IPCC, Paper 3, Costing, Chapter 4 B.N.Pattabhi., M.Com, FCA

Dedicated to my Noble, Ever Loving, Ever Inspiring Parents Lalitamma & Nanjappa

1 • Understanding the Meaning of Overheads

2 • Difference between Direct Costs & Overheads

3 • Allocation, Apportionment & Absorption of OH

4 • Identifying under or over absorption of OH

5 • Understand accounting & control of Factory,

Administrative, Selling & Distribution OHs

In a modern day manufacturing unit there are certain expenses incurred on general services & facilities which are essential for the manufacturing process but which can’t be directly identified with articles produced or services rendered

All those expenses which can not be identified or traced with a particular unit of production is termed as overheads.

With the automation of the production process the cost of the facility and ancillary services have increased drastically and are forming a major portion of the total cost of production. It has overtaken material and/or labour cost . Hence controlling of overheads has assumed a greater significance than ever before

Overheads are generally and predominantly period costs and associated with a facility or a department in an organisation.

We shall take up a comparative study of Overhead cost control and Activity Based Costing at a later stage

In fact, overheads have assumed such a significance that in some of the developed countries the study of overhead has become a subject in itself and is known as Activity Based Costing or ABC

Based on this overheads are classified as follows

Factory overheads

Administrative overheads

Selling & Distribution overheads

Research & Development overheads

One of the earliest and most often used Organisational Structure is Functional Departmentalisation.

As we all know the subject of cost accounting developed along with developments in the field of Management.

It is the sum total of all those indirect expenses which are incurred from the point when the materials are issued for production and ends with the primary packing of the product.

i.e all those expenses incurred within the factory premises from the beginning of the production to the point of primary packing is termed as Factory Overheads or Works overheads

It is the sum total of all indirect cost incurred in managing an organisation. By definition

The cost of formulating the policy, directing the organisation and controlling the functions of an organisation and which can’t be attributed to manufacturing, selling & distributing or research & development activity or function

Sales overheads are those costs which are incurred in creating and stimulating the demand for a particular product or service.

Distribution overheads are those cost which are incurred on the activities starting from making the packed product available for dispatch and up to the cost of making the reconditioned returned empty package ready for reuse

Research overheads are those costs which are incurred to search for new or improved products , new application for the materials, new or improved methods

Development overheads are those costs which are incurred to implement the decision to produce new or improved products

If the research & development is towards an existing product or improving the process of production, then the same will be added to Factory or works overheads and absorbed into the cost of production.

If it is incurred on developing a new product it is treated as a separate overhead and charged to costing profit & loss account.

Expenses or Income of

Purely financial nature

Capital in nature

Discretionary or arbitrary costs

incurred due to policy of the management

Appropriation of profit

Semi-variable

Changes with level of activity but not proportionately

Variable

Changes in direct proportion to level of activity

Fixed

Does not change with the level of activity

Based on the nature of the overheads are classified into

Controllability

Controllable & Uncontrollable

Element-wise

Indirect Materials Indirect Labour Indirect Expenses

One of the main objectives for development of cost accounting is to design a system which would furnish the management with an estimate which is accurate and close to reality.

This involves estimation of various costs involved because only direct costs like Materials, labour and direct expenses are the ones which are readily available, all other indirect expenses will have to be estimated. Based on such estimates recovery rates have to be arrived at

The various overheads are estimated at the beginning of the year and on a suitable scientific basis a recovery rate is arrived at. This is known as Overhead Recovery Rate (ORR) or Standing Order Rate (SOR)

The ORR or SOR helps in preparation of cost sheet to arrive at the cost of sale of a product or service as soon as the prime cost is known

Allocation

• It means assigning or allotment or identifying of an entire item of cost with a particular cost centre or cost unit

Apportionment

• There are some items of cost which can’t be directly identified with any particular cost centre or cost unit. These have to distributed to all those departments or cost centres which are utilising the benefits on a rational basis, this is termed as apportionment

Re-apportionment

• Once the overheads are allocated and apportioned to all the departments, the cost of service departments will have to be re-apportioned to the production departments

Absorption

• It is the process of applying & recovering the overheads to the cost of production of a product

It is to be noted that Allocation and Apportionment are facility or department or cost centre level activities, whereas Absorption is a product level activity i.e absorption is the process of recovering the overheads from all the products which have passed through a particular department or a cost centre.

