What is Administrative Overhead?
Administrative overheads are those expenses of the business that are not directly linked to the production & distribution of goods & services but are the expenses that are indirect in nature such as expenses incurred in the policy formulation, employee cost, legal and audit fees, telephone and electricity expenses, etc.
Administrative overheads are mostly related to the office expenses of the business. These expenses are not the manufacturing overheads as they are not directly related to the production of goods & services. The administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts. are the expenses on conducting the operations of the businessOperations Of The BusinessBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation., formulation of policies, and other expenses not related to production and research & development of the business.
Let’s take the example of a company named Clothes incorporation who deals with the manufacturing of clothes. The expenses incurred by the company during the financial year 2019-20 are as follows:
Calculation of Administrative Overheads:
Therefore, the total administrative overhead is $870,000. The direct material purchased and the salary paid to the factory staff are directly linked to the production, so it is not included in the administrative cost as they are production overhead. Moreover, the sales & marketing cost is the part of selling & distribution costDistribution CostDistribution cost is the total of all expenses incurred by the producer to make possible the delivery of the product from its location to the location of the end customer., and research & development expenses are part of research & development cost, so they are also not included.
What Does Administrative Overhead Include?
The administrative overhead includes all the expenses that are not linked to the specific business function. These expenses are necessary for conducting the operations of the business. The administrative expenses include wages & salaries to the office staff, audit and legal expenses, consultancy fees, rent, insurance premiums paid, utility expensesUtility ExpensesUtilities Expenses are the prices incurred by a Company for the usage of utilities like sewage, electricity, waste disposal, water, broadband, heating, & telephone. These are included as operating expenses in the Company’s income sheet. , rates & taxes, subscriptions, transport and conveyance charges, bank charges, repairs & maintenance expenses, printing & stationery expenses, etc.
Measures to Control Administrative Overhead
The various measures to control are as follows:
- Preparing Budgets: Separate budgets for the allocation of administrative overheads must be prepared just like the production & sales budgetSales BudgetThe sales budget forecasts the quantity that the entity expects to sell and the amount of revenue generated from the sale of such amount expected in the future, based on the management’s judgment related to the competition, economic conditions, market demands, and market demands past trends.. By preparing the budgets, the maximum limit for the expenses related to administration overhead is decided to control the amount of expenditure on administration work.
- Cutting Traveling Cost: The business should try to reduce the traveling and conveyance costs by doing the possible amount of work through video calls, phone calls, and emails. The visits should be tried to be done with the inexpensive means of transport.
- Use of Packages: If the travel work is done on a regular basis then the rewards given by the airlines on bulk purchases should be utilized, and even all other traveling benefits given by the agencies should be opted-out to reduce the traveling costs.
- Limit Entertainment Expenses: The face to face meeting, followed by the expensive dinner, can be switched to virtual meetings, which could help in reducing the cost of administrative overheads. Even the stay of an employee and unnecessary office events should be limited so that the overall cost of the organization can be reduced.
- Keeping a Check on Staff: The owners of the business should keep a check on the staff expenses and even see that the employees of the organization are not misusing the cash limit provided to them for doing day to day business expenditures.
- Eliminate Cost of Papers: In this era of technology, the files and documents should be kept electronically on the computer systems. Preparing and keeping the documents on the computer system reduce the cost of paper, and even the time is saved if documents are maintained electronically.
- Decentralizing Business Functions: The organizations working at large scales have centralized management that has high administrative expenses. Therefore, delegating some work to the subsidiariesSubsidiariesA subsidiary company is controlled by another company, better known as a parent or holding company. The control is exerted through ownership of more than 50% of the voting stock of the subsidiary. Subsidiaries are either set up or acquired by the controlling company. can help in lowering the administrative cost.
The administrative costs of the company can be accounted for by the following methods:
- The first method is booking the cost as an expense in the income statement of the company by assuming that all the expenses are not directly linked to the production, manufacturing & selling of goods & services.
- The second method of the accounting treatment is based on the assumption that the business has two main activities i.e., production activity and selling & distribution activity. So by following this assumption, the administrative overhead is apportioned between these two main activities.
- Now in this third method of accounting of administrative overhead, this expense is separately included in the work cost to measure the cost of production because an owner thinks that the administrative costs are as important as the production costs and the selling & distribution costs.
- The administrative overhead includes the cost of administration, like staff salary, rent, etc. These costs are fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. that has to be paid whether there is profit in the business or not. For example, if the business is shut down for a period of the month due to some unavoidable circumstances, then also the rent of the factory is to be paid.
- Also, these administrative costs being fixed in nature have the limited ability to get reduced. Companies that are having centralized management generally have high administrative overheads.
Administrative Overheads are the overheads that are not directly linked to the production and selling of the goods & services. These overheads are indirect expensesIndirect ExpensesIndirect expenses are the general costs incurred for running business operations and management in any enterprise. In simple terms, when you want to buy grocery from a supermarket, the transportation cost to get you to the supermarket and back is the indirect expenses. such as rent, insurance, salary paid to office staff, printing & stationery expenses, consultancy & legal charges, audit fees, etc. these expenses are incidental to main business activity and are also important to conduct the affairs of the company.
This has been a guide to what is administrative overhead. Here we discuss examples, accounting treatment, measures to control, and what does it include. You may learn more about financing from the following articles –