OVERHEADS

Introduction
 Overheads are the expenditure which cannot be conveniently traced to or identified
with any particular cost unit. Such expenses are incurred for output generally and
not for a particular work order e.g., wages paid to watch and ward staff, heating and
lighting expenses of factory etc.
 Overheads also represent expenses that have been incurred in providing certain
ancillary facilities or services which facilitate or make possible the carrying out
of the production process; by themselves these services are not of any use. For
instance, a boiler house produces steam so that machines may run and, without the
generation of steam, production would be seriously hampered. But if machines do not
run or do not require steam, the boiler house would be useless and the expenses
incurred would be a waste.
 The rate used in overhead are called absorption rate, pre-determined rate, recovery rate,
burden rate etc.

Actual Overhead/Expenses Absorbed Overhead (overhead charged in production)

Actual indirect expenses Actual output*Pre-determined OH Rate
110000 10000*10=100,000=under absorbed OH by 10,000
90000 10000*10=100,000=Over-absorbed OH by 10,000

Things to learn
Calculation of Absorption rate/pre-determined Rate/Recovery Rate
Calculation of Overhead absorbed=Actual Volume*absorption Rate
Calculation of under/over Absorbed OH=Actual OH-Absorbed OH
Treatment of Over/under absorbed OH

Pre-determined OH Rate= Estimated Overheads/Anticipated level of activity

Types of Overhead cost

1. 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 change in the same direction as change in the level of activity but not
in the same proportion.
− Semi variable expenses has two parts viz; fixed and variable.
Example: Repair and Maintenance, Delivery Van expenses etc.

Variable
Fixed
Amount
Semi-variable exp.

Output

2. On the Basis of Function

i) Factory or Manufacturing Overhead
ii) Office & Administrative Overhead
iii) Selling & Distribution Overhead
iv) Research & Development Overhead

Process of Overhead absorption

Step 1: Estimation and collection of manufacturing overheads.
Future Past
Pre-determined Actual OH Rate

Step 2: Cost Allocation/ Departmentalization of Cost

− Charging the Overhead / Expenses directly to the related cost center or department.
Example: Wages of engineering dept.
- Mainly to production and service Deptt

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/dept. on the basis of best
available information.
− At this stage, all cost will be either allocated or apportioned.
Basis of Apportionment of Various O/H Cost (Examples)
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
Indirect Labour Direct Labour
Total Production Dept. Service Dept.
P1 P2 P3 S1 S2 S3
(power) (Water) Cooling
Total Indirect Cost 254000 50000 60000 55000 30000 24000 35000
S1 (2:3:2:-:1.5:1.5) 6000 9000 6000 (30000) 4500 4500
S2 (3:3:2:-:-:2) 8550 8550 5700 (28500) 5700
S3 (3:3:4:-:-:-) 13560 13560 18080 (45200)
Total 78110 91110 84780 0 0 0
Total OH XXX XXX XXX 0 0 0
Volume XXX XXX XXX
OH Absorption X X X
Rate

Re-apportionment ratio
Service Dept P1 P2 P3 S1 S2 S3
S1 20 30 20 - 15 15
S2 30 30 20 - - 20
S3 30 30 40 - - -

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.

After this process, all overhead of service dept. to be charged to production dept and
overhead cost in the service dept. should be zero or equivalent.

Re-Apportionment of Service Department

i) Direct Redistribution Method
-If service dept. overheads are re-distributed only to the production dept. on some
reasonable basis, this is called direct re-distribution method.

ii) Step ladder Method / Secondary distribution / Non-Reciprocal Method

-identify the order of service is most important in this method
Total Production Dept. Service Dept.
P1 P2 P3 S1 S2 S3
(power) (Water) Cooling
Total Indirect Cost 254000 50000 60000 55000 30000 24000 35000
S1 (2:3:2:-:1.5:1.5) 6000 9000 6000 (30000) 4500 4500
S2 (3:3:2:-:-:2) 8550 8550 5700 (28500) 5700
S3 (3:3:4:-:-:-) 13560 13560 18080 (45200)
Total 78110 91110 84780 0 0 0
Total OH XXX XXX XXX 0 0 0
Volume XXX XXX XXX
OH Absorption X X X
Rate

