CMA/U2 Topic 3 Accounting for Overheads
Overhead includes all the costs associated with the predicated with the production of goods and services other than direct, direct materials and direct expenses. Hence, overhead costs can be stated as those costs which cannot be traced directly to any specific product and are supportive in nature to the output of the organization. These costs do not fluctuate with fluctuation in volume of output directly. Such as a supervisor under whom hundred employees are employed do not get less pay if s/he time and capacity. Supervisor under whom hundred employees are employed do not known as supportive department, depreciation of plant and equipment, depreciation of factory buildings, rent office expenses, property taxes, insurance, utility expenses such as electricity expenses are the example of overhead costs.
Hence, all the cost (i.e. indirect costs) which are not directly associated with production function but not total production or operation of an organization becomes impossible without it as it facilities the production system are categorized under overhead. It is the combination of indirect materials costs, indirect costs, indirect labor cost and other indirect costs.
Classification of overhead
Cost classifications is the process of grouping cost according to the common characteristic and establish a series of special group according to which costs are classified. Those beings so, overhead can be studies by classifying as follows:
- Overhead on the basis of elements
- Overhead on the basis of function
- Overhead on the basis of behavior
- Overhead on the basis of control
Overhead on the basis of element
Overhead may be classified into three different categories, on the basis of element. These are
- Indirect material: Those materials, which plays supplementary role in production and cannot be allocated to a particular unit of product nor form a part of finished product. These materials may be not be visible in finished product. So all those materials used to assist production, process, administrating, and selling and distributions are indirect materials. For example, lubricating oil, cotton waste, parts used for repair and maintenance.
- Indirect labor: for production and sales different types of payment have to be made to labor, which cannot be allocated to a particular unit of product. Such type of cost is knows as indirect labor. For example, wages for repair and maintenance, fringe and benefit, pay leave salary to storekeeper, Foreman etc.
- Indirect expenses: except indirect material and indirect labor, there are some other expenses, which do not come under these headings re indirect expenses. Only indirect materials and indirect labor are not sufficient to produce and sell the product. For example rent, lighting and heating, training expenses, insurance etc.
Overhead on the basis of function
Total function of an organization can be divided into manufacturing and non-manufacturing work. Manufacturing function of an organization is concerned with transferring (raw material) input to output (finish goods). Likewise, non-manufacturing function of an organization is concerned with office, administrative, distribution and selling of manufacture goods.
On the basis of work/job/function, overhead can be classified as
1. Production/ manufacturing/ factory overhead/ work overhead:the total indirect cost incurred for manufacturing department i.e. within factory are manufacturing overhead. It is also production overhead, factory overhead and work overhead. The manufacturing overhead starts with receiving materials to producing final product. The manufacturing overhead includes.
• Factory rent or depreciation of factory building.
• Lighting and heating, fuel.
• Insurance of factory building and equipment
• Stationary and printing and equipment.
• Depreciation of plant and equipment,
• Salaries and wages of factory staffs,
• Fringe and benefit of factory workers.
• Repair and maintenance of factory building and equipment
2. Office and administrative overhead: without policy formulation production process does not take place. To prepare policy office is needed. In office, different types of expenses were incurred for policy formulation and matriculation and management. It includes all such expenses which are incurred in office for proper management and administration i.e. planning, controlling, directing etc. some other example of office and administrative overhead are as:
• Office rent or depreciation of office building
• Office lighting, heating and cleaning
• Insurance & depreciation of office building and office equipment,
• Repair and maintenance of office building and office equipment
• Salaries of office staffs, office manager, director,
• Postage & telephone,
• Legal expenses,
• Financial expenses
• Financial expenses
• Bank charges
• Printing and stationary
• Audit fee
• Repair and maintenance office building etc.
3. Selling and distributing overhead: selling is the function, which generate revenues and distribution by means delivery of product to customer. All the indirect expenses incurred for distribution and sales of product come under this heading. Salesman salaries and commission, advertisement are the examples of selling and distribution overhead. It includes:
• C analogues expenses
• Samples, display material expenses
• Salary and commission of sales persons
• Advertisement expenses
• Cash discount
• Packaging charges etc.
Overhead on the basis of control
Controlling overhead is one of the major factions of management. All overhead cannot be controlled by management. Cost control helps to reduce cost and increase profit by best utilization of resources. From the controlling point of view, overhead can be derided into two. They are as follows:
1. Controllable overhead: controllable overhead are those which can be controlled by the efficient management. Those overhead which incurs in a particulars cost center or decrease due to managerial decision are known as controllable overheads. Indirect labor indirect material, telephone expenses and lighting and power expenses are the example of controllable overhead.
