CHAPTER 4

Overheads – Accounting and Control

Meaning and definition of Overheads
It may be recalled that the total cost is broadly divided into direct and indirect cost. The total
of the direct costs (i.e. direct materials, direct wages and direct expenses) is termed as Prime
Cost and the total of all indirect costs (i.e. indirect materials, indirect wages and indirect
expenses) is known as Overheads.
Overheads comprise all indirect expenditure. The CIMA of UK has defined overhead as “the
aggregate of indirect materials cost, indirect wages and indirect expenses”.
In the words of Wheldon, “Overhead may be defined as the cost of indirect materials,
indirect labour and such other expenses, including services, as cannot conveniently be
charged direct to specific cost units. Alternatively, overhead are all expenses other than
direct expenses.
According to Bloker and Weltmer, “Overhead costs are the operating costs of a business
enterprise which cannot be traced directly to a particular unit of output”.
Overhead is also known by other terms like oncost, supplementary costs, non- productive
costs, burden, etc. However, the term overhead is the most commonly used.
CLASSICATION OF OVERHEADS
Overhead costs may be classified into:
(a)Functions (b)Elements and (c)Behaviour

Classification
of elements

By Functions By Elements By behaviour

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
 By By By
functions Elements Behaviour
Production
Overhead Indirect materials Fixed Overhead

Administration
Overhead
Indirect labour Variable Overhead
Selling Overhead

Distribution Semi-variable
Indirect expenses
method overhead

Steps in Distribution of Overheads

The following procedure is followed in finding out the Overhead cost of individual cost units
of production:
1. Collection of Overhead under separate headings.
2. Allocation and Apportionment to production departments and service departments.
3. Re-apportionment of total overheads of each service department to production department.
4. Absorption of overhead.
The above steps have been explained in detail in the following pages.
COLLECTION OF OVERHEAD
Collection of overhead means collection of various items under suitable accounts. The main
sources from which overhead expenses are collected in cost accounts are given below:
(a)Stores requisition notes. For indirect materials issued from stores.
(b) Invoices. For payments made to outside parties for stores as well as other services.
(c) Wages analysis book. For wages paid to indirect workers.
(d) Journal entries. For those overhead items which do not involve cash payment and need
some adjustment or those relating to outstanding expenses, e.g., depreciation, outstanding
rent, etc.
ALLOCATION AND APPORTIONMENT (PRIMARY DISTRIBUTION)
Departmentalisation of overheads-

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
The distribution of overheads to various departments is known as departmentalisation of
overheads. This is done by allocation and apportionment of items of overhead to various
departments.
Allocation
It means charging the full amount of overhead cost to a cost centre e.g., to a department, to a
process, etc. It has been defined as “the allotment of whole items of cost to cost centre or cost
units”. Allocation depends on the nature of cost. If an item of cost can be easily identified to
a cost centre, it is allocated. For e.g., salary of a timekeeper can be easily allotted to time-
keeping department. Other e.g. of items which are allocated are indirect materials,
depreciation of machinery, idle time cost, overtime cost, etc.
Apportionment
It is “the allotment of proportions of items of cost to cost centres or cost units”. Where an
item of cost is common to various cost centres, it is allotted to different cost centres
proportioned to on some equitable basis, i.e. area occupied by departments concerned.
Similarly, salary of General Manager cannot be allocated wholly to any one dept. as he
attends in general to all the departments. It should therefore be apportioned on some equitable
basis.
Distinction between Allocation and Apportionment
The distinction between allocation and apportionment is important to understand. The
purpose of both cost allocation and apportionment is the identification or allotment of items
of cost to cost centres or cost units. However, the main difference between the two
procedures lies in that while allocation deals with whole items of costs, apportionment deals
with proportions of items of cost. Allocation is a direct process, but apportionment may be
made only indirectly and for which suitable bases are to be selected. Whether an item of cost
can be allocated or apportioned does not depend on the nature of cost but upon its
relationship with the cost centres or cost units to which it is to be charged.
Overheads should always be allocated as far as possible. If an overhead cannot be allocated,
it is apportioned. This involves finding some basis of apportionment that will enable the
overhead to be equitably shared between various production and service departments.
Production and Service Department
Departments are classified into production and service departments.
A production department engages in the actual manufacture of the product by changing the
shape, form or nature of material or by assembling the parts into the finished product. E.g. of
production department were melting shop, weaving department, spinning department,
grinding department, etc.
A service departmentalisation the other hand, is one rendering a service that contributes in an
indirect manner to the manufacturing of the product but which does not itself changes the
shape, form or nature of material that is converted into the finished product. E.g. are labour
welfare department, purchasing department, accounting department, canteen, etc.
Basis of Apportionment of Overhead

