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Notes of Overheads: Collection, Classification, Allocation, Apportionment and Absorption of Overheads(Primary and Secondary Distribution), Machine Hour Rate.
Overheads: Collection, Classification, Allocation, Apportionment, and Absorption
Introduction:
Overheads are indirect costs incurred in the production or provision of goods or services. Proper management of overheads is essential for cost control and accurate financial reporting. To effectively manage overheads, businesses need to understand the processes of collection, classification, allocation, apportionment, and absorption.
1. Collection of Overheads
Definition:
Collection refers to the systematic gathering of data related to all indirect expenses incurred by a business.
Importance:
Accurate collection is the foundation of overhead management.
It allows businesses to identify all indirect costs affecting their operations.
Steps in Collection:
Identify Overhead Categories: Start by identifying the various categories of overheads, such as rent, utilities, administrative salaries, office supplies, and more.
Data Gathering: Collect data from various sources, including invoices, payroll records, and utility bills.
Record Keeping: Maintain a well-organized record-keeping system to ensure no overhead cost is overlooked.
Consistency: Ensure that the collection process is consistent over time for accurate historical comparisons.
2. Classification of Overheads
Definition:
Classification involves categorizing overhead costs into groups to facilitate cost analysis and decision-making.
Importance:
Classification helps in understanding the nature of costs.
It aids in assessing the impact of various cost elements on the overall cost structure.
Common Overhead Classifications:
Fixed and Variable Overheads: Fixed overheads remain constant regardless of production levels, while variable overheads fluctuate with production.
Direct and Indirect Overheads: Direct overheads can be traced to specific cost centers or products, while indirect overheads cannot.
Production and Non-Production Overheads: Production overheads are related to the manufacturing process, while non-production overheads are associated with administrative and selling functions.
3. Allocation of Overheads
Definition:
Allocation assigns overhead costs to specific cost centers or departments based on a predetermined allocation basis.
Importance:
Ensures each department bears its fair share of overhead expenses.
Allows for more accurate cost control at the departmental level.
Methods of Allocation:
Direct Method: Allocates overheads based on a single, readily available cost driver, such as machine hours or labor hours.
Step-Down Method: Allocates overheads to one service department first and then distributes them to other departments.
Reciprocal Method: Recognizes mutual service relationships among departments and allocates costs accordingly.
4. Apportionment of Overheads
Definition:
Apportionment is used when an overhead cost cannot be directly attributed to a single department. It divides common overheads among various departments according to a predefined basis.
Importance:
Ensures that shared overheads are distributed fairly among departments.
Enables cost allocation in cases where a direct cause-and-effect relationship is absent.
Common Apportionment Bases:
Area occupied by each department, number of employees, machine usage, or any other reasonable basis reflecting resource consumption.
5. Absorption of Overheads
Definition:
Absorption refers to the process of absorbing overhead costs into the cost of a product or service.
Importance:
Helps in pricing products or services more accurately.
Facilitates accurate financial reporting and cost analysis.
Methods of Absorption:
Absorption Costing: In absorption costing, all production overheads are absorbed into the cost of goods, making it a fundamental component for financial reporting.
Variable Costing: Variable costing only includes variable production overheads in the cost of goods sold. It is often used for internal decision-making.
Primary and Secondary Distribution:
1. Primary Distribution
Definition:
Primary distribution is the initial allocation of overhead costs to production or service departments.
Importance:
Establishes a baseline for cost allocation.
Ensures that each department receives its share of overhead costs.
Process:
In primary distribution, overhead costs are assigned directly to the production or service departments based on the allocation and apportionment methods.
2. Secondary Distribution
Definition:
Secondary distribution is the further allocation of service department costs to production departments.
Importance:
- Reflects the total cost of production by including the costs of service departments.
- Ensures accurate product costing.
Methods of Secondary Distribution:
Step-Down Method: Allocates service department costs to other service departments and production departments in a sequential manner.
Direct Method: Allocates service department costs directly to production departments.
Reciprocal Method: Considers reciprocal relationships among service departments when allocating their costs.
Machine Hour Rate (MHR)
Definition:
Machine Hour Rate (MHR) is a cost accounting method used to allocate overhead costs associated with operating machinery or equipment to the products they produce.
Importance:
Helps in pricing products based on machine usage.
Ensures that overhead costs related to machinery are proportionally distributed across all products or services using the machines.
Calculating MHR:
MHR = Total Machine-Related Overheads / Total Machine Hours
MHR is a fundamental component of product costing, and it provides a clear picture of the costs associated with machine usage.
In conclusion, effective management of overhead costs, including collection, classification, allocation, apportionment, and absorption, is crucial for businesses in various industries. These processes help ensure accurate cost control, product pricing, and financial reporting. Similarly, the Machine Hour Rate plays a vital role in allocating overhead costs related to machinery, making it a valuable tool for cost accounting and product pricing. Understanding and implementing these concepts are essential for businesses seeking to optimize their cost structures and maximize profitability.
TEST YOUR KNOWLEDGES
FAQs
1.What Are Overheads in Business Accounting?
Overheads are indirect costs incurred by a business that can't be directly attributed to a specific product or service. They include expenses like rent, utilities, and office supplies.
2. How Are Overheads Collected and Recorded?
Overheads are collected through the systematic recording of all indirect expenses in an overhead ledger. This ledger tracks expenses associated with various cost centers.
3. What Is the Importance of Classifying Overheads?
Overhead classification helps businesses identify and categorize expenses, making it easier to allocate and apportion them accurately to the relevant cost centers.
4. What Is the Difference Between Allocation and Apportionment of Overheads?
Allocation assigns specific overheads directly to cost centers, while apportionment distributes common overheads among multiple cost centers using an appropriate basis, such as square footage or labor hours.
5. How Are Overheads Absorbed into the Cost of Products or Services?
Overheads are absorbed by applying predetermined overhead rates to cost centers. This process ensures that overhead costs are included in the cost of goods or services.
6. What Is Primary Distribution of Overheads?
Primary distribution allocates overheads directly to production or service departments based on their specific requirements and usage.
7. What Is Secondary Distribution of Overheads?
Secondary distribution further distributes overheads from service departments to production departments, ensuring that the costs are allocated accurately.
8. How Is the Machine Hour Rate Calculated, and What Is its Significance?
The machine hour rate is the cost incurred per machine hour of operation. It's calculated by dividing the total machine-related costs by the number of machine hours. This rate helps in pricing and budgeting.
9. What Role Does Machine Hour Rate Play in Costing and Pricing Decisions?
Machine hour rates are essential for determining the cost of manufacturing or providing services. They aid in pricing decisions and setting competitive rates.
10. What Are Some Tools or Software That Can Help Manage Overheads and Machine Hour Rates?
- Various accounting software like QuickBooks and specialized cost accounting software can help in tracking and managing overheads. Additionally, there are software tools that can calculate machine hour rates.