Overhead Costs: Meaning, Types, and Examples

When running a business, you'll need to incur various types of costs that will help guarentee the smooth running of your business. These costs depend upon the type and the nature of your business.

It is crucial to understand and classify these costs based on their nature, as it helps you control expenses, prepare budget estimates, and make important decisions for your business.

As part of your business operations, you'll incur certain costs that can be directly traced to the production of a specific good or service, like raw materials.

However, there are other costs that you can't directly trace to the production of goods. These are the supplementary costs that you incur to facilitate your production process, and are called overhead costs.

The overhead costs form an important part of the production process, as there might be times when these may exceed the direct cost of producing goods or services.

This means that neglecting overheads can be costly for your business when estimating the price of a product or controlling expenses.

In this article, you will learn:

What is an overhead cost?

Overhead costs refer to expenses that cannot be directly traced to or identified with any cost unit. These expenses are incurred to keep your business running and not for the production of a particular product or service.

Overhead costs will appear on the income statement of your company, as these expenses form an important part of the overall costs of your business, and are incurred when producing goods or services and selling them to customers.

Because of this overhead costs are the expenses that are incurred to provide ancillary services, which help in carrying out the production of goods or services uninterruptedly.

These services, by themselves, are not of any use to your business. For example, if you own a bakery, you'll incur advertising costs to promote your bakery products.

This is an overhead cost for your business as advertising helps reach potential customers who'd be interested in buying your products.

Aside from advertising, overhead costs also include production overheads, administration, selling and distribution.

These also make up the supplementary costs that cannot be ignored when deciding the price of your product, preparing cost estimates, or controlling expenses.

Because these form an important part of the costs that help you in running your business, ignoring such costs could be a big mistake on your part.

How To Categorize Overhead Expenses?

Overhead expenses can be categorized based on:

Element

As overhead costs are the indirect costs that cannot be directly assigned to a particular product, job, process, or work order, these costs can be classified into indirect material, indirect labor, and indirect overheads.

Indirect Material

Indirect material overheads are the cost of materials that are utilized in the production process but cannot be directly traced to the product. This means these materials are used in smaller quantities when manufacturing a single product.

Because of this, it is not sustainable to count them like a direct material would be. Indirect material overhead costs often include the cost of nails, oil, glue and tape, etc.

Indirect Labor

Indirect labor overheads include the cost of labor that is not directly involved in the manufacturing of the product. This labor supports the production process but is not involved in converting raw materials into finished goods. Indirect labor includes quality control staff, purchasing officers, supervisors, security guards, etc.

Indirect Expenses

Other manufacturing overheads are the costs that include the costs of factory utilities. These include gas and electricity, depreciation of manufacturing equipment, rent and property taxes on manufacturing facilities, etc.

Function

This method classifies overhead costs based on various functions performed by your company.

There are various divisions, each of which has its own functions, so overhead costs on the basis of function are categorized as follows:

Manufacturing or Factory Overheads

The factory overheads refer to the expenses incurred when running the manufacturing division of your company.

Examples of manufacturing overheads include:

• repairs and maintenance of the factory
• the salary of the quality assurance staff
• rent, property taxes, and depreciation of manufacturing facility
• depreciation of manufacturing equipment

Office and Administrative Overheads

Administrative expenses refer to the costs incurred with directing and controlling the operations of your business. These expenses are, however, not directly related to production, selling, and distribution.

Examples of office and administrative overheads include:

• office rent
• office staff salary
• depreciation on the office building
• office stationery
• office furniture
• depreciation on office furniture

Selling and Distribution Overheads

Selling overheads include both the direct and indirect costs of generating sales revenue.

Direct selling expenses are the costs incurred at the time when the sale is made, like commissions paid for selling goods and services or transaction costs.

On the other hand, the indirect expenses can be incurred either before or after products and services are sold. For example, the wages paid to salespeople, travel expenses, etc.

