In this article, you will learn:
You need to incur various types of costs for the smooth running of your business. These costs depend upon the type and the nature of your business.
Thus, it is crucial to understand and classify these costs based on their nature. This is because it helps you in controlling expenses, preparing budget estimates, and making important decisions.
Now, you incur certain costs that can be directly traced to the production of a specific good or service. For example raw materials.
However, there are other costs that you cannot directly identify with the production of final goods. Such costs are the supplementary costs that you incur to facilitate your production process. These are also called Overhead Costs.
The Overhead Costs form an important part of the production process. This is because there may be times when the Overhead Expenses may exceed the direct costs of producing goods or services.
Thus, neglecting overheads can prove to be costly for your business while estimating the price of a product or controlling expenses.
So let us define overhead cost and understand the overhead cost formula as well as how to calculate the overhead cost.
What is Overhead Cost?
Overhead Costs refer to the 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.
Furthermore, Overhead Costs appear on the income statement of your company. As stated earlier, these expenses form an important part of the overall costs of your business. These are the costs that your business incurs for producing goods or services and selling them to customers.
Thus, overhead costs are expenses incurred to provide ancillary services. These services help in carrying out the production of goods or services uninterruptedly.
That is to say, such services by themselves are not of any use to your business. For example, you own a bakery and incur advertising costs to promote your bakery products.
Such costs act as an Overhead cost for your business. This is because advertising helps to reach out to the potential customers who would be interested in buying your bakery products.
However, incurring advertising costs would be a waste if there are no bakery products to be sold. Thus, advertising costs incurred on promoting your bakery products helps in the smooth running of your business.
Apart from advertising, overhead costs also include production overheads, administration, selling, and distribution overheads.
Accordingly, overhead costs are the supplementary costs that cannot be ignored when deciding the price of your product, preparing cost estimates, or controlling expenses, etc.
This is so as these form an important part of the costs that help you in running your business. Thus, ignoring such costs could be a big mistake on your part.
How To Categorize Overhead Expenses?
The overheads can be categorized based on:
This method of classifying overhead costs goes by the definition of overheads. As stated earlier, the overhead costs are the indirect costs that cannot be directly assigned to a particular product, job, process, or work order.
Accordingly, Overhead costs are classified into indirect material, indirect labor, and indirect overheads.
Indirect Material Overheads are the cost of materials that are utilized in the production process but cannot be directly identified to the product. That is, they are used in smaller quantities in manufacturing a single product. So, it is not purposeful to keep counting them much like direct material. Indirect Material Overhead Costs include the cost of nails, oil, glue, tape, etc.
Indirect Labor Overheads include the cost of labor that is not directly involved in the manufacturing of the product. That is, such labor supports the production process and is not involved in converting raw materials into finished goods. Indirect Labor includes quality control staff, purchasing officers, supervisors, security guards, etc.
Other manufacturing overheads are the costs that include the costs of factory utilities. These include gas and electricity, depreciation on manufacturing equipment, rent and property taxes on manufacturing facilities, etc.
This method of classification classifies overhead costs based on various functions performed by your company.
There are various divisions, each of which has its own functions. Accordingly, overhead costs on the basis of function are categorized as follows.
Manufacturing or Factory Overheads
The Factory Overheads refer to the expenses incurred to run the manufacturing division of your company. These are indirect production costs other than direct material, direct labor, and direct expenses.
Thus, the following are examples of manufacturing overheads.
- 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, etc.
Office and Administrative Overheads
Administrative expenses refer to the costs associated with directing and controlling the operations of your business. Such expenses are, however, not directly related to production, selling, and distribution.
Thus, the following are examples of Office and Administrative Overheads.
- office rent,
- office staff salary,
- depreciation on the office building,
- office stationery,
- office furniture,
- depreciation on office furniture, etc.
Selling and Distribution Overheads
Selling Overheads include both the direct and indirect costs of generating sales revenue.
