Treatment of Administration Overheads: With Formula and Examples

In this article we will discuss about the treatment of overheads: 1. Administration Overhead 2. Selling and Distribution Overhead 3. Research and Development Expenses.

Administration Overhead:

The administration division of an organisation lays down policies and oversees the implementation of the policies. The main function of this division is planning and organising and control of various activities. This differentiates the administrative function from the other functions of the organisation namely manufacturing selling and distribution. The administration overheads constitute the costs incurred in formulating the policy, organising, directing and controlling the operations of an undertaking. The administration overhead is mostly in the nature of indirect costs.

Administration overhead is defined by the I.C.M.A., London, as “the cost of formulating the policy, directing the organisation and controlling the operations of an undertaking which is not related directly to production, selling, distribution, research or development activity or function”. Thus, the administration overhead is incurred in connection with management and administration of an enterprise. The administration costs are general in nature and the benefit goes to the firm as a whole.

The administration overhead is classified, subject to codification, and collected as done in the case of manufacturing overhead. The administrative overheads are collected under-standing order numbers or cost accounts numbers allocated and apportioned to departments on suitable basis. For effective control of administration overhead the amount of cost is departmentalised among general office, secretarial department, legal department, accounts department, personnel department, etc.

The nature of administrative overhead is such that for many of the items of administration overhead it is difficult to fix suitable norms. Moreover the amount of administrative overhead is such that for many of the items of administration overhead remains fixed regard less of volume of the production of sales. This is because the cost is incurred based upon the decisions of the management rather than activities of the concern.

The amount of overhead is generally small compared to manufacturing or selling and distribution overhead.

Treatment of Administration Overhead:

The administration overhead is accounted for by one of the following method:

(a) Write off to profit and loss account.

(b) Apportionment of Administration Overhead to Manufacturing Selling and Distribution Functions.

(c) Addition of Administration Overhead as a Separate Item of Cost.

(a) Writing off to Costing Profit and Loss Account:

The assumption of this method is that administration overheads have no direct relationship with manufacturing and selling activities of an undertaking. The items of administration overhead are fixed in nature and therefore called ‘period costs’. It is difficult to fix suitable bases for apportionment to cost units. They are to be transferred to costing profit and loss account as they are incurred for the whole organisation and are not related directly to production and sales.

This method is criticised for three reasons-

(a) Under-statement of cost of products as administration overheads are excluded,

(b) Effective control of costs is not possible as the cost is excluded from production and total cost,

(c) Accounting principle of charging full cost to output is not followed.

(b) Apportionment of Administration Overhead to Manufacturing Selling and Distribution Functions:

This method is based on the assumption that there are two main activities of an undertaking i.e., (1) Manufacturing (2) Selling and distribution. All the other activities are incidental. Therefore all the costs are to be identified with these two main functions. Thus, administration overhead is apportioned between production and selling and distribution functions.

The amount of administration overhead is debited to the administration overhead account and at the end of the period it is proportionately transferred to manufacturing overhead account and selling and distribution overhead account. The main limitation of this method is finding suitable bases for apportionment between manufacturing and selling overhead. Main criticism of this method is that the administration overhead loses its identity.

(c) Addition of Administration Overhead as a Separate Item of Cost:

Under this method the administration overhead is separately added to cost as is the case with production, selling and distribution overheads. Main argument in favour of this method is that administrative function is also equally important as production and selling and distribution. Therefore by following this method the administration overhead is added to works cost to arrive at cost of production. The bases followed are works cost, sales value, units produced and gross profit on sales or conversion cost, etc. Generally, works cost is the basis of absorption.

Control of Administration Overhead:

Administration overhead is a period cost and fixed in nature. The cost is incurred in accordance with management policy. The administration overhead is non-controllable. Some control of overhead is necessary to see that the amount does not grow disproportionately.

The following are the methods of control used:

Comparison with Previous Period:

The administration overhead incurred during the period are collected under various standing order number or cost account number and compared with amounts of previous period. This helps in analysing the reasons for the increase or decrease of items of cost over the previous period. If the amount has increased abnormally, suitable action is to be taken to prevent recurrence. Moreover it is helpful in deciding whether the benefit received by a department is more or less than the cost. If the cost is more than the benefit, the policy decision may be evolved to close the department.

Budgets:

Administrative overhead budget is prepared for different departments for a specific period. Actual figures are compared with budgets and differences are arrived at. The differences are enquired into and suitable action is taken.

Standards:

The standards are fixed for various items of administration overhead. The actual expenses are compared with standards set and the variances are calculated. The variances are analysed and suitable action is taken to remove them and effective control is enforced.

Selling and Distribution Overhead:

Intensive competition and large scale production has resulted in large amount of selling and distribution cost being incurred which makes it necessary for systematic analysis, accounting and control of these costs. Moreover selling and distribution costs constitute significant portion of total costs which makes it all the more necessary for enforcing effective control of these costs.

I.C.M.A., London has described the selling and distribution costs as below:

Marketing Cost:

The cost incurred in publicising and presenting to customers the products of the undertaking in suitably attractive forms and at acceptable prices together with the costs of all relevant research work, the securing of orders and usually delivery of goods to customers. In certain cases, after- sales services and/or order processing may also be included.

Selling Cost:

Marketing cost incurred for obtaining orders is the selling cost.

