Overheads
UNIT 2
Overheads
• ‘Expenditure on labour, material or services which cannot be
economically identified with a specific saleable cost per unit.’
• ‘Overhead is the aggregate of indirect materials, indirect wages and
indirect expenses.’
• Various other names of overheads are: (a) oncost; (b) supplementary
cost; (c) burden; (d) non-productive cost etc.
Importance of Overheads
• With increasing trend on plant automation, heavy expenditure is being
incurred which cannot be charged directly to any particular unit and can
be called as cost common to all units of production.
• They are the significant portion of the total cost.
• For cost ascertainment and control.
Are high overhead costs an indication of
inefficiency?
High overhead cost do not cost indicate inefficiency if it is accompanied by –
1. Large scale production or mass production;
2. Increase in efficiency and productivity of labour;
3. Less human efforts will required because of automatic machines but more machine
expenses will have to be incurred;
4. more depreciation, maintenance expenditure and similar other items because of more
use of machinery;
5. Improved method of managerial control like work study, production control, cost and
management accountancy techniques may reduce the direct cost but will increase the
overhead costs.
Features of Overheads
1. Overhead Expenses are indirect costs.
2. They are common costs.
3. They include both escapable and inescapable. Because, discontinuance of a
Cost Centre or Cost Unit results in the avoidance of incurrence of certain items of
Overhead Expenses. Therefore, they are called escapable. Other Overhead
Expenses (i.e., which cannot be avoided) are inescapable.
4. They comprise of both cash expenses (e.g., insurance, rent, etc.,) and book
expenses (i.e., depreciation).
5. They consist of both production expenses and non-production expenses (i.e.,
administrative, and selling and distribution expenses).
6. They can be fixed, variable or hybrid.
Classification of
Overheads
By
By Function By Element
Behaviour
Production Indirect Fixed
Overhead Material Overhead
Administrati Indirect Variable
ve Overhead Labour Overhead
Semi-
Selling Indirect
Variable
Overhead Expenses
Overhead
Distribution
Overhead
Research
and
Developmen
t Overhead
Importance of Classifying costs into Fixed and Variable
Cost
1. Fixation of selling price: Helpful in price policy. Sometimes different prices are charged
for the same article in different markets to meet the varying degrees of competition.
However, the lowest selling price of an article should atleast cover prime cost plus
variable overheads.
2. Framing of budget: Helpful in framing flexible budget for various levels of capacilty
utilization
3. Effective Cost control
4. Helpful in management decision making
5. Marginal costing and break-even analysis: This technique is totally dependent on
segregation of cost into fixed and variable.
6. Absorption of Overheads: Separate rates of absorption of overheads may be used for
fixed and variable overheads. The under/over-absorption arising out of two types of
overheads are different in nature and need different managerial action.
Overheads Distribution
Invoices ,
Stores requisition,
• Classification and collection of Overheads - wage analysis sheet ,
Journal entries
• Allocation and Apportionment of Overheads to Production and service
departments – Primary Distribution
- Departmentalization of Overheads
• Re-Apportionment of Service dept cost to production depts- Secondary
Distribution
• Absorption of Overheads of each production department in cost units.
Allocation and Apportionment of Overheads
(Primary Distribution)
1. After all the items are collected properly under suitable account headings, the
next step is allocation and apportionment of such expenses to cost centres or
departments. This is also known as departmentalisation or primary distribution of
overhead.
2. For smooth and efficient working, a factory is sub divided into a number of
departments, each of which denotes a particular activity of the factory, e.g.,
purchase department, stores departments, time-keeping department, personnel
department, crushing department and melting shop. These departments are
mainly of two types:
i. Production department; and
ii. Service department
1. Production Department: It is the one that engages in the actual manufacture of
the product by changing the shape, form or nature of material worked upon or by
assembling the parts into finished products.
2. Service Department: It is rendering a service to the production departments. It
contributes in an indirect manner to the manufacture of the product but it does
not itself change the shape, form or nature of the material that is converted into
the finished product.
Production Service Departments
Departments
Purchasing department
Weaving Stores department
department Time-keeping department
Spinning Personnel department
department Inspection department
Crushing Canteen
department Labour welfare department
Mixing department Accounting department
Grinding Internal transport
department department
Annealing
Objectives of Primary Distribution
1. Ensures greater accuracy in cost ascertainment
2. Control of overhead costs
3. Use of different methods of absorption
4. Valuation of work-in-progress
5. Cost of service of department
6. Forecasting and estimating
Allocation of Overheads
Allotment of certain items of overhead costs that can be directly identified with a
particular department or cost centre as having been incurred for that cost centre
to that particular cost centre is known as allocation.
It is “the assignment of whole item of cost directly to a cost centre”.
In order to that an overheads can be allotted, they should meet both the
following conditions:
The cost centre must have caused the overhead cost to be incurred; and
The exact amount incurred in a cost centre must be known.
Apportionment of Overheads
Certain overhead costs cannot be directly charged to a department or cost
centre. Such costs are common to a number of cost centres or departments and
do not originate from any specific department. Distribution of such overhead
costs to various department is known as apportionment.
It is “the distribution of overheads to more than one cost centre, on some
equitable basis”.
Allocation Apportionment
1. Allocation means the allotment of whole items 1. Apportionment means allotment of proportion of
of cost to a cost unit. items of cost to cost units.
2. It deals with the whole items of cost. 2. It deals with only proportion of items of cost.
3. Cost is directly allocated to any cost unit. 3. It needs a suitable basis for sub-division of cost
by cost units. It is indirect process of allotment.
4. Cost is allocated when the cost centre uses 4. Cost is apportioned when cost centres use only
whole of the benefits of the expenses. a portion of the benefits of the whole expenses.
