OVERHEAD EXPENSE

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Photo by: Michael Monahan

Although other types exist as discussed below, overhead expenses can be easily explained in terms of indirect manufacturing costs-that is, costs not associated with direct materials or direct labor. Overhead expenses—also called indirect manufacturing costs and factory overhead—encompass three general kinds of costs: those for indirect materials, indirect labor, and all other miscellaneous production expenses such as taxes, insurance, depreciation, supplies, utilities, and repairs. Direct material expenses are those for materials that become part of the finished product. For example, the cost of wood used to build furniture is a direct material expense. In contrast, indirect expenses are those that do not become part of the finished product. For example, electricity used to power equipment is an indirect manufacturing cost or overhead expense. Likewise, wage and salaries paid to workers who are directly involved with production are direct costs, whereas those paid to workers who repair and maintain equipment are indirect costs. In addition, overhead costs may include minor direct costs when they are so insignificant that they cannot be practically treated as direct expenses. Therefore, overhead expenses are part of the total costs of maintaining and staffing a business.

TYPES OF OVERHEAD COSTS

Overhead expenses can divided into three general categories: company overhead, selling overhead, and administrative overhead. These expenses cannot be directly linked with manufacturing products or providing services. These expenses constitute some of the most frequently discussed and illustrative kinds of overhead such as equipment maintenance and repair as well as utilities. Selling overhead refers to the costs related to product or service distribution and marketing. Hence, this type of overhead includes packaging and shipping, public relations, and sales staff expenses. Finally, administrative overhead expenses encompass expenses associated with general business operations such as office supply costs, management expenses, and labor costs from administrators and office workers who do not work directly for marketing and production departments. For purposes of explanation, the following discussion and examples will center on company overhead.

In addition, managers distinguish between variable, fixed, and mixed overhead costs in order to obtain information necessary for determining, planning, and controlling product costs. These types are differentiated based on the way changes in the level of production affect them—but these classifications tend to vary from industry to industry. Variable overhead costs are those that change depending on production levels. The cost of production supplies might be variable in that the more a company produces, the more supplies it needs. Fixed overhead costs are those that are constant even when production levels vary. Fixed overhead, for example, might include manager salaries, which remain constant when production levels fluctuate. Finally, mixed (or semivariable) overhead costs are those that are both partially variable and partially fixed. Some utilities, for instance, might be mixed costs if they have a connection fee (fixed cost) as well as a usage fee (variable cost). Consequently, determining the type of overhead cost requires examining whether and to what extent costs are dependent on production levels.

OVERHEAD APPLICATION

Accurate accounting and allocation of overhead expenses are very important in calculating the total cost of manufacturing a product and hence in setting a profitable selling price. The accounting of overhead is part of the control established during the budget process.

Because managers may not know total overhead costs until the end of an accounting period and because they generally need detailed information on costs before the end of an accounting period, accountants and managers use a series of steps called the overhead application to determine the overhead costs to allocate to production units. This process involves estimating an overhead rate and production volume that will apply to the coming fiscal year:

1. The type of overhead costs must be determined and classified as variable, fixed, or mixed. Then a projection of total overhead expenses must be made.
2. An activity base is chosen as a means for allocating overhead costs to production units. Activity bases are measures of production that can closely account for any differences in the amount of overhead actually incurred. Activity bases include direct labor costs, direct material costs, direct labor hours, machine hours, and units of production.
3. A budget is prepared to show the total projected volume of the activity base for the next period. For example, if direct labor costs are selected as the activity base, then the total amount expected to be spent on direct labor costs for the coming year would be budgeted.
4. Finally, an overhead application rate is determined by dividing the total budgeted overhead into the total budgeted activity level. Based on this rate, overhead costs are assigned to production units. Since this overhead application rate is determined while preparing a budget and not from actual production results, it is called a predetermined overhead rate.

A simple illustration of step four can be constructed by using units of production as the activity base. If the estimated overhead expenses were $400,000 and the projected number of units was 350,000 ($400,000/350,000), then the per unit overhead expense would be $1.14. Hence, if a company had a production goal of 100,000 units, it would assign overhead expenses of $140,000 ($1.14 multiplied by 100,000) to this goal.

However, this process can be far more complicated, especially if a company manufactures more than one product and if a company's different product processes vary considerably. For example, one product may require a labor-intensive finishing process, while another relies more on machinery. The relationships apparent between the finished product and these production processes provide accounting an activity base upon which to calculate the allocation of overhead, which would be divided by the number of direct labor hours and the number of machine hours, respectively. A company provides for overhead absorption by combining a number of these activity-based overhead rate allocation methods.

ABSORPTION AND OVERHEAD
VARIANCES

The monthly job cost ledger may indicate that, in applying the predetermined rate, the allocation either exceeded or fell short of actual costs. This variance, termed the "burden variance," means that overhead was either (1) overabsorbed (overapplied): the application of the predetermined rate exceeded the actual overhead used, or (2) underabsorbed (underapplied): the application of the predetermined rate fell short of the actual overhead used.

Burden variance can result from the following spending variations, or budget variance:

1. The total amount actually spent for production overhead varied from the budget.
2. The price paid for units of overhead factors varied from the budgeted prices.
3. The quantity of overhead factors per unit of finished product varied from the quantity per budgeted unit.
4. The mix of overhead factors used changed so that the average cost of overhead per unit of product varied from the amount budgeted.

Burden variance also results from the following volume variances:

1. Actual volume varied from the volume used to set the predetermined overhead rates.
2. Seasonal fluctuations distorted the averages.

Underabsorbed overhead exists as a debit balance in the production overhead clearing account at the end of the year. Overabsorbed overhead is a credit balance. To report these balances in the financial statements, the accountant examines the cause of the variance and chooses a method to satisfy the reporting objective. In reporting the variances the accountant considers at least three alternatives:

1. Divide the under- or overabsorption in any period between the income statement and the balance sheet in direct proportion to the distribution of the overhead absorbed during the period. The objective of this method is to have inventory cost and the cost of goods sold approximate the average costs of production in the period.
2. Report the variance in full as a loss or a gain on the income statement for the period in which it arises. The purpose of this method is to measure the inventory at its normal cost, with the income statement accounting for all variances from the budget. Inefficiencies due to overspending or underproduction are costs of the period rather than costs of the products manufactured during the period. When plant utilization falls short of budget, there is a loss (or an expense for idle capacity) to be reported in the income statement for the period.
3. Carry all burden variances to the balance sheet for the end of the period to be added to or offset against similar amounts arising in preceding or succeeding periods. Management exercises this option when it expects that a portion of the burden variance may be offset. Management does not extend this practice to the annual reporting, however, where it splits the burden variance between inventory and the cost of goods sold if the variance is (1) large enough to have a material effect on the financial statement and if it represents overabsorption, or (2) likely to be recoverable from the sale of the inventory in later periods.

COST CLASSIFICATION PROBLEMS

In some instances the cost of classifying production costs to specific units may be prohibitive. Therefore, management recognizes them as part of the production overhead to be absorbed on a per-unit basis and may devise some arbitrary method of allocation. Some examples of these costs are:

• Glue, staples, nuts, bolts, nails, plastic wrap, tape, etc., elements common to a variety of products without specific measurements.
• Shared time and travel expenses resulting from performing services at a number of customer sites.
• Overtime premiums, resulting from over-scheduling, are averaged over the entire production for the period.