What do you understand by term Overheads .Briefly classify and explain the Treatment of specific items of overheads in cost accounts?

Overheads comprise of indirect materials, indirect employee costs and indirect expenses which are not directly identifiable or allocable to a cost object in an economically feasible way. 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.  Overheads are to be classified on the basis of functions to which the overheads are related, viz - Production overheads - Administrative overheads - Selling overheads - Distribution overheads Overheads may also be classified on the basis of behaviour such as variable overheads, semi-variable overheads and fixed overheads. Thus, overheads is the sum total of indirect material, indirect labour and indirect expenses.

Overhead appear at all levels of the Income statement

Expenses that qualify as overhead can appear under all major expense categories on the Income statement. And, not all overhead expenses on the statement carry the name "Overhead." Some businesspeople, for instance, regard all entries under "Selling, General, and Administrative Expenses" as overhead, even though the statement does not label them as such.

The overhead role in costing, pricing, budgeting, and product management

Companies that sell products or services must know their per-unit product costs. This information is important when setting prices and it is crucial for managing the product portfolio effectively. The firm has a vital interest in knowing which products sell with acceptable Gross Margin and which sell at a loss. In product costing, however, overhead "muddies the waters" and makes it difficult to measure per-unit costs accurately.

In most cases analysts estimate rather than measure per-unit overhead costs. Sections below show how cost accountants use cost allocation to assign per-unit overhead costs indirectly.

The discussion below also presents an alternative approach to overhead costing, Activity Based Costing (ABC). This approach, arguably, does measure per-unit overhead costs directly.

Overhead plays an important role in competitive strategy

Business firms set overhead objectives when planning their own cost structures. This is because overhead targets are in fact a key component of the firm's high level business strategy . 

In competitive industries, business firms rightly call the top-level business strategy acompetitive strategy. Very briefly, this strategy explains how the firm differentiates itself from competitors and—through its business model—shows where and how the firm earns margins.

§  Some companies plan to operate with very low overhead. These firms expect to earn higher margins than their competitors, while charging the same prices as the competition.

§  Low overhead strategies can, alternatively, enable the firm to differentiate itself in the market by charging lower prices. This is possible because low-price sellers can still earn the same margins as their high-price competitors if they operate with lower overhead.

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:

i.          Fixed Costs :- Out of the total costs, some costs remain fixed irrespective of changes in the production volume. These costs are called as fixed costs. The feature of these costs is that the total costs remain same while per unit fixed cost is always variable. Examples of these costs are salaries, insurance, rent, etc.

ii.        Variable Costs :- These costs are variable in nature, i.e. they change according to the volume of production. Their variability is in the same proportion to the production. For example, if the production units are 2,000 and the variable cost is Rs. 5 per unit, the total variable cost will be Rs. 10,000, if the production units are increased to 5,000 units, the total variable costs will be Rs. 25,000, i.e. the increase is exactly in the same proportion of the production. Another feature of the variable cost is that per unit variable cost remains same while the total variable costs will vary. In the example given above, the per unit variable cost remains Rs. 2 per unit while total variable costs change. Examples of variable costs are direct materials, direct labor etc.

iii.      Semi-variable Costs :- Certain costs are partly fixed and partly variable. In other words, they contain the features of both types of costs. These costs are neither totally fixed nor totally variable. Maintenance costs, supervisory costs etc are examples of semi-variable costs. These costs are also called as ‘stepped costs’.

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.

Treatment of Special Items of Overheads in Cost Accounts

Material Handling Expenses:

These expenses are incurred while unloading the raw materials received from supplier, storing the raw materials, handling the raw materials to work place, handling of work-in-progress, storage of finished goods etc. It also includes costs incurred for weighing salaries of personnel involved in material handling, wear and tear of weighing equipment.

These costs are apportioned on the basis of physical quantities of different materials and goods handled in the factory. The stores overhead costs are apportioned to raw materials and finished goods as a percentage of issue rates. Other handling expenses are recovered through overhead recovery rates.

Market Research Expenses:

Market research cost is an item of selling overhead, incurred for market intelligence to ascertain the tastes and habits, market penetration of product, increase in demand of existing products, competitive situation, trading practices, distribution channels, customers requirements, existing and potential market for the product etc.

If the market research expenses are incurred for a single product it is absorbed into that particular product cost. If it is incurred for the product range for the enterprise as a whole, then the market research expenses are to be apportioned to different products in the proportion of sales value and absorbed into respective product cost.

