UNIT 4

Overheads 1

4.1 Definitions

All indirect costs are collectively termed as overheads. It is total of all indirect material, indirect labour and indirect expenses. They constitute an important component of total cost of a product, a job or a process. Overhead costs have to be incurred for production although they are not directly measurable, observed related to specific activity or unit of production. For example: depreciation of factory building and machinery, rent, taxes, insurance, maintenance etc

Classification of overheads

The process of grouping the overheads according to their common characteristics is known as classification of overheads. It provides the manager with information that enablesthem to manage the business effectively. The overheads can be classified according to:

a)     a.Element: Indirect materials, Labour Expenses;

b)    b.Functions: Production, Administration, Selling and Distribution overheads;

c)     c.Behaviour: Fixed,Variable, and Semi-variable overheads.

1. Fixed  overheads  remain  fixed  and  are  unaffected  by  the    changes  in  the  level  of production. For example, rent, rates, salaries, legal expenses etc.

2.     Variable overheads vary in direct proportion to changes in the volume of production, such as indirect materials, fuel, power, stationery, salesmen’s commission etc.

3.     Semi-variable  overheads  are  the  expenses  which  are    partly  fixed  and  partly variable.

They  remain  fixed  upto  a  volume  of  production  and vary  when  the  production  is  made beyond the particular volume. For example, telephone charges depreciation of machinery, repairs and maintenance, cost of supervision etc.

Allocation of overheads

Allocation of overheads is the Reallotment’ of all items of cost of cost centers or cost to units. It  refers  to  charging overheads  to the  cost  centers.  It  means  that  overheads  have  been incurred  because  of  the  existence  of  that  cost  centre.  When  the  company  provides  more than one product, factory overheads are allocated to various production departments or cost centers.  Proper  overheads  allocation  is  of  great  importance  as  wrong  allocation  can  distort  income determination, asset valuation and performance evaluation. The overhead allocation process is as follows:-

1. Accumulating overheads on the basis of departments or products.
2. Identifying the cost objectives of the allocated costs
3. Selecting the method of relating costs so accumulated to the cost objectives.

Apportionment of overheads

Apportionment  of  Overheads  refers  to  the  distribution  of  common  items  of  cost  to  two  or more cost centers on some appropriate basis. When overheads are incurred for the factory as  a  whole  and  benefit  two  or  more  cost  centers,  it  is  necessary  to  apportion  them  to different  departments that receive  benefits from such overhead costs. For example, factory rent benefits all the departments; hence it should be apportioned to all the departments on the  basis  of  the  floor  arean occupied  by  each  department  in factory. Thus,  common  factory overheads  have  to  be  apportioned  to  various  production  and  service  departments  in  the factory on some appropriate basis.

A  production  department  is  one  that  engages  in  the  actual  manufacture  of  product.  On the other hand, service department is one that renders a service which contributes indirectly in the manufacture of the product. It renders services to the production as well as other service departments.

The  common  factory  overheads  are  to  be  apportioned  to  various  production  and  service departments   on   some   equitable   basis   which   are called   principles   of   apportionment. Accordingly,  overheads  are  distributed  over  various  departments  on  the  basis  of  actual benefit  received  or  potential  benefits  to  be  received  by  the  respective   departments Overheads  can  also  be  apportioned  on  the  specific  criteria  or  given  ratio  which  may  be determined after careful survey for different service functions. Apportionment of overheads can also be made on the basis of ability to pay (Revenue) of the departments.

The  usual  basis  of  apportionment  of  commonitems  of factory  overheads  can  be  stated  a follows:-

4.2 Absorption of overheads : various methods and their application

CIMA defines Absorption of Overheads as “the process of absorb, overhead costs allocated or apportioned over a particular cost centre or production department by the units produced”.

The overhead absorption rate is calculated as follows:

Methods of Overhead Absorption:

1. Production Unit Method: Under this method, overhead absorption rate is calculated by dividing the overhead cost by number of units produced or expected to be produced as shown below:

Application of overhead absorption rate

For the application of pre-determined absorption rates, the actual (i.e., the actual number of units or other actual base data e.g., direct labour hours, machine hours etc.,) is multiplied by the predetermined rate. The resultant amount will give the amount of overhead to be applied (or charged) to production for the period.

It is seldom applied overheads agree with the actual overheads. There will always be a difference between the actual overheads and applied overheads. If the absorbed amount exceeds actual overhead, the difference would be called as “over applied overhead”. If however, it falls short of actual overhead, the difference would be called ‘Under applied overhead”.

4.3 Treatment of under absorption and over absorption overheads

On the basis of predetermined overhead absorption rate the overhead are absorbed according to the actual production of goods throughout the accounting period or specific period. To determine overhead rate budgeted overheads and budgeted output are used. If budgeted overhead and budgeted outputs differ from actual overhead and actual output, three is a difference between predetermined overhead rate and actual overhead rate.

Over absorption refers to the overheads absorbed are higher than the actual overheads incurred. Under absorption refers to the overhead absorbed is lower than the actual overheads incurred during the accounting period.

Reasons for Over or Under absorption of overhead

• The actual hours worked is more or less than budgeted hours
• The actual overhead costs are different from budgeted overheads
• The method of overhead absorption may be wrong
• Unexpected expenses may be incurred during the accounting period.
• Seasonal fluctuations in the overhead expenses from period to period
• Both actual overhead costs and actual activity level are different from the budgeted costs and level.

Treatment of over or under absorbed overheads

1. Application of supplementary rates - The supplementary rate is calculated by dividing the under or over absorbed amount by the actual base. The over recovered amount will be adjusted by applying the supplementary rate and vice versa, in case of over absorption.

2.     Adjustment to cost of sales - The over or under absorbed overheads is closed and transferred to the cost of sale account. This is done at the end of every month or at the end of accounting period by the Cost Accountant. If the transfer is made at the end of the accounting period, the over/under-absorbed overhead is carried forward from month to month treating it as deferred income if over applied and as deferred charges, if under applied.

4.4 Basic concepts of different capacities

Capacity means the ability of a company to produce a product or provide a service within a given period of time. It is defined by constraints such as space, labor, materials, equipment and access to capital.

1. Normal capacity - normal capacity is based on the theory of operational efficiency. Normal capacity is driven by business demand not by maximum capacity. It is estimated over a  two- to three-year period taking into consideration the seasonal and cyclical demand cycle. A rule of thumb is to take normal activity to represent 75% to 90% of practical capacity.

2.     Expected capacity – expected capacity is based on actual inputs and is updated version of normal capacity. The capacity is expected to prevail over the next year. This method is more appropriate than normal capacity when environ­mental conditions prevent reliable forecasts being made for periods in excess of one year.

3.     Practical capacity – practical capacity is also known as human error or "Murphy's law.". It involves the level of capacity a business can operate at that allows for a certain amount of inefficiency. It is based on theory not on actual demand like ideal capacity. It takes into consideration loss due to weather, holidays, repairs and breakdowns. Depending on nature of business practical capacity may be lower or higher than normal or expected capacity. Practical capacity is always lower than maximum or ideal capacity.

4.     Ideal capacity - when the volume of activity is at its peak performance, with no allowance for operational inefficiency refers to ideal capacity. This is also referred to as theoretical capacity or maximum capacity and is often used as the upper limit for determining capacity limitations. Normal capacity and expected capacity will always be lower than ideal capacity.

There is a gap between the 100% maximum of ideal capacity and the more realistic practical capacity due to inevitable but acceptable interruptions. Between practical capacity and normal capacity there is a gap which allows for the contingencies of uncertainty and environmental fluctuations.