Befitting Examples for a Better Understanding of Overhead Costs

Overhead costs are best understood in terms of examples, as they change according to the nature of a business. The examples presented further will clarify the concept for you.
Understanding the meaning of overhead expenses is very important for all students of accounting. An overhead is an indirect expense. It is the money spent on running the business on a day-to-day basis. In manufacturing, these costs need to be controlled to maintain high or significant profit margins. This requires proper financial management and planning on part of the senior management of a company.

Different Types of Overhead Expenses

These expenses can be fixed or variable. Variable costs are those which could change with an increase or decrease in the levels of production of the company. So, if a company decides to produce more goods, then these costs will go up. On the other hand, if the production is reduced because of lesser demand for the products or some other reasons, then the variable expenses will go down.

Examples of variable overhead costs can include raw materials which are used in increasing quantities. Fixed costs are those which will remain the same, irrespective of the production levels. These may consist of rent, insurance expenses, and salaries of employees.

The most important components are the factory overhead expenses, that are very useful in the calculation of factory cost. They mainly consist of lighting costs, machinery cost, salaries to workers, rent, power costs, fuel expenses, and the insurance cost. You can get the factory cost when you add the factory overhead expenses to the prime cost. The formula for the same, is presented below.

Factory Cost = Prime cost + Sum of all factory overhead expenses

The overhead costs also consist of director's fees, building charges, building maintenance charges, manager salaries, stationery expenses, and lighting expenses, which usually fall under the category of office and administration expenses. These costs, when added to the factory cost, will give you the cost of producing goods. The formula for calculating cost of production has been provided below.

Cost of Production = Factory cost + Office and administration overhead expenses

The next kind are the selling and distribution costs which can include postage expenses, transportation expenses, advertising expenses, marketing expenses, and carriage outwards. These are known as selling and distribution overhead costs for the simple reason that they are related to the marketing and promotion of the company products. These expenses, when added to the cost of production, give the total cost of goods. The mathematical formula for total cost is given below.

Total Cost = Cost of production + Selling and distribution overhead expenses

All these overhead expenses are used to find the total sales value. This can be easily calculated by adding the net profit to the total cost. So, the equation for total sales would be as follows.

Total Sales = Total cost + Net profit

These examples and formulas will help you understand how to prepare a cost sheet systematically. It holds a lot of importance in accounting and hence, you need to be aware of all the relevant facts.