Meaning and Definition of Overheads

Every cost a factory incurs falls into one of two broad groups. Some costs can be traced conveniently and wholly to a particular job, product or unit — the timber that goes into one specific table, the wages of the carpenter who makes it. These are direct costs, and together they make up the prime cost of a product (direct material + direct labour + direct expenses). But a factory also incurs a large mass of costs that are necessary for production yet cannot be traced to any one unit — the rent of the factory building, the salary of the works manager, the electricity that lights the whole shop, the depreciation of machinery shared by many products. These are indirect costs, and taken together they are called overheads.

Overhead is therefore the aggregate of indirect material cost, indirect labour cost and indirect expenses — the costs that are incurred for the benefit of production as a whole and cannot be economically identified with a single cost unit. The Odisha CHSE +2 Cost Accounting syllabus places overheads immediately after the study of material and labour precisely because overhead is the third and most troublesome element of cost: it cannot simply be added to a product the way material and labour can, but must be shared out among products through a careful sequence of collection, allocation, apportionment and absorption.

Overhead is also known by several other names in cost accounting — on-cost, supplementary cost, indirect cost, or burden. Whatever the name, the defining feature is the same: it is cost that cannot be conveniently and wholly charged to one unit of output, and so must be spread over output on some reasonable basis.

The three elements of overhead:

• Indirect material — material that does not form part of the finished product or cannot be traced to it economically: lubricating oil for machines, cotton waste, small tools, consumable stores.
• Indirect labour — wages and salaries of workers who do not work directly on the product: the foreman, the storekeeper, the timekeeper, the sweeper, the works manager.
• Indirect expenses — all other indirect costs: factory rent, insurance, depreciation, power, lighting, repairs, telephone and postage.

Understanding overhead correctly matters because if overhead is spread over products on an unfair basis, the cost of every product will be wrong — some will look cheaper than they really are and others dearer — leading to wrong pricing and wrong decisions.