Classification of overhead costs-using production volume-based criteria
1.1 Introduction
Based on the behavior of the overhead cost as compared to the level of production activities, this element of cost is divided in to three categories, namely;
1.2 Fixed Overhead Cost
Definition: Fixed overhead cost is the economic resources of the organization that are constantly forgone to facilitate activities such as manufacturing, administration, selling and distribution and research and development which indirectly support production of the final product apart from the direct materials and direct labor costs.
1.2.1 Examples of fixed overhead costs include:
i). Expenses paid or incurred by the organization for rent needed to secure production facility or corporate office.
ii). Salaries paid or incurred for manufacturing plant managers and supervisors who continuously watch over production activities undertaken.
iii). Depreciation expense-Loss of economic value due to wear and tear process of fixed assets or non-current assets used in production.
iv). Tax liabilities and insurance dues-that is expenses paid or incurred to cater for government liabilities and other related expenses and also insurance charges so as to ensure that no operational risks causing threat to the process of production.
1.3 Variable Overhead cost
Definition: Variable overhead cost is the economic resources of the organization that are variably forgone to facilitate activities such as manufacturing, administration, selling and distribution and research and development which indirectly support production of the final product apart from the direct materials and direct labor costs.
1.3.1 Examples of variable overhead costs are:
i). Expenses paid or incurred to provide other Supplies in the factory other than raw materials.
ii). Expenses paid or incurred in acquisition of indirect raw materials in addition to the direct materials used in production.
iii). Expenses paid or incurred for sales commissions which is dictated by the number of units of the finished products.
1.4 Semi-Variable Overhead Cost
Definition: Semi-Variable overhead cost is the economic resources of the organization that are semi-variably forgone to facilitate activities such as manufacturing, administration, selling and distribution and research and development which indirectly support production of the final product apart from the direct materials and direct labor costs. In other words, they are fixed costs at some point but they vary when the level of production change.
1.4.1 Examples of semi-variable overhead costs are:
i). Expenses paid or incurred when normal repairs and maintenance of factory machinery are serviced. This is a constant/fixed element of the overhead. But more costs are incurred or paid when there is a major breakdown due to increased production processes due to straining status of the machines. This increased aspect of overhead represents the variable part of overhead
ii). Telephone bills-outstanding amount of telephone bills are paid or incurred to ensure telephone services are guaranteed throughout in the organization. This is a constant/fixed element of the overhead. However, when the production in the factory increase, the number of telephone calls made increases. For example, when the production manager is making calls to suppliers of raw materials, or searching for repair and maintenance engineer to correct production machine anomaly. Or when the marketing manager is making calls trying to market the final product. All this increased telephone calls represents the variable part of overhead.
iii). Electricity bills-Certain outstanding amount of electricity bills are paid or incurred to ensure lights are on all through. For example, to ensure security is maintained. This is a constant/fixed element of the overhead. However, if production activities start, these bills go up. This increased aspect of overhead represents the variable part of overhead.
Advantages of classifying overhead costs using production volume-based criteria
1). Production convenience for the producer
The use of production volume-based criteria is appropriate especially when the production levels change with time or circumstances. Some levels of production go with a certain level of fixed cost. This criterion helps in avoiding over assumption that all levels of production match the same fixed cost level. So, no issues of misrepresentation of overhead cost information.
2). Aid in pricing policy
When production volume-based criteria is used, the production manager is in a position to assess the relationship between total production cost and the levels of output so as to apply the law of economies of scale which appropriately guide in charging lower selling prices when it necessary and high selling price when again is convenient to the firm.
3). Help in assessing the production technology to use
Production volume-based criteria is reliable for the technology used can be assessed using this tool and know whether to adopt labor- or capital-intensive technology. If the fixed overhead cost are emanating from capital aspect, the producer may change to the labor intensive technology if the end production cost will be cheaper.
4). Help in managerial decision making
The production volume-based criteria is a tool for managerial decision making especially in future investments. This is because based on the link between labor and capital technology, the management can know in advance whether to invest more in one option as compared to the other.
Disadvantages of classifying overhead costs using production volume-based criteria
1). Inappropriate
Where the technology used in production is just fixed and well known, production volume-based criteria does not apply.
2). Misleading
Where there are cases of semi-variable overheads, the production volume-based criteria may portray wrong report on overheads for the assessment of boundaries where fixed overhead reach and variable overhead costs start may not be clear.
