Question

Question 3

Discuss the steps followed in the entire process of accounting for overheads

Answer 1

The following points highlight the five main steps in overhead accounting. The steps are: 1. Classifications of Overheads Costs 2. Codification of Overheads 3. Collection of Overheads 4. Departmentalisation of Overheads 5. Absorption of Overheads.

Each steps are expalained in detail below.

1. Classifications of Overheads Costs:

Overheads can be classified on the basis of number of characteristics.

The following are the important basis of overhead classification:

1. Functionwise Classification.

2. Elementwise Classification.

3. Behaviourwise Classification.

4. On the Basis of Normality

5. Controllability Basis.

I. Functionwise Classification:

Under this method of classification, the various functions performed by the factory constitute the basis.

Accordingly overheads are classified as follows:

1. Production Overhead:

Production overhead is also termed as factory overhead, works overhead, or manufacturing overhead. It is the aggregate of factory indirect material cost, indirect wages and indirect expenses. Some examples of indirect material cost used in the manufacturing process are consumable stores, tiny part of materials such as thread and button in readymade garment industry, nails and polish in furniture making industry and so on.

Example of indirect labour cost incurred in production process are wages and salaries of repair and maintenance staff, salary of foreman, supervisor, inspector, watchman’s salary, work’s manager’s salary, etc. Example of indirect expenses incurred in production process are depreciation, repair and maintenance, rent, rates, taxes of factory building, drawing office expenses and so on.

2. Administration Overhead:

These overheads are of general nature and consist of all costs incurred in the direction, control and administration of an undertaking which is not related directly to production or selling and distribution function. Some examples of indirect material cost are office stationery such at paper, pen, ink, carbon papers, stapler, etc.

Some examples of indirect labour cost incurred in the administration department of a factory are salaries of managing director, accountant, secretary clerks and attenders. Some examples of indirect expenses incurred in office are lighting and heating, rent and taxes repairs and maintenance, bank charges, legal charges, telephone charges, etc.

3. Selling Overheads:

The overheads which are incurred in promoting sales and retaining customers is known as selling overheads. Selling overheads include internal material cost, indirect labour cost and indirect expenses. Some examples of indirect material cost are catalogues, price lists, free gifts and samples, etc.

Some examples of indirect labour cost incurred in the sales department are salaries of sales manager, salaries and commission of salesmen. Some examples of indirect expenses incurred in the sales department are expenses incurred in training salesman, advertisement, market research expenses, rent, insurance, heating and lighting of sales show room.

4. Distribution Overheads:

These are expenses which are incurred from the time finished products are packed until they reach their destination. Distribution overhead includes indirect material cost, indirect labour cost and indirect expenses. Some examples of indirect materials cost incurred in the distribution department of a factory are packing materials such as cardboard boxes, hammers, nails, etc.

Some examples of indirect labour cost incurred in the distribution department are salaries of warehouse staff, salaries of drivers of delivery vans, etc. Some examples of indirect expenses are rent, heating, lighting, repairs of warehouse, freight, maintenance of delivery vans, etc.

II. Elementwise Classification:

Under this method, expenditures are classified into three heads:

1. Indirect Materials:

These are the materials which cannot be conveniently identified with individual cost units. These are small and relatively inexpensive items which may become the part of the finished product. Examples of such materials are – lubricating oil, sand paper, nuts and bolts, tools for general use, gum, etc.

2. Indirect Labour:

Indirect Labour pertains to the wages of indirect workers and cannot be conveniently identified with a particular cost unit. Examples of indirect labour are – contribution to provident fund, gratuity, holiday pay, supervisor’s salary, overtime wages, etc.

3. Indirect Expenses:

All indirect costs, other than indirect material and indirect labour costs are termed as indirect expenses. These costs cannot be directly identified with a particular job, process or work rather these are common to cost centres. Examples of indirect expenses are – rent and rates, depreciation, lighting and power, insurance, etc.

III. Behaviourwise Classification:

Under this method expenditures are classified into three heads:

1. Fixed Overheads:

Subject to certain limitations, the amount of fixed overheads tends to remain constant for all volume of production within a certain limit. Fixed costs are relatively unaffected by the change in the level of production or sales. The amount of such costs does not depend upon the volume of production during a period. These costs accrue over a period of time.

Hence they are also known as ‘time costs’ or ‘period costs’. However, it should not be implied that fixed costs do not change at all. They do increase with the increase in the output beyond a certain level of capacity. Examples of fixed costs are – factory rent, office staff salaries, license fees, legal expenses, depreciation of building, insurance charges, etc.

2. Variable Overheads:

Variable items of overheads are those which vary with production. Thus, there is a linear relationship between variable cost and output. However, the variable cost per unit of output remains the same. Examples of variable costs are fuel, power, lighting delivery expenses, salesman commission, etc.

