unit 3 Overheads

Overheads: Meaning

 Meaning: Overheads are indirect costs. They do not participate in the production process directly rather they support and facilitate the production or service process. The relationship or connection as direct or indirect is with reference to or from the point of view of any cost centre, generally, this is the core or main activity of the entity. To exemplify, while manufacturing furniture, cost of wood, salary of carpenter, nails, glue, sandpaper, design/drawing of particular furniture are examples of direct costs.

However, expenses on travelling, telephone bill, insurance premium, bank charges, salary of security personnel, etc. do not take part directly or cardinally in the making of furniture rather they provide an eco-system necessary to carry out main, core or cardinal activity of the cost centre. Such costs are indirect costs and can either be indirect material or indirect labour or indirect expenses.

Another peculiarity which overhead may contain that benefit of overhead is not entirely consumed by the cost centre or production process under question, that is they are joint costs. This leads to a very tricky problem of charging various activities or cost centres with that portion of overhead cost which relates to the concerned cost centre or production process or service. For example, if general manager is devoting only one fifth of his time with cost centre A, then it would be just to charge only fifth of his salary to the cost centre

Following general principles should be kept in view while considering whether an item of expenditure is to be treated as overhead: 

1. Overhead comprises of indirect costs, i.e. the costs which cannot be directly charged or allocated to any particular job, process or product. Thus, the relationship of the items of expenditure to product, job etc., must be seen.
2. Direct costs are not to be treated as overheads. But in certain cases, even direct expenses may be treated as overheads; for example, when the cost of a particular item like screws, nuts, bolts etc. though incurred for a particular job or product is so small that it is not convenient to charge them as direct costs, is to be apportioned as overheads over the jobs or products.
3. Overheads may be attached to a cost centre in accordance with the principles of benefit and I or responsibilities. The benefit principle implies that if a cost centre occupies a proportion of a larger unit of space for which standing charges such as rent and rates are exactly ascertainable, it should be charged with a due proportion of such costs. The responsibility principle implies that as the departmental head has no control over the amount of rent and rates paid, these being fixed by decisions of others, his department should not bear any allocation of them.
4. All expenditures of capital nature should be excluded from costs and shall not be treated as overheads.
5. All expenditures which do not relate to cost, such as penal rates of interest on loans, donations, subscriptions, income-tax etc., are excluded from costs and shall not be treated as overheads.
6. If it is not convenient to charge items of direct costs to individual jobs, processes or products, it is advisable to apportion these costs as overhead. For example, electricity charges can be treated as direct costs if electric consumption meters are installed for separate machines or departments but when this is not so, the total electricity bill may be allocated and apportioned over various jobs, products or processes in the form of overheads.
7. All indirect expenses of such nature for which cash has been paid or liability contracted or a loss in capital value sustained should be treated as overheads. An example of the first type would be telephone bills or electricity charges paid by the factory and an example of the third type would be depreciation of fixed assets in the factory or the office.

8. The journey of overheads in costing travels through following

1.       Collect and classify overheads as (i) Manufacturing (ii) Office & Overheads (iii) Selling and Distribution overheads

2.       On the basis of variability, overheads can be classified as (i) Variable (ii) Fixed and (iii) Semi-variable overheads

3.       Semi-variable overheads present characteristics of both fixed and variable overheads. For practical purposes variable and fixed components need to be segregated. Methods used for this are: (i) High-low point method (ii) Scatter Diagram (iii) Method of Averages (iv) Simultaneous Equations method

4.       Overheads which are wholly and entirely related to a particular department (cost centre) should be allocated to that department

5.       Joint or common expenses/overheads should be apportioned to various department benefitted by that overhead on some suitable basis.

6.       Overheads allocated and apportioned to service departments should be transferred or charged to production departments. This is known as re-apportionment or re-distribution or secondary distribution of overheads.

7.       Add all overheads i.e. allocated, apportioned and re-apportioned to arrive at total overheads for that department.

8.       Divide total overheads arrived in step 7 by total of the base chosen, which may be either total units of output, quantity of raw material used, labour hour consumed, Prime cost, machine hours used or any other which may be suitably chosen to serve the purpose.

9.       Overhead absorption rate may either be (i) actual or normal (ii) Predetermined or (iii) Blanket

10.   The outcome under step 8 is known as overhead absorption rate expressed in terms of say percentage of quantity of raw material, Direct labour hours, Prime cost or Machine hour.

