Cost accounting

Overhead Allocation and Absorption

Overhead Costs Definition

Overhead costs are the continuous business expenses that are not directly related to
manufacturing a product or creating a service. It is an important part of the budgeting
process and also determines how much a company will charge for a product or service for
profit.

Simply put, an overhead meaning can be any expense a company incurs to support the
core business activities, while not being directly related to the business’ products and
services.

An organization has to pay overhead on various fronts on a regular basis, irrespective of the
company’s sales.

For example, a business that offers services with an office has overhead costs, like rent, insurance,
utilities, office supplies, etc. These are in addition to the direct costs of providing its services.

Overhead can be classified on the basis of:-

1. Element

2. Controllability

3. Behaviour

4. Nature

5. Variability

6. Normality

7. Function.

When it comes to functions, overhead costs are categorized into the following types:

administrative overhead costs:

These generally include costs related to the overall management and administration of an
organization, like the need for accountants, human resources, receptionists, errand
runners, and other administrative staff.
The indirect expenses (overheads) incurred within the administrative area
are classified as administrative or office overhead

Research and Development Overhead

Research overhead is the cost of searching for new products, new

techniques for production or finding new equipment. The development
overhead is the cost of implementation of research result on commercial
basis. Cost of raw materials used for research, salaries and wages of R and
D department staff, subscription to books and journals, subscription to
research association, patent feeds and the like are examples of research and
development overhead.

Selling overhead costs:

These are related to activities that are a part of marketing and are fundamental to the
sales of the goods or services. It may include printed material and television
advertisements, as well as the commissions/incentives offered to the sales team.
Depending on the nature of the business, there can be other categories as well, like
research overhead, manufacturing overhead, maintenance overhead, warehousing
overhead, sales point overhead, or transportation overhead.

The indirect expenses (overheads) incurred about the sales activities are
classified as selling overheads.

 Factory/Production overheads:

These are incurred for production activities. Some examples would be electricity bills, raw
materials packaging, repair costs for machinery and, spare parts.

The indirect expenses (overheads) incurred within the factory area are
classified as factory overheads.

Distribution overheads:

These are required to deliver and transport products and services to customers. Some examples of
distribution overhead costs would be rent for godowns, packaging charges, delivery vehicle fuel
costs, etc.
The indirect expenses (overheads) incurred concerning the distribution of
the product or service are classified as distribution overheads.

Together selling and distribution is called as After production cost

cost

Behavioral Classification of Overhead

Behaviorally, the overheads are classified under three heads.

1. Variable Overheads

The overhead expenses which vary directly with activity level

(production/sales) are called variable overheads. These costs change with
every small change in the activity level.
These fluctuate according to business activity. When there is an increase in business
activity, variable overhead costs are likely to increase, too. Similarly, when there is a
decrease in business activity, variable overhead costs are likely to decrease. Variable
overhead costs may include shipping charges, legal expenses, office supplies, equipment
maintenance, materials, advertising,

1. Fixed Overheads

The overhead expenses which do not vary with the activity level
(production/sales) are called fixed overheads. These costs would remain the
same whatever may be the activity level achieved.

They are also called committed costs as they have to be borne even if the
activity level achieved is not as planned.

These are those that remain the same amount every month. Fixed overhead costs do not
change with business activity. Fixed overhead costs can include rent, mortgage, utilities,
depreciation of assets, insurance, property taxes, annual salaries, and government fees.

1. Semi-Variable Overheads

The overhead expenses which behave both like a variable, as well as fixed
overheads, are called semi-variable overheads. These expenses remain fixed
within ranges of activity levels. They vary whenever the activity level crosses
certain points.

Elements wise classification of overheads

The overheads may be classified on the basis of element wise in the
following ways.
1. Indirect Materials
These lead to overhead costs because these materials are used in the production process,
but cannot be linked to a specific product or service. They are consumed as part of the
production process but are not integrated into major amounts into a product or service.
Some examples of the same would be fittings, cleaning supplies, oil. In other words,
materials used in the production process do not form part of end product. This type of
material is called indirect material. For example: Threads and buttons used in stitching
cloths and lubricants used in maintenance of plant and machinery.

Indirect Labor:

This is an overhead cost that is not directly related to the production of goods and the
delivery services, but adds to the production cost nonetheless. Some examples of indirect
labor costs would be the wages paid to executives for the transport of raw materials from
one warehouse to another.

Some laborers are employed for the purpose of helping the workers to
produce goods and services. These laborers are not permitted to engage in
the production process directly. Moreover, salaries and wages paid to such
type of laborers are not included in the salaries and wages paid to workers
who are working in the production process directly. This type of labor is
called indirect labor.

For example: Salaries and wages paid to store keepers, sales

representatives, personnel manager, accountant, supervisors, and the like.
These indirect labor costs can not be identified with any particular job,
process, cost unit or cost centre.