Re-apportionment ratio
Service Dept P1 P2 P3 S1 S2 S3
S1 20 30 20 - 15 15
S2 30 30 20 - - 20
S3 30 30 40 - - -

iii) Reciprocal Method

a) Repeated Distribution Method
b) Trial and Error Method
c) Simultaneous Equation Method
Total Production Dept. Service Dept.
P1 P2 P3 S1 S2
(power) (Water)
Total Indirect Cost 219000 50000 60000 55000 30000 24000
Trial & Error Method
S1 (4:3:2:-:0) 12000 9000 6000 (30000) 3000
S2 (3:3:3:1:-_) 2700 (27000)

S1 (4:3:2:-:0) (2700) 270

S2 (3:3:3:1:-_) 27 (270)

S1 (4:3:2:-:0) (27) 2.7

S2 (3:3:3:1:-_) 0.27 (2.7)
Total
Total OH XXX XXX XXX 0 0
Volume XXX XXX XXX
OH Absorption Rate X X X

Re-apportionment ratio
Service Dept P1 P2 P3 S1 S2
S1 40 30 20 - 10
S2 30 30 30 10 -

Simultaneous Equation Method

Service Dept. S1 total cost

S1= 30000+10% of S2
S2= 24000+ 10% of S1
Therefore, S1= 32727.27
S2= 27272.72
Distribution of Service Dept cost to production Dept.
Total P1 P2 P3
Cost of S1 in the ratio (4:3:2)-90% of 32,727.27 29,454.54
Cost of S2 in the ratio (3:3:3)-90% of 27,272.72 24,545.45
54,000

Step 5: Absorption rate and overhead absorption

− Absorption means the recovery of overhead in its respective cost centre on the basis of
absorption rates.
Pre-determined OH Rate= Estimated Overheads/Anticipated level of activity

OH Absorbed= Actual activity level* Pre-determined rate

Absorption of Overheads
-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 with actual
volume produced.

Types of Absorption Rates

1. 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.

2. 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, but:
a) All products pass through all departments &
b) All products are processed on the same time duration in each department.

Process I Process II Process III Total

Product A Yes (10 min) Yes (15 min) Yes -5 30
Product B Yes (10 min) Yes (15 min) Yes-5 30
Product C Yes (10 min) Yes (15 min) Yes-5 30
Departmental Rate:
-It refers to computation of different overhead rates for different cost centres in a
factory.

Methods/Basis of Absorbing Overhead to Various Products or Jobs

i. Percentage of Direct Material Cost:
ii. Percentage of Direct Labour Cost: Hours *Rate
iii. Percentage of Prime Cost:
iv. Labour Hour Rate:
v. Machine Hour Rate
vi. Output rate

Since the overhead is functions of time, the basis which factors time variable is most
appropriate.

Cost Sheet
Material
Labour
Prime Cost
Add: OH

Step 6: Treatment of Over & Under Absorption of Overhead

Over/Under Recovery of Overheads

-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. Use of Supplementary OH Rate

-In case the actual & absorbed overhead are different, and the difference is quite large, a
supplementary rate is used.
-Supplementary rate may be positive (for under-absorbed OH) and negative (for over-
absorbed OH)
-The objective of using supplementary OH Rate is to make actual OH get completely
absorbed

Supplementary Rate = Under/Over absorbed OH/Total Production

2. Transfer to Costing Profit or Loss Account

-This method is used in case the difference between actual or absorbed overhead is
negligible
-Under-absorbed overhead due to abnormal reason like defective planning, breakdown etc.
3. 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.
Year 1 2 3 4 5
Production 1000 2000 50000 100000 200000

Factory OH A/C

Rent 100000 Absorbed in production 300000

Depreciation 200000 Balance c/d 10000
Electricity 10000

Treatment of Certain Items in Costing

(i) Interest and financial charges : There is controversy whether financial

charges, specially interest, should be included in the costs or not. The following
arguments are generally advanced in favour of interest to be included in overhead
expenses.
(1) Element of cost: Computation of total cost is impossible unless interest is taken
into account. Interest is an element of cost and therefore, should be included in cost.
This is specially true in business where raw materials in different stages can be used. Thus
a timber merchant, if he buys standing trees and seasons the timber himself, would
incur a large amount of costs as interest. Another merchant who buys his timber already
seasoned would automatically have to pay a higher price; obviously, this price includes
interest.
(2) Part of Cost of capital: Interest is the cost to be paid for the use of capital; capital is
also a factor of production just as labour. Thus, if wages are included in cost of production,
why not interest ?