Distribution overheads refer to the costs incurred during the time when the product is manufactured in the factory until it's delivered to the customer, such as insurance, rent of a warehouse, and packing charges.

Behavior

Behavior refers to the changes in cost with respect to changes output volume.

There are certain costs that increase and decrease with the output. However, there are certain overheads that will not vary if the level of output changes.

These overhead costs can be classified into fixed, variable, and semi-variable costs.

Fixed Overheads

Fixed overheads are the costs that remain unchanged if the level of output changes. These expenses are incurred even if there is no output produced during the specific period.

These costs will decrease if output decreases and increase if output decreases because these are fixed in nature for a specific accounting period.

However, these costs do not always remain fixed, because there can be a permanent change in fixed expenses over a long period of time.

If you were to buy additional machinery or hire additional labor to increase production, there will be a permanent change in both the output and fixed expenses, and will remain constant within the production potential of your business.

Variable Overheads

Variable overheads are costs that change when the level of output changes. That means these expenses will increase and decrease with as production increases and decreases. Examples of variable overheads include lighting, fuel, packing materials, etc.

Semi-Variable Overheads

Semi-variable costs are expenses that are partially fixed and partially variable. These expenses remain fixed only up to a certain level of output, so would increase if the output goes beyond a certain point.

However, this an increase in expenses is not proportional with the increase in the level of output. For example, the depreciation of the plant and machinery, stationery, repairs, and maintenance.

Manufacturing Overhead Cost

Manufacturing pverheads are expenses that are incurred in a factory, seperate from the direct material and labor costs. These are indirect costs that are incurred to support the manufacturing of a product.

Manufacturing overheads are also called factory or production overheads, and include the costs of indirect material, indirect labor, and other indirect manufacturing overheads, such as depreciation, rent, electricity, etc.

You must remember that factory overheads only include indirect factory-related costs, and do not include costs such as general administrative expenses, marketing costs, and financing costs.

These non-manufacturing expenses are reported separately as selling, general, and administrative expenses and interest expenses on your income statement and are reported for the period for which they are incurred.

As per GAAP, a manufacturer needs to include the following costs in their inventory and the Cost of Goods Sold.

These include:

• Direct material costs
• Direct labor costs
• Manufacturing overhead costs

One of the crucial tasks for your accountant is to allocate manufacturing overheads to each of the products manufactured. This is quite a challenging task as there are indirect costs that have no direct relation with the goods manufactured. Still, your accountant will need to allocate these costs to the goods manufactured.

This means that the method of allocating such costs will vary company to company.

Examples of Manufacturing Overheads

Examples of manufacturing overheads include:

Indirect Material Overhead

Indirect material overheads include costs incurred on:

• Oil
• Nails
• Tape
• Glue
• Cleaning supplies
• Fittings and fasteners

Indirect Labor Overhead

Indirect labor overheads include salaries/wages paid to:

• Security guards
• Quality control staff
• Production supervisor
• Material handling staff
• Repairs and maintenance employees in the manufacturing unit

Other Manufacturing Overheads

Other manufacturing overheads include costs incurred on:

• Electricity and gas used in the manufacturing facility
• Rent, property taxes, and depreciation on the factory facility
• Depreciation on manufacturing equipment

Overhead Cost Formula

Simply totalling the overhead costs for the factory or various divisions for your business is not sufficient, as you need to assign these overhead costs to various products, jobs and work orders.

This a process is known as absorbing the overheads to various cost units. However, you'll first need to calculate the overhead rate to allocate the overhead costs, which the rate will then be used to allocate the overhead costs to various cost units.

The overhead rate is the cost that you, as a business, allocate to the production of a good or service. This allocation is done in order to understand the total cost of producing a product or service.

You'll first need to sum up all the indirect expenses that you've incurred, then allocate these expenses using a specific method to calculate the overhead rate.

