CHAPTER V

OVERHEADS

Define overhead and

mention the different methods of
1.
classification of overheads.

is defined as, "the aggregate nf

Definition of overhead: Overhead
indirect expenses. The term indirect
indirect material cost, indirect wages and
means that which cannot be allocated,
but which can be apportioned to0or
overhead refers to those
absorbed by cost units or cost centres. Therefore,
expenses which cannot be identified with
particular products, process or
jobs.
Classification of overheads: Classification is the process of grouping
ofcosts according to their common characteristics. Classification.of overhead
is important in order to identify costs with cost units or cost centres. There
are various methods for the classification of overhead. The method to be
adopted depends upon the type of business, nature of product or services
rendered and policy of management. Overheads may be classified in the
following ways.
1. Classification according to nature
Indirect Materials: Indirect materials are those materials which do nol
form a part of the finished product. Cost of indirect materials cannot be
identified with and allocated but can be apportioned to a particular produc
process or job. E.g. Cotton waste, lubricant, grease, small tools etc.

Indirect Labour: Indirect labour is that labour which is not direuy

engaged in production of goods or serviçes. It indirectly helps thedu
labour engaged in production. The wages paid for indirect labour 15 K
d with
as indirect Indirect be
wages. wages are those which cannot identineh
orjob.
and allocated but can be apportioned to a particular product, processe
keeper
E.g. Wages of mechanics, supervisors, watchman, sweepers,tu
etc.
terial and indirect
Indirect Expenses: Expenses (otherthan indirect mate
labour) that are not directly charged to production are indirect c
 5.2
Fo. Office expenses and selling and distribution expenses
2. Classification according to funetion
a. Factory overheads: These are also called
works
manufacturing
overheads or factory on cost. Factory overheads cover alloverheads,
expenses
incurred from the stage of raw materials to finished goods. It includes indirect
material, indirect labour and indirect expenses in producing an article.
E.g. factory rent, supervisior's salary, power and fuel., heating and lighting,
depreciation of factory building, consumable stores etc.

Administrative overheads: These are expenses incurred for running

b.
the administrative office. E.g. Office rent and salaries, printing and
stationery
telephone expenses, legal expenses, depreciation of office building etc.
c Selling overheads: These are expenses incurred for actual sales and
promotion of sales. Eg. Salaries of sales manager, commission, travelling
expenses of salesman and promotion expenses like advertisement and
publicity, after sales service etc.

d. Distribution overheads : These are expenses concerned with packing

and delivery of goods to the customèr. Eg. packing charges, warehouse
expenses, delivery van depreciation, loading charges etc.
3. Classification according to variability:

a. Fixed overheads : Expenses that do not vary with the volume of

production are known as fixed overheads. Eg. Salary, rent, insurance etc.

b. Variable overheads Expenses that vary with the volume of

production are known an variable overheads. These are direct costs. Eg.
material, wages, selling commission, electricity charges etc.
CSemi-variableoverheads Expenses that are partly fixed and partly
ariable are called semi-variable overheads, These expenses do not vary n
the same ratio
in which the output changes.
 assniCalNon according tonormmalily:
a. Normal overheads: Normal
are
overheads refer to such
overheads whicl
expccted to be incurred in
attaining given output.
a T hese ich
unavoidable. They are, therefore, included in
overheads ar.
are
production costs.
b.
Abnormal overheads: Abnormal overheads refer to such
which are not overhead.
expected to be incurred in attaining a
given output. Such
Overhead costs
charged to
are
abnormal idle time, abnormal costing profit loss account. E.g. Cost
of
wastage etc.
5.
Classification according to
controllability:
a.
Controllable overheads : Controllable costs are
can be variable costs which
controlled. Eg. Cost of power used in
controllable by the
a
particular department is
departmental manager.
b. Uncontrollable overheuds
which cannot be controlled. Uncontrollable costs are fixed costs
:

Eg. Rent, salaries, etc. These

inurred on time basis. expenses are
2. Explain the following terms :

a. Cost classification
c. Cost apportionment b. Cost allocation
d. Cost absorption.
a. Cost classification
Cost classification is the
:
of costs according to their common characteristics. process of groupin
is important in order to Classification of overhead
identify costs with cost units or cost centres. There
are various methods of
classification of averheads. The method to be adopted
depends upon the type and size of business, nature of
and policy of product or servico
management. Costs may be classified according to
function, variability, normality, and the
controllability.
b. Cost allocation: Cost allocation
is defined the allotment of whol
as
amount of cost to cost centres or cost units. In
other words it is the proc cess

of charging the full amount of overhead without division, to a particu.

