Tuesday, April 12, 2016

Overheads - Meaning and Classification

Overheads - Meaning
Cost related to a cost center or cost unit may be divided into two i.e. Direct and Indirect cost. The Indirect cost is the overhead cost and is the total of indirect material cost, indirect labour cost, indirect expenses. These indirect costs are called as ‘Overhead’ costs. According to CIMA, overhead costs are defined as, ‘ the total cost of indirect materials, indirect labor and indirect expenses.’ Thus all indirect costs like indirect materials, indirect labor, and indirect expenses are called as ‘overheads’. Examples of overhead expenses are rent, taxes, depreciation, maintenance, repairs, supervision, selling and distribution expenses, marketing expenses, factory lighting, printing stationery etc. In subsequent paragraphs, we will be discussing various aspects of overhead accounting.
Classification of Overheads: Classification is defined by CIMA as, ‘the arrangement of items in logical groups having regard to their nature or the purpose to be fulfilled. In other words, classification is the process of arranging items into groups according to their degree of similarity. Accurate classification of all items is actually a prerequisite to any form of cost analysis and control system. Classification is made according to following basis.
a)      Classification according to Elements:  According to this classification overheads are divided according to their elements. The classification is done as per the following details.
1.       Indirect Materials: Materials which cannot be identified with the given product unit of cost center is called as indirect materials. For example, lubricants used in a machine is an indirect material, similarly thread used to stitch clothes is also indirect material. Small nuts and bolts are also examples of indirect materials.

2.       Indirect Labour: Wages and salaries paid to indirect workers, i.e. workers who are not directly engaged on the production are examples of indirect wages.
3.       Indirect Expense:  Expenses such as rent and taxes, printing and stationery, power, insurance, electricity, marketing and selling expenses etc are the examples of indirect expenses.
b)      Functional Classification: Overheads can also be classified according to their functions. This classification is done as given below.
1.       Manufacturing Overheads:  Indirect expenses incurred for manufacturing are called as manufacturing overheads. For example, factory power, works manager’s salary, factory insurance, depreciation of factory machinery and other fixed assets, indirect materials used in production etc. It should be noted that such expenditure is incurred for manufacturing but cannot be identified with the product units.
2.       Administrative Overheads:  Indirect expenses incurred for running the administration are known as Administrative Overheads. Examples of such overheads are, office salaries, printing and stationery, office telephone, office rent, electricity used in the office, salaries of administrative staff etc.
3.       Selling and Distribution Overheads:  Overheads incurred for getting orders from consumers are called as selling overheads. On the other hand, overheads incurred for execution of order are called as distribution overheads. Examples of selling overheads are, sales promotion expenses, marketing expenses, salesmen’s salaries and commission, advertising expenses etc. Examples of distribution overheads are warehouse charges, transportation of outgoing goods, packing, commission of middlemen etc.
4.       Research and Development Overheads: In the modern days, firms spend heavily on research and development. Expenses incurred on research and development are known as Research and Development overheads.
c)       Classification according to Behavior: According to this classification, overheads are classified as fixed, variable and semi-variable. These concepts are discussed below.
1.       Fixed Overheads: Fixed overheads are commonly described as those that do not vary in total amount with increase or decrease in production volume, for a given period of time, may be a year. Salaries, depreciation of fixed assets, property taxes, are some of the examples of fixed costs. Total fixed costs remain same irrespective of changes in volume of production but per unit of fixed cost is variable. It increases if production decreases while if production increases, it decreases.
2.       Variable Overheads: Variable overheads are those which go on increasing if production volume increases and go on decreasing if the volume decreases. Such increase or decrease may or may not be in the same proportion. Variable overheads are generally considered to be controllable as they are directly connected with the production.
3.       Semi-variable Overheads:  These types of overheads remain constant over a relatively short range of variation in output and then are abruptly changed to a new level. In other words, they remain same up to a certain level of output and after crossing that level, they start increasing. For example, supervisor’s salary is treated as fixed but if a decision is taken to operate a second shift, additional supervisor may have to be appointed which results into increase in the salary of the supervisor. This indicates that it is a semi-variable overheads. Similarly, maintenance expenditure, fire insurance are also semi-variable overheads.
Usefulness of Overhead Classification
1.       It ensures effective cost control.
2.       It helps the management for effective decision making.
3.       The application of marginal costing is essentially for profit planning, cost control, decision making etc. are based on the classification of overheads.
4.       On the basis of classification of fixed and variable cost, flexible budgets are prepared at different levels of activity.
5.       It facilitates fixing of selling price.
6.       Cost classification is useful for break-even analysis. Break-even analysis mainly depends on overall cost and profit which can be useful for making or buying decision.
It helps to find out the unit cost of production.  

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