1. Introduction:

In a manufacturing company, two types of costs are incurred in the production of goods

– Direct Costs and Indirect Costs. Direct costs include cost of material and labour which are used directly in the production of goods. Indirect costs are those costs that are not incurred directly in the production of goods but are still necessary to be incurred for the continuation of production process and producing income. These are the indirect costs which are known as overhead expenses.

Overheads are the indirect costs that are incurred during the course of manufacturing an item, rendering a service or running a department but cannot be debited directly or wholly to an item, services or departments.

Suppose an organization produces three products: A, B and C. Material, labour and other direct expenses which an organization used for each product individually are the direct costs. Besides these, there are other expenses like rent, helper wages, salaries of office staff, rent of showroom; salaries of salesman etc. which are incurred for the benefit of the organization as a whole but cannot be charged separately for each product are overheads.

Thus, overheads is the sum total of indirect material, indirect labour and indirect expenses.

1. Categorization of Overheads

Overheads can be classified as follows:

Function wise:

1) Factory/Manufacturing overheads – Factory overheads are the expenses that are common to all the products produced within the factory. It is that part of the product which is invisible. E.g. adhesive in the furniture, glue in the book binding etc.

2) Office and Administration overheads – Office and Administration overheads are the expenses that are incurred for carrying on the general office activities of the enterprise which includes policy formulation, controlling and maintenance of accounts. Example of office administration can be printing charges, postage and stationary used in administration department, director’s fees, insurance of office building, office staff salaries etc.

3) Selling and Distribution overheads – Selling overheads are those expenses which a company incurs on marketing activities in order to stimulate the demand for goods or services and to secure the orders. E.g. Sales manager’s salary, sales’ director’s salary, printing and stationary cost used in sales department. Distribution overheads are the costs which are incurred to move a product from the producer or manufacturer to the consumer. E.g. Delivery expenses, carriage outward, godown charges, packaging charges, insurance of delivery vans etc.

Variability wise:

a. Fixed overheads – If the volume of production or level of activity increases or decreases but expenses do not change within a given range such expenses are known as fixed overheads. E.g. Manager’s salary, building rent, legal expenses etc. Fixed cost per unit changes as the volume of production changes i.e., it decreases when the production increases and vice-versa.

b. Variable overheads – If the volume of production increases and decreases and expenses fluctuates in total amount in direct proportion to the volume of production are known as variable overheads. E.g. Stores, salesmen’s commission, indirect material, indirect labour etc. Variable cost per unit remains static as the level of activity fluctuates.

Nature wise:

a. Indirect material – Those materials which are used in manufacturing a product but cannot be recognized and directly charged to a specific department are called indirect materials. E.g. oil, rags, cons. stores etc.

b. Indirect labour – The labour that is not directly involved in producing a product but helps those labours who are engaged in manufacturing a product is known as indirect labour. E.g. Supervisor, foreman, watchman etc.

c. Indirect expenses – Those expenses which are not incurred for a specific product and cannot be charged directly to cost centers are known as indirect expenses. E.g. rent of building, repairs etc.

Control wise:

a. Controllable overheads – Those overheads which can be controlled by the action of the management are known as controllable overheads. E.g. direct material, direct labour etc.

b. Uncontrollable overheads – Those overheads which cannot be controlled by the action of the management are known as uncontrollable overheads. E.g., Rent, Insurance, Salary etc.

Semi-variable overheads – It is mixture of both fixed and variable overheads. It does not change up to a set level of production and beyond that production level, increases in direct proportion to output. E.g. Salesman gets a fixed salary plus commission when sales beyond a certain level is achieved.

1. Stages of Factory Overhead Distribution:

The following stages are involved in distribution of overheads:

Codification and Collection of Overheads:

Codfication of overheads:

In codification, codes or symbols are allotted to each item of overhead. Code numbers are termed as Standing order number.

Different methods are used for codification:

a) Numerical Method: A fixed number is assigned to each type of expense. E.g.

Depreciation of plant 100

Labour 200

b) Mnemonic Method: An alphabet is assigned to identify the expenses. E.g. Repair RE

Maintenance MN

Depreciation DE

c) Decimal Method: For the main expenditure, the whole number is assigned and for its sub-division, decimals are assigned. E.g.

Factory office 1:1

Indirect labour	1.1
Salaries	1.1.2
Bonus	1.1.3

d) Alphabetical cum Numerical Method: Under this method, mixture of alphabet and

Departmentalization of Overheads:

After codification and collection, next step is to distribute the overheads to different cost centres on a suitable basis. This process is called Primary distribution.

Two stages are involved in departmentalization of overheads:

1. Allocation of overheads

2.Apportionment of overheads

Allocation of Overheads:

When the precise amount of overhead is known and a particular cost centre have incurred the overhead, in that case whole amount of overhead is charged to that cost centre, this process is known as allocation. E.g. If a machine is located in department A then repair cost of machine is charged to only department A.

