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Overhead Costs

Case Study: Malaysian Newspaper - The Star


Question 1: Can you think some examples of overhead costs that might be incurred by cafes Such as those described above?

Answer: Overhead costs are nothing but, the costs that are barred by the cafes other than the expenditure which they keep for the daily activities in their business.

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Some of the examples of overhead costs that are barred by cafes are Insurance where every business has to invest to protect their business in cases of any loses that occur due to unexpected reasons. For utilities like gas, electricity, water facilities, and disposal of sewage, etc.

For rent, for human resources, as they are important in dealing with the administration, and with the staff, office supplies like papers, pen, printer, toner cartridges, lights, etc. Repairs and maintenances, Taxes like municipality tax, security tax, etc. and for Accounting. Costs barred by the company regarding advertisements will also come under the Overhead expenses.

Question 2: Explain how overhead costs are treated in the following situations?

a) Assigning overhead to production and Service centers.

Answer: The most two important departments in any organization are the production and servicing departments. The output of any factory is dependent on the production department and for producing this; the services that are required to the production department are rendered by the service department. The service department is additional departments which don't have any connection to the production department but its presence is important for the production department to carry out its work and in the absence of service department it cannot give its efficient output. Expenses will be subjected by both service and production departments. If the expense has occurred for the benefit of only one department specifically then that cost should be bearable by that department alone but if the expenses have occurred for the benefit of all departments then that cost should be shared by all the departments respectively. This type of distribution is called Primary Distribution. Under primary distribution, one should know about allocating and apportionment of expenses.

Allocating expenses are the one where the expenses are kept by that respective department for their purposes, apportionment of expenses in nothing but sharing the expenses by all departments, for example, a separate water is not there for each department and it is combined for all the departments then that combined bill has to be shared by all the departments.


Service centers are the ones which will mainly support the production departments. Administration, Cafeteria maintenance and receiving are some of the works carried out by service departments. They can assist the number of production departments at a time and due to this reason accountant's has to allocate money for the expenses of this department to meet all the costs.

b) Reallocation of Overhead of service centers to production department?

Answer: Mainly there are three methods for allocating costs to the service department.

First one is the direct method which is the simplest of the three; the costs are allocated to each servicing department to serve the needs of each operating department. For example, if a company has to service department's maintenance and the administration and it has two operating departments X and Y. then the cost allocated by maintenance will be separately bearable by X and Y and for administration it is separately bearable by X and Y.

The second one is the allocation in stepwise, in this stepwise process, the service department which incurred the highest cost is taken first then the next highest cost like that it is allocated in a sequence until it was allocated for all its costs. Once the cost is allocated for each department again the costs will not be allotted. This is a sequential process and meets all the costs that are incurred by the service departments.

The third one is the Method of Reciprocals; It is the most accurate and complicated method. In this method, the connection between two service departments is identified and the costs are allocated to and from between those departments. As there will be a relation between the two service departments they have to share their expenses by using the allocated money.

c) How these overheads would affect profit if sales declined?

Answer: As the overhead costs increase it will show its effect on the profit of the organization. Because as the costs of overhead increases the profits in the income statement will be get affected and it will show its impact on operating profit, Gross profit, and Net profit. Some of the companies in order to meet their business strategies and to earn more margins when compared with their competitors at first only they will allocate fewer costs for the overhead. Because if the sales get declined the actual profit that the business will get will be get decreased and due to these all things company will plan to reduce the costs of their over expenses and keep their expenses in production to give more output which will, in turn, gives them profits to remain in the business. In this type of situations if the costs allocated on overheads are more it will become like a burden to that company to meet the needs of overheads in the cases of loses. This is the reason so many companies will plan to allocate less cost on overheads when compared with the production costs and also they will be secure if they plan less on overheads as they will show their impact on the income statement profits, business profits, gross profits, and net profits.


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