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What is an Overhead Cost?

Definition: Overhead costs are indirect costs that canít be traced back to a specific product as well as ongoing administrative expenses that do not generate revenues. These costs do not involve direct labor, direct materials, or direct expenses that customers pay for.

What Does Overhead Mean?

What is the definition of overhead costs? Overhead includes activities that are not directly related to the products or services that the firm offers, but they support the firmís profit-making activities. For example, paying the rent is not a profit-making activity, but it allows the firm to maintain a building and manufacture its products.

Therefore, the overhead is an important part of business operations, regardless of whether the firm generates a high volume of business or not. Overhead costs can include both fixed and variable costs such as rent, research & development, advertising, office supplies, taxes, interest, depreciation, insurance, and others. It can include pretty much anything that doesnít go directly into production.

Letís look at an example.

Example

James is an accountant in a manufacturing company. He wants to prepare an overhead budget for the first nine months to determine what percentage of the total costs corresponds to each overhead expense. In doing so, he will get an idea of areas that are inefficient or cause waste. Then, he will arrange a meeting with the pricing manager to determine the prices that the company should sell its products to make a profit.

James prepares an overhead budget spreadsheet, which includes information about costs related to indirect labor, employee benefits, depreciation, insurance and others, as follows:

Overhead Example

James notices that the highest weights of the budget are related to indirect materials (11.01%), indirect labor (20.11%), taxes (14.25%), and depreciation (20.61%). The management will have a look at the budget to determine if the profit-making activities that correspond to these supporting categories are effectively utilizing the firmís resources. If not, the management should take effective measures to improve these areas.

Summary Definition

Define Overhead: Factory overhead is the indirect costs associated with producing a good or service that cannot be readily traced back to an individual product or job.

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