Under functional classification, the overhead expenditure is identified under a particular head based on the purpose of the expenditure i.e. based on the functions that are accomplished by the expenditure incurred.

Functionally, the overheads are classified under three or four heads.

• Factory Overheads

  Indirect expenses (overheads) incurred within the factory area are classified as factory overheads.

• Administration or Office Overheads

  Indirect expenses (overheads) incurred within the administrative area are classified as administrative or office overheads.

• Selling Overheads

  Indirect expenses (overheads) incurred in relation to sales activities are classified as selling overheads.

• Distribution Overheads

  Indirect expenses (overheads) incurred in relation to distribution of the product or service are classified as distribution overheads.

• Selling and Distribution Overheads

  Indirect expenses (overheads) incurred in relation to sales activities as well as distributing the product or service are classified under a single head as Selling and Distribution Overheads.

Under the functional classification, overhead expenditure is identified under a particular head based on its inclination to vary with the level of activity achieved (production/sales).

Behaviorally, the overheads are classified under three heads.

• Variable Overheads

  The overhead expenses which vary directly with activity level (production/sales) are called variable overheads. These costs change with every small change in the activity level.

• Fixed Overheads

  Overhead expenses which do not vary with the activity level (production/sales) are called fixed overheads. These costs would remain the same whatever may be the activity level achieved.

  They are also called committed costs as they have to be borne even if the activity level achieved is not as planned.

• Semi-Variable Overheads

  Overhead expenses which behave both like variable as well as fixed overheads are called semi-variable overheads. These expenses remain fixed within ranges of activity levels. They vary whenever the activity level crosses certain points.

  Illustration

  A supervisor is needed for every 10 operators. An operator can produce 100 units everyday. If the production requirement is 500 units, the organisation needs 5 operators and a supervisor.

  For every 100 units increase in the production level an additional operator is needed. However, the supervisor who is already present would be sufficient to manage 10 operators. Therefore the supervisor cost is fixed till the production level reaches a requirement of 1,000 units.

  Immediately on crossing 1,000 units an additional supervisor would have to be employed as there would be more than 10 operators. At that point, the supervisor cost behaves as if it is a variable cost thereon till the next 9 operators are engaged, the supervisor cost becomes a fixed cost again.

  Since the behaviour of the cost keeps varying only during certain changes of production levels, we say it is a semi-variable cost.

The behavior of Fixed expenses and Variable expenses can be generalised and thus it would be possible to study these two types of costs in general.

No Tools to analyse Semi-Variable Expenses

A generalised study of semi-variable expenses would not be possible since we may not find the same characteristics in all situations. Some of them may vary for every 5% change in the level of activity, some others for every 25% change in activity level etc.

Because, it would be difficult to visualise a common thought process for semi-variable expenses in all situations, we do not find tools to analyse semi-variable expenses.

Semi-Variable Overheads = Fixed Part + Variable Part

Since, it would be difficult to study the behaviour of semi-variable expenses, they are segregated into the two component parts they are made up of. A fixed part and a variable part.

The fixed part is analysed as if it is a fixed expenditure and the variable part is analysed as if it is a variable expenditure.

What proportion of the semi-variable expenditure is treated as fixed and what proportion is treated as variable is dependent on the situation in consideration. There is no universal rule for this segregation.

Variance analysis involves analysis of manufacturing costs only. Manufacturing Costs include Prime cost and manufacturing overheads. It does not include office/administrative expenses (overheads) and selling/distribution expenses (overheads).

Thus, the total cost (as considered for variance analysis) is inclusive of Direct Material Cost (which is analysed under material variances), Direct Labour/Labor Cost (which is analysed under labour/labor variances) and Factory Overheads (which is analysed under overhead variances).

Thus, the term overheads in analysing variances is to be understood as Manufacturing/Factory Overheads.