Managing Office and Administration Overheads in Cost Accounting

Office and administration overheads represent the hidden costs that keep businesses running smoothly behind the scenes. These expenses, ranging from executive salaries to legal fees, might not directly touch your products, but they’re essential for maintaining organizational structure and control. Understanding how to properly account for these costs can make the difference between accurate pricing and financial surprises that hurt your bottom line.

What are office and administration overheads? 🔗

Think of administration overheads as the backbone expenses of any organization. These are the costs incurred to formulate policies, direct operations, and maintain overall control of the business. Unlike manufacturing overheads that directly support production, administration overheads keep the entire organizational machinery functioning.

Administration overheads encompass a wide range of expenses that support the general management and administrative functions of a business. These costs are necessary for running the organization but don’t directly contribute to the manufacturing process or sales activities.

Key components of administration overheads 🔗

Administration overheads include several categories of expenses that collectively support the organizational infrastructure:

Executive and administrative salaries: This includes compensation for top management, department heads, and administrative staff who don’t directly participate in production or sales activities. Think of your CEO’s salary, HR manager’s wages, or the finance director’s compensation.

Office expenses: These cover the day-to-day operational costs of running administrative offices, including rent for office spaces, utilities, office supplies, communication expenses, and maintenance costs for administrative facilities.

Legal and professional charges: Expenses for legal advice, audit fees, consultancy charges, and other professional services that support business operations fall under this category.

General administrative costs: This broad category includes insurance premiums, bank charges, depreciation on office equipment, and other miscellaneous expenses that support administrative functions.

Collection and classification of administration overheads 🔗

Proper collection and classification of administration overheads requires a systematic approach to ensure accurate cost accounting. This process involves identifying, recording, and categorizing all administrative expenses in a structured manner.

Collection methods 🔗

The collection of administration overheads begins with establishing clear procedures for identifying and recording these costs. Companies typically use expense codes and cost centers to systematically capture administrative expenses as they occur.

Most organizations maintain separate ledger accounts for different types of administrative expenses. For example, executive salaries might be recorded under one account, while office rent is captured in another. This separation allows for better tracking and analysis of cost patterns.

Classification approaches 🔗

Once collected, administration overheads are classified based on their nature and function. The most common classification methods include:

Functional classification: Expenses are grouped according to their administrative function, such as general administration, personnel administration, or financial administration.

Behavioral classification: Costs are categorized as fixed, variable, or semi-variable based on how they respond to changes in business activity levels.

Departmental classification: Administrative expenses are allocated to specific administrative departments responsible for incurring them.

Apportionment to administrative departments 🔗

After classification, administration overheads need to be apportioned to various administrative departments. This process ensures that each department bears its fair share of common administrative costs.

Common administrative departments 🔗

Most organizations have several administrative departments that share common overhead costs:

General office: This department handles overall administrative coordination, correspondence, and general management support functions.

Accounts department: Responsible for financial record-keeping, budgeting, financial reporting, and treasury functions.

Personnel department: Manages human resources functions including recruitment, training, employee relations, and payroll administration.

Legal department: Handles legal compliance, contract management, and litigation support when applicable.

Apportionment methods 🔗

The apportionment of administration overheads to departments requires selecting appropriate bases that reflect each department’s consumption of shared resources. Common apportionment bases include floor area occupied, number of employees, or value of assets used by each department.

For example, office rent might be apportioned based on floor area occupied by each department, while telephone expenses could be distributed according to the number of extensions or actual usage patterns.

Methods of absorption of administration overheads 🔗

Once administration overheads are collected and apportioned, they must be absorbed into the cost of products or services. This absorption process ensures that the final cost of goods sold includes an appropriate share of administrative expenses.

Production units method 🔗

This method absorbs administration overheads based on the number of units produced. The overhead absorption rate is calculated by dividing total administration overheads by the total number of units produced during the period.

For example, if your total administration overheads are $100,000 and you produce 10,000 units, each unit would absorb $10 of administration overheads. This method works well when products are relatively uniform and production volumes are stable.

Percentage of conversion cost method 🔗

Under this method, administration overheads are absorbed as a percentage of conversion costs (direct labor plus manufacturing overheads). This approach recognizes that administration costs often correlate with the overall production effort required.

If your conversion costs total $500,000 and administration overheads amount to $50,000, the absorption rate would be 10% of conversion costs. This method is particularly useful when conversion costs vary significantly between products.

Percentage of sales method 🔗

This method absorbs administration overheads as a percentage of sales revenue. It’s based on the assumption that administrative efforts increase proportionally with sales volume and value.

For instance, if your annual sales are $1,000,000 and administration overheads total $80,000, each sale would carry 8% of its value as administration overhead absorption. This method is popular in service industries where direct costs are minimal.

Percentage of works cost method 🔗

The percentage of works cost method is the most commonly used approach for absorbing administration overheads. Works cost includes direct materials, direct labor, and manufacturing overheads – essentially all costs incurred in the production process.

This method calculates administration overhead absorption rate as a percentage of works cost. If your works cost is $800,000 and administration overheads are $120,000, the absorption rate would be 15% of works cost.

Why percentage of works cost method is most popular 🔗

The percentage of works cost method has gained widespread acceptance because it provides a balanced approach to overhead absorption. Since works cost represents the total production effort, it serves as a comprehensive base for absorbing administrative expenses.

This method also offers practical advantages in terms of calculation simplicity and cost control. Companies can easily track works cost for different products and apply the administration overhead rate consistently across their product range.

Moreover, the percentage of works cost method tends to provide more stable absorption rates compared to methods based on single factors like production units or direct labor hours, which can fluctuate significantly with changes in production methods or product mix.

Practical considerations for overhead management 🔗

Effective management of administration overheads requires regular monitoring and periodic review of absorption methods. Companies should analyze whether their chosen absorption method continues to provide accurate cost allocation as business conditions change.

It’s also important to establish clear procedures for identifying and classifying new types of administrative expenses as businesses evolve and grow. Regular training of accounting staff on proper expense classification helps maintain consistency in overhead accounting.

Additionally, companies should consider the impact of seasonal variations or business cycles on their overhead absorption rates and adjust their calculations accordingly to avoid significant over- or under-absorption of costs.

What do you think? How might the choice of administration overhead absorption method affect pricing decisions in your industry? What factors would you consider when selecting the most appropriate method for a growing business?