5. No bases are required for allocation. 5. It is made on the basis of area, assets value,
number of workers, etc.
Principle of Apportionment of Overhead Costs
i. Service or use or benefit derived: It is the most common principle. It is
based on the theory that greater the amount of service or benefit received by a
department, the larger should be the share of the cost to be borne by that
department.
ii. Ability to pay method: Those departments that have the largest income may
be charged with the largest amount of overheads. This method is considered
inequitable because it penalizes the efficient and profitable departments to the
advantage of inefficient ones.
iii. Survey method: Used in cases where it may not be possible to measure
exactly the extent of benefit which the various department receive as this may
vary from period to period
Illustration 1: The “Modern Company” is divided into four departments: A, B, C are
production departments and D is a service department. The actual costs for a period
are as follows:
Rent 1,000 Supervision 1,500
Repairs to plant 600 Fire Insurance with respect to 500
stock
Depreciation of plant 450 Power 900
Employer’s liability for 150 Light 120
insurance
Following information is available in respect
Dept. A of theDept.
four departments:
B Dept. C Dept. D
Area (sq. meters) 1,500 1,100 900 500
Number of employees 20 15 10 5
Direct wages (Rs.) 6,000 4,000 3,000 2,000
Value of plant (Rs.) 24,000 18,000 12,000 6,000
Value of stock (Rs.) 15,000 9,000 6,000 -
H.P of Plant 24 18 12 6
Apportion the costs to the various departments on the most equitable basis.
Illustration 2: Following data were obtained from the books of Light Engineering Company for the
half year ended 30th Sep 2023.
Production Departments Service Departments
A B C X Y
Direct Wages (Rs.) 7,000 6,000 5,000 1,000 1,000
Direct Material (Rs.) 3,000 2,500 2,000 1,500 1,000
Employees (Nos.) 200 150 150 50 50
Electricity (kWh.) 8,000 6,000 6,000 2,000 3,000
Light points (Nos.) 10 15 15 5 5
Asset Values (Rs.) 50,000 30,000 20,000 10,000 10,000
Area Occupied (sq. 800 600 600 200 200
meters)
The expenses for 6 months were: Stores overheads Rs. 400; Motive Power Rs. 1,500; Electric Light
Rs. 200; Labour welfare Rs. 3,000; Depreciation Rs. 6,000; Repairs and Maintenance Rs. 1,200;
General Overheads Rs. 10,000; Rent and Taxes Rs. 600.
You are required to prepare Primary Overhead Distribution Summary for departments showing
clearly the basis of apportionment where necessary.
Re-Apportionment of Service Department Cost
(Secondary Distribution)
• Once the overheads have been allocated and apportioned to production and
service departments, next step in overhead distribution is to re-apportion the
service department total costs to production departments.
• As the ultimate object is to charge the overhead to cost units, and no cost units
pass through service departments, it becomes necessary to apportion the service
departments costs also to production departments on some equitable basis. This
is known as secondary Distribution.
• Re- app to production deptt only.
• Re app to production and service deptt – reciprocal basis(repeated distribution
method) and non- reciprocal basis(step ladder method).
APPORTIONME
NT OF SERVICE
DEPARTMENT
OVERHEADS
APPORTIONMENT APPORTIONMENT
TO PRODUCTION TO PRODUCTION
DEPARTMENTS AND SERVICE
ONLY DEPARTMENTS
NON
RECIPROCAL
RECIPROCAL
SIMULTANEOU REPEATED TRIAL AND
STEP LADDER S EQUATIONS DISTRIBUTI ERROR
METHOD METHOD ON METHOD METHOD
Step Ladder Method
• It is followed when the service department provide the services to other service
departments but not receive the services from other service departments significantly.
• This method is applied when service departments are not inter-dependent in rendering
services.
• Service departments are arranged in descending order of their serviceability.
• The service department which serves the largest number of departments is first
apportioned to other service and production departments.
• The service department which serves the next largest number of department it taken up
next and its cost (including the prorated cost of the first service department) is
apportioned to other service an production departments excluding the first service
department.
• This process is continued till the cost of the last service department is apportioned. Cost
of last production department is apportioned only to production department.
• The most important limitation of this method is that cost of one service center to other
service centers is ignored and thus individual cost centers are not truly reflected.
Illustration 3: A manufacturing co. has two production departments P1 and P2 and
three service departments, time-keeping, stores and maintenance. The
Departmental summary Service Departments
Production Department
(in order of their importance)
S1 S2 S3
P1 P2
(Time-keeping) (Stores) (Maintenance)
Rs. 16,000 Rs. 10,000 Rs. 4,000 Rs. 5,000 Rs. 3,000
The other informationService Department
relating to departments were: Production
Department
S1 S3
S2 P1 P2
(Time- (Maintenan
(Stores)
keeping) ce)
No. of employees - 20 10 40 30
No. of stores - - 9 24 20
requisition
Machine hours - - - 2,400 1,600
Repeated Distribution Method
• It is a method where the overheads of service department are distributed to other
departments on agreed percentage, and this process is repeated till the amount of
overheads are exhausted to consider further apportionment.
Illustration 4: A company has three production departments and two service departments, for
a period the departmental distribution summary is as follows:
Production Departments: P1 – Rs 800, P2 – Rs. 700 and P3 –Rs. 500
Service Department: S1 – Rs 234 and S2 – Rs. 300
The expenses of the service departments are charged out on a percentage basis as follows:
P1 P2 P3 S1 S2
Service Department 20% 40% 30% - 10%
S1
Service Department 40% 20% 20% 20% -
Prepare
S2 a statement showing the apportionment of two service departments expenses to
production departments by Repeated Distribution Method.
You are required to do the following:
i) A statement showing distribution of overhead.
ii) A statement showing re-distribution of service department cost to production department