Unit IV
Overheads
Overhead Functional Classification:
When you classify overhead costs by referring to the key activity categories involved, it is called the functional classification of overhead costs. This classification is necessary to separate the costs of each of the key functional departments involved and to establish separate methods for accounting and managing the diverse nature of the costs of each department.
- Production overhead
This is also known as manufacturing overhead, work overhead, and factory overhead. All overheads incurred on the factory premises in connection with the production of goods and services are treated as production overheads. Factory rents, fees, lighting, heating, idle wages, factories, buildings, depreciation of factories and machinery, cafeteria costs, etc. are examples of production overhead. Works overheads or manufacturing overheads refer to indirect factory-related costs that are incurred when a product is manufactured. They consist of :
RENT AND INSURANCE OF FACTORY BUILDING
Insurance of plant and machinery, stock of material
Municipal taxes for factory building
Welfare expenses at factory
Experimental and resarch work, designing for production, drawing office expenses
Power & fuel
Lighting and heating of factory
Carriage inwards, if not included in cost of material
Work's telephone expenses
Salary of works manager and other principal officers at factory
Holiday and sick leave pay
Salary of store keeper
Contribution to social security schemes like esic
Contribution to pf of factory employees
Overtime wages
Consumable stores like lubricating oil, cotton waste, etc.
Stationery used in factory
Some factory overheads have been discussed in detail as follows:
1. Depreciation
Depreciation means a decrease in the value of a fixed asset as a result of the use of the fixed asset and / or wear over time. In costing, you need to record depreciation to find the true cost of a manufactured product.
There are several ways to claim depreciation:
--Fixed installment method A method of billing a fixed amount of depreciation expense calculated using the initial cost, scrap price, and expected useful life every year.
--Machine time rate method that estimates the useful life of an asset in hours. The rest is the same as the previous method. Calculate the depreciation amount by dividing the original cost minus the scrap value by the useful life of the asset.
--The depreciation method charges depreciation every year at a fixed rate for depreciation depreciation (that is, depreciation deducted).
Compared to the above method, the depreciation method charges more depreciation in the first year.
--The revaluation method calculates depreciation by comparing the value of an asset at the beginning and end of the year. It is usually used for livestock, loose tools, etc.
--The exchange cost method charges the exchange price of an asset at a fixed rate for depreciation, provides the market value of the asset at the end of its useful life, and takes into account the current production cost.
Note: Even if the asset is in good working order, if the asset's depreciation value no longer exists, it is recommended that you record a reasonable amount of depreciation in your cost account. This expense should be transferred to the costing profit and loss account like any other out-of-pocket profit. Or loss. In addition, if a machine is scrapped before its useful life due to premature obsolescence, the difference between the book value and the realized value at the time of sale is considered an extraordinary loss and will be transferred to the costing income statement.
2. Cost of defective work
Defects are said to be normal if they are unique to the nature of the manufacturing process. For normal defects, the cost of fixing them should be spread across the output. That is, it is included in the manufacturing cost. If the number of defective products exceeds the normal limit or there are abnormal defective products, the correction cost is transferred directly to the profit and loss account of costing.
3. Provisions regarding disobedience
An entity may assume that the commercial life of a plant or machine may be shorter than the estimated useful life used to calculate depreciation. In such cases, this allowance is treated as additional depreciation and is included in the factory overhead. If it's just a precautionary measure, it's a disposal of profits and should be excluded from costing.
4. Machine removal and / or removal costs
Such costs are neither recurring costs nor the usual characteristics of labor. Therefore, these cannot be treated as manufacturing costs.
The cost of installing or constructing a new machine is capitalized and absorbed into production costs through depreciation. In the case of dismantling and re-installing the machine due to a change of location, these costs may be treated as overheads.
If the machine is permanently dismantled before its useful life due to inadequacy or redundancy to accommodate new assets, the difference between the acquisition price and the depreciation amount must be treated as anomalous loss. There is. After deducting the realized amount from the sale of the machine, this loss will be billed in the same year or will be distributed over the useful life of the machine.
If such costs are incurred in cases other than those listed above, the costs should be debited on the costing income statement.
5. Experimental cost
If a company incurs experimental costs for a particular job or order, they should be billed directly for that job or order, and if the same thing happens throughout the organization, it will be overhead for the work should be added.
6. Factory construction rent
If the factory building is owned by the company, financial accounting does not record some amount as rent in the expense account and should include reasonable costs in the overhead costs to facilitate comparison.
7. Idle facility / capacity
First, it is important to understand the difference between idle facilities and idle capacity. The former refers to idle plants, machines, or services, the latter actually or effectively for production purposes due to unavoidable reasons such as lack of demand, availability of resources, or availability. Refers to some of the capacity of an unused plant or equipment. Avoidable false plans.
Idle facilities and installed capacity do not reduce the burden of fixed costs such as rent and insurance. You can handle such costs as follows:
a) If the plant downtime is unavoidable, these costs must be included in the construction overhead and added to the capacity used using supplementary charges.
b) If the facility is not being used for unusual reasons, such as a trade recession, the resulting costs should be included in the costing of the income statement.
c) If the reason is avoided, such costs should be recorded in the costing income statement.
8. Interest in capital
The treatment of interest on capital in costing is a controversial issue.
Claims in favor of including interest in costs:
(a) Interest rate costs are similar to wage costs. Wages are paid for the use of labor and interest is paid for the use of capital. Therefore, both wages and interest must be included in production costs when determining total costs.
(b) If interest is not taken into account, cost comparisons can be misleading. For example, a timber merchant buys standing timber, waits a few years before he can seasonally adjust the timber himself, use or sell it, and then another merchant buys his own already seasoned timber, It may be ready for use or sale. The second merchant pays a much higher amount price. For the purpose of cost comparison, the former merchant needs to add interest on the waiting period.
