Overhead is the aggregate of indirect material, indirect labor, and indirect expenses. It refers to any cost which is not directly attributable to a cost unit.
The term indirect means that which cannot be allocated, but which can be apportioned to or absorbed by cost centers or cost units. All those costs/expenses which are not capable of being attributed directly to a particular product or service or cost center are called indirect costs/expenses.
We generally see that some material costs (identified as indirect materials), some labor costs (identified as indirect labor), rents, depreciation costs, salaries of staff, warehousing costs, etc are of such nature. These costs are collectively called overheads.
Overhead cost is, therefore, a group of expenses, which are not identifiable with the cost unit, but are incurred generally for the manufacturing and selling activities of the organization and can be apportioned to and absorbed by the cost units.
It is a distinct element of cost and needs different treatment in accounting and control compared to direct cost elements.
Classification of Overhead
Functional Classification of Overhead
Under functional classification, the overhead expenditure is identified under a particular head based on the purpose of the expenditure based on the functions that are accomplished by the expenditure incurred.
Functionally, the overheads are classified under three or four heads.
The indirect expenses (overheads) incurred within the factory area are classified as factory overheads.
Administration or Office Overheads
The indirect expenses (overheads) incurred within the administrative area are classified as administrative or office overheads.
The indirect expenses (overheads) incurred about the sales activities are classified as selling overheads.
The indirect expenses (overheads) incurred concerning the distribution of the product or service are classified as distribution overheads.
Selling and Distribution Overheads
The indirect expenses (overheads) incurred about the sales activities as well as distributing the product or service are classified under a single head as “Selling and Distribution Overheads”.
Behavioral Classification of Overhead
Under functional classification, the overhead expenditure is identified under a particular head based on its inclination to vary with the level of activity achieved (production/sales).
Behaviorally, the overheads are classified under three heads.
The overhead expenses which vary directly with activity level (production/sales) are called variable overheads. These costs change with every small change in the activity level.
The overhead expenses which do not vary with the activity level (production/sales) are called fixed overheads. These costs would remain the same whatever may be the activity level achieved.
They are also called committed costs as they have to be borne even if the activity level achieved is not as planned.
The overhead expenses which behave both like a variable, as well as fixed overheads, are called semi-variable overheads. These expenses remain fixed within ranges of activity levels. They vary whenever the activity level crosses certain points.
Basis of Apportionment of Overheads.
|Basis of apportionment||Items of expenditure|
|Floor area or cubic content’||Rent, rates, taxes, maintenance of building, depreciation and’ insurance of building, lighting, and heating, electricity.|
|Number of employees||Expenses associated with workmen such as supervision, canteen expense, recreation expense, timekeeping, ESIC, etc.|
|Capital value||Depreciation and insurance of plant and machinery equipment and furniture.|
|Value of materials||Material handling.|
|Horse-power hours, Kwh||Power|
|No. of material requisitions||Storekeeping expenses|
|Direct machine hour, direct labor hour, direct wages||Other overhead expenses|
Computation of Overhead Rate
To find the overhead rate, first determine the right basis that will describe the best the behavior of the cost. Then, divide the total budgeted overhead by the basis to calculate the overhead rate:
Overhead Rate = (Total budgeted overhead / Basis)
Factors to be Considered in the Computation of Overhead Rate
- Base To Be Used
- Physical Output
- Direct materials cost
- Direct labor cost
- Direct labor hours
- Machine hours
- Activity Level to Use
- Normal capacity
- Expected actual capacity
- Inclusion or Exclusion of Fixed Overhead
- Absorption costing
- Direct costing
- Used of Single Rate or Several Rates
- Plant-wide or blanket rate
- Departmentalized rate
- Cost center or cost pool rates