Overheads

Overheads are a central component of cost accounting and play a key role in pricing and profit determination in companies. However, accurately capturing and allocating them to different cost centers and cost objects is a challenge that requires a deep understanding of operational processes and precise cost analysis. In this article, we highlight the importance and methods of allocating these costs to provide better insight into their impact on financial management and strategic decision making in organizations.

Overheads definition: What are overheads?

Overheads are the costs incurred in a company that cannot be directly allocated to an individual product, service or cost center. They arise from general operational activities, such as rent, energy, administration or maintenance, and must therefore be allocated to several cost centers or cost units. Overheads are often recorded in cost accounting and distributed on the basis of various keys, such as working hours or machine running times, in order to enable more precise calculation and cost control.

Overhead cost characteristics: How do you recognize overhead costs?

Overhead costs have several characteristics that distinguish them from other types of costs. Here are the key characteristics that can be used to recognize overhead costs:

No direct attributability: overhead costs cannot be directly attributed to a specific product, service or individual cost center. Instead, they affect several areas of the company.
Allocation to different cost centers: Since overhead costs cannot be directly allocated, they must be distributed to different cost centers or cost objects using distribution keys.
Independence from production volume: Overheads are often incurred regardless of the production volume. For example, the rent for a production hall remains the same regardless of how many units are produced.
Operational necessity: Overheads arise from necessary operational activities that ensure the smooth operation of the company, such as administration, maintenance or energy supply.
Regular occurrence: Overhead costs occur regularly and are often recurring in nature, such as monthly rent payments or wages for administrative staff.
Difficulty of accurate cost control: Due to their nature, overhead costs are more difficult to control and reduce as they are not directly related to production and therefore cannot be easily influenced by changes in the production process.

These characteristics help to distinguish overhead costs from direct costs and to understand their importance in the context of cost accounting.

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Difference between Direct Costs and Overheads

This table shows the basic differences between direct costs and overheads and illustrates how they differ in cost accounting.

Criterion	Direct Costs	Overheads
Definition	Costs that can be directly allocated to a product, service or cost center.	Costs that cannot be directly allocated to a product, service or cost center.
Example cost types	material costs, production wages, direct production costs	rental costs, energy costs, administrative costs
Direct allocability	Yes, direct allocation to a specific cost object or cost center is possible.	No, require allocation to several cost objects or cost centers.
Dependence on production quantity	Often vary directly with the production quantity (e.g. material consumption).	Independent or less dependent on production quantity (e.g. rent).
Recording and allocation method	Are recorded and allocated directly and unambiguously.	Must be allocated using distribution keys or other methods.
Example	Costs for the material of a specific product	Electricity costs for lighting the entire production hall

Calculate Overheads

Calculating overheads requires careful recording of all indirect costs and a sensible allocation of these costs to the individual products or services. Whether you do this manually or with a formula depends on the complexity and requirements of your company.

Calculate Overheads with formula

The general formula for calculating overheads is as follows:

Example calculation of Overheads with formula

If the total overhead costs (rent, energy, administration) amount to 18,000 euros, and you distribute these costs among three products according to working hours, with product A requiring 40% of the working hours, then the overhead costs for product A are calculated as follows:

Overheads for product A = 18,000 euros x 0.40 = 7,200 euros

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Calculating Overheads without a formula (step-by-step explanation)

To calculate overheads, you generally proceed as follows:

Identify overheads: record all indirect costs incurred in your company that cannot be directly allocated to a product or service. This includes costs such as rent, energy costs, administrative costs, etc.
Allocation of overhead costs: Determine how these overhead costs are to be allocated to the various products or services. This is often done using distribution keys, such as working hours, machine running times or space used.
Allocation to the products/services: Use the determined distribution keys to allocate the overhead costs to the respective products or services.
Addition of overhead costs: Add the overhead costs attributable to each product to the directly allocated direct costs to determine the total costs of a product.

Example calculation of Overheads without formula

Assume a company has 10,000 euros in rental costs, 5,000 euros in energy costs and 3,000 euros in administration costs, which are to be allocated to three different products.

