Elements of cost and overheads

Direct material, labour and expenses, the classes of overhead, the cost ladder from prime cost to selling price, and overhead absorption by labour-hour, machine-hour and ABC.

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Why it matters

A selling price, a quotation or a make-or-buy decision is only as good as the cost behind it. Production engineers build product costs from materials, labour and expenses, then add a fair share of the overheads that keep the factory running. Getting the structure and the overhead absorption right is the difference between a profitable order and one that loses money on every piece.

Key ideas

Elements of cost. Every cost is either direct — traceable economically to one product or job — or indirect (overhead).

  • Direct material: raw material and bought-out parts that become part of the product (bar stock, castings, purchased bearings).
  • Direct labour: wages of operators who work directly on the product (turner, welder, assembler).
  • Direct expenses: other costs incurred specifically for one job — special jigs, fixtures or patterns made for it, hire of a special machine, royalty per unit, testing fees for that order.
  • Overheads: all indirect material, indirect labour and indirect expenses — lubricants, supervisors' salaries, factory rent, power and lighting, depreciation, office salaries, advertising.

Classification of overheads by function.

  • Factory (works, production) overheads — incurred in the shop: supervision, maintenance, power, depreciation of machines, stores.
  • Administrative (office) overheads — general management, accounts, office rent.
  • Selling overheads — advertising, sales staff, commissions.
  • Distribution overheads — packing, warehousing, transport to customers.

Classification by behaviour. Fixed costs do not change with output in the short run (rent, salaried staff, insurance); variable costs change in proportion to output (direct material, direct labour paid per piece, power for machines); semi-variable costs have both parts (telephone, maintenance). This split is the basis of break-even analysis.

Cost ladder (cost sheet).

  • Prime cost = direct material + direct labour + direct expenses.
  • Factory (works) cost = prime cost + factory overheads.
  • Production (office) cost = factory cost + administrative overheads.
  • Total (selling) cost = production cost + selling and distribution overheads.
  • Selling price = total cost + profit (or − loss).

Overhead absorption. Overheads cannot be traced to a job, so they are spread with a predetermined rate based on an activity that drives them:

  • percentage of direct material cost, direct labour cost or prime cost;
  • direct labour hour rate;
  • machine hour rate — best where machines, not people, cause most of the overhead;
  • activity-based costing (ABC), which uses several cost drivers (number of set-ups, inspections, purchase orders) and gives truer costs when product variety is high.

A predetermined rate is set from budgeted overhead and budgeted activity at the start of the year. Actual and absorbed overhead then differ (under- or over-absorption), and the difference is adjusted at the year end.

Formulas

  • Prime cost: PC = DM + DL + DE
  • Factory cost: FC = PC + FOH
  • Production cost: PrC = FC + AOH
  • Total cost: TC = PrC + SOH + DOH
  • Selling price: SP = TC + profit
  • Overhead rate on direct labour: FOH% = (budgeted factory overhead / budgeted direct labour cost) × 100
  • Labour hour rate: r_LH = budgeted overhead / budgeted direct labour hours
  • Machine hour rate: r_MH = (annual depreciation + power + maintenance + share of shop overhead) / annual machine hours
  • Profit as % of selling price p: SP = TC / (1 − p); as % of cost q: SP = TC(1 + q)

Symbols: DM, DL, DE = direct material, labour and expenses (₹); FOH, AOH, SOH, DOH = factory, administrative, selling and distribution overheads (₹); r_LH in ₹/labour-hour; r_MH in ₹/machine-hour; p, q as decimals.

Worked examples

Example 1 (standard) — cost sheet. For one batch: direct material ₹40,000, direct labour ₹25,000, direct expenses ₹5,000. Factory overheads are 60% of direct labour; administrative overheads 10% of factory cost; selling and distribution overheads ₹6,500. The firm wants a profit of 20% on the selling price. Find the selling price.

  1. Prime cost = 40,000 + 25,000 + 5,000 = ₹70,000.
  2. Factory overheads = 0.60 × 25,000 = ₹15,000; factory cost = ₹85,000.
  3. Administrative overheads = 0.10 × 85,000 = ₹8,500; production cost = ₹93,500.
  4. Total cost = 93,500 + 6,500 = ₹1,00,000.
  5. Profit is 20% of SP, so SP = TC / (1 − 0.20) = 1,00,000 / 0.8 = ₹1,25,000 (profit ₹25,000).

Example 2 (GATE level) — machine hour rate. A machining centre costs ₹12,00,000, salvage ₹2,00,000, life 10 years (straight-line), and runs 2,000 h/year. It draws 15 kW at ₹8 per kWh, maintenance is ₹40,000/year and its share of shop overheads is ₹60,000/year. A job needs ₹3,000 of material, ₹1,200 of direct labour and 6 machine hours. Find the machine hour rate and the factory cost of the job.

  1. Depreciation = (12,00,000 − 2,00,000) / 10 = ₹1,00,000/year → 1,00,000 / 2,000 = ₹50/h.
  2. Power = 15 kW × ₹8/kWh = ₹120/h.
  3. Maintenance = 40,000 / 2,000 = ₹20/h; shop overhead = 60,000 / 2,000 = ₹30/h.
  4. r_MH = 50 + 120 + 20 + 30 = ₹220 per machine-hour.
  5. Factory cost = 3,000 + 1,200 + 6 × 220 = ₹5,520.