3. Semi-Variable Overheads:

These types of overheads are partly fixed and partly variable. These expenses stand mid-way between fixed and variable expenses. Examples of variable expenses are – telephone and fax charges, repairs and maintenance of plant and machinery, electricity charges, material handling and storage charges, etc.

IV. On the Basis of Normality:

According to this basis, overheads are classified into two categories.

They are:

1. Normal Overheads:

Normal overheads are those overheads, which are expected to be incurred in attaining a given level of output. They are unavoidable. They have to be included in production cost.

2. Abnormal Overheads:

Normal overheads are those overheads which are not expected to be incurred in attaining a given level of output. Cost of abnormal idle time, abnormal wastage of materials, etc. are examples of abnormal overheads. Abnormal overheads are transferred to costing Profit and Loss Account.

V. Controllability Basis:

On this basis, overheads may be classified into two categories.

They are:

1. Controllable Overheads:

Controllable overheads are those overheads which can be controlled by efficient management. Costs of idle time, wastage, etc. are examples of controllable overheads.

2. Uncontrollable Overheads:

Uncontrollable overheads are those overheads, which cannot be controlled. Fixed costs are example of uncontrollable overheads.

2. Codification of Overheads:

Codifications of overheads are useful in accumulating and control of overheads. After classification of overheads, the next step involved in overhead accounting is to codify them. This is so because there are number of overheads which are incurred in factories and unless proper attention is given, the chances of accounting of all overheads may not be possible. Thus, all overheads falling under the category of depreciation relating to plant and machinery, factory building, factory furniture may be given a separate number.

So that depreciation related to all the assets can be properly accounted for codification of overheads refers to assignment of a number or symbol for each time of overheads with a view to accumulate them easily. To facilitate easy identification of different types of overheads, different code numbers are given. The code numbers given for factory overheads is known as standing number order and that to administration, selling and distribution overheads is known as cost accounting number.

Objects of Codification of Overheads:

Following are the main objects of codification of overheads:

1. To accumulate overheads systematically.

2. To facilitate control over them.

3. To distinguish between different types of overheads.

4. To account for all types of overheads.

5. To facilitate convenience of identifying the overheads.

Methods of Codification of Overheads:

The following are the important methods of codifying the overheads:

1. Numerical Method:

Under this method, numerical numbers are used to codify the overheads. In big factories, first of all the various expenses are first identified and a separate number is given to each expenses. Subsequently a sub-number is given for various overheads incurred under each category of expense. For example – depreciation is given a code number as 1.

Then depreciation relating to factory building will be given a code number of 1.1, depreciation relating to plant and machinery 1.2 and that relating to furniture 1.3 and so on. Similarly repairs may be given a code number as 2. Then repairs relating to factory building are given a code number as 2.1 repairs relating to plant and machinery as 2.2 and repairs relating to furniture as 2.3 and so on.

2. Alphabetic Method:

Under this method, alphabets are used to codify the overheads. Each item of overhead is given a code letter which happens to be the first letter of the overhead expenditure. However, items of overheads beginning with same letter will pose a problem. To avoid confusion, the next letter of the overhead can be used along with the first letter.

3. Alpha Numerical Method:

This method combines both the alphabetic and numerical methods. The alphabetic letter denotes the main expenditure while the numerical number denotes its sub-division. For example – Depreciation of plant is coded as D1, Depreciation of plant and machinery is coded as D2 and depreciation of assets as D3.

4. Decimal Method:

Under this method the various departments are first identified and a separate number is given to them. Then each and every overhead incurred in the respective departments are given a sub-number. For example – salary of clerk belonging to office department is given a code number as 1.1. The salary of clerk belonging to selling department is given a code number as 2.1 and so an.

3. Collection of Overheads:

The process of ascertaining the amount of overheads incurred for a period is called collection of overhead. The classified and coded overheads are collected and recorded under the standing over number and cost accounting number.

To facilitate recording of overhead as separate ledger known ‘overhead ledger’ is maintained. Separate accounts are opened for standing order number and cost accounting number in this ledger. Generally, overheads are collected at the end of every month and after totalling them, they are recorded in the overhead ledger.

Sources from Which Various Overheads are Collected:

1. Material Requisition Slips:

Indirect materials such as oil, grease, cotton waste, etc. are drawn by various departments on the basis of material requisition slips. At the time of issue, the particulars of issue of indirect materials and the departments to which they are issued are recorded in the material requisition slip.

At the end of the month, the various material requisition slips are summarised in a sheet known as ‘Material abstract’. From the material abstract the total of indirect material cost is posted to the debit of factory overhead control account and credited to store ledger control account.

