Classification of Overheads Under Production and Distribution

 

Classification of Overheads

According to the common characteristics, we can classify or group the overheads. This grouping helps the managers and other concerned officers to classify the overheads. The major common characteristics through which we can classify overheads are:

1. Behavior
2. Elements
3. Functions.

Behaviour-Wise Classification

Based on the variability nature of production, we can classify overheads as follows:

1. Fixed Overheads
2. Variable Overheads
3. Semi-variable overheads

1. Fixed Overheads: In most cases, the cost of certain overheads, such as salaries, rent and rates, legal expenses, bank charges, etc., remains fixed. These overheads do not change regardless of the output or level of production. A decrease or increase in production does not affect these overheads. The impact of fixed expenses decreases with an increase in production, as the cost is spread over a larger number of units. Conversely, a decrease in production increases the effect of fixed cost per unit.

2. Variable Overheads: Overheads such as power, fuel, sales commission, indirect materials, stationery, etc., vary according to the production or the number of products. These overheads are known as variable overheads. An increase in production leads to an increase in such overheads, while a decrease in production results in a decrease in variable overheads.

3. Semi-Variable Overheads: Overheads like depreciation, supervision costs, telephone charges, repair and maintenance expenses lie somewhere between fixed and variable overheads. They are classified as semi-variable overheads. These overheads are partly fixed and partly variable. The changes in such overheads are not directly proportional to the variation in production.

Element wise Classifiction

According to the elements, overheads can be classified into three groups:

1. Indirect Labour
2. Indirect Materials
3. Indirect Expenses

Indirect Labour:

These are the labor expenses incurred for the payment of watchmen, cleaners, clerks, supervisors, and peons. They are not directly part of the labor expenses for production, although they assist in the production process. Such overheads are classified under the category of indirect labor expenses.

Indirect Materials:

These are materials such as lubricating oil, grease, coal, sandpaper used in polishing, and cotton waste used for cleaning products. They do not become part of the finished goods. Materials that do not become part of the finished goods are referred to as indirect materials. Additionally, some materials of small value, such as pins, nuts, and screws, which may form part of the finished goods, can be considered as indirect materials for the purpose of cost calculation.

Indirect Expenses:

These include expenses such as insurance, advertising, rent, depreciation, power, and lighting. They fall under the category of indirect expenses. Any expenses that do not fall under indirect labor or indirect materials are classified as indirect expenses.

Function-Wise Classification

The classification based on department or function falls under the function-wise classification of overheads. The major functions or departments are as follows:

1. Production Overheads
2. Administration Overheads
3. Selling Overheads
4. Distribution Overheads
5. Research and Development

Production Overheads: From the initial stage of production to the completion of the finished product, various expenses are incurred. These include indirect wages, indirect material costs, and indirect factory expenses. These expenses fall under the function of production or the production department, which is responsible for maintaining and operating the production department of an organization. Indirect wages, indirect expenses, and indirect materials used in the production department are categorized as production overheads.

Examples of production overheads include:

1. Indirect expenses such as factory lighting, factory rent, normal loss of material, overtime, idle time, etc.
2. Indirect materials like cotton waste, grease, coal, oil, etc.
3. Indirect wages such as salaries of storekeepers, supervisors, peons, watchmen, etc.

Please note that terms like "Manufacturing overheads," "Factory overheads," or "Works overheads" are used interchangeably with production overheads.

Administration Overheads: Expenses related to functions such as managing, directing, planning, coordinating, and controlling fall under administration overheads. In short, all expenses other than those related to production, selling, distribution, and research and development are categorized as administration overheads. Examples of administration overheads include legal expenses, auditor's fees, telephone charges, vehicles for managers, office rent, salaries of office staff, office lighting, and repairs of office buildings and equipment.

Selling Overheads: Costs incurred in creating demand for the product, securing and servicing orders fall under selling overheads. Examples of selling overheads include advertising, bad debts, commission to selling agents, salaries of salespersons, showroom expenses, and travel expenses.

Distribution Overheads: Maintenance, depreciation, and repairs of delivery vans, packing costs, carriage outwards, wastage of finished goods, and warehouse expenses are examples of distribution overheads. These costs are incurred in connection with the delivery of goods to customers and are classified as distribution overheads.

Research and Development (R&D) Overheads: R&D overheads cover costs related to research activities, product development, and innovation. Expenses associated with R&D personnel, laboratory facilities, prototype development, and intellectual property protection are included. Classifying R&D overheads enables organizations to evaluate the return on investment in research and innovation endeavors.

In addition to the above, here is some more information about the classification of overheads based on department or function:

Research and Development:

This category includes expenses incurred for research activities and the development of new products or processes. Research and development overheads encompass costs related to laboratory facilities, research personnel salaries, prototype development, testing, and other activities aimed at innovation and improvement.

It's important to note that while the aforementioned functions or departments are commonly used for classifying overheads, the specific categorization may vary depending on the organization and industry. Some organizations may have additional or different departments that are relevant to their specific operations. The key is to identify and allocate overhead costs according to the relevant functions or departments within an organization to better understand the cost structure and make informed decisions.

Furthermore, it's worth mentioning that overhead costs are typically indirect costs, meaning they cannot be directly attributed to a specific product or service. Instead, they support the overall operations of the organization. Proper classification and allocation of overheads help in accurate cost analysis, budgeting, pricing decisions, and overall financial management.

Conclusion:

The classification of overheads is a fundamental aspect of cost management in any organization. Understanding the different types of overheads and categorizing them based on variability and function provides valuable insights into cost structures, cost drivers, and areas for optimization. Accurate classification of overheads facilitates budgeting, pricing decisions, profitability analysis, and strategic planning. By effectively managing overhead costs, businesses can enhance operational efficiency, improve financial performance, and maintain a competitive edge in today's dynamic business landscape.