Understanding Overhead Costs and Classification
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Dr UMA KUnderstanding Overhead Costs and Classification
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Dr UMA KSAI VIDYA INSTITUTE OF TECHNOLOGY
Module-02
OVERHEADS
Overheads: Classification and Collection, Difference between Cost Allocation and Cost
Apportionment, (Full-fledged Problems on Primary and secondary distribution, Simultaneous
equations, Absorption of Overhead, Theory on Under and Over absorption of Overhead).
Demerits of Traditional Costing, Activity Based Costing, Cost Drivers, Cost Analysis Under
ABC (Unit level, Batch Level and Product Sustaining Activities), Benefits and weaknesses of
ABC.(Theory & Problems).
OVERHEADS:
Overheads are the indirect costs that cannot be allocated to any specific job or process as they are not
capable of being identified with any specific job or process. It includes cost of indirect materials,
Indirect labor and indirect expenses that cannot be conveniently charged to any job or process.
The CIMA defines overhead cost as “the total cost of indirect materials, labor and indirect expenses.
In short, it is the cost of materials, labor and expenses that cannot be economically identified with
specific saleable cost unit.
CLASSIFICATION OF OVERHEAD COSTS:
The process of grouping costs according to their common characteristics is called cost classification. It
involves two steps: (i) the determination of the class or groups into which the overhead costs are
subdivided; (ii) the actual process of classification of the various expenses
The various types of classifications are:
1. Functional classification,
2. Classification with regards to behavior of the expenditure,
3. Element-wise classification,
Functional classification:
Manufacturing Overheads
Administration Overheads
Selling and Distribution Overheads
R&D Overheads
Classification with regards to behavior of the expenditure:
(a) Fixed overhead, (b) Variable overhead, and (c) Semi-variable overhead
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Element-wise classification,
a. Indirect material cost,
b. indirect labor cost and
c. indirect expenses.
Collection of Overheads:
Collection of overheads means the pooling of indirect items of expenses from books of account and
supportive/ corroborative records in logical groups having regards to their nature and purpose.
Overheads are collected on the basis of pre-planned groupings, called cost pools.
Steps of Factory Overhead costing-
Manufacturing overhead costing comprised of the following steps-
(i) Collection of factory overhead costs
(ii) Allocation of overhead costs
(iii) Apportionment or distribution of overhead costs
(iv) Re-distribution of service department cost to production department
(v) Absorption of overheads.
Allocation and apportionment- allocation refers to identification of overhead costs to the cost center.
But apportionment refers to the distribution of overhead cost on some logical base when identification
to cost center is not possible. A cost center may be a person or location or an equipment or group of
these in respect of which cost is ascertained for the purpose of cost control. It may be production cost
center or service cost center.
Apportionment or distribution of overhead costs- When overheads are not allocable, overheads would
be apportioned or distributed on some logical bases, some of these are as below
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Basis of apportionment:
Overheads Basis of apportionment
Insurance, depreciation, repairs & maintenance
Value of assets.
on plant & machinery, building & other fixed
assets.
Welfare expenses, time keeping & pay-roll office
expenses, canteen exp. Supervision charges, Number of employees.
medical expenses etc.
Supervisor’s salary, ESI contribution Direct wages
Electric charges( lighting) No of light points or floor area.
Power Hp of machines or kilo watts.
Air-conditioning, heating Floor area, weight volume.
Delivery van expenses Ton miles, or weight volume
Audit fees Sales or total cost
Insurance of stock Value of stock
No of stores requisitions or value of materials
Store keeping expenses
consumed.
Internal transport Weight of packages or mileage.
Purchasing expenses No of purchase requisitions.
Direct labour hours, machine hours, direct wages
Other exp. Or general exp. Or misc. Expenses
or direct materials.
Primary Distribution of Overheads
Primary distribution of overheads refers to allocation and apportionment of overhead expenses
among production and service departments of an organization.
This process involves allocation of overheads which can be directly identified with a particular
department and apportionment of common item of overheads on appropriate basis among all
the departments.
