In traditional business accounting, the term overhead expenses refer to costs that are not directly associated with the production of specific product units, specific service engagements, or specific sales. “Overhead,” instead, denotes the supplementary costs of production, service delivery, or sales activities. The overhead costs have to be paid regularly, irrespective of whether the company is engaged in a high or low production volume.
It is vital, not just for the sake of budgeting and bookkeeping, but for setting an optimum price for the products and services to make a profit. Firms plan, quantify, and examine overhead expenses. As a result, overheads, like other expenses, eventually influence how an income statement proceeds. With the increase in expenses, the profits decrease. Your income statement is affected, as a whole, because of these expenses, and you have to make the required adjustments to cater to them.
Overhead Expenses in Business Accounting
Overheads are either fixed, which means that they stay the same month after month, or variable, which means that they can vary depending on the business activity for the specific month. Some overheads fall into the semi-variable category, which means that they are incurred regardless of business activity, and some are related to the circumstances.
Utility bills can be categorized as semi-variable because some of the base charges are fixed, while the remainder depends on your usage. Overheads can be general as well as departmental. A general overhead would be distributed among the whole company while departmental overheads are charged strictly to the specific department. Typically, a service-based business will have more general expenses in the form of insurance and utilities.
Categorizing Overhead Expenses
Overheads can also be applied to many operational categories such as administrative and marketing. Administrative overhead costs are related to the business administration and include hiring and keeping a receptionist or bookkeeper.
Branding for your company also involves certain costs that fall into overheads. Your business accounting needs require you to identify these materials, commercial, printing, and other expenses and charge them into overheads.
Reporting for Overheads
Because the overhead expenses directly affect the company’s profitability, they appear in the company’s income statement. You must account for overheads to determine the net profitability of your company. These expenses will be deducted from the revenue, and the remaining income, after taxes, will determine your profits.
Applied overhead is generally recorded under the cost accounting method and is charged to a specific department or production job. They are quite dissimilar to general overheads and usually cater to depreciation and insurance expenses.
For business accounting purposes, applied overhead expenses are charged according to a specified formula over multiple departments. For example, if the expense is incurred by marketing, it may not be fully allocated. Instead, it will be distributed among various departments according to a specific percentage.
An overhead rate is applied to allocate overheads, which determines the resources used in the production of each product and then distributes the expenses accordingly. One way to accomplish that is by setting a fixed rate based on the machine hours required to produce a product.
Setting a fixed rate is a simplified approach. However, real-time business accounting scenarios require you to account for several cost drivers and then set an overhead rate. It cannot be easy to estimate the overhead expenses accurately. Therefore, the costs are generally estimated depending on the overhead rate for each cost driver.
Under Applied Overheads
Sometimes the assigned cost of work-in-progress goods does not equal the assigned amount and must be reported as a prepaid expense on the balance sheet. Debiting the cost of goods sold at the end of a year offsets the discrepancy.
Under applied overhead costs are also referred to as unfavorable variance. Adjusting your books for overhead expenses is an important task that every business must undertake to correctly estimate their profits and set an optimum price for their products.