Cost Accounting

Definition of Overhead in Cost Accounting

What is an Overhead?

Overhead is the portion of the cost of production that is not attributable to any cost object.

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

Administration 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 expenses 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 expenses are your costs for selling and distributing your products. This includes things like commissions paid to salespeople, salaries, marketing, distribution, storage, and shipping costs. The costs must be allocated to products sold during the period.

There are some expenses that are necessary to incur in order to make sales and deliver the products to the buyer. For example packaging cost, transportation cost, and so on and so forth. In the nutshell, it refers to the advertising and distribution cost etc.

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 that is constant throughout the life cycle of a product. 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 is producing a high volume of products, the costs of electricity may rise proportionally.

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