Overhead Costs: Types, Behavior & Allocation Methods

TAKEAWAYS:

• Overhead costs are indirect costs that cannot be traced directly to a product or service; they include factory rent, depreciation, and supervision salaries.
• Fixed overheads remain constant regardless of production volume (e.g., rent), while variable overheads change with activity (e.g., electricity for machines).
• Allocation methods like direct, step-down, and reciprocal distribute overheads to cost centers or products, each with trade-offs in accuracy and complexity.
• Under/over-absorption of overheads occurs when actual overheads differ from allocated overheads, impacting profit margins.
• Nepali businesses (e.g., hotels, manufacturers) use overhead allocation to set prices, control costs, and comply with tax regulations.
• The accounting cycle for overheads involves journal entries, ledger postings, and adjustments to ensure accurate financial reporting.

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1. What Are Overhead Costs?

Overhead costs are indirect costs incurred in the production or delivery of goods/services but cannot be directly traced to a specific product or unit. They are essential for business operations but are not part of direct materials or labor.

Types of Overhead Costs

Overheads are classified based on their behavior and function:

Example in Nepal:

• Hotel Everest (Kathmandu): Fixed overheads include rent for the building, salaries of receptionists, and insurance. Variable overheads include electricity for ACs (used per guest) and cleaning supplies per room.
• Nepal Pharmaceuticals Ltd.: Fixed overheads = factory rent; Variable overheads = power for machines.

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2. Fixed vs. Variable Overheads: Key Differences

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3. Allocation Methods for Overhead Costs

Overheads must be allocated to cost centers (e.g., production departments) or products for accurate costing. Common methods:

A. Direct Allocation Method

• How it works: Overheads are allocated directly to cost centers based on a single base (e.g., floor area, machine hours).
• Example:
  • Cost Center: Machining Department, Assembly Department.
  • Base: Machine hours.
  • Calculation:
    • Total overhead = Rs. 200,000.
    • Machining dept. uses 60% of machine hours → Allocated overhead = Rs. 120,000.
    • Assembly dept. uses 40% → Allocated overhead = Rs. 80,000.

Advantages: ✅ Simple and easy to apply. ✅ Low computational effort.

Disadvantages: ❌ Over/under-allocation if the single base is not representative. ❌ Ignores inter-departmental services (e.g., maintenance supporting multiple departments).

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B. Step-Down (Sequential) Allocation Method

• How it works: Overheads are allocated step-by-step, starting with the department that serves the most other departments.
• Example:
  • Departments: Maintenance (serves Machining & Assembly), Machining, Assembly.
  • Steps:
    1. Allocate Maintenance overhead to Machining and Assembly.
    2. Allocate Machining overhead to Assembly (if applicable).
    3. Final overhead for each department is used for product costing.

Worked Example: Kathmandu Textile Mills

Advantages: ✅ More accurate than direct allocation. ✅ Recognizes inter-departmental services.

Disadvantages: ❌ Arbitrary order of allocation can affect results. ❌ Residual overhead may remain unallocated.

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C. Reciprocal Allocation Method

• How it works: Uses algebraic equations to allocate overheads mutually between interdependent departments (e.g., Maintenance supports Machining, which supports Assembly).
• Example:
  • Departments: Maintenance (M), Machining (C).
  • Overheads:
    • M serves C with Rs. 40,000.
    • C serves M with Rs. 30,000.
  • Equations:
    • M’s total overhead = Rs. 50,000 (original) + Rs. 30,000 (from C).
    • C’s total overhead = Rs. 100,000 (original) + Rs. 40,000 (from M).
  • Solution:
    • Let $x$ = M’s overhead after allocation.
    • $x=50,000+0.3x$ (since 30% of C’s overhead goes to M).
    • Solve for $x$: $x=71,428$.
    • Similarly, C’s overhead = Rs. 128,572.

Advantages: ✅ Most accurate for interdependent departments. ✅ Eliminates arbitrary allocation.

Disadvantages: ❌ Complex calculations (requires algebra). ❌ Time-consuming for manual methods.

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4. Overhead Absorption and Variances

Overheads are absorbed into product costs using a predetermined rate (e.g., per machine hour or labor hour). At year-end, actual overheads are compared to absorbed overheads, leading to:

A. Over-Absorption

• Definition: When absorbed overhead > actual overhead.
• Cause: Underestimated overhead rate or overestimated production.
• Effect: Overstated profits (since less overhead is expensed).
• Example:
  • Budgeted overhead = Rs. 200,000 for 10,000 units → Rate = Rs. 20/unit.
  • Actual overhead = Rs. 180,000 for 9,000 units.
  • Absorbed overhead = 9,000 × Rs. 20 = Rs. 180,000.
  • Variance = Rs. 0 (but if rate was higher, over-absorption occurs).

B. Under-Absorption

• Definition: When absorbed overhead < actual overhead.
• Cause: Overestimated overhead rate or lower production.
• Effect: Understated profits (since more overhead is expensed).
• Example:
  • Budgeted overhead = Rs. 200,000 for 10,000 units → Rate = Rs. 20/unit.
  • Actual overhead = Rs. 220,000 for 8,000 units.
  • Absorbed overhead = 8,000 × Rs. 20 = Rs. 160,000.
  • Under-absorption = Rs. 220,000 - Rs. 160,000 = Rs. 60,000.