11.   Methods of re-apportionment of overheads: (A) under Non-reciprocal situation, two methods are available i.e. (i) Direct redistribution (ii) Step method or secondary method and under reciprocal situation, three methods are available i.e. (i) Repeated distribution method (ii) Trial and error method (iii) Simultaneous equations

 
In other words, following steps are carried out:

(A) Preliminary work comprising of (i) identification and collection (ii) Nomenclature of items (iii) Classification i.e. grouping and codification and

(B) Secondary steps involving (i) Allocation (ii) Apportionment (iii) Re-apportionment (iv)Absorption (v) Applying supplementary rates

Identification and collection of overheads: Overheads are routine expenses i.e. present outlay or future liability to pay for resources consumed. To identify an overhead, one has to physically visit the production facility or cost centre. A careful study of the commercial activity, processes/steps involved, roles assigned and undertaken help in understanding the nature of an expense leading to correct identification of overheads. Next step is proper nomenclature and coding of overheads. They should be properly named so the reader can clearly gauge the nature of expense. Coding helps in maintaining accuracy and speed, specially, with reference to modern age accounting software. Collection of overheads involves scrutiny and capturing of data from bills, invoices, payments through cheques or cash, payment registers, journal registers, contract notes etc to collect first hand information. 

Collection of overheads involves:

(I) identification of overheads such that the overheads /expenses have a relationship with the cost centre though an indirect one. Assessing the primary and secondary sources of data with respect to overheads. For example for production overheads one may have to visit the actual operation place and examine the records maintained there. Overheads relating to material procurement may be collected from purchase and stores records viz. invoices and receipt-issue registers/ledgers. Similarly overheads with respect to labour can be collected from the records of payroll department, appointment letters, wage/salary payment registers etc.

(ii) Making a list of such expenses and classifying them under appropriate group representing a particular type of expenses say office expenses, administrative expenses, conversion expenses etc. These groups are generally pre-planned according to the cost objective and are also known as cost pools. There is a popular technique of codification i.e. numerical or even alpha-numerical such that names, accounts, parent-child relationship is represented by codes. This increases ease, accuracy and automation.

(iii) If possible and desired, overheads should further be classified as fixed and variable overheads based on their behaviour.

For examples of office & administrative and selling & distribution overheads please refer above.

Classification of overheads: Normally overheads are classified on the basis of function towards which they are expended viz.

(i)  Production overheads. Examples:

(ii) Office & Administration overheads and

(iii) Selling & Distribution overheads.

Classification on the basis of behaviour

Overheads are also classified on the basis of behaviour of overheads viz.

(i) Fixed overheads,

(ii)Variable overheads and

(iii) Semi-Variable overheads

Semi variable overheads need some intervention to arrive at a just segregation into fixed and variable components:

Following methods are generally used to segregate fixed and variable component from such mixed costs i.e. semi-variable:

(i) High-low point method

(ii) Method of averages

(iii) Scatter diagram or graphical method

(iv) using simultaneous equation method method

(v) By using other mathematical models in case variable costs are not linear in nature. this may involve use of classical distribution models or other complex models requiring use of computers.