(c) It is not possible to compare the benefits of different jobs that require different capital or require different completion periods without interest. For example, job 1 is 3 months and Rs. 10,000 capital yield Rs. Job 2 requires Rs, but a profit of 1500. With a capital of 25,000 he will complete in 4 months. Yielding Rs. 2000 profit. If you impose an interest rate of 12%, the profit on your first job will be reduced to Rs. 1200 and Rs. 1250 in the second job. This facilitates a better comparison.
Replacement of existing machines with new ones are not appropriate without due consideration of profits.
(e) The cost comparison of products with substantial value differences is inappropriate without interest, as the amount of capital required for each product varies significantly.
(f) For stocks that fluctuate significantly, it is important to include interest as the amount of capital required to maintain them varies.
(g) When submitting a bid or estimating a price, you must give due consideration to the monetary interest required to undertake the job.
Counterargument to the inclusion of interest in costs:
(a) Interest payments are a matter of internal funding as they are purely dependent on the company's financial policies. The company may work primarily with the owner's capital or have more borrowed capital. The amount of interest varies from case to case and the inclusion of such interest can lead to erroneous results.
(b) It is difficult to determine the amount of capital for which interest is calculated. According to some people, working capital fluctuates, so interest should only be accrued on fixed capital. The process can be very tedious if you need to allocate interest to different departments.
(c) Determining the right interest rate is also difficult and depends on many factors such as risk, maturity, bank interest rates, industry and job nature.
(d) Allowing interest on non-borrowed capital will increase production costs and lead to overvaluation of inventories. However, you can maintain a provision for unrealized profits.
(e) It is not advisable to include interest if the turnover rate is high and the cost of each unit produced is low.
Conclusion: It is theoretically sound to include interest, but given the actual difficulties involved, interest should be excluded from the costing record, even if it was actually paid.
However, capital interests must be taken into account when making business decisions.
9 Research& Development expenses
"Research costs are the cost of finding improved or new products, materials and methods of application. Development costs are the cost of producing new or improved products or adopting new or improved methods. The cost of a process that begins with the implementation of a decision and ends with the formal production of the product or method. βDefined by CIMA in London.
There are two types of research, basic research or basic research and applied research.
--Basic research is conducted to investigate the possibility of technological development and improve the accumulation of basic knowledge of technological process know-how. The purpose is to improve the knowledge of engineers. The cost of basic research is inherently repetitive. The cost of such basic research is treated as manufacturing overhead.
--Applied research is about the application of basic research knowledge for the introduction or improvement of products, production methods or technologies.
Development costs may be billed as revenue expenditures during the period in which a particular product is incurred. If the costs are high, they can generally be billed as deferred revenue expenditures for a period not exceeding three years. If the product is abandoned at a later stage, the undepreciated balance may be charged to the costing income statement.
10. Pre-manufacturing costs
These costs are incurred when running the prototype before formal production. It usually occurs when a new product line is introduced or when a new factory is in the process of being set up. Such costs expense and charged for future production costs (excluding those capitalized).
11. Royalty and patent fees
Royalty and patent fees must be included in the cost. If it is based on production volume, it will be part of the manufacturing cost as a direct cost, and if it is based on sales, it will be part of the selling cost. This also applies to sales tax.
12. Maintenance and repair
Maintenance and repair costs are easy to find if done by an outside company, but in many cases large manufacturers have their own repair and maintenance departments. In order to confirm the amount in such a case, it is necessary to open an account individually with the identification number of the series called "service order" for each repair work undertaken.
The work manager sanctions the repair and then costs it. Factory costs include material costs, labor costs, and proportional costs of factory costs. You can also charge different departments for repair and maintenance equipment, depending on the uptime of the machine.
13. Fuel and power
If you purchase electricity from the outside, you can easily know the total charge of power consumption. However, for companies with their own power plants, a fair share of the material costs used, the wages working at the power plants, other direct costs, and other indirect costs such as general factory management and stores, is the factory's. "Fuel and power" as expenses. Such costs should be allocated to the production sector according to the horsepower of the installed machine.
14. Tool cost
The tool can be small or large. The cost of large tools is generally capitalized and the appropriate depreciation costs are capitalized as factory overhead. Small tools are machinery and equipment used in the workplace. The cost of small tools is usually charged to all departments based on the actual problem. If you can capitalize a small tool and see its useful life, or if you can use the depreciation revaluation method to find out the amount of depreciation that will be recorded as factory overhead, then that depreciation expense Can be accounted for. However, this rationale is less desirable.
15. Insurance
Insurance treatment varies from case to case.
a) Insurance for plants and machinery, buildings and equipment should be allocated to specific departments or cost centers as overhead items.
b) Warehouse inventory insurance costs are treated as logistics expenses.
c) Insurance premiums at the time of purchase may be added to the price of the purchased raw material or asset.
d) Insurance costs for raw material inventories are recorded in manufacturing overhead.
e) Insurance premiums paid to protect against robbery are treated as administrative overhead.
f) Premiums paid to fixed assets should be allocated directly. Otherwise, it may be distributed based on number, area, value, or volume.
g) Accident insurance costs should be allocated based on total wages, with appropriate weighting to more accident-prone cost centers.
16. Incentives for indirect workers
Direct workers are given incentives for better efficiency and performance. Similarly, indirect workers, that is, workers who are not directly involved in the production process, need to be provided with appropriate financial incentives. This indirect worker compensation is considered under factory overhead.
17. Business trip support
The costs of vacation travel assistance provided to direct workers are billed as direct labor costs, while those provided to indirect workers are in some cases charged to factory, office and administrative or sales and distribution overheads.
