What is Overhead Cost Control? Accounting and Control, Methods, Types

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What is Overhead Cost Control?

Overhead cost control refers to the process of managing and minimizing the indirect expenses associated with running a business or organization. These indirect costs, often referred to as overhead costs, include various expenses that are not directly tied to producing goods or services but are necessary for the overall operation of the business. Examples of overhead costs include rent, utilities, administrative salaries, office supplies, and maintenance.

Overheads are 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, for example, wages paid to watch and ward staff, heating and lighting expenses of factory, etc.

Overheads are also very important cost element along with direct materials and direct labor. Often in a manufacturing concern, overheads exceed direct wages or direct materials and, at times, even both put together.

On this account, it would be a grave mistake to ignore overheads either for the purpose of arriving at the cost of a job or a product or for controlling total expenditure. 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. Overheads are incurred not only in the factory of production but also on administration, selling and distribution.


Advantages of Classification of Overheads Into Fixed and Variable

The primary objective of segregating semi-variable expenses into fixed and variable is to ascertain marginal costs. Besides this, it also has the following advantages:

Controlling Expenses

The classification of expenses into fixed and variable components helps in controlling expenses. Fixed costs are generally policy costs, which cannot be easily reduced. They are incurred irrespective of the output and hence are more or less non controllable. Variable expenses vary with the volume of activity and the responsibility for incurring such expenditure is determined in relation to the output. The management can control these costs by giving proper allowances in accordance with the output achieved.

Preparation of Budget Estimates

The segregation of overheads into fixed and variable part helps in the preparation of flexible budget. It enables a firm to estimate costs at different levels of activity and make comparison with the actual expenses incurred.

Decision Making

The segregation of semi-variable cost between fixed and variable overhead also helps the management to take many important decisions. For example, decisions regarding the price to be charged during depression or recession or for export market. Likewise, decisions on make or buy, shut down or continue, etc., are also taken after separating fixed costs from variable costs.

In fact, when any change is contemplated, say, increase or decrease in production, change in the process of manufacture or distribution, it is necessary to know the total effect on cost (or revenue) and that would be impossiblewithout a correct segregation of fixed and variable costs. The technique of marginal costing, cost-volume-profit relationship and break-even analysis are all based on such segregation.


Accounting and Control of Manufacturing Overheads

We have already seen that overheads are, by nature, those costs which cannot be directly related to a product or to any other cost unit, yet for working out the total cost of a product or a unit of service, the overheads must be included. Thus, we have to find out a way by which the overheads can be distributed over the various units of production.

Manufacturing Overheads

Generally, manufacturing overheads form a substantial portion of the total overheads. It is important that such overheads should be properly absorbed over the cost of production. The following procedure may be adopted in this regard. The steps given below show how factory overhead rates are estimated and overheads absorbed on that basis and how actual amount is compared with the absorbed amount.

Estimation and Collection of Manufacturing Overheads

The first stage is to estimate the amount of overheads, keeping in view the past figures and adjusting them for known future changes. There are four main sources available for the collection of factory overheads, viz:

  • Invoices.
  • Stores requisition.
  • Wage analysis book.
  • Journal entries.

Cost Allocation

The term “allocation” refers to assignment or allotment of an entire item of cost to a particular cost center or cost unit. It implies relating overheads directly to the various departments. The estimated amount of various items of manufacturing overheads should be allocated to various cost centers or departments. For example, if a separate power meter has been installed for a department, the entire power cost ascertained from the meter is allocated to that department. The salary of the works manager cannot be directly allocated to any one department since he looks after the whole factory. It is, therefore, obvious that many overhead items will remain unallocated after this step.

Cost Apportionment

There are some items of estimated overheads (like the salary of the works manager) which cannot be directly allocated to the various departments and cost centers. Such unallocable expenses are to be spread over the various departments or cost centers on an appropriate basis. This is called apportionment. Thus apportionment implies “the allotment of proportions of items of cost to cost centers or departments.” After this stage, all the overhead costs would have been either allocated to or apportioned over the various departments.

Re-Apportionment

Up to the last stage, all overheads are allocated and apportioned to all the departments, both production and service departments. Service departments are those departments which donot directly take part in the production of goods. Such departments provide ancillary services. Examples of such departments are boiler house, canteen, stores, time office, dispensary, etc.

The overheads of these departments are to be shared by the production departments since service departments operate primarily for the purpose of providing services to production departments. The process of assigning service department overheads to production departments is called reassignment or re-apportionment. At this stage, all the factory overheads are collected under production departments.

Absorption

After completing the distribution, as stated above, the overheads charged to the department are to be recovered from the output produced in respective departments. This process of recovering overheads of a department or any other cost center from its output is called recovery or absorption. The overhead expenses can be absorbed by estimating the overhead expenses and then working out an absorption rate.