department or cost centre. Eg. Salary of sales manage is allocated to saiales
department. Similarly, overtime premium of a particular department can be
allocated to that department.
 5.4
.Costapportionnnent: Cost
apportionment is defined as the allotment
fnroportions of cost to cost centres or cost
cess of distribution units. In
of overheads to other words, it is the
proce
various departments cost centres
on some equitable basis or

Eo, Factory rent is an

expense which cannot be allocated to
department but is t0 be shared by all
production
any one

of floor area. departments

on the basis

d. Cost absorption: Cost

absorption means allotment of overheads to
iobs. In other words, distribution of the overhead expenses of a particular
department, over the units
produced in that
department is called cost
absorption.
3. Distinguish between Allocation and
Apportionment.
1. Allocation the allotment of whole amount of cost to cost
means
centres or cost units.
Apportionment means the allotment of proportions of
cost to cost centres or cost units.

2. Expenses which can be directly identified with a particular department

or cost centre is called allocation. On the other hand, expenses which cannot
be directly identified with a particular department or cost centre is called
apportionment.
3: Atlocation is much wider term than
apportionment.
4. What is meant by departmentalisation of overhead
expenses? What are its advantages?
Allocation and apportionment of overhead expenses to various
OOuction and service departments is known as departmentalisation of
Overhead expenses.
USually a factory is divided into number of departments, in order to
facilitate wor
ddiework and supervision. Departments can be divided into production
departments
COR ts and service departments. Production departments are
Ened with production of goods. Service departments are those which
enable other rtments to work. For ascertaining the expenses of each
department, first of all no distinction is made between the production
departments
and service
departments. findingAfter of service
the cost
departments,
Producti
e
production departments.
total cost of each service department is apportioned to the
 5.5
The following are the main
departnmentalisation:
Advantages of
advantages.
ascertainment
accuracy in cost
a. It ensures greater
b. It enables management to fix responsibility
c.It facilitates work and supervision
control.
d. It is essential for budgetary
e. It ensures greater control over costs by eliminating fluctuations in
Overheads.
for the department.
f.It helps in selecting a proper method of costing
g. It helps in the estimation and equitable
distribution
of overheads
among various departments.

5. Discuss different methods of overheads absorptien.

Explain their respective merits and demerits.
The following are the different methods of overheads absorption.

1. Direct material cost percentage: This rate is obtained by dividing

amount of overheads by the direct material cost and expressing this as
a percentage. The formula is
Factory overheads
X I00
Direct material cost

Suitability: It is suitable when:

a. only one kind of article is produced
b. prices of materials are stable
c. material cost forms a very high percentage of total cost.
Merits: It is simple and easy to operate.
Demerits
is
a. This method does not take into account the time factor Wnc
important for calculating overhead costs.
skilled

b. This method makes no distinction between jobs done by unss

jobs
workers and skilled workers. Similarly, it does not distinguish betwee
done by machine and manual labour.

c. No distinction is made between fixed and variable expenses

 5.6
Fluctuations in prices of raw materials are not
d.
uctuations in overhead expenses. So overhead accompanied by similar
rate based
cost would be misleading. on the material

2. Percentage of Direct Labour cost: This rate is

the amount of overheads by obtained by dividing
the direct wages cost and
percentage. The formula is expressing this as a
Factory overheads
x 100
Direct wages
Suitability: It is suitable when
a. the rates of wages are uniform.
b. the ratio of skilled and unskilled labour is
constant.
C. the direct labour forms a
greater part of the total cost
Merits
1.It is simple to understand and easy to
calculate.
2. This methods takes into account the time factor. since wages are
generally paid on time basis.
3. This is stable method because
a
labour rates are more stable than
material prices.
Demerits
1.
Ifpiece rate system is adopted, the time factor is completely ignored.
2. No distinction is made between the production of hand workers and
that of machine workers.
3. No distinction is made between fixed and variable costs.
4. This method gives inaccurate result when workers are paid overtime
u n . The reason is, higher hourly rates are paid for overtime work. But
cad expenses will not increase in the same proportion. In fact, many
actory expenses remain constant.
3.
the Percentage
the ercentage onon prime
j
amount of overheads
cost method: This rate is obtained by dividing
by the prime cost and expressing this asa
percentage. The formula is
Factory overheads
x 100
Prime cost
 As this method is a combination or h e avove w o n e n o a s , it has all

the merits and demerits of the first two methods.

4. Direet labour hour method: This is obtained by dividingtheamoint
of overhcads by the labour hours. The formula is

Factory overheads

Direct labour hours

Suitability: This is suitable when most ofthe work is done manually

Merits:
a. Time factor is taken into consideration.

b. This method is easy, as labour hours are readily available from the
time sheet, job cards etc.

