What is Overhead Cost?
Overhead cost refers to the indirect expenses incurred by an organization that are not directly tied to a specific business activity. Unlike direct costs, which can be traced back to the production of a specific good or service, overhead costs are necessary to keep the business running but are not linked to the production process on a unit-by-unit basis.
Types of Overhead Costs
Overhead costs encompass a range of expense categories, typically grouped as follows:
Manufacturing Overheads: These include all the costs related to the production process that are not directly attributable to the production of goods. Examples include factory rent, machinery depreciation, and salaries of production supervisors.
Administration Overheads: Expenses under this category relate to the general management and administration of the business. Common examples are the salaries of executive personnel, office supplies, and legal and accounting services.
Selling Overheads: These costs are associated with the efforts to sell the product or service. Advertising expenses, sales personnel salaries, and travel expenses fall under this category.
Distribution Overheads: These are the costs involved in delivering the product from the place of production to the place of sale. It includes transportation and warehousing costs.
Research and Development Costs: Although sometimes classified separately, these costs can be considered overheads as they are not directly linked to specific units of production. R&D costs involve the development of new products or processes and can be quite substantial in technology and pharmaceutical sectors.
Why is Understanding Overhead Important?
Knowing and managing overhead costs is crucial for effective financial management. Properly allocated overhead ensures accurate product pricing, assists in budgeting and forecasting, and is essential for cost control strategies. Overheads, if not monitored, can spiral out of control and erode the profitability of a business.
Related Terms
- Direct Costs: Expenses directly associated with the production of goods, such as raw materials and labor.
- Fixed Costs: These are expenses that do not change with the level of production or sales, like rent and salaries of administrative staff.
- Variable Costs: Costs that vary directly with the level of production, such as utilities for a manufacturing plant.
Further Reading
For those keen on diving deeper into the intricacies of overhead costs and managerial accounting, the following books might light your financial enlightenment path:
- “Managerial Accounting” by Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer - A comprehensive guide on the internal business processes including detailed chapters on cost behavior and overhead management.
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan – This book provides a thorough analysis of cost accounting principles, including a focus on overhead costs and how they influence business decisions.
