Unit 4
OVERHEADS
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.
The process of grouping the overheads according to their common characteristics is known as classification of overheads. It provides the manager with information that enables them to manage the business effectively. The overheads can be classified according to:
- Element: Indirect materials, Labour Expenses;
- Functions: Production, Administration, Selling and Distribution overheads;
- Behaviour: Fixed, Variable, and Semi-variable overheads.
- 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 up to 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.
Overheads are collected and codified under proper heads. Similar overhead cost items should be grouped together. The grouping of overheads is done through a technique called
‘Codification’. It is a method of identification and describing various overhead expenses in numbers or letter or in combination of both, so that cost data can be easily collected. Codification of the entire items is done through a proper coding system. Overheads are collected through the sources of stores requisitions, financial accounts, wage sheets, registers and reports.
Allocation of overheads is the Allotment’ of all items of cost to cost centres or cost to units. It refers to charging overheads to the cost centres. 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 centres. 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: -
- Accumulating overheads on the basis of departments or products.
- Identifying the cost objectives of the allocated costs
- Selecting the method of relating costs so accumulated to the cost objectives.
Apportionment of Overheads refers to the distribution of common items of cost to two or more cost centres on some appropriate basis. When overheads are incurred for the factory as a whole and benefit two or more cost centres, 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 area 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 common items of factory overheads can be stated a follows: -
Items of Overheads Basis of Apportionment
Rents rates, taxes and Insurance - Floor space/ area occupied
Depreciation & repairs of buildings
Canteen, welfare expenses - No. Of employees
Time keeping & Personnel office
Depreciation, repairs & maintenance - Capital cost of machinery
& insurance of machinery
Power, steam, lighting - Technical estimates (HP hours)
Compensation - Direct wages
Advertising, Packing, Warehousing - Sales value/ volume
Bases of absorption
Once the overheads are allocated and apportioned into the production departments the overheads need to be related to or absorbed into the units of product.
Overheads can also be absorbed into cost units using the following absorption bases:
- Units produced
- Machine-hour rate (when production is machine intensive)
- Labour-hour rate (when production is labour intensive)
- Percentage of prime cost
- Percentage of direct wages.
Production overheads are usually calculated at the beginning of an accounting period in order to determine how much cost to assign a unit before calculating a selling price
The overhead absorption rate (OAR) is calculated as follows:
Overhead Absorption Rate (OAR) = Budgeted Production Overheads
Budgeted total of absorption basis
The absorption basis is most commonly units of a product, labour hours, or machine hours.
Departmental OARs
It is usual for a product to pass through more than one department during the production process. Each department will normally have a separate departmental OAR.
- For example, a machining department will probably use a machine-hour OAR.
- Similarly, a labour-intensive department will probably use a labour-hour OAR.
- An alternative to a departmental OAR is what is termed a blanket OAR.
- With blanket OARs, only one absorption rate is calculated for the entire factory regardless of the departments involved in production.
- Blanket OARs are also known as single factory-wide OARs.
