Production overheads
Production overheads refer to the indirect costs associated with manufacturing or producing goods or services. These costs are not directly attributable to a specific product or service but are necessary for the overall production process. Examples of production overheads include rent, utilities, factory maintenance, equipment depreciation, and administrative expenses.
Production overheads, also known as manufacturing overheads or indirect costs, are expenses incurred during the manufacturing process that cannot be directly attributed to a specific product. These costs are necessary to facilitate the production process and support the overall operations of a manufacturing facility. Production overheads are different from direct costs, which are directly attributable to the production of goods or services, such as direct labor and raw materials.
Types of Production Overheads:
- Factory Overheads: These overheads are directly associated with the manufacturing facility and include expenses such as rent, property taxes, insurance, and building maintenance. The cost of operating and maintaining the factory or production facility is an essential part of the overall production overheads.
- Utilities: Costs related to utilities such as electricity, water, gas, and heating are considered production overheads. These expenses are necessary to power machinery, equipment, and provide a suitable working environment for the production process.
- Equipment Depreciation: Manufacturing equipment and machinery depreciate over time due to wear and tear. The depreciation expense, based on the useful life of the equipment, is considered a production overhead. It accounts for the gradual reduction in the value of the machinery as it is utilized in the production process.
- Maintenance and Repairs: Regular maintenance and repairs of machinery and equipment are essential to keep them in optimal working condition. These costs, including spare parts and labor, are classified as production overheads since they are not directly tied to a specific product but contribute to the overall production efficiency.
- Indirect Labor: Indirect labor costs include the wages and benefits of employees who are not directly involved in the production process but play a supporting role. This includes supervisors, maintenance staff, quality control personnel, and administrative employees.
- Factory Supplies: Expenses related to factory supplies such as lubricants, cleaning agents, and small tools are considered production overheads. These supplies are necessary for the smooth functioning of the production process but are not directly attributable to a specific product.
- Quality Control: Costs associated with quality control activities, including inspections, testing, and quality assurance, are considered production overheads. Ensuring the quality of products is essential for customer satisfaction and compliance with industry standards.
- Administrative Expenses: Administrative overheads, including salaries of management, accounting, and human resources personnel, office supplies, and other administrative costs, are part of the production overheads. These expenses are necessary for the overall management and coordination of the production process.
Significance of Production Overheads:
Production overheads play a crucial role in determining the total cost of production and ultimately the profitability of a manufacturing business. Understanding and effectively managing these costs are essential for maintaining competitiveness in the market. Here are some key points highlighting the significance of production overheads:
- Cost Allocation: Since production overheads cannot be directly attributed to specific products, appropriate cost allocation methods are used to assign these costs to individual products or production batches. This allows for accurate product costing and pricing decisions.
- Cost Control: Monitoring and controlling production overheads is vital for cost management. By identifying areas of excessive spending or inefficiencies in the production process, businesses can take corrective measures to reduce overhead costs and improve overall profitability.
- Decision Making: Accurate knowledge of production overheads enables informed decision-making. By understanding the impact of overhead costs on the overall cost structure, businesses can make strategic decisions regarding product mix, pricing, outsourcing, and investment in new technology or equipment.
- Decision Making: Accurate knowledge of production overheads enables informed decision-making. By understanding the impact of overhead costs on the overall cost structure, businesses can make strategic decisions regarding product mix, pricing, outsourcing, and investment in new technology or equipment.
- Budgeting and Forecasting: Production overheads are a significant component of the overall budgeting and forecasting process. By estimating and planning for these costs, businesses can set realistic financial targets, allocate resources effectively, and ensure adequate profitability.
- Performance Evaluation: Production overheads are taken into account when evaluating the performance of manufacturing operations. Key performance indicators (KPIs) such as overhead absorption rate, overhead efficiency variance, and overhead cost per unit produced are used to assess the efficiency and productivity of the production process.
- Cost Reduction Initiatives: Analyzing production overheads can help identify areas where cost reduction measures can be implemented. By streamlining operations, improving efficiency, and eliminating unnecessary expenses, businesses can reduce production overheads and increase their competitive advantage.
Treatment of Production overheads
Production overheads are indirect costs that are incurred in the manufacturing process and are not directly attributable to the production of specific products or services. These overheads include expenses related to the production facility, such as rent, utilities, and depreciation of equipment, as well as indirect labor costs, such as supervisory salaries.
- Allocation: The most common method of treating production overheads is to allocate them to the products or services produced based on a predetermined allocation rate or cost driver. This rate or cost driver may be based on factors such as direct labor hours, machine hours, or material costs.
- Absorption: An alternative method of treating production overheads is absorption. In this method, the overhead costs are absorbed into the cost of the product or service. This means that the cost of each product or service includes a proportionate share of the overhead costs incurred in the production process.
- Actual Costing: Another method of treating production overheads is actual costing, where the actual overhead costs incurred during the production process are allocated to the products or services produced. This method provides a more accurate reflection of the actual costs incurred in the production process, but it can be more time-consuming and complex to implement.