18. Shipping and shipping costs
Such costs are incurred in the process of moving materials and goods from one location to another. Their treatment can be explained as follows.
a) If certain raw materials occur specifically, they should be treated as direct charges. However, if it is not convenient to identify a particular raw material, it will be charged as overhead overhead.
b) If incurred due to indirect materials, they will be charged as overhead overhead.
c) If it occurs in the delivery of finished products, they will be treated as delivery overhead.
d) If they occur in unusual circumstances, they will be charged to the costing income statement.
19. Annual bonus
The amount of bonus payments under legal provisions is considered to be the manufacturing cost and will be charged to the costing income statement if the company voluntarily pays.
20. Benefits
Fringe benefits are paid in addition to regular wages and other benefits to increase employee morale, loyalty and stability. Such costs cannot be assigned directly to cost units.
However, it may be assigned to the specific department or cost center where the employee works. If the cost of the supplementary benefit is substantial, direct workers will have to charge the production as a supplementary wage rate. Otherwise, they are taken as part of the expenses.
2.Β Β Β Β Β Β Β Management or Administration Overhead
Management and administration overheads refer to costs relating to formulating the policy, directing the organization and controlling operations. They consist
Administrative and administrative expenses are detailed as follows:
1. Audit fee
Fees paid to statutory or internal auditors are included in administrative and administrative expenses. Expenses incurred are also recorded as expenses.
The fluctuation range of office costs is much smaller than the fluctuation range of construction costs. After careful consideration of known or expected changes, you can easily make an estimate based on last year's income statement.
2. Financing fee for acquisition of fixed assets
Interest on loans, corporate bonds, etc. paid for the acquisition of fixed assets are called financial fees. These costs are purely financial in nature and can be excluded from costing. The company can also decide to include them as part of the cost. If these costs are incurred to purchase materials for long-term storage such as seasonings, the costs will be recorded as material costs. The assumed interest on the owned capital and the actual interest on the borrowed funds are recorded as administrative and administrative expenses.
3. Nominated salary supervised by the employer
Cost accounts record both actual and assumed costs. Estimated salary is the amount that would be paid to another person if the owner himself did not work for the organization. This estimated salary must be included in administrative and administrative expenses.
3.Β Β Β Β Β Β Sales and distribution expenses
Sales overhead includes promotional and customer retention costs, while distribution overhead begins with the ability to ship the packaged product and recalibrates the returned empty package. The cost of the process that ends with making it reusable. They consist of:
Sales and distribution expenses are described in detail as follows:
1. Catalog and price list
The cost of printing the catalog and price list must be transferred to another account and billed equally during the period of use.
2. Bad debt
Credit selling essentially results in some bad debt. Expected bad debt to some extent is included in sales overhead. If the amount is unusual and significantly higher, it should be amortized to the costing P & L account.
3. Regular exhibition fee
Such costs are treated as sales expenses, and if the profits arising from such costs span the period between the two exhibitions, they are treated as deferred revenue expenditures and distributed over the expected lifetime of the profits. Should be done.
4. Market research
The cost of market research conducted on a particular product is included in the cost of that product and is treated as an annual deferred revenue expenditure that is expected to generate that profit. If costs are incurred to investigate market conditions and identify market potential, they should be allocated to different products based on sales.
5. Packing cost
Direct material costs include the cost of containers for which the product cannot be sold. For example, perfumes cannot be sold without bottles. If attractive packaging is in place, they will be treated as advertisements and will therefore be included in sales expenses.
6. Discounts and rebates
Discounts include transaction discounts or cash discounts. In some cases, cash discounts of a purely financial nature are excluded from costing, but trade discounts are deducted from the cost of purchase or sale. Rebates are usually offered for early payments and are therefore included in the cash discount.
7. Subscriptions and donations
Donations usually refer to charities, but subscriptions are usually made to a welfare system or facility. For welfare institutions where employees benefit, subscriptions are treated as overhead costs, while subscriptions or subscriptions to commercial institutions that help find prospects' financial position are treated as sales overheads.
8. Post-sale service costs
These costs must be charged to various products based on the sales achieved.
Key takeaways:
- When you classify overhead costs by referring to the key activity categories involved, it is called the functional classification of overhead costs.
- All overheads incurred on the factory premises in connection with the production of goods and services are treated as production overheads.
- Depreciation means a decrease in the value of a fixed asset as a result of the use of the fixed asset and / or wear over time.
- The former refers to idle plants, machines, or services, the latter actually or effectively for production purposes due to unavoidable reasons such as lack of demand, availability of resources, or availability.
- "Research costs are the cost of finding improved or new products, materials and methods of application.
- Direct workers are given incentives for better efficiency and performance.
- Management and administration overheads refer to costs relating to formulating the policy, directing the organisation and controlling operations.
Office rent, rates
Classification of spending behavior:
This overhead is categorized based on trends that change with production / sales volume or activity level. Some costs change directly to increase or decrease in output, others remain constant as the level of activity of interest changes, others remain constant only up to a certain level, and then. , What fluctuates by changing its properties, which depends on the amount of output, but is not proportional.
Based on this behavior, costs are categorized as follows:
(a) Fixed overhead,
(b)Variable overhead,
(c) Semi-variable or semi-fixed overhead.
This classification is not absolute, but for convenience. All costs fluctuate over the long term. This classification is important for cost control and decision making.
(a) Fixed cost:
Fixed overhead costs (also known as term costs and policy costs) are costs incurred over time and tend to be unaffected by fluctuations in activity levels within a certain range. These costs are fixed in total as the output or production activity increases or decreases over a period of time. Fixed overhead per unit decreases as production increases and increases as production decreases.
