OVERHEADS

Definition:
Expenditure which cannot be conveniently traced to or identified with any unit of production.
Example: Indirect Material, Indirect Labour, Other Indirect Expenses.

Classification of Overhead:
1) On the Basis of Function
i) Factory or Manufacturing Overhead
ii) Office & Administrative Overhead
iii) Selling & Distribution Overhead
iv) Research & Development Overhead

i) Factory or Manufacturing Expenses

a) Stores Overhead: Expenses connected with purchasing & handling of materials
b) Labour Overhead: Expenses connected with labour (indirect nature of expenses)
c) Factory Management Overhead: Expenses connected with administration of the
factory. E.g. Rent Depreciation of Machine, Foreman’s Salary, etc.

ii) Office & Administration Expenses

a) Office Expenses: Expenses incurred on routine office work. Eg. Printing Expenses
b) Administration Expenses: Expenses incurred on managerial personnel. E.g. Manager’s
salary

iii) Selling & Distribution Expenses

a) Selling Expenses: Expenses incurred for selling i.e. persuading customer. E.g. Fees to
directors for looking after sale, showroom expenses, entertainment expenses for
customers, etc.
b) Distribution Expenses: Expenses incurred in the course of distribution of customers.
E.g. Godown staff salary, rent of depot, insurance, packing cost, carriage outwards, etc.

Note: Same head of expense may be categorized under different overheads based on nature of
expenses made.
Example:
Salary of Clerk

Factory or Manufacturing Overhead: If concerned with work in factory.

Office & Administrative Overhead: If related to clerk’s work in general office.
Selling & Distribution Overhead: If clerk’s work in sales office.

2) On the Basis of Nature

i) Fixed or Constant Overhead
 ii) Variable Overhead
iii) Semi-variable Overhead

i) Fixed Overheads
➢ Expenses that do not charge with respect to the volume of activity.
➢ Such expenses remain the same during the period & from one period to another except
when they are deliberately changed.
➢ Example: Managerial Remuneration, Rent, Depreciation (time based).

ii) Variable Overheads

➢ Expenses that change with respect to the volume of activity.
➢ Example: Power Consumed, Consumable Stores, Depreciation (Production Units
Method).

iii) Semi Variable Overheads

➢ Expenses that do not change upto a fixed level and change thereon.
➢ OR; Expenses that change in the same direction as change in the level of activity but
not in the same proportion.
− Example: Delivery Van Expenses, Picnic Bus Expenses
− Semi variable expenses has two parts viz; fixed and variable.

Variable
Fixed
Amount
Semi-variable exp.

Output

FACTORY / MANUFACTURING EXPENSES

Process of Distribution of Overhead to Various Cost Centers

Step 1: Estimation and collection of manufacturing overheads.
Step 2: Cost Allocation
− Charging the Overhead / Expenses directly to the related cost center or department.
Example: Wages of engineering dept.
Step 3: Cost Apportionment
− Those expenses which cannot be directly charged / allocated to various departments /
cost centers are apportioned.
− Apportionment means the allotment of cost to cost center on the basis of certain
criteria.
− At this stage, all cost will be either allocated or apportioned.

Step 4: Re-apportionment
− After the overheads are distribution to production and service departments, the
overhead cost of service department is distributed over production department.
− Note: Service department means the department which directly do not take part in
production of goods but provide service to the production department.
− Example: boiler house, canteen, store, dispensary, etc.
At this stage, all factory overheads are collected under respective production department.

Step 5: Absorption
− Absorption means the recovery of overhead in its respective cost centre on the basis of
absorption rates.

Step 6: Treatment of Over & Under Absorption of Overhead

Basis of Apportionment of Various O/H Cost (Related to Step 3)

Overhead Basis of Apportionment
Rent Floor Area
Repair and maintenance of building Floor Area
Depreciation Asset value
Insurance Asset value
Supervision No. of workers
Power Horse power of machine
Gravities Direct labour/wages
Indirect material Direct material

Re-Apportionment of Service Department (Related to Step 4)

i) Direct Redistribution Method
ii) Step Method / Secondary distribution / Non-Reciprocal Method
iii) Reciprocal Method

i) Direct Re-distribution Method

➢ Service department cost is apportioned over production department only, ignoring the
service rendered by one service department to the other.
 ii) Step Method or Non-Reciprocal Method
➢ Distribute such service department that renders service to maximum number of other
service departments.
➢ Continue till cost of last service department is apportioned excluding previous one.

iii) Reciprocal Method

➢ This method is applicable in case of two or more service departments are rendering
service to each other in addition to rendering services to production department.
➢ Three Methods under Reciprocal Method are:
a) Simultaneous Equation Method
b) Repeated Distribution Method
c) Trial and Error Method

a) Simultaneous Equation Method

➢ Ascertain total cost of each service department and prepare simultaneous
equation.
➢ Re-distribute total service department cost to production department on the basis
of equations derived as above.

b) Repeated distribution method

➢ Service dept. costs are distributed to other service and production department on
agreed % of service provided & this process continues to be repeated, till figures
of service dept. are either exhausted or reduced to too small figure.

c) Trial and Error Method

➢ Apportion cost of first service department to other service department only at a
given % of service rendered.
➢ Repeat till apportionment is zero in the service department.
➢ Total Overhead of each service dept. = Overhead as per primary distribution of
service dept + Overhead apportioned in various steps.

Absorption (Related to Step 5)

➢ Absorption of overheads refers to charging of overheads to individual products or jobs.
➢ It is a process of distribution of overheads allotted to a particular department or cost centre
over the units produced.
➢ The absorption of overhead is done by applying overhead absorption rates.
➢ The overheads allocated or apportioned over different cost centres or cost units are again
absorbed into unit cost on some equitable basis.

Predetermined Overhead Rate

➢ Various items of Overhead expenses generally are not incurred uniformly throughout the
accounting period.
 ➢ It is necessary to absorb the overhead costs as soon as its manufacture is complete therefore,
an estimate of total amounts of annual overhead expenses must be made in advance.
➢ Old data or current estimated data is used for determining absorption base.

Blanket & Departmental Overhead Rates

Blanket Rate:
➢ Single overhead rate is used for absorption for the whole factory.
➢ It is suitable only in case:
i) Where only one major product is being produced
ii) Where several products are produced,
a) All products pass through all departments &
b) All products are processed on the same time duration in each department.

Departmental Rate:
➢ It refers to computation of different overhead rates for different cost centres in a factory.

Methods of Absorbing Overhead to Various Products or Jobs

1) Percentage of Direct Material & Prime Cost:
E.g. Direct Material Rs. 200,000
Direct Labour Rs. 100,000
Factory Overhead Rs. 90,000
% of FOH to DM = 45%
% of FOH prime cost = 30%
% of FOH to DL = 90%

Now, on a job if Material Cost is Rs. 10,000 & Direct Labour is Rs. 7,000, absorbing Factory
Overhead, the total cost is:
i) 17,000 + 45% x Rs. 10,000 = 21,500
ii) 17,000 + 30% x 17,000 = 22,100
iii) 17,000 + 90% x 7,000 = 23,300

2) Percentage of Direct Labour Cost:

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑
Recovery Rate = x 100%
𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟

3) Labour Hour Rate:

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑
Overhead Rate =𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟𝑠
E.g. Factory Overhead (Estimated) = Rs. 9,000
Labour Hours (Estimated) = 150,000
Overhead Absorption Rate = Rs. 0.60
 Therefore, If 795 direct LH are spent on job then, Rs. 477 will be absorbed as Factory
Overhead.

4) Machine Hour Rate (MHR)

➢ MHR is suitable for industries with high degree of mechanisation & automation.
➢ MHR is calculated for each machine or each group of identical machines.
Production O/H allotted & apportioned to a machine
➢ MHR for a machine = Budgeted machine hrs.

Statement Showing Computation of Machine Hour Rate

Per
Total per
Particulars Machine
Machine
Per Hour
A. Fixed Expenses / Standing Charges:
a. Rent, rates & taxes
b. Lighting xx
c. Salary of supervisor xx
d. Wages etc. of attendants xx
e. Wages etc. of mechanics xx
f. Lubricants, cotton waste, chemical, xx
etc. xx
g. Depreciation (time based) xx
h. Insurance xx
i. Departmental & General Overhead xx
j. Sundries shop supplies xx
k. Repair & maintenance xx . xxx

B. Variable Expenses: xx . xxx

a. Power
b. Depreciation (Machine hours run xxx . xxx .
basis)
C. Total cost (A+B) xxx
D. Productive Machine Hrs. xxx
E. Machine Hour Rate (C/D) xxx

Working Note:
i) Calculation of productive machine hours per machine
A. No. of working days (365 days) xx
B. No. of working hrs available per day xx
C. Total No. of working hrs (A x B) xx
D. Less: Hrs required for maintenance xx
E. Productive Machine Hrs xx
 (if set up time is assumed to be productive)
F. Less: Setting up time xx
(if assumed to be unproductive)
G. Productive machine hrs (E – F) xx

ii) Calculation of MH for calculation of cost of power

Case Use of machine hrs for calculating cost of power
a) Where power is consumed MH before making any adjustment for
in setting up. Setting up hrs.
b) Where power is not consumed MH after making adjustment for setting up hrs.
in setting up.

Over/Under Recovery of Overheads (Related to Step 6)

➢ Overheads are charged to different cost unit on the basis of predetermined overhead rate.
➢ In case the amounts of overheads recovered is more than actual overheads, there is said to be
“over absorption of overheads”. In a reverse case it is termed as “under absorption of
overheads”.

Treatment of Under/Over Absorption of overheads:

1) Carrying over of overheads
➢ Amount of under or over-absorbed overheads may be carried over to the next period in the
following cases:
❖ In case of business where output is affected by business cycles.
❖ In case of a new project, in the initial years the balance of one year may be transferred
to the next on the presumption that there will be more output in the next year which
will absorb more overhead.

2) Use of Supplementary Rate

➢ In case the actual & absorbed overhead are different and the difference is quite large, a
supplementary rate is used.
Amount of over or under absorbed Overhead
Supplementary Rate = Actual Base

3) Transfer to Costing Profit or Loss Account

➢ This method is used in case the difference between actual or absorbed overhead is not very
large or difference is due to abnormal circumstances.
Capacity Related Concepts
1. Rated Capacity
− Installed capacity or maximum capacity as indicated by manufacturer.
− Due to loss of operating time of a plant, it is difficult to achieve.
− Theoretical capacity.
2. Practical Capacity
− Operating capacity.
− Actually utilized capacity of a plant.
− Base for determining Overhead rates.
− Considered after taking loss of time into account.
− Practical Capacity = Maximum capacity – Normal capacity

3. Normal Capacity
− Considering average utilisation of plant capacity over a business cycle (which may extend
2 to 3 years), average capacity is calculated.

4. Capacity Based on Sales Expectancy

− Capacity based on expected sales of the forthcoming period.

5. Actual Capacity
− Capacity actually achieved during a given period.

6. Idle Capacity
− It is that part of the capacity of a plant machine or equipment which can not be effectively
utilized in production.
− Idle Capacity = Practical or Normal Capacity – Actual Capacity