OVERHEAD COSTING

CONCEPT OF OVERHEADS

 A cost is composed of three elements - (a) material, (b) labour, and (c) expenses.

Each of these costs can be further classifid as (1) direct and (2) indirect.

 Direct costs are costs which can be easily identified directly with a particular product, process or department.

Indirect costs, on the other hand, refer to costs which cannot be conveniently identified with a particular product, process.or department. These are common costs like rent, repairs, salaries, lubricating oil, which are incurred for the benefit of a number of cost units or costcentres. The total of all indirect costs i.e., indirect material, indirect labour and indirect expenses, is termed as 'overheads'. Other terms in use for overheads are 'on costs', 'overhead costs', 'supplementary costs', 'overhead expenses or charges', etc.

The National Association of Accountants (USA) defines overheads (overhead costs) as follows :

 (A) Fundamental concept : Costs that have to be incurred although they have no directly measureable, observable relationship to specific activity units, production or cost objectives.

 (B) Application definition : While related to the accomplishment of the firm's objectives, overhead cosp are costs which cannot, as a practical matter, be assigned to those objectives in a direct fashion. A consistent method of cost allocation, which by some measure approximates the economic sacrifices incurred, must be adopted. It is evident from the above that they cannot directly be identified to units of output and that they have to be suitably allocated or absorbed so as to determine the product cost, both total cost and unit cost.

CLASSIFICATION OF OVERHEADS

 Overhead classification refers to the process of grouping the overheads according to their common characteristics so as to provide the managers with information that will enable them lo manage the business effectively. The overheads can be classified according to :

 1 Elements

2 Functions and Departments

3 Behaviour.

Element-wise Classification

 According to elements overhead is divided into :

 i) Indirect materials

 ii) Indirect labour

iii) Indirect expenses

 i) Indirect materials :

It is that material which does not form a part of the finished product or saleable service. Examples of indirect materials are : coal, lubricating oil, grease, sand paper used in polishing, etc. There are some items which may become a part ol the Eiished product like nuts, screws, bolts, pins, etc., but these are still considered as indirect materials for costing purposes as their cost is comparatively small.

 ii) Indirect labour :

 Indirect labour is not directly engaged in the production operations. They only assist or help in production operations. Examples of indirect labour are supervisor, clerk, cleaner, inspector, peon, watchmen, etc. Remuneration paid to these employees is considered as indirect labour cost.

 iiI) lndirect expenses :

 All indirect costs, other than indirect materials and indirect labour are considered to be indirect expenses like rent, depreciation, lighting and power, advertising, insurance etc.

Function-wise Classification

This method of classification is based on the major functions/departments of a business organization. They are-

• Production overheads

These include indirect material cost, indirect wages and indirect factory expenses incurred from the stage of procurement of materials till the completion of the finished product. These are also known as ' 'manufacturing overheads', 'works overheads', 'factory overheads'.

• Administration overheads

These include all those expenses connected with the managerial functions of planning, directing, coordinating and controlling the operations of a business other than those related to production, selling, distribution and research and development

• Selling overheads –

These include the costs incurred for creating demand for the product, for securing and servicing orders. Advertising, bad debts, salaries and commission , to selling agenrs, travelling expenses, show room expenses are the examples of selling overheads.

• Distribution overheads-

These include the costs incurred in connection with the delivery of goods to customers. Some examples of distribution overheads are : packing cost, carriage outwards, maintenance, repairs and depreciation of delivery vans, warehouse expenses, wastage of finished goods, etc.

Behaviour-wise Classification

This classification is made on the basis of variability nature of overheads with production, Accordingly, they are classified into :

i) Fixed overheads

ii) Variable overheads

iii) Semi-variable overheads

i) Fixed overheads : These overheads remain fixed or unaffected by changes in the level of production. An increase or decrease in the output has no effect on the total amount of overheads. As a result, an increase in the volume of output will result in a decrease in the fixed cost per unit, owing to its spread over a large number of units and vice versa. Some examples of fixed overheads are rent and rates, salaries, legal expenses, bank charges, etc.

ii) Variable overheads : These overheads vary in direct proportion to changes in the volume of output. Variable overheads per unit remain fixed. Some examples of variable overheads are : indirect materials, fuel, power, stationery, salesmen commission, etc.

iii) Semi-variable overheads : These are the expenses that stand midway between fixed and variable overheads. They are partly fixed and partly variable. They vary with change in the volume of output but not in the same proportion as the change in the volume of output. Examples of such overheads are : telephone charges, depreciation, repair and maintenance, cost of supervision, etc.

 COLLECTION OF FACTORY OVERHEADS

There are four steps in overheads distribution. They are :

i) Collection of overheads

ii) Allocation and apportionment to production and service departments

iii) Re-apportionment of service department costs

iv) Absorption of overheads The first step in overhead distribution is the collection of overheads. This means the ascertainment of the total amount spent on each item of overheads during a particular period.

Standing Order Numbers-

After the classification of overheads, each group of expenses should be given a distinct symbol or number so that each such group is easily distinguished from that of the other. Such symbols or numbers are the codes for overheads and are known as 'standing order numbers.' Each standing order' number represent a particular type of expenditure and as and when the expenditure is incurred, it is appropriately classified. The code numbers may be alphabetical (Mnemonic method), numerical or a combination of both.