Examples of fixed costs are building rent, storage space, factory and machine depreciation, building depreciation, space salary and allowance, factory and machine depreciation, building depreciation. , Officers, managers' salaries and allowances, secretaries, accountants, etc., office expenses, stationery and postage, banking fees, litigation costs, work manager salaries, capital interest, costs.
Fixed overhead costs are not always completely fixed in nature.
If concerns increase its capacity, additional equipment and buildings will need to be introduced and more staff will need to be appointed to meet the changed production requirements. As a result, fixed costs are high.
Fixed overhead is constant only within plant capacity limits, and obvious changes in plant capacity affect fixed overhead. The definition that fixed overhead is constant regardless of activity level changes applies only in the short term when there is no apparent change in capacity.
Fixed overhead costs must be incurred during a specific period of time, regardless of changes in production. Therefore, fixed overhead is a period cost that represents a fixed amount of spending during a particular period. In some cases, it is also called the shutdown or standby cost.
Fixed overhead costs are constant in total during the accounting period, but fluctuate per unit as production volume changes. Fixed overhead per unit decreases as production increases as the same amount is distributed to more units. On the other hand, it increases if production capacity remains unused or if production declines due to production inefficiencies.
Fixed overhead costs fall into the uncontrollable cost category from a business management perspective, as there is little room for management action to reduce spending once certain equipment is installed. However, to minimize fixed costs per unit, it is desirable to make the most effective use of plant capacity.
(b) Variable overhead:
This is a cost that tends to follow the level of activity (in the short term). Variable overhead costs fluctuate in total in direct proportion to production. These costs per unit are relatively constant as production changes. In this way, variable costs fluctuate in direct proportion to total production, but tend to remain constant per unit even if production activity changes. Examples include indirect materials, indirect labor, corruption, tools, defective work losses, lubricants, idle time, lighting and heating costs, and sales commissions.
Fluctuating overhead rarely reveals the hallmark of complete volatility: spending that directly changes to fluctuations in production. They tend to change simply, rather than in direct proportion to the output.
In practice, you come across three types of variable overhead:
(i) 100% variable cost. For all productions, variable spending per unit of production is constant.
(ii) The cost per unit of production decreases as the production volume decreases, but gradually increases as the production volume increases.
(iii) The cost per production unit increases as the production volume decreases, but gradually decreases as the production volume increases.
c. Semi-variable costs (also known as mixed or semi-fixed costs) are costs that include both fixed and variable factors and are therefore partially affected by fluctuations in activity levels. These costs are partly fixed and partly variable. For example, telephone charges include a fixed portion of the annual charge and variable charges depending on the call, so the total telephone charges are semi-variable.
Similarly, if a salesperson is eligible to receive a fixed salary and a commission that exceeds a certain amount of sales, the salesperson's compensation is semi-variable overhead, the fixed element is constant at all levels, and the variable element is specified. Works after the level being done. Achieved sales.
There are two types of semi-variable overhead he follows:
(a) The first type shows the semi-variable cost in which the variable elements operate at all levels, as shown in the graph below.
(i) Semi-variable costs:
Variable elements work at all levels.
(b) The second type shows the semi-variable cost in which the variable factor works after a certain level of activity, as shown in the graph above.
(ii) Semi-variable cost:
The variable element works after a certain range.
Step cost:
These costs are progressively increasing costs. These remain constant in various small ranges of output, but the activity increases in discontinuous amounts as he moves from one range to the next. Examples include wages for employees in the employee cafeteria and salaries for supervisors.
Determining cost variability:
Separating semi-variable overhead into fixed and variable overhead is critical to accurate cost confirmation, cost control, and decision making.
You can use the following methods for this purpose:
(i) Graphical display method:
This method creates a scatter plot by plotting the volume (percentage of activity, hours worked, unit of product or machine time) on the X-axis and the cost corresponding to the Y-axis. The optimal line is drawn between these plotted points so that there are the same number of points on either side of the line at approximately equal distances.
Points far behind the line are unstable and are not considered for this purpose. This is the total cost line and extends along the Y axis. At this point, a line parallel to the X-axis is drawn to represent the fixed cost line. Any level of variable cost can be obtained by measuring the difference between the fixed and total cost lines.
Illustration 1:
Following figures have been extracted from the books of a manufacturing company:
Plot the above information on the graph to enable you to ascertain the fixed overhead of the company assuming that the cost-volume-profit relationship has been maintained throughout these months.
Solution:
Ii) Least squares method:
This is the best way to divide quasi-variable costs into fixed and variable elements. This is a statistical method and is based on finding the best line for many observations. This method uses a linear equation of the form y = mx + c, and you can enter different valuesΒ Β in the equation to get the best line. Where c = fixed cost, m = variable cost per unit, x = independent variable (output), y = dependent variable (total cost). Solving the equation gives the valuesΒ Β of m and c that help determine the relationship between fixed and variable costs.
This method calculates the average output and cost. Then calculate the deviation from the average volume of the volume for each period and the deviation from the average cost of the cost for each period as x and y, respectively. The regression line is y divided by x, that is, the slope of the variable method, which can be calculated by dividing x2 by xy. Variable overhead with xy / x2, and therefore fixed overhead, is calculated. This is illustrated below on the basis of data given in Illustration 1.
The method of least squares gives the most accurate results though the calculations are a little complicated.
(iii) High and low points methods:
In this method, the output at two different levels, high or low, is compared to the amount of cost incurred during these different periods. Since fixed overhead costs are fixed, the ratio of variable overhead costs is the change in cost divided by the change in output level.
This method is very easy, but you may not get accurate results. You can calculate variable and fixed costs by taking the highest and lowest points from the data. Similar results can be obtained by arranging the data in ascending and descending order and comparing any set of two consecutive numbers.