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
Different items of overhead are apportioned on different basis. Some of the common basis of
apportionment of different items of overhead are illustrated in the following table
Overhead cost Basis of Apportionment

I.
(i)Rent and other building expenses Floor area, or volume of department
(ii) Lighting and heating
(iii) Fire precaution service
(iv) Air condition

II.
(i)Fringe benefits Number of workers
(ii) Labour welfare expenses
(iii) Time keeping
(iv) Personnel office
(v) Supervision

III.
(i)Compensation to workers Direct wages
(ii) Holiday pay
(iii) ESI and PF contribution
(iv) Fringe benefits

IV. General overhead Direct labour hours, or direct wages

or machine hours
V.
(i)Depreciation of plant and machinery Capital values
(ii)Repairs and maintenance of plant and
Machinery
(iii)Insurance of stock

VI.

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
(i)Power and steam consumption Technical estimates
(ii)Internal transport
(iii)Managerial salaries

VII. Lighting expenses No. of light points, or Area

VIII. Electric power Horse power of machine, or no. of

Machine hours or value of
Machines
IX.
(i) Material handling Weight of materials, or volume or
Value of materials
(ii)Stores overhead

It should be noted that some overheads in the above list can be apportioned on more than
basis. The choice of an appropriate basis is really a matter of judgement. For e.g., welfare
expenses may be apportioned based on employees or total wages. Similarly lighting expenses
may be apportioned based on number of light points in each department in each department
based on floor area.
For allocation and apportionment of overhead, statement called ‘Overhead Distribution’ is
made.
APPORTIONMENT OF SERVICE DEPARTMENT COSTS
(SECONDARY DISTRIBUTION):

Once the overheads have been allocated and apportioned to production and service
departments and totalled, the next step is to re- apportion the service department costs to
production departments. This is necessary because our ultimate object is to charge overheads
to cost units, and no cost units pass through service departments. Therefore, the costs of
service departments must be charged to production departments.
There are various methods of apportionment of service departments
overheads. These methods are shown in the following chart:

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
 Apportionment of service Department Overheads

Apportionment to production Apportionment to production

Departments only as well as other service departments

Non-reciprocal basis Reciprocal basis

Simultaneous Repeated
Equations method Distribution method

I. Apportionment to production Departments only. Here the total amount of each

service department is distributed to only production department. Some of the
important bases of apportionment of service department overheads as given below:
Service Department Basis of Apportionment
1. Purchase Department (a) Value of material purchased
(b) No. of orders placed

2. Time office (a) No. of employees

Personnel Department (b) Wages paid
(c) Labour hours
3. Canteen Labour (a) No. of employees
Welfare (b) Wages paid

