Overheads

What it means

Overheads are costs connected with running the company as a whole or with several outputs at once, which cannot be attributed directly to a specific product or job. They include rent, energy, building management, management, administration, accounting and marketing.

Overheads are usually divided into production overheads, related to running production; administrative overheads, covering management and administration; and selling overheads, related to sales. The split matters for costing and for valuing self-produced inventory, which may include only production overheads.

Their opposite is direct costs. Overheads are often fixed costs that change little with output, so they strongly influence the company’s break-even point.

How it works in practice

We record overheads on cost centres and in costings allocate them to outputs using a key, such as labour hours, machine hours or direct wages. We agree the choice of key with the client, because it has a big effect on which products look profitable.

Within controlling we compare overheads with the budget and track their share of revenue over time. Overheads growing faster than revenue are a warning sign that often shows only when orders fall.

When deciding on a new job or product we separate overheads that will arise additionally from those that exist anyway. A job that covers its direct costs and contributes to existing overheads may be worthwhile even if it looks loss-making with overheads fully allocated.

What to watch out for

Allocating overheads with a single flat percentage distorts the picture, especially where products differ in complexity. Simple products then subsidise complex ones, and the company makes decisions on the wrong numbers.

When valuing work in progress and finished goods, a company may not include administrative or selling overheads. Overvalued inventory would shift costs into future periods and inflate the current year’s result.