Illustration 2:
Following data has been extracted from the records of a manufacturing company whose operations are varying from month to month.
(iv) Analysis method
In this way, from past experience, costing personnel empirically determine what percentage of semi-variable costs is variable and what is fixed. The degree of volatility varies depending on the item of quasi-variable cost. For example, if 60% of the Rs 6,000 quasi-variable costs are variable, then Rs 3,600 is variable and the remaining Rs 2,400 is fixed. This is an easy method, but there is a problem in estimating the degree of cost fluctuation.
Inflation adjustment:
With all the above methods, prices are at a certain level and cost movements are assumed to be caused solely by volume changes. In order to separate semi-variable costs into fixed and variable factors, it is desirable to eliminate the effects of price level changes by expressing costs for different periods at the price level of the base period.
Illustration 3:
Following details are available from the records of a manufacturing company.
Need to classify overhead costs into fixed and variable costs:
The need (or advantage) to classify overhead costs into fixed and variable costs arises for the following reasons:
(Π°) Fixed selling price:
This distinction helps determine the pricing policy for your concerns. In some cases, the same product may be priced differently in different markets to accommodate different levels of competition. However, the minimum selling price of a product in any market must at least cover prime costs and variable overhead costs. The corresponding fixed overhead may or may not recover if it is not practical to recover. Such fixed overhead can be recovered from sales in a more favourable market.
If the selling price in the market does not cover the variable overhead, it is better not to sell the item in that market. Similarly, during a trade recession, if the selling price is above the variable cost, it is beneficial for the manufacturer to sell the goods at less than the total cost. In this way, he can recover some of his fixed costs and minimize losses.
(b) Flexible budget structure:
Separating fixed overhead from variable overhead helps you budget flexibly for different levels of capacity utilization. The behavior of the cost is also forcibly drawn out.
(c) Effective cost control:
Fixed costs are incurred by management decisions and can be managed by top management, while variable costs can be managed by lower levels of management. Separating these allows lower level managers to know what types of spending they can manage.
(d) Useful for business decision making:
You will find this separation useful in administrative decisions regarding capacity usage. After all, the concept of fixed or variable spending is associated with a particular output rate. For example, if he starts a new shift, he may need to double the supervisor's salary.
In such cases, management needs to see if production in the second shift can withstand such rising production costs. The costs incurred for additional activities or alternative courses are easily available after classifying the costs into fixed and variable costs.
(e) Marginal cost and break-even point graph:
Dividing costs into fixed and variable costs is essential for calculating marginal costs, creating break-even graphs, and studying the relationship between costs, quantities, and profits.
(f) How to absorb overhead costs:
Various methods can be used to determine the absorption rate of fixed and variable overhead. The fixed overhead rate serves as a measure of facility utilization, and the degree of idle capacity is indicated by under absorption.
In short, classifying overhead costs into fixed and variable costs is very helpful in managing the efficient operation of the factory. It is useful not only for cost discovery, but also for cost management and management decision making.
The classification of costs into fixed and variable is not perfect as it is based on one assumption that costs are influenced only by volume is not true. But there are many other factors which influence costs as production specification, product mix, method of production, technology, plant and equipment, productivity, organisation structure, management policies and price indices etc. Moreover the linearity assumption is far from the actual reality.
Illustration 4:
Classify the following items of expenses by functions and variability:
(a) Depreciation on plant;
(b) Office telephone charges;
(c) Salary paid to salesmen;
(d) Rent of finished goods warehouse;
(e) Supervisory labour;
(f) General Managerβs salary;
(g) Consumable stores;
(h) Commission on sales paid to salesmen;
(i) Factory power;
(j) Delivery van expenses;
(k) Expenses of improving a product;
(I) Experimental expenses to develop a product;
(m) Compensation (fixed salary plus commission on sales).
Solution:
Β
III. Element-wise Classification:
This classification of overhead is done according to the nature and source of expenditure and follows naturally from the definition of overhead.
According to this classification, the total expenses are broken up into:
(i) Indirect Materials;
(ii) Indirect Labour; and
(iii) Indirect Expenses
V. Classification of overhead costs according to the nature of costs:
For a detailed and effective analysis of costs, manufacturing, management, sales and distribution indirect costs can be grouped into smaller sub-divisions and costs of similar nature can be grouped under one head. I can do it. This is accomplished by a standing order number or work order number and a cost account number syllabus. Automatic transfer numbers usually apply to factory overhead headings, while cost account numbers usually apply to administrative, sales, distribution, and R & D costs.
Compiling numbers is similar for both types of numbers. These numbers are so called because they appear in permanent types of schedules or manuals. Each standing order number indicates a particular type of spending, so spending items of similar nature at the time of occurrence fall into one of these appropriately. A schedule or manual for registering all permanent order numbers is maintained at the factory.
You must set separate standing order numbers for fixed and variable costs, especially if the department's indirect costs are billed separately for fixed and variable costs. So there are two rates, one for fixed overhead and one for variable overhead.
Individual charges are used for four reasons:
1. Fixed costs, which are policy costs, may not be recovered from costs in certain circumstances (such as a recession), but variable costs are fully recovered under normal circumstances.
2. The higher management level responsibility center is for managing fixed costs, while the variable cost overhead center is at the shop level.
3. You may need to adopt different criteria (working hours criteria or direct material cost criteria) to recover indirect costs from costs.
4. Marginal costs can be applied along with profits to establish an important business foundation.
The number of standing order numbers in a factory depends on the size of the factory, the type of cost, and the scope of control required. There are more continuous orders for a wide variety of spending or many types of spending in the factory. For better management, it is desirable to have less expense subdivision.
