Procedure for Accounting and Control of Overheads

1. Classifications of Overheads Costs:

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.

Function wise 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.

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.

III. Behaviour wise 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.

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.

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.

2. Codification of Overheads:

Codifications of overheads are useful in accumulating and control of overheads. After classification of overheads, the next step involved in overhead accounting is to codify them. This is so because there are number of overheads which are incurred in factories and unless proper attention is given, the chances of accounting of all overheads may not be possible. Thus, all overheads falling under the category of depreciation relating to plant and machinery, factory building, factory furniture may be given a separate number.

So that depreciation related to all the assets can be properly accounted for codification of overheads refers to assignment of a number or symbol for each time of overheads with a view to accumulate them easily. To facilitate easy identification of different types of overheads, different code numbers are given. The code numbers given for factory overheads is known as standing number order and that to administration, selling and distribution overheads is known as cost accounting number.

Methods of Codification of Overheads:

The following are the important methods of codifying the overheads:

1. Numerical Method:

Under this method, numerical numbers are used to codify the overheads. In big factories, first of all the various expenses are first identified and a separate number is given to each expenses. Subsequently a sub-number is given for various overheads incurred under each category of expense. For example – depreciation is given a code number as 1.

Then depreciation relating to factory building will be given a code number of 1.1, depreciation relating to plant and machinery 1.2 and that relating to furniture 1.3 and so on. Similarly repairs may be given a code number as 2. Then repairs relating to factory building are given a code number as 2.1 repairs relating to plant and machinery as 2.2 and repairs relating to furniture as 2.3 and so on.

2. Alphabetic Method:

Under this method, alphabets are used to codify the overheads. Each item of overhead is given a code letter which happens to be the first letter of the overhead expenditure. However, items of overheads beginning with same letter will pose a problem. To avoid confusion, the next letter of the overhead can be used along with the first letter.

Examples of this method are:

3. Alpha Numerical Method:

This method combines both the alphabetic and numerical methods. The alphabetic letter denotes the main expenditure while the numerical number denotes its sub-division. For example; Depreciation of plant is coded as D1, Depreciation of plant and machinery is coded as D2 and depreciation of assets as D3.

4. Decimal Method:

Under this method the various departments are first identified and a separate number is given to them. Then each and every overhead incurred in the respective departments are given a sub-number. For example; salary of clerk belonging to office department is given a code number as 1.1. The salary of clerk belonging to selling department is given a code number as 2.1 and so an.

3. Collection of Overheads:

The process of ascertaining the amount of overheads incurred for a period is called collection of overhead. The classified and coded overheads are collected and recorded under the standing over number and cost accounting number.

To facilitate recording of overhead as separate ledger known ‘overhead ledger’ is maintained. Separate accounts are opened for standing order number and cost accounting number in this ledger. Generally, overheads are collected at the end of every month and after totalling them, they are recorded in the overhead ledger.