CAS : 3 Overheads

COST ACCOUNTING STANDARD ON “OVERHEADS”
The following is the text of the draft COST ACCOUNTING STANDARD 3 (CAS 3) issued by the Council of the Institute of Cost and Works Accountants of India on “Overheads”. The standard deals with the method of collection, allocation, apportionment and absorption of overheads” In this Standard, the standard portions have been set in bold italic type. These should be read in the context of the background material which has been set in normal type.
1. Introduction
1.1 In Cost Accounting, the method of collection of overheads their allocation and apportionment to different cost centres and absorption to products or services are important steps. A system of better distribution of s can only ensure greater accuracy in determination of cost of products or services. It is, therefore, necessary to follow standard practices for allocation, apportionment and absorption of overheads for preparation of cost statements.
2. Objective
2.1 The standard is to prescribe the methods of collection, allocation, apportionment of overheads to different cost centres and absorption thereof to products or services on a consistent and uniform basis in the preparation of cost statements and to facilitate inter-firm and intra-firm comparison.
2.2 The standardization of collection, allocation, apportionment and absorption of overheads is to provide a scientific basis for determination of cost of different activities, products, services, assets, etc.
2.3 The standard is to facilitate in taking commercial and strategic management ` decisions such as resource allocation, product mix optimization, make or buy decisions, price fixation etc.
2.4 The standard and its disclosure requirement will provide better transparency in the valuation of excisable goods used for captive consumption.
3. Scope
3.1 The standard is to be followed for treatment of overheads by all enterprises including companies covered under Cost Accounting Records Rules issued in pursuant to Sec 209(1)(d) of the Companies Act, 1956 or under the provisions of any other Act.
3.2 The standard shall be applied in Cost and Management Accounting practices relating to
(a) Cost of products, services or activities
(b) Valuation of stock
(c) Transfer pricing
(d) Segment Performance
(e) Excise / Custom duty, VAT, Income Tax, Service Tax and other levies, duties and abatement fixation
(f) Cost statements for any other purpose
4. Definitions :
4.1 Overheads – Overheads comprise of indirect materials, indirect employee costs and indirect expenses which are not identifiable allocable to a cost object in an economically feasible way.
Overheads are to be classified on the basis of functions to which the overheads are related ( Refer to ‘ Classification of cost’ – CAS-1), viz
- Production overheads
- Research & Development expenses
- Administrative overheads
- Selling overheads
- Distribution overheads
Overheads may also be classified on the basis of behaviour such as variable overheads, semi-variable overheads and fixed overheads. Semi-variable overheads are further to be segregated into variable overheads and fixed overheads
Any items of overheads which are effect of abnormal situation in business activity will not be treated as overheads. They are charged to Costing Profit and Loss Accounts. Items not related to business activities such as donation, loss on sale of assets etc will not be treated as overheads.
Borrowing cost and other financial charges including foreign exchange fluctuations will not form the part of overheads.
4.2 Collection of Overheads - Collection of overheads means the collection of indirect items costs from books of account and supportive/ corroborative records in logical groups having regards to their nature and purpose.
Overheads are collected on the basis of pre-planned groupings, called cost pools. Homogeneity of the cost components in respect of their behaviour and character is to be considered in developing the cost pool. Variable and fixed Cost should be collected in separate cost pools for a cost centre. A greater degree of homogeneity in the cost pools are maintained to make the allocation of cost more rational and scientific. For example, a cost pool for maintenance expenses will help in apportioning them to different cost centres which use the maintenance service.
4.3 Allocation of overheads – Allocation of overheads is assigning a whole item of cost directly to a cost centre.
When an overheads item is directly related to a cost centre, it is allocated to the cost centre. For example, depreciation of a particular machine can be allocated to a particular cost centre if the machine is directly attached to the cost centre.
4.4 Apportionment of overhead - Apportionment of overhead is distribution of overheads to more than one cost centre on some equitable basis.