Apportionment of Overheads:

When an overhead expense cannot be charged fully to a particular department because it is incurred for a factory as a whole, in that case expenses are distributed among the number of departments on some equitable basis, this process is known as apportionment. E.g. Building or factory is used by all the departments, thus rent cannot be charged only to a specific department, it is to be apportioned to different departments on the basis of floor area occupied by various departments.

Basis of Apportionment

Reapportionment or Secondary Distribution

Redistribution of cost from services to production department is known as Reapportionment or secondary distribution.

Generally, cost centres are not engaged in manufacturing of goods but they assist production department in the production process. Because of this reason, production department bears all the cost of service department. Thus the process of charging the overhead cost of service department to production department is known as reapportionment or secondary distribution of overheads.

Basis of Reapportionment:

Methods of Secondary Distribution:

There are different methods through which cost of service department is apportioned to production department.

Direct Redistribution Method:

Under this method, service department cost is assigned only to production department and there is no interaction between the service departments.

Reciprocal Services Method:

This method is used when different services cost centres provide services to each other

In reciprocal basis, following methods are used to assign the costs:

i) Repeated Distribution Method – This method involves the following steps:

· Apportion the cost of first service department to production department and other service departments using agreed percentage.

· Distribute cost of second service department (including the proportion of first department) to other departments.

· This process goes on till the service department cost become insignificant.

Absorption of Overheads:

After allocation and apportionment of expenses to production department, the next step is recovering of overhead or levy or absorption of overhead.Absorption overhead means allotting the overhead expenses of a particular production department among the various products manufactured by it on basis of absorption overhead absorption rate

Overhead Absorption Rate= Total Overheads

Units of base

Rates of Overhead Absorption:

Overhead absorption rate may be of the following types

a. Actual Overhead Rate:

This rate is determined when the expenses have incurred during a particular period.

Actual Overhead Rate =Actual expenses for a period/Actual quantum of the base for a period

However, this method is not desirable because of the certain limitations:

· This rate can be calculated only when the data of actual expenses are available which is possible only after the end of a particular period. Thus it results in delay ascertaining the cost of products.

· There are certain costs like repairs, maintenance etc. which is not uniform throughout the year, this result in difference in actual overhead from period to period. This makes comparison between two overhead rates impossible.

· It does not help in controlling of cost.

B. Predetermined Overhead Rate:

This method has the following merits:

· Because this rate is calculated in advance, it results in prompt determination of cost.

· This rate helps in controlling of cost because of comparison of actual overhead with the predetermined overhead absorbed.

· This rate facilitates comparison between costs of two periods because same rate is used for the full period.

·
This rate is used in taking various managerial decisions like fixation and quotations.

C.

Blanket Overhead Rate:

It is a single rate which is determined for the whole factory. This rate is used in those firms which manufactures only one product or where two or more goods are manufactured but they pass through all departments.

Merits of blanket overhead rate:

· It is easy to calculate.

· It involves less clerical work.

Demerits of blanket overhead rate:

· When several products are produced and they do not go through all the departments then in that case this rate gives ambiguous results.

· It does not help in managerial control because the performance appraisal of the individual department is not possible with this rule.

· It results in over value work in progress.

b. Multiple Overhead Rates:

This rate is determined separately for each department/cost centres.

Advantages of multiple overhead rates:

· Comparison of cost behaviour between different departments is possible.

· This rate helps in assessment of different departments.

· When separate rate is calculated for fixed and variable overheads, it helps the firm in many ways.

Overhead Absorption Methods:

There are different methods of method of absorption of overheads

Methods of Absorption of Overheads

a. Direct Material Cost Method:

This method uses direct material cost used in producing a product as a base for calculation of production overhead absorption rate.

This material is applied in the following cases:

· Where the overheads amount is not significant in relation to material cost.

· Where only one product is manufactured.

· When material prices are not fluctuating.

Demerits of Direct Material Cost method

· Time factor is ignored in this method.

· When the prices of material are not stable, this stable is not suitable.

· It does not make any distinction between skilled workers and unskilled workers performance.

· It does not make any distinction between work done by labour and machines.

b. Direct Labour Cost Method:

This method uses direct labour cost used in manufacturing a product as a base for computing production overhead absorption rate.

This method is followed in following cases:

1) Where the larger proportion of total production cost is direct labour.

2) Where rates of labour are stable.

3) Where labour employed and performed work is uniform.

Merits of direct labour cost method:

1) It is easy to understand and use.

2) It does not ignore the time factor.

3) Normally, wages rates are stable than prices of material.

4) Cost of extra labour is not involved because data is easily available from the statement of wage analysis.

Demerits of direct labour cost method:

1) When a firm uses piece rate system, this method gives unsatisfactory results.

2) This method does not make any distinction between work done by skilled worker and unskilled workers.