These could include costs, like direct labor costs or machine hours, so it's important to calculate the overhead rate as it helps you to achieve the following:

• Determine the price of your products
• Estimate the overhead costs
• Know how these costs impact your business
• Determine the profit margin that you can earn

To calculate overhead costs, it is important to know the overhead rate. Which is why the general overhead cost formula involves calculating the overhead rate.

The overhead rate can be calculated in various ways using different methods, however, the basic formula for calculating basic rates is as follows:

Overhead Rate = Indirect Costs/Specific Measure

Examples of Overhead Rate Measures

There are various measures that are used to calculate the overhead rate, including:

Percentage of Direct Materials

With this method, you use the cost of direct material as the measure for determining the absorbed overhead cost.

As such, the formula for calculating the overhead rate using direct materials cost as the basis is as follows:

Percentage of Direct Materials Overhead Rate = (Overhead Costs/Direct Material Cost) * 100

Percentage of Prime Cost

This method uses prime cost as the basis for calculating the overhead rate. Prime Cost is the total of direct materials and direct labor cost of your business.

As per the Percentage of Prime Cost Method, the formula used to calculate the overhead rate is:

Overhead Rate = (Overheads/Prime Cost) * 100

Percentage of Direct Labor Cost

In this method, the direct labor cost is taken as a base for absorbing the overhead costs. The overhead costs are divided by direct labor costs and indicated as a percentage.

The formula to calculate the overhead rate using the direct labor cost as the base, is as follows:

Overhead Rate = (Overheads/Direct Wages) * 100

Labor Hour Rate

Labor hour rate is an improvised version of the direct labor cost method, as it completely considers the time element when absorbing overhead expenses.

This method is useful when calculating the overhead rate for operations that do not make use of large machinery.

To calculate the labor hour rate, the overhead costs are divided by the total number of direct labor hours.

The formula for calculating the labor hour rate is:

Labor Hour Rate = Overheads/Direct Labor Hours

Machine Hours Rate

With this method, you charge overheads to production based on the number of machine-hours used on a particular job.

So, the formula to calculate the machine hour rate is:

Machine Hour Rate = (Overheads/Number of Machine Hours) * 100

Rate Per Unit of Output

This is one of the simplest ways you can calculate the overhead rate. In this method, overhead is calculated by dividing the overheads by the number of units produced.

The overhead rate is calculated using the following formula:

Overhead Rate = (Overheads/Number of Units) * 100

How to Calculate Overhead Cost?

You can use the following steps for calculating the overhead costs of your business:

Write Down Indirect Costs

First you'll need to record all the indirect costs of your business, these are the costs that don't include the direct material and labor costs of producing goods and services, and are instead the expenses that cannot be directly traced to the final product or service.

Indirect costs include salaries of supervisors and managers, quality control cost, insurance, depreciation, rent of manufacturing facility, etc.

You must remember that while certain expenses may be direct for other industries, these may be indirect for your business.

For example, legal fees would be treated as a direct expense if you run a law firm, because such an expense would directly help you in providing legal services. But other businesses would treat these costs as an indirect expense.

Add Up All Indirect Expenses

Once you have recorded all these expenses, the next step is to calculate the sum total of the indirect expenses.

Calculate the Overhead Rate

Overhead rate is the overhead cost you attribute to the production of goods and services. This rate is calculated using specific measures as the base, including machine-hours, labor hours, direct material cost, direct labor cost, prime cost, and the number of units produced.

So, you can easily calculate the overhead cost that will be charged to the production of goods and services, provided you calculate the overhead rate using a specific measure.

Charging Overhead Costs To Production

After calculating the overhead rate, the next step is to calculate the overheads that will be charged to production.

If you use the labor hour rate to calculate the overheads to be attributed to production, you'd use the following formula:

Labor Hour Rate = Overheads/Direct Labor Hours

If the amount of the overhead is $100,000, but the labor hours are estimated at 200,000 hours, the absorption rate would be $100,000/200,000 = $0.5.

So, if 800 direct labor hours are spent on a job, $400 would be absorbed as overheads.