Overhead Costs - Capital Budgeting, Cost Management and Cost Estimating - Annotated Bibliography Example

OVERHEAD COSTS In the manufacturing world, the demands of the s are increasing day by day. The company has to meet the demands of the customers by making profits out of it. To make profits, firm has to allocate the cost to each and every product effectively. The company must know how to control its overhead cost and assign it correctly to every product being manufactured. Overhead costs can be divided into two types: Manufacturing overhead Non-manufacturing overhead Manufacturing overhead is the indirect factory cost that is incurred when the product is being manufactured. The cost of direct labor, direct material and manufacturing overhead must allocate to each and every unit produced. This is done to value the inventory and the costs of goods manufactured, and then report them according to the general accounting principles. Manufacturing overhead may include costs like electricity which is used to operate the factory equipment, depreciation of factory equipment, salary of indirect labor and all the cost related to production except direct labor and direct material. Nonmanufacturing overhead includes activities related to the selling and administration departments. These costs are not included in the cost of goods sold as they are taken directly in the income statement as expense. Nonmanufacturing overhead includes cost such as freight charges, property tax, maintenance of equipment and salary for employees of selling and administrative department etc. Although the nonmanufacturing overhead is not included in the cost of goods sold but they are actually the part of the combined cost incurred in the manufacturing of a product. LITERATURE REVIEW Don R. Hansen, M.M.M.L.G. (2009) Cost Management: Accounting & Control, Cengage Learning. Don Hansen defines overhead cost as all the production costs other than direct labor and direct material that are incurred during production process. All these mentioned costs fall into one single category that is the “overhead costs”. Overhead costs are also known as the “factory burden” or “manufacturing overhead”. Overhead costs contain a wide variety of item such as all the input that is required for the production of any product with exception to direct labor and direct material. The examples for overhead costs are depreciation on equipment and buildings, maintenance of equipment and supplies, taxes etc. Supplies are products that are used in the manufacturing of the product but are not the part of the final product or the services. Dishwasher detergents used in restaurants and oil lubricants used in production are the example of supplies. Direct material that is not the main or significant part of the final product is also included in the overhead costs under the category of indirect cost. An example of indirect material can be the glue used in the manufacturing of toys. The cost for the overtime for direct labor is also assigned to the overhead category. This is because no production has been identified that can be marked as the cause for overtime. Overtime cost is an indirect cost and therefore it is allocated to all the departments (DON R. HANSEN, 2009). Don Dayananda, R.I.S.H.J.H.P.R. (2002) Capital Budgeting: Financial Appraisal of Investment Projects, Cambridge University Press. Don Dayananda, Richard Irons, Steve Harrison, John Herbohn and Patrick Rowland in their book “Capital Budgeting: Financial Appraisal of Investment Projects” have stated two examples of overhead cost i.e. utilities (electricity, water and gas) and executive salaries. Cost accounting is all about allocating the overhead cost to their appropriate production units. In product evaluation the main issue is the identification of the incremental overhead cost rather than the allocation of overhead. On the basis of the overhead cost and the incremental overhead cost the firm decides to accept or reject proposals of any project. There are often times when there is not even a single project to which the overhead cost can be allocated. In such a situation the question that arises is that the overhead costs that have been incurred, whether they are an incremental cash flow associated with any project or not (DAYANANDA, 2002) Noreen, E. (1994) Are overhead costs strictly proportional to activity? ☆: Evidence from hospital departments, Journal of Accounting and Economics Volume 17, Issues 1–2, p. 255–278. In 1994 Noreen studied the relationship of overhead cost and overhead activities by using the relevant data from a Washington based hospital. The study conducted was to check whether the overhead cost is directly proportional to the overhead activities. The assumption made was that the average marginal cost is equal to the average of the cost incurred. The hypothesis was rejected for overhead accounts of most of the department since the average cost per unit overstated the marginal cost to over 40 percent and in many cases it was by 100 percent. The conclusion drawn was that average cost must be used with caution in an activity (NOREEN, 1994). Stewart, R.D. (1991) Cost Estimating, Second