Demerits:
This method cannot be used where machines
a. are used extensively
for production.

b. This method does not take into consideration the expenses which
are not dependent on labour hours such as insurance, depreciation, power
etc.

5. Machine hour rate method: Machine

hour rate is obtained by dividing
the amount of overheads by the machine hours. The formula is

Factory overheads
Machine hours
Suitability: This method is suitable where work performed is predominantly
machine based.

Merits:
1. It is a scientific method of recovering overhead
2. It helps
compare to the relative efficiencies and cost of operatimg
different machines.
3. It brings to light the existence and extent of idle time of machines
 5.8
4. It enables the
management to decide how for the use of machine
work is preferable to manual work.
5. The time factor is taken into
account
6. Cost reports prepared with the help of such rate are dependable and
help the management in decision making.
7. It provides useful data for
estimating cost of production, setting
standards and for fixing selling price for
quotations.
Demerits
1. It involves more clerical work and
thus it is costly
2.It does not take into account the
expenses that are not dependent on
the working hours of
machines.
3. It does not give accurate result
if manual labour is equally important
4. It is difficult to estimate the machine hours especially when the
production performance is not available in advance.
6. What do you understand by under absorption and over absorption of
overhead? Explain the causes and methods of dealing with both.
Overheads in cost accounts are usually charged on the basis of pre-
determined rates or estimated rates. When the overheads charged are on
the basis of
pre-determined rate, difference is bound to arise between the
amount of overheads
absorbed and the amount of overheads actually
ncurred. The reason is, that the rate is worked out on the
basis of past
records and before actual
production starts. The difference between the
overhead absorbed and the overhead actually incurred is
known as
absorption or over-absorption of overhead. Under absorption meansunder
that
the overheads absorbed in production are less than the actual overheads.
Over-absorpt means that the overheads absorbed in production are more
ver-absorption
than the
actualoverheads.
Causes for over or under-absorption of overheads:
Under or over-absorption of overhead may arise
following reasons due to any of the
 a. wrong estimation of overhead expenses

b. wrong estimation of output or working hours

C. under or over-utilisation ofproduction capacity
d. srasonal fluctuations in the level of production
e. changes in the technique and methods of production

f. valuation of work-in-progress without including proportionat

overhead cost in it.

Treatment (disposal) ofunderor over-absorption of overheads:

Under or over-absorption of overheads may be treated in any one of

the following ways :

a. Use of supplementary rate : When the anmount of under or over.
absorbed overhead is substantial, it is reasonable to charge that to the cost

of production itselfby using supplementary rate. The supplementary rate is

worked out as follows:
Amount of under or over -

absorbed overheads
Supplementary rate =
Actual base

The actual base may be either units of products, direct labour, labour
hours, machine hours or any base adopted for recovery of overheads.
In the case of under-absorption the supplementary rate is termeu a
rate IS
positive, while in the case of over-absorption the.supplementary
termed as negative.
sed
In the case of under-absorption, a positive supplementary rate i3
or
and the cost of production is increased by that amount. In the case cost is
absorption, a negative supplementary rate is used and the tola
overheads

the truc
deducted by that amount. The basic aim is to charge
cost to production.

b. Write ofto costing profit and loss account

I Sn o m i n a l

is
In case the amount of under or over-absorbed overheaa theamou
Where
may be transferred to costing profit and loss account. o m e abno

under or over-absorbed overhead is large, and is due to account.

1o53
Tactors, it should be transferred to costing profit and a
 5.10
c Carry overto nextyear 's account: Another method is to transfer the
amount ofunder or over-absorbed overhead to the next year. This method is
suitable wlhen the normal business cycle is more than one year.

This method is criticised on the ground that the cost should be absorbed
in the period in which it is incurred and it is not proper to transfer the cost of
one period to another. By doing so, the comparison between one period and
another period is rendered difficult
7. What is machine hour rate? How it is calculated? State its
merits and demerits.

Machine hour rate is the cost of running a machine per hour. It is one of
the methods of absorbing factory overhead to production. It is used in
industries or department where machinery is pre-dominant and there is little
or no manual labour. It is calculated by using the following formula.

