What it means
The dividing line is traceability rather than importance. The timber in a table and the hours of the carpenter who built it are direct costs, while the factory rent, the supervisor's salary and the electricity bill are overheads because no sensible person could say exactly how much of them belongs to that one table.
Overheads are usually split by function into production overheads, which relate to making things, and non production overheads covering administration, selling and distribution. The split matters because production overheads are absorbed into stock values under standard accounting rules, while administrative overheads are charged straight to profit in the period they arise.
They also behave differently from direct costs as volume changes. Most overheads are fixed or stepped, meaning they stay flat across a range of output and then jump when you need a second unit, a bigger warehouse or another supervisor, which makes them the main driver of operational gearing.
Because overheads cannot be traced, they have to be shared out using an absorption rate based on something measurable, such as direct labour hours, machine hours or units produced. The choice of basis quietly determines which products look profitable, so a machine intensive operation that allocates by labour hours will systematically misprice its output.
Activity based costing is the main refinement, allocating overheads through the specific activities that cause them, such as machine setups or purchase orders. It gives a far more accurate view of which products and customers genuinely earn their keep, at the cost of considerably more record keeping.
In practice
Real-world examples.
Example
A dental practice with $480,000 of annual overheads and four surgeries allocates $120,000 to each when reviewing profitability. One surgery used only three days a week turns out to be losing money once its share of the rent and reception costs is included.
Example
A print shop wins a large low margin contract and assumes the extra volume is free profit because the presses are already paid for. It is right until the volume forces a move to a bigger unit, at which point a step in overhead wipes out the gain.
Example
A software business classifies its customer success team as an overhead rather than a direct cost, then switches to charging that time to specific enterprise accounts. Two large customers immediately look far less profitable than the sales team had believed.
Think of it
“Overhead costs are like the base expenses of running a household-mortgage, utilities, insurance-that you pay whether you're home or traveling.
Formula
Calculation
Overhead absorption rate = total budgeted overhead / total budgeted units of the chosen activity base
A joinery workshop budgets $600,000 of production overhead for the year, covering rent, machine depreciation, supervision, power and factory insurance. It expects to work 30,000 direct labour hours across all jobs.
The absorption rate is $600,000 / 30,000 = $20 per direct labour hour. A kitchen installation that takes 12 direct labour hours therefore absorbs 12 x $20 = $240 of overhead, which is added to its direct materials and direct labour to give the full cost used for pricing and for valuing work in progress.Case study
Seen in the real world.
The following is an illustrative and entirely fictional case. Pelham Signs, an invented manufacturer of shop signage, priced every job at direct cost plus 60% and had done so for a decade. Turnover was healthy but profit had been flat for three years, and nobody could point to a single bad contract.
An outside accountant recalculated the overhead absorption. Pelham's fictional overheads had grown from $400,000 to $940,000 as it added design software, a second unit and three supervisors, but the 60% mark up had never been revisited even though direct labour hours had barely moved.
Recalculating gave an absorption rate that implied a mark up closer to 95% on labour intensive work. Pelham repriced its standard products, walked away from a low value contract that had been consuming a third of the design team's time, and returned to a 9% net margin within a year without any increase in sales.
Watch out
Common mistakes.
- Treating overheads as unavoidable background noise rather than as costs that must be recovered in every price you quote.
- Using the same absorption basis for years while the operation changes from labour intensive to machine intensive, which distorts every product cost.
- Confusing overhead with fixed cost, when some overheads such as power and packaging materials vary with activity.
Questions
People also ask.
Are overheads the same as operating expenses?
They overlap heavily, but operating expenses is a reporting term for the profit and loss account, whereas overhead is a costing term about traceability.
Should I include the owner's salary in overhead?
Yes, if the owner performs a management role, because leaving it out makes the business look more profitable than it really is.
How do I decide the right allocation basis?
Choose the activity that most closely drives the cost, so machine hours for a machine intensive plant and headcount or floor space for administrative costs.
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