7/30/2019 CHP 5 - DE&OH

1/25

Chapter 5

Direct Expenses And Overheads

7/30/2019 CHP 5 - DE&OH

2/25

Direct Expenses

Direct expenses are defined as the costs otherthan materials or wages, which are incurred for aspecific product or saleable service.

It includes cost of services provided to anundertaking and the notional cost of the use ofowned assets.

Thus, direct expenses are those expenses, which

are directly chargeable to a job or a process andbecome a part of prime cost.

It is also known as chargeable expenses.

7/30/2019 CHP 5 - DE&OH

3/25

Direct And Indirect Expenses

Direct Expenses Indirect Expenses

They can be directly charged to a specific

cost centre

They cannot be directly charged to a

specific cost centre

The benefit of such cost is received by a

specific job or cost centre

The benefit of such cost is not received by

a specific job or cost centre

Included in prime cost of a product Included in factory overheads

7/30/2019 CHP 5 - DE&OH

4/25

Direct Materials And Direct Expenses

Direct Materials Direct Expenses

It becomes a part of the manufactured

product

They are the costs other than direct

materials

It becomes a part of the finished product They can be directly identified with a cost

centre

Sometimes they form part of the final

product as indirect material

Sometimes they are treated as indirect

expenses

7/30/2019 CHP 5 - DE&OH

5/25

Limitations of Direct Expenses

Power expenses for running machines can be directly charged toproduction of that particular machine or to a cost centre.

But meters are not generally installed for each machine, costcentre, or department.

Hence, power expenses are treated as indirect expenses.

When a firm buys special tool or equipment for a particular order orjob, it should be treated as direct expenses of that job.

However, if such tools or equipments are useful for futureproduction, the whole of its cost is not treated as direct expenses.

Only a proportionate amount is treated as the direct expense.

Sometimes direct expenses may be too small to be absorbed asdirect expensesparticularly in case of materials of small value,e.g., gum used in binding books, strings used in shoes.

Such direct expenses are treated as indirect expenses.

7/30/2019 CHP 5 - DE&OH

6/25

Overheads

Total cost of a product involves direct costs andindirect costs.

Direct costs can be conveniently traced down to

the product manufactured. It includes direct materials, direct wages, and

direct expenses.

On the other hand, indirect costs cannot beidentified with the product manufactured.

Indirect costs are referred as overheads.

7/30/2019 CHP 5 - DE&OH

7/25

Overheads

Overhead costs are operating costs of a

business enterprise which cannot be traced

directly to a particular unit of out- put.

Blocker & Weltmer

Overhead is the total cost of indirect

materials, wages, and expenses.

7/30/2019 CHP 5 - DE&OH

8/25

Overheads

IndirectMaterials

IndirectWages

IndirectExpenses

7/30/2019 CHP 5 - DE&OH

9/25

Overheads

Function

Manufacturing

Administrative

Selling

Distribution

Element

IndirectMaterials

Indirect Wages

IndirectExpenses

Behaviour

Fixed

Variable

Semi Variable

Step

Control

Controllable

Uncontrollable

Nature

Normal

Abnormal

7/30/2019 CHP 5 - DE&OH

10/25

Accounting Of Overheads

Classification ofOverheads

Collection ofOverheads

Apportionmentof Overheads

Re-distribution

Absorption ofOverheads

7/30/2019 CHP 5 - DE&OH

11/25

Allocation And

Apportionment Of Overheads

Allocation is defined as the allotment of whole

items of cost to the cost centres or the cost units.

It is charging to cost centre those overheads that

result from the existence of cost centres. Apportionment is defined as the allotment to

two or more cost centres of proportions of thecommon items of cost on the estimated basis of

benefit received. It is charging to a cost centre the fair share of common

overhead.

7/30/2019 CHP 5 - DE&OH

12/25

Basis Of Allocation

And Apportionment

Principles ofAllocation andApportionment

Services or use

Ability to Bear

Survey

Efficiency

7/30/2019 CHP 5 - DE&OH

13/25

Departmentalization of

Overhead Expenses

In order to have an effective control over thefunctioning of the factory, the factory is divided into anumber of departments.

Each product passes through various departments andreceives benefits from them in different degrees.

