OVERHEADS NOTES

Overheads are the indirect costs which cannot be allocated to any specific job or 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. CIMA defines Overheads Cost as “the total cost of indirect materials, indirect labour and indirect expenses”.

The direct expenses refers to expenses that are specifically incurred and charged for specific or particular job, process, service, cost unit or cost centre. These expenses are also called chargeable expenses. The sum of direct material, direct labour and direct expenses is called prime cost. Sometimes, if the direct expenses are negligible or small amount, it will be treated as overhead.

Direct 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, process, services, cost units or cost centres.

An expense is whether a direct expense or overhead depend on the extent of departmentalisation 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 specific job, then the hire charges will be direct charge to that particular job. Another example is that power consumption is normally treated as direct expense if it is consumed for single plant or machinery. But if number of machines consume 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.

18.2 CLASSIFICATIONS OF OVERHEAD COSTS

Overhead costs may be classified according to:

• Functions,
• Element and (c)

18.2.1 Classification According to Functions

The main groups of overheads on the basis of this classification are:

• Production overhead,
• Administration overhead,
• Selling overheads,
• Distribution overhead.

Production Overhead: Also termed as factory overhead, works overhead or manufacturing overhead, it means indirect expenditure incurred in connection with production operations. It is the aggregate of factory indirect material cost, indirect wages and indirect expenses. Unlike direct materials and direct labour, production overhead is an invisible part of the finished product. Examples of these costs are: lubricants, consumable stores, indirect wages, factory power and light, depreciation of plant and machinery.

Administration overhead: This consists of all expenses incurred in the direction, control and administration (including secretarial, accounting and financial control) of an undertaking which is not related directly to production, selling and distribution function. Examples are: general management salaries, audit fees, legal charges, postage and telephone, stationary and printing, office rent and rates, office lighting, and salaries of office staff etc.

Selling overhead: These are the cost of seeking to create and stimulate demand or for scoring orders. Examples are advertising, salaries and commission of sales personnel, showroom expenses, travelling expenses, bad debts, catalogues and price lists etc.

Distribution overhead: It comprises all expenditure incurred from the time product is completed in the factory until it reaches its destination or customer. It includes: packing cost, carriage outward, delivery van costs, warehousing costs, etc.

Both selling and distribution costs are incurred after the production work is over and thus taken together, these are known as’ After Production Costs’.

18.2.2 Classification According to Elements

The main classes under this head are: indirect materials, indirect wages, and indirect expenses.

18.2.3 Classification According to Behaviour

Different overhead costs behave in different ways when volume of production changes. On the basis of behaviour, overheads may be classified into: (a) Fixed overhead, (b) variable overhead, and (c) Semifixed or semi-variable overhead.

Fixed overhead: These overheads remain unaffected or fixed in total amount by fluctuations in volume of output. Examples are rent and rates, managerial salaries, building depreciation, legal expenses etc.

Variable overhead: This is the cost which, in aggregate, tends to vary in direct proportion to changes in the volume of output. Variable overhead per unit remain fixed. Examples are indirect materials, indirect labour, salesmen’s commission, power, light, fuel, etc.

Semi-variable overhead: This overhead is partly fixed and partly variable. In other words, such costs vary in part with the volume of production and in part they are constant, whatever be the volume of production. Examples: supervisory salaries, depreciation, repairs and maintenance, etc.

18.2.4 Importance of Classifying Costs into Fixed and Variable

The fixed-variable cost classification is of great importance in planning, decision making and control as discussed below:

1. Preparation of budgets: This classification helps in the preparation of budgets. For instance, when flexible budgets are prepared for different levels of activity, the fixed cost remains constant at all levels of activity, whereas variable cost varies according to the actual level of output.
2. Decision-making: As most problems of decision-making relate to changes in volume, this classification acquires a special importance in managerial decision-making. This is so because fixed and variable costs behave in different ways when volume of output changes.
3. Control of costs: From control point of view, cost may be controllable or uncontrollable. The fixed costs are mostly uncontrollable and if, at all, any control can be exercised, it can be done by the top management. Variable costs, on the other hand, are mostly controllable. For example, rent of building (fixed) is not easily controllable but cost of materials (variable) may be controlled by purchasing in economic lots, seasonal purchasing, etc. Classifying costs into fixed and variable, therefore, helps in the effective control of costs by painting out where management should concentrate to control costs.
4. Marginal costing and break-even analysis: This technique is totally depends on segregation of cost into fixed and variable.
5. Absorption of overhead: By classifying cost into fixed and variable, separate rates of absorption of overhead may be used for fixed and variable overheads. The under/over absorption arising out of two types of overheads are different in nature and need different managerial action. For example, under-absorption of fixed overhead means the existence of surplus or idle capacity so that suitable steps may be taken to effectively utilise idle capacity.
6. Other uses: In addition to points stated above, fixedvariable cost classification is useful in many other areas. For example, while planning capital expenditure, effect of the proposed project on total fixed and variable costs should be studied. Moreover, differential and comparative cost analyses are based on this classification.

