Overheads – Definition & Classification

 

**Overheads – Definition & Classification**  

**Overheads** are indirect costs that cannot be directly traced to a specific product or job but are essential for operations. These costs include rent, utilities, depreciation, salaries of support staff, etc.  

**Types of Overheads**  

**1. Classification Based on Function**  

✔ **Factory Overheads** → Costs incurred in the manufacturing process (e.g., factory rent, electricity, depreciation on machinery).  

✔ **Administrative Overheads** → Costs related to office operations (e.g., office rent, salaries of management, legal expenses).  

✔ **Selling & Distribution Overheads** → Costs related to sales and distribution (e.g., advertising, sales commission, transportation).  

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 **2. Classification Based on Behavior**  

✔ **Fixed Overheads** → Do not change with production volume (e.g., rent, insurance, salaries).  

✔ **Variable Overheads** → Change with production volume (e.g., electricity, indirect materials, packaging).  

✔ **Semi-Variable Overheads** → Have both fixed and variable components (e.g., telephone bills, maintenance costs).  

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 **Overhead Absorption (Allocation & Apportionment)**  

Overheads must be allocated across products using a suitable **absorption rate**:  

\[

\text{Overhead Rate} = \frac{\text{Total Overheads}}{\text{Total Direct Labor Hours (or Machine Hours)}}

\]  

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 **Example of Overhead Calculation**  

A company has **total factory overheads of $50,000** and operates for **10,000 machine hours**.  

\[

\text{Overhead Rate} = \frac{50,000}{10,000} = 5 \text{ per machine hour}

\]  

If **Job #101** takes **8 machine hours**, then overhead applied:  

\[

8 \times 5 = 40

\]  

Total cost for the job = **Direct Costs + Applied Overheads**  

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**Advantages of Overhead Cost Control**  

✅ Helps in **budgeting & pricing  

✅ Improves **cost allocation accuracy  

✅ Identifies **cost reduction opportunities