Chapter

Overhead Allocation

❖ Definition of Overhead

Any expenditure incurred over and above prime cost is known as overhead. The direct
portion of the total cost is known as prime costs and the indirect portion is called overheads which
are the aggregate of indirect material cost, indirect wages and indirect expenses. In fact overheads
are the total of all indirect costs incurred in the production of outputs which must be taken into
account while ascertaining the total cost of a product or job. Some examples of overhead costs are:
Rent, Utilities, Insurance, Office supplies, Travel, Advertising expenses, Accounting and legal
expenses, Salaries and wages.
For example, a vehicle retail company pays a premium rent for business space in an area
with additional space to accommodate a showroom. The premium rent is one of the overhead costs
of the business. A business must pay its overhead costs on an ongoing basis, regardless of whether
its products are selling or not.

CIMA defines indirect cost as “expenditure on labor, materials or services which cannot be
conveniently identified with a specific saleable cost per unit.”

❖ Four Important Classification of Overheads

A) Function wise classification of overheads

The overheads can be classified into in the following ways on the basis of function wise
classification.

1. Production Overhead

It is otherwise called as manufacturing overhead, works overhead and factory overhead. All
the indirect expenses, which are incurred in the factory premises in connection with the production
of any goods and services, are treated as production overhead. Factory rent, rates, lighting, heating,
idle time wages, depreciation of factory, building, plant and machinery, canteen expenses and the
like are some of the examples of production overhead.
 2. Administration Overhead

The term administration refers to the formulation of policy, direction, control and management
of affairs. The general functional expenses are included in the administration overhead. In other
words, administrative services are necessary for the effective operation of any business. Hence,
such service expenses are treated as administration overhead. The printing and stationary for
administration, rent, rates, insurance of general office, bank charges, telephone, postage, and the
like are the examples of administration overhead.

3. Selling Overhead

The selling overhead refers to the cost of selling function i.e. the cost of activities relating to
create and stimulate demand for company products and to secure orders. Salaries, Commission and
traveling expenses of sales representatives and executives, advertising and publicity expenses,
samples, printing of price lists, discounts, rebates, bad debts and the like are the examples of selling
overhead.

4. Distribution Overhead

The term distribution refers to the activities relating to the sequence of operation starts from
making the packed product available for dispatch and ends with making reconditioned returned
empty package available for reuse.

Distribution is also one of the functions like manufacturing, administration and selling.
Running expenses of delivery van, wages of packers, carriage and freight outwards, rent, rates and
insurance of warehouses and the like are some of the examples of distribution overhead.

5. Research and Development Overhead

Research overhead is the cost of searching for new products, new techniques for production or
finding new equipment. The development overhead is the cost of implementation of research result
on commercial basis. Cost of raw materials used for research, salaries and wages of R and D
department staff, subscription to books and journals, subscription to research association, patent
feeds and the like are examples of research and development overhead.
B) Behavior wise classification of overheads

The overheads can be classified on behavior wise basis also. They are presented below:

1. Fixed Overhead

Fixed overhead represents indirect cost, which remains constant for a specific period regardless of
changes in volume of production. In other words, the fixed overhead may be increased after a
certain level of production. The fixed overheads do not vary in total in a certain level of production.

The fixed overhead cost per unit decreases if the volume of production increases and vice versa.
The fixed overhead is otherwise called as period cost, stand-by cost and fixed cost. Rent of
building, depreciation of plant and machinery, salaries and remuneration of management
executives, legal fees, audit fees and the like are the examples of fixed overhead.

The fixed overhead is not influenced by managerial action. But, it is fully depending on the policy
of the management. The management can appoint new staff members on fixed salary even though
there are no changes in the volume of production. If so, the fixed overhead increases in the same
level of production.

Likewise, the same management can discharge few employees due to various reasons. Now, the
fixed overhead decreases in the same level of production. This is the nature of fixed overhead.

Types of fixed overhead

There are three types of fixed overhead. They are briefly explained below.

1. Long Run Capacity Fixed Overhead: These are expired cost of plant and machinery and
other facilities used. It means that these expenses are incurred over a long period of time.

2. Operating Fixed Overhead: These types of expenses are incurred to maintain and use the
fixed assets. Heat, light, insurance and property taxes are paid in order to maintain and use the fixed
assets.

3. Programmed Fixed Overhead: Some special programs may be approved by the

management. For which, the expenses are incurred by the management. The expenses like
advertisement is issued to increase the volume of sales and research are carried on to improve the
quality of the product. These are examples of programmed fixed overhead.
 2. Variable Overhead

Variable overhead is a portion of indirect cost, which varies directly with change in the
volume of production. If varies in total but remains constant in per unit, power, fuel, transport
expenses, lubricants, tools and spares and the like are the examples of variable overhead.

3. Semi-Variable Overhead

Semi-variable overhead is a portion of indirect cost, which is partly fixed and partly variable.
It means that this type of overhead has the characteristics of both fixed overhead and variable
overhead. Semi-variable overheads may remain fixed up to a certain level of production and vary
after that level of production. In other words, semi-variable overheads do not fluctuate in direct
proportion to the volume of production.

c) Elements wise classification of overheads

The overheads may be classified on the basis of element wise in the following ways.

1. Indirect Materials

Some materials are used in the production process, which cannot be traced in the end product.
In other words, materials used in the production process do not form part of end product. This type
of material is called indirect material. Moreover, the cost of such material is insignificant and
cannot be considered as worth for analyzing. For example: Threads and buttons used in stitching
cloths and lubricants used in maintenance of plant and machinery.

