Updated July 14, 2023

Definition of Overhead in Cost Accounting

The following article provides an outline of Overhead in Cost Accounting. Any Cost which is not directly associated with profit production or it does not bring any kind of revenue to the firm is called as overhead; instead, it is consider as the cost requires running a firm or business and expenses made in the profit generation process and cannot be attributed directly to any particular activity of the business.

Overhead is costs that are indirectly associated with production but consider important. If a company uses machinery to produce goods, depreciation will be charged on a yearly basis; it is also a kind of overhead. Any expenses done for manufacturing a product comes directly under manufacturing expenses other than that labor or third party expenses, repairs, and rent comes under overhead expenses.

Classification of Overheads in Cost Accounting

Overheads are classified below as per cost Accounting.

1. Function Wise Classification

On the basis of function wise classification, this can be classified into the following types:

Administration Overheads

Administration overheads are expenses made to administrate an office and other operations which are not directly related to productions.

E.g., office rent, furniture, depreciation, electricity, staff salaries, etc

Manufacturing Overheads

Expenses made to produce a product and other production expenses come under manufacturing expenses.

E.g., Labor salary, Raw materials.

Selling Overheads

Expenses made to sell a product are covered under selling expenses.

E.g., Marketing, Third-party brokerage, or commission.

Distribution Overheads

Distribution overheads cover Expenses made to shift the products from the manufacturer to the consumer or retailer.

E.g., vehicle expenses made to shift the goods

Research and Development

Research and development expenses are also important parts of a firm as the company has to invent new products to develop and withstand in the market.

2. Behavior Wise Classification

On the basis of behavior wise classification, this can be classified into the following types:

Fixed Overhead

Costs which doesn’t change as per production or sales are called fixed overheads, e.g., rent.

Variable Overhead

Costs Which Varies as per production, e.g., advertising, labor charges

Semi-Variable Overhead

semi-variable cost consists of two parts, fixed and variable, the fixed part doesn’t change, and the variable varies as per production. e.g., Telephone Charges.

Examples of Overhead in Cost Accounting

Depreciation: Let’s consider if a company has machinery for $120,000 each year machine produces a lot of goods, and the company has to depreciate to show the true value of the asset; hence depreciation does not change as per the sales hence it is considered as the fixed overhead
Admin Cost: Admin costs include office expenses which can reduce as per requirements like phone charges etc
Rent and Electricity: Whether a company produces goods or not, it has to pay rent; hence it is consider as fixed overhead electricity charges vary as per usage, and some part is fixed hence it is considered semi-variable overhead.

Importance

The importance of accounting overheads is discussed below

It helps in fixing the price of the product as some companies add the cost of production to the selling price
Recording overheads helps in determining the amount of indirect costs incurred in the production of a product or running a business.
These are consider important expenses to run a business
A Financial report excluding overheads is not consider a fair one, and it never gets balanced
Though it doesn’t generate profit directly, it affects the profits of the firm
It helps to know how much each department is spending and helps to reduce the costs
Overhead plays a vital role in budgeting, pricing products, and cost control measures a firm takes.

Tools for Accounting Overheads

Activity-Based Costing (ABC): It helps to reduce costs by allocating the overall cost to each activity involved in producing products or services rendered.
Break-Even Analysis:Break-even analysis determines the point at which revenue equals cost or where a business earns some profit.
Shutdown Graph: The shutdown graph mainly focuses on whether a firm can cover its operational cost or not; if it can cover the cost, it can run the business, or it has to shut down.