4. Accounts office (a) No. of employees

(b) No. of time Cards handled

5. Laboratory (a) Testing laboratory hours

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
 (b) Units of output

6. Maintenance Department No. of hours worked in each department

II. Apportionment to production as well as Service Departments: Quite often, a

service department renders service not only to production department but also to
other service departments. For example, maintenance department looks after not
only the plant and machinery of production department but also the equipment of
other service departments like power-house, material handling, etc. Similarly, power-
house supplies electricity not only to production departments but also to other service
departments like canteen, maintenance department, etc. This type of inter-service
department apportionment may be either on reciprocal basis or non-reciprocal basis.
Non- reciprocal Distribution (step ladder Method): This is done when various service
departments are not interdependent. This means a service department provides its
services to other service department but doesn’t receive any service from that service
department. In such a case if there are two service departments, the cost of service
department which render service to other service department should be apportioned
first. Then the cost of the other service department will comprise of its own cost-plus
share allotted to it from the other service department. For example, there are two
service departments X and Y. X department provides its service to Y and other
production departments. On the other hand, Y doesn’t provide service to X
department but only to production department.

More than Two Service Departments:

When there are more than two service departments and distribution is to be done on non-
reciprocal basis, the service departments should be arranged in the descending order of their
serviceability. The cost of the most serviceable department i.e. the department which serves
the largest number of departments is apportioned first. The service department which serves
the next largest number of departments is then taken up for apportionment of its cost
(including the pro-rated cost of the first service department). In this way the cost of the third
serviceable department is taken up and this process continues till the cost of the last service
department is apportioned. It should be noted that the cost of the last service department is
apportioned only to production departments.

Reciprocal Distribution: This method is followed when service departments are mutually
dependent. For example, service to A and C and department render service to A and B. Thus,
each service department receives services service from each other service department. There
are two main methods which are used for reciprocal distribution: (I) simultaneous equation
method. (ii) Repeated Distribution Method.

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
Simultaneous Equations Method: In this method the algebraic equations given below help
in the apportionment of overheads.
X = a + bY and Y = a + bX the above method of simultaneous equations gives
accurate results. But if the number of service departments is more than two, calculations
become complicated.
Repeated Distribution Method: The following steps are involved in this method.
(a) Apply the given percentages to distribute the primary total of the first service department.
By charging the amount to other departments, the account of the first service department is
closed.
(b) Apply the given percentages to the second service department whose total is made up of
its primary charges plus amount apportioned from service department No.1. This closes the
account of the second service department but re-opens the account of service department
No.1.
(c) Apply the same percentage to all other service Departments.
(d) Repeat this process of distribution again starting with service department No.1 whose
total now consist only of amounts apportioned from other service departments. In this way
service department totals keep on reducing with each process of distribution because each
time a substantial amount is charged to the production departments.
(e) This process is stopped at the point where it is felt that the remaining figures are too small
to be of any consequence.
Though this method produces only approximate results but it can be conveniently applied
when number of service departments is even more than two.

ABSORPTION OF FACTORY OVERHEADS

Absorption is the allocation, appointment and re-appointment if overheads to production
departments are complete, the total overheads cost of the production department will consists
of:
(a) It’s own expenses, e.g., indirect materials, indirect wages, etc.;
(b) Share of common expenses ,e.g., factory rent, lighting and heating ,and
(c) Share the costs of service departments re-apportioned to it.
This gives total overhead cost of each production department. The total cost of production
department is then to be absorbed by the products manufactured in the respective production
departments. This is known as absorption.
The absorption of overheads is the last step in the distribution plan of production of
overheads. It is the process of charging to the product or output if production department, all
the overhead expenses which have been allocated and appointed to it. The purpose behind
absorption is that overhead should be absorbed in the cost of the output of the given period.
Absorption of overheads is also known as recovery or application of overheads.
Steps in Absorption of Overheads

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
There are two steps in the absorption of overheads:
(a) Computation of overhead absorption rate.
(b) Application of these rates to cost units.

