Overheads: Definition and Collection | Labour

In this article we will discuss about:- 1. Definition of Overheads 2. Meaning of Chargeable Expenses 3. Steps in Accounting of Overheads 4. Classification and Codification of Overheads 5. Collection of Overheads 6. Cost Allocation 7. Allocation and Apportionment of Overheads.

Definition of Overheads:

CIMA defines Overhead Cost as “the total cost of indirect materials, indirect labour and indirect expenses”. Overheads are the indirect costs which cannot be allocated to any specific job, process because they are not capable of being identified with any specific job or process.

Overheads include cost of indirect material, indirect labour, indirect expenses which cannot be conveniently charged to any job, process, cost unit etc. For example, costs like rent, rates, administration and supervision, depreciation, maintenance, selling and distribution expenses, cleaning materials etc. cannot be directly attributed to cost units produced.

The costing treatment of overheads deals with methods whereby these indirect expenses can be related to cost units. Overhead is the cost of materials, labour and expenses which cannot be economically identified with specific saleable cost unit.

Meaning of Chargeable Expenses:

These expenses are directly allocable to a job, process, service, cost unit or cost centre. It is not possible to allocate the overheads to jobs etc. and only through apportionment and absorption, it can be charged to different jobs, processes, services, cost units or cost centres. An expense is whether a chargeable expense or overhead depend on the extent of departmentalization and specific circumstances of a particular expense.

For example, a machine is hired for general purpose, the hire charges are treated as overhead. But if that machine is hired or used for a specific job, then the hire charges will be treated as chargeable expense and can direct charge to that particular job. Another example is that, power consumption is normally treated as chargeable expense if it is consumed for a single plant or machinery.

But if number of machines consumes the power, then power will be treated as overhead and will be apportioned to the different machine centres on some equitable basis, which have used power.

Some of the examples for chargeable expenses are:

(a) Cost of patents,

(b) Hire charges in respect of special machinery or plant,

(c) Architects, surveyors and other consultants fees,

(d) Travelling expenses to site,

(e) Freight inwards on special machine, and 

(f) Royalty paid for use of know-how etc.

Steps in Accounting of Overheads:

The important steps involved in accounting of overheads are as follows:

(i) Classification and Codification of Overheads,

(ii) Collection of Overheads, and 

(iii) Primary and Secondary Distribution of Overheads using:

(a) Allocation,

(b) Apportionment, and 

(c) Absorption.

Classification and Codification of Overheads:

CIMA defines classification as “the arrangement of items in logical groups having regard to their nature (subjective classification) or the purpose to be fulfilled (objective classification)”.

Classification is the process of arranging items into groups according to their degree of similarity. Accurate classification of all items is a prerequisite to any form of cost analysis and control system. The classification system must meet the objectives of all the systems which may use the classifications. For ascertainment of cost and profitability of each unit of production, it is necessary for the effective analysis of costs.

The direct materials and direct labour are easily attributed to cost objects but charging of overheads to cost objects poses a major problem. To overcome the difficulties in ascertainment of unit cost and profitability, proper classification and codification is done for ease of recording, collection and control of cost data.

Collection of Overheads:

Overheads collection is “the process of recording each item of cost in the records maintained for the purpose of ascertainment of cost of each cost centre or cost unit”. For ease in collection of overheads, classification and codification of overhead items is necessary.

For collection of overhead expenses, the following are some of the documents maintained:

i. Stores Requisitions:

Different cost centres will obtain their requirements of indirect material from stores by submitting the stores requisition notes which indicate the standing order number and the department which has used the indirect material issued from the stores.

A material issue analysis sheet is prepared at the end of every month and the total indirect materials issued from the store are charged or debited to Production Overhead Control Account and credited to Stores Ledger Control Account.

ii. Wage Sheets:

The wages and incentives paid to the indirect labour are recorded in the time cards and job cards along with the standing order numbers of each cost centre and wage analysis is prepared at the end of the month from the entries appearing in the time cards and job cards and the total is debited or charged to Factory Overhead Control Account and credited to the Wages Account.

iii. Cash Book:

The indirect expenses incurred will be entered in cash book, will be scrutinised on monthly basis and collected according to the standing order numbers department wise and debited to the respective control accounts like Stores Ledger Control Account, Wages Control Account, Cost Ledger Control Account.

iv. Purchase Orders and Invoices:

The indirect expenses pertaining to the purchases, sales and distribu­tion are collected, according to the purchase orders or invoices originated.

v. Journal Entries:

The overhead expenses relating to number of items can be collected from books of original record i.e. journal and necessary entries are passed in the Cost Ledger. It is to be noted that majority expenses are to be apportioned to Factory Overhead, Administration Overhead, Marketing and Distribution Overhead.

vi. Other Registers and Records:

Some of the overhead items which do not involve cash outlay like, depreciation, notional rent, accrued expenses, etc. can be collected from the miscellaneous registers and records available with the production, accounting, sales, personnel departments etc.

Cost Allocation:

A cost allocation can be defined as “the partitioning of a cost among a set of cost objects”. For this purpose, the cost object could be production units, machines, groups of machines, individual products or groups of products. Companies that price all or a large part of their output on a cost- plus basis certainly need to include overheads in their cost of production. Financial reporting is another reason for allocating costs.

In addition, internal management reports frequently use full costs for evaluating the financial performance of individual profit centres. The use of cost allocation in performance evaluation is, however, a very controversial subject. One view suggests that as overhead costs are a joint responsibility, all sections of the organization should be aware of them.

Furthermore, cost allocation can be used to motivate individual managers to exercise a degree of control over their consumption of central services. The alternative view is that such allocations more costs away from where they are incurred to other parts of the organization where it is more difficult to exercise control.

