Overheads costing

Overhead expenses are all costs on the income statement except for direct labor, direct
materials, and direct expenses. Overhead expenses include accounting fees, advertising,
insurance, interest, legal fees, labor burden, rent, repairs, supplies, taxes, telephone bills, travel
expenditures, and utilities.

Types of overheads

Examples of Overhead Costs

Overhead costs are important in determining how much a company

must charge for its products or services in order to generate a profit.
The most common overhead costs that any business incur include:

1. Rent
Rent is the cost that a business pays for using its business premises.
If the property is purchased, then the business makes mortgage
payments.

Rent is payable monthly, quarterly, or annually, as agreed in the

tenant agreement with the landlord. When the business is
experiencing slow sales, it can reduce this cost by negotiating the
rental charges or by moving to less expensive premises.

2. Administrative costs

Administrative costs are costs related to the normal running of the

business and may include costs incurred in paying salaries to a
receptionist, accountant, cleaner, etc. Such costs are treated as
overhead costs since they are not directly tied to a particular
function of the business and they do not directly result in profit
generation. Rather, administrative costs support the general running
of the business.

Examples of administrative costs may include audit fees, legal fees,

employee salaries, and entertainment costs. A business can reduce
administrative expenses by laying off some of its employees,
switching employees from full-time to part-time, hiring employees
on a contract basis, or by eliminating certain expenses, such as
entertainment and office supplies.
3. Utilities

Utilities are the basic services that the business requires to support
its main functions. Examples of utilities include water, gas,
electricity, internet, sewer, and phone service.A business can often
reduce utility expenses by negotiating for lower rates from
suppliers.

4. Insurance

Insurance is a cost incurred by a business to protect itself from

financial loss. There are various types of insurance coverage,
depending on the risk that may cause loss to the business. For
example, a business may purchase property insurance to protect its
property or business premises from certain risks such as flood,
damage, or theft.

Another type of insurance is professional liability insurance that

protects the business (such as an accounting firm or law firm) from
liability arising from malpractice. Other types of insurance
include health insurance, home insurance, renter’s insurance, flood
insurance, life insurance, disability insurance, etc.

5. Sales and marketing

Sales and marketing overheads are costs incurred in the marketing

of the company’s products or services to potential customers.
Examples of sales and marketing overheads include promotional
materials, trade shows, paid advertisements, wages of salespeople,
and commissions for sales staff. The activities are geared toward
making the company’s products and services popular among
customers and to compete with similar products in the market.

6. Repair and maintenance of motor vehicles and machinery

Rent and maintenance overheads are incurred in businesses that

rely on motor vehicles and equipment in their normal functions.
Such businesses include distributors, parcel delivery services,
landscaping, transport services, and equipment leasing.

Motor vehicles and machinery need to be maintained on a

continuous basis and repaired whenever they break down.

Allocation and Apportionment

of Overhead to Cost Centres
When all the items are collected properly under suitable
account headings, the next step is allocation and
apportionment of such expenses to cost centres. This is also
known as departmentalisation of overhead.
Departmentalisation of production overheads is the process
of identifying production overhead expenses with different
production/service departments or cost centres. It is done by
means of allocation and apportionment of overheads among
various departments.

Thus, it involves:

(i) Allocation and apportionment of overheads among

production and service departments and
(ii) Reapportionment of service departments
overheads among production departments.

Following factors must be taken into consideration

while organising a concern into a number of
departments:

(i) Every manufacturing process is divided into its natural

divisions in order to maintain natural flow of raw materials
from the time of the purchase till its conversion into finished
goods and sale.

(ii) For ensuring smooth flow of production, the sequence of

operations is taken into consideration while determining the
location of the various departments.

(iii) For physical control on production and maintaining

efficiency of the concern, division of responsibility must be
taken into consideration while organising departments.
Division of responsibility as far as possible should be clear,
without ambiguity and dual control.
Types of Departments:
In a manufacturing concern, there are three types of
departments:
(a) Manufacturing or producing departments

(b) Service departments

(c) Partly producing departments.

Allocation of Overhead Expenses:

Allocation is the process of identification of overheads with
cost centres. An expense which is directly identifiable with a
specific cost centre is allocated to that centre. So it is the
allotment of whole item of cost to a cost centre or cost unit
or refers to the charging of expenses which can be identified
wholly with a particular department. For example, the whole
of overtime wages paid to the workers relating to a
particular department should be charged to that
department.

