Cost concepts & overheads

Semi-variable overhead is an overhead that is partly fixed and partly variable. It has a fixed element incurred even at zero activity and a variable element that changes with the level of activity. For example, a telephone bill has a fixed monthly rental plus charges that vary with the calls made.

Allocation of overhead means the process of charging the whole amount of an overhead cost item directly to a specific cost centre or department where it is wholly and exclusively incurred, without dividing or apportioning it among other departments.

Controllable and uncontrollable overhead

On the basis of control, overhead is classified into controllable overhead (which can be controlled by the management at a given level of authority, e.g. indirect materials) and uncontrollable overhead (which cannot be controlled at that level, e.g. factory rent).

Based on function, overhead is classified into three types:

(i) Factory (production) overhead — indirect cost incurred inside the factory, e.g. factory rent, power, depreciation of plant.

(ii) Office and administrative overhead — indirect cost of running the office, e.g. office rent, salaries of office staff, stationery.

(iii) Selling and distribution overhead — indirect cost of selling and delivering goods, e.g. advertisement, salesmen's commission, delivery expenses.

Fixed Cost and Variable Cost

Fixed cost is the cost which remains constant in total amount irrespective of the volume of output or activity within a given period and relevant range. It is incurred even when there is no production, but the fixed cost per unit falls as output rises. It is also called period cost or capacity cost.

Examples: factory rent and rates, salary of permanent managers, insurance premium on plant and building, straight-line depreciation, interest on a long-term loan.

Variable cost is the cost which varies directly and in proportion to the volume of output or activity. Total variable cost rises when production rises and falls to zero when there is no production, but the variable cost per unit remains constant.

Examples: direct materials, piece-rate wages of direct labour, power and fuel used in production, packing materials, sales commission on units sold.

Fixed cost is time-based and does not respond to output, whereas variable cost is volume-based and moves directly with the level of activity.

Fixed overhead means those indirect costs which do not change in total with the level of output or activity within a given period. Examples include factory rent, insurance of plant, and salaries of permanent supervisors. Such costs remain constant in total, though fixed overhead per unit falls as output rises.

Variable overhead is the indirect cost that varies in total in direct proportion to the level of production or activity — for example, indirect materials, indirect labour, and power, which rise as output rises and fall as output falls.

Allocation and Apportionment of Overhead

Allocation of overhead means charging the whole amount of an overhead cost directly to the specific cost centre (department) where it is incurred and which is solely responsible for it. The cost is charged in full — it is not divided. Allocation is possible only when the cost can be identified with a particular cost centre.

Example: The salary of the supervisor of the Machining Department, Rs 40,000, is charged wholly to the Machining Department. Similarly, the rent of a factory building used only by the Assembly Department is allocated entirely to the Assembly Department.

Apportionment of overhead means the distribution of an overhead cost among two or more cost centres on a fair and reasonable basis, because the cost is common to those centres and cannot be identified wholly with any one of them. The total cost is divided in proportion to the benefit received by each centre.

Example: Factory rent of Rs 1,00,000 is common to the Machining Department (floor area 6,000 sq. ft.) and the Assembly Department (floor area 4,000 sq. ft.). It is apportioned on the basis of floor area as:

• Machining Department = Rs 1,00,000 × 6,000/10,000 = Rs 60,000
• Assembly Department = Rs 1,00,000 × 4,000/10,000 = Rs 40,000

Basis of difference: In allocation the entire cost goes to one cost centre, while in apportionment the cost is shared among several cost centres using a suitable basis (floor area, number of workers, machine hours, value of assets, etc.).

Controllable and Uncontrollable overhead.

According to controllability, overhead is classified into controllable overhead (which can be controlled or influenced by the management of a responsibility centre, e.g. indirect materials, indirect labour) and uncontrollable overhead (which cannot be controlled by a particular level of management, e.g. factory rent, insurance, depreciation).