What are Overhead Costs?
Overhead Cost refers to the cost of indirect material, indirect labor and other operating expenses which are associated with the normal day to day running of the business but cannot be conveniently charged directly to any specific product or service or cost center. In other words, it is the cost incurred on labor, material or services that cannot be economically identified with a specific saleable cost of goods or service per unit of the business. They are Indirect in nature and need to be shared out among the cost units as precisely as possible.
- Overhead Cost examples basically includes the cost of Indirect Material, Indirect Labor and Indirect Expenses. It varies from business to business and they are an indispensable part associated with the smooth running of the business.
- They vary with the level of production (Variable Overheads) or they may be altogether independent of the level of output (Fixed Overheads) or a mix of both (Semi-Variable Cost).
- It is very important for a business to keep a close watch on its Overhead Costs and efforts should be made to keep it low as that provides the business with the ability to price its products more efficiently so that it remains competitively superior to its competitors.
Example of Overhead Costs
Some of the examples of Overhead Costs include Advertising Cost, Insurance Cost, Rent, Utilities, Depreciation, Spoilage cost, Postage & Stationary Expenses etc.
Let’s understand the same with the help of a Numerical example:
ABC Limited has incurred a total overhead cost of Rs 120000 and spent 24000 direct labor hours (10 workers employed for 48 hours per week for 50 weeks during the year)in a production of its three product lines A, B, and C. ABC is trying to work cost one its product line A. Details of which are as follows:
Direct Labor Hour Rate= Rs 120000/24000.
= Rs 5.00 per hour
Types of Overhead Costs
Broadly they can be segregated/classified on the following basis:
#1 – Behavior- Wise Classification
Based on Behavior wise classification, Overhead Cost can be divided into the following types:
Such Overhead expenses are the ones which are fixed in nature and don’t get impacted by the increase or decrease in production activity or volume of output manufactured by the business. These Overheads are fixed within a specified limit and are not influenced by managerial actions up to such limits.
Fixed Overhead Cost Examples include Rent and Depreciation.
Such Overhead expenses are the ones which vary in direct proportion to the volume of output. These overhead expenses are directly affected by business activity.
Variable Overhead Cost Examples include Shipping expenses, Advertising Costs etc.
Semi-Variable Overhead Expenses are the ones which are partly fixed and party variable in nature. As such they contain both fixed and variable element and therefore don’t fluctuate in direct proportion to business output. Semi-variable overhead cost examples include Telephone Charges etc.
#2 – Function- Wise Classification
Based on Function wise classification, Overhead Cost can be divided into the following types:
It comprises of all indirect costs whether in the form of Indirect material, indirect Labor or Indirect Expenses which are incurred in the manufacturing of the goods and services. It is also known as Factory Overheads, Work Overheads etc.
It comprises of those overheads costs which are incurred in discharging the accounting and administrative services and it is not possible to associate the same with per unit cost of production.
Selling and Distribution Overheads
It comprises of the selling and distribution overheads which are incurred in marketing and dispatching of the products and includes expenditure incurred in transportation etc.
Research and Development Overheads
These Overhead expenses are usually incurred on a new product or process development and are not identifiable to be charged on any specific product or service line cater by the business.
Examples include the cost of raw material used in research, staff cost indulged in Research etc.
Allocation of Overhead Costs
It is a two-step process which comprises of:
#1 – Selection of Approximate Cost Center
This involves analysis of Overheads for selection to the appropriate Cost Centre and will depend on a number of factors including the level of control required and the information available pertaining to the Overhead Cost nature.
#2 – Determination of Overhead Cost
This stage involves analysis to determine the Overhead Cost which can be assigned to each Cost center and it involves Cost Allocation and Cost Apportionment. Cost Allocation is achieved by identifying a cost which is specifically attributable to a particular cost Centre and in cases where the same is not possible Cost Apportionment is applied to allocate the cost among cost centers based on the estimated benefit received by each cost center. For example, it is not possible to allocate electricity expenses in a Service Organization across its divisions and as such the cost is apportioned among the divisions based on Estimates.
Overhead Costs are an important part of the total cost incurred by a business in the production of goods or rendering of services and require close monitoring to ensure the same is within acceptable levels.
This has been a guide to what is Overhead Cost, its meaning and definition. Here we discuss types of overhead cost along with examples and how to allocate them. You may also have a look at the related articles: