Overhead costs are expenses associated with running a business, but they are not directly linked to producing goods or services. In simpler terms, these costs support the production process and the company’s overall operations.
Overhead costs are incurred regardless of the level of production or sales and are essential for the organization’s overall functioning. Unlike direct costs, which can be attributed to particular products or services, overhead costs are indirect and usually allocated across the whole business.
Types of Overhead Costs
In cost accounting there are three main types of overhead costs: fixed, variable, and semi-variable.
- Fixed Overhead: Fixed overhead are costs that remain constant regardless of the volume of goods or services produced. They are expenses like rent, salaries, and insurance premiums that employees receive regardless of their productivity levels.
- Variable Overhead: Variable overhead costs vary directly with the volume of goods or services produced. They include expenses like direct labor, raw materials costs, production expenses, and shipping expenses.
- Semi-Variable Overhead: Semi-variable overhead costs are those that exhibit characteristics of fixed and variable costs. They include expenses like utilities, repair expenses, maintenance, and depreciation.
Examples of Overhead
Rent and Utilities: Business owners must pay rent and utility bills, even when they do not have generate profits. The same amount of rent must be paid every month, whether the business is doing well or poorly.
Advertising and Marketing: Every business requires advertising and marketing to reach potential customers. However, this is an overhead cost that cannot be directly traced to the sale of any particular product.
Salaries and Wages: Employee salaries and wages are fixed costs, as well as business taxes, insurance premiums, and legal expenses.
Depreciation: Depreciation is an expense that’s associated with losing the value of assets used in the production of goods or services.
How to Calculate Overhead Costs
Accurately calculating overhead costs is essential for budgeting, pricing products or services, and evaluating the overall financial performance of a business. To calculate overhead costs, follow these steps:
- Identify and categorize overhead expenses: Make a comprehensive list of all indirect expenses incurred by the business, categorizing them as fixed, variable, or semi-variable costs.
- Assign costs to cost centers: Allocate each overhead cost to specific cost centers or departments within the organization. This helps in distributing expenses accurately.
- Determine allocation basis: Select an appropriate basis for allocating overhead costs to cost centers. Common allocation bases include direct labor hours, machine hours, or square footage.
- Calculate the overhead rate: Divide the total overhead costs by the total allocation base to calculate the overhead rate. The formula for calculating the overhead rate is: Overhead Rate = Total Overhead Costs / Total Allocation Base (For example, if the total overhead costs are $50,000 and the total allocation base is 10,000 direct labor hours, the overhead rate would be $5 per direct labor hour.)
- Allocate overhead costs to specific products or services: Once the overhead rate is determined, you can allocate overhead costs to individual products or services based on their respective allocation bases. For instance, if a product requires 10 direct labor hours, the allocated overhead cost would be $50 ($5 per hour x 10 hours).
- Monitor and adjust: Regularly review and monitor the overhead costs to ensure they remain accurate and relevant. Adjustments may be necessary based on changes in business operations or fluctuations in costs.