18.3 ALLOCATION AND APPORTIONMENT OF FACTORY OVERHEADS

Departmentalisation of Overhead: Generally, in big business houses, several departments are involved in the manufacture of the product or in rendering a service. In such cases, factory overhead costs should be accumulated department-wise. Departmentalisation of factory overhead means dividing the company into segments called departments or cost centres where expenses are incurred. In a manufacturing concern, there are mainly two types of cost centresproducing departments and service departments. A production department represents a submit of the company where manufacturing activity takes place. Some typical examples of producing departments include assembly, finishing, blending, painting and grinding departments. Service departments represent cost centres which provide support for the producing departments. Materials handling, personnel, plant maintenance, imposition, storage, purchasing, receiving, shipping medical and other similar activities which are not directly involved in production are considered to be service activities.

No definite rules can be suggested which can be applicable to all concerns for departmentalisation. Most commonly, the factory is divided on the basis of functional activities with in each department which performs a single activity or group of activities. Dividing the factory into separate, inter-related and independently governed units is important for the proper control of factory overhead and the accurate costing of jobs and products. The following factors must be considered while deciding the kind of departments or cost centres to be created for factory overheads collections and cost control purposes:

1. Similarity of operations, processes and machinery.
2. Location of operations, process and machinery.
3. Responsibilities for production and costs incurrence.
4. Number of departments or cost centres.

Advantages: Departmentalisation serves two purposes: (i) closer control of factory overheads costs, and (ii) more accurate costing of jobs and products. Closer control is possible because departmentalisation makes the incurrence of costs in department or cost centre, the responsibility of someone who heads the department or the cost centre.

More accurate costing of jobs and products is possible, if products are passed through more than one department. A job or product going through a department is charged with factory overhead for work done on that product in that department. Therefore, jobs or products are charged with different amounts of factory overhead depending on the number of departments through which they pass. This process results in accurate and reliable cost figures for the products or job.

Primary distribution: Some factory overheads can be directly identified with a particular department or cost centre as having been incurred for that cost centre. Examples of such factory overheads are repairs and maintenance expenses incurred in specific departments, supervision, indirect labour, overtime, indirect materials and factory supplies, equipment depreciation.

Expenses such as power, light, rent, depreciating of factory building, expenses shared by all departments, cannot be charged directly to a department, be it producing or service. These expenses do not originate in any specific department. They are incurred for all and must, therefore, be apportioned or prorated to any or all departments using such items. Cost apportionment is the process of charging expenses in an equitable proportion to the various cost centres or departments. The Institute of Cost and Management Accountant (UK) defines cost apportionment, “as the allotment of proportions of items of cost to cost centres or cost units”. The apportionment should be done on some rational and equitable tasks. In cost accounting this is known as primary distribution of factory overhead.

It would be difficult to give a comprehensive list of the bases of apportionment, but the following bases are in common use:

1. Floor area occupied- Overheads such as lighting and heating, rent and rates, depreciation of building, building repairs, caretaking, watching and patrolling.
2. Capital values- Depreciation on plant and machinery, insurance on building, and plant and machinery, maintenance of plant and machinery.
3. Direct labour hours and/or machine hours- Insurance on jigs, tools and fixtures, power, works management remuneration, repairs and maintenance cost.
4. Number of workers employed- Canteen, accident insurance, medical, dental and first aid, pensions, personnel department expenses, profit sharing payments, recreation, supervision, time office, wages department.
5. Technical estimate- Fire prevention, oil and grease, steam, water without meter.

APPORTIONMENT OF SERVICE DEPARTMENTS OVERHEADS TO PRODUCING DEPARTMENTS 

Secondary Distribution: It is necessary that overhead cost of service departments (accumulated through direct allocation or primary distribution) should be further assigned to producing departments. This is due to the reason that service departments do not themselves manufacture anything and it is the production department or cost centres which are involved in manufacturing activities. The reassignment or reapportionment of service departments overhead to producing departments or centres is termed as secondary distribution.

Secondary distribution helps in determining the cost of products or jobs sold and value of inventory. It is useful in determining the effect of various managerial decisions and actions on the total cost of the business firm. For example, decisions as to add or to drop a product line require information about its cost effect, which can be estimated after secondary distribution has been made. Secondary distribution also helps subsequently in determining the price of the product or job. In case of contracts based on cost in place of market price, secondary distribution helps in fixing a selling price which is advantageous to the parties concerned.

Bases of Secondary Distribution: The general basis for apportioning service departments’ overheads to producing departments are the following:

1. Services rendered- This is perhaps the most popular method of apportioning service department. The services rendered to different departments, i.e., benefits obtained by them can be a suitable basis. If a producing department has received large benefits, it must be charged for a share of overheads costs incurred to provide that quantity of benefits. This method is simple and economical.
2. Ability to pay- This method suggests that a large share of servicing departments overhead costs should be assigned to those producing departments whose product contributes the most to the income of a business enterprise.
3. Surveyor analysis- This method is applied where a suitable base is difficult to find or it would be too costly to select a method which is considered suitable. For example, the postage cost could be apportioned on a survey of postage used during a year.
4. Efficiency or incentives- This method uses standards and budgets and apportions the overhead costs on the basis of a present budget or standard.

