Key Concepts in Cost Accounting: Overheads & Budgeting
Understanding Overhead Costs
Any cost which cannot be directly charged to a cost center or cost unit is known as overhead. Overhead is the total of indirect material costs, indirect labor costs, and indirect expenses. Overhead costs are operating costs of a business enterprise that cannot be directly traced to an enterprise unit.
Overhead Classification Methods
- Function-wise Classification: Includes manufacturing, selling, and administration overheads.
- Behavior-wise Classification: Categorizes overheads based on how they change with activity levels (e.g., fixed, variable, semi-variable).
- Element-wise Classification: Groups overheads by their nature (e.g., indirect materials, indirect labor, indirect expenses).
Allocation of Overhead Expenses
Allocation is the process of identification and assignment of overheads to cost centers. An expense directly identifiable with a specific cost center is allocated entirely to that center. Thus, it is the allotment of a whole item of cost to a cost center or cost unit.
Key characteristics of allocation: It deals with whole items of cost, it is a direct process, there is no need to choose a base, it is a simple process, and it is accurate.
Apportionment of Overhead Expenses
Cost apportionment is the allotment of proportions of cost items to cost centers or cost units. If a cost is incurred for two or more divisions or departments, then it is to be apportioned among the different departments based on the benefit received by them.
Introduction to Service Costing
Service costing is the costing procedure used for determining the cost per unit of service rendered. It is a method of costing applied to undertakings which provide services rather than producing commodities. The services may be in the form of transport, supply services, welfare services, etc.
Note: There is a difference between operating costing and operation costing. Operating costing is a method of costing designed to find out the cost of operating or rendering a service.
Fundamentals of Budgeting
What is Budgeting?
Budgeting simply means preparing budgets. It is a process of preparation, implementation, and operation of budgets. Being a plan of action, a budget guides every manager in the decision-making process. Budgeting is the process of building budgets.
Budgetary Control Explained
Budgetary control is a system of using budgets for planning and controlling costs. The official terminology of CIMA defines the term ‘budgetary control’ as “the establishment of budgets relating to the responsibilities of executives to the requirement of a policy, and the continuous comparison of actual with budgetary results, either to secure by individual action the objectives of that policy or to provide a basis for its revision.” Thus, when plans are embodied in a budget and the same is used as the basis for regulating operations, we have budgetary control. As such, budgetary control starts with budgeting and ends with control.
Objectives of Budgetary Control
- To aid the planning of annual operations.
- To coordinate the activities of the various parts of the organization.
- To communicate plans to the various responsibility center managers.
- To motivate managers to strive to achieve organizational goals.
- To control activities.
- To eliminate wastes of all kinds.
Steps in Budgetary Control
- Laying down organizational goals or objectives.
- Formulating the necessary plans to ensure that the desired objectives are achieved.
- Translating plans into budgets.
- Relating the responsibilities of executives to the requirements of a policy.
- Recording and reporting actual performance.
- Continuous comparison of actual results with budgeted results.
Flexible Budgets (Sliding Scale)
A flexible budget, also known as a sliding scale budget, is a dynamic budget. It is defined as a budget designed to change in accordance with the level of activity actually attained. It shows estimated costs and profits at different levels of output. In a flexible budget, costs are analyzed according to their behavior, such as fixed and variable.
Features of Flexible Budgets
- Prepared for different levels of activity.
- Provides a basis for comparison between actual and budgeted performance at the actual activity level.
- Provides a ready-made budget for a particular volume of output achieved.