Definition

Every form of production involves two types of costs-Direct costs and indirect costs. Direct costs are those expenses which are identified and allocated to particular cost centers or cost units. Prime cost is the sum total of direct expenses like direct material, direct labour and changeable or direct expenses. All expenses over and above direct expenses are called overheads. Overhead expenses are those expenses which are incurred not exclusively for the manufacture of a single commodity or for the competition of a single job, but for the organisation as a whole. Other terms which are conveniently used for overheads are’ burden’, ‘supplementary costs’, ‘on costs’ and indirect opposes’.  

Overhead is the cost of indirect material, indirect labour and such other expenses including services as cannot conveniently be charged a specific unit. Alternatively, overheads are all expenses other from direct expenses.

Whelden

    Overhead is the total of indirect materials, indirect wages and expenses.

ICMA

Many of the materials which are consumed in the production does not form the part of the finished product. For example, lubricants, cotton waste ,other consumables etc. are overheads which cannot be conveniently traced and  charged to the finished product. Similarly, indirect labour is the labour which cannot be directly charged to particular cost units. Examples are salaries to foremen, inspectors, clerical staff, commission paid to sales staff etc. There are also some indirect expenses like rent, insurance, taxes, lighting, heating, audit fee etc. which cannot be linked with specific cost units. However, if any expense can be linked with a particular cost unit, it can be treated as ‘ direct expense’.

Treatment of overheads

        The procedure of linking overheads to cost units involves a number of steps.

         A. Collection and classification of overheads.

         B. Allocation and apportionment of overheads.

         C. Re-apportionment of overheads.

         D. Absorption of overheads.

A flow chart showing the treatment of overhead expenses is given below:

Classification of overheads

        There are different methods of classifying or grouping of overheads. Proper and efficient cost control requires a careful classification of overheads.

         The method of classification adopted by a concern department depends upon the objectives of classification, the nature of product or the server rendered and the policy of the management. At the same time there are no solid rules or principles regarding the classification of overheads. For costing purposes overhead expenses are classified into the following groups.

1. Business functions or departments

2. Elements or incidents

3. Behavior or variability

4. Controllability

(1) Business functions or departments 

Based on the major functions of the business, overheads are classified into production or work overheads, administrative of office overheads and selling and distribution overheads. 

      (a) Production or work overheads 

It consists of all indirect costs associated with the manufacturing activities. The following are some of the indirect expenses incurred in the manufacturing divisions. 

– Factory rent, rate, lighting and heating 

– Depreciation, repairs and maintenance, insurance of factory building and plant. 

– Consumable stores, small tubes, etc. 

– Salary of foreman, time keepers, works manager, etc. 

-Cost of overtime, idle time, holidays pay, etc.

      (b)  Administrative or office overheads 

Administrative expenses are incurred for overall management of the overheads. So, this head includes expenses connected with managerial functions of planning, directing, co-ordinating, and controlling the operations of the business.

Examples of administrative overheads are 

-Office rents and rates 

-Office lighting, heating and cleaning 

-Depreciation, repairs and maintenance of office buildings

-Salaries of the office staffs, director’s remuneration, etc. 

-Telephone charges, postage, printing and stationary 

-Audit fee, bank charges, legal expenses etc

   (c) Selling and distribution overheads 

Selling cost are those indirect costs associated with marketing and selling of products and services. Selling cost is defined as “that portion of marketing cost which is incurred in securing orders. Some example of selling costs are :

 -Salaries, travelling expenses and commissions of sales staff

-Sales offer expenses

-Brokerage and third party commissions

-Advertisement and show room expenses

-Bad debts

-Market research expenses etc.

 Distribution cost is “that partition of marketing cost which is incurred in warehousing saleable products and in delivering products to consumers”. It includes all expenses incurred from the time the product is completed in the factory until it reaches its consumers. In gas, electricity and water supply companies ” distribution ” means pipes , mains and other related services rendered to consumers.

 Examples of distribution expenses are:

 – Carriage and freight outwards

 – Depreciation, maintenance, operating charges etc of distribution vehicles

– Warehousing, packing, insurance of finished goods etc.

    2. Element-wise or incidence-wise classification

Classification of overheads in accordance with the elements of cost each as indirect material, indirect labour and indirect expenses is called element-wise classification.

 There are some materials which do not become part of the finished product or service .Examples of indirect materials are consumable stores , lubricating oil, cotton waste, small tools etc.