Factory over heads

Machine hour rate Machine hours for the period

Calculation ofmachine hour rate : The following steps are required

to be taken for calculating machine hour rate.
a. Each machine or a group of machines is treated as a cost centre in
order to identify the overhead expenses.

b. Overheads relating to machine are divided into 2 parts

i. Standing charges or fixed charges
ii. Machine expenses or variable expenses

L Standing charges (e.g. rent and rates, lighting, insurance etc.) are
nose expenses which are constant irrespective ofthe use of machine. These
xpenses for each machine are to be totàlled and is divided by the normal
working hours. This will give hourly rate of standing charges.
. Machine expenses (e.g. depreciation, repairs, power etc.) are those
Xpenses which vary with the use of machines. Each item of the expense is
mated separately and is divided by the normal working hours to get
rate. While calculating normal hours, the hours required maintenance,
Setting up time etc. are to be deducted.
 5.11
Total ofstanding charges per hour and machine expenses per hour will

give the simple machine hour rate. If machine operator's wages are also
added to the simple machine hour rate, then it will be called a comprehenci.
sive
machine hour rate. Pr
to
The following the suitable bases for apportionment of differen
are
hour rate. 1.
expenses for calculation of machine
2.
Bases
Expenses 3.
4.
1. Standingcharges:
Floor area used by each machine 5.
Rent and rates
6.
Lighting and heatingg Light points or heat points or .
floor area 8.
Supervision Time spent by supervisory 9
staff on each machine 10.
11.
Capital value of each machine
Insurance 12
2. Machine expenses: 13
Cost+ Installation expenses-Scra
14
15
Depreciation Workinglife of themachine 16.
17.
Cost of repairs 18.
machine
Repairs Working life of the Soluts
Power Horse power

5) Po
Merits and Demerits: (See pages 5.7 and 5.8 point No.
De

Ins
Inse
8 Re
Mat
.,
 PROI
BASES OF APPORTIONMENT

of apportionnent ofthe following

cxpenses
Problem: I Mer
:1Mention the bases

to departinents.

Rent
.
Lighting
Power
. & Machinery
Depreciation of Plant
4. of Plant & Machinery
[nsurance
5. Insurance of stock
5.
Repairs ofplant
7 Material handling charges
8
9 Supervision

10. Canteen expenses

11. Welfare expenses
12 Staffrecreation
13. Stores overheads

14. Indirect materials

15. Indirect wages

16. Time-keeping
17. Municipaltaxes
18. Advertising
Solution Bases of Apportionment

Expenses Floor area

Lightpoints/Floor
area
Rent
Horse
Lighting Kilo watt hours /
3. Power power of plant

4 Depreciation of Machine hours/

Plant&Machinery Value ofplant
S. Insurance of machinery
Plant & Machinery
Value ofplant &
6 Value ofstock
Insurance of stock Value of plant
Repairs to plant
8. Value ofmaterials
Material handling charges
 5.13
9. Supervision No of employees
10. Canteen expenses No of employees
11. Welfare expenses No of enployees
12. Staff recreation No of employees
13 Stores overheads Materials consumed by each
dept.
14 Indirect materials Direct materials
15. Indirect wages Direct wages
16. Time-keeping No. of employees
17. Municipal taxes Floor Area
18. Advertisting Actual expenses or % of sales

Problem: 2 Shiva Industries Ltd., has four departments. A.B and C are
production departments and D is the service departiment. The actual expenses
for a month were as follows
Rs.
Rent 6,000
Repairs to plant 3,600
Depreciation 2,700
Lighting charges 600
Supervision 9,000
Insurance of stock 3,000
Power S400
Employees' Insurance - Employer's liability 900
The following information is also available:

Dept.D
Dept.A Dept.B Dept.C
100
Area in Sq. ft. 300 220 180
l6
No. of workers 48 32 24
2000

Total wages Rs.8,000 6,000 4,000 6000

Value of plant Rs.24,000 18,000 12,000

Value of stock Rs. 15,000 9,000 6, oW method

e q u i t a b l

most
Apportion the costs to four departments on the ( B . C o m . ,B h a r a t h i d a s a
 $olution:

Overhead Distribution Summary

Basis of Departments
Expenses Total
Apportionment
A B C D

Rs. Rs. Rs. Rs. Rs.

Rent Area
(15:11:9:5) 6,000 2,250 1,650 1,350 750

Repairs to
Plant Plant value
(4:3:2:1) 3,600 1,440 1,080 720 360

Depreciation Plant value

(4:3:2:1) 2,700 1,080 810 540 270

Lighting Area
(15:11:9:5) 600 225 165 135 75

upervision No. of workers

(6:4:3:2) 9,000 3,600 2,400 1,800 1,200

Insurance of Stock value

Stock 3,000 1,500 900 600
(5:3:2)
Power Plant value
5,400 2,160 1,620 1,080 540
(4:3:2:1)

Employees
insurance- Wages
270 180 90
Employer's (4:3:2:1) 900 360
Liability