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Overheads - Classification, Collection, Allocation, Apportionment, Re-appointment, Absorption of Overheads

Contents -

1. Meaning and Definition of Overheads.
2. Classification of Overheads.
3. Procedure for Accounting & Control of Overheads.
    a) Collection of overheads.
    b) Allocation of overheads.
    c) Apportionment of overheads.
    d) Re-appointment of service department overheads.
    e) Absorption of overheads.

Meaning -

Overheads are the sum of the indirect cost which a cost accountant is not able to segregate among different cost units. Overhead is the sum of indirect material, indirect labour and indirect expenses incurred, that cannot be separately identified as a what product they are incurred and cannot be separately allocable to a particular cost centre in a effective manner. It is a total of all the indirect cost which are not directly attributable.

Definition -

According to Blocker and Waltmer -
"Overhead cost are the operating cost of the business enterprise which cannot be interact/traced directly to a particular unit of output".

According to CIMA, London -
"Overhead is the aggregate of indirect material, indirect wages and indirect expenses".

  • Classification of Overheads -
Classification of overheads means to group different expenses under the overhead into distinct groups based on the same features.
Thus, classification define the method of segregating the item into different groups on the basis of some common features. It is significant to classify the item accurately and effectively in order to meet the ultimate objectives.
The terminology of CIMA defines classification as "The arrangement of items in logical groups having regard to their nature or the purpose to be fulfilled".
The classification of overhead is based on, The nature of business, Size of Business and Nature of product produced/service rendered.
Generally, classification of overheads is done on the following basis :
A) Elementwise Classification :
Under this method, the total overheads are split into three basic parts, i.e. indirect material, indirect labour and indirect expenses. These elements are described as below :

1. Indirect Materials -
Those materials which are not separately identifiable as to which product they belong but are the significant as the other in completion of the manufacturing process are the indirect materials.
For example : Duster used for cleaning the plant and machinery, lubricants, engine oil, coolants etc. used in maintenance of the machinery. In many cases partly materials like thread, glue, buttons, zip etc. are termed as the indirect materials in manufacturing the shirts and shoes as the same are used in very small quantities.

2. Indirect Labour -
Indirect labour comprises of the labour cost that cannot be directly attributable to a particular product or service.
For example : Wages paid to supervisor, store keeper, production manager, quality control manager, security officer, accounts officer etc. These costs do not directly result in the production of goods and services must assist in carrying out the operations.

3. Indirect Expenses -
Those expenses that are not separately recognisable with regards to a particular product or service are known as the indirect expenses. These are the common expenses incurred for the goods, jobs, services but cannot be allocated specifically.
For example : rent, taxes, rates, postage, electricity, telegram, insurance premium etc. 

B) Behaviourwise Classification :
Different characteristics are exhibited by the overheads in the short duration based upon the level of the production and sales. This is termed as the behaviour of the overheads. Under this, the overheads are classified as under :

1. Fixed Overhead -
Those overhead which remains the same regardless with the production levels are termed as the fixed overhead. The amount of overhead are same even if full capacity is utilised or even when no production is carried out. In short, such expenses are fixed in nature and they remain same for a particular period of time.
For example : depreciation and amortisation, staff salary, rental expenses etc.

2. Variable Overhead -
Those overheads which directly fluctuate with a change in the level of production are known as the variable overhead. The per unit cost of overhead however remains the same.
For example : power consumption, stores and consumables consumptions etc.

3. Semi-Variable Overheads -
Under this category, some portion of the overhead is fixed and some is variable and thus it may also be termed as the semi-fixed overhead. Likewise, some overhead exhibit with characteristic of overhead. i.e. They remained constant despite the level of production, while some exhibit the characteristics of variable overhead i.e. they change with change in the level of the production.
For example : maintenance expenses, telephone expenses, stationery and service department expenses, like in case of telephone expenses some monthly rental is fixed and after that billing is done on the basis of the usage. So there is an element of both fixed and the variable expenses.

