Definition
Overhead costs are the indirect expenses required to run a business that are not directly tied to producing a specific product or service. They include rent, utilities, insurance, administrative salaries, and other costs that support daily operations but do not directly generate revenue.
Detailed Meaning
In business, not all expenses are linked directly to manufacturing or selling a product. While direct costs—like raw materials or wages for production staff—are easy to trace, overhead costs are more general in nature.
Overhead costs ensure the smooth functioning of a company’s operations. Without paying rent, hiring administrative staff, or maintaining utilities, the production process cannot run effectively.
These costs are often spread across different products, services, or departments and are used in cost accounting to determine accurate pricing and profitability.
Types of Overhead Costs
1. Fixed Overhead Costs
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Remain constant regardless of production levels.
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Examples: Office rent, salaried staff, insurance premiums.
2. Variable Overhead Costs
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Change proportionally with production volume.
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Examples: Utilities, indirect materials, maintenance costs.
3. Semi-Variable Overhead Costs
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Contain both fixed and variable components.
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Examples: Electricity bills (fixed meter charge + usage-based cost), telephone bills.
Formula for Overhead Costs
Overhead Rate Formula:
Activity base can be direct labor hours, machine hours, or direct material cost depending on the costing method used.
Example Calculation
If a company’s total overhead costs are ₹500,000 in a year and its total direct labor hours are 25,000 hours:
This means for every labor hour, ₹20 is added to cover overhead costs.
Accounting Treatment – Journal Entry
When recording overhead costs in accounting:
Example: Company incurs indirect expenses of ₹50,000.
Journal Entry:
(This records the overhead incurred)
When overhead is allocated to production:
Detailed Illustration
Scenario:
ABC Manufacturing Ltd. incurs:
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Rent: ₹120,000
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Indirect labor: ₹80,000
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Utilities: ₹50,000
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Insurance: ₹20,000
Total Overhead Costs = ₹270,000
If ABC produces 9,000 units in a year:
This ₹30 will be added to the direct material cost and direct labor cost to determine the total product cost.
Key Features / Components
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Indirect Nature: Cannot be directly linked to a specific product.
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Supports Operations: Essential for business functioning.
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Fixed, Variable, or Semi-variable: Based on behavior with production levels.
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Allocable: Spread across products or services using cost allocation methods.
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Non-revenue Generating: Does not directly generate sales but supports them.
Importance in Business
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Pricing Strategy: Helps determine accurate selling prices.
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Profitability Analysis: Identifies which products/services are profitable.
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Budgeting & Planning: Supports effective cost control and forecasting.
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Decision Making: Helps managers evaluate cost-cutting opportunities.
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Tax Compliance: Required for accurate reporting in financial statements.
Advantages and Disadvantages
Advantages:
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Ensures accurate product costing.
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Helps in tracking business efficiency.
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Aids in budgeting and forecasting.
Disadvantages:
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Allocation can be complex and subjective.
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Overhead increases fixed cost burden.
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Misallocation can lead to incorrect pricing decisions.
Usage
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Manufacturing: To determine the full cost of goods.
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Service Sector: Allocating administrative expenses to client projects.
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Retail: Distribution of store rent and utilities to sales operations.
Case Study: Toyota Motor Corporation
Toyota allocates overhead costs—like plant rent, administrative salaries, and equipment depreciation—using activity-based costing (ABC). This allows them to assign costs to specific vehicle models based on actual resource usage, ensuring competitive pricing and better profitability analysis.
Practical Example
A bakery spends ₹10,000 on rent, ₹5,000 on utilities, and ₹2,000 on indirect labor monthly.
Total monthly overhead = ₹17,000.
If they bake 1,700 cakes monthly, overhead cost per cake = ₹10.
Common Mistakes / Misunderstandings
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Confusing overhead costs with direct costs.
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Ignoring variable overhead changes during peak seasons.
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Incorrect allocation leading to underpricing or overpricing.
Real-Life Applications
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Legal & Tax Reporting: Overhead allocation is part of cost accounting records required under certain tax laws.
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Project Bidding: Contractors use overhead rates to quote project prices.
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Startup Budgeting: Helps new businesses avoid underestimating operational costs.
Table – Examples of Overhead Costs
| Type | Examples |
|---|---|
| Fixed | Rent, Salaries, Insurance |
| Variable | Utilities, Indirect materials |
| Semi-variable | Telephone bills, Maintenance costs |
FAQs
Q1: Are overhead costs the same as operating expenses?
Not exactly. Operating expenses include both overhead and direct costs, while overhead costs are strictly indirect.
Q2: How can businesses reduce overhead costs?
By outsourcing, renegotiating supplier contracts, or using energy-efficient systems.
Q3: Are overhead costs tax-deductible?
Yes, in most jurisdictions, they can be deducted as business expenses.
Q4: What happens if overhead is under-applied?
It means not enough cost has been allocated to products; adjustments are made at period-end.
Expert Tip from Learn with Manika
“Track and review your overhead expenses quarterly. Even small reductions—like switching to energy-efficient lighting or renegotiating office rent—can significantly improve your profit margins without affecting quality.”
Related Terms
- Direct Costs
- Fixed Costs
- Variable Costs
- Cost Allocation
- Activity-Based Costing (ABC)
- Operating Expenses