Re-Apportionment

The service and staff cost centres or departments provideessential services which support the production cost

centres, but they do not directly deal with the products.

The process is known as secondary distribution ofoverheads.

7/30/2019 CHP 5 - DE&OH

14/25

Apportionment Of Inter-Service

Department Overheads

Direct Distribution Method The integral part of costing being apportionment or

re-apportionment of the individual staff costs centres andservice cost centres costs to other cost centres receivingthe service, on a reasonable, logical and equitable basis.

Step or Non-Reciprocal Method The staff and service cost centres are arranged on an

analysis sheet in the descending order of theirserviceability. The most serviceable department or cost

centre, i.e. the department which renders significantservice to most of the other service cost centres, orputting it the other way, the cost centre which receives theleast service, is taken up first.

7/30/2019 CHP 5 - DE&OH

15/25

Apportionment Of Inter-Service

Department Overheads

Reciprocal Method

The reciprocal method is used to allocate service costcentre costs in situations when service cost centresrender service to one another in mutual orcomplementary relationship.

The methods available for dealing with reciprocalservices are:

Simultaneous equation method

Repeated distribution method (or Continued distribution orAttrition method)

Trial and error method

7/30/2019 CHP 5 - DE&OH

16/25

Absorption Of Overheads

The process of allotment of the overheads of

production department to the products is called

as theprocess of absorption of overheads.

The method of charging the overheads toindividual units is called absorption of overheads.

Overheads Absorptionis defined as, the

allotment of overheads to cost units. It is also called as recovery charge or application

of overheads

7/30/2019 CHP 5 - DE&OH

17/25

Absorption Of Overheads

Absorption of overheads may be done on the

following basis:

Figures of the previous year

Anticipated volume of production

Normal volume of output or capacity

7/30/2019 CHP 5 - DE&OH

18/25

Purposes of Overhead Rates

To compute the proper amount of overhead thatis to be included in the cost of individual jobs,batches, production lots, or processes.

To provide the basis for the formal accountingentries, transferring cost from overhead costaccounts to work-in-process accounts (in case ofprocess and manufacturing firms) or work-in-

progress accounts (in case of construction firms). To estimate overhead costs applicable to a

product in advance of actual production.

7/30/2019 CHP 5 - DE&OH

19/25

Overheads Rates

The base rate at which the overhead cost is

allocated to the product is known as the

overhead rate.

Historical Rate = Actual Overheads

Actual Base of the Year

Predetermined Rate = Budgeted Overheads

Budgeted Base of the Year

7/30/2019 CHP 5 - DE&OH

20/25

Overheads Rates

Steps in absorption of overhead

Computation of overhead absorption rate, and

Application of the rate so computed to the cost

units.

7/30/2019 CHP 5 - DE&OH

21/25

Methods ofAbsorption

ProductionUnit Method

PercentageMethods

Percentage ofDirect material

Percentage ofDirect Labour

Percentage of

Prime Cost

Hourly RateMethods

Labour-hourRate

Machine-hourRate

Composite-

hour Rate

Dual HourRate

7/30/2019 CHP 5 - DE&OH

22/25

Absorption Of

Administrative Overheads

Administrative overheads are absorbed by any

one of the following methods:

By transferring to P&L A/c.

By apportioning to production and selling

By adding separately to the cost of production

Rate = Total administrative overheads

The base selected

7/30/2019 CHP 5 - DE&OH

23/25

Under- Or

Over-recovery Of Overhead

When predetermined overhead rates are applied,it is obvious that the overhead absorbed will begreater or lesser than the actual expenditure

incurred on account of overhead, which is knownat a later date, usually at the end of some fixedperiod.

When the absorbed amount is greater, it is called

over-recovery, In case ofunder-recovery of overhead, just the

opposite happens.

7/30/2019 CHP 5 - DE&OH

24/25

Under- Or

Over-recovery Of Overhead

Treatment of under or over recovery of

overheads

Use of supplementary rates

To carry over the next years account

Charge to Costing P&L A/c

7/30/2019 CHP 5 - DE&OH

25/25

Overheads For Decision-Making

Overheads Costs

Charged to Jobs Product Balance Sheet andExpense of nextAccounting Period

Under-recovery ProductCosting P&L A/c.

Expense of CurrentAccounting Period