Unit 3
Overhead
Classification of overhead is made according to the following basis:
a) Based on Elements:
1) Indirect Materials: As per CAS-3 indirect material cost is defined as ‘Materials, the cost of which cannot be directly attributed to a particular cost object’. For example, lubricants used in a machine
2) Indirect labour: As per CAS-3, indirect employee cost is the employee cost, which cannot be directly attributed to a particular cost object. For example, wages and salaries paid to indirect workers
3) Indirect expenses: As per CAS-3, Indirect Expenses are expenses, which cannot be directly attributed to a particular cost object. For example, rent and taxes, printing and stationery, power, insurance, electricity, marketing and selling expenses etc.
b) Based on Functions of the organisation:
1) Manufacturing overheads: As per CAS-3, Indirect Cost involved in the production process or in rendering service. Manufacturing overheads has different names such as Production Overheads, Works Overheads, Factory Overheads.
2) Administrative overheads: As per CAS-3, Administrative Overheads are defined as Cost of all activities relating to general management and administration of an organisation.
3) Selling and Distribution overheads: As per CAS-3, Selling Overheads, also known as Selling Costs, are the expenses related to sale of products and include all Indirect Expenses in sales management for the organization.
4) Research & Development overheads: Research Cost is defined as the cost of searching for new or improved products, new applications of material, or new or improved methods, process, systems or services. In the modern days, firms spend heavily on Research and Development. Expenses incurred on research and development is known as Research and Development Overheads.
c) Based on the Behaviour:
1) Fixed Overheads: Fixed Costs are stated to be by and large uncontrollable, in the sense they are not influenced by the action of a specified member of an undertaking. For example, the supervisor has practically no control over the fixed costs like depreciation of plant & machinery.
2) Variable Overheads: Variable Costs are those which vary totally in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production.
3) Semi variable overheads: These are a sort of mixed or hybrid costs, partly fixed and partly variable costs. For example, Telephone expenses, include a fixed portion of annual charge plus variable charge according to the calls. Thus, total telephone expenses are semi-variable.
CIMA defines Cost Allocation as, ‘the charging of discrete, identifiable items of cost-to-cost centres or cost units. In other words, allocation is the process by which cost items are charged directly to a cost unit or cost centre. For example, electricity charges can be allocated to various departments if separate meters are installed, depreciation of machinery can be allocated to various departments as the machines can be identified, salary of stores clerk can be allocated to stores department, cost of coal used in boiler can be directly allocated to boiler house division.
Cost Apportionment is the allotment of proportions of items to cost centres. This process is called as ‘Apportionment’ of overheads. The basis for apportionment is normally predetermined and is decided after a careful study of relationships between the base and the other variables within the organisation.
Principles of Apportionment of Overhead Cost
(i) Services Rendered
The principle followed in this method is quite simple. A production department which receives maximum services from service departments should be charged with the largest share of the overheads. Accordingly, the overheads of service departments are charged to the production departments.
Ii) Ability to Pay: This method suggests that a large share of service department’s overhead costs should be assigned to those producing departments whose product contributes the most to the income of the business firm. However, the practical difficulty in this method is that, it is difficult to decide the most paying department and hence difficult to operate.
(iii) Survey or Analysis Method: This method is used where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable. For example, the postage cost could be apportioned on a survey of postage used during a year.
(iv)Efficiency Method: Under this method, the apportionment of expenses is made on the basis of production targets. If the target is exceeded, the unit cost reduces indicating a more than average efficiency. If the target is not achieved, the unit cost goes up, disclosing there by, the inefficiency of the department.
Absorption means ‘recording of overheads in Cost Accounts on an estimated basis with the help of a predetermined overhead rate, which is computed at normal or average or maximum capacity’.
In general, the formula for overhead absorption rate is give as: -
Overhead Rate = Amount of Overhead / No of units of the base
Overhead Absorption Rates: For the purpose of absorption of overhead in costs of jobs, processes, or products overhead rates related to suitable factors or bases to be determined. There are several methods in use for determining the overhead rates i.e. Actual or Predetermined Overhead Rate, Blanket or Multiple Rates.
