Indirect overhead, also known as indirect costs or overhead expenses, refers to the costs associated with running a business that cannot be directly tied to a specific product or service. These costs are necessary for the overall operation of the business but aren’t linked directly to the production or delivery of goods or services.
Indirect overhead can include a wide variety of costs, such as:
- Rent and Utilities: The costs of maintaining and operating physical facilities, including rent, utilities like electricity and water, property taxes, and so on.
- Salaries and Wages: The compensation for employees who aren’t directly involved in the production or delivery of goods or services, such as administrative staff, maintenance staff, and management.
- Depreciation and Amortization: The systematic reduction in the value of long-term assets over time, such as machinery, equipment, or intellectual property.
- Insurance: The cost of insurance policies to cover various risks faced by the business.
- Office Supplies: Items such as stationery, computers, and software used for general business operations.
These costs are typically allocated to products or services using some method of cost allocation, such as a predetermined overhead rate. Understanding the total cost, including both direct and indirect costs, is crucial for pricing, profitability analysis, and strategic decision-making.
Example of Indirect Overhead
Let’s consider an example of a company that makes custom hand-painted mugs.
Direct Costs: These are costs that can be directly traced to each mug produced. The cost of the blank mugs, the paint used, and the wages of the artists who paint each mug are all direct costs.
Indirect Overhead Costs: These are costs associated with running the business but cannot be directly tied to a specific mug.
- Rent and Utilities: The company pays monthly rent for their workshop and utilities such as electricity, water, and internet. These costs are necessary for the operation of the business, but they can’t be directly tied to a specific mug.
- Administrative Salaries: The company has administrative staff who manage orders, handle customer inquiries, and keep the books. Their salaries are an essential business cost but aren’t directly tied to the production of individual mugs.
- Office Supplies: The company uses computers, software, and other office supplies for managing orders, designing mug patterns, etc. These costs are also considered indirect overhead.
- Insurance: The company has a business insurance policy to cover various risks. This is also an indirect overhead cost.
To determine the total cost of each mug, the company would need to allocate a portion of these indirect overhead costs to each mug. This might be done based on direct labor hours, for instance. Understanding this total cost is crucial for setting the selling price of each mug and for analyzing the profitability of the business.