 Indirect labour means wages paid to these employees who do not work directly on a particular job or service. Examples of indirect labour are supervisory staff, maintenance and service staff, trainees and instructors, time keepers and security staff etc.

Expenses other than direct expenses . These expenses are incurred for the business as a whole and as such they cannot be allocated to any particular job or service. Examples are rent, rates, insurance, municipal tax, canteen expenses, telephone changes etc.

ICMA

(3) Behaviour wise classification

Overheads show the tendency to vary with production, sales volume or activity level. Classification of overheads according to variability or behavior is done for the purpose of cost control and decision making.

Based on the behavior, overheads can be classified into 

(a) Fixed overheads 

(b) Variable overheads 

(c) Semi-variable overheads

(a) Fixed overheads 

Fixed costs represents those costs which are unaffected by variation in the volume of the output. These expenses are to be met irrespective of quality of production. Fixed overheads remains fixed inaggregate but vary per unit. Fixed costs as it depends on the expiry of periods. The ICMA Terminology defines fixed cost as “a cost which accrues in relation to the passage of time and which, within certain output or turnover limits, tends to be unaffected by fluctuations in volume of output or turnover.” Examples of fixed expenses are rent of building, depreciation of plant, insurance, remuneration paid to directors, managers etc.

(b) Variable overheads

Variable overheads are those which vary in direct proportion to the production or sales volume or the activity level. Thus there is a linear relation between Variable cost and output. Variable cost per unit remains constant with changes in the activity level. This cost can also be known as product cost. Examples of variable overheads are indirect materials, indirect labour, cost of lubricants, lighting and heating etc.

 (c) Semi-variable overheads

These are also known as semi-fixed overheads. There are some overheads which are partly fixed and partly variable in nature.  They have two elements, a fixed cost element and a variable cost element. A part of the cost remains unchanged upto a particular level and the other part varies with a change in activity. This cost can also be called as step cost. With changes in the level of output they show the tendency to vary disproportionately. Such expenses are treated as semi variable expenses. Repairs and maintenance, postage and stationary, salesman’s commission beyond a certain level of sales, etc. Tends to increase in a narrow margin with change in the level of activity. 

(4) Controllability 

On the basis of controllability overhead costs can be divided into controllable costs and uncontrollable costs. 

Controllable costs are those which can be influenced by the action of the management of the undertaking. Uncontrollable costs are those which cannot be influenced by the action of the management. Costs maybe uncontrollable for an individual management, but maybe controllable at a senior level. 

                This classification has a much practical utility because it helps a manager to concentrate on such items which can be brought under control by his actions.

Codification of overhead

               Codification of overhead is done by allotting suitable numbers, letters or symbols for distinguishing each group of expenses. The costing department prepares a cost code manual listing various items of expenditure and the corresponding code number assigned to them. As and when expenditure is incurred, the same is booked under the related code number. This is a routine work done by the cost clerks.

Collection of overheads

              It involves the processing of various documents from which the data can be extracted. The data collected will be booked or accumulated under separate standing order number allotted to them. The source documents for various items of overheads are invoices, stores, requisition, wage analysis sheets, cashbook, journal entries, subsidiary records etc.

Departmentalization

              After collection of overheads on the basis of standing order numbers, the next step is allocation or apportionment of such expenses to cost centers .the allocation or apportionment of expenses to cost centers is known as departmentalization or primary distribution of overheads. 

              On the basis of the activity or the functions, a factory is divided into a number of departments. Departmentalization enables efficient administration and control of the organisation. The various departments in the factory can be grouped into 3 broad categories:

  • Production department
  • Service department
  • Partly producing department

      A production department is one which is actually involved in the process of production, i.e., converting raw materials to finished products. The number and names of production department will depend upon the nature of the industry, type of work and size of the factory. For example: a cotton textile mill has spinning department, weaving department and finishing department.

      A service department is an auxiliary department helping the production department by providing services. It is not directly involved in production, purchase department, stores department; timekeeping department, personnel department etc. are few of the service department generally found in an organisation.

Sometimes a service department becomes a partly producing department. For eg: in most concerns the tool room is a service department. But if the tool room is used for making special tools required for a particular job, it becomes a production department. Similarly, if the electrical maintenance department i.e. making a special motor for a particular job, it becomes a production department.