C) Functional Classification -
An organisation can engage in carrying out functions of production, administration, selling, marketing, finance, research and development etc. The functional classification divides the overheads in the following manner :

1. Production Overhead -
Production overhead is the sum total of all the three ingredients, i.e. indirect material, indirect labour and the indirect expenses incurred in the respect of carrying out the production. The manufacturing activities commence with the procurement of the material and terminate with the packaging of the finished goods. It is also termed as the factory overhead, work overhead and manufacturing overhead.

Following are the example of the production overhead :
i) Indirect Material Cost -
a) Cost are printing, postage and stationery etc. used in production department.
b) Cost of consumable stores and supplies like cotton waste, lubricant oil, coolant, engine oil etc.

ii) Indirect Labour Cost -
a) Contribution to ESI, provident fund (P.F.), leave pay, maternity benefit, staff welfare expenses etc.
b) Salary of supervisor, quality inspector, works manager, accounts incharge and departmental superintendents.

iii) Indirect Expenses Cost -
a) Lighting, heating, and cleaning of factory.
b) Factory telephone expenses.
c) Rent, rates and taxes of factory building.
d) Repairs, insurance and depreciation of factory building, plant and machinery, furniture and other assets.

2. Administration Overhead-
It is the sum of total of expenses incurred toward indirect material, indirect wages and indirect expenses during formulation of the policies, administration and controlling function of the firm. They are also termed as the office overhead or the general overhead.

Following are the examples of administration overhead :
i) Indirect Material Cost -
a) Cost of duster, brushes etc. for cleaning of the office.
b) Cost incurred toward printing, postage and stationery which is used in administration department.

ii) Indirect Labour Cost -
a) Remunration of internal and statutory cost, financial auditors and legal advisors.
b) Salary of managing director, whole time director, general manager, finance manager, account manager, secretary, legal manager and other staff working in administration department.

iii) Indirect Expenses Cost -
a) Lighting, heating and cleaning of administration office.
b) Telephone expenses of administration office.
c) Rent, rates and taxes of office building.
d) Repairs, insurance and depreciation of office building, equipment and furniture and other assets.

3. Selling Overhead -
The expenses incurred to boost the sales and retain the existing customers are known as the selling overheads. It includes the cost that is incurred towards indirect material, indirect labour and indirect expenses for promoting the sales and reaching out to the customers.

Following are the examples of selling overheads :
i) Indirect Material Cost -
a) Cost of catalogues, price lists, packing material etc.
b) Cost incurred toward printing, postage and stationery which is used in sales department.

ii) Indirect Labour Cost -
a) Commission paid to the selling agents.
b) Salary of sales director, sales officers, sales managers, salesmen and other staff working in sales department.

iii) Indirect Expenses Cost -
a) Debt collection charges.
b) Bad debts.
c) Salesmen's travelling expenses.
d) Entertainment expenses incurred on customers.
e) Advertisement expenses.
f) Telephone expenses of sales office.
g) Lighting, heating and cleaning of sales office.
h) Rent, rates and taxes of sales office, showroom and exhibition centres.
i) Repairs, insurance and depreciation of sales office building, furniture, equipment and other assets.

4. Distribution Overhead -
The expenses incurred toward providing after sale service to the customers in order to maintain and satisfy the demand is known as the distribution expenses. It is the sum total of the expenses incurred toward the indirect material, indirect labour and indirect expenses to make the firms product reach the customers.

Following are the examples of distribution overheads :
i) Indirect Material Cost -
a) Cost involved in secondary packaging.
b) Cost of materials used in reconditioning of the empty containers returned by customers for reuse.
c) Cost incurred towards printing, postage and stationery which is used in distribution office.

ii) Indirect Labour Cost -
a) Driver's salary of the distribution vehicles.
b) Staff salary attached to distribution office like dispatch staff, packers etc.

iii) Indirect Expenses Cost -
a) Depreciation, repairs and running expenses of delivery vans.
b) Insurance of finished stock in godown.
c) Rent, rates and taxes of distribution office and godown.
d) Repairs, insurance and depreciation of distribution office building, furniture, equipment and delivery van.
e) Lighting, heating and cleaning of distribution office.
f) Telephone expenses of distribution office.
g) Freight and carriage outward.

