Chapter 5

Direct Expenses And Overheads

Direct Expenses
Direct expenses are defined as the costs other than materials or wages, which are incurred for a specific product or saleable service. It includes cost of services provided to an undertaking and the notional cost of the use of owned assets. Thus, direct expenses are those expenses, which are directly chargeable to a job or a process and become a part of prime cost. It is also known as chargeable expenses.

Direct And Indirect Expenses

Direct Expenses They can be directly charged to a specific cost centre The benefit of such cost is received by a specific job or cost centre Included in prime cost of a product Indirect Expenses They cannot be directly charged to a specific cost centre The benefit of such cost is not received by a specific job or cost centre Included in factory overheads

Direct Materials And Direct Expenses

Direct Materials It becomes a part of the manufactured product It becomes a part of the finished product Sometimes they form part of the final product as indirect material Direct Expenses They are the costs other than direct materials They can be directly identified with a cost centre Sometimes they are treated as indirect expenses

Limitations of Direct Expenses

Power expenses for running machines can be directly charged to production of that particular machine or to a cost centre. But meters are not generally installed for each machine, cost centre, or department. Hence, power expenses are treated as indirect expenses. When a firm buys special tool or equipment for a particular order or job, it should be treated as direct expenses of that job. However, if such tools or equipments are useful for future production, 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 as direct 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.

Overheads
Total cost of a product involves direct costs and indirect 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 be identified with the product manufactured. Indirect costs are referred as overheads.

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.

Overheads Indirect Materials Indirect Wages Indirect Expenses

Manufacturing

Administrative
Function Selling

Distribution Indirect Materials Element Indirect Wages Indirect Expenses Fixed Overheads Variable Behaviour Semi Variable

Step

Controllable Control Uncontrollable

Normal Nature Abnormal

Accounting Of Overheads
Classification of Overheads

Collection of Overheads

Apportionment of Overheads

Re-distribution

Absorption of Overheads

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 the common items of cost on the estimated basis of benefit received.
It is charging to a cost centre the fair share of common overhead.

Basis Of Allocation And Apportionment

Services or use

Principles of Allocation and Apportionment

Ability to Bear

Survey

Efficiency

Departmentalization of Overhead Expenses

In order to have an effective control over the functioning of the factory, the factory is divided into a number of departments. Each product passes through various departments and receives benefits from them in different degrees. Re-Apportionment
The service and staff cost centres or departments provide essential services which support the production cost centres, but they do not directly deal with the products. The process is known as secondary distribution of overheads.

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 and service cost centres costs to other cost centres receiving the 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 their serviceability. The most serviceable department or cost centre, i.e. the department which renders significant service to most of the other service cost centres, or putting it the other way, the cost centre which receives the least service, is taken up first.

Apportionment Of Inter-Service Department Overheads

Reciprocal Method
The reciprocal method is used to allocate service cost centre costs in situations when service cost centres render service to one another in mutual or complementary relationship. The methods available for dealing with reciprocal services are:
Simultaneous equation method Repeated distribution method (or Continued distribution or Attrition method) Trial and error method

Absorption Of Overheads
The process of allotment of the overheads of production department to the products is called as the process of absorption of overheads. The method of charging the overheads to individual units is called absorption of overheads. Overheads Absorption is defined as, the allotment of overheads to cost units. It is also called as recovery charge or application of overheads

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

Purposes of Overhead Rates

To compute the proper amount of overhead that is to be included in the cost of individual jobs, batches, production lots, or processes. To provide the basis for the formal accounting entries, transferring cost from overhead cost accounts to work-in-process accounts (in case of process and manufacturing firms) or work-inprogress accounts (in case of construction firms). To estimate overhead costs applicable to a product in advance of actual production.

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

Overheads Rates
Steps in absorption of overhead
Computation of overhead absorption rate, and Application of the rate so computed to the cost units.

Methods of Absorption Production Unit Method Percentage Methods Percentage of Direct material Percentage of Direct Labour Percentage of Prime Cost Hourly Rate Methods Labour-hour Rate Machine-hour Rate Compositehour Rate

Dual Hour Rate

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

Under- Or Over-recovery Of Overhead

When predetermined overhead rates are applied, it is obvious that the overhead absorbed will be greater or lesser than the actual expenditure incurred on account of overhead, which is known at a later date, usually at the end of some fixed period. When the absorbed amount is greater, it is called over-recovery, In case of under-recovery of overhead, just the opposite happens.

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

Overheads For Decision-Making

Charged to Jobs Overheads Costs Under-recovery

Product

Balance Sheet and Expense of next Accounting Period Costing P&L A/c. Expense of Current Accounting Period

Product