Estimation & Collection of Overheads

Determining Recovery /Standing Order Rates

Departmentalisation / Allocation of overheads

Apportioning of the Overheads to various Deptt

Re-apportionment of Service Department overheads to Production Departments

Absorbing overheads over cost units/products

Direct re-distribution

Method

Step Method or Non Reciprocal

Method

Reciprocal Service Method

Simultaneous Equation Method

Repeated Distribution

Method

Trial & Error Method

Percentage of direct materials

Percentage of prime cost

Percentage of direct labour cost

Labour hour rate

Machine hour rate

Rate per unit of output method

Normal Rate

Predetermined overhead rate

Blanket overhead rate

Departmental Overhead rate

Overheads are applied to production on a pre-determined overhead recovery rate.

The actual overheads incurred during a period will vary from the overheads applied or absorbed into production.

The difference between overheads applied or absorbed and actual overheads incurred results in under or over recovery of overheads

Both overhead and production changing but not in the same proportion

Under or over recovery of overheads may result due to

Actual Overhead being higher or lower than budgeted overheads

Actual production being higher or lower than the budgeted

production

The difference in overheads incurred and absorbed is also called as overheads variance

If the under or over absorption is not material it is transferred to Costing Profit & Loss A/c and the cost of individual products is not affected.

If the under or over absorption is materail then the same is applied to the cost of individual products by using a supplementary overhead recovery rate

That portion of under or over absorbed overheads which is attributable to goods manufactured and sold, will have to be added to cost of sales.

That portion of under or over absorbed overheads which is attributable to Stock of Finished Goods and WIP will have to be adjusted in their carrying values

Any under or over absorption resulting out of abnormal reasons will have to be transferred to Costing Profit & Loss Account

Administrative overheads are the expenses incurred on General Management, accounting and other administrative services which can’t be directly attributed to Production, Marketing, Distribution, Research & Development activities

They are incurred in connection with formulating the policies, Directing the organisation and controlling the operations of an undertaking

Administrative overheads are dealt with as follows

• Apportioning them to Production & Sales Departments • Charging it to Costing Profit & Loss Account • Recovering Administration overheads separately to

cost of production / Sales on the basis of Works Cost, Sales Value or Quantity, Gross profit,Quantity Produced or Conversion cost

Classification and Analysis of Overheads by departments according to their functions

Control through Budgets Control through standard

It is the sum total of the expenses incurred from the point of secondary packing and ending with making the reconditioned returned empty package ready for reuse

We have discussed the meaning at length earlier in this chapter, let us look at the aspects of accounting & control over S&D OH

The bases used for distribution are

Sales Value of Goods sold

Cost of Goods Sold

Gross Profit on Sales

No of orders or Units sold

S&D Overheads are collected on the standing order numbers and analysed

Sales value is considered to be the most logical basis for recovering S&D OH since there is a direct relationship between the amount spent on selling & distribution activities and the sales achieved.

There is no relationship between Cost of Production or Gross Profit and the sales achieved and hence these can’t be a logical basis for recovering S&D OHs

The most widely used basis for Recovering S&D OHs is an estimated amount per unit.

The S&D expenses are categorised into fixed and variable portion. The fixed expenses are apportioned on the basis of the benefit derived

The variable S&D expenses are packaging, freight outwards, commission payable to sales man etc, these are ascertained unit wise and added to the fixed S&D expenses to arrive at total S&D OH / unit

Controlling S&D OHs is a difficult task

since Sales Budget is the master budget based on which an organisation plans

its entire operations. S&D OHs are critical

to achieve the targeted sales

The quantum of S&D OHs depends on

external factors like competition, product

positioning, target audience etc &

hence difficult to control

These are policy costs and hence

difficult to control

Even though it is very difficult to control the S&D OHs the following are some of the methods to control S&D OHs