In selecting a suitable base for apportioning service department overheads, considerations should be given to practicability, simplicity, economy, theoretical soundness and assistance in accurate costing and cost control.

Inter-departmental Services: While depreciation service departments overheads, one may notice two situations: (i) The entire amount of a servicing department is to be distributed to only the producing departments. This does not involve any practical difficulty and provides the simplest and quickest method for apportioning costs of the servicing department (ii) Services provided by some servicing departments are used partly by other servicing department. That is, many service department serve each other. For example, the payroll department in a firm prepares payroll for the entire organisation, but it depends on the building maintenance department for repair and maintenance services.

         ABSORPTION OF FACTORY OVERHEADS

Absorption of factory overheads refers to charging of the factory overheads of a particular production department to various products manufactured, or jobs completed, or orders executed in that department. The methods for absorption of these overheads may be put into two categories:

• Percentage methods
• Hourly rate methods.

Choice of a particular method depends on the circumstances of each individual case. As such the method of absorption may differ from industry to industry, and from company to company also. As far as possible, the method applied should be equitable so that the absorbed overheads are not in much difference with the actual overheads. Otherwise it will lead to excessive under or over absorption, simply because of the adoption of a particular method.

Percentage methods

1. Direct material cost method: In this method the cost of direct materials used in the manufacture of a product is used as the basis for allocation of factory overheads. The overhead rate is therefore, calculated on the basis of the following formula:

 

This method may give satisfactory results in the following circumstances:

• Where the amount of overheads is insignificant in relation to cost of materials and wages and, therefore, a simple method of allocation is desired.
• Where output is uniform, i.e., one kind of article is produced.
• Where the prices of materials do not fluctuate quite widely and frequently.

The method will not give satisfactory results except in the above cases on account of the following reasons:

Except a few items, factory overheads do not vary with variations in the value of material. Normal wastage of materials or coal or other sundry small stores used in manufacture naturally varies with the value of materials used, otherwise other important items such as works manager’s salary, factory rent, rates, insurance, lighting etc

• This method will result in greater recovery of factory overheads from those cost units which use superior quality of materials in comparison to those which use materials of inferior quality. This seems very illogical because actually reverse should have been the case.
• This method does not make any distinction between jobs done by skilled and unskilled workers, because works overheads not only depend upon materials used but also on the type of workers employed. Similarly it does not distinguish between manual and machine work.

2. Direct labour cost method: The cost of direct labour incurred in the manufacture of the product is used as a base for allocation of factory overheads in this method. The formula for calculating the factory overhead rate based on labour can be put as follows:

 

Merits: This method has the following advantages:

1. Factory overheads to a great extent depend upon the number of workers employed and the rate of direct wages. This method, therefore, gives satisfactory results in most cases.
2. The method is widely adopted on account of its similarity and of accuracy.
3. Direct wages normally do not fluctuate much. Therefore, this method gives stable results.

Demerits: It has the following disadvantages:

1. The method is not suitable where both skilled and unskilled workers are employed. As a matter of fact the amount of works overheads is less for skilled workers in comparison to the unskilled workers and, therefore, jobs done by the unskilled workers should be charged with greater amount of factory overheads, but reverse happens in case of this method.
2. Works overheads also depend upon time. The method therefore, does not give satisfactory results where the workers are remunerated on piece wage system.
3. Prime cost method: The method considers both direct materials and direct labour for allocation of overheads. The formula for calculating the factory overhead rate, therefore, can be put as follows:

 

The method has the advantage of simplicity. However, it suffers the same drawbacks from which the first two methods suffer and, therefore, is rarely used.

The method can give satisfactory results where a standard article is produced, requiring a constant quantity of materials and number of hours engaged upto its manufacture.

Hourly rate methods

(i) Machine hour rate method: The machine hour rate method of allocation of factory overheads is used in those cases where the processes of manufacture are carried out by machines and there is very little or practically no manual labour. It is determined by dividing the overhead cost to be apportioned or absorbed by the number of machine hours expended or to be expended. The formula for calculating the overhead rate may be put as follows:

The method thus estimates the cost of running a machine for one hour and a job is debited with an amount of overheads equal to the number of hours for which the machine was used on that job multiplied by the hourly rate. The steps for computing the machine hour rate may be put as follows:

1. All factory overheads are departmentalised as discussed before. The overheads of the Service Department are also apportioned among all Production Departments.
2. Each Production Department is divided into suitable cost centres comprising groups of similar machines, and the total factory overheads are apportioned among the different cost centres suitably as discussed before.
3. Machine hour rate is to be calculated for each machine separately and, therefore, overheads of one machine cost centre will be apportioned among the different machines to find out the amount of overheads per machine.
4. The overheads thus calculated will be divided between (i) Fixed or Standing charges, (ii) variable or Machine expenses. Fixed charges are those which remain constant irrespective of the use of the machine, e.g., rent, insurance charges etc. Variable expenses such as power, depreciation etc. vary with the use of machine.
5. An hourly rate of fixed charges will be calculated by totalling them and dividing by the number of normal hours worked by the machine.
6. The total of the fixed charges rate and the machine expenses rate will give the Machine Hour rate.