Publicity Cost:

Marketing cost incurred in publicity and advertising to assist the sales of products or services.

Distribution Cost:

The amount expended in warehousing of finished product and delivering it to customers. Selling overhead therefore is the cost incurred for creating and stimulating demand and obtaining orders.

Distribution ove^rhead is incurred in performing all the activities for warehousing of products and it includes delivery of products to customers.

Selling and distribution have no direct relationship with production. Therefore they are indirect costs and thus called overhead.

Selling overheads are different from manufacturing overhead due to the distinct features of selling and distribution overhead.

(1) The costs are directly linked with output sold.

(2) Same product may be sold in local and other distant markets.

(3) The overhead cost also varies with regard to various terms and conditions of sales.

(4) Selling costs may not be necessarily related to volume of sales.

Examples of Items of Selling and Distribution Overhead:

Salesman’s salaries

Salesmen’s commission

Salesmen’s travelling expenses

Sales department rent, lighting insurance

Sales related stationary

Sales office staff salaries

Advertisement

Sales promotion expenses

Packing expenses

Show room expenses

Warehouse rent

Warehouse keeper’s salary, and

Delivery vehicles’ depreciation and maintenance, etc.

Control of Selling and Distribution Overhead:

Since selling and distribution are not directly related to products, the control of selling and distribution is comparatively difficult. The incidence of the cost depends on terms of sales, marketing area and the extent of competition.

The difficulties in control of selling and distribution overhead are as follows:

(1) Control over customers and competitors is not possible.

(2) Sales capacity of the organisation is difficult to estimate.

(3) It is difficult to control sales staff who work in the field. To increase their efficiency additional remuneration is to be offered, which will increase the cost.

(4) It is difficult to obtain market related data.

(5) Market capacity cannot be easily ascertained.

(6) Some of the items of overhead are incurred on account of policy decisions of management which are uncontrollable at lower levels of management.

Techniques of Control of Selling and Distribution Overhead:

(1) Comparison with Previous Years’ Cost:

The items of selling and distribution costs are compared with past expenditure incurred. The cost may be expressed as percentage of sales or works cost and the comparison is made. The increase or decrease of cost over the previous years is revealed and suitable action may be recommended to prevent abnormal increase of overhead cost. This is a rough method and has no significant value in practice. This is followed only when budgets and standards are not used.

(2) Budgets:

Selling and distribution overheads are classified as fixed, variable and semi variable. Budgets are prepared and comparison with actuals is made periodically to reveal deviations, so that action is taken wherever it is warranted.

(3) Standard Costing:

This technique is used where the system is in operation. Standard costs are determined. Comparison with actuals is made and variances are ascertained accordingly to follow up with suitable action where necessary.

Absorption of Selling Overhead:

(1) Rate per Unit:

Under this method the total selling and distribution overhead is collected and divided by the units of sales. The result is rate per unit.

(2) A Percentage on Sales:

The selling and distribution overhead of preceding years is taken as bas s for absorption. The post expenditure incurred is ascertained as a percentage of sales and the same rate is applied on actual sales to recover selling and distribution overhead.

(3) A Percentage on Works Cost:

Under this method the past selling and distribution overhead is ascertained as percentage of works cost and the same rate is applied for the current year.

Research and Development Expenses:

With intensive competition and technological developments in the business world, research and development costs are to be incurred to keep up with others and go head along with new advancements. Research is of two type’s namely fundamental research and applied research. Fundamental research aims at increasing the general awareness of technicians while applied research is conducted to obtain specific technical knowledge.

The following are the objectives of specific research:

(1) Search for new applications of materials, new methods of production.

(2) Improving existing products and methods of production.

(3) Inventing new products.

Research and development cost has been defined by I.C.M.A., London as follows:

“Research cost is the cost of searching for new or improved products, new application of material or improved methods. Development cost is the cost of the process which begins with the implementation of the decision to produce a new product or improved product or to employ a new or improved method, and ends with the commencement of formal production of that product or by that method”.

Examples of research and development cost are the salaries of laboratory technicians, raw material used, depreciation on machinery and buildings used for research, their maintenance and repairs, cost of experimental production runs, patent fees, etc.

Treatment of Research and Development Cost:

Cost of Fundamental Research:

It does not aim at specific result and is a continuous process. Therefore expenses incurred are treated as manufacturing overhead of the period in which the cost is incurred. If the research work is not a continuous process the cost incurred may be recovered over a number of years depending on the volume of amount incurred.

Cost of Applied Research:

The specific costs incurred for improving the existing products and methods of production are treated as manufacturing overhead of that period. When specific amount is spent for particular products, it is to be absorbed by those products. If the expenses are incurred for new products or for new methods, the cost is to be collected for each type of product separately. If the research is a failure the cost-incurred is transferred to costing profit and loss account.

When the research is a success the cost is to be debited to development account. The research cost is added with development cost and the total cost is treated as deferred revenue expenditure and charged as revenue expenditure over a number of years. If the search for new method is for a particular product, it is charged directly to that product. If it is related to many products it is to be treated as manufacturing overhead.

Control of Research and Development Cost:

The costs are to be estimated as research and development costs and used as yard sticks to compare with actual cost and control accordingly. Each type of research is separated and suitably split into number of periods and the cost is estimated for these periods. This will be helpful in frequent review and effective control of cost.