(3) Hepls in managerial decision making:If interest is not included in cost calculation,
a number of managerial decisions may be taken wrongly. Thus, where a decision involves
replacement of labour with expensive machinery, the question of interest assumes
importance, since, if interest is not included, the cost accountant may conclude that
machinery is cheaper.
(4) Helps in comparison: Inclusion of interest also allows comparison of profit on
different jobs. Thus, if a job takes 3 months and another takes 6 months the cost of
the jobs must include a charge by way of interest before profit can be compared.
(5) Part of Inventory Cost:In inventory control, interest is an important item to be
considered. Where large stocks are kept, the advantage of one time purchase is offset
by increase in interest charges.
(6) Important element of cost plus contracts: While submitting tenders for cost
plus contracts, etc., interest must be taken into account.
However, many cost accountants argue that interest should not be included in cost accounts
since it is not an item of cost and would vary with different methods of financing. Some of the
arguments are listed below :
(1) Payment of interest depends entirely on the financing policies and financing pattern.
A firm working with proprietor’s capital only will have no interest to pay whereas a firm
working with borrowed capital will have to pay a large amount of interest. In reality,
whether a firm raises a certain sum of money from the proprietor or borrows from the
outside does not make any difference as far as production efficiencies are concerned. If
we compare the two firms and include interest as an item of cost, the firm, which works
on the proprietor’s capital will show very favourable results. Actually, this is a wrong
conclusion.
However, this argument can be met by including a notional amount of interest, irrespective
of the fact whether the funds belong to the owners or to the outsiders. Thus, an
amount of notional interest may be charged on the total capital whether it is borrowed or
not.
(2) Another practical difficulty arises in the calculation of the amount of capital on
which interest should be worked out. While the fixed capital is readily ascertainable, working
capital keeps on changing. Again, the difficulty becomes pronounced since the working
capital would be used by different departments, and allocation of the total interest charges
will have to be made over various departments at different points of time.
If notional interest is to be charged, the problem of determining a proper rate of interest also
arises. In the money and capital markets, there is a large number of rates depending upon
different factors like risk, period of maturity, bank rate, etc.
(3) By including interest on the proprietor’s capital and by taking that figure in the cost of
production, we would obviously be including profit since the closing stock will be valued at a
higher figure.
It appears that there are practical difficulties in including interest as part of the normal cost.
However, excluding it altogether may lead to wrong managerial decisions which is not
de- sirable.

It is therefore, suggested that while interest may be excluded from the regular cost
sheet, cost calculations for other purposes for decision making should include
a proper amount of notional interest where the interest will be material.
(ii) Depreciation: Depreciation “is the diminution in the intrinsic value of an asset due
to use and/or the lapse of time.” Depreciation is thus the result of two factors viz., the
use, and the lapse of time. We know that each fixed asset loses its intrinsic value
due to their continuous use and as such the greater the use the higher is the amount of
depreciation. The loss in the intrinsic value may also arise even if the asset in question is
not in service.
In Cost Accounting depreciation is charged to the cost of
production.
The various reasons for including the depreciation charge in Cost Accounting are as
follows: (a) To show a true and fair picture of Balance Sheet.
(b) To ascertain the true cost of production.
(c) To keep the asset intact by distributing losses in its value over a number of
years.
(d) To keep the capital intact and to make a provision of the resources for the replacement
of asset in future.
(e) To provide for depreciation before distribution of profit as required under the Companies
Act.
(iii) Packing expenses: Cost of primary packing necessary for protecting the product or
for convenient handling, should become a part of the prime cost. The cost of packing to
facilitate the transportation of the product from the factory to the customer should become a
part of the distribution cost. If the cost of special packing is at the request of the customer,
the same should be charged to the specific work order or the job. The cost of fancy packing
necessary to attract customers is an advertising expenditure. Hence, it is to be treated as a
selling overhead.
(iv) Fringe benefits: These are the additional payments or facilities provided to the
workers apart from their salary and direct cost-allowances like house rent, dearness and city
compen- satory allowances. These benefits are given in the form of overtime, extra shift duty
allowance, holiday pay, pension facilities etc.
These indirect benefits stand to improve the morale, loyalty and stability of employees towards
the organisation. If the amount of fringe benefit is considerably large, it may be recovered as
direct charge by means of a supplementary wage or labour rate; otherwise these may be
collected as part of production overheads.
(v) Expenses on removal and re-erection of machines: Expenses are sometime
incurred on removal and re-erection of machinery in factories. Such expenses may be
incurred due to factors like change in the method of production; an addition or
alteration in the factory building, change in the flow of production, etc. All such expenses
are treated as production overheads. When amount of such expenses is large, it may be
spread over a period of time.
If such expenses are incurred due to faulty planning or some other abnormal factor, then
they may be charged to costing Profit and Loss Account.