Overhead Class	Meaning	Examples
Factory or Manufacturing or Production Overhead	indirect cost incurred for manufacturing or production activity in a factory. Includes all expenditures incurred from the procurement of materials till it is converted into finished product.	(i) Stock keeping expenses, (ii) Repairs and maintenance of plant, (iii) Depreciation of factory building, (iv) Indirect labour, (v) cost of primary packing (vi) Insurance of plant and machinery etc. Production overhead include administration costs relating to production, factory, works or manufacturing.
Office and Administrative Overheads	Office and Administrative overheads are expenditures incurred on all activities relating to general management and administration of an organisation. It includes formulating the policy, directing the organisation and controlling the operations of an undertaking which is not related directly to production, selling, distribution, research or development activity or function.	(i) Salary paid to office staffs, (ii) Repairs and maintenance of office building, (iii) Depreciation of office building (iv) postage and stationery, (v) Lease rental in case of operating lease (in case of finance lease, lease rental excluding finance cost) (vi) accounts and audit expenses etc.
Selling and Distribution Overheads	(i) Selling overhead: expenses related to sale of products and include all indirect expenses in sales management for the organisation. (ii) Distribution overhead: cost incurred on making product available for sale in the market.	(i) Salesmen commission, (ii) Advertisement cost, (iii) Sales office expenses etc. (i) Delivery van expenses, (ii) Transit insurance, (iii) warehouse and cold storage expenses, (iv) secondary packing expenses etc.
Fixed Overhead	These are the costs which are incurred for a period, and which, within certain output and turnover limits, tend to be unaffected by fluctuations in the levels of activity (output or turnover). They do not tend to increase or decrease with the changes in output.	(i) Salary paid to permanent employees, (ii) Depreciation of building and plant and equipment, (iii) Interest on capital, (iv) Insurance
Variable Overhead	These costs tend to vary with the volume of activity. Any increase in the activity results in an increase in the variable cost and vice-versa.	(i) Indirect materials, (ii) Power and fuel, (iii) lubricants, (iv) tools and spares etc.
Semi-Variable Overheads	These costs contain both fixed and variable components and are thus, partly affected by fluctuations in the level of activity.	(i) Electricity cost, (ii) water cost, (iii) telephone and internet expenses etc.
Indirect materials	Materials which do not normally form part of the finished product (cost object) are known as indirect materials.	(i)Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks etc.) (ii) Stores used by service departments like power house, boiler house, canteen etc.
Indirect employee cost	Employee costs which cannot be allocated but can be apportioned to or absorbed by cost units or cost centres is known as indirect employee.	(i) Salary paid to foreman and supervisor (ii) Salary paid to administration staff etc.
Indirect expenses	Expenses other than direct expenses are known as indirect expenses, that cannot be directly, conveniently and wholly allocated to cost centres.	(i) Rates & taxes, (ii) insurance, (iii) depreciation, (iv) advertisement expenses etc.
Controllable costs	These are those costs which can be controlled by the implementation of appropriate managerial influence and proper policies.	(i) Materials cost, (ii) wages and salary, (iii) power and fuel etc.
Uncontrollable costs	Overhead costs which cannot be controlled by the management even after the implementation of appropriate managerial influence and proper polices are known as uncontrollable costs.	(i) Rates and taxes, (ii) Depreciation, (iii) Interest on borrowings

Allocation of overheads

Next step in overhead study or accounting is ‘Allocation’ of overheads. Allocation of overheads involves charging whole amount of overhead to the particular cost centre or department based on the understanding that overhead is fully and directly related to the cost object or cost centre.

Example Suppose a particular component testing machine is installed at pathology department then insurance premium cost for that machine should be allocated fully to pathology department only.

When items of cost are identifiable directly and entirely with some products or departments such costs are charged to such cost centres. This process is known as cost allocation. Wages paid to workers of service department can be allocated to the particular department. Indirect materials used by a particular department can also be allocated to the department. Cost allocation calls for two basic factors – (i) Concerned department/product should have caused the cost to be incurred, and (ii) exact amount of cost should be computable.

Apportionment of overheads

When items of cost cannot directly charge to or accurately identifiable with any cost centres, they are prorated or distributed amongst the cost centres on some predetermined basis. This method is known as cost apportionment. Thus, we see that items of indirect costs residual to theprocess of cost allocation are covered by cost apportionment. The predetermination of suitable basis of apportionment is very important and usually following principles are adopted – (i) Service or use (ii) Survey method (iii) Ability to bear. The basis ultimately adopted should ensure an equitable share of common expenses for the cost centres and the basis once adopted should be reviewed at periodic intervals to improve upon the accuracy of apportionment.

Apportionment of overheads is done in case where overheads are common to more than one department or cost centre. In such a situation, overheads are apportioned to concerned departments on an equitable basis.  Apportionment of overheads is thus the distribution of overheads to more than one cost centre on some equitable basis.

What is equitable basis will depend upon the judicious choice of the executive, however there are two commonly accepted guiding factors:

(I) Cause and effect relationship: here activity is the cause while expense is the effect

(ii) share of benefit: again, the portion of overhead to be charged to a particular cost centre or department should be rateable to the benefit derived by that department or cost centre from that overhead.

Some common bases used are 

Item of overhead	Basis of apportionment
1. (i) Rent and other building expenses (ii) Lighting and heating (conditioning) (iii) Fire precaution service (iv) Air- conditioning	Floor area, or volume of department
2. (i) Perquisites (ii) Labour welfare expenses (iii) Time keeping (iv) Personnel office (v) Supervision	Number of workers
3. (i) Compensation to workers (ii) Holiday pay (iii) ESI and PF contribution (iv) Perquisites	Direct wages
4. General overheads	Direct labour hour, or Direct wages, or Machine hours.
5. (i) Depreciation of plant and machinery (ii) Repairs and maintenance of plant and machinery (iii) Insurance of stock	Capital values
6. (i) Power/steam consumption (ii) Internal transport (iii) Managerial salaries	Technical estimates
7. Lighting expenses (light)	No. of light points, or Area or Metered units
8. Electric power (machine operation)	Horse power of machines, or Number of machine hour, or value of machines or units consumed.
9. (i) Material handling (ii) Stores overhead	Weight of materials, or volume of materials, or value of materials or unit of materials.