Thus, Direct Selling Expenses are the costs incurred at the time when the sale is made. For example, the commissions paid for selling goods or services, transaction costs, etc.
On the other hand, the indirect expenses are the ones that you incur either before or after you sell the products or services. For example, wages paid to the salespeople, travel expenses, etc.
Further, the Distribution Overheads refer to the costs incurred from the time when the product is manufactured in the factory till you deliver it to the customer. For example, insurance, rent of a warehouse, packing charges, etc.
Behavior refers to the change in the cost with respect to the change in the volume of the output.
Now, we know that there are certain costs that increase with an increase in output and decrease with a decrease in output. However, there are certain overheads that do not vary with the change in the level of output.
Accordingly, the overhead costs can be classified into fixed, variable, and semi-variable costs.
Fixed Overheads are the costs that remain unchanged with the change in the level of output. That is, such expenses are incurred even if there is no output produced during the specific period.
Furthermore, these costs decrease with an increase in output and increase with a decrease in output. This is because these costs are fixed in nature for a specific accounting period.
However, fixed costs do not always remain fixed. This is because there can be a permanent change in the fixed expenses over a long period of time.
Say you decide to buy additional machinery or hire additional labor so as to increase production. This will result in a change in both the output as well as fixed expenses permanently. Furthermore, this will remain constant within the production potential of your business.
Variable Overheads are the costs that change with a change in the level of output. That is, such expenses increase with increasing production and decrease with decreasing production. Examples of Variable Overheads include lighting, fuel, packing material, etc.
As the name suggests, the semi-variable costs are the expenses that are partially fixed and partially variable. That is, these expenses remain fixed only up to a certain level of output. In other words, such expenses would increase if the output goes beyond such a level.
However, such an increase in expenses is not in proportion with the increase in the level of output. For example, depreciation of plant and machinery, stationery, repairs, and maintenance.
Manufacturing Overhead Cost
Manufacturing Overheads are the expenses incurred in a factory apart from the direct material and direct labor cost. These are indirect costs that are incurred to support the manufacturing of the product.
Further, manufacturing overheads are also called factory or production overheads. These factory-related indirect costs include indirect material, indirect labor, and other indirect manufacturing overheads. The other indirect manufacturing overheads include depreciation, rent, electricity, etc.
Now, you must remember that factory overheads only include indirect factory-related costs. These do not include costs such as General Administrative Expenses, Marketing Costs, and Financing Costs.
Such non-manufacturing expenses are instead reported separately as Selling, General, and Administrative Expenses and Interest Expense on your income statement. These expenses are reported for the period for which they are incurred.
Further as per GAAP, a manufacturer needs to include the following costs in his inventory and the Cost of Goods Sold. These include:
- Direct Material Costs
- Direct Labor Costs
- Manufacturing Overhead Costs
Therefore, 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 these are indirect costs that have no direct relation with the goods manufactured. Still, the accountant needs to allocate these indirect costs to the goods manufactured.
Thus, the method of allocating such costs varies from company to company.
Examples of Manufacturing Overheads
Following are some of the examples of Manufacturing Overheads.
Indirect Material Overhead
Indirect Material Overheads include costs incurred on:
- 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 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, totaling the Overhead Costs either for the factory or for various divisions for your business is not sufficient. It is important to assign these Overhead Costs to various products, jobs, work orders, etc.
Such a process is called absorbing the overheads to various cost units. However, you need to first calculate the overhead rate to allocate the Overhead Costs. This Overhead Rate is then applied to allocate the overhead costs to various cost units.
So, the overhead rate is nothing but the cost that you as a business allocate to the production of a good or service. Such an allocation is done to understand the total cost of producing a product or service.
Thus, you first need to sum up all the indirect expenses that you incur. And then allocate such expenses using a specific measure to calculate the Overhead Rate.
Various methods or measures are used to calculate the overhead rate. And then allocate the overheads to jobs, products, etc.