  • 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.

  • A) Collection of Overheads -
Following are the source document which are used for the collection of the overheads.

1. Stores Requisitions -
These serves as the base for accounting of the indirect materials. This cost centre code is of significance while allocating the indirect material cost. These requests carry a cost centre code, with denotes the job or the service for which the material is used along with the name of the cost centre and their bead.

2. 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.

3. Wages Analysis Books -
The book depicts various control account. 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. Just like with the aid of fixed asset register, detail regarding the fixed assets can be calculated, similarly these records can be used.
For example : Provision is made for outstanding rent, salary and other expenses.

  • B) 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.

According to CIMA, Allocation is :
"The charging of discrete, identifiable items of cost to cost centre or cost units. Where a costs can be clearly identified with a cost centre or cost unit, then it can be allocated to that particular cost centre or cost unit".

Some of the overhead that are directly allocable to different department and the cost centre are insurance and depreciation of the plant and machinery, fuel oil and departmental electricity metered.

An overhead expenses is allocated to a particular cost centre only upon fulfillment of the following terms :
1. The overhead incurred in a cost centre can be measured accurately.
2. The overhead incurred in the result of a particular cost centre.

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.

Allocation Overheads Process -
The process of allocation of overheads consists the three basic activities. They are as follows :
1. To find out the beneficiaries of the allocated cost. It may be a particular department or the product.
2. Accumulating the cost as per different department, division or product.
3. Finally choosing a method to match the accumulated cost with the cost objects.
The last is the most critical of all as some common cost exist which cannot be attributed to a single department or the product. In order to attribute the same, reasonable care is required to relate the cost with the cost objects.
Allocation cannot be completely accurate, however, following bases can be adopted for reasonable allocation of the fixed overheads.

Methods of Allocation of Overheads -
Overheads can be allocated in the following three ways :

1. Dual Rate Method -
Under this method instead of having one cost pool, the same is split into two cost pools i.e. one for the fixed cost and the other for the variable cost. Different cost allocation base are used for allocating cost of each pool. Two cost drivers are made which are based on the expenses made by the provider department. For allocating the variable cost current uses of the user department are considered while long-term commitments are considered for allocating the fixed cost.

2. Actual Rates versus Budgeted Rates -
When the actual rate are used there is lesser uniformity of charges to the cost of objectives. In the case of actual rates some more fluctuations are observed that after the total cost of the end product. Budgeted rates on the other side are constant and lesser variations are found in the charges to the cost objective and ultimately to the end product. Whenever there are changes that the variations in the actual rate will mislead the allocation process, then budgeted rates are preferred.

3. Single Rate Method -
Under this, all expenses are grouped together in one of the cost pools and using a single base rate, these cost are allocated to cost object. No differentiation in made between the fixed and variable cost and all the cost are allocated collectively. The single rate is calculated as per the following formula :
Rate = Manufacturing overhead costs / labour hours .

  • C) 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.

According to CIMA, apportionment is :
"The allotment of two or more cost centre of proportions of the common item of cost on the estimated basis of benefits received".

Note : In the preparation of statement of "Primary Overhead Distribution Summary" both the statement of Allocation of Overheads and Apportionment of Overheads get combined to evaluate the total departmental overheads cost.