If the market research cost is substantial, it will be treated as deferred revenue expense and is taken into future period and absorbed when sales or production takes place. Sometimes market research expenses are incurred for raw material availability, such expenses will be allocated or apportioned to purchase department and it is recovered through overhead rate of purchase department.

Subscriptions and Donations:

The treatment suggested for subscriptions and donation in Cost Accounts as follows:

a) If these expenses are incurred for the benefit of or welfare of workers, it is treated as Production Overhead.

b) If subscriptions and donations for any technical and research institutions for obtaining data relating to technical, production or scientific nature, it is considered as Production Over­head.

c) If subscriptions to journals etc. for obtaining market data which help in increase of sales, it is considered as Selling Overhead.

d) If the subscriptions and donations not incurred for the benefit of employees or the organization, it should be excluded from the Cost Accounts.

After Sales Service Costs:

The costs are incurred for providing service to the customers after the sales took place during the warranty period. If the costs are incurred during the period of guarantee given to the customer, it is to be borne by the company, and hence it is treated as production overhead absorbed into product cost by applying predetermined absorption rates. If the after sales services costs are incurred after the guarantee period for which the organization will charge for the services rendered, then such costs are treated as Selling Overhead.

Royalties and Patent Fees:

The royalties and patent fees are payable for the use of technology, skill, brand, intellectual property rights etc. made in the form of periodical rent or based on the number of units produced or sold.

If it is based on sales, the expenditure is charged to Selling Overhead. If it is a fixed periodical rent, it is treated as Production Overhead. If it is payable on number of units produced, the expenditure is treated as a direct expense or chargeable expense and is forming part of the cost of the product.

Training Costs:

The training costs are incurred for training the workers, apprentices, office, administrative and selling staff. The training expenditure incurred for training the workers, apprentices and other production staff is treated as Production Overhead. If it is incurred for training the office and administrative staff, it is considered as Administration Overhead.

The expenses incurred for training the sales staff is treated as Selling Overhead. If there is any in-house training college or centre is giving training, cost of running the centre or college is apportioned to the cost centres based on the number of personnel trained or on the basis of wages and salaries paid etc.

Taxation:

Taxation is an appropriation of profit earned by the organization and any payment of taxes is excluded from the Cost Accounts. But the taxes will also be considered for planning and decision making exercises wherever it is necessary and appropriate for special purposes.

Financing Charges:

The finance charges like interest on working capital facilities from banks, interest on term loan for acquisition of fixed assets, interest on debentures etc. is payable by the company. Where financing charges are payable to outsiders on borrowings for acquisition of fixed assets, these charges are included in cost of Fixed Assets.

If the financing charges are payable for financing working capital, then these charges are included in Cost of Inventories. Interest on capital provided by the owners is excluded from Cost Accounts except for comparing or evaluating profitability of alternative investments. If the charges are payable for storing the materials like timber, wine etc. the charges are included in the cost of materials stored.

Major Repairs to Equipment:

The major repairs, if it prolong the useful life of an asset, the costs incurred on it is to be added to the existing value of assets and periodical depreciation is charged on the overall cost of the asset.

If the repair charges are incurred for upkeep and maintenance of the machinery and if it does not prolong the life of the asset, these expenses are treated as Production Overhead and is charged to the respective cost centre as repairs and maintenance and recovered from the current period production. If the amount incurred is substantial, it is treated as deferred revenue expenditure carried forward to the subsequent accounting periods for write off.

Cost of Tools:

Tools are classified into:

(a) Large tools, and

(b) Small tools.

The cost of large tools are capitalised like any other machine and depreciation is provided on it each accounting period over its useful economic life.

The cost of small tools are treated in any of the following three methods in Cost Accounts:

i. Capitalization Method:

Under this method, the cost of small tools is capitalised and depreciation is recovered as Production Overhead. If the life of small tools is relatively small, this method is not suitable.

ii. Revaluation Method:

Under this method, the small tools are revalued at the end of each accounting year and the difference between original cost and the revalued cost is charged as Production Overhead.

iii. Write off Method:

Under this method, the cost centre drawing such tools is debited with the value thereof. Alternatively, the total cost of tools is accumulated and apportioned to various cost centres on suitable basis.