- Standard Costing: Standard costing is a method of treating production overheads where a predetermined standard overhead rate is applied to the products or services produced. This method is based on a predetermined budget for overhead costs and is useful for providing a basis for comparing actual costs against budgeted costs.
- Activity-Based Costing (ABC): Activity-based costing is a method of treating production overheads that involves identifying and allocating costs based on specific activities performed during the production process. This method provides a more accurate reflection of the costs incurred in the production process, particularly for complex products or services that require a variety of activities to produce.
Importance of Treatment of Production Overheads:
- Cost Control: Effective treatment of production overheads is essential for controlling costs and managing profitability. By accurately allocating or absorbing overhead costs, businesses can ensure that they are pricing their products or services correctly and managing costs effectively.
- Decision-Making: Treatment of production overheads is important for informed decision-making. By understanding the true cost of production, businesses can make informed decisions regarding pricing, product development, and investment in new technology or equipment.
- Performance Evaluation: Treatment of production overheads is also important for evaluating the performance of the production process. Key performance indicators such as overhead cost per unit of production or overhead cost as a percentage of total production cost can be used to evaluate the efficiency and productivity of the production process.
Administration Overheads
Administration overheads are indirect expenses incurred in running and managing a business that cannot be directly attributed to a specific product or service. These expenses are necessary to support the day-to-day operations of a business and are not related to production or sales activities. Examples of administration overheads include salaries of administrative staff, office rent, utilities, office equipment, legal and professional fees, insurance, and other general expenses.
Types of Administration Overheads:
- Salaries and Wages: This includes salaries and wages of administrative staff, including managers, accountants, human resources personnel, and receptionists.
- Office Rent: The cost of renting office space, including rent, maintenance, and utilities, is considered an administration overhead.
- Office Equipment: Expenses related to office equipment, including computers, printers, copiers, and telephones, are part of administration overheads.
- Communication: Communication expenses, including internet and phone bills, are part of the administration overheads.
- Legal and Professional Fees: Expenses related to legal and professional fees, including accounting, legal, and consulting services, are part of the administration overheads.
- Insurance: The cost of business insurance, including property, liability, and employee insurance, is considered an administration overhead.
- Office Supplies: Expenses related to office supplies such as paper, stationery, and printer cartridges are part of administration overheads.
- Marketing and Advertising: Expenses related to marketing and advertising activities, including print and online advertising, promotional campaigns, and events, are considered administration overheads.
Significance of Administration Overheads:
- Cost Management: Controlling administration overheads is essential to manage costs effectively. By monitoring expenses and identifying areas where costs can be reduced, businesses can improve profitability.
- Decision Making: Understanding the impact of administration overheads on the overall cost structure is essential for informed decision-making. By analyzing these costs, businesses can make strategic decisions regarding resource allocation, pricing, and investment in new technology or equipment.
- Budgeting and Forecasting: Administration overheads are a significant component of the overall budgeting and forecasting process. By estimating and planning for these costs, businesses can set realistic financial targets, allocate resources effectively, and ensure adequate profitability.
- Performance Evaluation: Administration overheads are taken into account when evaluating the performance of a business. Key performance indicators (KPIs) such as administrative overheads as a percentage of revenue, overhead efficiency variance, and overhead cost per employee are used to assess the efficiency and productivity of the administrative function.
- Cost Reduction Initiatives: Analyzing administration overheads can help identify areas where cost reduction measures can be implemented. By streamlining operations, improving efficiency, and eliminating unnecessary expenses, businesses can reduce administration overheads and increase their competitive advantage.
Treatment of Administration overheads
Administration overheads are indirect costs that are not directly related to the production process, but are essential for running the business. These costs include expenses related to management, finance, and other administrative functions. The treatment of administration overheads involves allocating these costs to the various departments or functions of the business.
Methods that can be used to treat administration overheads:
Allocation based on direct labor hours: In this method, the total administration overhead cost is allocated to the different departments or functions based on the number of direct labor hours worked in each department. The formula for this method is:
Allocation rate = Total administration overhead cost / Total direct labor hours
Departmental allocation = Allocation rate x Direct labor hours in the department
Allocation based on direct labor costs: In this method, the total administration overhead cost is allocated to the different departments or functions based on the total direct labor cost incurred in each department. The formula for this method is:
Allocation rate = Total administration overhead cost / Total direct labor cost
Departmental allocation = Allocation rate x Direct labor cost in the department
Allocation based on floor space: In this method, the total administration overhead cost is allocated to the different departments or functions based on the floor space occupied by each department. The formula for this method is:
Allocation rate = Total administration overhead cost / Total floor space
Departmental allocation = Allocation rate x Floor space occupied by the department
Allocation based on number of employees: In this method, the total administration overhead cost is allocated to the different departments or functions based on the number of employees in each department. The formula for this method is:
Allocation rate = Total administration overhead cost / Total number of employees
Departmental allocation = Allocation rate x Number of employees in the department
Allocation based on activity level: In this method, the total administration overhead cost is allocated to the different departments or functions based on the level of activity or output in each department. The formula for this method is:
Allocation rate = Total administration overhead cost / Total activity level
Departmental allocation = Allocation rate x Activity level in the department
Once the administration overhead costs have been allocated to each department or function, they are added to the direct costs of production to determine the total cost of each product or service. This total cost is then used to set the selling price for the product or service to ensure that the business makes a profit.
