Overhead CostsExplained & Defined

Adiste Mae
Last Updated: September 21, 2022
Date Published: September 21, 2022

What are Overhead Costs?

Overhead Costs are described as indirect costs in manufacturing, retail, or service company.

They are indirect because even though they form part of the production process, they are not directly identified in the production of a product or service.

They are essential expenses that are regularly incurred regardless of the transactions made by the company within one accounting period.

Overhead costs are included in the presentation of the Income Statement.

Overhead costs differ from product costs (costs that are directly used in production).

For example, in a pottery business, the materials used in producing a pot like clay and pottery wheel are recognized as direct costs because they form a major part of producing the item.

Therefore, they are not classified as overhead costs. An example of overhead costs can be rent expense for renting out the facility where they make pots.

Overhead Cost Examples

overhead costs

Overhead costs differ across industries. The overhead costs of a manufacturing company will differ from that of a retail or service company.

The most common overhead costs include the following:

  • Administrative expenses (office employee salaries)
  • Rent
  • Office Equipment
  • Insurance
  • Utilities

Types of Overhead Costs

The three major types of Overhead Costs are:

  • Fixed Costs
  • Variable Costs
  • Semi-variable Costs

Fixed expenses function differently from variable expenses.

The former represents payments that are the same every month, while the latter varies depending on the level of production activities.

An example of a fixed expense is rent.

Regardless of business operations, it remains the same.

An example of a variable expense is salaries & wages. Semi-variable costs are partly dependent on the level of business activities – it is incurred regardless of the business activity level of a company but as the business levels increase, so will the cost.

For example, accounting firms incur expenses for purchasing printer toners.

However, during year end reporting and tax filing seasons, printer toner purchases increase because printing activities also increase.

Regular monitoring of overhead costs must be done since they are not directly related to the production of a company’s product or service for sales. If such costs are not monitored properly, the company may incur unwanted costs that may affect its profitability.

For example, a start-up company decides to put up its physical office in an expensive location.

Such a decision can be impractical since a company is still in the process of marketing its products and generating sales.

It is impractical to pay high rental fees when it has not yet established profitability.

Instead of wasting money on expensive rent, a remote set-up is advisable, if it is a reasonable option.

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