The required requirements for a valid automated money transfer system are:
1. These numbers need to be clearly defined in order to understand the classification and correctly classify each item of cost.
2. There should be no ambiguity as a schedule or manual that requires proper annotation of the permanent order number to help you properly classify each item of expense.
3. The system of standing order numbers must meet the needs of concern. To avoid increasing the cost of clerical work, do not go into too much detail. The classification should not be too broad so that it loses clarity and is useless for administrative purposes.
4. The code should be used for each heading. This is to help you find the item in a convenient way that avoids confusion and ultimately facilitates the collection of overhead.
Key takeaways:
- This overhead is categorized based on trends that change with production / sales volume or activity level.
- Fixed overhead costs (also known as term costs and policy costs) are costs incurred over time and tend to be unaffected by fluctuations in activity levels within a certain range.
- Fixed overhead costs are not always completely fixed in nature.
- Variable overhead costs fluctuate in total in direct proportion to production.
- Semi-variable costs (also known as mixed or semi-fixed costs) are costs that include both fixed and variable factors and are therefore partially affected by fluctuations in activity levels.
- The second type shows the semi-variable cost in which the variable factor works after a certain level of activity.
- Separating semi-variable overhead into fixed and variable overhead is critical to accurate cost confirmation, cost control, and decision making.
- In this method, the output at two different levels, high or low, is compared to the amount of cost incurred during these different periods. Since fixed overhead costs are fixed, the ratio of variable.
- The classification of costs into fixed and variable is not perfect as it is based on one assumption that costs are influenced only by volume is not true.
- For a detailed and effective analysis of costs, manufacturing, management, sales and distribution indirect costs can be grouped into smaller sub-divisions and costs of similar nature can be grouped under one head.
- The code should be used for each heading. This is to help you find the item in a convenient way that avoids confusion and ultimately facilitates the collection of overhead.
Overhead Rate
The apportionment of overhead expenses is done by adopting suitable basis such as output, materials, prime cost, labour hours, machine hours etc. In order to determine the absorption of overhead in costs of jobs, products or process, a rate is calculated and it is called as "Overhead Absorption Rate" or "Overhead Rate." The overhead rate can be calculated as below:
Overhead Absorption Rate =Β Overhead Expenses
Total Quantity or Value
Methods of Absorption of Production Overheads
Β
Β
Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β
- Direct Material Cost Percentage Rate: It is a percentage of overheads over direct material cost. Formula for calculating Direct Material Cost Percentage Rate is as follows:
Direct Material Cost Percentage Rate =Β Total Overheads
Direct Material Cost
X 100
2.Β Β Β Β Β Β Β Direct Labour Cost Percentage Rate: It is a percentage of overheads over direct labour cost. Formula for calculating Direct Labour Cost Percentage Rate is as follows:
Direct Labour Cost Percentage Rate = Total Overheads
Direct Labour Cost
X 100
3.Β Β Β Β Β Β Β Prime Cost Percentage Rate: It is a percentage of overheads over prime cost. Formula for calculating Prime Cost Percentage Rate is as follows:
Direct Prime Cost Percentage Rate = Total Overheads X 100
Prime Cost
4.Β Β Β Β Β Β Β Direct Labour Hour Rate: This is a rate per hour and not a percentage rate. It is obtained by dividing the total production overheads by the total number of direct labour hours for the period:
Direct Labour Hour Rate = Production Overheads
Direct Labour Hours
5.Β Β Β Β Β Β Β Machine Hour Rate: Machine hour rate is the overhead cost of running a machine for one hour. This rate is obtained by dividing the amount of factory overheads apportioned to a machine by the number of machine hours for the period under consideration.
Direct Material Cost Percentage Rate =Β Β Total Overheads
No. Of Machine hours
6.Β Β Β Β Β Β Β Rate Per Unit of Output:This is the simply the total overheads of a department over number of units produced.
Direct Material Cost Percentage Rate =Β Total overheads
No. Of Units Produced
Illustration5 A new machine has been installed in a factory for carrying out production process smoothly. The expenses for installing the machine are as follows:
Particulars | Amount |
Cost of machine | 2,40,000 |
Installation cost | 68,000 |
Salary of supervisors (Per annum) | 80,000 |
Rent for the factory (for six months) | 36,000 |
Insurance for the special machine (per quarter) | 6,000 |
Factory lighting (per month) | 4,000 |
Scrap value of the machine at the end of its life | 20,000 |
Power consumption =8 units per hour @ Rs. 3 per unit |
|
Annual Maintenance of the special machine (estimated) | 1,20,000 |
Estimated half-yearly consumption of stores | 30,000 |
Estimated life of the machine in years is 12. The factory is expected to work 300 days in a year, 8 hours per day, and the capacity utilization of machine is estimated 80%. The machine occupies 20% of the factory area and the supervisor devotes one-eighth of his time on the machine.
Compute the machine hour rate for the machine.