Comparison with past performance

Budgetary Control

Standard Costing

• It is the maximum capacity of a machine/plant as Indicated by its manufacturer. It is a theoretical capacity since 100% efficiency is seldom achieved

Rated / Installed Capacity

• It is the actual production time available for any machinery/plant after taking into account the normal idle time, maintenance and delays. It is also called as net capacity or available capacity. It is also used to determine the overhead recovery rate or standing order rates

Practical /Operating Capacity

• It is that capacity which a plant is expected to be utilised over long term based on expected sales

Normal Capacity

• It is the actual utilisation during the given period Actual

Capacity • It is that portion of the installed capacity which was

not utilised for production, this may be due to slack Demand, non availability of raw materials or skilled labourers, power or fuel or Seasonal nature

Idle Capacity

The idle capacity cost is treated as follows

If it is due to unavoidable reasons then the cost is recovered by applying a supplementary overhead recovery rate and added to cost

If it is due to avoidable reasons then the cost is transferred to costing P&L A/c

If it is due to seasonal factors, then it is charged to the product as a part of ORR

Interest & Financial Charges Pure financial costs like interest and dividend are excluded from cost since the incurrence of the same depends on the Financial Managers decision as regards capitalisation of a business.

Inclusion of financial cost will increase the cost of production of a product and there by the selling price and consequently the sales or market share

Moreover it is provided to maintain the production capacity or for replacing an asset after its useful life and hence it is cost and considered as such in costing

Depreciation

It is a charge to reflect the reduction in intrinsic value of an asset due to normal wear & tear or by efflux of time and hence it is considered as a Cost.

Cost of packing which is to facilitate movement and grab the attention of the customer is treated as Distribution and Selling Expenses respectively Specific special packing done at the behest of the customer is directly charged to such customer/order

Packing

Primary packing which is necessary to maintain the product for its intended use forms part of production cost.

Expenses on Removal & Re-erection of Machine

If it is due to routine maintenance it will be treated as plant cost and recovered as depreciation or production overheads. If its due to faulty

planning then the same is transferred to Costing P&L A/c

Fringe Benefits & Canteen Expenses & Welfare Activities Cost

These are additional expenses incurred to boost the morale of the workers and hence forms part of either labour cost or production overhead

Bad Debts

Normally these are excluded from cost, but some authors feel that it should form part of S&D Ohs

Training Expenses

Normal training Expenses are treated as part of labour cost, however training cost incurred due to abnormal labour turnover should be transferred to costing P&L A/c

• These are transportation costs and are included in material cost if its incurred on raw materials, In FOH if its incurred on indirect materials In S&D OH if its incurred on finished goods

Carriage and Cartage

Expenses

• If is due to general work pressure it forms part of the labour cost, if incurred at the behest of a customer then it is charged to that particular job, if its due to faulty planning it is transferred to costing P&L A/c

Night Shift Allowance

Overheads represent expenses that have been incurred to provide certain ancillary facilities or services which facilitate or make possible the carrying out of the production process, by itself these facilities or services are not of any use

Over heads are classified as follows On functionality Factory or Manufacturing , Administration, Selling & Distribution and R&D Overheads On Nature Fixed, Variable and Semivariable

Allocation, Apportionment, Reapportionment and Absorption

Allocation is identifying a cost with a particular activity or a cost centre

Apportionment is distribution of Overheads which can’t be allocated, on a rational basis to all user departments or departments utilising such benefit

Reapportionment is the process of reapportioning or redistributing service department costs to production departments

Absorption is applying the allocated, apportioned & reapportioned overheads to products or services

Methods of Reapportionment Direct Redistribution method Step Method or Non Reciprocal Method Reciprocal Services Method Simultaneous Equation Method Repeated Redistribution Method Trial & Error Method Bases for Overhead Recovery Blanket ORR, Percentage of Direct Materials,

Percentage of Prime Cost, Percentage of Direct Labour Cost, LHR, MHR

Methods of Accounting & Control of Admin OH Apportioning AOH between Production & Sales Dept Charging to Costing P&L A/c Treating AOH as a separate addition to cost of

production or sales Bases of apportionment Works Cost, Sales Value or Quantity Gross Profit on Sales, Quantity Produced Conversion Cost etc