Sources

The sources from which overhead costs are collected are as follows :

a) Invoices : These are documents received for sundry purchases against purchase I requisition made by a particular tlepartment. The name or code number of the department will be indicated in the invoice itself. At the end of the month the total amount I of purchases will be debited to Factory Overhead Account and credited to Cost Ledger - Control Account.

b) Stores Requisitions : Materials would be issued from stores only on receiving stores requisition from the departments. On the stores requisition, the code number of the department making the requisition would be indicated. This helps in charging the indirect materials to the particular department using them.

c) Wages Analysis Book : This book gives information relating to indirect wages,  overtime, bonus etc. When wages are paid to indirect workers, they are entered against I the standing order numbers on the basis ol job cards, time cards etc.

d) Cash Rook : The overheads which are paid in cash but not recorded anywhere else can be collected from this book.

e) Journal : It gives the information relating to non-cash items i.e depreciation, notional rent,accruals and payments in advance. Therefore, it is necessary to scrutinise the journal for the accumulation of manufacturing overheads,

f) Subsidiary Records : It is necessary to look into the reports regarding scrap, waste, spoiled materials, idle time and idle facilities for ascertaining their costs to be adjusted in overheads.

ALLOCATION AND APPORTIONMENT OF FACTORY OVERHEADS

According to the ICMA Terminology, allocation is "the allotment of whole items of cost to cost centres or cost units". It refers to charging to the cost centre tiJose overheads that have been incurrcd for that cost centre. It means that overheads have been incurred because of the existence of that cost centre.

Thus, it can be said that, an overhead can be allocated to a cost centre if he following two conditions are satisfied :

1 The overhead must have been incurred because of the existence of that particular cost centre. 2 The exact amount of overhead incurred in a cost centre must be known

Apportionment

Apportionment refers to the distribution of common items of cost to two or more cost centres on some appropriate basis. When the costs which are incurred for the factory as a whole and benefit two or more cost centres, then it is necessary to apportion them to different departments that receive benefit from such costs. For example, factory rent benefits all the departments. Hence, it should be apportioned lo all the departments on the basis of the floor area occupied by each department in the factory.

The common factory overheads have to be apportioned various production and service departments in the factory on some equitable basis. A production department is one that engages in the actual manufacture of the product. Examples of production departments are weaving, spinning, crushing, mining, grinding, etc, A service department is one which renders a service that contributes indirectly in the manufacture of a product. It renders service to the production as well as other service deparments. Examples of service departments are purchasing, stores, time keeping, personnel inspection, etc.

Principles of Apportionment-

Actual benefit : According to this principle, overheads are distributed over various departments on the basis of the actual benefit received. This can be adopted where it is possible to measure the actual benefit derived from a particular expense.

Potential benefit : It would be ideal to distribute common costs on the basis of actual benefit received, but, in most cases, the measurement of actual benefit may not be possible or it may be too cumbersome to keep he ncccssary records. Hence, it is advocated that the apportionment may be done on the basis of potential benefit (benefit likely to be received).

For example, if lighting costs were Lo be apportioned on the basis of actual benefit received, you will have, to keep record of the numbcr of lighting points in each department, the wattage of bulbs used in each lighting point, and the amount of time for which each point was on.

Specific criteria : According to this principle, the overheads can be apportioned to different departments in a given ratio which may be determined after careful survey for different service functions. This method, therefore, is also known as 'survey method' and it is particularly useful where it is difficult to select a suitable basis for apportionment. For example, for the apportionment of works manager's salary, it may be difficult to identify a suitable basis. Hence a survey may be conducted to ascertain the time and attention given by him to different cost centres and a reasonable ratio fixed for the purpose.

Ability to pay : This method is based on the principle that more the revenue of a department, the higher should be the proportionate charge for the services, For example, the cost of maintaining stores may be apportioned to different production departments on the basis of the value (not the volume) of materials consumed.

Basis of apportionment :

In the light of the above principles, the usual his for apportioning common items of factory overhead can be as follows :

ExpensesBasis

1. Rent, Rates, and taxes, insurance,Floor area occupied

and repairs of buildings

2 Canteen, welfare expenses,No. of employees

time keeping, personnel office

3 Depreciation, repairs andCapital cost of plant

insurance to plant and machineryand machinery

4 Power/Steam consumption,Technical estimates (i.e HP hours,

lighting ,number of light points)

5 Store keeping expensesWeight/value of Materials

6 Internal transport,Number of requisition, Weight/ Value of inaterials

7 Compensation to workers,Direct wages

ESI and PF contribution

PREPARATION OF OVERHEADS DISTRIBUTION SUMMARY

The allocation and apportionment of overheads to production and service departments is also known as 'departmentalisation or primary distribution of overheads'. It is done by preparing an overheads distribution summary.

For the preparation of overheads distribution summary, all those overheads which can be directly identified with a particular department, will be taken/allocated to the concerned department and those which cannot be identified with a particular department .will be apportioned i.e., distributed on equitable basis to different departments,

Re-Apportionment of Service Department Costs :

Once the overheads have been allocated and apportioned to production and service departments, next step in overhead distribution is to re-apportion the service department total costs to production department. As the ultimate object is to charge the overhead to cost unit, and no cost units pass through service departments, it becomesnecessary to apportion the service departments costs also to production departments on some equitable basis. This is known as secondary Distribution .