Overhead definition
/Overhead is those costs required to run a business, but which cannot be directly attributed to any specific business activity, product, or service. Thus, overhead costs do not directly lead to the generation of profits. Overhead is still necessary, since it provides critical support for the generation of profit-making activities. For example, a high-end clothier must pay a substantial amount for rent (a type of overhead) in order to be located in an adequate facility for the sale of clothes. The clothier must pay overhead to create the proper retail environment for its customers. Examples of overhead are accounting and legal expenses, administrative salaries, depreciation, insurance, licenses and government fees, property taxes, rent, and utilities.
The other type of expense is direct costs, which are those costs required to create products and services, such as direct materials and direct labor. Overhead and direct costs, when combined, comprise all of the expenses incurred by a company.
A business should set its long-term product prices at levels that account for both its overhead costs and direct costs. Doing so allows it to earn a profit on a long-term basis. However, it is is possible to ignore overhead costs for the pricing of special one-time deals, where the minimum price point only has to exceed the relevant direct costs.
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How to Calculate Overhead
Accounts are usually designated as being overhead by accounting policy, which is rarely changed. If an account falls into this category, its monthly total is added to a cost pool, from which the total overhead cost is allocated to a cost object (usually inventory). For example, the factory overhead cost pool for a reporting period is divided by the number of units produced within that period, to arrive at the amount of overhead to be allocated to each unit. So, if the factory overhead total is $100,000 for March and 2,000 units were produced in March, then $50 of overhead will be allocated to each unit. If these units are held in stock, then the allocated overhead is classified as part of the inventory asset. When the units are sold, the allocated overhead is charged to the cost of goods sold.
Types of Overhead
A business may have several types of overhead. The version most commonly referred to is factory overhead, which is all indirect costs associated with the production process. There is also general and administrative overhead, which includes all costs associated with running a business, such as the accounting, IT, and human resources departments. In addition, the sales department may have its own form of overhead, which is the administrative costs associated with running the department (such as training costs and the compensation of the sales manager).
Control of Overhead Costs
Overhead costs tend to be fixed, which means that they do not change from period to period. Examples of fixed overhead costs are depreciation and rent. Given the fixed nature of these costs, they tend to increase the breakeven point of a business, which means that more sales must be generated before a firm will realize a profit. Therefore, it makes sense to continually analyze the extent to which overhead costs are needed, and to pare them back whenever possible.
Terms Similar to Overhead
Overhead is also known as burden or indirect costs. A subset of overhead is manufacturing overhead, which is all overhead costs incurred in the manufacturing process. Another subset of overhead is administrative overhead, which is all overhead costs incurred in the general and administrative side of a business.