When overheads are estimated, their absorption is carried out by adopting a pre-determined overhead absorption rate. This rate can be calculated by using any one method as discussed later in the chapter. As the actual accounting period begins, each unit of production automatically absorbs a certain amount of factory overheads through pre-determined rates. During a year, a certain amount will be absorbed over the various products. This is known as the total amount of absorbed overheads.

Treatment of Over- and Under-Absorption of Overheads

After a year ends, the total amount of actual factory overheads is known. There is bound to be some difference between the actual amount of overheads and the absorbed amount of overheads. So the overheads are generally either under-absorbed or over-absorbed. The difference has to be adjusted keeping in view of such differences and the reasons thereof.

It serves the following two purposes:

  • To charge various products and services with an equitable portion of the total amount of factory overheads.

  • To charge factory overheads immediately as the product or the job is completed without waiting for the figures of actual factory overheads.

Distribution Overheads

The various steps for the distribution of overheads have been discussed in detail as follows:

Estimation and Collection of Manufacturing Distribution Overheads

The amount of factory overheads is required to be estimated. The estimation is usually done with reference to past data adjusted for known future changes. The overhead expenses are usually collected through a system of standing orders.

Standing Orders

In every manufacturing business, expenses are incurred on direct materials and direct labor in respect of several jobs or other units of production, manufacture of which is undertaken. The incurring of these expenses is authorized by production orders or work orders. The work order numbers are not ordinarily fixed or permanent.

They are generally allotted in a serial order according to the number of manufacturing jobs undertaken by the business. In addition, indirect expenses are incurred in connection with the rendering of services to the production departments, or to the manufacturing process. The term “standing order” denotes sanction for indirect expenses under various heads of expenditure.

In large factories, usually the classification of indirect expenditures is combined with a system of standing orders (sometimes also referred as “service orders”). It is a system under which a number is allotted to each item of expense for the purpose of identification and the same is continued from year to year.

All the indirect expenditure in such a case is charged to one or the other of the standing orders and periodical summaries, giving total of each standing order, are prepared for comparison with budgets, as well as for apportioning them among the various departments. The extent of such analysis and the nomenclature adopted are settled by the management according to the needs of the industry.


Allocation of Overheads Over Various Departments or Departmentalization of Overheads

Most of the manufacturing processes functionally are different and are performed by different departments in the factory. Where such a division of functions had been made, some of the departments should be engaged in actual production of goods and others in providing services ancillary thereto. At this stage, the factory overheads which can be directly related to the various production or service departments are allocated in this manner.

It may, sometime, become necessary to sub-divide a manufacturing organization into several cost centers so that a closer distribution of expenses and a more detailed control is practicable. It is thus obvious that the principal object of setting up cost centers is to collect data, in respect of similar activities more conveniently. This avoids a great deal of cost analysis.

When costs are collected by setting up cost centers, several items can be ascertained definitely and the element of estimation is reduced considerably. For instance, the allowance of the normal idle time or the amount to be spent on consumable stores, etc. There are two main types of cost centers, machine or personal, depending on whether the process of manufacture is carried on at a center by man or machine. For the convenience of recording of expenditure, cost centers are sometimes allotted a code number.

Advantages of Departmentalization

The collection of overheads department wise gives rise to the following advantages:

  • Better estimation of expenses: Some expenses which relate to the departments will be estimated almost on an exact basis and, to that extent, the accuracy of estimation of overheads will be higher.

  • Better control: For the purpose of controlling expenses in a department, it is obviously necessary that the figures in relation to each department should be separately available. It is one of the main principles of control that one should know for each activity how much should have been spent and how much is actually spent. If information about expenses is available only for factory as a whole, it will not be possible to know which department has been over spending.

  • Ascertainment of cost for each department: From the point of view of ascertaining the cost of each job, the expenses incurred in the departments through which the job or the product has passed should be known. It is only then that the cost of the job or the product can be charged with the appropriate share of indirect expenses.

    It is not necessary that a job must pass through all the departments or that the work required in each department should be the same for all jobs. It is, therefore, necessary that only appropriate charge in respect of the work done in the department is made. This can be done only if overheads for each department are known separately.

  • Suitable method of costing: A suitable method of costing can be followed differently for each department, for example, batch costing when a part is manufactured, but single or output costing when the product is assembled.

Apportioning Overhead Expenses Over Various Departments

After the allocated overheads are related to the departments, expenses incurred for several departments have to be apportioned over each department, for example, rent, power, lighting, insurance and depreciation. For distributing these overheads over different departments benefiting thereby, it is necessary at first to determine the proportion of benefit received by each department and then distribute the total expenditure proportionately on that basis. But the same basis of apportionment cannot be followed for different items of overheads since the benefit of a service to a department in each case has to be measured differently.