Product A: 40% of the overheads
Product B: 30% of the overheads
Product C: 30% of the overhead costs

Overheads for product A = (10,000 + 5,000 + 3,000) x 40% = 7,200 euros
Overheads for product B = (10,000 + 5,000 + 3,000) x 30% = 5,400 euros
Overheads for product C = (10,000 + 5,000 + 3,000) x 30% = 5,400 euros

Important terms for Overheads

terms for overheads

Term	Description
Cost center accounting	A method of allocating overhead costs to the various areas or departments (cost centers) of a company.
Allocation key	A method of allocating overhead costs to different cost centers or cost objects based on certain criteria such as floor space, working hours or machine running times.
Cost element accounting	Part of cost accounting that records and categorizes the type and origin of costs, including overheads.
Cost unit accounting	Method of allocating costs to individual products or services (cost units) in order to determine their cost structure.
Fixed costs	Overhead costs that remain constant regardless of the production volume, e.g. rent or insurance.
Variable costs	Costs that vary depending on the production volume, some of which can also be overhead costs, e.g. energy consumption as production increases.
Internal cost allocation	Procedure for allocating overhead costs within the company in order to allocate costs to the various departments according to their origin.
Depreciation	Depreciation of equipment or buildings, which is distributed as overhead costs over the useful life.
Budgeting	The process of planning income and expenditure, including the setting of overhead budgets for different departments.
Contribution margin	The amount remaining after variable costs (including variable overheads) are deducted from revenues and contribute to covering fixed costs.
Break-even analysis	Method for determining the production volume at which the revenues just cover the total costs (including overheads).

This table summarizes important terms that are relevant in connection with overheads and are frequently used in cost accounting.

How are Overheads allocated to cost units?

The allocation of overheads to cost units is carried out in several steps, which are intended to ensure that costs are distributed precisely and in line with their origin. Here is an overview of the process:

Recording overhead costs
- Cost type accounting: First, the overhead costs are recorded by cost type. These include, for example, energy costs, rental costs, administrative costs, etc.
Allocation to cost centers
- Cost center accounting: The recorded overhead costs are allocated to the corresponding cost centers. A cost center is a defined area in the company, such as a department or a production area, where the costs are incurred.
Determining the distribution key
- Determine distribution key: A distribution key is a method for allocating overhead costs to different cost objects (products or services). Commonly used allocation keys are:
- Labor hours: When overhead costs, such as administrative costs, are allocated in proportion to the number of hours worked.
- Machine running times: Costs are allocated to different products depending on how the machines are used.
- Square meters: Building costs such as rent or energy costs are allocated to cost centers according to the area used (square meters).
- Revenue share: Overhead costs are allocated according to the revenue share generated by a product.
Internal activity allocation
- Allocation between cost centers: Some overhead costs are first allocated between different cost centers as secondary overhead costs via internal activity allocations before being assigned to cost objects.
Allocation to cost objects
- Cost object accounting: The costs that have now been allocated to the individual cost centers are distributed to the individual products or services (cost objects). This is done based on the distribution keys and the actual utilization of the resources by the respective cost units.
Cost of goods sold calculation
- Cost price accounting: The allocated overhead costs are finally combined with the directly attributable direct costs to determine the cost price of a product or service. This helps with pricing and profit calculation.

This process ensures that the overheads are allocated as accurately as possible to the relevant products or services to ensure realistic and causal costing.

Types of Overheads

Overhead costs can be divided into different types, depending on which operational areas they affect and how they are incurred. Here are the most common types of overheads:

Overview: Types of Overheads

The following diagram shows an overview of the types of overheads that exist.

Explanation: Types of Overheads

These different types of overheads help to understand the overall cost structure of a company and make cost accounting more effective.

Material Overheads

These costs are incurred in connection with materials that are used in a company but cannot be directly allocated to a specific product. Examples include storage costs, transportation costs within the company, or costs for materials management.

Production Overheads

These are incurred in the production area, but not directly for an individual product. Examples are the costs for machine depreciation, energy costs in production, salaries for production personnel (if not directly attributable) and maintenance costs for production facilities.

Administrative Overheads

These costs relate to the company's general administrative tasks. They include salaries for administrative staff, office supplies, depreciation on administrative buildings, rent and other costs for maintaining the administrative infrastructure.

Sales Overheads

Sales overheads arise in connection with the sale of products, but are not directly attributable to individual sales activities. These include salaries for sales staff, advertising and marketing costs, costs for warehousing finished products and transportation costs to customers.

