What do you understand by term Overheads? What are stages and methods involved in distribution of overheads methods of absorption of overheads ? Explain treatment of under and over absorption of overheads

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.

§  There are three stages in the absorption of overheads which are discussed in detail below:

Stage I: Allocation and Apportionment of Overhead:

The first stage in the absorption of overhead costs is to identify and collect overhead costs for different production and cost centres. The first stage is known as ‘primary distribution.’

Primary Distribution:

Some overhead costs can be directly identified with a particular department or cost centre as having been incurred for that cost centre. These items of overhead cannot be traced to products or jobs but can be allocated specifically to departments. Examples of such overhead costs are repairs and maintenance expenses incurred in specific departments, supervision, indirect labour, overtime, indirect materials and factory supplies, equipment depreciation.

§  Expenses, such as power, light, rent, depreciation of factory building, expenses shared by all departments, cannot be charged directly to a department, be it production or service. They are incurred for all and must, therefore, be apportioned or prorated to any or all departments using such items. Cost apportionment is the process of charging expenses in an equitable proportion to the vari­ous cost centres or departments.

The Institute of Cost and Management Accountant (U.K.) defines cost apportionment “as the allotment of proportions of items of cost to cost centres or cost units”. The apportionment should be done on some rational and equitable bases. In cost accounting this is known as primary distribution of overhead.

It would be difficult to give a comprehensive list of the bases of apportionment, but the following bases are in common use:

1. Floor Area Occupied:

Overheads such as lighting and heating, rent and rates, depreciation on building, building repairs, caretaking, watching and patrolling.

2. Capital Values:

Depreciation on plant and machinery, insurance on building, and plant and machinery, maintenance of plant and machinery.

3. Direct Labour Hours And /Or Machine Hours:

Insurance on Jigs, tools and fixtures, power, works management remuneration, repairs and maintenance cost.

4. Number of Workers Employed:

Canteen, accident insurance, medical, dental and first aid, pensions, personnel department expenses, profit sharing payments, recreation, supervision, time office, wages department.

5. Technical Estimate:

Fire prevention, oil and grease, steam, water without meter.

Example:

The Modern Company has four departments. A, B and C are the production departments and D is a servicing department.

The actual costs for a periods are as follows:

Stage II: Apportionment of Service Departments Overhead to Producing Departments:

In stage II, overhead costs of service departments are apportioned to production departments. Such apportionment is termed as ‘Secondary Distribution’.

Secondary Distribution:

The primary distribution of factory overhead apportions all overhead costs to the different departments or cost centres — production and service departments. It is necessary that overhead costs of service departments (accumulated through direct allocation or primary distribution) should be further assigned to producing departments.

This is due to the reason that service departments do not themselves manufacture anything and it is the production departments or cost centres which are involved in manufacturing activities. The reassignment or reapportionment of service departments overhead to producing departments or centres is termed as secondary distribution.

Secondary distribution is useful in the following matter:

1. It helps in determining the cost of products or jobs sold and inventory figures.

2. It helps in determining the effect of various managerial decisions and actions on the total cost of the business firm. For example, decisions as to add or to drop a product line require information about its cost effect which can be estimated after secondary distribution has been made.

3. It helps subsequently in determining the price of the product or job. In case of contracts based on cost in place of market price, secondary distribution helps in fixing a selling price which is advantageous to the parties concerned.

4. It promotes motivation among employees of the producing departments to take up service department activities.

Bases for Secondary Distribution:

It is difficult to suggest a sample list of service departments and equitable bases of distribution of overhead costs. The objective is to find the allocation base that best measures the causal or beneficial relationship between the department whose costs are being apportioned and the departments receiving the service.

The general basis for apportioning service department overheads to producing department are the following:

1. Service Rendered (Benefits Obtained):

This is perhaps the most popular method of apportioning service department costs. The service rendered to different departments, i.e., benefits obtained by them can be a suitable basis.

2. Ability to Pay:

This method suggests that a large share of servicing department’s overhead costs should be assigned to those producing departments whose product contributes the most to the income of a business enterprise. However, it is difficult to measure the ability to pay of different departments and also this method is not based on equity.