Some of the basis that are generally adopted for the apportionment of expenses are stated in Table.

Overhead CostBases of Apportionment
Rent and other building expenses
Lighting and heating
Fire precaution service
Air-conditioning
Floor area or volume of department
Perquisites
Labor welfare expenses
Time keeping
Personnel office
Supervision
Number of workers
Compensation to workers
Holiday pay
ESI and P.F. contribution
Perquisites
Direct wages
General overheadsDirect labor hours, direct wages or machine hour
Depreciation of plant and machinery
Repair and maintenance of plant and
machinery
Insurance of stock
Capital values
Power/steam consumption
Internal transport
Managerial salaries
Technical estimates
Lighting expensesNumber of lighting points or area or metered units
Electric powerHorse power of machines, or number of machine hours, or value of machines or units consumed
Material handling
Stores overhead
Weight of materials or volume of materials or value of materials or unit of material
Basis of Overheads Allocation

Other Basis of Apportioning Overhead Costs

We have considered already that the benefit received by the department generally is the principal criterion on which the costs of service departments or common expenses are apportioned. But other criteria are equally valid.

Three of them are mentioned below:

  • Analysis or survey of existing conditions.
  • Ability to pay.
  • Efficiency or incentive.

A single concern may have only one criterion under consideration predominantly or may use all (including the service or benefit criterion) for different phases of its activity.

Analysis or Survey of Existing Condition

At times, it may not be possible to determine the advantage of an item of expenses without undertaking an analysis of expenditure. For example, lighting expenses can be distributed over departments only on the basis of the number of light points fixed in each department.

Ability to Pay

It is a principle of taxation which has been applied in cost accounting as well as for distributing the expenditure on the basis of income of the paying department, on a proportionate basis. For example, if a company is selling three different products in a territory, it may decide to distribute the expenses of the sales organization to the amount of sales of different articles in this territory.

This basis, though simple to apply, may be inequitable since the expenditure charged to an article may have no relation to the actual effort involved in selling it. Easy selling lines thus may have to bear the largest proportion of expenses while, on the other hand, these should bear the lowest charge.

Efficiency or Incentives

Under this method, the distribution of overheads is made on the basis of pre-determined levels of production or sales. When distribution of overhead cost is made on this basis and if the level of production exceeds the predetermined level of production, the incidence of overhead cost gets reduced and the total cost per unit of production or of sales is lowered.

The opposite is the effect if the assumed levels are not reached. Thus the department whose sales are increasing is able to show a greater profit and thereby is able to earn greater good-will and appreciation of the management than it would have if the distribution of overheads was made otherwise.


Difference Between Allocation and Apportionment

The difference between the allocation and apportionment is important to understand because the purpose of these two methods is the identification of the items of cost to cost units or centers.

However, the main difference between the above methods is given below:

  • Allocation deals with the whole items of cost which are identifiable with any one department. For example, indirect wages of three departments are separately obtained and hence each department will be charged by the respective amount of wages individually.

    On the other hand, apportionment deals with the proportions of an item of cost, for example, the cost of the benefit of a service department will be divided between those departments which has availed those benefits.

  • Allocation is a direct process of charging expenses to different cost centers, whereas apportionment is an indirect process because there is a need for the identification of the appropriate portion of an expense to be borne by the different departments benefited.

  • The allocation or apportionment of an expense is not dependent on its nature, but the relationship between the expense and the cost center decides that whether it is to be allocated or apportioned.

  • Allocation is a much wider term than apportionment.

Methods of Absorbing Overheads to Various Products or Jobs

The method selected for charging overheads to products or jobs should be such as will ensure the following:

  • Total amount charged (or recovered) in a period does not differ materially from the actual expenses incurred in the period.

  • Amount charged to individual jobs or products is equitable. In case of factory overhead, this means that:

    • The time spent on completion of each job should be taken into consideration.

    • A distinction should be made between jobs done by skilled workers and those done by unskilled workers.

    • Jobs done by manual labor and those done by machines should be distinguished.

In addition, the methods should be capable of being used conveniently and yield uniform result from period to period as far as possible; any change that is apparent should reflect a change in the underlying situation such as substitution of human labor by machines. Several methods are commonly employed, either individually or jointly, for computing the appropriate overhead rate.

The more common of these are as follows:

  • Percentage of direct materials.
  • Percentage of prime cost.
  • Percentage of direct labor cost.
  • Labor hour rate.
  • Machine hour rate.
  • Rate per unit of output.

