Welcome to Scribd. Sign in or start your free trial to enjoy unlimited e-books, audiobooks & documents.Find out more
Standard view
Full view
of .
Look up keyword
Like this
0 of .
Results for:
No results containing your search query
P. 1


|Views: 62|Likes:
Published by atifas

More info:

Published by: atifas on Feb 01, 2011
Copyright:Attribution Non-commercial


Read on Scribd mobile: iPhone, iPad and Android.
download as PDF, TXT or read online from Scribd
See more
See less





217 / 1
Oklahoma State University
Phil Kenkel
Extension Economist
Oklahoma Cooperative Extension Service • Division of Agricultural Sciences and Natural Resources
Understanding, Allocating,and Controlling Overhead Costs
verhead costs are expenses which cannotbe conveniently identified with a specificproduct or activity. Unlike materials andproduction labor, overhead is an invisible part of thefinished product. Yet, overhead is a basic input into theproduction process just like raw materials. Understand-ing the nature of overhead costs can assist agribusinessmanagers in controlling these expenses. Proper allo-cation of overhead costs among products, or depart-ments, permits the agribusiness manager to under-stand their firm’s production costs. It also allows themanager to determine how much each product orsegment of the firm is contributing to overall profitability.The purpose of this publication is to provide agribusinessmanagers with information on understanding, allocat-ing and controlling overhead costs.
The Importance of Overhead Costs
Cost control is one of the most difficult and impor-tant aspects of a manager’s job. In many ways, it ismore important to control costs than it is to increasesales. To illustrate this point, consider the followingexample. Your firm has current sales of $1,000,000,fixed costs of $300,000 and variable costs of $600,000for a before-tax income of $100,000. Assuming thatvariable costs remain at 60¢/$Sales, increasing salesby $100,000 will only increase net income by $40,000.On the other hand, a decrease in overhead costs of$100,000 increases before-tax income by that sameamount. Quite simply, cost control is important be-cause, unlike sales increases, most of the cost savingsgoes directly to the bottom line.The allocation of overhead costs is important whenthe firm has more than one product or activity or morethan one department (area of business). Allocation ofoverhead costs is most important when the firm isconsidering adding, dropping, or changing the level ofany business activity. Overhead cost allocation allowsthe manager to calculate the profitability of a productline, determine the economic impacts of alternativebusiness plans, and to value inventory. The principle ofoverhead cost allocation is that overhead costs shouldbe charged to the areas of the firm which indirectlycause these costs to be incurred.The control of overhead costs is particularly diffi-cult. However, determining direct labor and materialexpenses is easier; hence, managers tend to concen-trate on these costs. The successful control of over-head costs requires daily attention. Some managers donot consider overhead costs when developing pricingstrategies. This could result in some products oractivities not fully recovering their overhead costs. Inthe long run, unless other products are offsetting thisdeficiency, this type of pricing strategy will not returnsufficient profits to provide a return for the capital,management, and risk involved.Understanding overhead costs is also importantwhen considering changes in the production process.For example, purchasing a new machine will increaseyour overhead through interest and depreciation. How-ever, the new machine may reduce direct labor ex-penses. By understanding how to classify and allocateoverhead costs a manager can determine whether thepurchase of a new machine will increase the profitabilityof the firm.
Classifying Costs
Accountants classify costs and expenses by relat-ing them to the operations of the business. A typicalclassification would be:Direct Manufacturing Cost+Manufacturing Overhead=Manufacturing Cost+Marketing and Administrative Expense=Total Operating Cost
217 / 2
In agribusiness, manufacturing overhead and market-ing and administrative expenses are often combinedinto a general overhead category. For example, themanager’s and bookkeeper’s salary, interest and de-preciation on the office building, and the fees for themarket news service may all be classified as “GeneralOverhead.”Economists classify costs according to their rela-tionship with changes in the volume of production.Variable costs are costs which increase or decrease indirect proportion to the volume of production. Fixedcosts are costs which are fixed in total amount within arelevant output range. Some costs, called semivariablecosts, contain fixed and variable elements. For ex-ample, electricity costs may be semivariable. Electricityused for lighting the plant will not vary with the volumeof production. On the other hand, electricity used tooperate equipment will increase as the plant’s outputincreases.Overhead costs are costs which cannot be directlyidentified with a product or production activity. Over-head costs can be either fixed or variable. Examples offixed factory overhead costs include depreciation, inter-est, rent, insurance, taxes, advertising, maintenance,and the manager’s salary. Variable overhead costsmight include some categories of supplies, utilities,communication costs, receiving costs and miscella-neous labor costs. For the small agribusiness opera-tion, most overhead costs tend to be fixed. The classi-fication of costs will be shown to be important whenpricing strategies and break-even analysis are dis-cussed.
Controlling Overhead Costs
There are several ways to decrease overheadcosts. These include:Decreasing working capitalImplementing total quality managementControlling sales costsStudying maintenance costsDecreasing transportation expensesWorking capital refers to funds tied up in productionand inventories from the time when the raw materialsare purchased until the account is collected. Bettermanagement of raw materials, inventories and ac-counts receivable will decrease the working capitalrequired by the firm and hence the overhead.Since most overhead costs are fixed, increasedsales will obviously decrease per unit overhead. Everymanager would like to increase sales volume. How-ever, volume refers to salable units. Mistakes, reworksand incorrectly filled orders increase costs and de-crease salable units. The payoff from implementing atotal quality management system may be similar to anincrease in sales volume. Some Japanese firms expe-rienced a 30 percent increase in productivity afterimplementing a total quality management system withno increased investment.Every manager is familiar with the adage “advertis-ing doesn’t cost, it pays.” In order to survive, a firm mustbe customer oriented. However, it must also control thecosts created by sales and promotional activities anduse these funds effectively. Managers can reducesales costs by relating sales incentives to the profitabil-ity (as opposed to the sales price) of the product.Developing a well-thought-out, long-run plan for adver-tising and promotion can also reduce sales expenses.Too often, sales efforts are erratic and fail to achievemeaningful results. A careful analysis of sales expen-ditures may allow reduction and reallocation of salesexpenditures while increasing advertising effectiveness.Maintenance and repairs are carried out in order tokeep equipment running. The overall objective is tokeep equipment running in order to meet productiongoals.