Research and Development (R&D) Overheads

These costs are incurred in the area of research and development and relate to expenses that cannot be directly attributed to a specific development project. Examples include costs for laboratory buildings, salaries for R&D employees and general material costs for research.

Maintenance Overheads

These refer to the costs for the maintenance and servicing of operating facilities and buildings that cannot be directly allocated to a specific department or project. Examples include costs for cleaning services, repairs and minor renovation work.

Social Overheads

This type of overhead relates to expenses for social facilities and services within the company, such as company canteens, company doctors or leisure activities for employees.

Examples of Overheads

The following table provides a structured overview of the different types of overheads and their typical examples. These examples illustrate how diverse overhead costs can be in a company and how they affect different areas.

Type of Overheads	Examples
Material overheads	Storage costs for raw materials and materials, costs for material management (e.g. salaries of warehouse workers), depreciation of warehouse buildings or equipment
Production overheads	Energy costs for production machinery, maintenance and repair costs for machinery and equipment, salaries for production managers and foremen, depreciation of production equipment, rent for production halls
Administrative overheads	Salaries for administrative staff (e.g. accountants, HR department), office supplies (e.g. paper, printer cartridges), costs for IT systems and software licenses, depreciation of office buildings and equipment, insurance premiums for the office building
Sales overheads	Salaries for sales staff supporting several products, costs for general advertising and marketing measures (e.g. online advertising, commercials), storage costs for finished products, transport costs to distribution centers, costs for customer service and support covering several products
Research and development (R&D) overheads	Salaries for R&D employees working on various projects, costs for the use of laboratories and technical facilities, material costs for general research, depreciation on laboratory buildings and R&D equipment
Maintenance overheads	Costs for cleaning and maintenance of buildings and facilities, repairs to general infrastructure (e.g. electrics, sanitary facilities), costs for security and monitoring of company premises
Social overheads	Costs for company canteens and meal allowances, expenses for company sports and leisure activities, health programs and medical care (e.g. company doctor)

Distinctions in Overheads

These distinctions help to better understand and specifically analyze the structure of overhead costs in a company.

Genuine and non-genuine Overheads

Genuine overheads: Due to their nature, these costs cannot be directly allocated to a product or service. They affect the entire company or large departments and cannot be further differentiated in their recording. Examples include rent for company buildings, energy costs for lighting and heating or salaries for administrative staff.
Non-genuine overheads: These are costs that could theoretically be allocated directly to a product or service. For practical reasons, however, they are treated as overheads in order to reduce administrative costs. One example is electricity consumption in production, which could be recorded per machine, but is recorded as an overall item in overheads for simplicity.

Primary and secondary Overheads

Primary overheads: These arise from the use of goods or services that the company purchases from external suppliers. They can usually be seen on external invoices and include expenses such as raw material costs, external services (such as maintenance or consulting) and energy costs.
Secondary overheads: These arise within the company through the recharging of services between different departments. They are based on the primary overheads that are charged internally. An example would be the allocation of administrative costs to the production department.

Summary of distinctions in Overheads

Differentiation	Genuine or non-genuine?	Primary or secondary?	Description
Genuine overheads	Genuine	Primary	Costs that cannot be directly allocated to a product, e.g. rental costs, energy costs.
Non-genuine overheads	Non-genuine	Primary	Costs that could theoretically be allocated directly, but are treated as overheads for reasons of simplification, e.g. electricity consumption.
Primary overheads	Genuine	Primary	Costs incurred through the use of external goods or services, e.g. material purchases, external services.
Secondary overheads	Real	Secondary	Costs arising from internal cost allocations, e.g. internal allocation of administrative costs.

FAQ

What are the most important Overheads?

The most important Overheads are typically rent, energy costs, salaries for administrative staff and depreciation on buildings and machinery. These costs are incurred regularly and affect the business as a whole without being directly attributable to a specific product or service.

What percentage of Overheads?

The proportion of Overheads varies depending on the industry and company, but is often between 10% and 40% of total costs. It depends on how efficiently the overheads are distributed and managed.

Are wages direct or Overhead costs?

Wages can be both direct and overhead costs, depending on whether they can be directly allocated to a product (e.g. production wages) or not (e.g. wages for administrative staff).