what is overhead in cost accounting

what is overhead in cost accounting

Understanding Overhead in Cost Accounting

1. Introduction to Overhead Costs

Most companies now appreciate that overhead does not behave in this mechanistic fashion, that the ‘relationship between volume of production and production overhead costs is more variable and unpredictable than the relationship between volume of production and direct labour or material costs’. Instead, they recognize that overhead is incurred in the form of fixed costs that do not change with fluctuations in production volume, and variable overhead costs that do change with fluctuations in production volume. Although estimating what proportion of overhead costs is absorbed by variable costs and what proportion by fixed costs is a contentious issue, companies usually split their overhead costs in this way because it is more rational to absorb overhead on a basis that reflects the relationship between cause and cost.

Rise 2: Making Sense of Overhead Only in management accounting would we consider setting a budget for overhead costs on the basis of a company’s output, in terms of numbers of products produced, and then dividing that total budgeted overhead cost by units output to get a single overhead rate, which is subsequently used all the way through cost accounting as a means of apportionment. The cost accountant would never be so naive.

Under the traditional approach to cost accounting, direct costs are traced to the products produced, and it is assumed that there is a straightforward relationship between the volume of a product, or a batch of like products, produced and the amount of production overhead that will be incurred. For example, as demonstrated on the grid, if a company expects to produce 5,000 units, it plans to incur a production overhead of £150,000. This allows the cost of production overhead to be absorbed into the product cost at a rate of £30 per unit, as reflected in column 5 of the grid, against the headings ‘Tracing’ and ‘Rate’. The product cost, in this case, is the opening stock plus those costs that have been incurred freshly in the course of the accounting period.

2. Types of Overhead Costs

The traditional method of classifying overhead costs categorizes them as either variable or fixed. A variable cost changes in direct proportion to the level of activity. A part-time bookkeeper is an example of a variable overhead cost. His or her hours worked increase as the workload increases. A fixed cost stays constant regardless of the level of activity within a relevant range. An example of a fixed overhead cost is an annual salary of $45,000 paid to a supervisor whether the plant produces 10,000 or 20,000 units of output this year. The traditional classification system, however, is often not useful when determining the cost of a job. For example, an increase in production activity might require a new production supervisor, in effect making the former supervisor a variable cost rather than a fixed one. Further, some overhead costs are distinguishable by their physical characteristics or frequency of use, or they might be incurred inside or outside the production department.

3. Allocating and Apportioning Overhead Costs

Before attempting to allocate overhead to production products, it will be necessary to accumulate overhead charges in a specific cost accounting control account. Most of these costs can be distributed to production products by use of cost drivers such as the application of direct labor or on the basis of processes, or the number of actual machine hours. Examples of such costs are depreciation, energy, materials, utilities, indirect labor, and indirect materials. Once these costs have been accumulated in the cost accounting control account, the production products can be assigned a portion of the overall usage of these items. The final step will be to take the remainder of the overhead and apply a standard rate across the board. This is usually called a general factory expense.

Allocating is the process of placing a portion of an overhead cost into the unit in which it is consumed. For example, we might allocate the cost of indirect materials which was item from the stores or warehouse to the appropriate job or department. Allocating is also known as charging off. Apportioning is the process of collecting the costs among the different cost centers to which the overhead might be allocated, and this is usually based on the use made of the particular item or service. Lastly, absorption is the process of including all overhead costs into the total or ending work-in-process or finished goods. These processes are found under process costing. While the job cost sheets described in chapter 10 will keep track of direct labor and inexpensive materials, a review of the financial statements will provide evidence of a portion of the overhead resulting in the cost of goods sold.

4. Overhead Absorption and Costing Methods

In the Traditional Costing Method, a company assigns or allocates the cost of direct labor and materials by using a single cost driver – volume of production. The overheads are accordingly apportioned, absorbed, and either included under or over absorbed. These applications are then used to create a unit cost. The experience of these companies has been that the overhead costs themselves and their volume as a proportion of total costs have dramatically increased, and with a large majority of overhead costs being volume related, it is not surprising that nearly all of the present cost accounting models are designed to deal with volume-related overhead costs.

4.1 Traditional Costing Method

Overhead absorption is the process by which overheads are divided between the different units. This process is used in both job order costing systems and process costing where standard costs have been established. Our main focus in this section is job cost accounting systems. There are two main methods we can use to absorb overheads: the Traditional Costing Method (TCM) and the Activity Based Costing Method (ABC).