Solution:
Particulars | Rs. |
Depreciation: Purchase cost Freight, Insurance and erection | 2,40,000 68,000 |
Total Scrap Value | 3,08,000 20,000 |
Net cost for depreciation | 2,88,000 |
Machine life is 12 years
Depreciation = Rs. 2,88,000/12 Years = Rs. 24,000 per annum Working hours per annum = 300 days X 8 hours X 80% = 1,920 hours Power cost = 8 units X Rs. 3 = Rs. 24 per hour
Items | Expenses (Rs.) | Period | Expenses per annum (Rs.) | Share of Machine (%) | Machine Expenses (Rs.) |
Depreciation |
|
|
|
| 24,000 |
Supervisorβs Salary |
| Annual | 80,000 | 12.50 | 10,000 |
Rent | 36,000 | Half Yearly | 72,000 | 20 | 14,400 |
Insurance | 6,000 | Quarterly | 24,000 | 100 | 24,000 |
Lighting | 4,000 | Monthly | 48,000 | 20 | 9,600 |
Power | 24 per Hour | 1920 Hours | 46,080 | 100 | 46,080 |
Maintenance | 1,20,000 | Annual | 1,20,000 | 100 | 1,20,000 |
Consumables stores | 30,000 | Half Yearly | 60,000 | 100 | 60,000 |
πππβπππ π»ππ’π π ππ‘π = Β Β Total Overheads
Working Hours
πππβπππ π»ππ’π π ππ‘π = 3,08,080 = Rs. 160.46 per hour
1920
Illustration 6Deepaenterprises has three manufacturing departments and one service department. X, Y, Z are manufacturing departments and T is the service department.
Particulars | Total (Rs.) | X | Y | Z | T |
Electricity | 1,100 | 200 | 300 | 360 | 240 |
Salary of supervisors | 2,000 | 30% | 30% | 20% | 20% |
Rent | 500 |
|
|
|
|
Employee Welfare | 600 |
|
|
|
|
Others | 1,200 | 200 | 400 | 400 | 200 |
No. Of Labours |
| 30 | 40 | 20 | 10 |
Floor area in sq. |
| 600 | 800 | 600 | 500 |
ServiceΒ renderedΒ byΒ service Department to production departments |
| 50% | 30% | 20% |
|
Compute labour hour rate for the production departments from the given data.
Computation of Labour Hour Rate
| Production Deptt. | Services Deptt. | ||
| X | Y | Z | T |
Electricity | 200 | 300 | 360 | 240 |
Salary of supervisors | 600 | 600 | 400 | 400 |
Rent | 120 | 160 | 120 | 100 |
Employee Welfare | 180 | 240 | 120 | 60 |
Others | 200 | 400 | 400 | 200 |
Total | 1,300 | 1,700 | 1,400 | 1,000 |
Share of service department | 500 | 300 | 200 | 1000 |
Total Overheads | 1,800 | 2,000 | 1,600 |
|
Labour Hours | 6,000 | 8,000 | 4,000 |
|
|
|
|
|
|
πΏππππ’π π»ππ’π π ππ‘π = Total Overheads
Labour Hours
πΏππππ’π π»ππ’π π ππ‘π (π·πππ‘π‘. π) = 1,800 = Rs. 0.30
6,000
πΏππππ’π π»ππ’π π ππ‘π (π·πππ‘π‘. π) = 2000 = Rs. 0.25
8,000
πΏππππ’π π»ππ’π π ππ‘π (π·πππ‘π‘. π) = 1,600 = Rs. 0.40
4,000
Key takeaways:
- The apportionment of overhead expenses is done by adopting suitable basis such as output, materials, prime cost, labour hours, machine hours etc.
- The overhead rate can be calculated as below:
Overhead Absorption Rate =Β Overhead Expenses
Total Quantity or Value
3.Β Β Β Β Β Β Β Methods of Absorption of Production Overheads
Β
4.Β Β Β Β Β Β Β Prime Cost Percentage Rate: It is a percentage of overheads over prime cost.
5.Β Β Β Β Β Β Β Machine hour rate is the overhead cost of running a machine for one hour.
Overhead / under absorption
Overhead is absorbed over a period of accounting or a specific period, depending on the actual production of the product, based on a given overhead absorption rate. Budgeted overhead and budgeted output are used to determine overhead rates. If the budget overhead and budget output differ between the actual overhead and the actual output, then 3 is the difference between the given overhead rate and the actual overhead rate.
If the overhead absorbed is greater than the overhead actually incurred, it is called overabsorption. If the overhead absorbed is less than the actual overhead incurred during the accounting period, it is said to be absorbed.
Reasons for overhead over or under absorption
The reasons for overabsorption or underabsorption of overhead are as follows:
1. Actual working hours are more or less than budget hours.
2. Actual overhead costs are different from budget overhead costs.
3. Both actual overhead costs and actual activity levels differ from budget costs and levels.
4. The overhead absorption method may be incorrect.
5. Unexpected costs may be incurred during the fiscal year end.
6. Overhead costs may be included in the calculation of overhead absorption rates.
7. Major changes, such as changing from manual to mechanical. This leads to increased capacity levels.
8. Seasonal variation of overhead costs over time.
Handling of over or under absorption overhead
Overhead or shortage overhead is treated in the cost account in one of the following ways:
1. Application of additional charges
The subsidy rate is calculated by dividing the amount of underabsorption or overabsorption by the actual basis. In the case of overabsorption, the compensation rate is applied to adjust the overrecovery amount and vice versa.
2. Cost of sales adjustment
Over- or under-absorbed overhead costs are closed and transferred to the cost of goods sold account. This is done by the cost accountant at the end of each month or at the end of the accounting period. If a transfer is made at the end of the accounting period, excess / unabsorbed expenses will be treated as deferred income in the case of over-application and deferred expense in the case of under-application and will be carried forward monthly.
3. Amortization to costing profit and loss account
If the overhead or underabsorption overhead is small, it is amortized by transferring it to the costing profit and loss account. If so, the closing inventory valuation is overvalued or undervalued.
4. Adjust to gross profit
Under-absorbed or over-absorbed overhead balances are closed by adjusting gross profit.
5. Carry over to the next year
Over-absorbed or over-absorbed overhead costs can be carried forward to the next fiscal year. It may be transferred to an overhead suspense account or an overhead reserve account. This overhead suspense account or overhead reserve account appears on your balance sheet.