Similarly, the cost of repairs and maintenance of a particular

machine should be charged to that particular department
wherein the machine is located. Power, if separate meters
are provided at each cost centre and fuel oil for boilers are
other examples of allocation. So, the term allocation means
the allotment of the whole item without division to a
particular department or cost centre.

Apportionment of Overhead Expenses:

Cost apportionment is the allotment of proportions of items
to cost centres or cost units on an equitable basis. The term
refers to the allotment of expenses which cannot identify
wholly with a particular department. Such expenses require
division and apportionment over two or more cost centres or
units.

So cost apportionment will arise in case of expenses

common to more than one cost centre or unit. It is defined as
the allotment to two or more cost centres of proportions of
the common items of cost on the estimated basis of benefit
received. Common items of overheads are rent and rates,
depreciation, repairs and maintenance, lighting, works
manager’s salary etc.

Bases of Apportionment:
Suitable bases have to be found out for apportioning the
items of overhead cost to production and service
departments and then for reapportionment of service
departments costs to other service and production
departments. The basis adopted should be such by which the
expenses being apportioned must be measurable by the
basis adopted and there must be proper correlation between
the expenses and the basis.

Therefore, the common expenses have to be apportioned or

distributed over the departments on some equitable basis.
The process of distribution is usually known as ‘Primary
Distribution’.

Following are the main bases of overhead

apportionment utilised in manufacturing concerns:
(i) Direct Allocation:
Overheads are directly allocated to various departments on
the basis of expenses for each department respectively.
Examples are: overtime premium of workers engaged in a
particular department, power (when separate meters are
available), jobbing repairs etc.

(ii) Direct Labour/Machine Hours:

Under this basis, the overhead expenses are distributed to
various departments in the ratio of total number of labour or
machine hours worked in each department. Majority of
general overhead items are apportioned on this basis.

(iii) Value of Materials Passing through Cost Centres:

This basis is adopted for expenses associated with material
such as material handling expenses.

(iv) Direct Wages:

According to this basis, expenses are distributed amongst
the departments in the ratio of direct wages bills of the
various departments. This method is used only for those
items of expenses which are booked with the amounts of
wages, e.g., workers’ insurance, their contribution to
provident fund, workers’ compensation etc.
(v) Number of Workers:
The total number of workers working in each department is
taken as a basis for apportioning overhead expenses
amongst departments. Where the expenditure depends more
on the number of employees than on wages bill or number of
labour hours, this method is used. This method is used for
the apportionment of certain expenses as welfare and
recreation expenses, medical expenses, time keeping,
supervision etc.

(vi) Floor Area of Departments:

This basis is adopted for the apportionment of certain
expenses like lighting and heating, rent, rates, taxes,
maintenance on building, air conditioning, fire precaution
services etc.

(vii) Capital Values:

In this method, the capital values of certain assets like
machinery and building are used as basis for the
apportionment of certain expenses.

Illustration 1:
What basis would you follow for distribution of the
following overhead expenses to departments?
(a) Store Service Expenses,

(b) Employees’ State Insurance,

(c) Factory Rent,

(d) Municipal Rent, Rates and Taxes,

(e) Insurance on Building and Machinery,

(f) Welfare Department Expenses,

(g) Creche Expenses,

(h) Steam,

(i) Electric Light,

(j) Fire Insurance.

Departmentalisation of overhead expenses has the

following advantages:
1. Allocation and apportionment of overhead expenses to the
respective departments facilitate control of overhead cost by
means of budgets predetermined.
2. Apportionment of service department cost to production
and other service departments facilitates control of the uses
made of the services rendered to respective departments.

3. Absorption of overhead costs in the products produced by

departmental overhead rates facilitates ascertainment of
cost as the overhead costs of the respective departments are
taken into consideration in determining the overhead rates.

4. The basis used in the predetermination of the

departmental overhead rates may be used for control of
actual basis in comparison to the quantity predetermined.

5. Analysis of under or over absorption of overhead discloses

the reasons for variances which indicate the remedial
measures to be taken.

6. For working out correctly the cost of work-in-progress. If

the overhead is not departmentalised, the cost of work-in-
progress will be loaded with a proportion of overhead of all
the departments including those in which the product is yet
to be processed.
References:

 https://corporatefinanceinstitute.com/resources/knowledge/accounting/overheads/
 https://en.wikipedia.org/wiki/Overhead_(business)
 http://www.yourarticlelibrary.com/cost-accounting/overheads-cost-accounting/allocation-and-
apportionment-of-overhead-to-cost-centres/55631
 http://www.yourarticlelibrary.com/cost-accounting/overheads-cost-accounting/allocation-and-
apportionment-of-overhead-to-cost-centres/55631