What is the Importance of Overhead Costs

Overhead costs are expenses incurred during the production of a product or the operation of a department but cannot be directly attributed to the product or department.

Unlike direct costs, which can be readily traced to specific products or services, overheads represent the indirect expenses that underpin the overall functioning of an organization. While they may not directly contribute to the creation of tangible outputs, their importance in financial health and profitability cannot be overstated.

Let’s understand what are overhead costs and what is the importance of overhead costs or expenses in running the business operations smoothly.

Overhead Costs

All factory overheads are indirect costs of the product. Some examples of factory overheads are:

• Heating and lighting the factory
• Repairing and maintaining factory equipment
• Property taxes on factory buildings and land
• Insurance of factory building
• Depreciation of factory plant and equipment

Factory overheads also include material and labour costs that are not directly attributable to the production process. For example, the cost of oil to lubricate the machine, wages paid for cleaning the machine or wages of supervisors. The main feature of overheads is that, unlike direct costs, these costs cannot be easily charged to cost centres.

Importance of Overhead Costs

Overheads are an integral part of any organisation’s total expenses and costs. Especially in the service-based organisation where there is no manufacturing still, the cost of service is quite high. Why? Due to overhead costs.

As we know, overhead costs sometimes cannot be allocated to the products, services, and departments, but all the cost drivers benefit from the overhead expenditure.

It becomes essential to ascertain and allocate the appropriate amount of overhead to each cost element or driver. Apportionment of typical overheads utilised by multiple departments is done using an arbitrary basis or using a predetermined factory overhead application rate.

Selecting Cost Drivers

Overhead can be allocated in any way management chooses based on the underlying calculation driver. In the example above, you need to allocate $1,000 across two goods. If one product takes up 70% of the warehouse, the square footage can allocate the costs at $700 for one good and $300 for the other.

If one product produces 90% of the quantity of the finished goods, the costs are allocated $900 to $100. If management chooses to allocate evenly to each item, the allocation is $500 for each one. With the method chosen above, the dollar amount assigned to each item changes, all based on the cost driver.

Impact on Balance Sheet

Why does it matter whether a product is assigned $900 or $500 of the costs in the example above? One important aspect relates to the balance sheet. All overhead manufacturing items are classified in a general asset account on the balance sheet. However, as these costs are assigned, they are transferred to a specific asset account for each item. This inventory balance is essential to report as this is the valuation of the goods available for sale.

Anything not sold remains on the balance sheet. Therefore, if $900 is assigned to a not sold product, $900 stays on the balance sheet. If only $700 is assigned to a product that is not sold, this means the balance sheet reports $200 less inventory simply because of the costs assigned to the good.

Impact on Income Statement

The ultimate impact of assigning overhead costs is reflected in the income statement, as manufacturing overhead directly impacts net income. This occurs through the cost of goods sold account because this figure is derived from what is reported on the balance sheet. Based on the balance of the finished goods on the balance sheet, the costs that flow through to the income statement change.

In the above situation, the company allocated $900 to one product and $100 to another. All of the first product was sold, while none of the second product was sold. In this example, the $900 that is now in the finished goods inventory is reassigned to the cost of goods sold. The expense recognised is the total cost of goods sold, including the $900. In another comparison example, the manufacturing overhead above was split $500 for the goods sold and $500 for the goods that were not sold.