Overhead Expenses: Meaning, Examples, and Role in Business

 

Definition of Overhead Expenses

Overhead expenses are the indirect costs a business incurs to run its operations, but which cannot be directly traced to a specific product, project, or service. They support the overall functioning of the company, such as rent, utilities, insurance, and administrative salaries.

Detailed Meaning of Overhead Expenses

In accounting, business, and economics, overheads represent the “necessary but indirect” expenses that ensure smooth operations. Unlike direct costs—such as raw materials or direct labor—overhead does not directly contribute to the production of goods or services but is essential for sustaining the business environment.

For example, a manufacturing company needs electricity to run machines. Even though electricity powers production, the monthly utility bill cannot be allocated precisely to one single unit produced. Hence, it is considered an overhead expense.

Categories of Overhead Expenses

To better understand, overhead expenses can be broken down into:

Administrative Overheads

Costs incurred for general management, such as salaries of office staff, accounting fees, and office supplies.

Selling and Distribution Overheads

Expenses related to marketing, sales promotions, advertising, delivery, and packaging.

Manufacturing Overheads

Indirect costs of production, such as factory rent, indirect materials (lubricants, cleaning supplies), and equipment depreciation.

Fixed Overheads

Expenses that remain constant regardless of production volume, e.g., rent or insurance.

Variable Overheads

Costs that fluctuate with production, e.g., electricity or shipping charges.

Semi-Variable Overheads

A mix of fixed and variable elements—for example, a phone bill with a fixed line rental plus usage charges.

Formula for Overhead Expenses

The calculation of overhead expenses depends on allocation. A general formula is:

Overhead Rate = (Total Overhead Expenses ÷ Total Direct Costs or Activity Base) × 100

Where the activity base could be labor hours, machine hours, or direct costs depending on the company’s system.

Example Calculation

Suppose a factory has:

• Rent: ₹50,000

• Utilities: ₹20,000

• Indirect labor: ₹30,000

• Depreciation: ₹10,000

Total Overheads = ₹1,10,000

If direct labor hours worked = 5,000 hours:

Overhead Absorption Rate = (₹1,10,000 ÷ 5,000) = ₹22 per labor hour

This means for every labor hour, ₹22 of overhead is allocated.

Journal Entry for Overhead Expenses

In accounting, overheads are first recorded in Overhead Control Accounts and then absorbed into cost accounts.

Example Journal Entry:

• For incurring overhead expenses:

  Factory Overhead A/c     Dr  
       To Cash/Bank A/c  
       To Payables A/c  
  

• For absorption of overhead into production:

  Work in Progress A/c     Dr  
       To Factory Overhead A/c  
  

Illustration of Overhead Calculation

Let’s assume XYZ Ltd. manufactures furniture.

• Direct labor: ₹1,00,000

• Direct materials: ₹1,50,000

• Factory rent: ₹40,000

• Utilities: ₹20,000

• Supervisor salary: ₹30,000

Total Overheads = ₹90,000

Total cost of production = Direct labor + Direct materials + Overheads
= ₹1,00,000 + ₹1,50,000 + ₹90,000
= ₹3,40,000

Overheads account for 26.5% of total cost, showing their major role in pricing decisions.

Key Features of Overhead Expenses

• Indirect in nature.

• Cannot be linked to a single unit of product.

• Essential for business operations.

• Vary across industries.

• Need systematic allocation for accurate costing.

Importance of Overhead Expenses in Business

• Cost Control: Helps identify areas where expenses can be reduced.

• Accurate Pricing: Ensures correct cost per unit for competitive pricing.

• Profit Analysis: Overhead tracking helps in measuring actual profitability.

• Budgeting: Businesses forecast overheads to plan cash flow.

• Tax & Compliance: Overheads reduce taxable income when claimed as business expenses.

Advantages and Disadvantages of Overhead Expenses

Advantages

• Ensures smooth functioning of business.

• Helps in financial reporting accuracy.

• Provides insights for efficiency improvements.

Disadvantages

• Difficult to allocate accurately.

• Excessive overheads reduce profitability.

• Mismanagement can distort product pricing.

Usage of Overhead Expenses

• Used in Cost Accounting to determine unit cost.

• Essential in Budgeting & Forecasting.

• Used for Break-even Analysis.

• Important in Project Management to estimate total costs.

Case Studies on Overhead Expenses

Case 1: Toyota Manufacturing

Toyota streamlined its production overheads by implementing lean manufacturing. By reducing wastage in electricity, space, and idle time, it lowered overhead costs and improved efficiency.

Case 2: Amazon Warehousing

Amazon faces huge distribution overheads due to packaging, logistics, and delivery. By using AI-driven supply chain optimization, it reduces overhead per package.

Practical Example

A bakery shop spends on:

• Flour: Direct expense

• Baker’s wages: Direct labor

• Oven electricity: Overhead expense

Without allocating oven electricity (overhead), the real cost of bread would be understated.

Common Mistakes or Misunderstandings

• Confusing direct costs with overheads.

• Ignoring semi-variable overheads.

• Allocating overhead equally instead of activity-based costing.

• Treating all fixed overheads as unavoidable.

Real-Life Applications

• Startups monitor overheads closely to maintain profitability.

• Manufacturers use absorption costing for overhead allocation.

• Retail stores consider rent and utilities as part of overhead when deciding selling prices.

• Service industries (like IT) allocate overhead on billable hours.

Legal Implication: For tax filing, businesses must categorize overheads correctly to claim deductions and avoid compliance issues with the Income Tax Act.

FAQs on Overhead Expenses

Q1. Are overheads the same as operating expenses?
No. Operating expenses include both direct and indirect costs, while overheads only cover indirect costs.

Q2. Can overheads be eliminated?
Not entirely. They can be reduced but never fully removed.

Q3. Which costing methods are best for overhead allocation?
Activity-Based Costing (ABC) and Absorption Costing are widely used.

Q4. Is depreciation an overhead expense?
Yes, because it is an indirect cost of using assets.

Expert Tip from Learn with Manika

“Always track overhead expenses separately from direct costs. Using activity-based costing improves accuracy and prevents under- or over-pricing of products.”

Related Terms

• Direct Costs
• Fixed Costs
• Variable Costs
• Operating Expenses
• Cost Allocation
• Activity-Based Costing (ABC)
• Absorption Costing