Introduction
A manufacturing
concern incurs different items of costs while converting raw materials into
finished outputs. Such costs can be classified on different bases. One such
basis is the directness of the costs to the product unit or identification of
costs with a particular product unit. The direct portion of the total costs is
called known as prime cost and the indirect portion is called overheads.
MEANING AND DEFINITION
The cost that can be
easily defined with and directly allocated to a particular cost center or cost
is known as a direct cost. The cost is divided into direct and indirect costs.
Direct materials, direct labours, and direct expenses are some examples of
direct costs and the total of these costs is known as prime cost.
CLASSIFICATION OF OVERHEADS
BASED ON FUNCTIONS
A manufacturing
concern carries out mainly two types of functions. These are manufacturing and
non-manufacturing functions. Manufacturing functions are concerned with converting
raw materials into finished goods while non-manufacturing functions are
concerned with general administration, selling, and distribution of goods. The organization
incurs several indirect expenses while performing such manufacturing and
non-manufacturing activities.
The major types of
overheads are;
1. Manufacturing
overheads:
They are also known as
production overheads or works or factory overheads. These are indirect expenses
that are incurred in carrying out manufacturing activities of the concern.
Manufacturing overheads include all the indirect expenses incurred in
converting raw materials into finished goods. Power, factory rent, factory
insurance, indirect materials, indirect wages depreciation, and repair and
maintenance are the example of manufacturing overhead.
2. Non-manufacturing
overheads:
The non-manufacturing
overheads include the following two overheads:
3. Administrative
overheads:
These are indirect
expenses that are incurred in connection with the general administration of the
whole concern. These overheads incur while carrying out office and administrative
activities. Example: office salaries, rent, printing and stationery, telephone
and electricity, depreciation and repair and maintenance of office building,
furniture, and other office expenses.
4. Selling and
distribution overheads:
All the indirect
expenses incurred for selling and distribution of finished goods are known as
selling and distribution overheads. Selling overheads are incurred for creating
demand, attracting present and potential customers, and retaining old
customers.
Examples: free gift,
advertisement, showroom expenses, and so on.
Distribution overheads
are incurred in maintaining stocks and carrying the goods to customer
destinations. Examples: packing charges, carriage, and freight out, warehouse
expenses, depreciation, and others.
Classification of overheads based on behavior
This classification is
based on the behavior or variability of overheads. Such a classification of
overheads is based on the change in the amount of overheads with the change in
output. There are four types of overheads;
1. Fixed overheads: These overheads
are also called period costs or capacity costs. They are incurred for creating
an output capacity of the concern for a fixed period, say, month, or a year.
They are the costs, which remain fixed or constant in total despite changes in
the volumes of production or sale. Examples: rent, salaries, depreciation,
interest, and legal expenses.
2. Variable overheads: These are the
overheads which vary positively with the production and sales volume. Hence,
they vary directly in proportion to the volume. They increase in total with the
increase in volume and vice versa. Examples; indirect materials, indirect
wages, indirect expenses.
3. Semi-variable
overheads: These
variables are neither completely fixed nor variable. Therefore, they are also
called semi-fixed costs. These overheads comprise the quality of both the fixed
and variable costs. They vary disproportionately with the change in the volume
of output. Examples; salesman remuneration, heating, lighting, supervision,
etc.
4. Step fixed: These overhead
remain fixed within a certain range of output level and jump up once the range
of output level exceeds. They remain constant for a given volume, but increase
by another fixed amount the moment there is the addition of volume, and keep on
focusing by a fixed amount with the addition of volume.
Classification of
overhead based on elements
Based on the
components or elements, overheads can be classified as indirect materials,
indirect labour, and other indirect expenses. This classification is also known
as the classification of overheads according to their nature of sources.
Each element of such
overheads is described below;
1. Indirect materials:
All materials other
than direct ones are indirect materials. They do not form part of the finished
product. They cannot be identified with or traceable to a particular cost unit
or cost center. They cannot be allocated but can be apportioned to a number of
cost units or centers. Examples: cost of lubricants, cotton waste, grease and
others.
2. Indirect labour:
The labour that is not
directly involved in the production process is called indirect labour and wages
paid to such labour are called indirect wages. Indirect labour, however,
assists in the production process. Examples; watchmen, sweepers, a worker in
department services, supervisors, and so on.
3.Other indirect
expenses:
The indirect expenses
other than indirect materials and indirect labour are called other indirect expenses.
These expenses also cannot be directly traced to any product unit or cost center.
Examples: rent, insurance, telephone, charges, lighting, office salaries, and
depreciation.
Classification of
overheads based on control
Control of costs is
one of the prime concerns of management. Some expenses can easily be controlled
by the management while some others cannot be. From cost control, therefore,
overheads can be divided into two types;
1.Controllable
overhead:
These are the indirect
expenses that the management of a manufacturing concern can keep under its
control, as they are influenced by its decisions. Therefore, those overheads
that vary due to the management decisions are called controllable overheads.
Examples: indirect materials, power expenses, and lighting expenses.
2.Uncontrollable overhead:
On the other hand,
those indirect expenses that are beyond the control of the management are known
as uncontrollable overheads. Examples; factory rent, office salaries,
depreciation, and legal expenses.
Allocation of
overheads
Meaning
Allocation of
overheads is the process of charging overhead costs to a particular department
or cost center. It is the allotment or assignment of an overhead cost to a
particular cost unit. If the overhead cost is associated with a single
department or cost center, the whole amount is charged or distributed among the
units of the output of that particular department. For example, the whole
amount of repair and maintenance expenses for a machine is charged pr allocated
to that department where the machine has been installed.
Apportionment of
overhead
Distribution of an
overhead cost to several departments or cost centers is known as the apportionment
of overheads. It is the process of charging or apportioning costs to a number
of cost centers or cost units. If a given cost is common to two or more
departments or cost centers, such cost should be apportioned or divided among theses
departments on an equitable basis.
For example, the
amount of factory rent should be apportioned to all the departments. Similarly,
the amount of remuneration to the general manager should be distributed to the
production, administration, and marketing departments, as the general manager
is associated with all these departments.
Differences between
allocation and apportionment of overheads
|
Allocation |
Apportionment |
|
It
involves a particular department or cost center. |
It
involves two or more departments or cost centers. |
|
The process of charging the costs
to a particular department or cost center is the allocation of overheads. |
The process of charging the costs
to a number of departments or cost centers is the apportionment of overheads. |
|
It
is based on direct distribution. |
It
is distributed on some equitable bases like direct labour hours, a number of
workers, machine hours, and space and area occupied. |
|
It is applicable when the overhead
cost is associated with a single department or cost center. |
It is applicable when the overhead
cost is associated with two or more departments or cost centers. |
|
Allocation
of overhead is done when the most center uses while of the benefits of the
expenses. |
Apportionment
of overhead is done when the cost centers use only a portion of the benefits
of the whole expenses. |
Absorption of overhead
The absorption of overheads
is also called the recovery of the overhead costs. It is the process of sharing
the overhead costs by all products of a particular department. It is the
application of overheads to each unit of output. In other words, the process of
ascertaining the total overhead costs if each unit of output or job by using
overhead rate is known as the absorption of overhead. Thus, the distribution of
the overhead expenses allotted to a department over the units produced in that
department is the absorption of overheads.
Reviewed by Bijay Munikar
on
March 15, 2021
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