Concept, Meaning & Classification of Overhead

Concept and Meaning of Overhead

The term overhead can be defined as the production cost other than direct cost, which is necessary for production but does not become the part of finished goods. The direct cost is easily traceable with output units. These costs include depreciation on buildings and equipment, maintenance, supplies, supervision, materials handling, power, property taxes, landscaping of factory grounds and plant security. These costs do not become the part of the finished goods. However, these costs are essential for the production process.

In some cases, the direct costs are also lumped into the overhead category if they form an insignificant part of the final product. This is justified on the basis of cost and convenience. If the cost of tracing is greater than the benefit of increased accuracy, such type of direct costs are lumped into an overhead category as indirect costs. The glue and nails used in making furniture or toys and the thread used in making clothes are examples of materials treated as overhead.

The institute of Cost and Management Accountant defined overhead as, "Overhead is an expenditure of labor, materials or services which cannot be economically identified with a specific saleable cost per unit."

Classification of Overhead

Overhead can be classified on a variety of ways. The major bases of overhead classification are:

• On the basis of function
• On the basis of behavior / variability
• On the basis of elements / nature
• On the basis of control

On the basis of Function

In the functional classification of overhead, the base of classification is the major activity of the concern. Based on major activities, the overhead can be classified into three categories, overhead incurred in production or factory department, office or administration department and selling and distribution department.

The types of overhead classified on the basis of function are as follows:

• Production or work manufacturing overhead

The indirect expenses incurred in operating manufacturing activities or operating the factory or manufacturing overhead. It includes all the indirect expenses incurred in factory process where the raw materials are converted into finished goods.

• Office / Administration overhead

It is the indirect expenses incurred in maintaining the administration of the whole organization. It includes all the expenses related to the formulation of plans and policies, their effective implementation through proper directions, coordination and controlling of the business activities.

• Selling and Distribution overhead

The indirect expenses incurred for the selling and distribution of finished goods to customers are known as selling and distribution overheads. It includes expenses that are incurred to create and stimulate demand and to distribute the goods.

• Research and Development overhead

Customer’s interest, expectation are changeable day to day. Likewise, newly innovation, speed development of technology and facilitated distribution are challenges for every business concern nowadays. By considering these challenges, business concern should establish research and development department. This department concern with development department, new product, new production planning and finding new needs of customer, etc. The cost is related to research and development department is called research and development cost.

On the basis of Behavior or Variability

The behavioral classification of overhead considers the direction of the overhead in response to a change in the level of output. Based on the behavior, the overheads are either fixed or variable or semi – variable as explained below:

• Fixed overhead

Fixed overhead are those expenses which remain fixed in a total amount of increase or decrease in the volume of output for a given period of time. Fixed overhead cost per unit decreases as production unit increases and vice versa. It shows a negative relationship between production unit and fixed overhead cost per unit. Examples of such expenses are rent of building, salaries, depreciation, interest, etc.

• Variable overhead

Variable overheads are those which vary in direct proportion to the volume of output. There is a positive relationship between production units remains constant with the change in output. There is a positive relationship between production units and variable overhead. E.g. indirect materials, indirect wages, fuel, power, etc.

• Mixed overhead

Expenses which shows both the nature of fixed and variable overhead are called mixed overhead. These expenses are constant up to a certain level of output and the vary with the changes of production units, but they do not fluctuate proportionately to the output units. Examples of such overheads are telephone charges, electricity, repairs and maintenance, etc.

On the basis of Element or Nature

According to the nature or sources of indirect expenditure, the overheads are classified into three types as follows:

• Indirect materials

The materials which cannot be identified with a particular cost unit or cost centre are called indirect materials. They do not form the major component of the finished product. They are not identified with a particular cost centre or cost unit.

• Indirect labour

The wages which are paid to the workers who are not directly involved in the production process is called indirect labor. It cannot be identified with a particular cost unit.

• Indirect Expenses

It includes indirect expenses other than indirect materials and indirect labor. It cannot be identified with a particular cost unit or cost center but can be apportioned to a number of cost centers.

On the basis of Control

On the basis of control, overheads are classified into two types as shown below:

• Controllable overhead

The overhead which is controlled by the decision taken by the management are called controllable overheads. These expenses are influenced by the action of management. Consumable materials, power expenses, lighting expenses, etc. are the examples of controllable overhead.

• Uncontrollable overhead

It is the indirect expenses which are not under the control of management. These expenses are not influenced by the decision or action taken by the management. The examples of uncontrollable overheads are fixed overhead cost like rent, salaries, legal fees, etc.

References:

Koirala, Madhav et.al., Principles of Accounting -XII, Buddha Prakashan, Kathmandu

Shrestha, Dasharatha et.al., Accountancy -XII, M.K. Prakashan, Kathmandu

Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu