Functional Analysis of Overheads
Overhead costs can be classified according to the function of the organization responsible for incurring the cost. Examples of general expense classifications include production overhead, selling and distribution overhead, and administrative overhead. Generally, most overhead costs can be classified in this way, but some overhead costs relate to the organization as a whole and may be called overhead costs.
In this article, the focus is on production overhead. Production is that business function that converts raw materials into the finished product of the organization. The production department is usually divided into several departments. Some of these are directly involved with the production process. These are called production cost centers and may include, for example, the cutting department and the finishing department.
Others in the production department are not directly involved with the production process, but provide production support services. These are called service cost centers and examples include the maintenance department and stores.
Overhead Allocation and Contribution
The first stage in the analysis of production overheads is the selection of the appropriate cost centers. The selection will depend on a number of factors, including the level of control required and the availability of information.
Having selected the appropriate cost centers, the next stage in the analysis is to determine the overall cost for each cost center. This is accomplished through the allocation and contribution process.
Cost allocation is possible when we can identify a cost as specifically attributable to a particular cost center. For example, the salary of the manager of the packaging department can be assigned to the cost center of the packaging department. There is no need to share the cost of salary among several different cost centers.
The cost contribution is necessary when it is not possible to assign a cost to a specific cost center. In this case, the cost is divided between two or more cost centers according to the estimated benefit received by each cost center. To the extent possible, the contribution base is selected to reflect this benefit received. For example, the cost of rent and fees can be prorated according to the space occupied by each cost center.
Overhead absorption in salable cost units
The last stage in the analysis of general expenses is their absorption in the cost units produced in the production centers. This is sometimes called overhead recovery.
To begin with, we need to measure the level of production achieved. There are many measures that can be used, but the most common are:
Physical units produced;
Labor hours worked;
Hours of operation of the machine.
In a standard costing environment, the two hourly rate-based methods use standard labor hours and standard machine hours as the absorption base.
Different production departments are likely to measure their output in different ways. The goal is to use a measure that reflects the nature of the work in question. The physical unit of measure is theoretically the simplest, but it is only valid if all items produced require the same amount of resources.
The overhead costs of each production cost center are then divided by the amount of production achieved to calculate the amount of overhead costs to be attributed to each unit. This is the overhead absorption technique and we will illustrate it by expanding on our example on allocation and apportionment.
The output of the machining department will be measured using the number of machine hours produced, while the output of the assembly and finishing departments will be measured using the number of direct labor hours produced. The reasons for this can be seen in the number of machines and direct labor hours for each department shown in the original data for the example. The machining department is clearly machine-intensive, while the other departments are labor-intensive.
Absorption rates are calculated by dividing the costs attributed to the department by its appropriate measure of output.
Application of the overhead absorption rate
When using an absorption method based on direct labor hours or machine hours, the direct cost attributed to each unit is obtained by multiplying the time spent per unit by the absorption rate per hour.