Classification of overhead costs-using nature of activity-based criteria
1.1 Introduction
Overhead costs are classified based on the type of the activity which is being financed using the forgone economic resources. Under this criterion, we have the following FOUR types of overhead costs, namely;
1.2 Manufacturing Overhead
1.2.1 Definition
Manufacturing overhead cost is also known as production overhead cost and it is the economic resources of the organization that are forgone to facilitate manufacturing activities which indirectly support production of the final product apart from the direct materials and direct labor costs.
1.2.2 Examples of Manufacturing costs
Examples of such manufacturing costs are;
i). Depreciation of manufacturing plants and equipment or facilities.
ii). Factory supervisors and managers who oversee the process of manufacturing or production.
iii). Repair and maintenance of manufacturing facilities such as processing plants.
iv). Salaries and wages for those workers who repair and maintain machineries involved in production or manufacture.
v). Electric power used in running the manufacturing machines and electricity used in factory building lighting.
vi). Factory accessory supplies which facilitate the smooth production process to take place.
vii). Any factory affiliated cost as long as it is not direct raw materials or direct factory labor cost.
1.3 Administrative Overhead
1.3.1 Definition
Administration overhead cost is the economic resources of the organization that are forgone to facilitate administrative activities which indirectly support production of the final product apart from the direct materials and direct labor costs.
1.3.2 Examples of Administrative overheads.
Examples of such administrative overheads are;
i). Employee salaries for those working in the administration office such as front office.
ii) Office equipment and supplies acquired for paper work activities to ensure production is accomplished
iii) External legal and audit fees paid for the legalization of production such as acquisition of intellectual properties such as copy rights or trademarks.
iv). Company vehicles for office administrators. So, expenses such as repair and maintenance of administration cars and depreciation of administration cars.
v). Travel and entertainment costs for the employees who are working in the administration office.
1.4 Selling and Distribution Overhead. (Marketing overhead)
1.4.1 Definition
Selling and Distribution overhead cost is the economic resources of the organization that are forgone to facilitate Selling and Distribution activities which indirectly support production of the final product apart from the direct material cost, direct labor cost and direct expense.
1.4.2 Examples of selling and distribution overheads are;
Examples of selling and distribution overheads are;
i). Rent paid or incurred for warehouse storage of the finished products; any cash amount paid or expense incurred to ensure that the produced products are kept under safety awaiting sale.
ii). Expenses paid or incurred in maintenance for delivery vans. Delivery vans are directly related to distribution of the completed products.
iv). Expenses paid or incurred on carriage on sales. These are expenses related to hiring of carriers of the sold goods or products to the customers’ final destiny.
v). Expenses paid or incurred in packaging of final products are referred to as packing charges. These expenses are catered for so as to ensure that the final products are more appealing to the customers. This increases the demand level
1.5 Research and Development Overhead
1.5.1 Definition
R&D overhead cost is the economic resources of the organization that are forgone to facilitate R&D activities which indirectly support production of the final product apart from the direct materials and direct labor costs.
NB: Research and Development expenses are costs paid or economic resources forgone to innovate a way or method of producing used to come up with new products which in turn result to acquisition of intellectual property.
Advantages of classifying overhead costs using nature of activity-based criteria
1. Correct pricing of final products.
Since nature of activity-based criteria categorizes the various types of overhead costs without mix ups, pricing of the final products becomes easy and appropriate.
2. Easy to understand and apply in production.
Nature of activity-based criteria is easy to apply in production process and therefore no misleading cases of overhead costs such as exaggerations.
3. Increased transparency and accountability.
Nature of activity-based criteria helps in ensuring that no misplacement of the various overhead costs in different inappropriate cost Centers either knowingly or by collusion.
4. Useful in delegation of duties and responsibility to employees in production sections.
Based on nature of activity-based criteria, it is possible to place each employee in the right section or department and be responsible in controlling overhead costs that he or she is conversant with.
5. Universally acceptable.
Use of nature of activity-based criteria is common for almost every employee is familiar with the categories of nature of activities such as manufacturing, administration and so it applies to almost all firms. Hence advantageous in costing products.
Disadvantages of classifying overhead costs using nature of activity-based criteria
1). Inappropriate
The nature of activity-based criteria may not be appropriate especially where there are no clear demarcation of the types of overhead costs such as research and development. This is common in small firms.
2). High chances of mix ups
Where the production officers or managers are not very much conversant with the definition of each category of overhead cost confusion may arise resulting to misplacements which may give misleading results.