Selling & Distribution Overheads
Selling and distribution overheads are indirect expenses incurred in the process of selling and distributing products or services. These costs are not directly attributable to the production of goods or services but are necessary for the promotion and distribution of products to customers. Examples of selling and distribution overheads include advertising, sales commissions, transportation costs, packaging, and warehousing expenses.
Types of Selling and Distribution Overheads:
- Advertising and Promotion: Expenses related to advertising and promotion of products or services, including print and online advertising, promotional campaigns, and events, are part of selling and distribution overheads.
- Sales Commissions: Commission paid to sales representatives or agents is considered a selling overhead.
- Transportation Costs: Expenses related to transportation of goods from the production facility to the warehouse or distribution center, as well as expenses related to delivery of products to customers, are part of the distribution overhead.
- Packaging: Expenses related to packaging of products, including packaging materials, labeling, and design, are part of the distribution overhead.
- Warehousing Expenses: Expenses related to the storage, handling, and management of inventory, including rent, utilities, and equipment, are considered a distribution overhead.
- Sales Salaries and Wages: This includes salaries and wages of sales personnel, including sales managers, sales representatives, and customer service personnel.
- Sales Training and Development: Expenses related to training and development of sales personnel are considered a selling overhead.
Significance of Selling and Distribution Overheads:
- Cost Management: Controlling selling and distribution overheads is essential to manage costs effectively. By monitoring expenses and identifying areas where costs can be reduced, businesses can improve profitability.
- Decision Making: Understanding the impact of selling and distribution overheads on the overall cost structure is essential for informed decision-making. By analyzing these costs, businesses can make strategic decisions regarding resource allocation, pricing, and investment in new technology or equipment.
- Budgeting and Forecasting: Selling and distribution overheads are a significant component of the overall budgeting and forecasting process. By estimating and planning for these costs, businesses can set realistic financial targets, allocate resources effectively, and ensure adequate profitability.
- Performance Evaluation: Selling and distribution overheads are taken into account when evaluating the performance of a business. Key performance indicators (KPIs) such as selling and distribution overheads as a percentage of revenue, sales per employee, and distribution efficiency variance are used to assess the efficiency and productivity of the sales and distribution function.
- Cost Reduction Initiatives: Analyzing selling and distribution overheads can help identify areas where cost reduction measures can be implemented. By streamlining operations, improving efficiency, and eliminating unnecessary expenses, businesses can reduce selling and distribution overheads and increase their competitive advantage.
Treatment of Selling & Distribution overheads
Selling and distribution overheads are indirect costs that are incurred in the process of selling and delivering products or services to customers. These costs include expenses related to advertising, sales personnel, warehousing, transportation, and other related activities. The treatment of selling and distribution overheads involves allocating these costs to the different products or services that are sold by the business.
Methods that can be used to Treat selling and distribution overheads:
Allocation based on sales value: In this method, the total selling and distribution overhead cost is allocated to the different products or services based on their respective sales value. The formula for this method is:
Allocation rate = Total selling and distribution overhead cost / Total sales value
Product allocation = Allocation rate x Sales value of the product
Allocation based on units sold: In this method, the total selling and distribution overhead cost is allocated to the different products or services based on the number of units sold. The formula for this method is:
Allocation rate = Total selling and distribution overhead cost / Total units sold
Product allocation = Allocation rate x Number of units sold for the product
Allocation based on weight or volume: In this method, the total selling and distribution overhead cost is allocated to the different products or services based on their weight or volume. The formula for this method is:
Allocation rate = Total selling and distribution overhead cost / Total weight or volume
Product allocation = Allocation rate x Weight or volume of the product
Allocation based on number of deliveries: In this method, the total selling and distribution overhead cost is allocated to the different products or services based on the number of deliveries made. The formula for this method is:
Allocation rate = Total selling and distribution overhead cost / Total number of deliveries
Product allocation = Allocation rate x Number of deliveries made for the product
Allocation based on activity level: In this method, the total selling and distribution overhead cost is allocated to the different products or services based on the level of activity or output in each department. The formula for this method is:
Allocation rate = Total selling and distribution overhead cost / Total activity level
Product allocation = Allocation rate x Activity level for the product
Once the selling and distribution overhead costs have been allocated to each product or service, they are added to the direct costs of production to determine the total cost of each product or service. This total cost is then used to set the selling price for the product or service to ensure that the business makes a profit.