Overheads and Its Types [with Accounting Treatment]| Cost Accounting

Overheads are costs, which are not traced directly to cost units. In other words, over­head is the total of indirect material costs, indirect labour costs, and indirect expenses. The terms ‘burden’, ‘supplementary costs’, ‘on costs’, and ‘indirect expenses’ are used interchangeably for overhead. Overheads are aggregated under some account head (e.g. supervisors’ salary, office lighting, depreciation, and building up-keep) and then assigned to cost units on some equitable basis.

Overheads are usually classified in terms of functions- factory overhead, administra­tion overhead, selling overhead, and distribution overhead. The terms factory overhead, manufacturing overhead, and production overhead are used interchangeably.

Types of Overheads:

1. Manufacturing Overheads:

Manufacturing overheads are indirect costs associated with the manufacturing process. In a product manufacturing set-up, we say manufacturing process is the sequence of operations that begin with supplying materials to workstations and end with the primary packing of the product.

In the context of producing services, the manufacturing process is the process of performing activities, concurrently or in sequence, which are directly related to creating the service. E.g., in the context of an organisation providing road trans­port services, manufacturing overheads are overheads associated with the operation of the vehicles. Indirect costs incurred in stores department and in departments providing support services are also included in manufacturing overhead.

2. Administration Overheads:

Administration overheads are costs of formulating the policy, directing the organization, and controlling the operations which are not directly related to production, selling, distribution, and research or development, or any other function.

Cost of factory administration is a part of manufacturing overhead. Similarly, the cost of administration of marketing offices is a part of selling overhead.

3. Selling Overheads:

Selling overheads are the costs associated with marketing and selling (excluding distribution) activities.

4. Distribution Overheads:

Distribution overheads are the costs associated with the distribution of finished products. Distribution includes such activities as moving finished goods to central or local storage and moving finished goods to and from prospective customers as in case of goods on sale or return basis. In gas, electricity, and water industries, ‘distribution’ means pipes, mains, and services which may be regarded as equivalent to packing and transportation.

5. Administration Overheads:

Administration overheads are expenses associated with the administration of an under­taking. Costs of formulating the policy, directing the organization, and controlling the operations of an undertaking which are not directly related to production, selling, distribution, research or development activity, or function, are administration overheads.

Thus, administration overheads do not include costs of administering manufacturing activities. Those costs are treated as manufacturing overhead. E.g., costs of operating a time office are manufacturing overheads and not administration overheads.

Examples of administration overheads are as follows- office rents and rates; expenses of office lighting, heating, and cleaning; depreciation, costs of maintenance, repair, and insurance of office building, office furniture, and office equipment; salaries to office staff; director’s remu­neration; office supplies and other expenses; expenses on postage, telephone, and courier services; printing and stationery; audit fees; legal expenses; and bank charges.

Administration is an independent function and is as important as the other major functions. Since no direct relationship can be established between administration over­head and products or jobs manufactured and sold, and because these costs are largely fixed in nature, they are treated as period costs and charged directly to Costing Profit and Loss Account.

6. Selling and Distribution Overheads:

Selling overheads are costs of creating and stimulating demand and securing and execut­ing orders. Costs of manufacturing and distributing finished products are excluded from selling overheads.

Distribution overheads are costs of moving finished products to central and local stor­age, moving finished products to the customers, moving finished products to and from the prospective customers as in the case of goods on sale or return basis, and making empty packages reusable.

In short, when a product is placed in a saleable condition, production function ends and distribution function begins. Overheads related to distribution function are termed as distribution overhead. Many accountants prefer to deal with selling and distribution overheads together.

Examples of selling overheads are as follows:

Salaries, commissions, travelling expenses of salesmen and technical representatives; sales office expenses; bad debts; brokerage or third-party commissions; cost of operating the marketing information system including market research; expenses on advertisement and publicity; cost of cata­logues and price lists; and costs of maintenance of showrooms.

