Features, Classification

Features of Overhead Costing

Overhead costs have several distinct features that differentiate them from direct costs:

1. Indirect Nature: Overheads cannot be directly or economically traced to a specific product, job, or service. They are general expenses incurred to support multiple activities or departments.
2. Shared Costs: They are common costs incurred for the benefit of several cost centers or products. For example, factory rent benefits all products manufactured in that factory.
3. Variability in Behavior: Overheads can behave differently with changes in the level of activity or production volume (fixed, variable, semi-variable).
4. Control Difficulty: Controlling overheads can be more challenging than controlling direct costs because their impact on individual cost units is not immediately apparent.
5. Necessity for Operations: Despite being indirect, overheads are essential for the smooth functioning of a business. Without them, production or service delivery would not be possible (e.g., administrative salaries, factory electricity).
6. Requires Allocation and Apportionment: Due to their indirect nature, overheads must be systematically distributed to cost centers or cost units using various allocation and apportionment bases (e.g., machine hours, labor hours, floor area).
7. Impact on Pricing: Accurate overhead costing is crucial for determining the true cost of a product or service, which directly influences pricing decisions and profitability.
8. Budgeting and Forecasting: Understanding overhead patterns is vital for effective budgeting and financial forecasting.

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Classification of Overhead Costing

Overheads can be classified in various ways, helping management to understand their nature, behavior, and controllability for better decision-making. The primary classifications are:

1. Classification by Function (Functional Classification) 🏭

This classification groups overheads based on the business function they relate to.

• Manufacturing/Factory Overheads: These are indirect costs incurred in the factory or production area. They are essential for manufacturing but cannot be directly attributed to a specific product.
  • Examples: Factory rent, depreciation of factory machinery, indirect labor (e.g., supervisor's salary, maintenance wages), indirect materials (e.g., lubricants, cleaning supplies), factory utilities (electricity, water).
• Administration Overheads: These are indirect costs incurred for general management, secretarial, accounting, and administrative services that support the overall organization.
  • Examples: Office rent, salaries of administrative staff (e.g., HR, accounts, legal), office supplies, depreciation of office furniture, audit fees, legal expenses.
• Selling Overheads: These are indirect costs incurred to create and stimulate demand, obtain orders, and secure sales.
  • Examples: Sales staff salaries and commissions, advertising expenses, promotional materials, market research costs, showroom expenses.
• Distribution Overheads: These are indirect costs incurred from the point a finished product is ready for dispatch until it reaches the customer.
  • Examples: Warehouse rent, packing costs (secondary packing), delivery vehicle depreciation, salaries of delivery drivers, transportation costs, freight outwards.
  • [Image of a delivery truck]
• Research & Development (R&D) Overheads: Costs incurred for undertaking research to develop new products or improve existing ones.
  • Examples: R&D staff salaries, laboratory expenses, costs of experimental materials.

2. Classification by Behavior (Behavioral Classification) 📈

This classification groups overheads based on how they react to changes in the volume of activity or production.

• Fixed Overheads: These costs remain constant in total, regardless of changes in the level of production or activity within a relevant range and time period. Per unit, fixed costs decrease as production increases.
  • Examples: Factory rent, insurance premiums, depreciation (straight-line method) of factory buildings/machinery, salaries of permanent administrative staff.
• Variable Overheads: These costs change in direct proportion to changes in the volume of production or activity. Per unit, variable costs remain constant.
  • Examples: Indirect materials (e.g., small components, consumables), indirect labor (e.g., wages tied to output), power costs (if directly proportional to machine usage), sales commissions.
• Semi-Variable Overheads (Mixed Costs): These costs have both a fixed and a variable component. They remain fixed up to a certain level of activity, but once that level is exceeded, they vary with changes in activity, though not necessarily in direct proportion.
  • Examples: Utility bills (fixed basic charge + variable charge based on consumption), telephone charges (fixed rental + charge per call/data), maintenance costs (fixed routine maintenance + variable based on usage/breakdowns), supervisor's salary with overtime.
• Step Costs: A type of semi-variable cost that remains fixed over a certain range of activity but then "steps up" to a new fixed level once that range is exceeded.
  • Example: Hiring an additional supervisor when production reaches a new level, requiring another shift.

3. Classification by Elements (Elemental Classification) 🧾

This classification breaks down overheads into their fundamental cost elements.

• Indirect Materials: Materials that cannot be directly traced to a specific product but are necessary for production (e.g., lubricants, cleaning supplies, nuts and bolts in general use).
• Indirect Labor: Wages paid to workers who do not directly work on the product but support the production process (e.g., supervisors, maintenance staff, security guards).
• Indirect Expenses: All other indirect costs that are not indirect materials or indirect labor (e.g., factory rent, insurance, depreciation, utilities, legal fees, advertising).

4. Classification by Controllability (Controllability Classification) 🕹️

This classification helps in performance evaluation and responsibility accounting.

• Controllable Overheads: These are costs that can be influenced or controlled by a specific manager or department within a given time frame.
  • Examples: Repair and maintenance costs (can be managed by the maintenance manager), advertising expenses (controlled by the marketing manager), indirect materials consumption (can be controlled by the production supervisor).
• Uncontrollable Overheads: These are costs that cannot be influenced or controlled by a specific manager or department within a given time frame. They are typically decided by higher management or external factors.
  • Examples: Factory rent (determined by a lease agreement), depreciation (based on asset purchase and accounting policy), property taxes.