Definition

Ongoing expense for operating a business that cannot be directly linked to producing goods or services, such as rent, utilities, and administrative salaries.

Description

Overhead cost refers to the ongoing expenses necessary to run a business not directly tied to a specific product or service. These costs include rent, utilities, insurance, office supplies, and administrative salaries. Unlike direct costs, which can be attributed to producing goods or services (like raw materials and labour), overhead costs are essential for overall business operations. 

Managing these expenses effectively is crucial for maintaining profitability, as they impact the overall financial health of a company. By controlling overhead costs, businesses can ensure they remain competitive and financially stable, even when direct production costs fluctuate.

Importance of classification of overheads

Here is the why the classification of overheads important for startups:

Cost Control:

Classifying overheads helps identify and manage various expenses, making implementing cost-saving measures easier and improving overall financial efficiency.

Accurate Pricing:

Through proper classification, you ensure that all overhead costs are factored into your product pricing, giving you a strategic edge with more accurate and competitive pricing strategies. 

Budgeting and Forecasting:

Categorising overheads allows for more precise budgeting and financial forecasting, aiding in better financial planning and resource allocation.

Performance Analysis:

It helps analyse different cost centres' performance, identify areas of inefficiency, and make informed decisions to enhance operational effectiveness.

How to calculate cost accounting overhead?

Calculating overhead in cost accounting involves several detailed steps to ensure accuracy and proper allocation. Here are five steps to guide the process:

Step 1: Identify Overhead Costs:

• List All Overhead Expenses: Compile all indirect costs not directly attributable to specific products or services. These typically include rent, utilities, office supplies, administrative salaries, insurance, and maintenance.
• Categorize Overhead Costs: Group these expenses into categories such as fixed (e.g., rent, salaries), variable (e.g., utility bills that fluctuate with usage), and semi-variable costs (e.g., telephone bills with a fixed line charge plus variable usage charges).

Step 2: Select an Allocation Base:

• Choose a Relevant Allocation Base: Decide on allocating overhead costs to products or services. Typical bases include direct labour hours, direct labour cost, machine hours, or any other measure that reflects the usage of overhead resources.
• Gather Data for the Allocation Base: Collect data on the chosen allocation base, such as the total number of labour hours worked or machine hours used during the accounting period.

Step 3: Calculate the Overhead Rate:

• Determine the Total Overhead Costs: Sum up all identified overhead costs for the accounting period.
• Calculate the Overhead Rate: Divide the total overhead costs by the total units of the allocation base. For example, if using direct labour hours, the formula is:
• Overhead Rate=Total Overhead CostsTotal Direct Labor HoursOverhead Rate=Total Direct Labor HoursTotal Overhead Costs​
• Example Calculation: If total overhead costs are $50,000 and total direct labour hours are 10,000, the overhead rate is $5 per labour hour.

Step 4: Allocate Overhead to Products or Services:

• Apply the Overhead Rate: Multiply the overhead rate by the allocation base units incurred by each product or service. This allocates a portion of the total overhead costs to each product based on its usage of the allocation base.
• Example Allocation: If a product used 200 direct labour hours, its allocated overhead would be:
• 200 hours×$5 per hour=$1,000200 hours×$5 per hour=$1,000

Step 5: Review and Adjust as Necessary:

• Monitor Allocations: Regularly review the overhead allocation process to ensure accuracy and relevance. Adjust the allocation base or overhead rates as needed to reflect changes in production processes or cost structures.
• Analyze Overhead Variances: Compare allocated overhead to the actual overhead incurred to identify variances and investigate reasons for significant differences. This helps refine the allocation process and improve cost management.

Trends that impact overhead cost

Some of the trends that impact overhead cost:

1. Technological Advancements:

Adopting new technologies such as automation, artificial intelligence (AI), and cloud computing can significantly affect overhead costs. While initial investments may be high, these technologies often lead to long-term savings by reducing the need for manual labour, increasing efficiency, and lowering maintenance costs. 

Cloud services can reduce costs related to physical infrastructure, such as servers and data storage.

2. Remote Work and Flexible Workspaces:

The shift towards remote work and flexible workspaces is reshaping traditional office expenses. Companies can reduce overhead costs related to physical office space, utilities, and office supplies by allowing employees to work remotely. 

Flexible workspace arrangements, such as coworking spaces, can also provide cost-effective alternatives to long-term office leases, allowing businesses to scale their workspace needs up or down as required.

Example

Small Indian manufacturing company, ABC Pvt. Ltd., which produces automotive components.

Overhead Costs of ABC Pvt. Ltd.:

1. Rent: ₹50,000 per month
2. Utilities (electricity, water): ₹20,000 per month
3. Salaries for Administrative Staff: ₹1,00,000 per month
4. Depreciation of Office Equipment: ₹10,000 per month
5. Insurance: ₹5,000 per month

Total Monthly Overhead Costs:

To find the total overhead cost per month for ABC Pvt. Ltd., add up all the overhead expenses:

Total Overhead Cost=Rent + Utilities + Salaries + Depreciation + Insurance

Total Overhead Cost=₹50,000+₹20,000+₹1,00,000+₹10,000+₹5,000

Total Overhead Cost=₹1,85,000 per month 

Allocation to Products:

Assuming ABC Pvt. Ltd. calculates overhead based on machine hours and the total machine hours logged in a month are 2,000 hours, the overhead cost per machine hour would be:

Overhead Cost per Machine Hour=

Total Overhead Cost/Total Machine Hours

Overhead Cost per Machine Hour=₹1,85,000/2,000 hours

Overhead Cost per Machine Hour=₹92.5 per hour 

This per-hour overhead cost can then be applied to producing each automotive component, depending on how many machine hours each component requires for manufacturing. 

FAQ

What is the classification of overheads?

Overheads in cost accounting can be classified into three main categories:  

1. Nature or Elements: Overheads are classified based on their nature or type, such as manufacturing overheads (e.g., factory rent, utilities), selling overheads (e.g., advertising, sales staff salaries), and administrative overheads (e.g., office salaries, depreciation).  

2. Behaviour: Overheads can be classified according to their behaviour about changes in activity levels. This includes fixed overheads (costs that do not change with production volume), variable overheads (costs that vary directly with production volume), and semi-variable overheads (costs containing both fixed and variable components).  

3. Function: This classification involves assigning overheads based on the function they support, such as production, research, or selling and distribution functions.

What is overhead?

Overhead refers to the ongoing general business expenses not directly attributable to creating a product or service. These can include costs like rent, utilities, and administrative salaries necessary to keep the business operational but do not directly contribute to production.