BASIS FOR APPORTIONMENT OF DIFFERENT EXPENSES

Expenses	Basis
Standing Charges 1.              Rent and Rates	According to the floor area occupied by each machine including the surrounding space.
2.         Heating and lighting	The number of points used plus cost of special lighting or heating for any individual machine, alternatively according to floor area occupied by each machine.
3.         Supervision	Estimated time devoted by the supervisory staff to each machine.
4.       Lubricating oil and consumable stores	Capital          values,          machine        hours, or           past experience.
5.         Insurance	Insured value of each machine.
6.       Miscellaneous expenses	Equitable basis depending upon facts.

Labour hour rate method: According to this method, the overheads are charged to production on the basis of number of labour hours of work put forth on every job. The overhead rate is calculated by dividing the total works overheads for the shop or department for a given period by the total estimated direct labour hours for the same period.

Dual hour rate method: Where in a shop both manual labour and machines play an equally important roles overheads are classified into two categories:

• those which relate to manual work, such as proportionate charge for lighting and foreman’s salary, employee’s insurance premium etc.;
• those which relate to machines as depreciation, power, repairs, operator’s wages etc.

          DEPRECIATION

Depreciation is provided in cost accounts before working out the profitability of a job or cost unit. Depreciation is a gradual diminution, loss, or shrinkage in the utility of value of an asset due to wear and tear in use, affluxtion of time or obsolescence. Deprecation is the allocation of the depreciable amount of an asset over its estimated useful life.

The cost of a product consists of not only normal expenses like direct material, direct labour, factory cost etc. which involve in cash outgo but also non-cash like depreciation which does not involve in cash outgo.

CIMA defines depreciation as “the measure of wearing out, consumption or other loss of value of fixed asset whether arising from use, fluxion of time or obsolescence through technology and market changes.” Depreciation does not mean set money aside for the future replacement of assets. It is provided to match the use of asset, its deterioration and obsolescence with the income it generates.

Depreciation and Cash Flow: Depreciation is neither a source nor a use of funds. The use of funds obviously began when the fixed asset was purchased. It would be double counting to regard each year’s depreciation as a further use of funds. The relevant figure for profit from operation profit before charging depreciation. The quantum of operational funds flow cannot be influenced by the method of depreciation charged.

Depreciation and inflation: Depreciation should be provided irrespective of the increase in value of asset due to inflation. It is not appropriate to omit charging depreciation of a fixed asset on the grounds that its market value is greater than its net book value. If account is taken of such increased value by writing up the net book value of a fixed asset, then, an increased charge for depreciation will become necessary.

Methods of Depreciation

The following are the methods of depreciation

1. Straight line method: This method provides for depreciation by means of equal periodic charges over the life of the asset. For example, suppose the cost of a plant is Rs. 1,00,000 and its life is 10 years. Then the charge of depreciation per annum will be Rs. 10,000.
2. Diminishing balance method: This method tends to write-off higher amounts in the beginning and comparatively lower amounts in subsequent parts of the life of an asset. The amount of depreciation is calculated at a constant rate at the balance of the value of the asset after deducting the amounts of depreciation previously provided. For example, taking the above illustration, the amounts of depreciation at the rate of 10% p.a. would be Rs. 10,000 for the first year, Rs. 9,000 for the second year, Rs. 8,100 for the third year, and so on.
3. Production unit method: This method charges the amount of depreciation by means of fixed rate per unit of production calculated by dividing the value of the asset by the estimated number of units to be produced during its life. The formula for calculating depreciation under this method is as follows:
4. Annuity Method: This method assumes that the capital used in the purchase of plant should have earned interest if invested somewhere else. The amount of depreciation in this method is calculated by dividing the aggregate of the cost of the asset depreciated and interest at a given rate, at a constant rate, on the written doen value of the asset.
5. Sinking fund method: Under the annuity method, expected interest of the investment (equivalent to the cost of the asset) is assumed. However, no actual investment is made. But under the sinking fund method, the amount of depreciation written off every year is invested in some securities, which would accumulate at compound interest to provide, at the end of the life of the asset, a sum equal to its costs. This method provide for depreciation of fixed periodic charges.
6. Endowment policy method: This method is similar to the sinking fund method. It provides for depreciation by means of fixed periodic charges equivalent to the premium on an endowment policy for the amount required to provide, at the end of the life of the asset, a sum equal to its cost. The amount of depreciation is equivalent to the premium payable on the policy.
7. Production hour method: This method provides for depreciation by means of a fixed rate per hour of production by using the following formula:

Depreciation (per unit) = Cost of the asset

Estimated number of working hours of its life

8. Sum of digits method: Under this method depreciation is calculated by means of differing periodic rates computed according to the following formula: If it is the estimated life of the asset, the rate is calculated each period as a fraction in which the denominator is always the sum of the series 1,2,3, … n and the numerator for the first period is n, for the second n-1, and so on. In this method, depreciation is highest in the year of purchase and go on reducing in the subsequent accounting periods. This method is mainly used in assets like, furniture, electronic goods, automobile vehicles etc. In this method differing periodic rate are used.

