Costs are classified into direct and indirect costs. Overhead represents total of indirect costs. Direct costs are those, which can be tracked directly to the cost object. When we consider cost unit (e.g. a batch, a job and a process) as a cost object, direct costs are those, which can be tracked to the cost unit. Costs, which are common to more than one cost units are necessarily classified as indirect costs. Some costs, which can be tracked to cost units by installing an elaborate cost accounting system are often classified as indirect costs because cost of operating such an elaborate system outweighs the benefits of tracking those costs to cost units. Overheads are accumulated against account numbers and then are assigned equitably to cost units.
Overheads are normally classified on the basis of functions for which they are incurred. Production overheads are included in cost of production. Administrative overheads are charged to cost accounting profit and loss account. Marketing overheads are assigned to customers and markets to determine profitability of a customer or a market segment.
The Discussion Paper entitled â€˜Conceptual Issues Faced in Development of Cost Accounting Standardsâ€™ issued by the Institute of Cost of Works Accountants of India (ICWAI) raises the question on whether the following items should be included in overheads: donations and gifts including political donations; expenses on CSR activities; and bad debts.
Traditionally those items are excluded from the realm of cost accounting. Donations are considered to be voluntary in nature with little or no business consideration. Therefore, donations are considered as an appropriation of profit and not a business expense. They are not considered as resources used to carry on the business. Accordingly they were kept outside the realm of cost accounting. Similarly CSR activities are considered philanthropic in nature and not related to business. However, it is now established that firms spend money on business considerations and no expenditure is incurred on pure philanthropic activities. Only individuals (e.g. promoter) spend a part of their wealth on philanthropy. Therefore, all activities flow from the business strategy and expenditures incurred on those activities are business expenditures. Therefore, it is logical to consider donations and expenditure on CSR activities as overheads.
Once we consider those expenditures as cost, the question that immediately arises is how to relate those overheads to different functions.
This will be a contentious issue. Management accountants have to apply their mind and ICWAI should issue guidelines to facilitate classification of such overheads. For example, donations to institutions located close to production facilities or facilities to render services should be considered as production overheads because they contribute in smooth operation of the facilities.
Similarly, expenditures incurred for the development of the local community should be considered as production overheads. Others may be classified as administration overheads.
It may not be appropriate to classify any of those overheads as marketing overheads.
Expenditures, which are classified as production overheads, should be included in cost of production. Difficulty will arise in identifying an appropriate basis for assigning those overheads to cost units because they cannot be identified with individual cost centres or activity pools.
However, Those expenditures should be assigned to cost units unless the management accountant fails to find any equitable base for allocation of those overheads. In situations where those expenditures cannot be assigned to cost units, regulators should consider the same in deciding the margin to be allowed to the firm.
Traditionally bad debt is considered outside the realm of cost accounting because that is considered as a loss arising from managerial inefficiency. This perspective is not appropriate. Bad debt is a normal business expense. Managers sell goods and services to marginal customers who might fail to pay for those goods and services to increase turnover and margin.
They charge a premium on sale to marginal customers. An example is the differential interest being charged by banks based on the assessed credit risk of loans to different constituents.
Therefore, bad debt is a part of cost and not a loss due to managerial inefficiency. Perhaps, it is most appropriate to classify it as marketing overhead.
ICWAI should issue guidance notes to will direction to discussions on such vexed issues and will help to understand practical difficulties in implementing theoretically correct principles and methods.