The amount of overhead absorbed in costs is the sum total of the overhead costs allotted to individual cost units by application of the overhead rate. When a predetermined rate worked out on the basis of anticipated or budgeted overhead and base is applied to the actual base, the amount absorbed may not be identical with the amount of overhead expenses incurred if either the actual base or the actual expenses or both deviate from the estimates or the budget. If the amount absorbed is less than the amount incurred, which may due to actual expenses exceeding the estimate and / or the output or the hours worked being less than the estimate, the difference denotes under-absorption.
On the other hand, if the amount absorbed is more than the expenditure incurred, which may be due to the expense being less than estimate and / or the output or hours worked being more than the estimate, this would indicate over-absorption, which goes to inflate the costs.
Under or over absorption of overhead may arise due to one or the other of the causes given below: -
(a) Error in estimating overhead expenses.
(b) Error in estimating the level of production, i.e. the base.
(c) Major unanticipated changes in the methods of production.
(d) Unforeseen changes in the production capacity.
(e) Seasonal fluctuations in the overhead expenses from period to period.
(f) Overhead rate may be applied to the Normal Capacity which may be less than the full operating capacity of the undertaking.
Capacity costs are expenditures made to provide a certain volume of goods or services to customers. For example, a company may operate a production line on three shifts in order to provide goods to its customers in a timely manner. Each successive shift constitutes an incremental capacity cost. If the company wishes to reduce its cost structure, it can eliminate a shift, though doing so reduces its capacity.
Capacity refers to the maximum level of output that a company can sustain to make a product or provide a service. Planning for capacity requires management to accept limitations on the production process. Capacity requirements planning (CRP) is the process of discerning a firm's available production capacity and whether it can meet its production goals. Capacity requirements planning weighs the costs of increasing capacity against the company's actual production capabilities to see if the current capacity can successfully meet the existing production schedule and at budget.
Capacity costs include a wide range of cost types. Some are fixed and are not affected by small shifts in business productivity. Typical examples of this nature are items such as rent or lease payments, depreciation on equipment or machinery, property taxes, insurance, and basic utilities such as heating. If a company dramatically increases its sales and needs to increase its production to make sure products are available to its new customers, the business may need to add additional manufacturing facilities.
Types of Capacity Costs
A wide range of costs can be included in the capacity cost concept. For example, if an organization constructs a manufacturing facility to expand its capacity, it will incur costs for building and equipment depreciation and maintenance, insurance on the facility and equipment, property taxes, security for the building, and utilities.
The Nature of Capacity Costs
Capacity costs tend to be largely fixed. This means that a business must incur them even in the absence of any sales activity. Given their fixed nature, capacity costs will increase the risk that a business will generate losses during a sales decline. Consequently, it is common for businesses to pare back their capacity levels during business cycle downturns, which may involve shuttering facilities. The exact amount of capacity to maintain can be planned for using capacity requirements planning, which calculates required capacity levels at different sales levels and product mixes.
How to Reduce Capacity Costs
It is possible to largely eliminate capacity costs by shifting work to third parties. However, the result is usually a higher cost per unit produced, since these third parties will include an overhead charge in their pricing. Also, the increased variable cost charged by third parties tends to reduce the overall profit earned by a business.
Another option is to cut back on capacity and also raise product prices. This combination reduces customer demand to match the reduced capacity level, while potentially enhancing company profits. However, this approach only works when customers are relatively insensitive to price increases, which is more likely to be the case if a company has strong product brands that customers perceive as having great value.
Key takeaways-
1) Allocation is the process by which cost items are charged directly to a cost unit or cost centre.
2) Absorption means ‘recording of overheads in Cost Accounts on an estimated basis with the help of a predetermined overhead rate, which is computed at normal or average or maximum capacity’.
References:
- Arora M.N.: Cost Accounting - Principles and Practice; Vikas, New Delhi.
- Jain S.P. And Narang K.L.: Cost Accounting; Kalyani New Delhi.
- Anthony Robert, Reece, et al: Principles of Management Accounting; Richard D. Irwin Inc.Illinois.
- Horngren, Charles, Foster and Datar; Cost Accounting - A Managerial Emphasis; Prentice – Hall of India, New Delhi.
- Khan M.Y. And Jain P.K.: Management Accounting; Tata McGraw Hill
Unit 3
Overhead
Classification of overhead is made according to the following basis:
a) Based on Elements:
1) Indirect Materials: As per CAS-3 indirect material cost is defined as ‘Materials, the cost of which cannot be directly attributed to a particular cost object’. For example, lubricants used in a machine
2) Indirect labour: As per CAS-3, indirect employee cost is the employee cost, which cannot be directly attributed to a particular cost object. For example, wages and salaries paid to indirect workers
3) Indirect expenses: As per CAS-3, Indirect Expenses are expenses, which cannot be directly attributed to a particular cost object. For example, rent and taxes, printing and stationery, power, insurance, electricity, marketing and selling expenses etc.
b) Based on Functions of the organisation:
1) Manufacturing overheads: As per CAS-3, Indirect Cost involved in the production process or in rendering service. Manufacturing overheads has different names such as Production Overheads, Works Overheads, Factory Overheads.
2) Administrative overheads: As per CAS-3, Administrative Overheads are defined as Cost of all activities relating to general management and administration of an organisation.
3) Selling and Distribution overheads: As per CAS-3, Selling Overheads, also known as Selling Costs, are the expenses related to sale of products and include all Indirect Expenses in sales management for the organization.
4) Research & Development overheads: Research Cost is defined as the cost of searching for new or improved products, new applications of material, or new or improved methods, process, systems or services. In the modern days, firms spend heavily on Research and Development. Expenses incurred on research and development is known as Research and Development Overheads.
c) Based on the Behaviour:
1) Fixed Overheads: Fixed Costs are stated to be by and large uncontrollable, in the sense they are not influenced by the action of a specified member of an undertaking. For example, the supervisor has practically no control over the fixed costs like depreciation of plant & machinery.
2) Variable Overheads: Variable Costs are those which vary totally in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production.
3) Semi variable overheads: These are a sort of mixed or hybrid costs, partly fixed and partly variable costs. For example, Telephone expenses, include a fixed portion of annual charge plus variable charge according to the calls. Thus, total telephone expenses are semi-variable.
CIMA defines Cost Allocation as, ‘the charging of discrete, identifiable items of cost-to-cost centres or cost units. In other words, allocation is the process by which cost items are charged directly to a cost unit or cost centre. For example, electricity charges can be allocated to various departments if separate meters are installed, depreciation of machinery can be allocated to various departments as the machines can be identified, salary of stores clerk can be allocated to stores department, cost of coal used in boiler can be directly allocated to boiler house division.
Cost Apportionment is the allotment of proportions of items to cost centres. This process is called as ‘Apportionment’ of overheads. The basis for apportionment is normally predetermined and is decided after a careful study of relationships between the base and the other variables within the organisation.
Principles of Apportionment of Overhead Cost
(i) Services Rendered
The principle followed in this method is quite simple. A production department which receives maximum services from service departments should be charged with the largest share of the overheads. Accordingly, the overheads of service departments are charged to the production departments.
Ii) Ability to Pay: This method suggests that a large share of service department’s overhead costs should be assigned to those producing departments whose product contributes the most to the income of the business firm. However, the practical difficulty in this method is that, it is difficult to decide the most paying department and hence difficult to operate.
(iii) Survey or Analysis Method: This method is used where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable. For example, the postage cost could be apportioned on a survey of postage used during a year.
(iv)Efficiency Method: Under this method, the apportionment of expenses is made on the basis of production targets. If the target is exceeded, the unit cost reduces indicating a more than average efficiency. If the target is not achieved, the unit cost goes up, disclosing there by, the inefficiency of the department.
Absorption means ‘recording of overheads in Cost Accounts on an estimated basis with the help of a predetermined overhead rate, which is computed at normal or average or maximum capacity’.
In general, the formula for overhead absorption rate is give as: -
Overhead Rate = Amount of Overhead / No of units of the base
Overhead Absorption Rates: For the purpose of absorption of overhead in costs of jobs, processes, or products overhead rates related to suitable factors or bases to be determined. There are several methods in use for determining the overhead rates i.e. Actual or Predetermined Overhead Rate, Blanket or Multiple Rates.