2. Non-controllable overhead: those overhead which are beyond the management or which do not change due to managerial decision are known as non-controllable overhead. All types of fixed overhead rent, salaries, depreciation etc. are the best example.
Overhead on the basis of behavior
On the basis of behaviors/ nature of overhead, it can be classified into three parts
1. Variable overhead: that portion of overhead which increase or decrease proportionately with the increase or decrease in output is known as variable overhead. The variable overhead cost per unit remains unchanged though the production unit changes. For example, indirect material, direct labor etc.
2. Fixed overhead: those overhead which remains constant up to a certain level of production is called fixed overhead. In total, it does not changes, though production unit increase or decrease. But fixed overhead per unit decrease when production unit increase and fixed overhead per unit increase, when production unit decrease. For example, rent, salaries depreciation etc.
3. Semi-variable overhead/mixed overhead: those indirect expenses, which neither remain constant nor change proportionately as per change in production unit is called semi variable overhead. Semi-variable overhead is the aggregate of variable overhead and fixed overhead for example: electricity, water supply, telephone expenses, supervision cost, repair and maintained cost.
Overhead allocation and apportionment
Allocation of overhead
Allocation of overhead means assigning overhead to cost center. Only those cost and be allowable, which is directly identified or related to any specific cost center. It is the process of charging overhead to a particular department or cost center. For example, repair and maintenance of equipment is allocated to factory department.
In general, there are two departments involves in manufacturing concern, production department and service department. Allocation of overhead cost means thus allotment whole amount of overhead cost not in proportion to cost center.
Apportionment of overhead
Some overhead cannot be identified with specific department, to distribute such overhead to different department, different basis are used. To apportion the overhead suitable basis are used, which is based on benefit or service received or capacity to bear cost etc.
Overhead and allocation of overhead are important to all concern organization from the following reasons.
• Overhead is significant part of total cost of product so it needs very careful allocation.
• It helps to make proper judgment for measurement of department efficiency.
• It helps to provide cost information for planning, controlling and managerial decision making.
• It provides basis for product costing.
• It helps to make accurate pricing for competitive market.
• It provides basis for effective use of available resources.
• It can be used to control wastage and defective.
Apportionment of overhead
Some overhead cannot be identified with specific department, to distribute such overhead to different department, different basis are used. To apportion the overhead suitable basis are used, which is based on benefit or serviced or capacity to bear cost etc.
Absorption of overhead
The term absorption refers to changing of overhead to products or jobs. It is the process of determining of overhead, which is incurred to a particular. Ascertaining the total overhead of a particular job or output by using different overhead rate is known as overhead absorption rate.
Steps In Accounting Overheads
- Actual Rate:
An actual rate is obtained by dividing the actual overhead to be absorbed by actual base selected. Actual overrate can be calculated only historically.
Actual overhead rates are not popularly used because they suffer from the following limitation:
(1) Since actual overheads are available at the end of financial year so ascertainment of cost will be delayed.
(2) It is not possible to prepare tender statement for quotation. Thus, prospective orders are lost if actual overhead rates are used.
(3) Actual overhead rates cannot be controlled.
(4) Cost comparison is not facilitated when actual overhead rates are used. This is so because certain overheads like overtime wages, leave and holiday pay, repairs and maintenance are not uniformly spread over the entire accounting year. So overhead rate fluctuates making difficult cost comparison.
- Pre-Determined Overhead Rates:
Due to the limitations of actual overhead rate, in most of the cases pre-determined overhead rate is used. This rate is calculated in advance. It is calculated by dividing pre-determined overhead by a pre-determined base. Budgeted overhead and budgeted base could be used to calculate this overhead rate.
- Single Rate/Blanket Rate:
When a single overhead rate of absorption is set up for the entire factory, it is known as single rate or blanket rate. This rate is calculated by adding up the overheads of all the production departments and dividing by the base which is the total of the quantity or amount. The use of blanket rate may not give accurate result when the amount of overheads differs from department to department.
- Multiple Rates:
When a separate overhead rate is set up for each department for absorption of overheads it is known as multiple rate. This is calculated by dividing departmental overheads by the departmental base. Multiple absorption rates are popularly used because they give accurate results.