3) It does not make any distinction between machine work and labour work.

c. Prime Cost Percentage Method:

This method uses direct material cost and direct labour cost used in manufacturing a product as a base for calculating the production overhead rate.

This method is used when constant material quantity and labour hours are required in producing a standard item in a factory.

Demerits of Prime cost percentage method:

· It does not make any distinction between labour work and machine work.

· It does not make any distinction between fixed and variable expenses.

· When time factor is not taken into account and cost of material is major proportion of prime cost.

b. Direct Labour Hour Rate Method:

This method uses number of labour hours spent on a job to compute production overhead rate.

This method is suitable where production is done by manual labour.

Merits of direct Labour Hour Rate method:

· Time factor is considered in calculation of this rate.

· Data on labour hours are easily accessible from job card, timesheet etc.

Demerits of Direct Labour Hour rate method:

· This method gives lot of consideration to labour only and not any other factor. This leads to wrongful overhead distinction.

· When the concern uses piece rate system, then data is not available to calculate this rate as no record of time is retained.

· This method does not take into account of the expenses which are not dependent on labour hours such as power, fuel etc.

b. Machine Hour Rate Method:

This method uses total number of machine hours used in production as a basis for computation of overhead absorption rate.

This method is followed in those factories where major portion of work is done by machines rather than labour. It is not advantageous to compute machine hours rate for a factory as a whole because all the machines are not same in every respect. Because of this reason, for each machine or for a group of identical machines, machine hour rate is calculated separately. If there are 15 machines in a factory, 15 machine hour rates would be calculated.

Computation of Machine Hour Rate:

To calculate machine hour rate, following steps are followed:

· Treat every machine or a group of identical machines as a separate cost centre to apportioned overhead cost.

· Machine related overheads are divided into two types such as fixed or standing charges and running or machine expenses.

· Calculate effective machine hours for a given period for each machine. While calculating effective working hours, hours required for maintenance or setting up time should be reduced.

· Estimate total standing charges for each machine for a given period and then it is divided by total number of effective working hours to calculate standing charges per hour.

· Calculate running charges per hour for each expense separately. It is calculated by dividing the running expenses by normal working hours.

· By adding fixed charges per hour and variable charges per hour, we get machine hour rate.

Merits of Machine hour rate:

· It helps in comparing the efficiencies and operating cost of different machines.

· This method is more practical, scientific and accurate.

· This rate helps in preparing dependable cost reports and helps the management in taking various types of decisions.

· This method helps in estimation of production cost setting of standards and fixation of selling price for quotations.

· This method helps in determining the cost of idle machines in case individual rates are fixed and variable overhead rates are computed.

Demerits of Machine hour rate:

· This method is very costly because extra work is involved in determining the working hours of machines.

· Expenses that are not proportional to machine working hours are not considered.

· In case program of production is not available in advance, it is not easy to calculate machine hours.

· When manual labour is equally involved, it does not give accurate results.

b. Dual Hour Rate Method:

Those factories where both manual and machine manual and machine work are involved, dual hour rate method are used. This method uses both direct labour hour rate and machine hour rate. In departments where manual work is being carried out, overhead are recovered by using direct labour hour rate and there machine work is being carried out, machine hour rate is used.

h. Rate per unit of output method

This method is used in those cost centres where single article is manufactured.

1. Under and Over Absorption of Overheads:

When a department uses predetermined overhead rate for charging overheads to different products manufactured by it, then in that case, actual overhead may differ from absorbed overhead. Two possibilities arise:

Under absorption of overhead

When the amount of overhead absorbed is less than the actual overhead incurred, it is said to be under absorption of overheads.

Under Absorption = Actual Overheads – Absorbed Overheads

Over absorption of overhead

When the amount of overhead absorbed is more than the actual overhead incurred, it is said to be over absorption of overheads.

Over Absorption = Absorbed Overheads – Actual Overheads

Causes of Under and Over Absorption

· When overhead amount is estimated wrongly.

· When the production level and hours to be worked estimated wrongly.

· When method of production changes.

· When productive capacity if over/under utilized.

· Seasonal fluctuations in the overhead expenses.

Treatment:

1) Use of supplementary rate – When the difference between actual overhead and absorbed overhead is significant and difference is due to normal reasons, in that case, supplementary rate method is used.

It is calculated as

Supplementary Rate = Under/Over absorption of overhead

Actual Base

In case of under absorption, use positive rate to increase the cost of sales, stock of finished goods and work in progress.

In case of over absorption, use negative rate to decrease the cost of sales, stock of finished goods and work in progress.

2) Transfer to costing profit and loss account – when the difference between actual and absorption overhead are insignificant and small and due to abnormal reasons which are not within the control of management, in that case amount is transferred to costing profit and loss account.

Under absorption --à transfer to debit side

Over absorption --à Transfer to credit side

3) Carry over to the next year – This method is used

· When demand and production in an industry is not stable.

· When normal business cycle period is more than one year.

· When new projects involve more output in coming years that in initial period.

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