B. ALLOCATION AND APPORTIONMENT OF OVERHEADS

Allocation

   Allocation of overheads or identification of overheads with a specific cost centre or cost unit is essential for cost control and decision making. The ICMA terminology defines allocation as “the allotment of whole items of cost to the cost centres or to cost units.”

This definition makes it clear that allocation is the charging of expenses

Which can be identified wholly with a particular department or cost centre? For example : overtime wages of department “A” is allocated to A only.

Apportionment

It means proportional allotment of overhead expenses which cannot be wholly charged to a particular department the ICMA terminology defines it as “the allotment of proportions of items of cost to cost centres or cost units”. There are certain expenses which require division or apportionment over two or more cost centres or units. Apportionment requires a proper assessment of ‘the benefits received’ by various cost centres from each common overhead. The benefit received need not be uniform for all items of expense. Sometimes the ability of the department to bear such share of overhead is taken as the basis of apportionment.

Difference between Overheads Allocation and Apportionment

Allocation Apportionment
It is the allotment of whole item of cost to cost centres or cost units.

There is no need of a basis for the allocation of overheads to departments.

The items of overheads aredirectly attributable to particular department or cost centre.

So, they are direct in nature. Cost control is more easy as overheads are identified with each department.
It is the allotment of proportion of items of cost to cost centres or cost units.

There is the need of some suitable basis for the apportionment of overheads.

The items are shared by two or more departments. So, they are indirect in nature.

Cost control is difficult as overheads are not identified with specific department.

C. Re-Apportionment of Overheads

By primary distribution, factory overheads are spread over production and service departments. Service departments do not produce anything. They render services to various other departments. Since actual production takes place only in the production departments, the service department costs should be finally charged to production departments for costing purposes. The process of re-distribution of costs of service departments to production departments is termed as secondary distribution or re-apportionment. The various basis commonly adopted for re-apportionment of service department costs are:

Re-apportionment of service department expenses is done by applying the following important methods.

  1. Direct distribution
  2. Step method

Direct Distribution

A service department renders services to production departments and other service departments. This method ignores the services rendered by one service department to another service department. So overhead expenses of service department are directly allocated to production departments. This method is simple, but unscientific.

Step Method

Under step method, the expenses of the most serviceable department is first apportioned to other production and service departments. After this, the next service department is taken up. Finally, the expenses of the last service department will be apportioned only to the production departments.

Machine Hour Rate

Machine hour rate is computed for the recovery of factory overhead in those industrial concerns where machines are employed for most of the manufacturing operations. In a highly mechanised factory, the majority of the overheads are related with machines. For example, depreciation, repair and maintenance, insurance, power charges, lubricants etc. In a factory, if different types of machines are used for operations, each machinery can be treated as a separate cost centre for the computation of machine hour rate. If the machines are homogeneous in nature, a single machine hour can be computed and applied to all machines.

The formula used for computation of machine hour rate is given below:

Factory Overhead/Machine Hours

If the factory overhead is Rs. 30,000 and the machine hours are 15,000, the machine hour rate is

    30,000 /15,000  i.e., Rs. 2                                                                                                                  

There are two types of machine hour rates.

  1. Ordinary machine hour rate, and
  2. Composite machine hour rate.

In ordinary machine hour rate, only those overheads which are directly associated with the ‘running of the machinery are considered for computing the machine hour rate.’ For example, power charges, fuel, depreciation, repair and maintenance etc. The total of these expenses will be divided by the machine hours to compute the machine hour rate.

In composite machine hour rate, certain other expenses known as standing charges or fixed expenses are also considered for computing machine hour rate. For example, rent and rates, insurance charges, supervisory labour, lighting, heating etc. These expenses are fixed in nature. They are apportioned to different departments and machine cost centres on a reasonable basis. Composite machine hour rate in the most commonly used method of factory overhead recovery.

Principal factors to be considered while calculating Machine Hour Rate

  1. Identify the machine for which the machine hour rate is to be calculated. Different machine hour rates are required if the machines are of different nature and value. A single machine hour rate is enough if all the machines are homogeneous in nature.
  2. A ‘base period’ must be decided for the machine identified for computing the rate. The base period can be a year, or a quarter or a month or a week or a day.
  3. The ‘normal working hours’ for the base period for the machine is to be calculated. While calculating the normal working hours, the hours required for maintenance, annual repairs and setting up must be deducted.
  4. All expenses should be divided into standing charges or fixed charges and variable changes or floating charges.

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