The entire process of allocation and apportionment is systematically presented in a perform
which is known as primary distribution overhead summary or overhead distribution summary.
Secondary distribution of overheads:
The cost of service cost centers are apportioned to production cost centers as well as other service cost
centers. Secondary distribution of overheads may be done by following either Reciprocal basis or Non-
Reciprocal Basis. While reciprocal basis considers the exchange of service among the service
departments, non-reciprocal basis considers only one directional service flow from a service cost
centre to other production cost centre(s).
Secondary Apportionment of Overheads on Reciprocal Basis The services rendered by certain service
cost centers are also utilized by other service cost centers. In reciprocal secondary distribution, the cost
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of service cost centers are apportioned to production cost centers as well as other service cost centers.
In such case, any one of the following three methods may be followed :
Repeated Distribution Method
Simultaneous Equation Method
Trial & Error Method
ABSORPTION OF OVERHEADS
The process of distributing the overhead costs of production department cost centers to the cost units.
There are different methods of absorption of overheads. Such methods are –
1. Percentage of value of raw material
2. Percentage of Direct labour cost(Applicable in case production process is labour intensive and depends
on labour time and type)
3. Labour hour rate method (Applicable in case production process is labour intensive and depends on
labour time)
4. Machine hour rate method. (Applicable in case production process is machine based)
UNDER ABSORPTION AND OVER ABSORPTION OF OVERHEADS
If overhead absorbed exceeds the actual overhead the excess of absorbed overhead over the actual overhead
is called over absorption of overhead as the amount charged to production has not been incurred On the other
hand when actual overhead is more than the overhead absorbed then the excess of actual overhead over
absorption overhead is known as under absorption of overhead as this amount remains uncharged to
production
Over absorption takes place:
1. The total overhead incurred is less than the estimated or budgeted overhead
2. The output (or hours worked) are more than the estimate or budget.
Under absorption takes place when:
1. The total overhead incurred exceeds the estimated overhead
2. The output are less than the estimate or budget
3.
Causes of Under or Over absorption of Overheads
The following are the cause of under or over-absorption of overheads:
1. Error in estimating the overheads may lead to over or underabsorption of overheads.
2. The anticipated output may be different from the actual output
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3. The hours anticipated may be more or less than the actual hours worked.
4. Due to fluctuations in the prices of material or wage rates, the basis upon which the factory overhead
is recovered from production may not be correct.
5. If overhead are not charged to work-in-progress proportionately.
6. Non-recurring expenditure incurred due to unexpected changes in the methods of production.
7. Seasonal fluctuations in the overhead expenses.
Disadvantages of the Traditional Costing System
1. It offers limited accuracy, even in the best of situations.
2. It wants to ignore unexpected circumstances.
3. It isn’t always a helpful system.
4. Its simplicity may be too simple.
5. It does not account for non-manufacturing costs.
ACTIVITY-BASED COSTING (ABC)
The activity-based costing (ABC) system is a method of accounting you can use to find the total cost of
activities necessary to make a product. The ABC system assigns costs to each activity that goes into production,
such as workers testing a product, setting up of machines, orders passed for purchase of raw materials etc.
Cost pool: It is an aggregate of all the costs associated with performing a particular business activity.
Cost driver: It is an activity that is the root cause of why a cost occurs. It must be applicable and relevant to the
event that is incurring a cost. A cost driver assists with allocation expenses in a systematic manner that results
in more accurate calculations of the true costs of producing specific products
Steps in ABC:
For allocating/absorbing overheads to products/services under Activity-Based Costing, the following steps are
to be taken:
1. Identifying Activities: The first stage is to identify the functional areas or major activities involved in the
production. Examples of activities include machine related activities, divert labour related activities and
various support activities like ordering, receiving, material handling, packing, despatching etc. Various
activities are identified by carrying out activity analysis. The activities may be basically fall into four categories
as suggested by Cooper and Kaplan’.
a) Unit Level Activities or Primary Activities: The cost of primary activities (like use of indirect materials and
consumables, testing of every item produced) may be correlated to number of units produced (i.e. on volume-
basis).
b) Batch Level Activities: These are manufacturing support activities (like material ordering, machine set-up
costs, inspection of products etc). The cost of such activities is driven by number of batches of units produced.
