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Classification of Overheads

Before you can absorb overheads into product costs, you need to classify them — put them in the right box. Think of it like sorting your monthly expenses before budgeting: groceries, rent, travel. Same logic applies in a factory. The ICAI curriculum recognises three primary ways to classify overheads, and the exam tests all three.

By Function (Where did the cost happen?) — This is the most exam-heavy classification. Overheads are split into: Production/Manufacturing overheads (factory rent, machine depreciation, power in the shop floor), Administration overheads (MD's salary, office stationery, accounting software), Selling overheads (salesman commission, advertisement spend), and Distribution overheads (warehouse rent, delivery van fuel). A cost like the factory manager's salary is a production overhead; the HR manager's salary at head office is an administration overhead. Don't mix them.

By Nature/Element (What type of cost is it?) — Here you classify as Indirect Material (lubricants, consumables — materials you can't trace to one unit), Indirect Labour (supervisor wages, security guards — labour you can't pin to one unit), or Indirect Expenses (factory rent, insurance — neither material nor labour). This classification matters when you're building a cost sheet and you need to know what you're dealing with before you decide where it belongs.

By Behaviour (How does it react to output?) — This is critical for marginal costing and budgeting. Fixed overheads stay flat regardless of production — factory rent is ₹2 lakh whether you make 500 units or 5,000 units. Variable overheads move in direct proportion — power cost doubles when output doubles. Semi-variable (or mixed) overheads have a fixed core and a variable tail — a phone bill with a ₹500 line rental plus per-call charges is a classic example. The exam often gives you a mixed cost and asks you to separate it using the High-Low method.

This is asked frequently as a 4-mark theory question or as the lead-in to a larger absorption costing problem. Nail the classification first — everything else in overhead accounting flows from it.

📊 Worked example

Example 1 — Classify each overhead (function + behaviour)

Rajesh & Co. Pvt. Ltd. manufactures auto components. In April 2026, the following costs were incurred:

| Cost Item | Amount |

|---|---|

| Factory rent | ₹1,20,000 |

| Salesman commission (2% of sales) | ₹45,000 |

| MD's salary | ₹80,000 |

| Lubricants used in machines | ₹18,000 |

| Delivery van fuel | ₹22,000 |

| Factory supervisor wages | ₹35,000 |

Working:

  • Factory rent → Production overhead / Fixed / Indirect Expense
  • Salesman commission → Selling overhead / Variable / Indirect Expense
  • MD's salary → Administration overhead / Fixed / Indirect Labour
  • Lubricants → Production overhead / Variable / Indirect Material
  • Delivery van fuel → Distribution overhead / Variable / Indirect Expense
  • Factory supervisor wages → Production overhead / Fixed / Indirect Labour

Answer: Total Production overheads = ₹1,20,000 + ₹18,000 + ₹35,000 = ₹1,73,000

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Example 2 — High-Low Method to split semi-variable overhead

Ms. Iyer, cost accountant at a garment unit, has the following electricity data:

| Month | Units Produced | Electricity Cost |

|---|---|---|

| January | 4,000 | ₹36,000 |

| April | 10,000 | ₹60,000 |

Step 1 — Variable cost per unit:

(₹60,000 − ₹36,000) ÷ (10,000 − 4,000) = ₹24,000 ÷ 6,000 = ₹4 per unit

Step 2 — Fixed component (plug into either month):

₹36,000 − (4,000 × ₹4) = ₹36,000 − ₹16,000 = ₹20,000 fixed per month

Answer: Electricity = ₹20,000 fixed + ₹4 per unit variable. At 7,000 units → ₹20,000 + ₹28,000 = ₹48,000

⚠️ Common exam mistakes

  • Confusing selling and distribution overheads — Don't club them together. Selling overhead is incurred to get the order (ads, salesman salary); distribution overhead is incurred to deliver the goods (packing, freight outward). They have separate treatment in the cost sheet.
  • Treating supervisor wages as direct labour — A factory supervisor oversees multiple products and cannot be traced to a single unit, so it's indirect labour (production overhead), not direct labour. Direct labour means workers directly working on the product.
  • Assuming all fixed costs are non-controllable — Students often write that fixed overheads are uncontrollable. Wrong. Factory rent may be fixed and controllable if management can renegotiate the lease. Controllability is a separate classification axis.
  • Applying the High-Low method to only 2 months without checking for outliers — In exam problems, always use the highest and lowest activity levels, not highest and lowest cost. Sometimes the highest cost month is not the highest output month.
  • Forgetting that administration overheads are not included in cost of production — In a cost sheet, administration overheads are added after works cost to get cost of production (or sometimes cost of goods sold). Don't add them to factory overhead when computing the factory cost.
📖 Reference: Classification — Institute of Chartered Accountants of India
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