Debit and credit balances that represent absorbed overhead or absorbed overhead that appear on the asset or liability side of the balance sheet. The basic idea is that he offsets the underabsorption overhead in one year and the overabsorbed overhead in another year. However, many accountants disagree with this idea. The reason is that the balance of unabsorbed / overabsorbed overhead must not be carried over from one year to another. This method is also known as the use of reserve accounts.
Direct labor cost method: calculation, advantages and disadvantages!
The Direct Labor Expenses Act is a simple and easy method and is widely used for most concerns.
The overhead rate is calculated as follows:
Overhead cost rate = Manufacturing overhead cost / Direct labor cost x 100
In general, the ratio of factory expenses to direct wages is calculated from past experience or based on estimates, and jobs are charged according to this ratio. Assume that the direct wage paid at the factory in a year is estimated at 60,000 rupees and the factory cost is estimated at 30,000 rupees. Then the percentage of factory costs to direct wages is 50. Factory costs for the following year will be recorded at 50% of direct wages.
The Direct Labor Expenses Act is suitable for the following situations:
(i) When direct labor accounts for the majority of total production costs.
(ii) When production is uniform.
(iii) When the type of work employed and the type of work performed are the same.
(iv) When the ratio of skilled labor to unskilled labor is constant.
(v) If the wage rate does not fluctuate, that is, the wage rate and payment method are the same for the majority of interested workers.
For some concerns, a different rate is calculated for the additional benefit and is applied directly on the basis of labor costs.
Advantage:
The advantages of this method are:
(i) Wages paid are usually proportional to working hours, so the time factor is automatically taken into account.
(ii) The labor rate is more stable than the material price.
(iii) Certain variable overhead costs vary to some extent depending on the number of workers employed, so costs for production are related to wage payments proportional to the number of workers.
(iv) The basic data needed to calculate this rate is readily available from the wage statement and there is no additional labor cost.
Disadvantage:
The main drawbacks are:
(i) There is no distinction between skilled and unskilled labor and the difference in wage rates. Jobs carried out by high-paying workers cost more than jobs involving low-paying workers. This is unreasonable because unskilled workers incur more costs in the form of material waste, depreciation, and so on.
(ii) If the worker is paid on a piece-by-piece basis, the time element is completely ignored.
(iii) There is no distinction between the production of manual workers and the production of mechanical workers.
(iv) Overtime pays higher hourly wages, so this method has inaccurate results when workers are paid extra overtime wages. However, overhead costs increase at the same rate. In fact, many costs remain unchanged.
(v) There is no distinction between fixed and variable costs.
(vi) Absorption of overhead costs is unfair if labor is not an important factor in production. Ignore important factors such as widespread use of plants and equipment.
(vii) For pay-as-you-go workers, both efficient and time-consuming workers and inefficient and time-consuming workers apply the same rate to absorb the indirect costs of all workers. , This is not appropriate.
Illustration 7:
In a factory, there are three Production Departments P1, P2, P3Β and one service department S1. Following figures are available for one month of 25 working days of 8 hours each day.
All departments work all these days with full attendance:
Prime cost method:
Under the prime cost method, recovery is calculated by dividing budgeted overhead costs by the sum of direct material costs and direct labor costs for all products in the cost center.
If the budget overhead is Rs 50,000 and the estimated costs of direct materials and labor are Rs 30,000 and Rs 20,000, then the overhead recovery is 100%, or Rs 50,000 / Rs 30,000 + Rs 20,000 x 20,000 x 20,000. Suppose.
This method is simple and easy to operate. The data needed to calculate this rate is easily available from the record. This can be adopted when standard products are produced that require a certain amount of material and the number of hours it takes to manufacture it.
Limitations:
This method is not typically used due to the following limitations:
I. When material cost is the main item of the main cost and the time factor is not fully considered.
Ii. There is no distinction between manual labor and mechanical worker production.
Iii. There is no distinction between fixed and variable costs.
Iv. Combines the shortcomings of both direct materials and direct labor law.
v. In the calculation of overhead costs, both direct materials and direct labor are equally important. Overhead is, of course, more related to labor than material.
Illustration 1:
In a certain factory, three products are made from different materials by similar processes.
For a typical period, production costs are as under:
Key takeaways:
- Overhead is absorbed over a period of accounting or a specific period, depending on the actual production of the product, based on a given overhead absorption rate.
- If the overhead absorbed is greater than the overhead actually incurred, it is called over absorption.
- If the overhead absorbed is less than the actual overhead incurred during the accounting period, it is said to be absorbed.
- Reasons for overhead over or under absorption.
- Handling of over or under absorption overhead.
- The Direct Labor Expenses Act is a simple and easy method and is widely used for most concerns.
- Wages paid are usually proportional to working hours, so the time factor is automatically taken into account.
- There is no distinction between the production of manual workers and the production of mechanical workers.
- Absorption of overhead costs is unfair if labor is not an important factor in production.
- Under the prime cost method, recovery is calculated by dividing budgeted overhead costs by the sum of direct material costs and direct labor costs for all products in the cost center.
Reference:
- Https://www.yourarticlelibrary.com/cost-accounting/overheads-cost-accounting/prime-cost-and-direct-labour-hour-method-limitation-and-calculation/55618
- Https://accountlearning.com/methods-of-overhead-absorption-advantages-disadvantages/
- Https://www.yourarticlelibrary.com/cost-accounting/overheads-cost-accounting/overhead-definition-importance-and-classification/55573
- Https://www.yourarticlelibrary.com/cost-accounting/overheads-cost-accounting/selling-and-distribution-overheads-accounting-and-other-details/55673
- Https://www.yourarticlelibrary.com/accounting/overheads/classification-of-overheads-4-categories/74467