3. Survey or Analysis:

This method is applied where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable. For example, the postage cost could be apportioned on a survey of postage used during a year.

4. Efficiency or Incentives:

This method uses standards and budgets and apportions the over­head costs on the basis of a present budget or standard. Sometimes this method is used along with the bases of services rendered or ability to pay method.

In selecting a suitable base for apportioning service department overheads, consideration should be given to practicability, simplicity, economy, theoretical soundness and assistance in accurate costing and cost control. If a service department overhead is allocated on the basis over which the production manager has no control, the prorated cost may result in an inappropriate charge to the producing department.

The following list gives a few service departments and bases commonly used to apportion the respective overhead costs:

Stage III: Absorption of Overhead Costs:

After all service departments overhead costs have been apportioned to producing departments, the next step is to spread factory overhead to different products or jobs produced. This is termed as “Overhead absorption” in cost accounting. The Institute of Cost and Management Accounts (U.K.) define overhead absorption as “the allotment of overhead to cost units.” Known by different names, such as recovery, overhead application, overhead costing, levy, burden rate, etc. the term “absorption” implies that expenses pertaining to a producing department or cost centre are finally charged to or absorbed in the cost of products, jobs, etc. passing through it. As a result of absorption, the cost of each unit of product of the producing department includes an equitable share of the total overhead of that department.

Over / Under absorption of overhead

The overheads are absorbed on the basis of predetermined overhead absorption rate according to the actual production of goods throughout the accounting period or specific period. Budgeted overheads and budgeted output are used to determine overhead rate. If budgeted overhead and budgeted output differ from actual overhead and actual output, three is a difference between predetermined overhead rate and actual overhead rate.

If the overheads absorbed are higher than the actual overheads incurred, it is called over absorption. If the overhead absorbed is lower than the actual overheads incurred during the accounting period, it is called under absorption.

Reasons for Over or Under absorption of overhead

The reasons for over or under absorption of overheads are as follows.

1. The actual hours worked is more or less than the budgeted hours.

2. The actual overhead costs are different from budgeted overheads.

3. Both actual overhead costs and actual activity level are different from the budgeted costs and level.

4. The method of overhead absorption may be wrong.

5. Unexpected expenses may be incurred during the accounting period.

6. Extra ordinary expenses might have been included in the calculation of overhead absorption rate.

7. Major changes like replacement of manual labour with machines. This leads to increase in capacity levels.

8. Seasonal fluctuations in the overhead expenses from period to period.

Treatment of Over or Under absorbed overhead

The over or under absorbed overheads are treated in the cost accounts in any one of the following ways.

1. Application of Supplementary Rates

The supplementary rate is calculated by dividing the under or over absorbed amount by the actual base. In case of over absorption, the over recovered amount will be adjusted by applying the supplementary rate and vice versa.

2. Adjustment to Cost of Sales

The over absorbed or under absorbed overheads is closed and transfers the same to the cost of sale account. This is done by the Cost Accountant at the end of every month or at the end of accounting period. If the transfer is made at the end of the accounting period, the over/under-absorbed overhead is carried forward from month to month treating it as deferred income if over applied and as deferred charges, if under applied.

3. Write off to Costing Profit and Loss Account

If the over or under absorbed overhead is small, and then it will be written off by transferring it to the costing profit and loss account. If so, the valuation of closing stock is over stated or under stated.

4. Adjusted to Gross Profit

The under or over absorbed overhead balances are closed by making the adjustment in gross profit.

5. Carry Forward to Subsequent Year

The under or over absorbed overhead may be carried forward to the subsequent accounting year. This may be transferred to Overhead Suspense Account or Overhead Reserve Account. This Overhead Suspense Account or Overhead Reserve Account will appear in the Balance Sheet.

The debit and credit balances representing under/over absorbed overhead showing in the asset side or liabilities side of the Balance Sheet. The basic idea is to off set the under absorbed overhead in one year with over absorbed overhead in another year. But, many accountants oppose this idea. The reason is that balances of under/over-absorbed overhead should not be carried forward from one year to another year. This method is otherwise called as use of reserve account.