Reapportionment of overheads: This is also known as secondary apportionment and arises where there are (I) main activity or product centre and (ii) service or support centres.

Service or support centres can be viewed as facilities which do not take a direct or cardinal part in the main revenue producing activity but provides support to the main or principal activity to function smoothly. Few examples of support departments or centres are Public Relation office, Post sales customer support cell, General maintenance, IT support cell, Accounts department etc.

In a multi-product/service scenario as is the case with a hospital, support centres are providing facilities to more than one department or cost centre, in such a case common indirect costs are first apportioned to service departments as well as principal departments in first round.

Next the total indirect costs of service departments so arrived at, as a result of first round of apportionment of overheads, are re-apportioned to the principal cost centres. This second apportionment of overheads of service departments to main or principal departments is known as secondary apportionment or re-apportionment of overheads.

To understand this, one can visualise the services of general administration department of a multi-specialty hospital. The general manager or administrator would be spending his time for not one single department but would be devoting time to issues relating to all departments as per merit or his discretion. Thus, the expenses of administration department would be apportioned not only to principal revenue generating activities like that of radiology department, pathology department, cardiology department, orthopedics department etc but also to support activities and departments like Accounts, Human Resource, Legal, Information & Technology, Inventories/Stores, Purchase etc. 

The purpose of above exercise is to arrive at the total cost to be charged to that department and includes both direct and equitable share of indirect costs. This in turn is required to arrive at the pricing of the services or activity of the department.

Note: Apportionment is done on some just and reasonable basis. Basis is generally arrived at by following principles of

(i) higher the benefit received, higher the share of costs or burden

(ii) Ability to pay method

(iii) Survey Method

The re-apportionment of the service department cost to the production department is known as secondary distribution. This apportionment, of course, has to be done on some reasonable basis. More general bases that may be adopted for reapportionment are given below:

Item of overhead	Basis of apportionment
1. Maintenance and Repair	Direct labour hours or Machine hours
2. Planning and progress	Direct labour wages, Asset value
3. Tool room	Hours worked.
4. Canteen and Welfare	No. of direct workers
5. Hospital and Dispensary	No. of employees
6. Personnel Department	No. of employees
7. Time-keeping	No. of card punched, No. of employees
8. Computer Section	Computer hours, Specific allocation to departments
9. Power House (electric lighting cost)	Floor area, Cubic content, No. of electric Points, Wattage
10. Power House (electric power cost)	Horse power, kWh, Horse power × Machine hours
11. Stores Department	No. of requisitions, Weight or value of Materials issued.

There is one more issue in re-apportionment. Sometimes, Service department A may serve only to production departments. Likewise service department B may also serve only to production departments. This is a simple situation it may or may not be the case. A more complex case is where Service department A supplies services to production departments as well as to Service department B. Similarly service department B may supply both to production departments as well as to Service department B. 

based on above situations, a suitable method or model of re-apportionment is used.

Methods of reapportionment:
(i) Direct Method
(ii) Step method or non-reciprocal method
(iii) Reciprocal Methods

Reciprocal method is applied when cross supply of services are in practice. Reciprocal methods include:
(i) Repeated distribution method
(ii) Trial and Error method
(iii) Simultaneous method

Absorption of Overheads

Distributing total overheads over units of production or level of activity represents absorption of overheads.

To understand this, following points need to be kept in contemplation:

1. Absorption of overheads takes place at production departments.

2. There are two aspects to be identified before absorption of overheads can take place: 
      
        (i) Accumulation of total overheads i.e. allocated, apportioned and reapportioned
       
        (ii) level of activity in that department represented either by resources consumed viz. material   
       consumed, Labour bill, Labour hours, Machine hours or by level of output i.e. units produced             served etc.

3. Process: Total overheads so accumulated are divided by the unit produced or some other base representing level of activity. This is in fact absorption or distribution or recovery or levy or charge of overheads. Remember absorption in essence, represents burden of overheads bore by each unit of production.

