Overhead Analysis

Definition and Importance

• Overhead Analysis is a method used to understand the fixed costs, or overheads, that a business incurs.

• The technique is of fundamental importance for management accounting as it provides insight into the business costs that do not directly relate to the production of goods or services, enabling better control and reduction.

Types of Overheads

• The overheads of a business are typically categorised as production, administration, selling, and distribution overheads.

• Production overheads include the costs associated with the fabrication process not directly tied to a single unit of production.

• Administration overheads cover the costs of managing the business as a whole.

• Selling overheads are related to the process of selling and marketing the products or services of the business.

• Distribution overheads refer to the expenses incurred when delivering the product or service to the customers.

Allocation and Apportionment

• The process of assigning overheads to cost centres is called allocation.

• If the overhead cannot be directly allocated, it's apportioned based on an appropriate basis such as floor area, labour hours, or machine hours.

Absorption Costing

• Absorption costing is a technique where all costs, including overheads, are absorbed into the cost of a product.

• This method tries to give a more realistic cost per unit by including both direct costs and allocated overheads, thus providing a fuller picture of a product's profitability.

Overhead Absorption Rate

• The Overhead Absorption Rate (OAR) refers to the rate at which overheads are absorbed into a cost centre or a unit of output.

• It is usually calculated by dividing total overheads by the volume of output or activity levels, providing a cost per unit basis for overhead costs.

Over and Under Absorption

• When the actual overheads differ from the absorbed overheads, an over or under absorption occurs.

• Over absorption refers to a situation where the overheads absorbed exceed the actual overheads incurred; under absorption is when the actual overheads are greater than the absorbed overheads.

• Over and under absorption issues need to be adjusted in the cost statements to ensure accurate cost and profitability figures.

Importance of Overhead Analysis in Decision Making

• Overhead analysis aids management in cost control, budgeting, setting selling prices, and performance evaluation.

• By understanding overheads, management can make informed decisions that increase operational efficiency, reduce costs, and improve profitability.

Overhead Analysis is pivotal for understanding the full cost of production and service delivery, aiding in strategic decisions and driving business success.