Classification of overheads

Overheads can be classified on the basis of number of characteristics.

The following are the important basis of overhead classification:

1. Function wise Classification.
2. Element wise Classification.
3. Behaviour wise Classification.
4. On the Basis of Normality.
5. Controllability Basis.

1. Functionwise Classification:

Under this method of classification, the various functions performed by the factory constitute the basis.

Accordingly overheads are classified as follows:

1. Production Overhead:

Production overhead is also termed as factory overhead, works overhead, or manufacturing overhead. It is the aggregate of factory indirect material cost, indirect wages and indirect expenses. Some examples of indirect material cost used in the manufacturing process are consumable stores, tiny part of materials such as thread and button in readymade garment industry, nails and polish in furniture making industry and so on.

Example of indirect labour cost incurred in production process are wages and salaries of repair and maintenance staff, salary of foreman, supervisor, inspector, watchman’s salary, work’s manager’s salary, etc. Example of indirect expenses incurred in production process are depreciation, repair and maintenance, rent, rates, taxes of factory building, drawing office expenses and so on.

2. Administration Overhead:

These overheads are of general nature and consist of all costs incurred in the direction, control and administration of an undertaking which is not related directly to production or selling and distribution function. Some examples of indirect material cost are office stationery such at paper, pen, ink, carbon papers, stapler, etc.

Some examples of indirect labour cost incurred in the administration department of a factory are salaries of managing director, accountant, secretary clerks and attenders. Some examples of indirect expenses incurred in office are lighting and heating, rent and taxes repairs and maintenance, bank charges, legal charges, telephone charges, etc.

3. Selling Overheads:

The overheads which are incurred in promoting sales and retaining customers is known as selling overheads. Selling overheads include internal material cost, indirect labour cost and indirect expenses. Some examples of indirect material cost are catalogues, price lists, free gifts and samples, etc.

Some examples of indirect labour cost incurred in the sales department are salaries of sales manager, salaries and commission of salesmen. Some examples of indirect expenses incurred in the sales department are expenses incurred in training salesman, advertisement, market research expenses, rent, insurance, heating and lighting of sales show room.

4. Distribution Overheads:

These are expenses which are incurred from the time finished products are packed until they reach their destination. Distribution overhead includes indirect material cost, indirect labour cost and indirect expenses. Some examples of indirect materials cost incurred in the distribution department of a factory are packing materials such as cardboard boxes, hammers, nails, etc.

Some examples of indirect labour cost incurred in the distribution department are salaries of warehouse staff, salaries of drivers of delivery vans, etc. Some examples of indirect expenses are rent, heating, lighting, repairs of warehouse, freight, maintenance of delivery vans, etc.

2. Elementwise Classification:

Under this method, expenditures are classified into three heads:

1. Indirect Materials:

These are the materials which cannot be conveniently identified with individual cost units. These are small and relatively inexpensive items which may become the part of the finished product. Examples of such materials are – lubricating oil, sand paper, nuts and bolts, tools for general use, gum, etc.

2. Indirect Labour:

Indirect Labour pertains to the wages of indirect workers and cannot be conveniently identified with a particular cost unit. Examples of indirect labour are – contribution to provident fund, gratuity, holiday pay, supervisor’s salary, overtime wages, etc.

3. Indirect Expenses:

All indirect costs, other than indirect material and indirect labour costs are termed as indirect expenses. These costs cannot be directly identified with a particular job, process or work rather these are common to cost centres. Examples of indirect expenses are – rent and rates, depreciation, lighting and power, insurance, etc.

3. Behaviourwise Classification:

Under this method expenditures are classified into three heads:

1. Fixed Overheads:

Subject to certain limitations, the amount of fixed overheads tends to remain constant for all volume of production within a certain limit. Fixed costs are relatively unaffected by the change in the level of production or sales. The amount of such costs does not depend upon the volume of production during a period. These costs accrue over a period of time.

Hence they are also known as ‘time costs’ or ‘period costs’. However, it should not be implied that fixed costs do not change at all. They do increase with the increase in the output beyond a certain level of capacity. Examples of fixed costs are – factory rent, office staff salaries, license fees, legal expenses, depreciation of building, insurance charges, etc.

2. Variable Overheads:

Variable items of overheads are those which vary with production. Thus, there is a linear relationship between variable cost and output. However, the variable cost per unit of output remains the same. Examples of variable costs are fuel, power, lighting delivery expenses, salesman commission, etc.

3. Semi-Variable Overheads:

These types of overheads are partly fixed and partly variable. These expenses stand mid-way between fixed and variable expenses. Examples of variable expenses are – telephone and fax charges, repairs and maintenance of plant and machinery, electricity charges, material handling and storage charges, etc.

Importance of Behaviourwise Classification of Overheads:

The advantages of this classification are:

1. Cost Control:

Fixed overheads are not controllable at all points and levels of management. At the most fixed overheads can be controlled only by the top level management, whereas, variable costs are capable of controlling at all levels of management. Thus a proper classification of overheads into fixed and variables help in controlling overheads.

2. Preparation of Flexible Budgets:

A flexible budget is prepared for various levels of production capacity. In its preparation classification of overheads into fixed and variable is very important. Fixed overheads remain constant for all levels of activity, whereas variable overheads vary with every change in the level of activity.

3. Marginal Costing:

Under marginal costing technique only variable overheads are taken into cost of production, whereas fixed overheads are charged to costing profit and loss account. So for the application of marginal costing technique it becomes inevitable to classify overheads into fixed and variable overheads.

4. Break-Even Analysis:

For preparation of breakeven chart it is also very essential to classify overheads into fixed and variable. Only then it is possible to know the point of no profit no loss in a business.

5. Marginal Decision-Making:

Management is very often confronted with number of problems and alternate proposals. To take decision among various proposals it is necessary to classify overheads into fixed and variables. This is so because some decisions such as make or buy, fixation of price, etc., are affected by variable overheads but not by fixed overhead.

6. Cost Analysis:

Analysis of overheads into fixed and variable is important because though fixed overheads remains fixed in respect of its amount, it decreases per unit when the volume of output is increased. Similarly, though variable overheads per unit remain the same it increases when production volume is increased. When it is necessary to know the cost per unit, it is also necessary to classify overheads into fixed and variable components.

7. Overheads Absorption:

In order to charge overheads to various products or jobs it is essential to calculate two separate overheads rate, viz., fixed overhead rate and variable overhead rates. In order to calculate these rates overheads are to be classified into fixed and variable.

4. On the Basis of Normality:

According to this basis, overheads are classified into two categories.

They are:

1. Normal Overheads:

Normal overheads are those overheads, which are expected to be incurred in attaining a given level of output. They are unavoidable. They have to be included in production cost.

2. Abnormal Overheads:

Normal overheads are those overheads which are not expected to be incurred in attaining a given level of output. Cost of abnormal idle time, abnormal wastage of materials, etc. are examples of abnormal overheads. Abnormal overheads are transferred to costing Profit and Loss Account.

5. Controllability Basis:

On this basis, overheads may be classified into two categories.

They are:

1. Controllable Overheads:

Controllable overheads are those overheads which can be controlled by efficient management. Costs of idle time, wastage, etc. are examples of controllable overheads.

2. Uncontrollable Overheads:

Uncontrollable overheads are those overheads, which cannot be controlled. Fixed costs are example of uncontrollable overheads.