Overhead costs may be defined as the total cost of indirect materials, indirect labour and indirect expenses. They may occur or be charged to:
- Production cost centers i.e. making, finishing and packing departments.
- Service costs centers for example maintenance and power generation
- Other non production cost centers for example administration, selling and distribution
In this section, we will look at how these overhead costs are changed to production and non-production departments so as to determine the total cost incurred by every department in the organization.
Overhead cost classification and analysis
Overhead costs may be analyzed into
- That which may be directly identifiable with a single cost center, for example, wages paid to indirect workers who work solely in one cost center such as making department.
- That which is incurred as a single figure and is then shared amongst cost centers which make use of it, for example, the rates payable to the local authority
- The total cost of a service department, for example, maintenance department will have various costs charged to it for material, labor and other expenses.
Purposes of overhead cost analysis
There are a number of situations in which the analysis of overhead costs will assist in the satisfactory evaluation of the relevant cost data. These include:
- The control of overhead expenditures
There must be a link between overhead cost and the manager responsible for its control. This is best achieved by having the planned level of overhead costs for each cost center compared to the actual cost incurred in order that any differences may be investigated and corrective measures taken.
- Charging of overheads to cost units
As products pass from one cost center to another in the production cycle, direct costs for material and labour are charged to them. In addition, each product or job should share a part of indirect costs of the business. This may be done by assessing the benefits extracted from each cost center through which the product or job passes and then choosing a suitable absorption basis
- Valuation of work in progress
At any point in time, there may be partly completed goods in the production cycle. Such work in progress must be valued at the end of an accounting period in order that profit be calculated and a balance sheet arrived at. This may be achieved by the absorption of production overheads in each cost center.
- Valuation of abnormal losses
This is a similar procedure to that for work in progress. Such losses also need to be charged to the departments that incur them for efficiency analysis purposes.
- Profit measurement
The valuation of work in progress and finished goods stock will affect the profit reported. The basis on which production overhead has been absorbed by cost units will therefore have a direct influence on the level of profit reported during the period.
- Decision making
It is vital that relevant costs are used in any decision making situation. Production overhead costs may be allocated to a department (cost center) or apportioned to it using some arbitrary apportionment basis. In addition overhead cost may be a fixed or variable behaviour pattern as activity changes. The total costs associated with cost centre and the organization as a whole affect the kind of decisions made by the management. But such relevant costs need to be incremental (making a difference) and futurecosts (not sunk costs) that are controllable (not uncontrollable) by management.
The process described in this lesson by which total overheads are absorbed into production naturally enough is known as absorption costing. The absorption of total overheads into product costs has implications for performance measurement, cost control and stock valuation and students should be aware that the process described is subject to criticism by some managers and accountants.
The criticism arises from the fact that overheads contain items, known as fixed costs – which do not change when the activity level changes and which would still have to be paid if there was no activity, e.g. rates – and items, known as variable costs, which vary more or less directly with activity, e.g. power consumption. To overcome some of the difficulties, an alternative method of costing has been developed, known as marginal costing, which, although using the process of absorption, excludes fixed costs from the absorption process.