What is Overhead Cost and How to Calculate It

What is Overhead Cost and How to Calculate It

All indirect costs associated with operating an organisation or project are called overhead. 

These running costs help your firm run, but they are unrelated to the production of goods or services. 

It's common for businesses to divide their overhead costs into different categories, for example, administrative, manufacturing, and others. 

They then calculate the overhead allocation rate by dividing the total overhead cost by an allocation metric, like direct labour or direct machine hours. 

This allows a business to choose how much money to spend on specific services or initiatives.

Overhead in Cost Accounting

Overhead costs meaning in cost accounting, are simple; they are the expenses associated with running a business, whether they are directly or indirectly related to producing a profit. 

The type of business will determine overhead costs in cost accounting and how much it costs to rent office space, equipment, and other facilities. 

Let’s understand the overheads definition with a few examples. Even if overhead costs are low, they are still necessary because they give the actions that lead to important support.

Overhead costs include, for instance:

  • Rent/Utilities/Insurance
  • Office equipment
  • Travel costs and advertising costs
  • Financial and legal costs
  • Wages and salaries
  • Depreciation
  • Government licenses and fees
  • Tax on real estate

Rent, payroll, insurance, and another set of monthly and annual expenses come under the category of overhead costs

Variable costs like advertising costs that might change from month to month also come under the category of overhead.

Overhead expenses do not include the cost of producing goods and other services like direct labour and materials. 

To determine the long-term product and service prices, businesses must include both overhead costs and direct expenses. By doing this, the company can generate profits in the long run.

Cost of goods sold (COGS) and cost of services (COS), respectively, are terms that refer to operating costs incurred in the production of a good or service, like labour or raw material costs.

Why is overhead cost important?

Calculating overhead expenses is necessary for budgeting and for determining how much to charge for a commodity or service to make a profit. 

As an illustration, if your business is centred on providing services, in addition to the direct costs of doing so, there are overhead expenditures like rent, electricity, and insurance.

Since they directly affect profitability, all businesses must maintain track of their overhead costs

By deducting operating and overhead costs from net revenue, or income from sales of a company's goods and services, one can determine the company's net income or bottom line. This calculation heavily weighs overhead expenses.

Three Different Types of Overhead Costs

In a business, three types of overhead expenses signify the use of overheads in cost accounting:

1. Fixed overhead costs:

Fixed overhead cost definition is the overhead that must happen regardless of the business activity of a firm; fixed overhead costs are costs that do not over a certain time (often month to month). 

Full-time employee salaries, office rent, business insurance, property taxes, mortgage interest, depreciation of assets, and government licensing are a few examples of fixed overhead expenses. 

A business discloses these costs on its income statement.

2. Semi-variable overhead costs:

A semi-variable overhead cost consists of a fixed component, such as a baseline cost, and a variable component that varies according to the degree of company activity. 

Janitorial services, commissions, and bonuses are all examples of semi-variable costs.

3. Variable overhead costs:

Variable costs are overhead charges that change based on the volume of business activity, as their name implies. 

Some utilities, consulting and legal fees, office equipment and related repairs, administrative expenditures, office supplies, and the hiring of seasonal or temporary support employees are examples of variable overhead costs.

How to calculate overhead costs?

It would be best if you classified each overhead expense of your company for a given time, often by breaking them down by month, to compute the organisation's overhead costs

Even though all indirect costs are overheads, you must be cautious when classifying these expenses.

Like legal fees are usually considered overhead costs by businesses. But if you own a law practice, these charges are part of your direct costs because they directly support your output.

After classifying the expenditures, total all the overhead in cost accounting for the accounting period to determine the overhead cost.

An overhead percentage reveals how much of your company's budget goes to overhead and how much is used to produce goods or services.

Calculate the overhead rate

Divide the company's monthly sales by its overall overhead expenses to determine the overhead rate. Now, multiply this value by 100 to get the overhead rate.

Consider a scenario in which your company's monthly overhead costs were $1,000 and its monthly sales were $5,000.

  • Overhead Rate = Overhead Costs / Sales
  • The overhead rate equals $1,000 divided by $5,000, or .2, or 20%.

This indicates that for every $0.1 the company earns, it spends $2 on overhead.

How Do You Allocate Overhead Costs?

To determine the complete cost of producing a good or service and, thus, to determine a fair selling price, overhead costs must be allocated.

Calculate the overhead allocation rate

It would be best to determine the overhead allocation rate before allocating overhead charges. 

To do this, divide the total overhead by the number of direct labour hours.

The overhead allocation rate is calculated like this:

If the total overhead for producing a good is $600 and the total direct labour hours are 100:

  • Total overhead / total labour hours are the overhead allocation rate.
  • $600/100 = $6

This indicates that you must budget $6 in overhead for every hour that it takes to produce a product.

Allocate overhead costs

To calculate overhead, multiply the overhead allocation rate by the number of direct labour hours to produce each good.

  • You must allot $240 in overhead to product X if it takes 40 hours to complete (40 hours x $6).

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Overhead costs directly impact profitability and must be tracked by businesses of all sizes, as stated on their balance sheets. 

Overhead expenditures are an important factor in determining a company's net profits.

Businesses should keep an eye on their overhead because they need to be more effectively managed to drain resources from the company efficiently. 

These costs may make up a higher portion of overall costs and burden a corporation because they are not immediately tied to revenue.

Faq related to Overhead Cost 

1. Give an example of Overhead Costs.

Indirect costs, such as rent, utilities, insurance, and salaries for office workers and supplies, come under the overhead costs since they are not directly tied to the production activity. Overhead costs must be paid even if there is no production.

2. What is the overhead cost of a project?

Director and senior-level workers, office space, electricity, benefits, insurance, taxes, and other fees may be included in the project's overhead costs. These expenses are fixed costs and apply uniformly to all projects in the organisation.

3. How are overhead costs per employee determined?

Companies usually divide the cost of an item, like a specific piece of machinery, by the total number of employees at the company to get the average overhead cost per employee.

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