Functional Analysis of Overhead Costs
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Overhead costs may be classified according to the function of the organization responsible for incurring the cost. Examples of overhead cost classifications include production overhead, selling and distribution overhead, and administration overhead. It is usually possible to classify the majority of overhead cost in this way, but some overhead costs relate to the organization generally and may be referred to as general overhead.
In this articles focus is on production overhead. Production is that function of the business which convents raw materials into the organization’s finished product. The production department is usually divided into a number of departments. Some of these are directly involved with the production process. These are called production cost centers and might include, for example, the cutting department and the finishing department.
Others in the production department are not directly involved with the production process but provide support services for the production. These are called service cost centers, and examples include the maintenance department and the stores.
Overhead allocation and apportionment
The first stage in the analysis of production overheads is the selection of appropriate cost centers. The selection will depend on a number of factors, including the level of control required and the availability of information.
Having selected suitable cost centers, the next stage in the analysis is to determine the overhead cost for each cost center. This is achieved through the process of allocation and apportionment.
Cost allocation is possible when we can identify a cost as specifically attributable to a particular cost center. For example the salary of the manager of the packing department can be allocated to the packing department cost center. It is not necessary to share the salary cost over several different cost centers.
Cost apportionment is necessary when it is not possible to allocate a cost to a specific cost center. In this case the cost is shared out over two or more cost centers according to the estimated benefit received by each cost center. As far as possible the basis of apportionment is selected to reflect this benefit received. For example, the cost of rent and rates might be apportioned according to the floor space occupied by each cost center.
Absorption of overheads into salable cost units
The last stage in the analysis of overheads is their absorption into the cost units produced in the production centers. This is sometimes referred to as overhead recovery.
To begin with, we need to measure the level of production achieved. There are many measures which may be used, but the most common are:
Physical units produced;
Labor hours worked;
Machine hours operated.
In a standard costing environment, the two methods based on hourly rates use standard labor hours and standard machine hours as the absorption basis.
It is quite likely that different production departments will measure their production in different ways. The objective is to use a measure which reflects the nature of the work involved. The physical unit measure is in theory the simplest but it is only valid if all of the items produced require the same amount of resources.
The overhead costs of each production cost center are then divided by the quantity of production achieved to calculate the amount of overhead cost to be attributed to each unit. This is the technique of overhead absorption and we shall illustrate it by extending our example on allocation and apportionment.
The output of the machining department is to be measured using the number of machine hours produced, while the output of the assembly and finishing departments is to be measured using the number of direct labor hours produced. The reasons for this can be seen from the number of machine and direct labor hours for each department shown in the original data for the example. The machining department is clearly machine- intensive, whereas the other departments are labor -intensive.
The absorption rates are calculated by dividing the costs attributed to the department by its appropriate measure of output.
Applying the overhead absorption rate
When using an absorption method based either on direct labour hours or on machine hours the cost direct attributed to each unit is obtained by multiplying the time taken per unit by the absorption rate per hour.
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Source by Randika Lalith Abeysinghe