When the indirect costs are common to different cost centres, these are to be apportioned to the cost centres on a reasonable basis. For example, the expenditure on general repair and maintenance pertaining to a department can be allocated to that department but has to be apportioned to various machines (Cost Centres) in the department. If the department is involved in the production of a single product, the whole repair & maintenance of the department may be allocated to the product.
4.5 Primary and Secondary Distribution of Overheads :
In case of multi-product environment, there are common service cost centres which are providing services to the various production cost centres and other service cost centres. The overhead costs are required to be allocated or apportioned to the relevant cost centres. First step to be followed is to apportion the overheads expenses to different cost centres and then second step is to apportion the costs of service cost centres to production cost centres on a suitable basis. The first step is termed as primary distribution and the second step is termed as secondary distribution of overheads.
4.6 Absorption of overheads - Absorption of overheads is charging of overheads from cost centres to products or services.
Absorption is done by means of absorption rate which is calculated as follows :
Total overheads of the cost centre
Overhead absorption Rate = _____________________________
Total quantum of base
The base ( denominator) is selected on the basis of type of the cost centre and its contribution to the products or services, for example, machine hours, labour hours, quantity produced, etc.
5. Apportionment and absorption of Production Overheads
5.1 Cost is to be apportioned to different cost centres based on following two principles :
i) Cause and Effect - Cause is the process or operation or activity and effect is the incurrence of cost. Apportionment of cost based on this criterion is to be adopted to ensure a better rationality as it is guided by the relationship between cost object and cost.
ii) Benefits Received – Cost is to be apportioned to the various cost centres in proportion to the benefits received by them.
5.2 Primary Distribution of overheads :
Basis of primary apportionment of items of production overheads is to be selected to distribute it to the cost centres in the proportion of their use.
Basis of apportionment must be rational to distribute overheads. Once the base is selected, the same is to be followed consistently and uniformly. However, change in basis for apportionment can be adopted only when it is considered necessary due to change in circumstances like change in technology, degree of mechanization, product mix, etc. In case of such changes, proper disclosure in cost records is essential.
Examples of basis of primary distribution of some items of production overheads
Item of Cost
Basis of Apportionment
Power
Fuel
Jigs, tools & fixtures
Crane hire charges
Supervisors’ salary & fringe benefits
Labour welfare cost
Rent & rates
Insurance
Depreciation
(H.P. rating of Machines x hours x LF
Consumption rate x hour x LF
Machine hours / Man hours
Crane hours/ weight of materials handled
Number of employees
Number of employees
Floor / Space area
Value of fixed asset
Value of fixed asset
* LF = Load Factor
5.3 Secondary Distribution of Overheads :
Secondary distribution of overheads may be done by following either Reciprocal basis or Non-Reciprocal Basis. While reciprocal basis considers the exchange of service among the service departments, non-reciprocal basis considers only one directional service from a service cost centre to other service cost centre(s).
5.4 Secondary Apportionment of Overheads on Non-Reciprocal basis
In non-reciprocal secondary distribution, the costs of service cost centres are apportioned to the production cost centres. Steps involved are :
i) The cost of first service cost centre is apportioned on a suitable basis to production cost centres.
ii) The next step is to apportion the cost of second service centre.
iii) The process is to be continued till the costs of all service cost centres are apportioned. This method is known as Step Ladder Method.
For example, refer to Exhibit 1
5.5 Secondary Apportionment of Overheads on Reciprocal Basis
The services rendered by certain service cost centres are also utilized by other service cost centres. In reciprocal secondary distribution, the cost of service cost centres are apportioned to production cost centres and other service cost centres. In such case, any one of the following three methods may be followed :
I. Repeated Distribution Method
II. Trial & Error Method
III. Simultaneous Equation Method
5.5.1 Repeated Distribution Method
Steps to be followed under this method are :
i) The proportion at which the costs of a service cost centres are to be distributed to production cost centres and other service cost centres are determined.
ii) Costs of first service cost centres are to be apportioned to cost centres in the proportion as determined in step (i).
iii) Similarly, the cost of other service cost centres are to be apportioned.
iv) This process as stated in (ii) and (iii) are to be continued till the figures remaining undistributed in the service cost centres are negligibly small. The negligible small amount left with service centre may be distributed production cost centres.
