Overheads

Overheads
Aggregate of indirect materials, indirect labour and indirect expenses. Classification of Overheads : Functional Classification :
Manufacturing / factory / works / production Administration / general / office Selling and Distribution

Element-wise Classification :
Indirect materials Indirect Labour Indirect Expenses

Classification of Overheads - continued

Behavioral Classification :
Fixed rent , insurance, salary Variable consumable stores, nuts/bolts Semi Fixed or Semi variable maintenance, power,
electricity

Incidence-wise Classification :
Direct / relatable / allocable Indirect / general / common

Controllability :
Normal / Controllable Abnormal / non-controllable

Procedure for charging the overheads Primary Allocation

Expenses incurred for the comany as a whole Allocation: Identify expenses allocable to individual department eg. Wages paid to maintenance workers from wage sheet to allocate to maintenance dept. Primary Apportionment : Common expenses to apportion on suitable basis. Item of Expenditure Canteen Exps / Staff Supervision Rent / Taxes Power General Lighting Depreciation Supervision Telephone Exps Repairs Fire Insurance Base Number of workers Area HP/Kwh Number of light points Value of assets Number of employees / wages paid No. of telephones / calls made Wages paid Value of stock / asset

Procedure for charging the overheads Secondary Apportionment

Transfer of the overheads of nonproduction departments to production department. If non-production department render services either Ignore the services but the defects are obvious Or allocate based on the % in which services given by Simultaneous Equation Repeated distribution method Non-production Departments Maintenance Dept. Stores Dept. Purchase Dept. Building service dept. Welfare, Canteen and other facilities Personnel or Time keeping Dept. Internal transport Base No. of hours worked No. of requisitions Number of Purchase orders Area No. of employees No. of employees Weight / value of goods moved

Procedure for charging the overheads Absorption

Charging expenses of production departments to each job or product. Various methods of absorption are: Direct Materials cost % rate i.e.
Amount of overheads to be absorbed Direct Materials cost This method may not be effective if - Material prices vary without much variation in overheads - job using expensive material may get high loading of overhead as compared to job using cheap material, which may not be fair

Direct Wages % Rate i.e

Amount of overheads to be absorbed Direct Wages Cost The problem is there is a very little relationship betwn. Direct wages and overheads.

Procedure for charging the overheads Absorption - continued

Prime Cost % Rate It considers both material as well as labour cost
Amount of overheads to be absorbed Prime Cost

Labour Hour Rate Useful only if labour is the most important element of job
Amount of overheads to be absorbed Labour hours required for production

Machine Hour Rate Useful only if machine use account for a large element of cost in overall production cost.
Amount of overheads to be absorbed Number of Machine Hours

Overhead Absorption Rates

Overhead absorption rates can be Actual based on actual data of previous period
but the problem is actual data will be available only after end of the previous period or if the products are of seasonal in nature comparison is difficult

Predetermined estimated rates In case of predetermined absorption there can be

Under absorption actual overheads being more than the estimated or actual output or hours worked being less than estimated Over absorption actual overheads being less than the estimated or actual output or hours worked being more than those estimated

Treatment of Under or over Absorbed Overheads

Use of supplementary rate If the difference is considerably significant, cost of the cost centres is adjusted by supplementary absorption rate Carrying over to remaining period carried over to the remaining part of the a/cing period Writing Off to costing P&L a/c In case of underabsorption out of abnormal circumstances, they are written off to a costing P&L

Control Over Overheads

Correct classification If correct classification is done, Variable and factory overheads are controlled by lower and middle level management and Fixed and administrative overheads are controlled by top management. Either budgetary or standard costing method is used for proper control

ABC Activity based Costing

Discuss case ABC - Rather than using single departmental overhead rate for the entire department, separate cost allocation rates for each activity is
used eg. Number of Pos for purchase dept cost, No. of inspection for QA dept. etc.

Therefore least cost distortion among products because indirect costs are allocated to the products based on the
Type of activities used by the product and The extent to which the activity is used.

ABC System
1. Identify activities 2. Estimate the total indirect costs associated with each activity 3. Identify the allocation base for each activitys indirect costs primary cost driver 4. Estimate the total quantity of each allocation base 5. Compute the cost allocation rate for each activity i.e.

ABC System
Estimated total indirect cost of activity Rate = -------------------------------------------------------------------Estimated total quantity of cost allocation base

6. Obtain the actual quantity of each allocation base used by the cost object 7. Allocate the costs to each cost
Allocated activity cost = Activity cost allocation rate x Actual quantity of cost allocation base used by the cost object

Example
Chemtech is a chemical development and manufacturing firm. Most of the chemicals the company develops are licensed and sold to other manufacturers. However Chemtechs chemical manufacturing dept continues to produce two types of chemicals : Common chemical (Aldehyde) used for producing plastics and a specialty chemical (Phenylephrine Hydrochloride) used in a blood-pressure medication. Chemtech produces mass quantities of the common chemical for large customers. It produces small batches of the specialty chemical for only one customer (a pharmaceutical company). Last updated several years ago, the Chemical Manufacturing depts cost system uses a single plantwide overhead rate that allocates manufacturing overhead (5 mio for a year) at 200% of direct labour cost.

Because of the profitability of specialty chemical, the CEO wonders whether Chemtech should switch its focus to specialty chemical. However the production supervisor says that it takes no more time to mix a large batch of common chemical than it does to mix a small batch of the specialty chemical. The CEO is also puzzled because Chemtechs competitors seems to be earning good profits. He want to better understand manufacturing overhead what drives it and how it should be allocated.

Chemtech Traditional Costing system

Common Chemical Sales per unit Less : Manufacturing cost per unit: Direct Materials Direct labour Manufacturing overhead (at 20% of direct labour cost) Total manufacturing cost per unit Gross profit per unit Number of units produced and sold Total Manufacturing overheads = 50,00,000 5.00 1.00 2.00 20.00 10.00 20.00 10.00 Specialty Chemical 70.00

8.00 2.00 2,000,000 2 x 20,00,000

50.00 20.00 50,000 20 x 50,000

ABC Example
Step 1 Identify activities The team identifies three primary activities in the Chemical Manufacturing Dept. Mixing Processing Testing Total 8,25,000 - 38,00,000 - 3,75,000 - 50,00,000

Step 2 Estimate total indirect costs to each activity

Step 3 Identify allocation base for each activity

Mixing Number of batches Processing Machine hours Testing Number of samples