The Concept Of Overheads

Most of the students are point-blank when someone has asked them that indirect cost and overheads are same? But here, no need to wonder. There are enough reasons provided for that similarity. Here it goes, but before explaining the reasons, one needs to understand what direct and indirect cost is? Cost which is traceable with the product is the direct cost. To grasp the concept deeply, take an example, suppose there are five sales offices in different cities and managers are appointed for each separately. Say Rs. 50,000 is the total salary that a company has to pay to their managers. Now the question is how much salary a manager is entitled to get? It is so simple to trace the salary directly with the number of offices. It is Rs. 10,000 which is directly traceable with the sales offices is a direct cost. However, cost which is not traceable with the product is an indirect cost. So let’s take an example again, in a restaurant, where several food items are cooked and served. There is only one man who looks after the restaurant and getting a salary of Rs. 5,000. Can you trace the salary of man with the food items? No, it’s not possible is an indirect cost. Indirect material, indirect labor and indirect expenses collectively make the word overheads.

The most crucial part of the overheads is how to charge it to the cost units equitably as it is an indirect cost? Mainly three terms are used to equal distribution of overheads. These are ALLOCATION, APPORTIONMENT AND REAPPORTIONMENT of the overheads. 

Before arriving at ALLOCATION, we must understand the DEPARTMENTALIZATION. It is a process by which we divide the whole firm into several departments. Once departmentalization is done, we reached at ALLOCATION which means to charge the overheads to respective cost units and cost centers directly. For clear understanding take an example, electric charges can be allocated directly to respective department if separate meters are installed and cost of coal which is used for boiler is directly allocated to boiler house division. Thus, allocation is direct process of identifying overheads to the cost units or cost centers.

Now we reach at another step, APPORTIONMENT, it is a process where we apportion the overheads which are not allocated to cost units or cost objects directly. Reconsider the above example, if meters are not installed, you will definitely wonder that how it could be done. But, here the electricity charges are apportioned on some suitable basis like number of light points to various departments. This is how the apportionment takes place. It is also called a “primary Distribution Summary” of overheads.

Now the journey of overheads is headed towards the REAPPORTIONMENT of overheads, here we again discuss further a bit about departmentalization. That is classification of departments, which are broadly classified into PRODUCTION AND SERVICE DEPARTMENTS. As we know that production department is place where actual production takes place. And service department that renders the services to production departments. In primary distribution summary, overheads are allocated to departments i.e. production department and service department. But absorption of the overheads to cost units demand that overheads of service department should be redistributed to production department which is called redistribution of overheads. It is also called SECONDARY DISTRIBUTION SUMMARY of overheads. Now the question is Why the REDISTRIBUTION demanded? Because how many units are manufactured to be traced from production departments. Once total cost of concerned department found it is divided by number of units produced by that department. This is how one can find the cost of one unit. Which is also called ABSORPTION RATE.