4. Overheads

8/3/2019 4. Overheads

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Overheads


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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


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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


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Procedure for charging the overheads

Primary Allocation

Expenses incurred forthe comany as a whole

Allocation:

Identify expensesallocable to individual

department eg. Wages paid tomaintenance workersfrom wage sheet toallocate tomaintenance dept.Primary

Apportionment : Common expenses to

apportion on suitablebasis.

Item of Expenditure Base

Canteen Exps / Staff

Supervision

Number of workers

Rent / Taxes Area

Power HP/Kwh

General Lighting Number of light points

Depreciation Value of assets

Supervision Number of employees /

wages paid

Telephone Exps No. of telephones /

calls made

Repairs Wages paid

Fire Insurance Value of stock / asset


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Secondary Apportionment

Transfer of theoverheads of non-productiondepartments toproduction department.

If non-productiondepartment renderservices either

Ignore the services butthe defects are obvious

Or allocate based onthe % in whichservices given by

Simultaneous Equation

Repeated distributionmethod

Non-production

Departments

Base

Maintenance Dept. No. of hours worked

Stores Dept. No. of requisitions

Purchase Dept. Number of Purchaseorders

Building service dept. Area

Welfare, Canteen and

other facilities

No. of employees

Personnel or Timekeeping Dept.

No. of employees

Internal transport Weight / value of goods

moved


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Procedure for charging the overheads -

Absorption

Charging expenses of production departments to each job orproduct. 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 ascompared to job using cheap material, which may not be fair

Direct Wages % Rate i.e

Amount of overheads to be absorbedDirect Wages Cost

The problem is there is a very little relationship betwn. Direct wages andoverheads.


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Absorption - continued

Prime Cost % Rate It considers both material as well as labour

cost


Prime Cost

Labour Hour Rate Useful only if labour is the most importantelement of job


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


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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 thanestimated

Over absorption actual overheads being less than theestimated or actual output or hours worked being more thanthose estimated


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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 theremaining part of the a/cing period

Writing Off to costing P&L a/c In case of under-

absorption out of abnormal circumstances, they are

written off to a costing P&L


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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 topmanagement.

Either budgetary or standard costing method is used for

proper control


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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 isused eg. Number ofPos for purchase dept cost, No. of

inspection for QA dept. etc.

Therefore least cost distortion among products

because indirect costs are allocated to theproducts based on the

Type of activities used by the product and

The extent to which the activity is used.


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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

base5. Compute the cost allocation rate for each

activity i.e.


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ABC System

Estimated total indirect cost of activity

Rate = --------------------------------------------------------------------

Estimated total quantity of cost allocation base

6. Obtain the actual quantity of each allocationbase used by the cost object

7. Allocate the costs to each costAllocated activity cost = Activity cost allocation rate x Actual quantity of

cost allocation base used by the cost object


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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 specialtychemical (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.


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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.


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Chemtech

Traditional Costing system

Common Chemical Specialty Chemical

Sales per unit 10.00 70.00

Less : Manufacturing

cost per unit:

Direct MaterialsDirect labour

Manufacturing overhead

(at 20% of direct labour

cost)

5.001.00

2.00

20.0010.00

20.00

Total manufacturing cost

per unit

8.00 50.00

Gross profit per unit 2.00 20.00

Number of units

produced and sold

2,000,000 50,000

Total Manufacturing

overheads = 50,00,000

2 x 20,00,000 20 x 50,000


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ABC Example

Step 1 Identify activities The team identifies three primary

activities in the Chemical

Manufacturing Dept.

Step 2 Estimate total indirect costs

to each activity

Mixing 8,25,000

Processing - 38,00,000

Testing - 3,75,000

Total - 50,00,000

Step 3 Identify allocation base for

each activity

Mixing Number of batches

Processing Machine hours

Testing Number of samples

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4. Overheads