2. Invoices:

Those indirect materials which are directly requisitioned by departmental heads, such as stationery by the office superintendent does not pass through a material requisition note. Such types of indirect materials are collected from invoices.

The various invoices supporting the purchase of indirect materials by various departmental heads are entered in purchase journal meant for the purpose of collection of overheads. At the end of the month, the totals from the purchase journal is posted to the debit of factory overhead account and credited to cost control account.

3. Wages Abstract:

The indirect wages paid to various employees are recorded in the wage abstract on the basis of time cards. From wages abstract, the total indirect labour cost is posted to the debit of factory overhead account and credited to wages control account.

4. Subsidiary Records:

Certain items of expenses or indirect expenses are recorded separately in subsidiary or special records. For example – depreciation on machinery is recorded in a plant register. Similarly scraps can be recorded in a ‘scrap report’ and postal expenses in a postage book. So overheads of this nature are collected from subsidiary register meant for this purpose.

5. Cash Book:

Sundry items of expenses or indirect expenses are recorded in an analytical petty cash book. The total of indirect expenses are collected from the petty cash book on the basis of standing order number and cost accounting number. They are then posted to the debit of factory overhead control account and credited to cost control ledger account.

6. Journal:

All notional expenses and transactions regarding adjustments, such as accrued expenses, prepaid expenses are posted into the journal. The total of these expenses are posted to the debit of factory overhead control account and credited to cost control ledger account.

4. Departmentalisation of Overheads:

Departmentalisation of overhead is the process of allocation and apportionment of overhead to different departments or cost centres. For smooth and efficient working a factory is sub-divided into a number of departments, each of which denotes a particular activity of the factory e.g. purchase department, stores department, time keeping department, personnel department, crushing department, melting shop, etc.

In a large sized factory there exists number of departments. Some departments are concerned with production process, while other departments render useful services to production department. The former type of department is known as production department and latter is known as service department.

Whenever overheads are incurred in a factory, they have to be charged to these two departments. Thus, the process of allocation and apportionment of overheads to various departments is known as departmentalisation of overheads.

Objectives of Departmentalisation of Overheads:

Departmentalisation of overheads serves the following purposes:

1. Control of Overhead Costs:

Effective control of overhead cost is possible because departmentalisation makes the incurrence of costs in a department or cost centre the responsibility of someone who heads the department or the cost centre. Thus, with the help of departmentalisation, responsibility accounting can be effectively introduced for control purposes.

2. Ensures Greater Accuracy in Cost Ascertainment:

Departmentalisation helps in achieving greater accuracy by proper allocation and apportionment of overheads. For accurate costing of each function or operation, overhead absorption rates should be determined separately for each cost centre. This is possible only with the help of departmentalisation.

3. Valuation of Work-in-Progress:

Correct cost of work-in-progress cannot be ascertained unless overheads are departmentalised.

4. Cost of Service Departments:

Departmentalisation helps in ascertaining the cost of various departments which is useful for making estimates and submitting quotations for those items which make use of the services of various cost centres.

5. Forecasting and Estimating:

Because of greater accurate in cost ascertainment and cost control, departmentalisation ensures more accurate forecasting and estimating and decision-making.

Allocation of Overheads:

The term ‘allocation of overheads’ refers to identifying an item of overhead and the allotment of the whole amount to one department or cost centre. In other words, charging the entire amount of overhead to a particular department or cost centre, is called allocation of overhead. A point to be clearly understood is that allocation can be made only when exact amount of overhead incurred in a cost centre is definitely known.

For example – rent cannot normally be allocated, since rent is payable for the factory as a whole and the exact amount of rent for each department cannot be known. Some examples of allocation are – salary of a foreman, wages of a machine operator, power expenses if separate meter is installed for each production department.

Apportionment of Overheads:

Those overheads which cannot be allocated to a specific department or cost centre need to be apportioned to various departments or cost centres the process of charging proportionate amount of overheads to various departments is known as apportionment of overheads. As overheads are to be charged proportionately to various departments it has to be done on some equitable basis. For example, salary of general manager is to be apportioned to various departments on the basis of time devoted by him on different departments.

Basis of Apportionment of Overheads:

Items of overhead expenses which are incurred as a common expense is to be apportioned among all the departments. Though different basis are available for apportionment, it is essential to satisfy that the overheads are closely related to the basis selected. In other words, the overheads should involve a direct impact on the basis selected. The basis should also ensure accuracy under the prevailing situations.