Bases of Apportionment -
Common bases of apportionment of overheads may be summarised as below :
 

Overhead cost

Bases of apportionment

1. Rent and other building expenses

2. Lighting and heating

3. Air conditioning

4. Fire precaution service

Floor area or Volume of department

1. Supervision

2. Time keeping

3. Personal office

4. Labour welfare expenses

5. Fringe benefits

Number of workers

1. Holiday pay

2. Compensation to workers

3. ESI and PF contribution

4. Fringe benefits

Direct wages

General overhead

Direct labour hours or Direct wages or machine hours

1. Depreciation of plant and machinery

2. Repairs and maintenance of plant and machinery

3. Insurance of stock

Capital values

1. Internal transport

2. Managerial salaries

3. Power consumption

Technical estimates

Lighting expenses

No. of light points or area

Electric power

Number of machine hours or Value of machines

1. Stores overhead

2. Material handling

Weight of materials or volume of materials or value of materials


  • D) Re - Appointment of Service Department Overheads -
The service cost centre offer their services to the production departments. Therefore their overheads are re-apportioned only to Production department. Re-apportionment refers to the process of re-distribution service cost centre to production department. The process is also known as secondary distribution of overheads. The Re-apportionment of overheads is done on the basis of the proportionate benefits received by the cost centre. The technical estimates related to apportionment are taken by the management.

Service Cost Centres Cost

Basis Of Apportionment

1. Maintenance department.

Hours worked for each department.

2. Payroll or time-keeping department.

Total labour or machine hours or number of employees in each department.

3. Employment or personnel department.

Rate of labour turnover on number of employees in each department.

4. Store keeping department.

Number of requisition, quantity or value of material for each department.

5. Purchase department.

Number of purchase orders or value of materials purchased for each department.

6. Welfare, ambulance, canteen service, reception room expenses.

Number of employees in each department.

7. Building Service department.

Relative area of each department.

8. Internal transport service, overhead crane service.

Weight, value, graded products handled, weight and distance travelled.



Methods of Re-Apportionment of Overheads -
Following are the methods used for the re-apportionment of service cost centre overheads :

1. Step Down Distribution Method -
This method recognises the fact that a Service Department may offer its services to other service departments in addition to production department. This method is easy to use but ignore the principle of reciprocal services and thus not take into account the complexity of the situation. This method is also known as Elimination Method. This method works on the assumption that one service department cost is apportioned, then such department is excluded from any further apportionment of cost of other service departments.

2. Direct Distribution Method -
This method assume that service cost centre offer their services only to production department. The apportionment totally depend on the amount of benefits received by the production department. This method is easy to use but does not give accurate result. In this method, the overhead of the service cost centre are re-apportioned to the production cost centre.

3. Reciprocal Approach -
This method is used in cases where service department not only offer their services but also receive services from other service department.
For example : A factory may have two Service Department, i.e. boiler room and pump room. Pump room need boiler room for steam power while boiler room need pump room for water supply.
Following are the three main methods used under this approach :
1. Trial and error method.
2. Simultaneous equation method.
3. Repeated distribution method.

  • E) Absorption of Factory Overheads -
The process of absorption of overhead is also known as Application, Levy or Recovery of Overhead. It involves proper allocation and apportionment of the total factory overhead to each production department. It is also called as Applied Factory Overheads.
Absorption of factory overhead constituted the last step in the process of overhead distribution. This process also include the redistribution of service department cost to production department. Through the output of department an equitable base is form for the absorption of total overhead of each production department at the end after the beta distribution process. The first step involves the distribution of total factory overhead to the production department by allocating department cost and apportionment of common cost over different production and service departments.

According to CIMA, absorption of overhead is :
"The process of absorbing all overhead cost allocated for apportioned over a particular cost centre or production department by the units produced".

Common Bases for Absorption of Production Overhead from Production Cost Centre to Products or services.
  

Basis of Denominator

Applicability

Unit of ProductionWhen single product is produced for several products are similar in specification.
Direct Labour CostWhen conversion process is labour intensive and wage rates are substantially uniform.
Direct Labour CostWhen conversion process is labour intensive.
Machine hour or Vessel Occupancy or Reaction hour or crushing hour etc.

When production mainly depends on performance of the base


Various units such as machine hours, direct labour hour, direct wages or production unit may be used for the purpose of apportionment. All relevant factors should be considered before choosing the unit. Then, the absorption rate is obtained by dividing the total overhead with the produced unit.

