent plus its own costs (e.g., cook's salary). But the canteen doesn't make furniture! Its purpose is to serve the employees in the production departments. So, we must take all the costs from the service departments and share them out to the production departments. This is called re-apportionment.

A common basis for re-apportioning canteen costs is the number of employees in each production department.

Step 3: Absorption (The Final Step!)

Now, all the overhead costs are sitting in the production departments. The final step is to absorb these costs into the products that pass through them. To do this, we calculate an Overhead Absorption Rate (OAR).

The formula is a very important one:

    Overhead Absorption Rate (OAR) = Total Budgeted Overheads / Total Budgeted Activity Level

The 'Activity Level' can be different things. The most common ones are:

• Direct Labour Hours: Used when production is labour-intensive (lots of hands-on work).
• Machine Hours: Used when production relies heavily on machines.
• Units of Production: Used when a company produces identical units.

Image Suggestion: A split-panel image. On the left, a close-up of a worker carefully assembling a product by hand, with the text "Labour Intensive - Use Direct Labour Hours for OAR". On the right, a large, automated machine running with minimal human supervision, with the text "Machine Intensive - Use Machine Hours for OAR".

Let's Calculate an OAR!

Let's say after apportionment and re-apportionment, the Finishing Department at Pendo Furniture has total overheads of KES 200,000. The department expects to work for a total of 4,000 direct labour hours for the month.

    --- OAR Calculation for Finishing Dept ---

    OAR = Total Overheads / Total Direct Labour Hours
    OAR = KES 200,000 / 4,000 hours
    OAR = KES 50 per direct labour hour

What does this mean? It means for every hour a worker spends finishing a piece of furniture, we add KES 50 to its cost to cover the overheads.

So, if a chair takes 3 hours to finish, the overhead cost absorbed by that chair will be:

    Overhead Absorbed = OAR * Hours taken
    Overhead Absorbed = KES 50 * 3 hours
    Overhead Absorbed = KES 150

Now we know the true cost of that chair! It's the direct materials (wood), direct labour (carpenter's time), AND the KES 150 of overheads. Brilliant!

A Quick Word on Under and Over Absorption

Since we use budgeted (estimated) figures to calculate our OAR at the start of the year, the actual costs and activity levels might be different.

• If we absorb less overhead than we actually incurred, it's called Under Absorption.
• If we absorb more overhead than we actually incurred, it's called Over Absorption.

This is a topic for another day, but it's good to know that our estimates sometimes need adjusting!

You've Mastered It!

Congratulations! You've just walked through one of the most important processes in cost accounting. You learned how to take a big, confusing pile of indirect costs and systematically and fairly assign them to products. This skill is vital for setting correct prices, making smart business decisions, and understanding the true profitability of a company.

Keep practicing, stay curious, and you'll be a top-notch accountant in no time. Kazi nzuri!