Percentage of Direct Material Cost

This method is based on the fact that both materials as well as labor contribute in raising factory overheads. Hence, the total of the two, that is, prime cost should be taken as base for absorbing the factory overhead. The overhead rate in this method is computed by the following formula:

Overhead rate = ( Total production overheads of a department / Budgeted direct material cost of all products ) × 100

Percentage of Prime Cost Method

This method is based on the fact that both materials as well as labor contribute in raising factory overheads. Hence, the total of the two, that is, prime cost should be taken as base for absorbing the factory overhead. The overhead rate in this method is computed by the following formula:

Overhead rate = ( Total production overheads of a department / Prime cost ) × 100

Percentage of Direct Labor Cost

Formula to be used under this method is:

Overhead rate = ( Total production overheads of a department / Direct labour cost ) × 100

Labor Hour Rate

This method is an improvement on the percentage of direct wage basis, as it fully recognizes the significance of the element of time in the incurring and absorption of the manufacturing overhead expenses. This method is admirably suited to operations which do not involve any large use of machinery.

To calculate labor hour rate, the amount of factory overheads is divided by the total number of direct labor hours. Suppose factory overheads are estimated at Rs. 90,000 and labor hours at Rs. 1,50,000. The overhead absorption rate will be 0.60. If 795 direct labor hours are spent on a job, 477 will be absorbed as overhead. It can be calculated for each category of workers.

Formula to be used under this method is as follows:

Direct labor hour rate = ( Total production overheads of a department / Direct labour hours )

Machine Hour Rate

By the machine hour rate method, manufacturing overhead expenses are charged to production on the basis of number of hours machines are used on jobs or work orders. The machine hour rate is computed by the following formula:

Machine hour rate = ( Production overheads / Number of machine hours ) × 100

There is a basic similarity between the machine hour and the direct labor hour rate method so far as both are based on the time factor. The choice of one or the other method is conditioned by the actual circumstance of the individual case. In respect to departments or operations in which machines predominate and the operators perform relatively a passive part, the machine hour rate is more appropriate.

In such case, the machine hour rate method alone can be depended on to correctly absorb the manufacturing overhead expenses to different items of production. Usually, the computation is made on the basis of the estimated expenses or the normal expenses for the coming period. Thus, the machine hour rate usually is a pre-determined rate. It is desirable to work out a rate for each individual machine; where a number of similar machines are working in a group, there may be single rate for the whole group.

Rate Per Unit of Output Method

This is the simplest of all the methods. In this method, overhead rate is determined by the following formula:

Overhead rate = Amount of overheads / Number of units × 100


Types of Overhead Rates

The overhead rates may be of the following types:

Normal Rate

This rate is calculated by dividing the actual overheads by actual base. It is also known as the actual rate. It is calculated by the following formula:

Normal overhead rate = Actual amount of overheads / Actual base

Pre-Determined Overhead Rate

This rate is determined in advance by estimating the amount of the overhead for the period in which it is to be used. It is computed by the following formula:

Pre-determined rate = Budgeted amount of overheads / Budgeted base

The amount of overhead rate of expenses for absorbing them to production may be estimated on the following three basis:

  • The figure of the previous year or period may be adopted as the overhead rate to be charged to production in the current year. The assumption is that the value of production as well as overheads will remain constant or that the two will change proportionately.

  • The overhead rate for the year may be determined on the basis of estimated expenses and anticipated volume of production activity. For instance, if expenses are estimated at Rs. 10,000 and output at 4,000 units, the overhead rate will be Rs. 2.50 per unit.

  • The overhead rate for a year may be fixed on the basis of the normal volume of the business.

Blanket Overhead Rate

Blanket overhead rate refers to the computation of one single overhead rate for the whole factory. It is to be distinguished from the departmental overhead rate which refers to a separate rate for each individual cost center or department. The use of blanket rate may be proper in certain factories producing only one major product in a continuous process or where the work performed in every department is fairly uniform or standardized.

This overhead rate is computed as follows:

Blanket rate = Total overheads for the factory / Total number of units of base for the factory

A blanket rate should be applied in the following cases:

  • Where only one major product is being produced.

  • Where several products are produced, but

    • All products pass through all departments.

    • All products are processed for the same length of time in each department. Where these conditions do not exist, departmental rates should be used.

Departmental Overhead Rate

It refers to the computation of one single overhead rate for a particular production unit or department. Where the product lines are varied or machinery is used to a varying degree in the different departments, that is, where conditions throughout the factory are not uniform, the use of departmental rates is to be preferred. This overhead rate is determined by the following formula:

Departmental overhead rate = Overhead of department or cost center / Corresponding base

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