Overhead Costs

Overhead costs are indirect expenses incurred during the production of goods or services but cannot be directly traced to specific products, services, or cost units. These costs support the production process and include expenses such as factory rent, electricity, and administrative salaries.

Classification of Total Cost

Total cost in a manufacturing setup is typically categorized into three main components:

1. Direct Material Costs: Raw materials directly used in the production of goods.
2. Direct Labor Costs: Wages paid to workers directly involved in production.
3. Overhead Costs: All indirect costs required to maintain the production process.

Categories of Overheads

Overheads are broadly divided into three categories based on their nature:

a) Manufacturing Overheads

These are costs associated with the production process but not directly attributable to a specific product.
Examples: Factory rent, utilities, depreciation of manufacturing equipment, maintenance, and indirect labor.

b) Administrative Overheads

Costs incurred for general management and administrative functions of the organization.
Examples: Office salaries, legal expenses, stationery, and IT support.

c) Selling and Distribution Overheads

Costs related to marketing, selling, and distributing the product to customers.
Examples: Advertising expenses, sales commission, packaging, and transportation costs.

Allocation and Apportionment of Manufacturing Costs
Allocation and apportionment ensure fair distribution of overhead costs across cost centers or units.

a) Allocation: Directly assigning overhead costs to a specific cost center or cost unit.
Example: Machine maintenance costs allocated to the machinery department.

b) Apportionment: Distributing shared overhead costs among multiple cost centers based on an appropriate basis.
Common Bases: Floor area (for factory rent), Number of employees (for administrative expenses), Machine hours (for depreciation).

c) Re-apportionment: Reassigning service department overheads to production departments using methods like:

• Direct Method: Allocates service costs to production departments directly.
• Step-Down Method: Allocates service costs sequentially, considering inter-departmental services.
• Reciprocal Method: Allocates costs considering mutual services provided between departments.

Traditional Allocation Methods
The traditional allocation method assigns overhead costs to products using a single predetermined overhead rate based on a cost driver, such as labor hours or machine hours.
Overhead Rate= Total Overhead Costs/Total Units of Cost Driver

Plant wide and Departmental Overhead Rates
The Plant-Wide Overhead Rate applies a single predetermined rate across the entire manufacturing plant, making it simple and cost-effective for operations with uniform processes and products. However, this approach may lead to inaccurate costing in complex environments where departments consume resources differently.

Departmental Overhead Rate calculates separate rates for each department based on specific cost drivers, such as machine hours or labor hours, reflecting the distinct resource usage of each department. While more accurate and suitable for diverse production setups, departmental rates require detailed data tracking and are more time-intensive to implement.

Activity-Based Costing (ABC)
Activity-Based Costing (ABC) is a costing methodology that identifies and assigns costs to activities based on their use of resources. It then assigns these costs to products or services based on their consumption of activities, offering a more accurate representation of cost allocation compared to traditional methods.

Key Concepts of Activity-Based Costing

1. Activities: Actions or tasks that consume resources in the production or delivery of goods and services.
   Examples: Machine setups, quality inspections, material handling.
2. Cost Drivers: Factors that cause or drive the cost of activities.
   Examples: Number of setups, hours worked, units produced.
3. Cost Pools: Groups of costs accumulated for each activity identified in the system.
   Example: A cost pool for "machine setups" includes wages of setup workers, setup materials, and machine downtime costs.
4. Resource Allocation: Costs are allocated to activities based on their consumption of organizational resources.
5. Product Allocation: Activity costs are assigned to products or services based on the level of activity they require.

Steps in Implementing Activity-Based Costing

1. Identify Activities: Analyze processes and identify key activities involved in production or service delivery.
2. Create Cost Pools: Group all indirect costs associated with each activity into specific cost pools.
3. Determine Cost Drivers: Identify the most significant factor influencing the cost of each activity.
4. Compute Activity Rates: Divide the total cost of each activity pool by its total cost driver units.

Activity Rate = Total Cost of Activity Pool/Total Activity Driver Units ​

5. Assign Costs to Products/Services: Multiply the activity rate by the number of cost driver units consumed by a product or service.

Question: A company makes 3 products – Alpha, Beta and Gamma. The total overheads are $900,000. These were allocated based on units produced. A close inspection revealed the below data.

Compute the costs under traditional costing and ABC Costing and compare the results. Also prepare the income statement under traditional v/s ABC Approach.

Answer:

Overheads Allocation under traditional costing:
Total overhead: $900,000
Total units Produced: 45,000.
Allocation:
Alpha: $900,000 / 45,000 * 10,000 units = $200,000

Beta: $900,000 / 45,000 * 15,000 units = $300,000

Gamma: $900,000 / 45,000 * 20,000 units = $400,000

Under-Absorption and Over-Absorption of Overheads

Overheads in a manufacturing or service organization are allocated to products or services using predetermined rates. These rates are based on estimated costs and activity levels (e.g., labor hours, machine hours). Discrepancies between the absorbed (allocated) overheads and actual overheads incurred result in either under-absorption or over-absorption. Proper handling of these variances is essential for accurate product costing, financial reporting, and managerial decision-making.

Under-Absorption of Overheads

Under-absorption occurs when the actual overheads incurred are higher than the overheads absorbed using the predetermined rate.

Causes

• Higher Actual Costs: Unexpected increases in utility bills, maintenance costs, or wages.
• Lower Activity Levels: Fewer hours worked or lower production output than anticipated, leading to underutilization of resources.
• Inaccurate Estimations: Errors in forecasting activity levels or costs during budget preparation.

Implications

• Costs of production appear lower than they actually are.
• Leads to understated Cost of Goods Sold (COGS) and overstated profits.
• May mislead management about operational efficiency and profitability.

Over-Absorption of Overheads

Over-absorption occurs when the absorbed overheads exceed the actual overheads incurred during a period.

Causes

• Lower Actual Costs: Savings on energy, maintenance, or labor costs.
• Higher Activity Levels: More hours worked or higher production output than estimated.
• Overestimated Rates: Excessively high predetermined rates due to inaccurate forecasting.

Implications

• Costs of production appear higher than they actually are.
• Leads to overstated COGS and understated profits.
• May cause management to make conservative or less competitive pricing decisions.

Impact on Costing and Profitability

Under-Absorption:

• Requires an upward adjustment to costs to align reported figures with actual expenses.
• May reduce profit margins or highlight inefficiencies.

Over-Absorption:

• Requires a downward adjustment to costs.
• May reflect operational efficiencies but also risks overestimating product costs, impacting competitiveness.