18.7 PLANT REGISTER AND OTHER FIXED ASSETS REGISTER

A plant register is maintained keeping all details about the plant and machinery. It generally contains the following details:

• Description of each individual machine, identification number, original cost of the machine, name of supplier, date

of installation and commercial run, etc. Technical details like speed, fuel consumption, capacity, grade and quality of output etc.

• Details of the asset located in the factory. Details of estimated economic life, estimated output or production run hours during the economic life time, method of depreciation, estimated residual or scrap value etc.
• Details of capital allowances, balancing charges or other allowance.
• Details of major break-downs and maintenance.
• Details of additions and alterations.
• Details of disposal of asset.

A register is also maintained for other fixed assets like buildings, vehicles, furniture and fixtures etc. similar to that of plant register.

These registers will enable calculation of depreciation, book values etc. of each item and it will enable to allocate and apportion depreciation charges and other overhead costs like, repairs and maintenance, insurance etc.

18.8 USING ASSET AFTER FULLY DEPRECIATED

Sometime it will happen to continue in use of an asset after it is fully depreciated. The main reason for early recovery of depreciation is due to under estimation of economic life of the asset. In such situations it is usual to continue to charge depreciation so as to maintain cost comparability with previous accounting periods and current cost of the product will reflect the cost of using the asset. The excess depreciation so charged will either be kept in reserve against obsolescence or credited to Costing Profit and Loss Account. If before the asset is fully depreciated, its economic life is estimated to be further extended, then the balance depreciation will spread over to such enhanced period, and the problem of using asset after it is fully depreciated will not arise.

18.9 RESEARCH AND DEVELOPMENT COSTS AND ITS TREATMENT

The Research and Development expenditure is a deferred charge which is in the nature of non- recurring expenditures which are expected to be of financial benefit to several accounting periods of indeterminate total length. It is the expenditure incurred for searching a new product or improved product or new methods of production and improved technologies.

Research Costs are incurred for carrying basic research or applied research. But the development costs start with decision taken to produce new product or improved product and when the decision is taken to adopt new technologies and new production methods. The objective in carrying basic research is to improve the existing scientific and/or technical knowledge. But the applied research is carried for a purpose directed towards a specific practical aim or objective.

Treatment of Research Costs: The treatment of research costs is studied under two heads:

1.           Basic research costs (2) Applied research costs.
2. Basis Research Costs: These costs relate to all existing product, methods of operation, techniques of production and, therefore, the basic research costs should be treated as production overhead for the period during which it has been incurred and has to be absorbed into product costs.
3. Applied Research Costs: The applied research costs is classified into two for absorption purpose:

• If applied research costs relate to improvement of existing product and methods of production, it should be treated as manufacturing overhead for the period and has to be absorbed to the product cost.
• In case, applied research costs are incurred for searching new products or methods of production etc., then such costs are amortised to the product that is newly invented or new method of production adopted. The whole of such expenditure should not be absorbed in the year in which expenditure has been incurred but a part it should be carried over the expenditure which, though of revenue nature is spread over a number of years because its benefit is derived during those years.

When the applied research aimed at improvement of existing product or to invent a new product or development of new technology, and if the research works appears failure in getting the desired results, then such applied research expenditure is charged against profit in the Costing Profit and Loss Account of one or more years depending upon the size of expenditure incurred.

18.10 TREATMENT OF DEVELOPMENT COSTS

Development costs begin with the implementation of the decision to produce a new or improved product or to employ a new or improved method. The treatment of development costs is similar to that of treatment of applied research costs.

18.11 TREATMENT OF SPECIAL ITEMS OF OVERHEADS IN COST ACCOUNTS

Material handling expenses: These expenses are incurred while unloading the raw materials received from supplier, storing the raw materials, handling the raw materials to work place, handling of work- in-progress, storage of finished goods etc. It also includes costs incurred for weighing salaries of personnel involved in material handling, wear and tear of weighing equipment. These costs are apportioned on the basis of physical quantities of different materials and goods handled in the factory. The stores overhead costs are apportioned to raw materials and finished goods as a percentage of issue rates. Other handling expenses are recovered through overhead recovery rates.

