Overhead costs are those costs that cannot be traced directly to the level of activities of an organization. The overhead cost can be further described as “the cost of indirect materials, indirect labor, and indirect expenses”.
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What are Indirect Costs?
Indirect costs are costs that are not directly accountable to a cost object (such as a particular project, facility, function or product). Indirect costs may be either fixed or variable. Indirect costs include administration, personnel and security costs.
Overhead costs are considered fixed costs, that is, they do not rise or fall directly with the cost of goods sold. Overhead costs are important to monitor and control.
What are Direct Expenses?
Direct Expenses are expenses which are directly allocated to a job, service, cost centre, cost unit, or to a process. A direct expense is an expense incurred that varies directly with changes in the volume of a cost object. A cost object is any item for which you are measuring expenses, such as products, product lines, services, sales regions, employees, and customers.
What are the Overhead Expenses?
Overhead Expenses are expenses that cannot be allocated to service, job, etc… because they are charged to a different job, services, cost centers etc… they only go through apportionment and absorption.
Overheads are the expenditure which cannot be conveniently traced to or identified with any particular cost unit, unlike operating expenses such as raw material and labor.
What are Expenses
An Expense is the amount of money spent in order to buy or do something. In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs.
For example; For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often referred to as an expense. Wikipedia
Types and Classification of Overhead Costs
- Production overhead.
- Administrative overhead.
- Selling and distribution overhead. (Marketing overhead).
- Research and development overhead.
OVERHEAD COSTS can further be analyzed as either:
- Variable Overhead: They are indirect costs that change along with the level of activities. (Unit of production)
- Fixed Overhead: They are indirect costs that remain constant regardless of the level of activities. i.e they are costs that do not change/will not change even when the level of activity is changing.
COST represents alternative forgone. i.e, the cost of having access to a particular thing. Cost can also be the value of the amount to be paid or spent in order to obtain a particular thing.
Elements of Costs
The elements that constitute the cost of manufacture are known as the elements of cost. Such element of cost is divided into three categories. In a manufacturing concern, raw materials are converted into a finished product with the help of labor and other service units. The elements of cost are;
- Material Cost
- Labour cost
- Expenses
Each element of cost is categorized into two, namely; Direct Cost (it is been traced to a cost centre) and Indirect cost (It cannot be traced). These costs are derived as follows;
- Material Cost: It is derived when the Direct Material Cost and Indirect Material Cost are summed up.
- Labour Cost: It is derived when the Direct Labor Cost and Indirect Labor Cost are summed up.
- Expenses are simply the summation of Direct Expenses and Indirect Expenses.
Note that;
Variable cost changes at the level of production, while fixed cost does not change.
Some Helpful Terminologies in Overhead Accounting
- Cost Centre: This is a location or department where cost is incurred or ascertain.
- Cost Unit: This is an item that makes the cost to be incurred.
- Direct Cost: This is a cost incurred that can be traced to a particular cost centre (location) or cost unit (an item). A direct cost will not require apportionment (sharing) since it can be traced to the cost centre where it is incurred.
DIRECT COST
Direct cost is the aggregate of direct material cost, direct labour cost, and direct expenses and it indicates that both direct cost and prime cost can be used interchangeably.
INDIRECT COST
This is a cost that cannot be traced to any cost centre or cost unit. It is a cost that will require apportionment since it cannot be traced to any cost centre or unit.
Indirect cost is the aggregate of indirect material cost, indirect labour cost, and indirect expenses. It means that indirect cost is the same as an overhead cost.
Apportionment of Overhead Costs – Primary Method
OVERHEAD COST ITEMS (1)
Rent, Lighting and Heating, Rate, Repairs, Depreciation of building, Insurance of building, and any other relating to buildings.
BASIS OF APPORTIONMENT – Floor Area Occupied
OVERHEAD COST ITEMS (2)
Depreciation of fixed assets, Insurance of fixed assets, and any other cost relating to a fixed asset.
BASIS OF APPORTIONMENT – Netbook Value (NBV) of the Fixed Asset
OVERHEAD COST ITEMS (3)
Personnel cost, Canteen cost.
BASIS OF APPORTIONMENT – Number of Employees
OVERHEAD COST ITEMS (4)
Factory power, Heating.
BASIS OF APPORTIONMENT – Horsepower or Kilowatt
OVERHEAD COST ITEMS (5)
Material Handling.
BASIS OF APPORTIONMENT – The weight of the material
Video Guide on Apportionment of Overhead Costs.
In this video, you’re going to learn how to apportion these costs using the basis of apportionment in the table above