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c) Product Level Activities: Activities like designing of the product, keeping technical drawings of product,
activities up to date, advertising of a specific product are called product level. The cost of these activities is
driven by the creation of a new product line and its maintenance.
d) Facility Level Activities: Certain activities cannot be related to a particular product, instead may be related
to certain facilities like maintaining the building, security of plant, salaries of production manager,
advertisement to promote organisation etc. It may be noted that unit level activities and facility level activities
are the same as those in traditional absorption costing which will be allocated on physical volume basis, ABC
will be more useful if there is significant size of batch level and product level activities.
2. Assigning Costs to Activity Cost Centres: The second stage requires that a cost centre (also called a cost
pool) be created for each activity. After the activities have been identified the cost of resources consumed
over a specified period must be assigned to each activity. These costs will have to be apportioned on some
suitable basis. For example, the total costs of all set ups might constitute one cost centre for all setup related
costs.
3. Selecting Appropriate Cost Drivers: The third stage of designing ABC system is to identify the factors that
influence the cost of a particular activity. The term cost-driver is used to describe the significant determinant
of the cost of the activity. The most suitable cost driver in each activity under functional areas should be
identified. A cost driver is any factor that influences costs.
4. Assigning the Cost of the Activities to Products: The final stage is to trace the cost of the activities to
products according to each product’s demand for these activities using cost drivers as a measure of demand. A
product’s demand for the activities is measured by the number of transactions it generates for the cost driver.
The cost driver should be measurable in a way that enables it to be identified with individual products.
Uses of ABC
• Identification of necessary activities: The ABC system shows how overhead is used, which helps to
determine whether certain activities are necessary for production.
• Focus on Value adding activities: The Activity Based Costing helps the management on focusing the forces on
value adding activities and eliminate non-value adding activities.
• Ensuring profit margin: The specific allocation of costs also helps to set prices that produce a healthy small
business profit margin.
• Product pricing: With an ABC system, the business can assign costs to each activity in the production process,
allowing it to more accurately set a price that accounts for how much it costs to create a product.
• Measures to improve productivity: The accurate cost information helps the management to adopt
productivity improvement approaches like Total Quality Management (TQM), Business Process Re-engineering
(BPR) etc.
• Help in deciding Make or Buy: The management can take make or buy decisions by considering the cost of
manufacture of a product or sub contract the same with an outside agency through Activity Based Costing
analysis.
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Difference between Traditional and ABC Costing
Benefits of using ABC System:
1. ABC helps to reduce costs by providing meaningful information for cost-management. It helps in making the
right decision.
2. ABC technique provides due importance to non-manufacturing cost which constitute a substantial portion
of total cost. Traditionally non-manufacturing costs have been allocated under volume basis and thus, high
volume products have been overvalued.
3. ABC technique provides accurate and reliable cost information. This cost information is essential for recent
approaches in productivity improvement like Total Quality Management (TQM) and Business Process
Reengineering.
4. ABC enables the management in formulating an effective pricing policy while fixing prices.
5. Cost of each activity is determined with the help of ABC. There is accuracy in indirect cost-allocation to
products. This technique is helpful in make or buys decisions and transfer pricing.
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Weakness of ABC System
1. It is based on historical costs; while for planning decisions future costs are more relevant.
2. For many short-term decisions, identification of variable costs is very important. But ABC system does not
partition variable and fixed elements of overhead costs.
3. The accuracy of ABC system fully depends upon the quality of cost drivers. The allocation and absorption of
costs may become an arbitrary allocation process, if the cost drivers are not associated with the factors
causing costs.
