It is common practice to classify and separately collect production, administrative, selling, and distribution costs.
Administrative overheads are related to office expenses. By contrast, selling and distribution expenses are related to marketing. All these expenses combined give the total selling cost.
In accounting for the production overheads and valuing closing stock, no administrative, selling, or distribution expenses are considered. They are separately accounted for and are shown separately in the cost sheet.
Administrative Overheads: Definition
Administrative overheads are indirect expenditures incurred in connection with any of the following:
- Formulating policy
- Directing the organization
- Controlling the operation of the enterprise
- Other allied matters pertaining to administration, but not related to research and development expenses directly
Administrative overheads are concerned with expenditures of a general nature, which do not relate to any particular function (e.g., production, sales, or distribution).
An important characteristic of administrative overheads is that they are usually constant. They are not affected by changes in the volume of production, sales, or other factors.
Administrative Overheads: Examples
Examples of office and administrative overheads are listed below:
1. Indirect Materials
- Office printing and stationery
- Cost of cleaning materials (e.g., dusters and brushes)
2. Indirect Labor
- Salaries and allowances or fees for directors, managers, managerial staff, accounts staff, secretaries, and the staff associated with the office
- Salaries and allowances of public relations officer and their staff
- Salaries and allowances of a legal adviser, their staff, and other allied expenses
- Other statutory expenses (e.g., fees, salary, and allowances to internal auditors)
3. Indirect Expenses
- Office rent, rates, and taxes
- Office insurance, heating, cleaning, etc.
- Depreciation of office buildings, equipment, etc.
- Repairs and maintenance for office buildings, etc.
- Legal charges
- Bank charges
- Trade subscription
- Other expenses related to office operation
Having considered the above examples of administrative overheads, it is worthwhile to examine the definition from the Institute of Cost and Management Accountants (ICMA) in England. ICMA defines administrative overheads as:
Administrative overheads are the cost of formulating the policy, directing the organization, and controlling the operations of an undertaking, which are not related directly to research, development, production, distribution, or selling activities or functions.
Apportionment of Administrative Overheads
There are three methods used to apportion administrative overheads:
- Apportionment to manufacturing and selling divisions
- Transfer to costing profit and loss account
- Addition as a separate item of cost
1. Apportionment to Manufacturing and Selling Divisions
Here, the principle followed is that administrative overheads are also incurred for the manufacturing and selling divisions. A portion of administrative expenses, therefore, must be charged to the manufacturing division and another part to the selling division.
In this way, administrative overheads are absorbed in both manufacturing and selling and distribution overheads.
However, the problem here is that it is not easy to find a suitable basis for apportioning this overhead between the two divisions. The nature, object, and function of administrative overheads will thus form the basis of apportionment.
If depreciation of buildings is to be apportioned, then the space occupied or floor area of each division shall form the apportionment basis.
2. Transfer to Costing Profit and Loss Account
In this case, the principle applied is that the administrative overheads have no direct relationship with the manufacturing or selling divisions.
Hence, they should not be charged to these divisions. Instead, they should be shown in the costing profit and loss account by transferring the same.
One argument in support of this principle is that there cannot be any equitable basis for charging office and administrative overheads to other functions of the products; therefore, it is a wise step to transfer them to the costing profit and loss account.
The manufacturing and selling divisions cannot function effectively without the help of the administrative function. Administrative overheads should, therefore, be charged to these two divisions.
3. Addition as a Separate Item of Cost
According to this method, office and administrative overheads are added separately to the cost of the job, process, or product according to some suitable basis selected for the purpose.
The basis may be the sales value, sales quantity, manufacturing cost, or number of units to be manufactured. The rate of absorption is calculated using the formula below:
Overhead absorption rate = (Administrative overhead x 100) / Sales quantity (if this is the base)
If an administrative overhead has been calculated as $5,000 and the sales volume during the period is 50,000 units, the rate will be 5,000 x 100 / 50,000 = 10%.
It is possible to control administrative overheads by classifying them and analyzing them properly, or by comparing the current overheads to those of past overheads and drawing sound conclusions.
Afterward, control measures and corrective measures can be adopted, and budgetary control techniques can be used. Similarly, setting standards may help in controlling administrative overheads.