Market research expenses: Market research cost is an item of selling overhead, incurred for market intelligence to ascertain the tastes and habits, market penetration of product, increase in demand of existing products, competitive situation, trading practices, distribution channels, customers requirements, existing and potential market for the product etc. If the market research expenses are incurred for a single product it is absorbed into that particular product cost. If it is incurred for the product range for the enterprise as a whole, then the market research expenses are to be apportioned to different products in the proportion of sales value and absorbed into respective product cost. If the market research cost is substantial, it will be deferred revenue expense and is taken into future period and absorbed when sales or production takes place.

Sometimes market research expenses are incurred for raw material availability, such expenses will be allocated or apportioned to purchase department and it is recovered through overhead rate of purchase department.

Subscriptions and donations

• If these expenses are incurred for the benefit of or welfare of workers, it is treated as production overhead.
• If subscriptions and donations for any technical and research institutions for obtaining data relating to technical, production scientific nature, it is considered as production overhead.
• If subscriptions to journals etc. for obtaining market data which help in increase of sales, it is considered as selling overhead.
• If the subscriptions and donations not incurred for the benefit of employees or the organisation, it should be excluded from the cost accounts.

After Sales Service Costs: The costs are incurred for providing service to the customers after the sales took place during the warranty period. If the costs are incurred during the period of guarantee given to the customer, it is to be borne by the company, and hence it is treated as production overhead absorbed into product cost by applying predetermined absorption rates.

If the after sales services cost are incurred after the guarantee period for which the organisation will charge for the services rendered, then costs are treated as selling overhead.

Royalties and patent fees: The royalties and patent fees are payable for the use of technology, skills, brand, intellectual property rights etc. made in the form of periodical rent or based on the number of units produced or sold. If it is based on sales, the expenditure is charged to selling overhead. If it is fixed periodical rent, it is treated as production overhead. If it is payable on number of units produced, the expenditure is treated as a direct expenses or chargeable expenses and is forming part of the prime cost of the product.

Training Costs: The training costs are incurred for training the workers, apprentices, office, administrative and selling staff. The training expenditure incurred for training the workers, apprentices and other production staff is treated as production overhead. The expenses incurred for training the sales staff is treated as selling overhead.

If there is any in house training college or centre, cost of running the centre or college is apportioned to the cost centres based on the number of personnel trained on the basis of wages and salaries paid etc.

Taxation: Taxation is an appropriation of profit earned by the organisation and any payment of taxes is excluded from the cost accounts. But the taxes will also be considered for planning and decision making exercises wherever it is necessary and appropriate for special purposes.

Financing charges for acquisition of fixed assets and Inventories: The finance charges like interest on working capital facilities from banks, interest on term loan for acquisition of fixed assets, interest on debentures etc. is payable by the company.

Where financing charges are payable to outsiders on borrowings for acquisition of fixed assets, these charges are included in cost of fixed assets. If the financing charges are payable for financing working capital then these charges are included in cost of inventories.

Interest on capital provided by the owners is excluded from cost accounts except for comparing or evaluating profitability of alternative investments.

If the charges are payable for storing the materials like timber, wine etc. the charges are included in the cost of materials store.

Costs of Tools: Tools are classified into large tools and small tools. The cost of large tools are capitalised like any other machine and depreciation is provided on it in each accounting period over its useful economic life.

The cost of small tools are treated in any of the following three method in cost accounts:

• Capitalisation method: Under this method the cost of small tools is capitalised and depreciation is recovered as production overhead. If the life of small tools is relatively small, this method is not suitable.
• Revaluation method: Under this method, the small tools are revalued at the end of each accounting year and the difference between original cost and the revalued cost is charged as production overhead.
• Write off method: Under this method, the cost centre drawing such tools is debited with the value thereof. Alternatively, the total cost of tools is accumulated and apportioned to various cost centres on suitable basis.

Bad Debts: When the company allow credit to its customers as part of its selling policy, some credit sale may turn bad due to default by the customers internationally or otherwise. As a safe guard, a part of such default amount treated as bad debt is recovered as a selling overhead and absorbed in product cost.

If the bad debt is abnormal in nature, the abnormal portion in excess of the standard normal portion should be excluded from cost accounts and transferred to Costing Profit and Loss Account.

Notional Rent: Notional rent is a cost included in the cost accounts so as to represent a benefit enjoyed by the organisation even though no actual cost is incurred for rent. The company owned premises does pay rent, but it is considered as notional charge in the cost of accounts for comparability of cost with different accounting period and with other organisations. This would reflect the accurate cost of cost centre or cost unit. It is a reasonable or nominal charge included in the cost accounts for the owned premises as if it is a rented premises.

Packing expenses: The packing is classified into (i) Primary Packing and (ii) Secondary packing.

The primary packing is done when the material is packed in tines, bottles, jars, etc., without which a product cannot be sold. For example, jam is packed in bottles, baby food packed in tin, beverages in bottles etc. The costs incurred on primary packing materials is treated as part of direct material cost.

If the packing is made to facilitate the transportation and distribution of the finished product, it is called secondary packing and the cost incurred for this is treated as distribution overhead.

