Understanding Overhead in Finance, Business, and Accounting

 

Definition of Overhead

In accounting and business, Overhead refers to the ongoing expenses required to run a business that are not directly tied to producing a product or service. These are indirect costs such as rent, utilities, insurance, administrative salaries, and office supplies. Unlike direct costs (like raw materials or labor directly used in production), overhead supports the entire business but cannot be easily traced to a single product, job, or project.

Meaning of Overhead in Detail

Overhead is an essential concept in financial management, cost accounting, and business decision-making. Every organization incurs expenses beyond the raw materials and direct labor used in production. These expenses, though not directly tied to the creation of a product, are vital to keeping the business running.

For example, a factory manufacturing furniture must pay for electricity, rent, and supervision staff. These costs are not directly traceable to a chair or table but are necessary to run operations. Such costs are called overheads.

Overheads are categorized into fixed, variable, and semi-variable expenses and help in determining the true cost of production, pricing, budgeting, and profitability.

Types of Overheads

To understand overhead more clearly, businesses classify it into categories:

Fixed Overheads

These remain constant regardless of production or sales volume. Example: Rent, insurance, and depreciation.

Variable Overheads

These change with production activity. Example: Electricity used by machinery, indirect materials, overtime costs.

Semi-Variable Overheads

A combination of fixed and variable components. Example: Telephone bills (fixed line rent + variable call charges).

Administrative Overheads

Costs related to office and administration. Example: Office salaries, stationery, IT systems.

Selling & Distribution Overheads

Expenses related to marketing and delivering products. Example: Advertising, sales commissions, shipping.

Formula for Overhead Calculation

The basic formula for calculating overhead is:

$$\text{Overhead Rate} = \frac{\text{Total Indirect Costs (Overheads)}}{\text{Total Direct Costs or Allocation Base}} \times 100$$

Another common approach is:

$$\text{Overhead Absorption Rate (OAR)} = \frac{\text{Total Overhead Costs}}{\text{Total Units Produced or Labor Hours}}$$

Example Calculation

Suppose a company’s total indirect costs for a year are ₹5,00,000. The company produces 50,000 units.

$$\text{Overhead per unit} = \frac{₹5,00,000}{50,000} = ₹10 \text{ per unit}$$

This means every unit of production carries an additional ₹10 of overhead expense.

Journal Entry for Overhead (Accounting Term)

When recording overhead in cost accounting, journal entries are made to allocate indirect costs:

1. For recording indirect expenses:

Factory Overhead A/C    Dr
      To Indirect Materials A/C
      To Indirect Wages A/C
      To Indirect Expenses A/C

2. For absorption of overhead into production:

Work-in-Progress A/C    Dr
      To Factory Overhead A/C

Detailed Illustration of Overhead Allocation

Assume XYZ Ltd. incurs the following indirect costs in one month:

• Rent: ₹1,20,000

• Factory utilities: ₹30,000

• Indirect salaries: ₹50,000

• Indirect materials: ₹20,000

Total Overhead = ₹2,20,000

If the company produces 11,000 units:

$$\text{Overhead absorbed per unit} = \frac{₹2,20,000}{11,000} = ₹20$$

Thus, each unit must carry ₹20 of overhead in addition to direct material and direct labor costs.

Key Features of Overheads

• Indirect in nature – cannot be traced to one product.

• Recurring expense – happens regularly.

• Classified by behavior – fixed, variable, or semi-variable.

• Essential for operations – keeps business running.

• Allocated across products/services – ensures fair cost distribution.

Importance of Overheads in Business

• Helps in accurate product costing.

• Aids in budgeting and cost control.

• Influences pricing decisions.

• Important for profitability analysis.

• Critical for financial planning and cost efficiency.

Advantages and Disadvantages of Overheads

Advantages

• Supports smooth functioning of business.

• Helps allocate resources effectively.

• Provides insight into operational efficiency.

• Ensures accurate financial reporting.

Disadvantages

• High overhead can reduce profitability.

• Difficult to allocate overhead fairly.

• Increases complexity in cost accounting.

Usage of Overheads

• Used in Cost Accounting for product costing.

• Used in Managerial Decision-Making (pricing, expansion, outsourcing).

• Used in Budgeting for estimating future expenses.

• Used in Performance Evaluation of departments.

Case Studies on Overheads

Case Study 1: Manufacturing Industry

A textile company reduced its electricity overhead by investing in solar power, saving ₹50 lakhs annually, which directly increased profit margins.

Case Study 2: Retail Industry

A large supermarket chain optimized its distribution overhead by centralizing warehouses, reducing transportation costs by 15%.

Case Study 3: IT Company

An IT firm outsourced its customer service department, cutting administrative overhead while focusing on core activities.

Practical Example

Suppose a bakery spends the following in one month:

• Ingredients (Direct Cost): ₹1,00,000

• Staff wages (Direct Labor): ₹80,000

• Rent & Utilities (Overhead): ₹50,000

Total Production Cost = Direct Cost + Direct Labor + Overhead

$$= 1,00,000 + 80,000 + 50,000 = ₹2,30,000$$

Overhead increases the actual cost of producing baked goods.

Common Mistakes or Misunderstandings

• Treating overhead as unnecessary expense.

• Ignoring semi-variable overhead costs.

• Failing to allocate overhead correctly between departments.

• Assuming overhead is always fixed.

• Underestimating its role in pricing strategy.

Real-Life Applications of Overheads

• Manufacturers use overhead allocation to calculate unit costs.

• Startups monitor overhead to stay lean and profitable.

• Service businesses track overhead like office rent and salaries.

• Legal implications – tax authorities often require clear overhead allocation for accurate reporting.

FAQs on Overheads

Q1: Is overhead the same as operating expense?
No. Overhead is part of operating expenses, but direct costs are excluded.

Q2: How do companies reduce overhead?
By outsourcing, automation, energy efficiency, and cost-cutting strategies.

Q3: Why is overhead allocation important?
Because it ensures true product costing and fair profitability analysis.

Q4: What is overhead absorption rate?
The rate at which overhead is distributed across units or labor hours.

Q5: Is depreciation an overhead?
Yes, depreciation of buildings and machinery is considered an overhead.

Expert Tip from Learn with Manika

"Always track overheads separately from direct costs. A business with low direct costs but high overhead may still struggle with profitability. Smart overhead management leads to sustainable growth."

Related Terms

• Direct Cost
• Fixed Cost
• Variable Cost
• Operating Expense
• Absorption Costing
• Indirect Cost Allocation