Overhead cost
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Overhead costs are indirect expenses that are incurred in addition to direct material and direct labor costs. They include indirect materials, indirect labor, and indirect expenses. Overheads must be classified, collected, allocated to cost centers, and then absorbed or charged to production units. They are classified as factory, office/administrative, or selling/distribution overheads. Overhead allocation involves allotting whole costs to cost centers, while apportionment involves allotting proportionate shares of common costs between cost centers. Absorption of overheads involves charging production with an equitable share of overhead costs using an absorption rate.
Overhead cost
- 1. Overhead Costs • Overheads or overhead costs are brief expression for all indirect expenses. • It indicates the expenditure incurred over and above the direct material and direct labour. • According to CIMA, London- Overhead is an aggregate of indirect materials, indirect labour and indirect expenses. • According to National Accounting Association, these are the costs that have to be incurred although they have no directly measurable relationship to specific activity units, production or cost objectives.
- 2. Procedure for accounting and control • Classification and codification • Collection and accumulation • Departmentalization through allocation and apportionment • Re-apportionment to production department • Absorption or charge to production unit
- 3. Classification of Overheads • Factory Overhead - Indirect Material, -Indirect Labour - Indirect Expenses • Office & Administrative - Indirect Material, -Indirect Labour - Indirect Expenses • Selling & Distribution - Indirect Material, -Indirect Labour - Indirect Expenses
- 4. Allocation of Overhead • According to CIMA, allocation is defined as allotment of whole item of cost to cost centres or cost units. • Expenses which originates directly and completed in a department are identified with the foreman responsible for the supervision of the department. • Direct departmental overhead in production and service department can be categorized as under: -supervision, indirect labour and overtime -labour fringe benefits -indirect material & factory supplies -R & M - Equipment depreciation
- 5. Case-1 B ltd. has two production departments and two service departments, provides you the following data: Production Dept. Service Dept. A B C D Direct Materials 40,000 30,000 20,000 10,000 Direct Wages 20,000 15,000 10,000 5,000 Direct Expenses 10,000 7,500 5,000 2,500 Indirect Materials 5,000 5,000 5,000 5,000 Indirect Wages 2,500 1,500 5,000 4,000 Common indirect expenses = Rs. 20,000 Prepare a statement showing the allocation of overheads
- 6. Apportionment of Overheads • Expenses such as power (HP of machine), light (light points), rent (floor area), depreciation of factory buildings are expenses shared by all departments and can not directly charged to a particular department, be it producing or servicing department. • They are incurred for all to use and therefore, be apportioned to all departments using such items. • According to CIMA, apportionment is defined as the allotment of proportion of items of cost to cost centres or units.
- 7. Basis of Apportionment of some common items of Production Overhead Items Basis of Apportionment Factory rent, rates, taxes Floor area occupied Repair & Maintenance of Factory Building -do- Insurance of Factory Building -do- Depreciation of Factory Building -do- Repair & Maintenance of Plant & Machinery Capital cost of plant & machinery Insurance of Plant & Machinery -do- Depreciation of Plant & Machinery -do- Insurance of stock/ inventory Insured value of stock Supervision No. of workers Canteen, Staff Welfare Expenses -do- Time Keeping and Personnel Office Expenses -do- Compensation to workers Wages Employees’ State Insurance Contribution Wages Provident Fund Contribution Wages
- 8. Case-2 XYZ ltd. has two production departments and two service departments, provides you the following data: Production Dept. Service Dept. A B C D Direct Materials 40,000 30,000 20,000 10,000 Direct Wages 15,000 20,000 5,000 10,000 Floor Area (Sq. ft.) 5,000 4,000 3,000 2,000 Value of Plant & Machinery 50,000 60,000 20,000 10,000 Value of stock 35,000 25,000 5,000 5,000 No. of workers 100 50 25 25 No. of light points 200 50 25 25 Horse Power of machine 50 25 15 10 Indirect expenses for the period were: Factory Rent, Rates and Taxes – Rs. 14,000/ Depreciation, Insurance & Repairs of machinery – Rs. 28,000/ Insurance of stock – Rs. 700/, Store overheads –Rs. 1,000 , Lighting & Heating – Rs. 3,000/ Supervision & Staff Welfare expenses – Rs. 2,000/, Power – Rs. 1,000/
- 9. Solution Statement Showing the Apportionment of Overheads Items of Overheads Basis Total (in Rs.) Production Dept. Service Dept. A B C D Factory Rent, Rates and Taxes Floor Area 14,000 5,000 4,000 3,000 2,000 Depreciation, Insurance & Repairs of machinery Value of P & M 28,000 10,000 12,000 4,000 2,000 Insurance of stock Value of stock 700 350 250 50 50 Store overheads Value of materials 1,000 400 300 200 100 Lighting & Heating No. of light points 3,000 2,000 500 250 250 Supervision & Staff Welfare expenses No. of workers 2,000 1,000 500 250 250 Power H.P. of machinery 1,000 500 250 150 100 TOTAL 49,700 19,250 17,800 7,900 4,750
- 10. Case-3 S. will Ltd. has two production departments A, B and one service department S. The actual costs for a period are as follows:
- 11. Solution-3
- 12. Case-4 Swill Co. Ltd. has three production departments and two service departments. From the following information show the distribution of service departments cost under the repeated distribution method:
- 13. Solution-4
- 14. Basis of Apportionment of Overheads of Service Departments Service Department Basis of Apportionment Purchase Department No. of purchase orders or no. of purchase requisition or value of material purchased Stores Department No. of material requisition or value of materials used Time Keeping/Pay-roll Department No. of employees or Total labour hours/ Machine hours Personnel/Canteen/ Welfare/ Medical Department No. of employees or Total wages Repair and Maintenance No. of hours worked in each dept. Power House Meter reading or H.P. hour for power Inspection Inspection hours or Value of items inspected Drawing office No. of drawings made or Man-Hours worked Accounts department No. of workers in each department or Time devoted Tool Room Direct labour hours or Machine hours or Wages
- 15. Absorption of Overheads • In simple words, absorption means charging equitable share of overhead expenses to the products. • As the overhead expenses are indirect expenses, the absorption is to be made on some suitable basis. The basis is the ‘absorption rate’ which is calculated by dividing the overhead expenses by the base selected.
- 16. Illustration A firm produces two products, A and B. Direct material costs for A are Rs. 2,50,000 and for B, Rs. 1,50,000. The overheads will be charged to these products as shown in the following statement, assuming the rate of absorption as 50% as shown above. Particulars Product A Product B Direct Materials (DM) 2,50,000 1,50,000 Overheads 50% of DM 1,25,000 75,000 Total DM + Overheads 3,75,000 2,25,000 This method is suitable in those organizations where material is a dominant factor in the total cost structure.
- 17. Over Vs. Under Absorption • If actual production overheads of a period is absorbed at an absorption rate on actual production during a period, the overhead absorbed must be equal to the actual overhead costs incurred. But this seldom happens especially when pre- determined overhead rates are applied. • Since there are seasonal differences, the difference between the budgeted overheads and actual overheads incurred is bound to happen. • The difference between overheads charged and the overheads incurred is called the “under or over-absorption of overheads. • When overheads absorbed exceeds the actual overheads, it is called over-absorption and when actual overheads exceeds the overheads absorbed , it is called under-absorption of OH.