The amount of overhead absorbed in costs is the sum total of the overhead costs allotted to individual cost units by application of the overhead rate. When a predetermined rate worked out on the basis of anticipated or budgeted overhead and base is applied to the actual base, the amount absorbed may not be identical with the amount of overhead expenses incurred if either the actual base or the actual expenses or both deviate from the estimates or the budget. If the amount absorbed is less than the amount incurred, which may due to actual expenses exceeding the estimate and / or the output or the hours worked being less than the estimate, the difference denotes under-absorption.
On the other hand, if the amount absorbed is more than the expenditure incurred, which may be due to the expense being less than estimate and / or the output or hours worked being more than the estimate, this would indicate over-absorption, which goes to inflate the costs.
Under or over absorption of overhead may arise due to one or the other of the causes given below: -
(a) Error in estimating overhead expenses.
(b) Error in estimating the level of production, i.e. the base.
(c) Major unanticipated changes in the methods of production.
(d) Unforeseen changes in the production capacity.
(e) Seasonal fluctuations in the overhead expenses from period to period.
(f) Overhead rate may be applied to the Normal Capacity which may be less than the full operating capacity of the undertaking.
Capacity costs are expenditures made to provide a certain volume of goods or services to customers. For example, a company may operate a production line on three shifts in order to provide goods to its customers in a timely manner. Each successive shift constitutes an incremental capacity cost. If the company wishes to reduce its cost structure, it can eliminate a shift, though doing so reduces its capacity.
Capacity refers to the maximum level of output that a company can sustain to make a product or provide a service. Planning for capacity requires management to accept limitations on the production process. Capacity requirements planning (CRP) is the process of discerning a firm's available production capacity and whether it can meet its production goals. Capacity requirements planning weighs the costs of increasing capacity against the company's actual production capabilities to see if the current capacity can successfully meet the existing production schedule and at budget.
Capacity costs include a wide range of cost types. Some are fixed and are not affected by small shifts in business productivity. Typical examples of this nature are items such as rent or lease payments, depreciation on equipment or machinery, property taxes, insurance, and basic utilities such as heating. If a company dramatically increases its sales and needs to increase its production to make sure products are available to its new customers, the business may need to add additional manufacturing facilities.
Types of Capacity Costs
A wide range of costs can be included in the capacity cost concept. For example, if an organization constructs a manufacturing facility to expand its capacity, it will incur costs for building and equipment depreciation and maintenance, insurance on the facility and equipment, property taxes, security for the building, and utilities.
The Nature of Capacity Costs
Capacity costs tend to be largely fixed. This means that a business must incur them even in the absence of any sales activity. Given their fixed nature, capacity costs will increase the risk that a business will generate losses during a sales decline. Consequently, it is common for businesses to pare back their capacity levels during business cycle downturns, which may involve shuttering facilities. The exact amount of capacity to maintain can be planned for using capacity requirements planning, which calculates required capacity levels at different sales levels and product mixes.
How to Reduce Capacity Costs
It is possible to largely eliminate capacity costs by shifting work to third parties. However, the result is usually a higher cost per unit produced, since these third parties will include an overhead charge in their pricing. Also, the increased variable cost charged by third parties tends to reduce the overall profit earned by a business.
Another option is to cut back on capacity and also raise product prices. This combination reduces customer demand to match the reduced capacity level, while potentially enhancing company profits. However, this approach only works when customers are relatively insensitive to price increases, which is more likely to be the case if a company has strong product brands that customers perceive as having great value.
Key takeaways-
1) Allocation is the process by which cost items are charged directly to a cost unit or cost centre.
2) Absorption means ‘recording of overheads in Cost Accounts on an estimated basis with the help of a predetermined overhead rate, which is computed at normal or average or maximum capacity’.
References:
- Arora M.N.: Cost Accounting - Principles and Practice; Vikas, New Delhi.
- Jain S.P. And Narang K.L.: Cost Accounting; Kalyani New Delhi.
- Anthony Robert, Reece, et al: Principles of Management Accounting; Richard D. Irwin Inc.Illinois.
- Horngren, Charles, Foster and Datar; Cost Accounting - A Managerial Emphasis; Prentice – Hall of India, New Delhi.
- Khan M.Y. And Jain P.K.: Management Accounting; Tata McGraw Hill
