1. Functional Classification of Overhead:

When overhead expenses are classified with reference to major activity divisions of a concern, it is called functional classification of overhead. This classification is necessary for the segregation of the cost of each of the principal functional division of the concern and for having separate methods of accounting and control for the diverse nature of expenses in each division.

The main groups forming the basis of the classification are:

(a) Manufacturing Overhead,

(b) Administration Overhead,

(c) Selling Overhead,

(d) Distribution Overhead, and

(e) Research and Development Expenses

1. Classification with Regard to Behaviour of Expenditure:

Under this overheads are classified with reference to their tendency to vary with production/sales volume or activity level. Some expenses vary directly with the rise and fall in output, some remain constant in spite of change in the level of activity of the concern whereas there are some other items which are constant only upto a certain level and then change their character to become variable or which vary with volume of output but less than proportionately.

Based on this behaviour, the expenses may be classified into:

(a) Fixed overhead,

(b) Variable overhead,

(c) Semi-variable or Semi­-fixed overhead.

This classification is not absolute but is one of convenience. All costs are variable in the long run. This classification is important for cost control and decision making.

(a) Fixed Overhead:

Fixed overhead cost (also called period cost and policy cost) is the cost which accrues in relation to the passage of time and which, within certain limits tends to be unaffected by fluctuations in the level of activity. These expenses remain fixed in total amount with increases or decreases in the volume of output or productive activity for a given period of time. Fixed overhead cost per unit decreases as production increases and increases as production declines.

Examples of fixed expenses are rent of building, storage space etc., depreciation of plant and machinery, depreciation of buildings, pay and allowances of space etc., depreciation of plant and machinery, depreciation of buildings, pay and allowances of directors, managers, secretaries, accountants etc., office expenses, like stationery and postage etc., bank charges, legal expenses, salaries of the works manager, interest on capital, if included in costs.

(b) Variable Overhead:

It is a cost which tends to follow (in the short-term) the level of activity. Variable overheads costs vary in total in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production. Thus variable costs fluctuate in total amount in direct proportion to the volume of output but tend to remain constant per unit as production activity changes. Examples are indirect material, indirect labour, spoilage, tools, defective work loss, lubricants, idle time, lighting and heating expenses and commission to salesmen.

The overhead, which can be easily identified with a particular department that is charged only to the specified department, is called allocation. There is no question of sharing of such expenses by any other department.

Appointment of Overhead

The overheads, which can be easily shared by the two or more departments on suitable basis, are called apportionment. The basis is determined according to the extent of services derived by the departments or benefits available to the department.

Departmentalization of Overhead

An organization is divided into many departments such as Production, Finance, Personnel, Accounts, Selling, Research and

Development and the like for efficient working and for collection allocation and absorption of costs. Thus, collected overheads are allocated or apportioned to the respective departments on suitable basis. This process is called departmentalization of overhead.

This process helps the management in ascertainment of cost of each department and control of expenses. Moreover, the cost of production of goods and services is ascertained or jobs passed through the departments or services rendered by the departments.

Criteria for Overheads Allocation And Apportionment

The following are the criteria used for the purpose of allocation and apportionment of overheads.

1. Neutral

The basis for cost allocation is neutral. It does not interfere with the decision making process even after the allocation. A decision is taken on the basis of neutral allocation of overhead; certainly, there is a possibility of optimum utilization of resources.

2. Ability to Bear

The overheads are allocated on the basis of ability of each department to bear the expenses. Sales revenue, total value of assets and gross profits are the some examples of basis for allocation. It is assumed that maximum ability department bears maximum expenses and vice versa.

3. Cause and Effect Relationship

There may be a meaningful casual relationship between the cost objects and the costs to be allocated. For example: Insurance might be allocated among the various departments in proportion to the value of fixed assets handled by each department. If so, there is a meaningful relationship between insurance and value of fixed assets.

4. Benefits Received

The overheads are allocated on the basis of benefits received by the each department. For example: Power expenses. The power expenses might be allocated in proportion to the consumption of power by the different departments or divisions.

5. Equity or Fairness

The basis for allocation of overheads is just and fair to all parties involved. Each party should bear an equitable share of the allocated costs.