4. ABC system tends to be more costly than the traditional methods of applying costs to products.
Activity & cost driver
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Common questions
Powered by AIUnder and over absorption of overheads occur due to various reasons: 1) Errors in estimating the overheads often result in discrepancies between the budgeted and actual overheads; 2) Differences in actual versus anticipated output can skew overhead recovery; 3) Discrepancies between anticipated hours and actual hours worked; 4) Fluctuations in material prices or wage rates affecting recovery bases; 5) Overheads not being proportionately charged to work-in-progress; 6) Non-recurring expenditures due to unexpected production changes; and 7) Seasonal variations in overhead expenses .
A cost center enhances control and allocation of overheads by serving as a focal point where costs can be gathered and managed. By designating specific areas, equipment, or groups as cost centers, organizations can track expenses more accurately. This allows for targeted management actions, helps identify inefficiencies, and facilitates the accurate allocation and apportionment of indirect costs. The clear delineation of costs supports cost control measures and aids decision-making by providing more granular insights into where costs occur .
The weaknesses of the ABC system include its reliance on historical costs, which might not be relevant for future planning. It does not distinguish between variable and fixed cost elements, which are crucial for short-term decisions. Moreover, the accuracy of ABC depends on the quality and relevance of cost drivers, and poor selection can lead to arbitrary cost allocations. Furthermore, implementing ABC can be more costly and complex compared to traditional costing methods .
Primary distribution of overheads involves the initial allocation and apportionment of overhead expenses among production and service departments. It allocates directly identifiable overheads to specific departments and apportions common overheads based on logical bases among all departments. Secondary distribution, in contrast, involves redistributing service department costs to production departments and other service departments. This step further refines cost allocation by considering inter-departmental services, and can be done using methods like Reciprocal and Non-Reciprocal Basis .
Under and over absorption of overheads can significantly impact cost reporting by distorting the actual cost of production. Over absorption may result in under-reporting costs, leading to inflated profits, while under absorption may show reduced profits due to unaccounted costs. These inaccuracies affect budgeting, pricing decisions, and financial performance evaluations. They may lead to incorrect insights into productivity and efficiency, affecting strategic planning and management decisions, ultimately influencing the financial health of the organization .
ABC contributes to strategic decision-making by providing detailed insights into cost structures and profitability. It identifies value-adding and non-value-adding activities, allowing management to focus on efficiency-enhancing measures. With ABC, accurate cost information helps in setting appropriate product prices that reflect true production costs, thereby ensuring better profit margins. It supports make-or-buy decisions and facilitates productivity improvements through management techniques like Total Quality Management (TQM) and Business Process Re-engineering (BPR).
Cost drivers are critical in ABC as they explain the root cause of costs associated with specific activities. Properly selected cost drivers allow for accurate allocation of overheads to products based on their consumption of activities. They are chosen based on their relevance and ability to accurately measure the cost of activities, such as machine hours for machine-related costs or number of set-ups for setup costs. Accurate selection ensures that cost assignments reflect true resource usage, facilitating better strategic decisions and cost management .
The ABC system enhances cost accuracy by assigning costs to specific activities that consume resources and associating these with cost drivers that accurately reflect the consumption of resources. This method provides a more accurate allocation of indirect costs based on activities such as ordering, machine setup, and material handling, rather than spreading them evenly across all products, as traditional costing methods do. ABC thus reduces misallocation and overvaluation seen in traditional systems, particularly in complex and diversified operations .
Behavior-based classification categorizes overheads into fixed, variable, and semi-variable, helping managers understand how different costs respond to changes in the activity level. Fixed overheads remain constant irrespective of output, variable overheads fluctuate directly with production volume, and semi-variable overheads have both fixed and variable components. This classification aids managers in predicting how costs will behave with changes in production level, enabling more accurate budgeting, forecasting, and cost control measures .
Cost allocation involves identifying and assigning overhead costs directly to a cost center, which could be a person, location, equipment, or group specifically responsible for those costs. On the other hand, cost apportionment is the distribution of overhead costs among different cost centers on some logical basis when direct allocation is not possible. Allocation is used when overheads can be directly tied to a cost center, whereas apportionment spreads costs that cannot be directly allocated, using bases like floor area for electric charges or number of employees for supervision charges .