Common mistakes

  • Putting direct material or direct labour inside "overheads" — overheads are only the indirect costs.
  • Treating a special fixture made for one order as overhead; it is a direct expense of that order.
  • Applying the administrative overhead percentage to prime cost when the question says factory cost (read the base carefully).
  • Confusing profit on cost with profit on selling price: 20% on selling price is 25% on cost.
  • Absorbing machine-driven overheads on labour hours in an automated shop, which undercosts machine-heavy jobs.
  • Calling all fixed costs "overheads" and all variable costs "direct"; power for machines is variable but is still an overhead.

For GATE PI

Expect cost-sheet numericals (prime, factory and total cost, selling price with a stated profit margin), machine-hour or labour-hour overhead rates, and classification MCQs (is this item direct material, direct expense or overhead; fixed or variable). Practise reading which base each percentage applies to, and keep the cost ladder in the right order.

Quick check

  1. Direct material ₹8,000, direct labour ₹5,000, direct expenses ₹2,000. What is the prime cost?
  2. Is a pattern made specially for one casting order a direct expense or an overhead?
  3. Total cost is ₹90,000 and profit must be 10% of the selling price. Find the selling price.
  4. Which absorption basis suits a highly automated shop best?

Answers: 1. ₹15,000; 2. a direct expense; 3. 90,000 / 0.9 = ₹1,00,000; 4. machine hour rate (or ABC with machine-hour drivers).

Interview questions

All Engineering Economics and Product Design interview questions

Try answering each one aloud before you open it.

  1. 1.What are the main elements of cost in production and industrial engineering?Concept

    Cost is split into direct material, direct labour and direct expenses — which together form prime cost — and overheads, the indirect costs that cannot be traced economically to one product. Overheads are grouped as factory, administrative, and selling and distribution overheads. Adding them in that order gives factory cost, production cost and total cost; profit on top gives the selling price.

  2. 2.Explain the difference between fixed and variable overheads.Concept

    Fixed overheads stay constant in total over the normal output range in the short run — factory rent, supervisors' salaries, insurance, time-based depreciation — so their cost per unit falls as output rises. Variable overheads change in proportion to output — power for machines, consumable tools, lubricants — so their cost per unit stays roughly constant. Direct material and direct labour are variable costs but are not overheads. The split underlies break-even analysis and flexible budgets.

  3. 3.Why is it important to allocate overhead costs accurately in product design?Application

    Accurate allocation of overhead costs is crucial in product design because it ensures that the product pricing reflects the true cost of production. This helps in setting competitive prices while maintaining profitability. It also aids in identifying cost-saving opportunities and improving overall efficiency in the production process.

  4. 4.How does the concept of economies of scale relate to overhead costs?Application

    Economies of scale refer to the cost advantages that a business can achieve by increasing its production scale. As production increases, the fixed overhead costs are spread over a larger number of units, reducing the cost per unit. This can lead to lower overall production costs and increased competitiveness in the market.

  5. 5.What happens if overhead costs are underestimated in a project budget?Application

    If overhead costs are underestimated, it can lead to budget overruns and reduced profitability. The project may face financial strain, and the company might need to find additional funding to cover the unexpected costs. This can also affect the company's ability to invest in future projects and may damage its reputation with stakeholders.

  6. 6.Explain how activity-based costing (ABC) can improve overhead cost allocation.Concept

    Activity-based costing (ABC) improves overhead cost allocation by assigning costs to products based on the activities required to produce them. This method provides a more accurate reflection of the resources consumed by each product, leading to better pricing and cost management decisions. ABC helps identify inefficient processes and areas where cost savings can be achieved.

  7. 7.Why might a company choose to use a predetermined overhead rate?Application

    A company might use a predetermined overhead rate to allocate overhead costs more consistently throughout the year. This rate is calculated at the beginning of the period based on estimated costs and activity levels. It helps in budgeting and financial planning by providing a stable basis for cost allocation, even when actual costs fluctuate.

  8. 8.Calculate the overhead cost per unit if the total overhead cost is ₹50,000 and the production volume is 10,000 units.Numerical

    Overhead per unit = total overhead / units = 50,000 / 10,000 = ₹5 per unit. If part of that ₹50,000 is fixed, the per-unit figure holds only at this volume; at higher output the fixed share per unit falls.

  9. 9.A company has fixed overheads of ₹1,00,000 and variable overheads of ₹5 per unit. If it produces 20,000 units, what is the total overhead cost?Numerical

    Variable overhead = 5 × 20,000 = ₹1,00,000. Total overhead = fixed + variable = 1,00,000 + 1,00,000 = ₹2,00,000, i.e. ₹10 per unit at this volume.

  10. 10.Discuss the impact of overhead cost control on a company's profitability.Application

    Effective overhead cost control can significantly enhance a company's profitability by reducing unnecessary expenses and improving operational efficiency. By closely monitoring and managing overheads, a company can allocate resources more effectively, reduce waste, and improve its competitive position. This leads to better financial performance and the ability to invest in growth opportunities.

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