Overhead Recovery Rates -
Overhead rate is determined by dividing the total overhead by the quantity or the value of other determined units. Following figure shows various type of overhead rates :

1. Actual Rate -
This rate is determined by dividing the actual overhead by the actual quantity or value of the base. Direct material, direct labour hour, direct wages, machine hour or production units may be used as a base to calculate the actual rate.
                          Actual Overheads
Actual Rate = --------------------------------
                           Actual Base

2. Standard Rate -
Standard rate is determined by dividing the standard overhead by the standard rate. Following formula is used for this purpose.
                             Standard Overheads
Standard Rate = -----------------------------------
                                Standard Base

3. Predetermined Rate -
This rate is determined by dividing the budgeted overhead by the budgeted units of the year. Following formula is used for the purpose of calculating pre-determined rate.
                                        Estimated or
                                     Budgeted Overheads
Predetermined Rate = --------------------------------
                                         Estimated or        
                                        Budgeted Base
This rate helps in directing the total overheads of the year by the total units. This rate is also used in costing.

4. Blanket and Multiple Rates -
These are explained below :

i) Blanket Rate -
It denotes a single rate computed for the entire factory. Following formula is used for the purpose of calculating blanket rate.
                            Total Overheads
                            of the factory
Blanket Rate = --------------------------------
                            Total value of the base                                    for the factory
Blanket rate may give inaccurate result in the case where product go through one or more different department or processes.

ii) Multiple Rates -
These are the different rates calculated for each of producing departments, cost centre or product lines etc. this rates are also known as departmental rates.


Methods of Overhead Absorption -
Following are the methods of overhead absorption :

1. Rate per unit of production -
This method uses number of units of production at base for calculating the factory overhead rate. Following formula is used for this rate : 
                                    Amount of
                                  Production o/h
Factory o/h Rate = --------------------------------
                                     No. of units                                                      of production

2. Machine hour rate -
It is the cost of running a machine for one hour. This method uses machine hour as the basis for the absorption of overhead. Following formula is used for the purpose of calculating the rate : 
                               Amount of
                            Production o/h
Blanket Rate = --------------------------------
                            Machine hour                
                 
3. Percentage of direct material cost -
Under this method the cost of direct materials are used manufacturing product is used as the base for calculating absorption rate of factory overhead in terms of percentage. Following formula is used for this purpose :
                             Factory overhead
Overhead Rate = ----------------------------- x100
                             Direct material cost        
                            
4. Percentage of direct labour cost -
This method charges overheads as a percentage of the direct wages incurred on jobs. Following formula is used for calculating overhead rate :
                             Factory overhead
Overhead Rate = -------------------------------x100
                            Direct labour cost    
                           
5. Direct labour hour rate -
Overhead absorption rate is calculated using direct labour hours as a base. Following formula is use for this purpose :
                                   Amount of
                                 Production o/h
Factory o/h Rate = -------------------------------
                                  Direct labour hours                                  

6. Percentage of prime cost method -
This method uses the prime cost for determining the overhead absorption rate. This method is computed as : 
                                   Amount of
                                  Production o/h
Factory o/h Rate = ----------------------------x100
                                     Prime cost     
                              

Steps in Absorption Overhead -
Following steps are involved in the process of absorption overhead :

Step 1 :
Computation of Overhead Absorption Rate -
The determination of absorption of overheads in cost of the cost unit are mostly done by absorption rate. This rate can be calculated by different ways also. Generally, to calculate the overhead rate the total amount of overheads of department or cost centre is divided by the number of units in the base like machine hour, direct labour cost, price cost, number of cost units etc.
                                    Total Overheads
                                        Cost centre
O/h absorption Rate = ------------------------------
                                        Total unit in base               
Only one rate is calculated for each group of overhead.

Step 2 :
Application of Rates to Cost Units -
Overhead rate is multiplied by the number of units of base in the cost unit to get the overhead cost of each cost unit.
Overhead absorption = No. of units of base in the cost unit x Overhead rate

For example :
Machine hour rate is Rs. 50 and a cost unit has used 10 hours of the machine, overhead absorbed will be = 10 hours x Rs. 50 = Rs. 500

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