(vi) Bad debts: There is no unanimity among different authors of Cost Accounting about
the treatment of bad debts. One view is that ‘bad debts’ should be excluded from cost.
According to this view bad debts are financial losses and therefore, they should not be
included in the cost of a particular job or product.
According to another view it should form part of selling and distribution overheads, especially
when they arise in the normal course of trading. Therefore bad debts should be treated in
cost accounting in the same way as any other selling and distribution cost. However extra
ordinarily large bad debts should not be included in cost accounts.
(vii) Training expenses: Training is an essential input for industrial workers. Training
expenses in fact includes wages of workers, costs incurred in running training department, loss
arising from the initial lower production, extra spoilage etc. Training expenses of factory
workers are treated as part of the cost of production. The training expenses of office; sales or
distribution workers should be treated as office; sales or distribution overhead as the case may
be. These expenses can be spread over various departments of the concern on the basis of the
number of workers on roll.
Training expenses would be abnormally high in the case of high labour turnover such
expenses should be excluded from costs and charged to the costing profit and loss
account.
(viii) Canteen expenses: The subsidy provided or expenses borne by the firm in running
the canteen should be regarded as a production overhead. If the canteen is meant only for
factory workers therefore this expenses should be apportioned on the basis of the number of
workers employed in each department. If office workers also take advantage of the canteen
facility, a suitable share of the expenses should be treated as office overhead.
(ix) Carriage and cartage expenses: It includes the expenses incurred on the
movement (inward and outwards) and transportation of materials and goods. Transportation
expenses related to direct material may be included in the cost of direct material and those
relating to indirect material (stores) may be treated as factory overheads. Expenses related
to the transportation of finished goods may be treated as distribution overhead.
(x) Expenses for welfare activities: All expenses incurred on the welfare activities
of employees in a company are part of general overheads. Such expenses should be
apportioned between factory, office, selling and distribution overheads on the basis of
number of persons involved.
(xi) Night shift allowance: Workers in the factories, which operate during night time
are paid some extra amount known as ‘night shift allowance’. This extra amount is
generally incurred due to the general pressure of work beyond normal capacity level and is
treated as production overhead and recovered as such.
If this allowance is treated as part of direct wages, the jobs/production carried at night will be
costlier than jobs/production performed during the day. However, if additional expenditure on
night shift is incurred to meet some specific customer order, such expenditure may be
charged directly to the order concerned. If night shifts are run due to abnormal
circumstances, the additional expenditure should be charged to the costing profit and loss
account.

(xii) Research and Development Expenses: The Terminology defines research

expenses as “the expenses of searching for new or improved products, new application of
materials, or new or improved methods.” Similarly, development expenses are defined as
“the expenses of the process which begins with the implementation of the decision to
produce a new or improved product.”
If research is conducted in the methods of production, the research expenses should
be charged to the production overhead; while the expenditure becomes a part
of the administration overhead if research relates to administration. Similarly, market
research expenses are charged to the selling and distribution overhead.
Development costs incurred in connection with a particular product should be charged
directly to that product. Such expenses are usually treated as “deferred revenue expenses,”
and recovered as a cost per unit of the product when production is fully established.
General research expenses of a routine nature incurred on new or improved methods of
manufacture or the improvement of the existing products should be charged to the general
overhead.
Even in this case, if the amount involved is substantial it may be treated as a deferred
revenue expenditure, and spread over the period during which the benefit would accrue.
Expenses on fundamental research, not relating to any specific product, are treated as a
part of the administration overhead. Where research proves a failure, the cost associated
with it should be excluded from costs and charged to the costing Profit and Loss Account.
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