Examples of distribution overheads are the following:

Carriage and freight outwards; depreciation, cost of repair and maintenance, insurance charges, and operating costs of distribution vehicles; costs of secondary packing; warehousing expenses; expenses on insurance of finished goods; and wastage of finished goods.

Selling and distribution overheads are treated as period costs and charged directly to Costing Profit and Loss Account.

7. Research and Development Costs:

Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development is the application of research findings or other knowledge into a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services prior to the commencement of commercial production or use.

An enterprise undertakes research to increase the stock of its scientific knowledge, devices, and new applications which is expected to create competitive advantage for its business.

Research activities aim at the discovery of new knowledge which can be used in devel­oping new products, services, processes, and techniques or in improving existing products or processes. Development starts where research ends. The results of a research cannot be put directly to commercial use. It requires feasibility study and identifying practical difficulties which may arise in its applications. Development activities include conceptual formulation, design and listing of product/process alternatives, development of prototypes, etc.

Research and development costs are likely to benefit future products and, therefore, an elaborate system of absorbing these costs to products, orders, or process is hardly justi­fied. Where research has been undertaken at the request of a client, it should obviously be charged to the customer.

If research is specifically related to an existing product, it should be directly assigned to the product and considered in analysing the profitability of the product. Research undertaken for the general interest of the firm should be treated as period cost.

Accounting for Certain Key Items of Overheads:

1. Bad Debt:

There are two approaches for treating bad debt in cost accounts. One view is that bad debt is a financial loss only and should be excluded from cost accounts. The other view is that bad debt is similar to other expenses and should not be excluded from cost accounts.

Accordingly, bad debt is considered an item of selling overhead. Abnormally high bad debts and bad debts of exceptional nature should be excluded from cost accounts. They should be charged to the Profit and Loss Account.

2. Advertisement Costs:

Advertisement costs should be allocated and apportioned to various functions. E.g., cost of adver­tisement for recruitment should be allocated to the personnel function. Costs of advertisements to create and retain demand for products and services should be allocated to selling function. Advertisement cost is an overhead but its accounting depends on its exact nature.

Advertisement cost which is likely to result in a long-term benefit should be treated as fixed asset and depreciation on the same should be treated as selling overhead, e.g., the cost of neon signs.

3. Market Research Costs:

Market research addresses itself to specific marketing problems. This includes the study of potential markets, customer’s behaviour, competitor’s strategy, etc. It is like a policy cost because it does not depend on the activity level, but varies with management policy on market research.

The market research cost is treated as a selling overhead. However, if it is high in a particular period, it should be treated as a deferred charge. Only a portion of it should be included in the overhead for the current year and the balance should be carried forward to future years for inclusion in overhead costs for those years.

4. Royalty and Patent Fees:

Royalty and patent fees may either be based on the units sold or produced, or may take the form of a periodical payment of a predetermined amount. If royalty and patent fees are fixed charges in the nature of rent, or are based on the number of units produced, they should be treated as manufacturing overheads. On the other hand, if they are based on the number of units sold, they should be treated as selling overhead.

5. After-Sales Services:

It is a common practice to offer continued free support/maintenance services during a stipulated guarantee period.

Treatment of cost of after-sales services in cost accounts depends upon the cause which has given rise to the after-sales services. If it is to rectify manufacturing defects, the cost is treated as manufacturing overhead. If design department is responsible for the defect, the cost is allocated to design department. If damage is caused in transit, the cost is treated as distribution overhead.

The following after-sales service costs are usually treated as selling overhead:

(1) Costs of routine services

(2) Costs of after-sales services rendered only to retain customer’s goodwill, even though such services are not covered under any agreement.

Appropriate accounting of costs of after-sales services requires a careful analysis of the total costs. Costs on after-sales services of an exceptional nature should be charged off to Profit and Loss Account.

E.g., if suddenly an electrical engineering company incurs an abnormally heavy expenditure in rectifying a defect in a transformer supplied to a customer, inclusion of the same in production or selling costs would distort costs of production or sales. It is, therefore, logical to charge such a heavy expenditure to Profit and Loss Account.