Definition of Overhead in Cost Accounting

Overhead is an essential category to be tracked and thus controlled in the cost accounting system for effective management of expenses because profitable operations are only sustainable if cost accounting is managed along a profitable line and also for operational efficiency.

Overhead is the indirect cost incurred by the use of a business and cannot be traced to a specific good or service produced. Such costs like rent, utilities, and administrative salaries basically contribute to sustaining production, thus not adding to the goods or services produced.

This blog post digs deep into the definition of overhead in cost accounting, and types of overhead accounts, and their treatments in the books of accounts.

Indirect Labour

Indirect labour refers to the wages paid to employees who are not directly involved in producing the product or service. This can include office staff, janitors, and security guards. Indirect expenses are all other non-labour costs, such as utilities, rent, insurance, and office supplies.

Overhead is a necessary part of doing business, but it can be a difficult expense to track. This is because overhead costs are often incurred by multiple departments within a company. For example, the marketing department may incur the cost of office supplies, while the accounting department incurs the cost of rent. As a result, it can be difficult to allocate overhead costs to the specific products or services that they were used for.

One way to overcome this challenge is to use activity-based costing. This method allocates overhead costs to specific activities, rather than products or services. This can provide a more accurate picture of the true cost of production.

Overall, overhead is a key cost to consider in any business. By understanding the different types of overhead and how to track them, companies can make smarter decisions about where to allocate their resources.

Treatment of Overheads in Cost Accounting

Cost pertaining to a cost centre or cost unit may be divided into two portions direct and indirect. The indirect portion of the total cost constitutes the overhead cost which is the aggregate of indirect material cost, indirect wages and indirect expenses.

CIMA defines indirect cost as “expenditure on labour, materials or service which cannot be conveniently indirect with a specific saleable cost per unit.”

Overhead is considered to be indirect costs because they are not related to a specific product. Overhead costs must be assigned to cost objects. For example, a factory that produces widgets simultaneously produces scrap. The scrap is considered to be an overhead cost. The scrap is not related to a specific product and is not traceable to a customer or order.

In general terms, overhead comprise all expenditure incurred for or in connection with the general organisation of the whole or part of the undertaking i.e. the cost of operating supplies and services used by the undertaking including the maintenance of capital assets. The terms burden’ ‘supplementary cost’ ‘on cost’ and indirect expenses are used interchangeably for overhead.

Types of Overheads

Overheads can be classified into three parts:

a. Production Overhead

It refers to the indirect expenses incurred at the site of production or factory. For example, oil and grease for machinery. Production Overheads include all the costs related to producing the goods and services in the production function.

The production of a certain good or service can be made up of several smaller production operations. Production Overhead is the sum of all the costs incurred during a single production operation.

b. Administration Overhead

Administrative overheads are the costs incurred by the business for running it. They are the costs involved in running the business, including office rent, utility bills, office supplies and salaries paid to your administrative staff. It refers to the office expenses like salaries, rent of the office and any other costs pertaining to the office and administration. The salary of the factory manager will not be put in this category.

c. Selling and Distribution Overhead

Selling and distribution overheads are all the costs associated with selling and distributing a company’s products or services. This includes the costs of sales staff, marketing, advertising, and shipping. Selling and distribution overheads are key components of a company’s overall operating expenses.

The goal of any business is to minimize its selling and distribution overheads so that it can maximize its profits. To do this, businesses must carefully manage their sales staff, marketing campaigns, and shipping costs. Additionally, businesses must always be on the lookout for ways to automate and streamline their selling and distribution processes.

Fixed and Variable Overheads

There are several types of overheads. These types can be broken down into two primary types of overhead: Fixed Overhead and Variable Overhead.

Fixed Overhead

Fixed overhead is an expense constant throughout a product’s life cycle. It is usually fixed to a certain percentage of a product’s selling price, but not always. Some examples of fixed overhead would include the salaries for management and accounting staff, rent, etc.

Variable Overhead

Variable overhead is an expense that varies throughout the life cycle of a product. An example would be the variable cost of electricity for a manufacturing plant. If the plant produces a high volume of products, electricity costs may rise proportionally.