Indirect Expenses
These are those overhead costs that do not add any value to the production of goods,
and services, but are miscellaneous costs that aid the day-to-day activities of an
organization. Some examples of this would be postage, printing, research and,
development. Some expenses are incurred by the organization in order to run the
business but not connected with the production of any goods and services. Without
incurring such expenses, nothing will be happen. Moreover, these expenses cannot be
conveniently allocated to job, process, cost unit or cost centre. Hence, these expenses are
treated as indirect expenses. Rent, rates, postage, insurance, light, depreciation and the
like are the examples of indirect expenses.
Control wise classification of overheads

Overheads may be classified in the control wise basis in the following ways.

1. Controllable Overhead

Overheads, which can be easily controlled by management through

exercising various steps, are called controllable overhead.

2. Uncontrollable Overhead

Overheads, which cannot be, controlled whatever the steps taken by the
management are called uncontrollable overhead.

Normal and Abnormal Costs.

Normal Cost are the normal or regular costs which are incurred in the normal
conditions during the normal operations of the organization. They are the sum of
actual direct materials cost, actual labour cost and other direct expense. Example:
repairs, maintenance, salaries paid to employees.

Abnormal Cost are the costs which are unusual or irregular which are not incurred
due to abnormal situation s of the operations or productions. Example: destruction
due to fire, shut down of machinery, lock outs, etc.

 Procedure for Accounting & Control of Overhead -

Following procedure is adopted for the accounting and control of overheads.
1. Collection of overheads.
2. Allocation of overheads.
3. Apportionment of overheads.
4. Re-appointment of service department overheads.
5. Absorption of overheads.

Collection of Overheads -

Following are the source document which are used for the collection of the
overheads

Stores Requisitions -

These serves as the base for accounting of the indirect materials

Invoices -

This includes the bills of the services or the material that is received by the
firm from the outside agencies. They serve as the evidence input document
based on which the payments are to be done. These payment are then
transferred in the financial accounts and the indirect expenses are collected
only through these invoices.

Wages Analysis Books - These accounts can be used while maintaining

the records for indirect wages and salaries.

4. Estimation from Financial Accounts -

Some expenses are charged over different accounting periods.

For example : Heavy advertisement expenses, prepaid expenses etc. These

expenses are apportioned among different accounting period. The best
possible way for their collection is the financial records of the company.

5. Subsidiary Records -

In accounts necessary provision is made for the expenses that are to be

incurred in the near future. These above provisions are reflected in the
subsidiary books. These records are serve as the source document for
collection of the overhead.

For example : Provision is made for outstanding rent, salary and other
expenses.
Classification of overheads

 Systematic process of grouping overheads on the basis of common

characteristics and specific objectives

 3 broad categories of factory overheads;

 Plant overheads

 Overheads relating to production cost centres

 Overheads relating to service cost centres

Allocation of Overheads -

Allocation of overheads is the mechanism of allocating the different

overheads among the production and the services cost centre.

For example : wages of the maintenance staff which is ascertained

from the record books can be directly allocated to the maintenance
cost centre. Indirect material cost can also be allocated to different
department on the basis of the material requests made by them.

Some of the overhead that are directly allocable to different

department and the cost centre are like insurance and depreciation of
the plant and machinery, fuel oil and departmental electricity
metered.

Reasons for Allocation of Overheads -

Following are the reasons behind allocation of overheads :

1. To report and communicate to the internal and external interested

parties.

2. To give ground for the cost incurred.

3. For encouraging the managers and the employees

4. To provide timely input for economic decisions.

  Apportionment of Overheads -
Some overhead cost are shared by a number of cost centre or department
and they do not originate from any single department. Such overhead cost
are disbursed among various department using the method of
apportionment.

Some overhead costs such as electricity, rent, salary of factory manager and
canteen expenses etc. are incurred for the entire factory and cannot be
assigned to a particular department. Such costs should be appointed or
distributed among the department based on the proportion of benefits
received by them.

Distribution of such (UNALLOCATABLE) overheads to various departments

is called as Apportionment

Limitations of Cost Accounting:

The following limitations below are;

 It is based on estimation: as cost accounting relies heavily

on predetermined data, it is not reliable.
 No uniform procedure in cost accounting: as there is no
uniform procedure, with the same information different results
may be arrived by different cost accounts.
 A large number of conventions and estimate: There are
several conventions and estimates in preparing cost records such
as materials are issuing on an average (or) standard price,
overheads are charging on the percentage basis, Therefore, the
profits arrive from the cost records are not true.
 Formalities are more: Many formalities are to be observed to
obtain the benefit of cost accounting. Therefore, it does not apply
to small and medium firms.
 Expensive: Cost accounts expensive and requires reconciliation
with financial records.
 It is unnecessary: Cost accounts of recent origin and an
enterprise can survive even without cost accounting.
 Secondary data: It depends on financial statements for a lot of
information. Any errors or shortcomings in that information creep
into cost accounts also.