These could include direct labor costs, machine hours, etc. Therefore, it is important to calculate the overhead rate because 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
As stated above, to calculate the overhead costs, it is important to know the overhead rate. Thus, the general overhead cost formula involves calculating the overhead rate.
As mentioned above, the overhead rate can be calculated in various ways using different measures. 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. Some of these are as follows:
Percentage of Direct Materials
In this method, you use the cost of direct material as the measure for determining the absorbed overhead cost.
Thus, below is the formula for calculating the overhead rate using direct materials cost as the basis.
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 nothing but the total of direct materials and direct labor cost of your business.
As per the Percentage of Prime Cost Method, the below formula is used to calculate the overhead rate.
Overhead Rate = (Overheads/Prime Cost) * 100
Percentage of Direct Labor Cost
In this method, direct labor cost is taken as a base for absorbing the overhead costs. Accordingly, overhead costs are divided by direct labor costs. These are further indicated as a percentage.
Thus, below is the formula to calculate the overhead rate using the direct labor cost as the base.
Overhead Rate = (Overheads/Direct Wages) * 100
Labor Hour Rate
Labor Hour Rate is an improvised version of the Direct Labor Cost Method. This is because it completely considers the time element in absorbing the overhead expenses.
Such a method is useful to calculate the overhead rate for operations that do not make use of large machinery.
Therefore, to calculate the labor hour rate, the overhead costs are divided by the total number of direct labor hours.
So, below is the formula for calculating the Labour Hour Rate.
Labor Hour Rate = Overheads/Direct Labor Hours
Machine Hours Rate
As per this method, you charge overheads to production based on the number of machine-hours used on a particular job.
Thus, below is the formula to calculate the Machine Hour Rate.
Machine Hour Rate = (Overheads/Number of Machine Hours) * 100
Rate Per Unit of Output
This is one of the simplest ways of calculating the overhead rate. In this method, overhead is calculated by dividing the overheads by the number of units produced.
Thus, the overhead rate is calculated using the following formula:
Overhead Rate = (Overheads/Number of Units) * 100
How to Calculate Overhead Cost?
Now let’s understand how you can calculate the overhead cost as we now know the various methods of calculating the absorption rate.
Hence, following are the steps for calculating the overhead costs of your business.
Write Down Indirect Costs
The first step involves recording all the indirect costs of your business. As mentioned earlier, the indirect costs do not include direct material and direct labor costs of producing goods and services. These are the expenses that cannot be directly traced to the final product or the service.
Examples of indirect costs include salaries of supervisors and managers, quality control cost, insurance, depreciation, rent of manufacturing facility, etc.
Here, you must remember that certain expenses that may be direct for other industries may be indirect for your business.
For example, the legal fees would be treated as a direct expense if you run a law firm. This is because such an expense would directly help you in providing legal services. Whereas other businesses take such an expense as an indirect expense.
Add Up All Indirect Expenses
The next step is to calculate the sum total of the indirect expenses once you have recorded all such expenses.
Calculate the Overhead Rate
Overhead Rate is nothing but the overhead cost that you attribute to the production of goods and services. As stated earlier, the overhead rate is calculated using specific measures as the base. These measures include machine-hours, labor hours, direct material cost, direct labor cost, prime cost, and the number of units produced.
So, you can thus easily calculate the overhead cost to 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 to be charged to production.
Suppose, you use the Labor Hour Rate to calculate the overheads to be attributed to production. Thus, below is the formula you can use to calculate the Labor Hour Rate.
Labor Hour Rate = Overheads/Direct Labor Hours
Now, suppose the amount of the overhead is $100,000 whereas the labor hours are estimated at 200,000 hours. Thus, the absorption rate would be $100,000/200,000 = $0.5.
Thus, if 800 direct labor hours are spent on a job, $400 would be absorbed as overheads.
June – 1454
July – 1454
August – 1454
September – 1454
October – 1454
November – 1454
December – 1454
Study – 1710
Sofa – 1454
Dining – 1360
Bed, Coffee Table, Mattress – 1927
29,982 + 5,516 =