overhead costs and various methods in which the overhead costs are classified.
Ehrhard Brigham, a renowned author, states that a business cannot consider all kind of money that it earns as profits. The reason for not calling the entire amount "profit" is that the business has to pay expenses for carrying out business activities and processes. These expenses are regarded as the operating costs. (Brirgham, 2008) International Accounting Standards Board states that the most common type of overhead costs includes maintenance, production expenses and salaries. It is a common practice of businesses to track their gross income and net incomes. The two figures represent different values. Gross income is usually of a larger amount and consists of all the money a particular business takes in. (International Accounting Standards Board, 2008)
The nature of business decides the type of overhead costs that a business will have to pay. Some businesses have many different types of overhead costs e.g. cement business, while some businesses have few overhead costs such as software manufacturer. (Kaplan, 1987) Every business has overhead costs in any form. (IASC Foundation, 2009) Net income is the total amount of money that remains after all the overhead costs are subtracted from the amount. The amount of the overhead costs can be extremely high or can be low depending on the business. Sometimes the overhead costs are so much that the company has to face debts. (Benninger, 1954)
Crovitz Gordon mentions in his journal that one of the most important and common overhead costs are the cost of renting. Renting cost is a must for all the businesses except for those that are operated online without any physical existence; all other businesses have to pay a heavy amount for purchasing a facility or renting a facility. Rent is considered to be the most important, necessary and expensive overhead cost. (Crovitz, 2008) The location of the facility plays an important role in deciding the total price of the renting costs, a location which is situated in prime areas are high priced as they can give a company a competitive advantage.
Ball Rawlins mentions in his research journal that apart from the rent, utilities are also considered to be extremely important overheated costs for any business. (Ball, 2003) Utilities include the basic necessities that are required to carry out operation of a business like plumbing, connections, electricity and lighting. Utilities are ongoing costs which are to be paid in intervals usually monthly. Without these basic utilities, a company cannot function efficiently and effectively. (Jerry, 2010)
The overhead costs which can vary in a business and business to business, the most are the supplies. For example a convenience store will have a large amount of supplies like snacks, newspapers, bags, grocery etc. On a frequent basis, while a small computer repair business will have a limited number of supplies. For some business, supplies can be the most expensive overhead costs. Supplies can also be subject to seasonal demands and in such cases the contribution of the supplies to the overall overhead cost will differ greatly from season to season. For example the demand in Christmas season for grocery store will differ from the demand post Christmas. (Cusmio, 2003)
Marketing costs are quite similar to the costs of supplies, as they can also vary a great amount from business to business. Cherrington states that the marketing costs depend a lot on the nature of the business and the current position in the market. A company which is coming up with a new product or a new service will have to spend heavily on the marketing activities. (Cherrington, 2003) The contribution of marketing costs to the total overhead costs can potentially be huge or can be low depending on how the business activities are carried out and what exactly are the aims and objectives of the businesses. (Clinton, 2011)
Taxes are applicable to all the organizations except for the nonprofit organizations. Rao, an Indian economists, mention in Forbes that Taxes vary from country to country and tax laws are applicable different in each country. (Rao, 1997) Taxes are paid annually and account for a significant portion of the overhead costs. The taxes are also deducted on the overall profits so the higher the profits, the higher would be the taxes paid and their contribution to the overall overhead costs. (Choudhury, 1983)
The overhead costs can also be classified into fixed, variable and indirect overhead costs. The fixed overhead costs are those which are related to the company's ongoing operations. Fultz Jack in his research journals has mentioned that the overhead fixed costs are usually constant and are billed in the subsequent periods. These fixed expenses do not affect the overall profits or the overall output of the services and goods. Similarly the overhead costs of fixed nature are not affected by the fluctuation in the sales. Rent is the most common form of the fixed overhead costs; salaries are also in most cases fixed overhead costs. (Jack, 1980)
The variable overhead costs are opposites of fixed overhead costs. The variable overhead cost change and differ at different levels of activities, these also include onetime accrued expenses for specific activities or a number of activities that are carried out together in sync. The most common forms of variable overhead costs include the general selling expenses, administrative costs and production costs. (Van Der Merwe, 2008)
Under normal circumstances, the contribution of the variable overhead costs is much smaller to that of the fixed overhead costs. As far as production costs are considered, they are also included in the category of variable costs. The production costs can be classified into three categories i) Variable overhead costs ii) direct materials iii) direct labor. Direct materials are the materials that are necessary for the production of the materials. Direct labor refers to the labor hours that are used in transforming the direct materials into the final goods. (Pieters, 2009)
Similarly another classification of the overhead costs is the indirect overhead costs. (Keiso, 2007) The indirect overhead costs include all the secondary expenses of the business that are also important for the business to run smoothly. (Meigs, 1980) The utilities fall into this category. Without utilities like electricity, connections and water, a business cannot function. (Shillinglaw, 1976)
The secondary personnel which are hired in the organization for specific projects and tasks are also categorized into this category of indirect overhead costs. (Richardson, 2002) These personnel do not affect the overall production or manufacturing of the final goods and service and are not a part of transforming the direct materials into the final good therefore they are not considered to be a part of the direct fixed costs. The indirect overhead costs are considered to be extremely difficult to project and predict and the overall projections usually are hampered due to the incorrect predictions of the overall indirect overhead costs. (Barry, 2007)
The calculation of the total overhead costs determines how much money the company is actually generating. The categorization of the overhead costs depends on the accounting methods which a particular company is using. Departments usually evaluate their individual overhead costs and then inform the aunt department. The departments individually categorize the costs in different segments, for example, production department will divide the costs into different categories such as manufacturing expenses and non-manufacturing expenses.
The overhead figures play an important role in analyzing the competitiveness of the company. Therefore the importance of the overhead costs is as important as the profits. The knowledge of the expenses is necessary in setting up prices. Companies such as automobile companies which have high overhead costs have to set up high prices, on the contrary companies with low overhead costs setup lower prices such as a grocery store. Therefore for pricing strategies, knowledge of the overhead costs is a must.
The overhead costs calculations are considered to be a primary task of an accountant and are one of the important financial data needed by the organization. The overall profits are dependent on the overhead costs therefore the stakeholders keep a continuous eye on the overhead cost figures. Accountants spend much of their time on calculating the overhead costs and finding out new ways to limit these expenses.
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