For example, refer to Exhibit 2
5.5.2 Trial and Error Method
This method is to be followed when the question of distribution of costs of service cost centres which are interlocked among themselves arises. In the first stage, gross costs of services of service cost centres are determined and then in the second stage costs of service centres are apportioned to production cost centres. Steps to be followed :
i) The proportion at which the costs of a service cost centre to be distributed to other service cost centres is determined.
ii) Cost of first service cost centre is distributed to the other service centres in the proportion of service they received from the first as assessed in step (i).
iii) In the next step, total cost of second service cost centre so arrived has to be distributed to the other service centres in the proportion of service they received from the second as assessed in step (i).
v) Similarly, the cost of other service cost centres are to be apportioned.
vi) This process as described in (iii) and (iv) is to be continued till the figures remaining undistributed in the service cost centres are negligibly small.
vii) At last, Cost of Service Cost Centres to be distributed to Production Cost Centres
For example, refer to Exhibit 3
5.5.3 Simultaneous Equation Method
The simultaneous equation method is to be adopted to take care of secondary distribution of cost of service cost centres to production cost centres with the help of mathematical formulation and solution. Steps to be followed :
i) Proportion of service benefits received by different cost centres from a cost centre are assessed on the basis of records
ii) The same ratios are used as co-efficients in the equations framed for apportionment of cost of service cost centres to production cost centres.
iii) Solution of the equations gives the cost of service cost centres.
iv) At last, Cost of Service Cost Centres to be distributed to Production Cost entres.
For example, refer to Exhibit 4
5.6 Common bases for absorption of Production overhead from production cost centre to product or services :
Bases of denominator
Applicability
Unit of Production
When single product is produced or various products are similar in specification.
Direct labour cost
When conversion process is labour intensive
and wage rates are substantially uniform
Direct labour hour
When conversion process is labour intensive
Machine Hour or Vessel Occupancy or Reaction Hour or Crushing Hour etc
When production mainly depends on performance of the base
5.7 Absorption of Production Overheads and production capacity
The fixed production overheads shall be absorbed on the basis of normal capacity or actual capacity utilization, whichever is higher, of the product or plant as the case may be. ( refer to CAS-2).
In case of less production than normal, under-absorption of overheads shall be adjusted in Costing Profit & Loss Account. In case of higher production than normal, the over-absorption of overheads shall also be adjusted in Costing Profit & Loss Account.
Variable production overheads are assigned to each unit of production on the basis of the actual capacity utilization.
5.8 Absorption of Production overheads to products :
Production Overheads absorption rate for each cost centre is to be determined with the help of quantum base as indicated in 5.6 above and the formula as indicated below :
Fixed overheads
Fixed overheads absorption rate = _____________________________
Normal or actual quantum of base,
whichever is higher
Variable overheads
Variable overheads absorption rate = ______________________
Actual quantum of base
5.9 A pre-determined rate may be used on a provisional basis for internal management decision making such as cost estimates for quotation, fixation of selling price etc. These rates are to be calculated for each cost centre for a particular period. Budgeted overheads for the respective cost centres for the period concerned are to be taken as numerator for determining the rate.
Budgeted Overheads for the period
Pre-determined overhead Rate = _______________________________
Budgeted normal base for the period
The amount of total overheads absorbed by a product, service or activity will be the sum total of the overheads absorbed from individual cost centres on pre-determined basis. The difference between overheads absorbed on pre-determined basis and the actual overheads incurred is the under-or over-absorption of overheads.
The under-or-over absorption of overheads is mainly due to error in estimating or unforeseen changes in the productive capacity.