maintenance involves making minorchanges in design, materials or construction.
maintenance involves using sensing, measuring orcontrol devices to identify and correct problems beforea break-down occurs.
describe maintenancework done to return equipment to production.
maintenance involves work undertaken on a pre-determined schedule when corrective maintenance isnot justified, predictive maintenance cannot be appliedand repair maintenance is too costly. Each type ofmaintenance carries its own cost, but few managersfully consider their options in reducing maintenancecosts.Recording repairs for each machine is vital incontrolling maintenance costs. Equipment history isimportant in considering the best type of replacementsto buy. Furthermore, a few machines often contributemore than their share to costs. Industry surveys haveshown that 3 percent of the equipment are responsiblefor 25 percent of the total maintenance costs.To get a quick look at the potential benefits fromcontrol of transportation expense, compare 10 percentof your transportation costs with your net profits for lastyear. If it represents 20 percent of your profit, your firmis not unusual. Should your firm be in the transportationbusiness? Have you compared the total cost of trans-portation with the costs of having an outside firm per-form these services? Other techniques for decreasingtransportation expenses include using a computerizedsystem to optimize the timing and routing of deliveries.In general, there is more money to be saved in smallshipments than in truckload lots. Scheduling “milk runs”or more or less set, periodic routes have been usedsuccessfully by some firms to decrease delivery costs.“Educating” your customers concerning the merits of aregular schedule and avoiding extra deliveries are keyingredients to reducing small lot delivery expense.
217 / 3
Allocating Overhead Costs: The Conceptof Departmentalization
Departmentalization refers to dividing the businessinto segments, called departments, to which incomeand expenses can be allocated. Dividing the firm intodepartments allows the manager to identify which seg-ments of the business are the most profitable and whichactivities are being supported from earnings from otherareas. The use of departments helps to assign respon-sibilities and identify and control costs. The process ofallocation can also be used within a department toallocate revenues and expenses to particular products.Large firms often have both production and servicedepartments. A production department engages in theactual transformation of materials into final products. Aservice department renders services which contributein an indirect manner to the production process. Ex-amples of service departments include purchasing,receiving, shipping, personnel, and security. The costsrelating to service departments contribute to the firm’soverhead and are ultimately transferred to productiondepartments. Smaller firms, including most agribusinessfirms, group all service activities in a single departmentor a “general overhead cost pool.”
Selecting Departments
There are no hard and fast rules for the selection ofdepartments. A department should group similar op-erations or activities so that the contribution of theseactivities to the overall objectives of the firm can beidentified. Factors to be considered when selectingdepartments include:Similarity of operationsResponsibilities for production and costsLocation of operations to the flow of productThe total number of departments or costcenters
Examples of departmentalization include
Grain ElevatorGrain HandlingGrain StorageFarm SupplyTires, Batteries and AccessoriesMeat Processing FirmSlaughterCustom ProcessingWholesale ProductsRetail Products
Allocating Overhead Costs
Sales revenues and direct expenses can usually beeasily identified with a department. Overhead ex-penses, by their very nature, must be allocated orassigned among the departments. Most overheadexpenses such as power, light, rent, depreciation, andmanagement expenses do not originate within anyspecific department. These expenses must be pro-rated among the departments using the related ser-vices.Selecting an appropriate basis for the distribution ofoverhead expenses is difficult, and in some instances,must be somewhat arbitrary. In order to charge eachdepartment with its fair share of overhead expenses, abase using some factor common to all departmentsmust be used. Different criteria may be used fordifferent aspects of overhead expenses. For example,square footage may be used in allocating rent or build-ing depreciation. An estimate of the horsepower-hoursof equipment usage might be used to allocate utilityexpense. Some common bases for the distribution ofvarious overhead expenses are:
ndirect Expense CategoryBasis for Distribution
RentSquare footageBuilding depreciationSquare footageProperty insuranceSquare footageUtilitiesHorsepower-hoursManagers salarySales revenues,Number of employeesMarketing expensesSales revenueWater chargesEstimated usageAutomotiveOwners judgement
Some managers use a single basis for the distribu-tion of all overhead expenses. Examples include allo-cating on the basis of sales revenues, labor expense, orthe ratio of departmental direct expenses to total ex-penses. Every manager must decide at what point theadvantages of a more complex allocation system out-weigh the costs. Allocating costs on the basis of salesrevenues could be deceptive and provides incorrectsignals to supervisors or departmental managers. Re-pairs and maintenance expenses, material handlingcosts, and even the time commitment of management,are unlikely to change when sales for a “star” producttake off. Allocating all overhead expenses on the basisof sales revenues tends to understate the profitability ofgood aspects of the business by saddling them with agreater proportion of overhead costs while overstatingthe performance of weak departments.
Contribution Margin
A useful measure of the contribution of a depart-ment or of a product is the contribution margin. Thecontribution margin is defined as sales revenues minusvariable costs. Since overhead expenses are chieflyfixed costs, the contribution margin may also be re-

You're Reading a Free Preview

/*********** DO NOT ALTER ANYTHING BELOW THIS LINE ! ************/ var s_code=s.t();if(s_code)document.write(s_code)//-->