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Church, A. H. 1995. Overhead: The cost of production preparedness. Journal of Cost Management (Summer): 66-71. (Reprint of Church, A. H. 1931. Overhead: The cost of production preparedness. Factory and Industrial Management (January): 38-41.

Summary by Hsin-Yi Chen
Master of Accountancy Program
University of South Florida, Fall 2004

Capacity Related Main Page | Overhead Main Page

The purpose of this article (originally published in 1931) is to clarify the traditional concept of overhead under the ordinary methods of burden distribution. At the beginning of the article, Alexander Hamilton Church, clearly states the principle of overhead that he developed a long time ago. In his opinion overhead is a cost of production preparedness rather than a cost of production because overhead is a cost to maintain the plant in a condition ready to process whether there is work going on in the plant. According to Church, overhead is merely a collective term for several distinct and separate services, each of which has its separate incidence on production, and that it is possible to waste these services as well as to utilize them for actual production (p. 66).

Church gives an example to depict the true picture of overhead in three different illustrations. First, in figure 1, total overhead for a month of 200 hours in a plant is $5,400. This means the cost of the manufacturing capacity is $27 per hour. There are nine processes in four different departments in this plant. Thus each process rate can be calculated by subdividing the manufacturing capacity cost. For example, the rate for the single process in department B is $4 per hour and for the single process in department D is $6 per hour. Whether there is work going on in each department, the cost for each process remains the same.

In figure 2, Church presented this concept again from another perspective. The clock dials show the intervals at which the process dollars drip from the delivery points. Whether there is a job there to absorb the cost, the process dollar keeps dripping.

In figure 3, Church shows what happens. Overhead flows evenly into the hopper, which represents the process in order to maintain the manufacturing capacity. Then the jobs would pass the hopper to absorb the process cost. If there is an interval between two jobs, the process cost would drip into the pool of waste.

Flow of Overhead

This concept of overhead includes four efficiency measurements: (p. 67-68)

1. The cost of preparedness, or the efficiency of the actual as compared with the possible cost of maintaining a required capacity;

2. The efficiency of utilization, or ratio of the actual to the expected or possible use of this capacity;

3. The efficiency of process time, or of the actual as compared with the possible speed with which any job is done; and

4. The efficiency of direct labor, as expressed in earnings.

Church continues by explaining these four efficiencies in detail.

1. Efficiency of Preparedness - how does the actual compare with the necessary cost of maintaining a capacity?

Standardization such as time, cost and rate is required to measure all kinds of efficiencies. Thus for this efficiency measurement, standardized cost of preparedness is required. In fact, it is affected by budgeted legitimate overhead, which is comprised of various services against the normal capacity of each department process measured in actual working hours. This would result in a standardized process rate. Then this standardized process rate would be applied at anytime and at any condition to measure the efficiency of preparedness unless there is a dramatic change in cost such as the wage rate.

However, overtime would be an issue that requires special attention because it would affect both overhead cost and standardized capacity. It is important to decide whether to find out a special overtime process rate or simply regard it as giving rise to a small net credit or charge to “loss and gain.”

2. Efficiency of Utilization - how much of the normal capacity is utilized?

By comparing the actual utilization of the capacity with the standardized one allows the manager to recognize whether there is a failure to use the capacity completely. In addition, this allows obtaining actual profit by not including the cost collected from the pool of waste as the cost of product, but instead charging the waste off to the loss-and-gain account.

3. Efficiency of Processing Time - is each done in the shortest possible time?

For finding out the processing time of a product, it would be necessary to include both preparing time and the actual processing time. Church explained that shortening the time can provide two advantages: (1) less process rate being charged to the job and (2) processing capacity is freed up for other jobs. However, when processing time can be shortened, it means that the job can be done with a lower process rate but the cost from the pool of waste would be a loss against the profit from the product. Under the ordinary burden distribution method, this would not happen because the overhead is slipped between all the products produced. Thus the process rate for each product is higher and there is no cost from the pool of waste.

Efficiency of Direct Labor - are wage costs too high relatively to process cost?

Both process rate and direct labor cost are based on hours. The higher the process rate, the higher the wage rate would be because it creates more incentive in order to work efficiently. Thus this can reduce the processing time, save process cost and total cost. In addition, it can free up certain capacity to produce more product to make more profits. However, it would be really important to notice that there is a maximum wage rate for any given process rate beyond which it would turn out not to be profitable. According to Church, only when overhead can be recognized as a cost of preparedness, can a profitable wage rate be known for each type of work.

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Related summaries:

Brausch, J. M. and T. C. Taylor. 1997. Who is accounting for the cost of capacity? Management Accounting (February): 44-46, 48-50. (Summary).

Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13. (Summary).

Debruine, M. and P. R. Sopariwala. 1994. The use of practical capacity for better management decisions. Journal of Cost Management (Spring): 25-31. (Summary).

Gantt, H. L. 1994. The relation between production and costs. Journal of Cost Management (Spring): 4-11. This is a presentation Gantt made in 1915. (Summary).

Greer, H. C. 1966. Anyone for widgets? The Journal of Accountancy (April): 41-49. (Summary).

Martin, J. R. Not dated. 200 years of accounting history dates and events. Management And Accounting Web. https://maaw.info/AccountingHistoryDatesAndEvents.htm

McNair, C. J. 1994. The hidden costs of capacity. Journal of Cost Management (Spring): 12-24. (Summary).