Some of the bases used for apportionment are as follows:

(a) Direct Wages:

The following overheads are apportioned on the basis of direct wages:

1. Worker’s compensation

2. Contribution to Provident Fund

3. Contribution to E.S.I.

(b) Number of Labour Hours:

The following overheads are apportioned on this basis:

1. Salaries of inspector

2. Salaries of supervisors

3. Other administrative expenses

(c) Number of Employees:

The following overheads are apportioned on this basis:

1. Canteen expenses

2. Welfare expenses

3. Salaries of time keeping staff

4. Medical expenses

5. Fringe benefits

(d) Floor Area:

The following overheads are apportioned on the basis of floor areas:

1. Rent and rates

2. Taxes

3. Heating and Lighting

4. Repairs and maintenance of building

5. Accident prevention cost

(e) Capital Value of Assets:

The following overheads are apportioned on this basis:

1. Depreciation

2. Repairs and maintenance

3. Insurance

(f) Machine Hours:

The following overheads are apportioned on this basis:

1. Consumable stores

2. Supervision charges

3. Repairs and maintenance

(g) Number of Watts, Kilowatt, hours and light point:

The following overheads are apportioned on this basis:

1. Electricity charges for lighting, heating, and air-conditioning.

2. Electricity charges for productive purposes.

(h) Technical Estimates:

The following overheads are apportioned on the following basis:

1. Sundry Overheads

2. Internal Transport cost

3. Director’s salaries

Principles of Apportionment:

Overheads which are incurred for various departments should be apportioned to different departments on the basis of a suitable method or principle.

The following are the important principles for the apportionment of overheads:

1. Service Criterion:

It is based on the assumption that the services rendered to different departments can be easily measured. In other words, department which derives of maximum services should share more amount of overheads, when compared to other departments.

2. Ability to Pay Principle:

This principle is applied where overheads are to be apportioned to different departments or products of which one of them happens to be a new line. According to this principle, the overheads are charged on what is termed as ‘ability to pay’. That means those departments which earn more profit should bear a higher share of overheads as compared to new department or product.

3. Incentive Principle:

Under this principle, production target is fixed for each department and overheads are apportioned according to the target set. In order to encourage the departmental managers to attain the targets they are also given incentives.

When the targets are attained, the unit cost of production decreases, which reveals the efficiency of the department. On the other hand, if the targets are not attained the unit cost of the production will be high and thereby proves inefficiency of the department.

4. Analysis Principle:

This principle is adopted where it is not possible to measure the services rendered directly because of its variation from time to time. In such a situation an analysis is made to know the impact of overheads on different departments and accordingly a fair share of overheads are apportioned to all the departments.

The best examples are apportionment of salary of general manager to various departments based on the assessment of his time spent on different departments. Similarly, the salary of sales manager can be apportioned to different products based upon the time spent on promoting the sales of all products.

5. Absorption of Overheads:

This is the last step in the accounting procedure of overheads. After all the overheads are apportioned from the service departments to production departments, it involves charging of production department overheads to the number of units produced in those departments. The process of charging the overheads from cost centre to cost unit is known as absorption of overheads.

In other words, the recovery of overheads by the finished goods from various production departments is known as absorption of overheads. The finished products absorb the factory overhead through overhead absorption rates. The overhead absorption rates are obtained by dividing the overheads to be absorbed by a basis to be decided by the management.

1. Actual Rate:

An actual rate is obtained by dividing the actual overhead to be absorbed by actual base selected. Actual overrate can be calculated only historically.

Actual overhead rates are not popularly used because they suffer from the following limitation:

(1) Since actual overheads are available at the end of financial year so ascertainment of cost will be delayed.

(2) It is not possible to prepare tender statement for quotation. Thus, prospective orders are lost if actual overhead rates are used.

(3) Actual overhead rates cannot be controlled.

(4) Cost comparison is not facilitated when actual overhead rates are used. This is so because certain overheads like overtime wages, leave and holiday pay, repairs and maintenance are not uniformly spread over the entire accounting year. So overhead rate fluctuates making difficult cost comparison.

2. Pre-Determined Overhead Rates:

Due to the limitations of actual overhead rate, in most of the cases pre-determined overhead rate is used. This rate is calculated in advance. It is calculated by dividing pre-determined overhead by a pre-determined base. Budgeted overhead and budgeted base could be used to calculate this overhead rate.

3. Single Rate/Blanket Rate:

When a single overhead rate of absorption is set up for the entire factory, it is known as single rate or blanket rate. This rate is calculated by adding up the overheads of all the production departments and dividing by the base which is the total of the quantity or amount. The use of blanket rate may not give accurate result when the amount of overheads differs from department to department.

4. Multiple Rates:

When a separate overhead rate is set up for each department for absorption of overheads it is known as multiple rate. This is calculated by dividing departmental overheads by the departmental base. Multiple absorption rates are popularly used because they give accurate results.