Overhead Part1

ACCA F2 - Management Accounting

Indirect costs are also known as overhead costs. It may include some production related costs, which cannot be traced to individual products (known as production overhead).  However, when we talk about production, direct expenses related to production are less then selling price does not guarantee a reasonable profit. This is because of the overhead cost, which can add substantial portion to total cost of product.

  Overhead, Direct Expenses, Allocationand Apportionment Expenses that can be allocated are simply direct expenses or direct costs and the ones we apportion are simply indirect costs or indirect expenses.

There is NO such thing as “direct overheads”. Overheads are always indirect production costs.

Let us identify overhead activities using Porter's value chain. We can say that most of the cost related to three primary activities (inbound logistic, process and outbound logistic) are direct in nature while all other activities cost are indirect in nature. This illustrates how significant are indirect costs for a company.

Until now, we grasp some idea on why organisations record overheads. Overhead costs are ongoing expense incurred in day-to-day running of business. Appropriation of overhead helps to predetermine overhead cost per unit, make pricing decision and controlling/monitoring of overhead. Thus, overhead management is responsibility of managers of all responsibility (cost / revenue / investment) centers.

All overheads are not identifiable in the start. Some overhead occurs in uneven time interval. Some overhead cannot be precisely predicted. Some overhead are incurred because of non-compliance with rules (i.e. negligence). Let us list some of overhead expenses. Regular overheads (e.g. accounting cost, rent, utility charges, insurance, repairs…..)&  Irregular overheads (e.g. litigation charges, penalty - fines, warranty cost….)

Overhead cost is directly connected to sector of operation, structure, culture (technology) and role of management. Organisations with functional structure are likely to have higher overhead cost than those with divisional structure. Overhead proportion for service organizations are likely to be higher as compared to manufacturing. Use of advanced technology can pull down overhead cost.

By nature overhead costs are classified as fixed overhead costs, variable overhead costs and semi-variable overhead costs. Cost equation (y=a+bx) is used to segregate semi-variable cost into variable and fixed elements.