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5. Journal Entries for Overhead Costs

Proper accounting for overheads involves:

1. Recording actual overheads (e.g., rent, utilities).
2. Absorbing overheads into production.
3. Adjusting for under/over-absorption at year-end.

Example: Nepal Ceramics Ltd.

Explanation:

• Rent (Rs. 50,000) is recorded as a fixed overhead.
• Overhead absorbed = 3,000 units × Rs. 20 = Rs. 60,000.
• Actual overhead = Rs. 70,000 → Under-absorption = Rs. 10,000 (adjusted to COGS).

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6. Real-World Applications in Nepal

A. Hotels (e.g., Hotel Himalaya, Kathmandu)

• Fixed Overheads:
  • Rent for the building (Rs. 500,000/month).
  • Salaries of security and housekeeping staff (Rs. 2,000,000/month).
• Variable Overheads:
  • Electricity for ACs (Rs. 50 per room-night).
  • Laundry services (Rs. 200 per guest).
• Allocation Method:
  • Step-down allocation for departments (Front Desk, Housekeeping, Kitchen).
  • Reciprocal method for interdependent services (e.g., Maintenance supports Kitchen and Front Desk).

B. Manufacturing (e.g., Nepal Pharmaceuticals Ltd.)

• Fixed Overheads:
  • Depreciation of machinery (Rs. 1,000,000/year).
  • Factory insurance (Rs. 200,000/year).
• Variable Overheads:
  • Power for machines (Rs. 5 per tablet produced).
  • Lubricants for equipment (Rs. 10,000/month).
• Allocation Method:
  • Direct allocation based on machine hours.
  • EOQ-based ordering for indirect materials to minimize carrying costs.

C. E-Commerce (e.g., Daraz Nepal)

• Fixed Overheads:
  • Warehouse rent (Rs. 3,000,000/year).
  • IT infrastructure (servers, software).
• Variable Overheads:
  • Packaging materials (Rs. 50 per order).
  • Last-mile delivery costs (Rs. 200 per delivery).
• Allocation Method:
  • Activity-Based Costing (ABC) to allocate overheads per order type (e.g., groceries vs. electronics).

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7. Worked Example: Overhead Allocation for a Nepali Business

Scenario: Kathmandu Biscuit Factory produces 50,000 biscuits/month. Overheads for the month:

• Fixed Overheads: Rs. 200,000 (rent, salaries).
• Variable Overheads: Rs. 50,000 (electricity, packaging).
• Production Details:
  • Product A (Digestive): 30,000 units.
  • Product B (Marie): 20,000 units.
• Allocation Bases:
  • Fixed Overheads: Allocated based on labor hours.
    • Product A: 60% of labor hours.
    • Product B: 40% of labor hours.
  • Variable Overheads: Allocated based on machine hours.
    • Product A: 70% of machine hours.
    • Product B: 30% of machine hours.

Calculations:

1. Fixed Overhead Allocation:

   • Total fixed overhead = Rs. 200,000.
   • Product A: Rs. 200,000 × 60% = Rs. 120,000.
   • Product B: Rs. 200,000 × 40% = Rs. 80,000.

2. Variable Overhead Allocation:

   • Total variable overhead = Rs. 50,000.
   • Product A: Rs. 50,000 × 70% = Rs. 35,000.
   • Product B: Rs. 50,000 × 30% = Rs. 15,000.

3. Total Overhead per Product:

   Product	Fixed Overhead (Rs.)	Variable Overhead (Rs.)	Total Overhead (Rs.)
   Digestive	120,000	35,000	155,000
   Marie	80,000	15,000	95,000

Per-Unit Overhead Cost:

• Digestive: Rs. 155,000 / 30,000 = Rs. 5.17/unit.
• Marie: Rs. 95,000 / 20,000 = Rs. 4.75/unit.

Decision Impact:

• The factory can now price Digestive biscuits higher (since overhead is higher) or invest in efficiency to reduce variable overheads.

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8. Exam Tips for Overhead Costs

1. Understand the Difference:

   • Fixed vs. Variable: Always ask, "Does this cost change with production?"
   • Direct vs. Indirect: Can it be traced to a product? If not, it’s overhead.

2. Allocation Methods:

   • Direct: Use when departments are independent.
   • Step-down: Use when one department serves others (e.g., Maintenance → Machining → Assembly).
   • Reciprocal: Use when departments mutually support each other (requires algebra).

3. Over/Under-Absorption:

   • Over-absorption → Higher profits (but may indicate inefficient costing).
   • Under-absorption → Lower profits (adjust COGS at year-end).
   • Formula: $$\text{Overhead Variance}=\text{Actual Overhead}-\text{Absorbed Overhead}$$

4. Journal Entries:

   • Always close overhead accounts to COGS or WIP at year-end.
   • Example:

5. Common Exam Pitfalls:

   • ❌ Mixing fixed and variable overheads in allocation.
   • ❌ Ignoring inter-departmental services (use step-down or reciprocal).
   • ❌ Forgetting to adjust for variances at year-end.

6. Numerical Problems:

   • Step 1: Classify overheads as fixed/variable.
   • Step 2: Choose the correct allocation method.
   • Step 3: Calculate per-unit overhead.
   • Step 4: Adjust for variances if needed.

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