Bad Debts:

When the company allow credit to its customers as part of its selling policy, some credit sales may turn bad due to default by the customers intentionally or otherwise. As a safeguard, a part of such default amount is treated as bad debt is recovered as selling overhead and absorbed into product cost. If the bad debt is abnormal in nature, the abnormal portion in excess of the standard normal portion should be excluded from cost accounts and transferred to Costing Profit & Loss Account.

Notional Rent:

Notional rent is a cost included in the Cost Accounts so as to represent a benefit enjoyed by the organization even though no actual cost is incurred for rent. The company owns premises does not pay rent, but it is considered as notional charge in the Cost Accounts for comparability of cost with different accounting periods and with other organizations. This would reflect the accurate cost of cost centre or cost unit. It is a reasonable or nominal charge included in the Cost Accounts for the owned premises as if it is a rented premises.

Packing Expenses:

The packing is classified into:

(i) Primary packing, and

(ii) Secondary packing.

The ‘primary packing’ is done when the material is packed in tins, bottles, jars, etc., without which a product cannot be sold. For example, jam is packed in bottles, baby food packed in tins, beverages in bottles etc. The costs incurred on primary packing material are treated as part of direct material cost.

If the packing is made to facilitate the transportation and distribution of the finished product, it is called ‘ secondary packing’ and the cost incurred for this is treated as Distribution Overhead. Sometimes, cost is incurred on packing the product to make it more attractive to the customers to increase sales. This cost is treated as advertisement cost and is included in Selling Overhead.

Data Processing Cost:

In the environment of processing information with the help of computers, the data processing cost represents the cost incurred for processing data relating to accounts, secretarial, personnel, finance, marketing, sales etc. This may be done either utilizing in house facilities or hiring outside facilities.

The cost incurred is accumulated for separate service centre if in-house facilities are made available. Where the costs of data processing centre or hiring charges are identifiable to a particular department or activity it should be charged with its portion of cost. In case of common costs incurred for service of all departments, the data processing cost should be apportioned to different departments on equitable basis.

Stores Overhead:

The stores department in an organization perform the function like receipt of material and stores items purchased, storing and issue of materials and stores items to different departments.

The stores is considered as a separate cost centre and the stores expenditure like rent of store, salaries and wages of stores personnel, freight, carriage inwards, insurance etc. are collected separately for the stores and will be apportioned to other cost centres.

The following bases are used in apportionment of stores overhead:

(a) Number of stores requisitions,

(b) Value of material requisitioned, and

(c) Standard predetermined stores overhead absorption rate.

Erection and Dismantling of Plant and Machinery:

The costs incurred on erection and dismantling of plant and machinery are treated in cost accounts as follows:

(a) The costs incurred on erection of plant and machinery is capitalised and treated forming part of capital cost and depreciation is recovered on the total cost

(b) If the plant and machinery is required to be shifted to different locations, the costs incurred in layout and shifting is treated as production overhead. When such costs are substantial, it may spread over a period of time as deferred revenue expenditure.

(c) If the asset is replaced, before its useful economic life, with a new machine, the written down value of the asset less the scrap value plus the cost on dismantling is treated as capital loss and charged to profit and loss account. However, the erection cost of new machine is capitalised.

(d) If expenses of dismantling and re-erection are incurred due to faulty planning or due to abnormal factors, then such expenses are charged to Costing Profit and Loss Account.

Transport Cost:

The classification of transport costs and their treatment in cost accounts is given below:

(a) The costs incurred to bring the materials to the production site is included in cost of materials.

(b) The costs incurred for bringing the plant and machinery, equipment etc. is added to the capital cost of respective asset and depreciation is recovered.

(c) The cost of dispatch of finished goods is treated as distribution overhead.

(d) The costs incurred for internal movements within work are initially charged to specific cost centres and thereafter apportioned to different production and service centres on the basis of services rendered.

Insurance Cost:

The treatment of insurance cost is categorized into the following:

(a) Insurance premium on storage-cum-erection and commissioning is capitalised to the asset value.

(b) Premium on transit of materials is included in cost of materials.

(c) Premium on transit of finished products is treated as distribution overhead.

(d) Premium on fire and breakdown of machinery policy is treated as production overhead.

(e) Premium on loss of profit policy due to fire and breakdown of machinery is treated as production overhead.

(f) Premium on miscellaneous policies like vehicles, burglary, accident etc. are treated as administration overhead.

(g) Premium on raw materials and stores is treated as production overhead.

(h) Premium on warehouse and finished stock is treated as distribution overhead.