Definition of Overhead in Cost Accounting
The following article provides an outline of Overhead in Cost Accounting. Any Cost which is not directly associated to profit production or it does not bring any kind of revenue to the firm is called as overhead; instead, it is considered as the cost required 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 are costs that are indirectly associated to production but considered an important one. 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, rent comes under overhead expenses.
Classification of Overheads in Cost Accounting
Overheads are classified as 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 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
Expenses made to produce a product and other production expenses come under manufacturing expenses.
E.g. Labor salary, Raw materials.
Expenses made to sell a product are covered under selling expenses.
E.g. Marketing, Third-party brokerage or commission.
Distribution overheads cover Expenses made to shift the products from the manufacturer to 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 its products and to withstand in the market.
2. Behavior Wise Classification
On the basis of behavior wise classification, this can be classified into the following types:
Costs which doesn’t change as per production or sales are called as fixed overheads, e.g. rent.
Costs Which Varies as per production, e.g. advertising, labor charges
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 company has to depreciate to show the true value of 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 it can be reduced as per requirement like phone charges etc
- Rent and Electricity: Whether a company produces goods or not it has to pay rent hence it is Considered as fixed overhead and electricity charges vary as per usage, and some part is fixed hence it is considered as semi-variable overhead.
The importance of accounting overheads are 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 to know how much indirect cost is incurred to produce a product or to run a business
- These are considered as important expenses to run a business
- A Financial report excluding overheads is not considered as 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 taken by a firm.
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 the point where some profit is earned to manage a business.
- 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.
This is a guide to Overhead in Cost Accounting. Here we discuss the definition and classification of overheads in cost account along with importance and examples of overhead. You may also look at the following articles to learn more –