Overheads introduction

Cost pertaining to a cost centre or cost unit may be divided into two portions direct and indirect. The indirect portion of the total cost constitutes the overhead cost which is the aggregate of indirect material cost, indirect wages and indirect expenses. CIMA defines indirect cost as “expenditure on labour, materials or services which cannot be conveniently identified with a specific saleable cost per unit.”

Indirect costs are those costs which are incurred for the benefit of a number of cost centers or costs units. Indirect cost, therefore, cannot be conveniently identified with a particular cost centre or cost unit but it can be apportioned to or absorbed by cost centres or cost units.

Cost pertaining to a cost centre or cost unit may be divided into two portions direct and indirect. The indirect portion of the total cost constitutes the overhead cost which is the aggregate of indirect material cost, indirect wages and indirect expenses. CIMA defines indirect cost as “expenditure on labour, materials or services which cannot be conveniently identified with a specific saleable cost per unit.”

Indirect costs are those costs which are incurred for the benefit of a number of cost centers or costs units. Indirect cost, therefore, cannot be conveniently identified with a particular cost centre or cost unit but it can be apportioned to or absorbed by cost centres or cost units.

Broadly speaking, any expenditure over and above prime cost is known as overhead. In general terms, overheads comprise all expenditure incurred for or in connection with the general organisation of the whole or part of the undertaking i.e. the cost of operating supplies and services used by the undertaking including the maintenance of capital assets. The terms ‘burden’, ‘supplementary costs’, ‘on costs’, ‘indirect expenses’ are used interchangeably for overhead.

Importance of Overhead Costs:

In various five-year plans, industrialisation was given due importance. The result is that a large number of establishments have grown up both in the public and private sectors for mass production for which use of improved and costlier and special type of machines has become absolutely necessary. With the increasing trend towards 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.

Overhead expenses being a significant proportion of the total cost have assumed an added importance and require analysis for purposes of cost ascertainment and control by function and for guidance in certain managerial decisions by the extent of the variability with production.

Overhead costs cannot be allocated but have to be suitably apportioned and then absorbed by suitable methods. The cost accountant is required to pay so much attention to the accounting of overhead cost as prudence choice of various bases used for apportionment and absorbing the overheads in the cost of products has to be made by him.

Are High Overhead Costs an Indication of Inefficiency?

These days we find that overhead expenses are increasing in every organisation. Some people may have the feeling that high overhead costs are an indication of inefficiency. But this is not correct.

High overhead costs do not indicate inefficiency if it is accompanied by:

(i) Large scale production or mass production

(ii) Increase in efficiency and productivity of labour

(iii) Less human efforts will be required because of automatic machines but more machine expenses will have to be incurred

(iv) More depreciation, maintenance expenditure and similar other items because of more use of machinery

(v) Improved methods of managerial control like work study, production control, cost and management accountancy techniques may reduce the direct cost but will increase the overhead costs.

Classification of Overhead Costs:

Cost classification is the process of grouping costs according to their common characteristics and establishing a series of special groups according to which costs are classified.

Thus, it involves two steps:

(i) The determination of the class or groups in which the overhead costs are subdivided,

(ii) The actual process of classification of the various items of expenses into one or the other of the groups.

The method to be adopted for the classification of overhead costs depends upon the type and size of the business, nature of the product or services rendered and policy of the management.

The various classifications are:

(i) Functional classification

(ii) Classification with regard to behaviour of the expenditure

(iii) Element-wise classification

(iv) Classification according to nature of expenditure.

A concern may adopt one or more of the above classifications. For example, the overhead expenses in a concern may be first divided according to functions i.e. manufacturing, administration, selling and distribution groups. The expenses pertaining to one group say manufacturing may further be classified into fixed, variable and semi-variable.

Each of these groups may then be grouped into the elements i.e. indirect material, indirect labour and indirect expenses and under each element, the expenses may be further subdivided according to their nature i.e. depreciation, salary, repairs and maintenance etc.

1. Functional Classification of Overhead:

When overhead expenses are classified with reference to major activity divisions of a concern, it is called functional classification of overhead. This classification is necessary for the segregation of the cost of each of the principal functional division of the concern and for having separate methods of accounting and control for the diverse nature of expenses in each division.

The main groups forming the basis of the classification are:

(a) Manufacturing Overhead

(b) Administration Overhead

(c) Selling Overhead

(d) Distribution Overhead

(e) Research and Development Expenses

2. Classification with Regard to Behaviour of Expenditure:

Under this overheads are classified with reference to their tendency to vary with production/sales volume or activity level. Some expenses vary directly with the rise and fall in output, some remain constant in spite of change in the level of activity of the concern whereas there are some other items which are constant only upto a certain level and then change their character to become variable or which vary with volume of output but less than proportionately.

Based on this behaviour, the expenses may be classified into:

(a) Fixed overhead

(b) Variable overhead

(c) Semi-variable or Semi­-fixed overhead.