Overheads, Methods of Absorbing Overheads, Classifying the Overheads

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In business, an overhead or overhead expense is the outgoing expense of the operating business. The term is used for grouping of expenses which are necessary for the continuing of the business of the enterprise but cannot be directly associated with the products and services which are being produced or offered by the enterprise.

Methods of absorbing overheads

The method which is used for charging overheads to product must ensure that,

1. The total amount being charged or recovered in a given period is not in difference with the actual expenses which are incurred in that specific period, materially. Putting it in simple words, there should be no significant over or under recovery of the overheads.

2. The amount which is charged to individual products and jobs is equitable.

3. Should be convenient to use.

4. Yields uniform results in various periods (to the most possible extent). The changes when occurring should reflect the changes in the underlying situations (for example, substitution of human labor by computer and other machines)

Classifying the overheads

When the activity levels are changed, there is change in the behavioral patterns of overheads also. The expenses can be classified into three categories, when based on this consideration:-

1. Constant or fixed overheads- any variation in activity does not affect these overheads (for example office remuneration). They only vary from one period to another when there is a deliberate change made to them (for example engaging of additional staff).

2. Variable overheads- these overheads change in proportion to the volume of activity. For example, when the activity has a 10% percent hike, the variable overhead expenses also go up by 10% and vice versa. This also makes them constant to per unit of output or activity.

3. Semi variable overhead- these overheads vary when there is a big change in the level of output or activity. Though there ongoing direction is the same as that of changing activity, the two are not in proportion. For example, change of 5% of the activity might result in a 3% change in the overhead expense. Semi-variable overheads can be composed of a fixed term and a variable term. They can be explained as follows:-

The amount of depreciation depends on two factors usually. One is time which is fixed, and the other is wear and tear, which is variable. These two join up to make depreciation on-a-whole as a semi-variable.

Concepts relating to capacity

Rated capacity- it is also known as the installed capacity of the plant or machine and is the maximum production capacity of the plant or machine, as indicated by the manufacturer.

Practical capacity- it is that capacity of the plant or machine which is actually utilized. Also known as the operating capacity, it takes into account the los of time which has occurred because of repairs, minor breakdowns, maintenance, normal delays, idle set-ups etc. It is around 80% to 90% of the related capacity.

Normal capacity- it is also called as average capacity and is used for computing the overhead recovery rates by considering the average utilization of the plant capacity in one full business cycle which often extends for 2 to 3 years. This capacity of the plant of machine is expected to get utilized over a given period of sales expectancy.

Capacity based on sales expectancy- this capacity is based entirely on sales expectancy.

Actual capacity- it is the capacity which is achieved in actual and real terms during a given period of time. It generally lies between the capacity base on sales expectancy and the practical capacity.

Idle capacity- the capacity of plant, equipment or machine which cannot be utilized for production processes in a given period is called idle capacity. The idle capacity is found due to shortage of skilled labor, non-availability of raw material, product demand, seasonal nature of product, shortage of power or supplies etc.

Manufacturing overheads

The manufacturing overheads form a major chunk of total overheads. It is very important for a business firm to properly absorb these overheads over the cost of the production. The absorption of manufacturing overheads is done by estimating and collection of cost allocation. After cost apportionment and reapportionment, the absorption of manufacturing overheads is done. The over and under absorbed overheads are then treated for adjustment.

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