Importance of Overhead Costs

Overhead Costs

Costs other than direct material and direct labour incurred in the manufacturing process are known as factory overheads costs or simply overhead costs. All factory overheads are indirect costs of the product. Some examples of factory overheads are:

  • Heating and lighting the the factory
  • Repairing and maintaining factory equipment
  • Property taxes on factory building and land
  • Insurance of factory building
  • Depreciation of factory plan and equipment

Factory overheads also include the material and labour costs that are not directly attributable to the production process. For example: cost of oil to lubricate the machine, wages paid for cleaning machine or wages of supervisors. The main feature of overheads is that unlike direct costs, these costs cannot be easily charged to cost centres.

Importance of Overhead Costs

Overheads are an integral part of total expenses and cost of any organisation. Especially in the service based organisation where there is no manufacturing still the cost of service is quite high. Why? Due to overhead costs. As we know that overhead costs sometimes cannot be allocated to the products, services and departments but the fact that all the cost drivers are getting benefit from the overhead expenditure. It becomes important to ascertain and allocate the appropriate amount of overhead to the each cost element or driver. Apportionment of common overheads utilised by multiple departments is done using arbitrary basis or using predetermined factory overhead application rate.

Selecting Cost Drivers

Overhead can be allocated in any way management chooses based on the underlying calculation driver. In the example above, you need to allocate $1,000 across two goods. If one product takes up 70% of the warehouse, the square footage can allocate the costs at $700 for one good and $300 for the other. If one product produces 90% of the finished goods quantity, the costs are allocated $900 to $100. If management chooses to allocate evenly to each item, the allocation is $500 for each one. With the method chosen above, the dollar amount assigned to each item changes, all based on the cost driver.

Impact on Balance Sheet

Why does it matter whether a product is assigned $900 or $500 of the costs in the example above? One important aspect relates to the balance sheet. All manufacturing overhead items are classified on the balance sheet in a general asset account. However, as these costs are assigned, they are transferred to a specific asset account for each item. This inventory balance is important to report as this is the valuation of the goods available for sale. Anything not sold remains on the balance sheet. Therefore, if $900 is assigned to a product that is not sold, $900 stays on the balance sheet. If only $700 is assigned to a product that is not sold, this means the balance sheet reports $200 less inventory simply because of the costs assigned to the good.

Impact on Income Statement

The ultimate impact of assigning overhead costs is reflected on the income statement, as manufacturing overhead has a direct impact on net income. This occurs through the cost of goods sold account because this figure is derived from what is reported on the balance sheet. Based on the balance of the finished goods on the balance sheet, the costs that flow through to the income statement change.

In the situation above, say the company allocated $900 to one product and $100 to another. All of the first product was sold, while none of the second product was sold. In this example, the $900 that is now in finished goods inventory is reassigned to cost of goods sold. The expense recognised is the total cost of goods sold, including the $900. In another example for comparison, the manufacturing overhead above was split $500 for the goods that were sold and $500 for the goods that were not sold. Therefore, the cost of goods sold is the total expenses of the goods in addition to the $500. Expenses are $400 less, net income is $400 higher, and income taxes are higher because of higher income

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