4. Purpose: This helps in two ways: (i) in ascertaining per unit cost thus fixing per unit sale price
                                                          (ii) in ascertaining overhead absorption rate, which has its own use like forecasting of costs through predetermined overhead absorption rates.

Usually any of the following methods are adopted for cost absorption – 
(i) Direct Material Cost Percentage 
(ii) Direct Labour Cost Percentage 
(iii) Prime Cost Percentage 
(iv) Direct Labour Hour Rate Method 
(v) Machine Hour Rate, etc. 

The basis should be selected after careful maximum accuracy of Cost Distribution to various production units. The basis should be reviewed periodically and corrective action whatever needed should be taken for improving upon the accuracy of the absorption.

Conversion Cost

This term is defined as the sum of direct wages, direct expenses and overhead costs of converting raw material to the finished products or converting a material from one stage of production to another stage. In other words, it means the total cost of producing an article less the cost of direct materials used. The cost of indirect materials and consumable stores are included in such cost. The compilation of conversion cost is useful in a number of cases. Where cost of direct materials is of fluctuating nature, conversion cost is used to cost control purpose or for any other decision making. In contracts/jobs where raw materials are on account of the buyers conversion cost takes the place of total cost in the books of the producer. Periodic comparison/review of the conversion cost may give sufficient insight as to the level of efficiency with which the production unit is operating.

Case of Over or Under Absorption of Overheads:

The amount of overhead absorption in costs is the total amount of the overhead costs allotted to individual cost units by application of overhead rate. Overhead costs are fully recovered from production if actual rate method of absorption is adopted as the amount charged to production is equal to the amount of overheads incurred. But when a predetermined rate is used on the basis of budgeted overheads and the rate is applied to the actual base, the actual overhead expenses may be different from the charged or budgeted overhead expenses.

This leads us to a very important conclusion: Over or under absorption of overheads happens only when predetermined absorption rates are applied resulting in estimated or budgeted overheads. As estimated overheads are bound to vary from actual overheads, they will either be more or less than actual overheads resulting in over or under absorption of overheads.

There will be no over or under absorption of overheads, if absorption rates are based on actual overheads. (AND advantage or virtue of cost accounting to peek into future will also be lost)

If the amount absorbed is less than the amount incurred which may be due to actual expenses exceeding the estimates and/or the output or hours worked being less than the estimates, the difference is known as under-absorption. Under-absorption of overheads thus means the amount by which the absorbed overheads fall short of the actual amount of overheads incurred. It represents understating the costs as the overhead expenses incurred are not fully recovered in the cost of jobs, processes etc.

On the other hand, if the amount absorbed is more than the expenditure incurred due to expenses being less than the estimates and/or the output or hours worked exceeding the estimates, it would mean over-absorption of overheads and will inflate the costs. Over-absorption of overheads thus means the excess of overheads absorbed over the actual amount of overheads incurred.

Under or over-absorption of overheads may arise due to any of the following reasons:

(i) Error in estimating overheads

(ii) Error in estimating of proper volume

(iii) The actual hours worked may be more or less than hours anticipated.

(iv) The basis upon which the factory overheads are recovered from production may no longer be correct on account of changes in the prices of material or wages rates.

(v) Work-in-progress might not have been charged with its share of overhead in cost accounts.

(vi) Major unanticipated changes in method of production might have occurred due to which an expense of a non-recurring nature might have been incurred during the year.

(vii) Seasonal fluctuations in the overhead expenses from period to period. 
(viii) There may be some important changes in the work situation such as heavy overtime, introduction of another shift, substitution of manual labour by equipment etc.

Accounting of Under and Over-Absorbed Overheads:

The accounting treatment of under or over-absorption of overheads depends upon the extent of such under or over-absorption and the circumstances under which it arises. 

Following are the main methods of disposal of under or over-absorption of overheads.

(i) Use of Supplementary Rates:

If the amount of under or over-absorption is considerable; the cost of job or process is adjusted by means of supplementary levy of the overhead. Supplementary rate is calculated by dividing the amount of under or over-absorption by the actual base. Under-absorption is set right by the plus rate while over-absorption is adjusted by minus rate. The supplementary rate may also be calculated as a percentage of the amount absorbed.