(1)Computation of overhead absorption rate: Absorption rate are computed for the
purpose of absorption of overheads in cost of cost units. There are six methods for
determining absorption rate which have been described later in this chapter. In all
these methods the overhead rate is computed by dividing the total amount of overhead
of the department by the number of units in the base, such as number of cost units,
machine hours, labour hours, direct labour cost, prime cost, etc. This is shown below:
Overhead absorption rate =Total overhead of cost center /Total units of base used
(2)Application of rate of cost units: In order to arrive at the cost of each cost units,
the overhead rate is multiplied to the units of base in the cost units .i.e.,
Overhead to be absorbed =Units of base in cost units X Overhead rate
To illustrate, machine hour rate is ₹250 and a cost has taken 12 hours of machine,
overhead to be absorbed by the cost units will be : 12 hours X ₹250=₹30
Actual and Pre-determined rates: Overhead absorption rate may be based on actual
figures or estimated figures.
Actual rate: It is calculated by dividing the actual overhead by actual base. Thus:
Actual overhead rate =Actual amount of overhead /Actual base
On account of certain limitations of actual rate, it is not always desirable to use it for
the absorption of overhead.
Pre-determined rate: This rate is determined in advance of the period it n which it is
to be used. It is computed by dividing the estimated or budgeted amount of overhead
by the budgeted base. Thus:
Pre-determined overhead rate =Budgeted amount of overhead /Budgeted base
As compared to actual rate a pre-determined rate is of greater practical utility. This is
because a pre-determined rate enables prompt preparation of tenders and quotations
and fixation of selling prices. Cost control is also facilitated by comparing the actual
overhead with the pre-determined overhead recovered.
Blanket and Multiple Rates
A blanket overhead rate is a single overhead rate for the entire factory. It is computed
as follows:
Blanket rate= Total overhead for the factory /Total No. of utility of base for the
factory
Blanket overhead rate should not be used expect when output is uniform. Otherwise it
will result in over-costing of certain cost units. Moreover, when a blanket overhead

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
 rate is used performance of individual department or cost centres cannot be properly
assessed and exercise of control becomes difficult.
Multiple rates mean a number of separate rates of each other centre or department.
For instance separate rates are calculated for each production department, product line
and for fixed and variable overhead. The following formula is used to calculate
multiple rates:
Overhead rate=overhead of the cost centre /corresponding base
Multiple rates are of more practical utility and should be preferred over blanket rates
for accuracy and control.
Methods of Absorption of Factory Overhead
1. Percentage on Direct Material: OH’s are absorbed on the basis of direct
material consumed in producing the product.
OH Rate = Factory OH/Direct Materials * 100
Advantages
• Simple to calculate
• Accurate result when material price is do not fluctuate
Disadvantages
• Material Price fluctuates frequently
• Illogical as Material and OH are not connected
• Ignores time factor
2. Percentage on Direct Wages: OH’s are absorbed on the basis of direct wages
incurred in producing the product.
OH Rate = Factory OH/Direct Wages * 100
Advantages
• Simple to calculate
• Less fluctuate compared to material
• Consider Time factor – More wage for more time spent
Disadvantages
• When labour is not main factor of production
• When workers are not paid on time rate
• No distinction between skilled and unskilled workers

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)
3. Percentage on Prime Cost: OH’s are absorbed on the basis of both direct material and
direct wages incurred in producing the product.
OH Rate = Factory OH/Prime Cost * 100
Advantages
• Simple to calculate
Disadvantages
• Combines the limitation of both 1 and 2 methods
4. Direct Labour Hour Rate: Direct Labour Hour Rate is the OH cost of a direct worker
working for one hour.
DLHR = OH Expenses/Total No. of Labour
Advantages
• Consideration to time factor
• Useful when labour is the important factor of production
Disadvantages
• Additional records of labour hours
• 5. Machine Hour Rate: Used when work is mainly with machines. Separate rate for
each type of machine.
• MHR is the cost of running a machine for one hour.
• MHR = F OH for Machine X/No. of Machine hours
• 6. Rate Per Unit of Production: Based on No. of Units produced
• OH Rate = F OH/ Units produced
• Used when Uniform output.

Chapter 4 Overheads
Prof. Jerlin Jose, DPS, CHRIST (Deemed to be University)