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EXPENSES AND ABSORPTION OF OVERHEADS

EXPENSES AND ABSORPTION OF OVERHEADS

LEARNING OBJECTIVE

  1. EXPENSES
  2. TYPES OF INDIRECT EXPENSE OR OVERHEAD
  3. CAPITAL AND REVENUE EXPENDITURE
  4. COST CENTRES
  5. ALLOCATION, APPORTIONMENT,REAPPORTIONMENT AND ABSORPTION FOR OVERHEAD

1.EXPENSES

In cost accounting terms there are three types of business expenditure: materials, labor and expenses.

Expenses are all business costs that are not classified as materials or labour costs.

It is possible to identify direct expenses, for example the cost of a royalty paid for each unit of output produced or the cost of machine hired to complete a particular job. These expenses are direct because they can be identified with specific cost units.

However, the majority of expense items cannot be traced to a specific cost unit and they are classified as indirect expenses or overheads.

2.TYPES OF INDIRECT EXPENSE OR OVERHEAD

Manufacturing expenses:

Sub-contractors’ cost, depreciation of machinery ,etc.

Selling expenses:

Cost of delivering to customer, costs of after sales care, warehouse rental for storage of goods, depreciation of packing machine, etc.

Administration expense:

Telephone bills, stationary, costs of providing a canteen for the employees, auditor’s fee business rates on buildings, rent of building, etc.

Finance expenses:

  • Loan interest
  • Lease charge if any equipment or buildings are leased rather than purchased.

3.CAPITAL AND REVENUE EXPENDITURE

Capital expenditure is expenditure by a business on non-current ( fixed) assets.

Revenue expenditure is all expenditure other than capital expenditure and represents day-to-day or operating expenses.

Revenue expenditure will therefore include expenditure on materials, wages, power costs, lighting and heating bills, telephone bills, rent.

4. COST CENTRES

Business might treat its factory as a cost centre. That would mean that all manufacturing costs were add together. It would, however, be perfectly possible to divide the factory up into two or more cost centres. For example, if there are three production lines then the factory could treat each one as a separate manufacturing cost centre. Activities common to all the three production lines, such as maintenance or health and safety, could then be treated as service cost centres within manufacturing process.

In general, it will be cheaper and easier to run a system where there are fewer cost centres. However, there may be a drawback to that because management may not be able to identify the overall effect of certain activities on the business as a whole.

5.ALLOCATION, APPORTIONMENT,REAPPORTIONMENT AND ABSORPTION FOR OVERHEAD

The various expenses of a business can be split into two types: expense that can be directly attributed to a single cost centre and expnese that need to be shared between a number of cost centres. If there is more than one manufacturing cost centre then the cost of cleaning the factory will have to be shared out between them. If the factory is a single cost then it will not be shared out.

Direct labour, materials and expenses can be specifically allocated to cost units while indirect labour, materials and expenses must be allocated to overhead cost centres or apportioned between a number of different cost centres on an appropriate basis.

Allocation (Directly attributable expenses): the process of allocating a whole item of overhead cost to a cost centre is called allocation. For example, if the whole of the sales function is a single cost centre then sales commission paid to sales staff will be directly attributable to that cost centre.

Apportionment: for example, the rent of the buildings will relate to the manufacturing costs centre(s), the sales department cost centre(s), the accounting cost centre and the canteen cost centre. This also applies to other expenses such as rates, insurance, electricity bills and telephone bills. These joint expenses must therefore be shared out between each of the cost centres that incur some these expnese in a fair manner. This process is known as apportionment.

Reapportionment:  a service cost centre is a centre whose activity supports that of the production cost centres but which does not produce any production output. Examples include maintenance, stores and administration. After the initial process of allocation and apportionment of overheads, the total of the service cost centre overheads must be reapportioned to the production cost centres.

Absorption: production cost centres’ overhead costs must be absorbed by each individual product or cost unit in some way. This process is called absorption. Absorption of overhead costs is a method of including a fair proportion of the total overhead costs in the cost of each cost unit.

Different possible methods (units or time) of absorption as follows.

  1. Units produced ( for identical or similar unit): total estimated production overhead divided by number of units expected to be produced in the period.
  2. Labour hours: for labour intensive production environment
  3. Machine hours:  machine-based or automated production environment

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