Overheads are the indirect costs incurred in the production of goods or the operation of a business that cannot be directly identified with a specific product, job, or service. These costs are essential for carrying out business activities but are not directly traceable to individual units of production. Overheads include expenses such as indirect materials, indirect labour, factory rent, electricity, depreciation, maintenance, insurance, office expenses, and selling and distribution costs. In cost accounting, overheads are collected, classified, allocated, and apportioned to determine the total cost of production accurately. Proper control and analysis of overheads help management reduce unnecessary expenses, improve operational efficiency, prepare realistic budgets, fix appropriate selling prices, and increase the overall profitability of the organization.
Features of Overheads:
1. Indirect Nature
Overheads are indirect costs that cannot be directly identified with a specific product, job, or service. Unlike direct materials and direct labour, these expenses support the overall production or business operations. Since they benefit multiple activities, they are allocated or apportioned using suitable costing methods to determine the total cost of production.
2. Essential for Business Operations
Although overheads are not directly involved in manufacturing a product, they are necessary for the smooth functioning of the business. Expenses such as factory rent, electricity, supervision, maintenance, and administration ensure uninterrupted operations. Without these costs, production and business activities cannot be carried out effectively.
3. Cannot Be Directly Traced
One of the main features of overheads is that they cannot be directly linked to a particular product or service. Since these costs are common to several departments or production processes, they must be distributed among products using appropriate allocation and apportionment methods for accurate cost determination.
4. Includes Various Types of Costs
Overheads consist of different categories of indirect expenses, including indirect materials, indirect labour, and indirect expenses. They also include factory, administrative, selling, and distribution overheads. This wide range of costs makes overhead accounting an important part of cost accounting and cost control.
5. Vary According to Business Activity
Some overheads remain fixed regardless of production levels, while others change with business activity. Fixed overheads include rent and salaries, whereas variable overheads include power, fuel, and indirect supplies. Semi variable overheads contain both fixed and variable elements. This behavior helps management in planning and budgeting.
6. Important for Cost Determination
Overheads form a significant part of the total cost of production. Proper recording and allocation of overheads ensure accurate product costing, pricing decisions, and profit measurement. Incorrect treatment of overheads may result in under costing or over costing, affecting business performance and decision making.
7. Requires Proper Control
Effective control of overheads is necessary to avoid unnecessary expenses and improve profitability. Regular monitoring, budgeting, variance analysis, and cost control techniques help management reduce waste, improve efficiency, and ensure that overhead costs remain within planned limits without affecting business operations.
Collection of Overheads:
Collection of overheads is the process of identifying, recording, and accumulating all indirect costs incurred during a specific accounting period. These costs are gathered from different departments before they are allocated or apportioned to cost centres or products. Proper collection of overheads ensures accurate cost determination, effective cost control, and reliable financial reporting.
1. Collection of Indirect Material Costs
Indirect material costs include consumable stores, lubricants, cleaning materials, small tools, and other materials that cannot be directly traced to a specific product. These costs are collected from purchase records, stores requisitions, and inventory records. Proper recording ensures accurate overhead accumulation and effective inventory control.
2. Collection of Indirect Labour Costs
Indirect labour costs include wages paid to supervisors, storekeepers, maintenance workers, security staff, quality inspectors, and other employees who support production indirectly. These costs are collected from payroll records, attendance registers, and wage sheets. Accurate collection helps in proper allocation of labour overheads.
3. Collection of Indirect Expenses
Indirect expenses include factory rent, electricity, insurance, depreciation, repairs, telephone charges, and maintenance costs. These expenses are collected from invoices, bills, vouchers, and accounting records. Proper documentation ensures that all indirect expenses are included while calculating total overheads.
4. Department wise Collection
Overheads are collected separately for each department or cost centre to determine the expenses incurred by different sections of the organization. This method improves cost control, helps compare departmental performance, and ensures fair allocation of overheads to products or services.
5. Collection Through Cost Centres
Overheads are accumulated according to cost centres such as production, service, administration, and selling departments. Collecting costs in this manner helps identify where expenses are incurred and supports accurate allocation, apportionment, and cost control within each functional area.
6. Collection by Nature of Expense
Overheads are also collected according to their nature, such as indirect materials, indirect labour, and indirect expenses. This classification provides a clear understanding of different cost elements, simplifies accounting procedures, and assists management in analyzing and controlling overhead costs effectively.
7. Collection for Budgeting and Cost Control
Collected overhead information is used to prepare budgets, estimate future costs, and compare actual expenses with planned expenses. This enables management to identify unnecessary expenditure, take corrective action, improve operational efficiency, and achieve better cost control throughout the organization.
Classification of Overheads:
Overheads are classified into different categories based on their nature, behavior, and function. The classification helps in better analysis, control, and allocation of overheads. Here’s an overview of how overheads are typically classified:
Classification by Nature:
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Indirect Materials:
These include materials that cannot be directly traced to a specific product, such as lubricants, cleaning supplies, and small tools.
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Indirect Labor:
The wages of employees who do not directly contribute to production, such as supervisors, maintenance staff, and security personnel.
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Indirect Expenses:
Costs other than indirect materials and labor. Examples include factory rent, utilities, insurance, and depreciation.
Classification by Function:
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Manufacturing Overheads:
Costs associated with the production process, including indirect materials, indirect labor, and factory-related expenses like machine maintenance and factory utilities.
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Administrative Overheads:
Costs related to the general management and administration of the business, such as office rent, salaries of administrative staff, and legal expenses.
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Selling and Distribution Overheads:
Costs incurred in promoting, selling, and delivering products to customers. These include advertising, sales commissions, packaging, and transportation costs.
Classification by Behavior:
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Fixed Overheads:
Costs that remain constant regardless of production levels, like rent, insurance, and salaries of permanent staff. These costs do not change with the volume of production.
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Variable Overheads:
Costs that vary directly with production levels, such as power consumption, indirect materials, and commission on sales.
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Semi-Variable Overheads:
Costs that contain both fixed and variable components. Examples include telephone bills (with a fixed line rental and variable usage charges) and maintenance costs.
Classification by Controllability:
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Controllable Overheads:
Costs that can be regulated or influenced by a manager at a specific level of the organization. For example, a factory manager can control indirect material usage and overtime pay.
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Uncontrollable Overheads:
Costs that cannot be easily regulated by a manager, such as rent or depreciation.
Classification by Normality:
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Normal Overheads:
Regular, expected costs necessary for business operations. These are usually included in product costs.
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Abnormal Overheads:
Unexpected costs, like excessive wastage or abnormal idle time, that are not included in product costs and are charged directly to the profit and loss account.