Criteria for Common Cost Allocation:

The following are the criteria based on which cost will be allocated:

i. Neutrality:

A cost allocation scheme is neutral if it does not interfere, after or in any way distort the decision making process. Any departure from the principle of neutrality is assumed to lead to economic inefficiency. However, a neutral allocation scheme will lead to decisions that satisfy marginal optimality conditions. It thereby avoids distorting the decision making process. An allocation scheme which is neutral with respect to one decision may not be neutral for all other decisions.

ii. Ability to Bear:

Costs should be assigned to cost objects in proportion to their ability to bear those costs. Sales revenues, gross profits, total value of assets and total costs are examples of bases used to relate costs to cost objects. The presumption is that ‘larger’ cost objects can afford to bear larger share of overhead costs.

iii. Cause and Effect:

The cause and effect relationship criterion requires a meaningful casual relationship between the cost objects and the costs to be allocated. Here the basic principle is to allocate costs to those factors which cause the costs. For example, factory maintenance costs might be allocated among divisions in proportion to the hours of maintenance work performed in each division.

iv. Benefits Received:

This criterion is primarily concerned with allocating costs in proportion to the benefit received by each cost object. The premise is that cost objects should be charged for the amount of service they receive. For example, the costs of a power plant might be allocated in proportion to the consumption of power by the different departments or divisions.

v. Equity or Fairness:

It implies that the scheme should produce an allocation which is just and fair to all parties involved. Each party should bear an equitable share of the allocated costs.

Service departments may exist to provide services of various kinds to other departments. In some instances the service departments may even consume part of their services themselves.

Allocation and Apportionment of Overheads:

Cost allocation and cost absorption is the partitioning of a cost among a set of cost objectives. For this purpose, the cost object could be production units, machines, groups of machines, individual products or group of products, companies that price all or a large part of their output on a cost plus basis certainly need to include overheads in their cost of production. Financial reporting is another reason for allocating costs. In addition, internal management reports frequently use full costs for evaluating the performance of individual cost centres.

i. Departmentalization:

For efficient working, and for collection, allocation and absorption of costs, an organization is divided into number of departments like machining, fabrication, assembling, maintenance, power, personnel, tool room, stores, accounts, costing, etc. and the overheads are collected, allocated or apportioned to the respective departments.

This process is called ‘departmentalization’ of over­head which will help in ascertainment of cost of each department and control of expenses. This will help in computation of cost of different units, products or jobs passed through the depart­ments or services rendered by the departments.

ii. Allocation:

CIMA defines Cost Allocation as “the charging of discrete, identifiable items of cost to cost centres or cost units”. Where a cost can be clearly identified with a cost centre or cost unit, then it can be allocated to that particular cost centre or cost unit. Allocation is the process by which cost items are charged direct to a cost unit or cost centre.

It is the process of charging the traceable amount of overhead to cost centre or cost unit. Overhead costs by their nature cannot often be related to one particular cost centre. Where a cost is directly attributable to a department e.g. electricity metered to that department, allocation can take place.

If a cost can be specifically identified with a department that cost is allocated to that department. For example, depreciation on machinery of machining department can be directly allocated to machining department. The salary of stores clerk can be allocated to stores department. Cost of coal used in boiler can be directly allocated to boiler house division.

iii. Apportionment:

CIMA defines apportionment as “the allotment of two or more cost centres of proportions of the common items of cost and the estimated basis of benefits received”.

Some costs cannot be identified as arising from the activities of one specific department or function. Non-allocable costs, however, must be apportioned on some logical basis to be divided between the related cost centres. For example, rent, rates and taxes incurred for the entire factory cannot be directly allocated to different cost centres, but can be apportioned to more than one cost centre on some equitable basis for benefits received.

The basis normally used for rent, rates and taxes being the floor area occupied by various cost centres. Apportionment is the division of costs among two or more cost centres in proportion to the estimated benefits received, using a proxy e.g., square feet. The choice of an appropriate basis is a matter of judgment to suit the particular circumstances of the organization and wherever possible there should be a cost/cause relationship.

Criteria for Apportionment of Overheads:

The following are the criteria based on which overhead costs will be allocated and apportioned:

i. Neutrality:

A cost allocation scheme is neutral if it does not interfere, after or in any way distort the decision making process. Any departure from the principle of neutrality is assumed to lead to economic inefficiency.

However, a neutral allocation scheme will lead to decisions that satisfy marginal optimality conditions. It thereby avoids distorting the decision making process. An allocation scheme which is neutral with respect to one decision may not be neutral for all other decisions.

ii. Ability to Bear:

Costs should be assigned to cost objects in proportion to their ability to bear those costs. Sales revenues, gross profits, total value of assets and total costs are examples of bases used to relate cost to cost objects. The presumption is that ‘larger’ cost objects can afford to bear larger share of overhead costs.

iii. Cause and Effect Relationship:

This criterion requires a meaningful casual relationship between the cost objects and the costs to be allocated. Here the basic principle is to allocate costs to those factors which cause the costs. For example, factory maintenance costs might be allocated among divisions in proportion to the hours of maintenance work performed in each division.

iv. Benefits Received:

This criterion is primarily concerned with allocating costs in proportion to the benefit received by each cost object. The premise is that cost objects should be charged for the amount of service they receive. For example, the costs of a power plant might be allocated in proportion to the consumption of power by the different departments or divisions.

v. Equity or Fairness:

It implies that the scheme should produce an allocation which is just and fair to all parties involved. Each party should bear an equitable share of the allocated costs.