Edition edition, Canada: Library of Congress Cataloging. Some years ago a young government negotiator in meeting with the financial manager of a renowned firm, questioned about the importance of overhead costs. The negotiator claimed that there is no need for the overhead cost. He argued that the important costs are the direct labor and the direct material and overhead cost is of no significance and therefore he is only going to account for the direct costs. The senior financial manger pointed out the importance of skilled labor as well as the mix of supplies, equipment and other important and significant cost related to production that falls in the category of overhead costs. These overhead costs were related to some essential elements that are needed to produce the final output. The final product cannot be provided and the organization cannot exist without incurring overhead costs. The only way to pay for these overhead cost is to charge them in the final output. There are various cost categories that are included in the overhead costs. These categories may vary from business to business and industry to industry. Insurance cost is an important overhead cost for many organizations. The rate of property insurance depends upon the investment done by the firm in facilities, supplies, protection in plant and so on. Other factors considered by the insurance companies are the location of any firm, the type of industry the firm belongs to, its previous history and its replacement as well as construction cost. There are large numbers of factors that are considered while making insurance and therefore the insurance rate varies from one geographical location to the other (STEWART, 1991) Conclusion Overhead costs are essential for a company to carry out its operations but are not directly attributable to any specific project. This category of cost also brings into its account all the costs that are not feasible or traceable because on an individual basis they may be small. The company cannot calculate the amount of money it is generating without calculating the overhead cost. Suppose if an organization is buying its merchandise from a factory, the money they are generating from the sale of the merchandise is not only being used for re buying new inventory but also to pay for other charges such as electricity bills, property tax, etc. Even if the firm is manufacturing its own inventory there are still many other costs that will be incurred other than direct material and direct labor, which are included in the overhead costs. Cost allocation done by companies often provides misleading information. This may affect a firm’s ability to calculate the profit on their product lines, products and customers. According to the traditional practice of cost allocation all the direct as well as indirect costs were included into one single category. Today the cost allocation allows firms to allocate the cost on the basis of their nature. The method of calculating overhead cost varies from one firm to the other. Some companies have the basic accountings methods for the calculation of the overhead cost while others have complex accounting systems which allow the calculation of the overhead cost separately for all departments. Some companies calculate their overhead costs by categories; they calculate separate overhead cost for the manufacturing expense and for non-manufacturing expense. Overhead cost can make or break any company. When an entrepreneur is first starting his business, he must first identify the fixed overhead cost. The fixed overhead costs remain the same month after month. A company has to pay their fixed overhead expense whether the company generates any profit or not. The company must first figure it out whether they have enough funding to pay their fixed overhead costs for several months. Fixed overhead cost may be changed if the companies start finding out cost effective ways to carry on their production processes. They must use certain energy saving equipment, they must find out ways to cut the cost of the office supplies and ways to reduce cost and spending without having any negative effect on the employees’ activities. The scope of calculation of overhead cost is not only limited for determining the profit. It also plays an important role in identifying the competitiveness of a company. A company needs to know its expenses before setting the selling price of their product. A company with more overhead expense sets its product’s price higher than a firm with less overhead expense. Therefore firms must be aware of their overhead expense in order to develop cost effective strategies. References Don R. Hansen, M.M.M.L.G. (2009) Cost Management: Accounting & Control, Cengage Learning. Stewart, R.D. (1991) Cost Estimating, Second Edition edition, Canada: Library of Congress Cataloging. Noreen, E. (1994) Are overhead costs strictly proportional to activity? ☆: Evidence from hospital departments, Journal of Accounting and Economics Volume 17, Issues 1–2, p. 255–278. Don Dayananda, R.I.S.H.J.H.P.R. (2002) Capital Budgeting: Financial Appraisal of Investment Projects, Cambridge University Press. Read More