Sometimes, cost is incurred on packing the product to make it more attractive to the customers to increase sales. This cost is treated as advertisement cost and is included in selling overhead.

Stores Overhead: The stores department in an organisation perform the function like receipt of material and stores items purchased, storing and issue of materials and stores items to different departments. The stores is considered as a separate cost centre and the store expenditure like rent of store, salaries and wages of stores personnel, freight, carriage inwards, insurance etc., are collected separately for the stores and will be apportioned to other cost centres.

The following bases are used in apportionment of stores overhead:

• Number of stores requisitions
• Value of material requisitioned
• Standard predetermined stores overhead absorption rate

Transport Cost: The classification of transport costs and their treatment in cost accounts is given below:

• The costs incurred to bring the materials to the production site is included in cost of materials.
• The costs incurred for bringing the plant and machinery, equipment etc., is added to the capital cost of respective asset and depreciation is recovered.
• The cost of despatch of finished goods is treated as distribution overhead.
• The costs incurred for internal movements within work are initially charged to specific cost centres and thereafter apportioned to different production and service centres on the basis of services rendered.

Insurance Cost: The treatment of insurances cost is categorised into the following:

• Insurance premium on storage-cum erection and commissioning is capitalised to the asset value.
• Premium on transit of materials is included in cost of materials.
• Premium on transit of finished products is treated as distribution overhead. Premium on loss of profit policy due to tire and break down of machinery is treated as production overhead.
• Premium on miscellaneous policies like vehicles, burglary, accident etc. are treated as administration overhead.
• Premium on raw materials and stores is treated as production overhead. Premium on warehouse and finished stock is treated as distribution overhead.

18.12 INTEREST ON CAPITAL

There is a difference of opinion as to whether interest on capital employed in manufacture should be treated as an item of cost. The following arguments are given in support of treating interest as an item of cost:

1. Interest is the reward of capital just as wages are the reward of labour. Profit, in the true sense, cannot be computed without considering interest.
2. The comparison of operations, different processes, etc.

without due consideration of the interest factor may lead to unreliable conclusions.

3. Interest considers time factors as it is computed on the basis of time and time is regarded as an important factor in production.
4. The inclusion of interest is of particular importance where articles of different values are produced and the capital invested in each product line differs considerably.
5. The cost of carrying inventory cannot be determined without giving due recognition to the interest on capital employed in it.

The following arguments are against including interest in the cost accounts:

1. Cost accounting considers only actual expenditures and can include only interest paid.
2. The interest factor is in no way connected with cost of manufacture. Whatever may be the method of raising finances-owned capital loans, debentures, etc. does not affect manufacturing cost. It only affects the profits of the period.
3. Inclusion of interest in product costing will inflate the values of inventory and work-in-progress and therefore will tend to increase the profit unreasonably.
4. Interest is calculated on capital and the term “capital” has many concepts such as total capital employed in business, equity capital and borrowed capital both.
5. A reliable and correct rate of interest is difficult to determine and is likely to be influenced by naked fluctuations.
6. The cost accounting and product costing systems get complicated unnecessarily by inclusion of interest on capital and financial statements also become misleading.

There is one point upon which opinion is not divided. If interest is to be considered at all, it must not be confined merely to such interest as may actually have been paid by the business. Therefore, if it is decided to exclude interest from the cost accounts, interest which has been paid, must also be ignored.

Of late, cost accounts in India tend to agree that interest on capital or funds borrowed from outside and paid or to be paid in cash should be included in product cost. This has been supported of the grounds that it implies cash outflow and affects the operating results of a business firm. The Bureau of Industrial Cost and Price in India includes actual interest on borrowed funds as an element of cost in cost price studies. However, the Bureau does not considered the notional type of interest on owned capital as an element of cost.

18.13 SELLING AND DISTRIBUTION OVERHEADS

Selling and distribution costs are usually incurred after the production of products or services is completed, and therefore, such costs are sometimes known as ‘After Production Costs’.

Selling cost is “the cost of seeking to create and stimulate demand (sometimes termed marketing) and of securing order”. These costs are thus incurred for increasing sales to the existing and potential customers. Examples and advertisement, samples and free gifts, showroom expenses etc.

Distribution cost is “the cost of sequence of operations which begins with making the packed product available for despatch and ends with making the re-conditioned retuned empty packages, if any, available for re-use”. Thus distribution costs are incurred in placing the articles in the possession of the customers. Examples are carriage outwards, insurance of goods-in-transit, maintenance of delivery vans, warehousing etc.

For costing purposes, selling costs and distribution costs are generally considered together although in some circumstances, it is desirable to deal with them separately.

Difference between selling overhead and distribution overhead: Selling overhead and distribution overhead differ in their nature and purpose. Selling overheads are incurred for promoting sales and securing orders while distribution overheads are mainly incurred in moving the goods from the company’s godown to customers’ place. The object of selling overhead is to solicit orders and to make efforts to find and retain customers. The object of distribution overhead is the safe delivery of the goods to the customers.