Correction of overheads costs by a supplementary rate is nothing but recovering the overhead by actual rates. All the shortcomings of actual rate method will make the supplementary rate as unnecessary and add to the clerical expenses. When the overhead rate is linked with maximum attainable or normal capacity but other than actual capacity, then calculation of supplementary rate will defeat the purpose (i.e. to reveal the idle capacity) for which it is calculated.

Supplementary rate is useless in those cases where in order to have a uniform charge of overhead throughout, the accounting period is fixed in order to avoid seasonal fluctuations in the overhead cost or level of activity.

Correction of costs through supplementary rate is necessary when the management likes to maintain actual historical costs for future comparison. Its use is made when prices are fixed on cost plus basis.

The amount of under or over-absorption at the end of the accounting period is adjusted in work-in-progress, finished stock and cost of sales in proportion to direct labour hours or machine hours or the values of the balances in each of these accounts by the use of supplementary rate. Subsidiary records or individual items are not corrected. The amounts so adjusted will be shown in the Balance Sheet as deductions from or additions to the work-in-progress and finished goods stock.

Under this method, the profit for the period will be reduced or increased by the amount adjusted to cost of sales and value of stock will increase or decrease by the amount adjusted to work-in- progress and finished goods stock. The latter will affect the profit of the subsequent period.

(ii) By Writing Off to Costing Profit and Loss Account:

If the amount of under or over- absorption is small, it may be written off to Costing Profit and Loss Account instead of calculating a supplementary rate by complicated procedure. Under-absorption due to idle facilities should be written off in this manner whatever the amount may be.

The amount of under or over-absorption at the end of accounting period is transferred to the Overhead Suspense Account which is ultimately transferred to the Costing Profit and Loss Account or directly to Costing Profit and Loss Account. If some portion of under or over-absorption arises due to abnormal causes such as strikes, lock-outs, major breakdown etc., then such portion should be carried over to the next year and is taken into account while fixing the rate for that period.

The main defect of this method is that it will distort the value of stock as the amount of under or over-absorption of overheads is directly transferred to Costing Profit and Loss Account and not allocated to the stock of work-in-progress and finished goods. The value of such stock will either be under or over-stated in the next accounting period. Under-absorption will reduce the profit of the concern by the same figure for the period.

(iii) Absorption in the Accounts in Subsequent Years:

The amount of under or over- absorption of overheads may be carried over as deferred charge or deferred credit to the next accounting period by transferring to a Suspense or Overhead Reserve Account. The use of this method is justified when the normal business cycle is more than one year and in the case of new projects and schemes when the output is low in the initial stages of production and cannot bear the entire share of overheads.

Under such circumstances, it is desirable that some portion of such cost be carried over to the next period to be absorbed in the production of subsequent years. One criticism which is generally levied against this method is that cost should be absorbed in the period in which it is incurred and utilized and should not be carried over to the next period for the purpose of absorption as it will distort the costs for the purpose of comparison.

Note: The process of allocation, apportionment and re-apportionment of overheads is collectively known as departmentalization of overheads

You are provided with the following data relating to overheads of semi-variable nature, segregate the overheads into fixed and variable components.

Month	Output (Units)	Semi-variable cost (Rs.)
Jan	80	2,200
Feb	40	1,600
Mar	120	2,800
Apr	160	3,400
May	200	4,000
Jun	140	3,100

1^st Method: (High-Low point method)

If we observe output data highest value is 200 in May and lowest value is 40 in Feb, difference of which is 160

Similarly, highest semi-variable costs are 4000 in May and lowest being 1,600 in Feb, difference in which case comes out to Rs.2,400

Dividing 2,400 by 160, we get variable cost as Rs.15 per unit. Using this relationship in data of any month, say for Jan, we get fixed cost: 2200 – (80 x 15) = 1000

IInd Method: (Method of Averages)

Here we divide the data set in two equal parts i.e. Jan to Mar and Apr to Jun (if there were odd month or number of observations, middle observation would have been knowingly left to get two equal parts).

Taking averages for both output and semi-variable costs data sets, we get

For Jan-Mar: Av. output => (80+40+120)/3 = 80 and SV costs => (2200+1600+2800)/3 = 2200

For Apr-Jun: Av. output => (160+200+140)/3=166.67 and SV costs => (3400+4000+3100)/3

                                                                                           =>3500

Now, finding variable component per unit => 3500-2200/166.67-80

ð 15/unit

Applying this relationship of variable cost of Rs.15 per unit in any months data we can solve that fixed cost element is Rs.1000/-

IIIrd Method: Graphical method or Scatter diagram method