6. Apportionment and absorption of Administrative Overheads
6.1 Administrative overheads include the following items of cost :
Printing and stationery, other office supplies
Employees cost – salaries of administrative staff
Establishment expenses – Office rent & rates, insurance, depreciation of office building and other assets, legal expenses, audit expenses, bank charges etc.
7.1 Administrative overheads may be collected in different cost pools as given under :
- General Office
- Personnel department
- Accounts department
- Legal department
- Secretarial department etc
7.2 Administrative overheads are to be segregated into two – one for manufacturing activities and other for sales and distribution activities. Basis of segregation may be ratio of total manufacturing expenses to selling and distribution of expenses. Some other rational basis may be used. Administrative overheads relating to production are to be apportioned to different production cost centres.
7.3 Basis of apportionment of various items of administration is to be selected to distribute it to the production cost centres in the proportion of their use.
Examples of basis of apportionment of some of the administrative overheads items to production cost centres :
Items of Cost
Basis of Apportionment
Office Rent and rates
Floor area
Depreciation of office building
Floor area
Legal Expenses
Nature of expenses
Personnel department expenses
Number of employees
Salaries
Number of employees
Insurance
Asset values
Printing and stationeries
No of employees
Data processing Service
Machine time / Number of Machines
7.4 Administrative overheads for a period are to be absorbed in different processes, products or activities on the basis of following :
In the proportion value of the base
When to be applied
Production unit
When single product is manufactured or the products are similar.
Conversion cost
When the administrative function has a direct link with production process
Cost of production
When the administrative function closely linked with all factory activities
Cost of sales
When administrative function is a comprehensive one and it becomes difficult to identify the contribution of administration for a particular product
8. Apportionment and absorption of Selling overheads and Distribution overheads
8.1 System of allocation and apportionment of selling overheads and distribution overheads is same. The selling overheads and distribution overheads are collected under different cost pools as :
(i) Sales Employees cost
(ii) Rent
(iii) Traveling expenses
(iv) Secondary Packaging
(v) Freight & forwarding
(vi) Warehousing & storage
(vii) Warranty claim
(viii) Brokerage & Commission
(ix) Insurance
(x) Advertisement relating to sales and sales promotion
(xi) Sales incentive
(xii) Bad debt etc
8.2 Some items of selling overheads and distribution overheads are directly absorbed to products and some are apportioned to respective service cost centres which are finally absorbed. In case of absorption to different products or processes or jobs or services, sales value may be taken as the basis.
8.3 Basically the cost drivers for the cost of activities in sales and distribution function are the bases for apportionment / absorption.
Examples of bases for apportionment / absorption of selling and distribution overheads :
Items of Selling & Distribution overheads
Basis of absorption
Sales Employees Cost
Number of Employees
Rent
Floor space
Brokerage & Commission
Sales value
Secondary packaging
Cost of product/ Sales Value
Freight & forwarding
Weight / No of products & Distance
Insurance
Value of asset
Warehousing
Volume of products / floor space
Traveling expenses
Sales value
Sales incentive
Sales value / direct
Warranty claim
Sales value
Advertisement and sales promotion
Sales Value
Bad Debt
Sales value
9. Presentation and Disclosure:
9.1 Basis of allocation and apportionment should aim at most rational distribution of cost components among the cost centres.
9.2 Once the basis of allocation and apportionment and absorption rate for different production cost centres are selected, the same are to be followed continuously for the sake of consistency and uniformity
9.3 Change in basis for allocation and apportionment and absorption rate can be adopted only when it is compelled by the change in circumstances like change in technology, degree of mechanization, product mix etc and the change would provide more scientific approach. In case of such changes, proper disclosure in cost records is essential..
9.4 Any change in basis for allocation and apportionment and rate of absorption which has a material effect on the cost of the product should be disclosed in the cost statements. Where the effect of such change is not ascertainable wholly or partly, the fact should be indicated in the cost statement.
9.5 In case of treatment of research and development expenses as deferred revenue expenses, the detailed disclosure should be made.