Special Features

Selling distribution overhead costs have certain peculiar features which have a bearing on the accounting and control of these costs. These features are:

• Unlike production costs, most of the selling and distribution costs cannot be identified with the units of products.
• Selling costs are incurred as a matter of policy of management.
• Selling costs are not always related to the volume of sales.
• The characteristics and attitude of the customers also affect the selling costs.
• The same product may be sold in near or distant market. This will affect cost of packing and transportation.
• Selling costs vary widely depending upon the degree of competition.

Accounting Treatment

The accounting procedure of selling and distribution cost is comprised of

1. Classification, collection and analysis of these expenses.
2. Apportionment and allocation to cost centres.
3. Absorption by products or product groups.

These three stages are discussed below:

1. Classification, collection and analysis: This is first step and is similar to classification and collection of production of overheads. Selling and distribution overheads may be classified on the basis of products, sales territories, channels of distribution, salesmen etc.

When classification of expenses is complete, expenses are collected under standing order numbers provided for this purpose.

2. Apportionment and allocation to cost centres: In this step, selling and distribution overheads are allocated or apportioned to various products, sales territories or other cost centres. Selling of the common basis used for distribution of selling and distribution overheads are:

	Expenses	Basis for distribution
1.	Remuneration of salesmen	Direct allocation
2.	Advertising	Direct allocation or value of sales or space used
3.	Catalogues	Direct allocation or space used
4.	Showroom expenses	Direct allocation or space used
5.	Packing	Direct allocation
6.	Collection of overdue accounts	No. of orders or sales value
7.	Insurance	Value of stocks
8.	Transport-outside carrier	Direct allocation
9.	Own transport	Drive allocation or Weight of product carried
10.	Warehousing	Cubic ft. of product stores X times (days)

• Absorption of selling and distribution overhead: Absorption of selling and distribution overheads means charging of these overheads to various product jobs or orders. Various methods for absorption of selling and distribution overhead are as follows:
• A rate per unit: This method is employed when the company is selling one uniform type of product. The total selling and distribution overheads to be absorbed are divided by the number of units sold to arrive at a rate per unit.

For example, a company is manufacturing only type of TV picture tube. During the month of May, its selling and distribution overhead amounted to Rs. 75,000 and during this period, the number of picture tubes sold is 1,000 the rate per unit for the absorption of selling and distribution overhead will be Rs. 75,000 – 1,000 = Rs. 75.

A percentage of selling price: This method is recommended when the concern is selling more than one type of product. A percentage of selling and distribution overheads of selling price is ascertained from an analysis of past records.

• A percentage of works cost: In this method, a percentage of selling overheads to works cost is ascertained. This percentage rate is applied for the absorption of selling and distribution overheads.

 

SUMMARY

Overheads constitute one of the important elements of cost of production. Overheads may be classified according to functions element and behaviour. In allocation of overheads, the entire amount is charged to a department. In case of apportionment of overhead only a proportionate amount is charged to a department. Though different basis are available for apportionment, it is essential to satisfy that the overhead is closely related to the basis selected. Absorption of factory overhead refers to charging of the factory overheads of a particular production department to various products manufactured or jobs completed or orders executed in that department. There are broadly two methods for absorption of factory overheads. The accounting procedure of selling and distribution cost consists of (a) classification, collection and analysis of expenses (b) apportionment and allocation to cost centres and (c) absorption by products or product groups.

18.15 KEYWORDS

Overhead: Overhead is the aggregate of indirect material cost, indirect labour cost and indirect expenses.

Allocation of overheads: It refers to identifying an item of overhead and the allotment of whole amount to one department or cost centre.

Apportionment of overheads: The process of charging proportionate amount of overheads to various department is known as apportionment of overheads.

Absorption of overheads: The process of charging the overheads from cost centre to cost units is known as absorption of overheads.

Machine hour rate: It refers to the overheads incurred for running a machine for one hour.

18.16 SELF ASSESSMENT QUESTIONS

1. What is meant by overhead expenses? Describe the steps that are necessary for the computation of the direct labour hour rate. In what respect is the direct labour hour rate method of absorbing overhead different from the percentage of direct wages method?
2. What are the requisites of a good method of absorption of factory overhead?
3. Describe the different bases on which factory expenses can be apportioned. Describe the merits and suitability of each of them.
4. Write a detailed critical note on the direct labour cost method of absorption of factory overheads.
5. What information is necessary to calculate a machine hour rate for overhead absorption? State the conditions in which the method is most effective.
6. Discuss the importance of machine hours as a basis for the absorption of factory overheads.
7. What do you understand by classification, allocation and apportionment in relation to overhead expenses? Explain fully.
8. What is meant by absorption of overhead? Discuss briefly the different methods for absorption of factory overheads?
9. Why do you consider departmentalisation of overheads necessary?
10. Discuss the methods of absorption of selling and distribution overheads.
11. How do you deal with the following in cost accounts:

• Advertising
• Research and development cost
• Bad debts
• Rent of factory buildings