2. Indirect Labor

Some laborers are employed for the purpose of helping the workers to produce goods and
services. These laborers are not permitted to engage in the production process directly. Moreover,
salaries and wages paid to such type of laborers are not included in the salaries and wages paid to
workers who are working in the production process directly. This type of labor is called indirect
labor.

For example: Salaries and wages paid to store keepers, sales representatives, personnel
manager, accountant, supervisors, and the like. These indirect labor costs can not be identified with
any particular job, process, cost unit or cost centre.
 3. Indirect Expenses

Some expenses are incurred by the organization in order to run the business but not connected
with the production of any goods and services. Without incurring such expenses, nothing will be
happen. Moreover, these expenses cannot be conveniently allocated to job, process, cost unit or
cost centre. Hence, these expenses are treated as indirect expenses. Rent, rates, postage, insurance,
light, depreciation and the like are the examples of indirect expenses.

D) Control wise classification of overheads

Overheads may be classified in the control wise basis in the following ways.

1. Controllable Overhead

Overheads, which can be easily controlled by management through exercising various steps,
are called controllable overhead.

2. Uncontrollable Overhead

Overheads, which cannot be, controlled whatever the steps taken by the management are
called uncontrollable overhead

Production Overhead

➢ Overhead distribution to Production and Service Department

In a manufacturing concern, there are two types of departments:

a) The Production Departments, i.e., departments where goods are produced

b) The Service Departments, i.e., those render services to Production Departments. The typical
example of service departments are: Stores, Time –keeping, Canteen, Boiler House, Repairs
and maintenance, Personnel Department, Inspection, Dispensary and Hospital, Laboratory,
etc.
 ❖ Bases for Primary Distribution of Overheads

The following bases are commonly used by many organizations for distribution of overhead.

SL. NO Types of Overhead Basis for Apportionment

Rent, rates and taxes, depreciation of
1 Floor Area/ Area Occupied
building, heating, repairs
2 Lighting Number of light points, area occupied.
3 Heat Cubic Content
House power of machines or machine
4 Power
hours.
5 Electric power, electric light Kilowatt-hours.
Depreciation, insurance, repairs, and
6 Book value of asset or original cost.
maintenance of plant and vehicles
Group insurance, Canteen expenses, E.S.I.
7 contribution, Supervision, Personnel, Staff Number of employees or Wages paid.
welfare, Wages, Cost office
No. of stores requisitions or value of
8 Stores material issued or value of material
stored.
9 Delivery expenses Weight, Volume, tone-miles
10 Carriage inwards Value of material used.
11 Audit feeds Sales, total cost.
12 Selling and distribution expenses Sales value
Maintenance hours, maintenance wages
13 Maintenance
or plant value.
No. of production employees or No. of
14 Inspection
jobs or No. of inspection tickets.
15 Advertising Sales value
Direct labour hours or wages paid or
16 Remuneration of Works Director
number of employees.
17 Sundries Direct Wages

Problem=01

Moon Ltd has five departments of which X, Y & Z are production departments while A & B are
service departments. The following are the particulars relating to the departments:
X Y Z A B
Floor area occupied (sq. meters) 360 240 200 140 60
No of employees 40 30 24 16 10
Horse power of machines 1200 800 1000 __ __
Wages ($) 100000 80000 60000 30000 10000
Value of plant ($) 480000 400000 320000 200000 100000
Value of buildings ($) 1000000 600000 400000 200000 100000
No of light points 60 40 30 20 10
Value of stocks ($) 300000 200000 100000 ___ ___

Distribute the following costs to the various departments on the most suitable basis:

Rent, rates & taxes $ 10000, Repairs to building $ 23000, Repairs to plant $ 15000, Depreciation of
plant $ 45000, Insurance of stock $ 3000, Insurance of plant $ 1500, Power $ 9000, Lighting
$1600, Supervision $ 12000, Premium for workmen’s compensation insurance $ 2800.

❖ Redistribution of Service Department Costs

Expenses of Service Department Basis of Redistribution

1. Personnel department No. of workers who are direct, No. of

employees working etc.

2. Time-keeping No. of workers who are direct, No. of

employees working etc.
 3. Canteen & welfare No. of workers who are direct, No. of
employees working etc.

4. Hospital & dispensary No. of workers who are direct, No. of

employees working etc.

5. Power house (electric lighting cost) Area of the floor, wattage, No. of electric
points,

6. Power house (electric power cost) Horse power, Kwh.

Machine hours Kwh * machine hours *
Horse power

7. Maintenance & repair shops; Planning & Direct labor hours, Direct labor
Progress; & Tool room wages, Machine hours, Asset value * Hours
worked.

8. Stores Department Weight or Value of materials which are

issued, No. of requisitions.

9. Transport Department Tonnage handled, Truck hours, tonnage of Truck,

milage of Truck, ton-hours of truck,
No. of packages which are of standard size.

10. Inspection Inspection hours

11. Fire protection Capital Values

❖ Methods of Redistribution
There are three recognized methods of redistribution of service department costs. They are:

1. Direct Redistribution
2. Step Method
3. Reciprocal Services Method
a. Trial and Error Method
b. Repeated Distribution Method
c. Simultaneous Equation Method
 ➢ Repeated Distribution Method
Problem 2:

Swill Co. Ltd. has three production departments and two service departments. From the following
information show the distribution of service departments cost under the repeated distribution
method:
 ➢ Simultaneous Equation Method
Problem 3:

A manufacturing company has three production departments and two service departments.

The primary distribution summary of March 1999 gives the following information:

The service departments’ expenses are charged on a percentage basis which is as follows: