How to Treat Overhead Expenses in Cost Accounting

Put simply, overhead costs are any and all costs not directly associated with generating profit for a firm. That is not to say overhead costs are not important or necessary. It is just that, on their own, overhead costs do not actually bring in revenue. Some standard tasks or operations considered to be overhead include the following:

A large number of overhead categories center around manufacturing, such as the expenses incurred to set up and maintain equipment, inspect products, clean factories, or keep records. Other typical examples of overhead in cost accounting include indirect labor, indirect materials, utilities, and depreciation.

What Is Cost Accounting?

Companies use cost accounting to identify the expenses associated with manufacturing. For example, a shoe manufacturer uses cost accounting to track the material inputs for its shoes, the labor hours for its production workers, and all other factors considered by a traditional production budget. Cost accounting is different from financial accounting, which companies use to highlight overall performance and state assets and liabilities. Financial accounting has strict guidelines and is regulated by the IRS and the Financial Accounting Standards Board (FASB). Cost accounting is firm-specific and not regulated by the government.

Overhead Treatment in Cost Accounting

For any given manufactured object, such as a shoe, all associated costs are either direct costs or overhead costs. Overhead costs need to be allocated to the cost object. To begin this process, the company's accountants first need to identify the overhead costs associated with the production of the object. Let's continue with our shoe example.

If the shoe is produced using a machine or other capital equipment, a very small portion of the expenses associated with the equipment are allocated to it. This includes indirect labor, or those people who set up, repair and clean the equipment (as opposed to those who use the equipment to make the footwear; these would be considered direct labor). It also includes electricity for the factory and any other energy inputs for the aforementioned equipment. The depreciation for the factory and its equipment are also considered.

Under cost accounting, there is always an "allocation base" that links the overhead costs to the cost object. Since it is arduous to apply overhead cost to each individual cost object, such as a shoe, companies tend to use the average of an aggregate number of objects. So the shoe manufacturer might spread overhead costs over 10,000 shoes rather than calculate each one separately.

Suppose that, over some period of time, the accrued wages for indirect labor, accumulated depreciation, accounts payable and utilities are equal to $500,000. That factory overhead needs to be allocated over all work-in-progress and finished goods during the period. There is some degree of subjectivity in the choice of allocation base for factory overhead, but managers should aim for a cause-and-effect relationship if they want to produce the most useful accounting of their operations and obtain the most accurate sense of their profitability.