OVERHEADS AND THEIR RECOVERY

The costs of a business are of two types – direct and indirect. The direct costs vary
directly with production. If one additional unit of production is made, there will be a
measurable increase in direct cost. When one unit less is made, ther will be similar
measurable decrease in direct cost. Direct – or raw – material is normally the largest
component of direct cost. It includes all items of material that are of sufficient size to
warrant the effort of charging directly to the job. Small item, such as glue, paint, and small
quantities of nails, screws, and rivets, do not merit the clerical effort involved in charging
directly to the job, and would be recovered as an overhead.
Direct wages will vary directly with production where remuneration is based upon
*piecework only. This means that a specific amount is paid when a production operation is
successfully finished. If it is not finished, no payment is made. In this book it is assumed that
direct labour is of this nature. Many organisations remunerate labour on the basis of a large
basic wage, topped up with a productivity bonus. The basic element is paid regardless of the
level of production. In such wages will not vary directly with production, and fall into the
category of an indirect cost or overhead.
Overhead is a general term applied to all the costs involved in running a business,
other than direct costs. It covers the costs of running the works organization; product
research and development; the administration of the business; selling and distributing the
product; and the cost of raising finance. Overheads are diverse, covering the whole of the
business organization. The management accountant has the problem of allocating these
costs to the individual product lines being manufactured.
COST CENTRES
To help in this task, the organization is split up into cost centres. These are areas of activity
to which are gathered all costs of a like nature. A maintenance department, canteen, and
stores are examples of cost centres. Normally centres will identify with physical areas of the
organisation. A stores cost centre is a physical area in which materials are kept, while
awaiting issue to production. A centre may also not be identifiable with a physical area. The
finance cost centre will gather together all the costs of raising finance for the business,
other than from owners or shareholders. It is a function of the administration department,
and cannot be identified with a physical area of the business.
 Where a cost centre has a product which is being manufactured, it is known as a
product centre. Examples are a machine shop which is machining parts for assembly into
saleable product in an assembly shop. Where a centre has a product that is saleable, thus
giving rise to an income, it is also known as a profit centre. It is capable of showing a profit
or loss on its overall activities.
COST ALLOCATION
The management accountant’s task is to allocate the many, diverse overheads, onto the
cost of each product manufactured. It is a major task requiring the use of many different
bases of allocation. The allocation of direct cost to a product cab be precise. In the case of
overhead allocation an element of logical guesstimation enters. There is a two-fold process,
firstly to collect all overhead costs onto the product or profit centres; and secondly to load
the overheads onto each product passing through the centre.
‘Accounting for Management’, Counsell, R.E. (Cassell, 1980)

COMPREHENSION
1. The text says that ‘direct costs vary directly with production’ (lines 1-2). What does this
sentence suggest about indirect costs?
2. Complete these sentences according to the information in the text.
(i) The largest element of direct cost is usually ………………………
(ii) All raw material costs are included in the direct costs of a product except ….
(iii) Those raw materials of which only very small quantities are used ………
3. Finish the statement below with the best ending according to the text.
Wages are part of direct costs when:
(i) they are linked to the speed of production
(ii) they are related to the quantity of output started
(iii) they depend entirely on the quantity produced
(iv) they are partly fixed and partly linked to output
4. Which of the following statements are not true about overheads?
(i) They include all costs of a business.
(ii) They exclude those costs which can be directly related to a product’s production.
(iii) They relate to certain aspects of the business only.
(iv) They are difficult to relate to individual products of a company.
5. (a) How do management accountants use ‘cost centres’ in dividing company’s costs?
(b) What important division can be made between types of cost centre within a business.
6. According to the text, what is the difference between a ‘product centre’ and a ‘profit
centre’? Can a product centre also be a profit centre?

TEXT ORGANISATION
7. The ideas of Paragraph 6 are listed below but not in the correct order according to the
text. Number them in the order they occur in the text.

Idea Order
(i) There are two stages in the allocation of orders.
(ii) Direct costs can be related accurately to products.
(iii) The many different overheads must be allocated to particular
products.
(iv) The first task is to link overheads to their product or profit
Centre
(v) Overheads are distributed among different products using a
large variety of cost centres.
(vi) Next the overheads are linked to each product connected with that
centre.
(vii) Relating overheads to individual products is not entirely accurate

VOCABULARY
8. Find words or phrases in the text which have the following meanings.

Meaning Word/phrase in text

(i) element/part (paragraph 1)
(ii) justify/make worthwhile – two answers
(both in paragraph 1)
(iii) payment (paragraph 2)
(iv) fixed/known (paragraph 2)
(v) given an additional amount (paragraph
2)
(vi) divided (paragraph 4)
(vii) similar/the same (Paragraph 4)
(viii) different kinds/various (paragraph 3)
(ix) exact (paragraph 6)
(x) having two stages (paragraph 6)

9. The word ‘guesstimation’ (line 47) is not really a word. What two words is it formed from?
What does the word mean?