Overhead is the aggregate of indirect material, indirect labor, and indirect expenses. It refers to any cost which is not directly attributable to a cost unit.
The term indirect means that it cannot be allocated but can be apportioned to or absorbed by cost centers or units. All those costs/expenses that cannot be attributed directly to a particular product or service or cost center are called indirect costs/expenses.
We generally see that some material costs (identified as indirect materials), some labor costs (identified as indirect labor), rents, depreciation costs, salaries of staff, warehousing costs, etc., are of such nature. These costs are collectively called overheads.
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Definition of Overhead
Overhead cost is, therefore, a group of expenses that are not identifiable with the cost unit but are generally incurred for the organization’s manufacturing and selling activities and can be apportioned to and absorbed by the cost units.
It is a distinct element of cost and needs different treatment in accounting and control compared to direct cost elements.
Classification of Overhead
Functional Classification of Overhead
Under functional classification, the overhead expenditure is identified under a particular head based on the purpose of the expenditure based on the functions that are accomplished by the expenditure incurred.
Functionally, the overheads are classified under three or four heads.
Factory Overheads
The indirect expenses (overheads) incurred within the factory area are classified as factory overheads.
Administration or Office Overheads
The indirect expenses (overheads) incurred within the administrative area are classified as administrative or office overheads.
Selling Overheads
The indirect expenses (overheads) incurred in the sales activities are classified as selling overheads.
Distribution Overheads
The indirect expenses (overheads) incurred concerning the product or service distribution are classified as distribution overheads.
Selling and Distribution Overheads
The indirect expenses (overheads) incurred from the sales activities as well as distributing the product or service, are classified under a single head as “Selling and Distribution Overheads.”
Behavioral Classification of Overhead
Under functional classification, the overhead expenditure is identified under a particular head based on its inclination to vary with the level of activity achieved (production/sales).
Behaviorally, the overheads are classified under three heads.
Variable Overheads
The overhead expenses which vary directly with activity level (production/sales) are called variable overheads. These costs change with every small change in the activity level.
Fixed Overheads
The overhead expenses that do not vary with the activity level (production/sales) are fixed overheads. These costs would remain the same, whatever the activity level achieved.
They are also called committed costs, which must be borne even if the activity level is not as planned.
Semi-Variable Overheads
The overhead expenses, which behave like variable and fixed overheads, are called semi-variable overheads. These expenses remain fixed within ranges of activity levels. They vary whenever the activity level crosses certain points.
Basis of Apportionment of Overheads.
| Basis of apportionment | Items of expenditure |
|---|---|
| Floor area or cubic content | Rent, rates, taxes, maintenance of building, depreciation and insurance of building, lighting, heating, electricity. |
| Number of employees | Expenses associated with workmen such as supervision, canteen expense, recreation expense, timekeeping, ESIC, etc. |
| Capital value | Depreciation and insurance of plant and machinery equipment and furniture. |
| Value of materials | Material handling. |
| Horse-power hours, Kwh | Power |
| No. of material requisitions | Storekeeping expenses |
| Direct machine hour, direct labor hour, direct wages | Other overhead expenses |
Computation of Overhead Rate
To find the overhead rate, first, determine the basis that will describe the best cost behavior. Then, divide the total budgeted overhead by the basis to calculate the overhead rate:
Overhead Rate = (Total budgeted overhead / Basis)
Factors to be Considered in the Computation of Overhead Rate
- Base To Be Used
- Physical Output
- Direct materials cost
- Direct labor cost
- Direct labor hours
- Machine hours
- Activity Level to Use
- Normal capacity
- Expected actual capacity
- Inclusion or Exclusion of Fixed Overhead
- Absorption costing
- Direct costing
- Used of Single Rate or Several Rates
- Plant-wide or blanket rate
- Departmentalized rate
- Cost center or cost pool rates
What are Under-applied overhead and Over-applied overhead? How are these amounts handled at the end of the accounting period?
Under-applied overhead occurs when the actual overhead cost exceeds the amount of overhead cost applied to the Work in Process inventory during the period.
Over-applied overhead occurs when the actual overhead cost is less than the amount of overhead cost applied to the Work in Process inventory during the period.
The under-applied or over-applied overhead is resolved by either closing out the amount to the Cost of Goods Sold or by allocating the amount between the Cost of Goods Sold and ending inventories based on the proportion of applied overhead in each account.
Adjusting for under-applied overhead increases the Cost of Goods Sold (and inventories) while adjusting for over-applied overhead decreases the Cost of Goods Sold (and inventories).
Enumerate two reasons why overhead might be under-applied in a given year.
Manufacturing overhead can be under-applied for several reasons. Poor control over overhead spending is one possible reason.
Alternatively, if some of the overhead is fixed and the actual amount of the allocation base is less than the initial estimate for the period, the applied overhead to inventory will be lower than the actual overhead cost incurred.